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Robo-Advisors: Digital Transformation in Investment Management

When hearing the expression robo-advisor, you might be thinking of Siri, or Alexa, or one of their robo-siblings giving you advice about the next big investment opportunity. That’s not what these robots are about, at least not yet. Rather than giving advice, at the moment robo-advisors are nothing more than automated portfolio managers. These digital investment services with minimal human intervention are aimed at investors who want inexpensive savings plans and a convenient way to manage the investment choices.

Digital Transformation in Financial Services

Meet Tim, head of product and one of the founders at a rapidly growing FinTech startup. He started by telling us about the early days of their company.

…algorithms have come a long way and together with new technologies they have transformed everyday activities in ways that allow cars to assist people with driving, make recommendations for music to listen to, news to read, even match people for a date. Recent disruptions to the financial services sector target how we make payments, arrange lending, and consume advisory services.

Digital transformation has been upon the financial services sector for some time. Tim’s company discovered that the lack of innovation in parts of the sector made it an ideal target for disruption.

We realized that a segment of advisory services was ripe for automation, that’s how we ended up in wealth management. The business processes for these services are simple enough to allow automation of them to a great degree — provided that the needs of our customers fall within a range with regard to acceptable risk, investment choices, and mode of interaction.

He continues:

Until recently, the two options for investing were self-invest (DIY) or the involvement of asset managers for fee. Recent studies about customer satisfaction also revealed that financial services ranks at the bottom of the industry sector list. Many customers had bad experiences with advisors, which prompted the question: would they trust a machine more than a human? We saw an opportunity to offer a third option: automated investment services. The technology was already available to us to build our digital product – smart algorithms backed by deep learning, interconnected digital ecosystems, cloud hosted platforms.

Tim explains how they differentiated their product in this space:

When we set out to define our product and services we specifically focused on making them to…

Be easily accessible – starting with web access, and increasingly putting more and more effort into the mobile channel.

Be more economical by reducing costs significantly, and making them accessible to a larger customer base.

Be more transparent about pricing, risks, and really all aspects of the services we offer.

The time was also right for tapping into a new breed of customers, who are increasingly digitally literate and open to exploring new channels and ways of interacting not only with their peers but also with businesses.

Financial services is a prime target for agile, digital companies eager to transform the customer experience and automate operations. Tim’s company had to move fast:

We wanted to launch quickly because of the fierce competition between providers of financial services fueled by the latest technological innovations. We have launched our robo-advisor product to a group of early (beta) customers in 6 months.

What is the market for robo-advisors?

Ana is a twenty-something graduate from a top school, currently working at one of the multi-national firms. She is a typical millennial in many ways – enjoys hanging out on social media, and updates friends using a variety of messaging apps. Time is important for her, she hates queuing in line, gets food delivered to her, and works strictly office hours.

Although she has a lot of time for friends, followers, and listens to influencers, she first heard about investing from her senior colleagues during a conversation. It was not long before she came across Tim’s company offering investment products to young folks like her.

She commented:

The ease of use was a big plus. It completely demystified complex financial products and services.

I liked that I could invest small amounts of money. I can only afford to save a few hundred per month at this time.

I also liked the personalized services made available right from the app, and the fact that I did not have to go to some branch, queue, deal with paperwork, and engage in boring small talk just to open an account.

Customers of recent generations, in general, are more comfortable with interacting with digital services than previous ones. The digital customer journey is, and will be, a differentiator amongst robo-advisor providers. Not only for making customer acquisition more efficient, but also for retaining customers for the long term. This tendency allows services in general to replace humans with automated tasks, and direct interactions to purely digital channels such as web, chat-bots, apps, and others.

Tim’s reflection on the market:

Millennials are increasingly looking for ways to manage their money, with cheap investment options, and economies of scale, our robo-advisor services are able to fill a gap for this customer segment.

There is also increasing evidence suggesting that actively managed funds, and their human managers, are unable to produce the returns that plain index funds can deliver in the long term. This gives us the opportunity to look at new customer segments and also engage with Baby Boomers at or approaching retirement, and High Net Worth Individuals for our new services.

