Robo-financial advice is an idea that is as old as the web itself. Vanguard had plans for a robo-advice product in 1999. Now there is a new surge of energy in this space with a large group of fintech startups going after the opportunity. Imagine that you were building a robo-advice product, then what would your business model look like? What service would you provide? What market segment would you go after? What would your revenue model be?
Most of the robo-advisors that are up and running, such Betterment or WealthFront in the US, or InvestSmart or Stockspot in Australia, are trying to emulate traditional financial advisers. You go to their website and they ask you a lot of questions – just as if you had gone to the office of a financial planner.
- They try to understand your current situation: your goals, age, income, responsibilities, risk aversion, current investments, etc.
- They then recommend choices: How much to save; how much to invest in each asset class (stocks, real estate, bonds, cash, etc.); how much to borrow; how much insurance you need; etc.
- Finally, they implement each choice for you: Choosing investment products in each asset class; purchasing insurance, arranging loans, etc. They are not very sophisticated at this stage – but these are early days.
More doctor and less architect
I would describe this approach as the ‘design and implement approach’. It is conceptually the same type of service as offered by architects – understanding of your situation, design and implementation.
I think this is the wrong approach for do-it-yourself (DIY) investors who are the natural clientele of robo-advisers. Those investors have already made investment choices and implemented them. Robo-advisors should be working with the client to examine those choices and find improvements.
That is, robo-advisers should be using a ‘diagnostic approach’. When you go to the doctor you don’t need design and implementation. You just need to know what is wrong with the body you already have, and how to fix it.
Successful robo-advisors will be more diagnostic. They will not start from scratch with the goal of implementing choices for investors, but instead ask investors why they have made the current choices and suggest changes. Questions like:
- Why are you 25% invested in cash, when your situation (young, few responsibilities, safe employment) suggests that you should take a relatively large amount of risk?
- Why do you have an SMSF? How is that helping you? Here is a list of ways in which self managed super adds value for investors. Which of these apply to you? None of them? Ok, why don’t you switch to a low cost industry fund, like AustralianSuper or UniSuper?
- Why do you have growth assets (high capital gain, low income) in your family trust and income assets (low capital gains, high income) in your SMSF? Here are two reasons why that might be best practice. Does either apply to you?
- Why do you have a fixed rate loan for that investment property instead of a floating rate loan? Here are three reasons why that would make sense. Does one apply to you?
How to charge for the robo-financial advice? Ideally all financial advisers would charge a fee for service. For instance, $350 per hour x 24 hours = $8,400 per year. But, in reality they almost always charge a fraction of funds under advice (FUA). For instance, $840,000 x 1% = $8,400.
Even advisers who claim to charge an hourly fee usually want to know how much of your money they will have under their advice before they quote the number of hours they expect to charge. That allows them to charge their 1% and then work backwards to the ostensible number of hours.
So it is with robo-advisers. They charge a percentage of FUA – typically between 25 and 75 basis points (0.25 to 0.75%). This is partly why they emulate financial advisers rather than providing a purely diagnostic service. Unless they are providing ongoing advice and administration it is very difficult to charge an ongoing fee.
This is the challenge for a diagnostic robo-advice service — how to charge ongoing rather than one-off, or episodic, fees. There are two approaches that could be taken. First, a diagnostic robo-adviser could be embedded in a wider service. It might be bundled with the services of an SMSF administration provider. Secondly, the diagnostic service could be provided at low cost by a private wealth management firm, private bank or even an industry fund as a way of establishing contact with wealthy investors.