November 2015
In a world where we’re heading for driverless cars, drones that deliver groceries to your back garden and smartphones that switch your lights and radiators on and off automatically while you are miles away from home, is it strange to think about handing over your money to a robot to look after?
No, it’s not such a daft idea as it may first appear — and if the trend to robotise your finances gains traction, as many in the financial business expect, it will mean exciting opportunities for investors and potential trouble for the army of financial advisers and wealth managers who make a well-paid living looking after your money today.
The phenomenon everyone in the sector is suddenly talking about goes under the generic name of ‘robo-advice’ — which is how it is known in the United States, where all things techy and most tech-related fads inevitably originate. As is the way of such things, however, it’s a bit of a misnomer. What we are talking about with ‘robo-advice’ does not involve robots providing the full spectrum of financial advice in the sense that the Financial Conduct Authority, the UK industry regulator, currently defines and regulates it.
Financial advice, in its broadest sense, involves looking at an individual’s circumstances in the round, taking account of their age, family circumstances, income, wealth and tolerance for risk. It encompasses not just how you invest your money, but also more specialist fields, such as insurance, tax avoidance, divorce and estate planning. Financial advice, in this all-encompassing sense, is not going down the robot route any time soon.
But key parts of the range of services for which savers and investors currently pay investment professionals, including some elements of financial advice, will increasingly be placed in the hands of machines. If you use an online platform, the record-keeping and performance monitoring of your money is already automated. If you do your own research into shares or funds and buy, say, a passively managed tracker fund — as more and more people sensibly do — the shares in that fund will in practice be chosen, and then bought and sold, by a computer following a simple set of investment rules: for example, buy all the constituent shares of the FTSE 100 index in proportion to their weights in the index and sell them when they drop out of the index.
But there is potential for automation to do a lot more. ‘Robo-advice’, loosely defined, is making waves precisely because it is about extending the reach of computerised rule-based approaches into other links in the value-chain of services that investors currently pay for. Increasing automation of fact-finding and portfolio construction in particular is set to become much more widespread.
How does that work? Well, go to one of the robo-advice websites and you will typically find a detailed questionnaire that asks you about how much money you have to invest, how long you want to keep it invested, and your attitude to risk. Once you have completed the process, in your own time and at your own expense, your robo-adviser will use a set of algorithms to come up with what it considers the optimal asset allocation for your portfolio — so much in shares, so much in bonds and other fixed interest instruments, so much in property and so on.
In practice this is no more than most advisers and wealth managers already do, more painstakingly, when you go to see them in person. It can take several hours to go through all the relevant questions, all of which you eventually pay for, either as fees (if you have hired a fee-based financial adviser) or in future management charges (if and when you then sign up as a client). Going down the robo route should save you those costs, depending on which business model the robo firm has chosen to adopt.
Nick Hungerford is chief executive of Nutmeg, one of the UK pioneers. The challenge, he says, is this: ‘How can you give people great service without charging them a fortune or requiring them to come into the fancy office once a year for the privilege of a nice lunch and dramatically high fees?’
But does an automated asset allocation service really also offer you a genuinely valuable investment proposition? It’s too early to say for sure how the performance of funds managed or recommended by robo-advisers stack up. Nutmeg will shortly disclose its first set of externally audited three-year performance figures — and says it is confident that its portfolios, which are built with passive funds along standard portfolio-theory lines, will show up in the top 25 per cent of advisers and wealth managers as measured in the Private Client Indices, a respected independent monitoring service.
For those with relatively straightforward needs, there is no good reason to fear that the robo-advice, or the investment performance generated, will be worse than average. If you are the wealthy client of a blue-chip private bank, you may still get a genuinely personalised investment portfolio and regular opportunities to talk to a charming person called Hamish or Joanna about your money. But what you are paying so handsomely for, in many cases, is likely to be just as much a hand-holding service as it is a bespoke investment solution tailored precisely (as opposed to roughly) to your needs.
One of the guilty secrets of the investment world is that many firms which look after private clients, including many with fancy reputations, simply push you into one of a number of cheap-to-run standardised portfolios, based on their initial fact-find. Some advisers already use the software that powers the algorithms in robo-advice to come up with their recommended portfolios. While they may genuinely be able to help you with financial planning, investment advice is routinely outsourced to another firm. Until the practice was banned by the regulator two years ago, advisers were often rewarded with hefty commissions from those firms whose funds or portfolios in which they invested your money, creating blatant conflicts of interest.
The chances are that the investment performance you get from a private bank or a private-client broker won’t be any better than a good robot can provide — but it will certainly be more expensive. For years the financial services business has been able to conceal the true cost of investing your money behind an aura of mystique. New regulations on fee transparency, combined with consumer pressure, are starting to change that. Most private-client firms still don’t publish how well their clients have done, or disclose all their charges clearly, including add-ons such as commissions, custody and so on.
Behind the hype bandied about by attention-seeking newcomers, what the robo-advice story is really about is using the power of computers and the internet to empower consumers and eliminate traditional layers of profit margin in the industry, just as they have in many other business areas.
In the United States, the mutually-owned low-cost fund management company Vanguard is one of those pioneering this route. Under its scheme you pay nothing for the fact-finding, but still have the option to take personal advice when you have completed the process. It then offers to run and rebalance the investment portfolio designed by the algorithm for a modest 0.3 per cent annual management fee (compared to the two per cent or even more that most traditional firms demand).
In the UK, the Vanguard-type approach has caught the attention of Whitehall and the regulators, who see cheap and cheerful standardised advice propositions as a potential solution to the so-called ‘advice gap’ in this country: the well-documented phenomenon that people with relatively few financial assets (less than £50,000) lack access to affordable professional advice of any kind. Few firms wish to (or can afford to, given their hefty overheads) take on this kind of business. And yet these are the potential clients who could most clearly benefit from advice.
A number of start-up firms in the UK are rushing to fill this space, advertising their willingness to take on minimum lump sums as low as £1,000. As with peer-to-peer lending, their initial hopes are pinned on targeting a younger generation of savers who are comfortable with transacting their lives and finances online and through smartphones. A number of established firms that serve the so-called ‘mass affluent’ market, such as Hargreaves Lansdown, Investec and Brewin Dolphin, are meanwhile launching low-cost ready-made portfolio services of their own.
Others are treading more cautiously, fearful of being punished by the regulator if an algorithm-based process turns out to deliver poor results. In a 2011 study the Financial Services Authority (as it then was) looked at 11 risk-profiling tools used by firms to provide advice and suggested that nine of them might lead to ‘flawed outcomes’.
If history is any guide, the path to a more automated future in financial advice is bound to be a bumpy one. Some fear that the high street banks will eventually try to muscle in on this area, with the usual disastrous results for their long-suffering customers. You can be sure that established wealth managers and advisers will make strenuous efforts to guard their turf (and fees) against troublesome new entrants. Most of the new entrants will fail to make the grade, and those that do may well end up being swallowed up by more established rivals.
But, in the end, the sheer power and cost-effectiveness of using sophisticated algorithms to design and manage investment portfolios will open up new ways for all of us to invest more cheaply — while any existing players who fail to adapt risk finding their business models withering on the vine.
This article first appeared in the Spectator in November 2015. Link here.
Jonathan Davis 