Investment advice is inherently complicated for most people — anything associated with financials tends to be complicated naturally. Robo-advisors allow a set it and forget it approach to investment, putting it on auto-pilot that performs best in the long term.

Tim also admits, it has not been a smooth ride for the company.

While the technology is in place, and the market together with demand is seemingly there, the marketing efforts and costs involved in turning our robo-advisor into the product we wanted to offer was a grueling task. It is a service that competes on ease of use, and most importantly on price.

The rock-bottom pricing means that we must seek to profit from the economies of scale, and long-term customer loyalty. Achieving a higher customer lifetime value over customer acquisition cost in this environment is not a trivial task, and puts our marketing and sales departments on their toes.

At the same time, technological advances have created an environment that makes product innovation, development, and launch increasingly rapid. Digitization of capabilities and processes have allowed the introduction of new products and business models, and lowered the barrier for entry for many new businesses. The marketing challenges and increasing competition put Tim’s company under pressure.

As soon as the first version of our product was out, we started working on the next iteration. We had major plans, and an ambitious roadmap.

A Day in the Life of a robo-advisor

Two years after those first beta users at Tim’s company, multiple robo-advisor platforms sprung up sharing the same mode of operation:

  1. Customer acquisition
  2. Customer assessment, investment portfolio selection or construction
  3. Continuous portfolio monitoring and rebalancing

Tim explains:

Customer acquisition is a critical step in the process although not tightly related to the advisory activities. As with many digital offerings, the marketing and selling of the service is just as important as providing a good service itself.

It is the customer assessment, investment portfolio construction, and rebalancing activities where our smart algorithms take center stage and differentiate us from others. The assessment is based on a customer questionnaire with the purpose of homing in on the critical parameters of the most suitable investment portfolio.

Modern Portfolio Theory provides the foundation for portfolio construction, informed by the goals and parameters — such as appetite for risk or expected returns, investment duration, amount of money invested, and so on.

For most services, the universe (a set of securities with common features) for selecting investment from is limited to ETFs. For customers with larger investable amount on their account, we also offer the option to allocate a portion of the investment to trading individual shares from the stock market. Our system regularly rebalances the portfolio, based on our proprietary strategy, to maximize the performance considering current market trends and industry performances.

Naturally, we also send regular updates to our customers about the performance of their investment, and inform them about our efforts to better manage their assets.

Although nobody should expect to become a financial guru from using robo-advisors, user experience plays a critical role in eliciting a more thoughtful customer behavior for managing finances. People tend to overestimate their tolerance for risk when it comes to their investments. Robo-advisors allow for more guided and informed decisions on investments, and protection of assets from unwanted risk.

Transforming an industry is not an easy task

Let us not forget that many of the industries in existence today, including the once from the financial services sector, have been around for a long time. In comparison, the Digital Transformation movement is in its infancy. Bringing together people, process, and technology to make business successful remains a challenging task – a statements Tim agrees with.

While most robo-advisor services, including ours, are just front ends to existing financial systems, the effort going into providing an excellent user experience to our customers on desktop and increasingly on mobile channels cannot go unnoticed. Therefore, removing the worry from the process, offering a hugely valuable service, while hiding the complexity of the underlying financial systems is a feat that few of the robo-advisors are capable managing well.

The opportunity for robo-advisors comes from offering cheaper, superior investment advice, and reaching a massive market with the low-cost service. These services charge roughly an order of magnitude lower rates (0.1% instead of 1%) to manage individual portfolios. At these rates, client acquisition remains a question and a challenge for most robo-advisors.

We have asked Tim – how do you make sure the profitability of the customer grows beyond the costs of acquisition?

“Indeed, some of the services fell for the if you build, they will come fallacy, and ignored the significant effort required on the digital marketing side.

After recognizing the marketing challenges, we immediately started looking for new opportunities to turn profit. We set out two paths in our strategy:

  • Partnering with established financial firms with wealth management arms, which could allow us to tap into a more affluent segment of the market.
  • Discovering new channels and digital marketing platforms for reaching customers at a lower cost, experimenting with multiple social media channels.”

What is the reaction from the financial services industry?

