Robo-advisors threaten to disrupt

November 23, 2015 11:00 AM

The debate rages today on whether robo-advisors threaten human advisors or whether solutions combining technological and human potential ultimately will prevail. Unfortunately, by framing this argument as one of technology versus humans, it misses the real threat posed by robo-advisors and a critical element about performance among active and passive management. 

As technology platforms, robo-advisors’ disruptive potential extends far beyond an impact on financial advisors.

For instance, the ability of software tools to re-create index funds—without requiring the mutual fund or ETF wrapper—creates the potential for robo-advisors to disintermediate much of the existing index fund industry. This is aided by tax code benefits that uniquely favor new (Indexing 2.0) robo-platforms over current fund-based solutions. Similarly, robo-advisors as trading software create the potential to eliminate many active management middlemen, allowing the implementation and automation of a wide range of smart beta and rules-based trading algorithms.

And as robo-technology trends shift from a business-to-consumer focus to business-to-business solutions, new platforms will threaten today’s existing RIA custodians, who face a generational shift as new less-investment-centric financial planners adopt simplified robo-advisor investment platforms. 

You see, the real robo-advisor threat could be how human advisors adopt them to disrupt much of the existing FinTech ecosystem and change the active versus passive debate forever.

Robo indexing 2.0 

The origination of the mutual fund was driven by two primary needs: A more efficient process for an active investment manager to handle a single pool of funds, and a way to lower investors’ transaction costs through the economies of scale of pooled trading. Decades later, the index mutual fund was invented. While pooling investments for the efficiency of an active manager wasn’t relevant, index mutual funds still benefitted investors with lower transaction costs.

As transaction costs inevitably slide lower, a need to pool funds to lower trading costs becomes less relevant. Retail investors can use any number of online trading platforms to execute a trade for less than $10, a nearly 90% drop over previous decades. Still, for a wide number of investment positions, even $10 per trade adds up. But as costs continue to decline, a point will come when no incremental benefit exists to pooled mutual funds or ETFs (see “How low can it go” below). 

This is significant: As transaction costs approach zero, eventually no reason exists to own an index ETF or mutual fund. Certainly, the investor may desire an index’s diversified exposure, but that can be realized by directly purchasing every underlying security. Rather than own the S&P 500 Index Fund, automated software would purchase every S&P 500 stock for an equivalent (near-zero) transaction cost with a simple mouse click.

Of course, software is necessary to manage the process—but that’s exactly what robo-advisor platforms are positioned to do. Wealthfront’s Direct Indexing solution has this functionality. Similarly, Motif Investing can construct at least mini versions of an index, up to 30 securities at a time, through its motifs.

These Indexing 2.0 solutions can disintermediate index ETFs and mutual funds altogether, potentially saving investors a layer of cost. And though robo-advisors charge a service fee—partially reintroducing that middle man [or middle robot]—the software can scale to a lower cost than many of today’s index funds with greater technology-driven economies of scale. 

At a minimum, shifting a layer of costs from today’s mutual fund and ETF complex to software functions would provide a tremendous disruption to the status quo.

An even more notable benefit is found in the tax code. Indexing 2.0 solutions offer an explicit tax benefit over today’s Indexing 1.0 mutual funds and ETFs. Current tax policies limit investors’ ability to enjoy deductions on losses in pooled vehicles. Mutual funds and ETFs cannot pass through net losses, and thus cannot selectively harvest losses in excess of gains to generate current deductions for investors. However, direct ownership of an index’s underlying stocks can be loss harvested at the security level, creating an indirect tax incentive that favors Indexing 2.0 solutions.

Smart beta 

While robo-advisor Indexing 2.0 platforms threaten the existing index ETF and mutual fund industry, such solutions are not necessarily relevant for a subset of advisors more inclined to active management solutions. Even if transaction costs fall to zero, pooled investment vehicles remain relevant for active managers to operate efficiently.

However, some active managers implement what are fundamentally fairly passive strategies in that they’re not based on ongoing subjective manager decisions but rely on a pre-built series of trading algorithms, screens, filters or other rules-based systems. And if software can apply a filter like “buy all the stocks in the S&P 500” to replicate an index, software can apply other filters like tilt a portfolio to value stocks, small-cap, low volatility, favorable Price/Earnings or other Fundamental Indexing-style screens.

Robo-advisor software as a trading tool creates potential for investors to implement and self-automate their own tilts, filters, screens, algorithms and rules-based strategies. Popular strategies (like various forms of smart beta) could be licensed directly through the platform, allowing any investor to access a fund manager’s strategy, implemented automatically on their behalf. Or alternatively, investors could create personal strategies and allow software to automate their implementation.

Here’s why it’s so critical to the active versus passive debate: Robo-advisors as a passive investor tool threaten index ETFs and mutual funds as an Indexing 2.0 solution, but robo-advisors as an active investment and trading tool threaten to disintermediate a wide segment of today’s active management industry, from Smart Beta funds to hedge fund algorithms to low volatility, DFA-style small-cap and value tilts and more.

Just as with Indexing 2.0 solutions, robo platforms avoid pooled investment vehicles, allowing investors to own underlying securities and obtain more favorable tax benefits.

Notably, a small subset of true active managers, who conduct some kind of (individual security, macroeconomic or other) analyses requiring unique intellectual capital, may remain relevant and uniquely suited to a pooled investment vehicle. But by the time other types of active management strategies are automated, it’s not entirely clear how many managers could be left.

Most of today’s robo-advisors have negotiated brokerage, trading, custody and clearing arrangements, or they aim to fulfill some of these roles by creating their own entities. Some have created a vertically integrated management solution to reduce transaction costs and facilitate everything from trading in fractional shares to netting investors’ trades to reduce volumes.

For advisors who have an existing RIA built around the infrastructure of an existing custodian, not much pressure may exist to change in the near term (except perhaps to use robo-advisors as a segmented solution for smaller AUM clientele). However, for newer advisors, the opportunity to build businesses and gather assets on today’s emerging robo-advisor-for-advisors platforms may avoid the need to work with traditional RIA custodians or even start-up friendly platforms like SSG. 

Of course, for many new advisors, traditional custodians won’t accept them because of advisor asset minimums anyway (SSG being a notable no-advisor-minimum exception). However, an advisor who builds a business on a robo-advisor platform now, and accumulates significant assets over time, may not show any interest in transitioning to a traditional custodian in the future, either.

The longer-term threat from robo-advisor platforms is that as the next generation of advisors comes along  —focusing more on adding value in financial planning and advisor gamma rather than investment management and investment alpha—a generational shift may occur. It may not simply be that robo-advisors-for-advisors accept small advisors while traditional custodians serve big ones; it may also be that robo-advisors serve younger (Gen X and Gen Y) advisors while traditional custodians serve older (some Gen X and Baby Boomer) advisors. 

This does not present an optimistic outlook for traditional custodians in another decade, regardless of whether Baby Boomer advisors retire en masse. The risk of this generational shift in advisor platforms is not merely an issue for the traditional custodians themselves, but also the technology ecosystem that builds around them. 

An advisor using a platform like Betterment Institutional or Motif Advisor not only avoids needing a traditional custodian, but also with the ground-up technology being built no longer needs portfolio accounting, reporting tools or rebalancing software. And it’s not difficult to imagine an additional layer of the FinTech ecosystem being built around new robo-advisor platforms with client portals and practice management dashboards and integrations to advisor CRM and financial planning software being built directly.

Of course, to the extent that today’s robo-advisor solutions may simply represent a more efficient and effective set of technology tools to manage and implement an advisory firm practice--while gaining tax benefits--the potential exists that some of today’s custodian platforms will boost their own technology to fill the void. The first player in this space is Charles Schwab with its Schwab Intelligent Portfolios solution, which will use ETFs rather than disintermediate them.

In fact, arguably one of the most significant consequences of the robo-advisor movement has been its ability to highlight the relatively poor quality of technology solutions--at least from the perspective of user experience for both advisors and clients. That also means the robo-advisor trend has placed new pressure on RIA custodians and supporting technology providers to either step up or risk being left behind by the next generation of advisors.

Michael Kitces an American financial planner, commentator, speaker and educator. He is publisher of & Partner at Pinnacle Advisory Group.

About the Author

Michael Kitces is a Partner and the Director of Research for Pinnacle Advisory Group, co-founder of the XY Planning Network and publisher of the financial planning industry blog Nerd’s Eye View. You can follow him on Twitter at @MichaelKitces.