Most recently, robo-advisor companies looked to move from direct to consumer (B2C) to partnering with existing advisors and adopting a business-to-business (B2B), or B2B2C model. The immediate opportunity was in leveraging automated advisory services and augmenting human advisors.

Rob who works at one of the largest bank’s wealth management arm explains:

The emergence of ETFs and index trackers gave rise to a simpler and lot more economic investment option: passively managed investments, as opposed to actively managed funds and portfolios involving human fund managers.

At the same time, robo-advisors have transformed the way investments portfolios are constructed and managed. Robo-advisors have the additional benefit of simplifying, even removing the complexities of tax implications, investment methodology, and philosophy choices.

We have observed that some people have difficulties entrusting a computer to manage their investment wholly, something that lacks personality, empathy, and human intuition.

We believe that the emerging trend of hybrid robo-advisors provides a solution by mixing automated and traditional human services. With the hybrid model, human advisors can focus on what they do best — consulting the client about their financial position, and needs on a more personal level — and scale their services at the same time.

Until the underlying products and technologies for automated investment advisor services develop further, human advisors will have the benefit of leveraging current automation services, and augmenting their own offerings.

Rob’s bank has tremendous interest in robo-advisors and Rob is leading the effort internally. His team recently started working with Tim’s company.

We have looked at a variety of products and features available on the market at the time, and found a wide spectrum across the board.

The summary some of the findings from the bank’s research analysis focused on the limitations and differences among the automated investment advisory services:

  • The level of personalization provided by the robo-advisors varies widely, but in general remains limited. A degree of personalization comes from the variety of niches available in this space aimed at women, students, or Islamic investors for example.
  • Most services select pre-constructed portfolios based on a limited set of outcomes from the customer assessment.
  • Investment strategies and features such as tax optimization, tax harvesting, and rebalancing are not available to all services, or to all customer segments.
  • Tax-loss harvesting, for example, requires buying individual shares rather than ETFs in order to account for losses in individual shares.
  • User experience, from onboarding to regular updates, is a huge differentiator among the businesses.
  • In a similar fashion, channel strategy and digital marketing also set many of these services apart.
  • There is also a geographic differentiation of these services, driven by regional specifics such as state of economy, regulation, and customer behavior.
  • The countries with the most robo-advisor services at the time were: United States, United Kingdom, Canada, and Australia. Asian and South American countries were also represented in much smaller numbers.

Rob summarized the bank’s stance on the industry itself:

We have been pleasantly surprised and happy with the hybrid robo-advisor model. The partnership with Tim’s company allowed us to introduce a new set of products for our clients.

Automated investment advisory services made an impact on the wealth management industry and will continue to grow. We believe it will take a long time for robo-advisors to claim a significant portion of all assets under management. Until then, human advisors will continue to have a significant role in this industry.

What is the future for robo-advisor services?

We also asked Tim what he thought about the future directions for the industry.

Ultimately Robo-advisory services would be able to learn about the client’s’ financial needs and investment behavior to advise based on up to date individual characteristics.

Data collection and analysis will always have a tremendous role in collecting, connecting of relevant data, and in turning it into meaningful information for machine processing. Forming the ideal data set for the best advisory service will have to overcome privacy and security concerns, as well as quality issues for an ever-increasing mountain of data.

Future development stages of strong machine intelligence will be able to bring new levels of personalization to investment advisory. They will gradually incorporate qualitative (as opposed to quantitative) assessments in portfolio allocation, and will eventually develop an edge over their human counterparts. The research in artificial intelligence will fuel new developments in these fields, and increase the benefits to the clients of investment and other advisory businesses.

Final thoughts

ETF-s brought the democratization of financial services by their simplicity and low-cost structure. Social media platforms will further democratize the access and delivery of them, and the services based on such products. The combination of market trends and new technologies gave way to the emergence of robo-advisors. Advances in the fields of data analytics, and research in artificial intelligence will gradually remove current limitations, and services will eventually evolve beyond today’s best human advisors.

In the future, we can expect Alexa to wake us up to some good news about our financials.

Hello Dave, your portfolio is looking well today. Last night, I have reallocated some moderately performing investments into a higher risk/benefit asset in line with your preferences. Would you like to know more?

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