Robo-advisors in the investment and wealth management industry
What are our Future FinTech Champions learning at the moment? And what are their thoughts on the current development of FinTech? Read through this submission from one of our FFCs, Tejassvi Santhoky, currently studying a BSc(Hons) Management Accounting and Finance @ University of Mauritius.
It may appear that planning your finances is a challenging task. On the one hand, there is a confusing diversity of options; on the other, there is the ongoing effort required to plan, manage, and adjust one’s portfolio. But what if you had a technology that could manage all of your investments for you? Robo-advisors are emerging as a viable option for wealth management in a world where automation has pervaded every aspect of life.
What Is a Robo-Advisor and How does it work?
A robo-advisor is a form of digital financial advisor that performs the same functions as a traditional financial advisor; it gives financial advice or manages investments. Robo-advisors use artificial intelligence that give investors advice based on their inputs. Although robo-advisors are designed to perform with minimum human involvement, this is not always the case. Most robo-advisors are currently relatively simple, relying on a basic risk-tolerance questionnaire to evaluate investor behaviour and algorithmically generate an appropriate portfolio.
In most cases, a few simple questions will be given to validate an individual’s identity before being asked to complete a questionnaire. The client’s present income, estimated future income, costs, risk tolerance, investment goals and their chosen timeframes are all gathered through the questionnaire. Models then use this data to determine an appropriate asset mix for achieving those objectives. Automated investing platforms use models that combine modern portfolio theory, historical returns, and volatility data to optimise each portfolio’s asset allocation.
The client creates a monthly debit order to fund the plan once the account and portfolio are set up. The rest of the procedure is fully automated. Monthly payments are invested automatically across all investments, and portfolios are rebalanced automatically on a regular basis. As the investor approaches retirement age, the asset mix may need to be modified over time to reduce volatility.
Investors can access their investments, account balances, and progress toward their investing goals at any time by logging into the system. They are not required to do anything else. Robo-advisors typically employ a specific set of financial products to carry out an investment strategy. The majority of them are passive investing products such as ETFs (exchange traded funds).
Other sorts of products, such as hedge funds and other alternative investments, are likely to become offered on these platforms as the business becomes more competitive. The majority of robo advisers also provide a variety of tax-advantaged retirement accounts.
Benefits and challenges for the customer of using robo-advisors in investment advisory processes
When providing online advisory services for investors, the complexity of the advisory services, the relevance of the service to the customer, and the importance of trust are all factors to consider. The artificial intelligence-based robo-advisors create and invest in a portfolio based on the investor’s risk preferences and investment horizon, as well as manage the portfolio afterward, keeping track of market changes and asset features and informing the investor of these changes that affect the individual’s financial situation.
Benefits to the customer
1. Advisory services available for a broader customer group
Robo-advisors make advisory services available to both wealthy customers and those with smaller investment portfolios. This is achievable because robo-advisors are built with a low-cost framework in mind . Hence, with the emergence of robo-advisors, a new low-budget investor class has emerged, which traditional investment advisors have not previously served.
For instance, there is Robinhood, a mobile-first brokerage based in the United States, that offers commission-free investing to investors looking for a simple trading app. Robinhood does not require a minimum deposit. This makes it the ideal broker for anyone who wants to trade or invest with a small amount of money.
2. User experience
From the customer’s perspective, using online platforms to obtain investment advice and online surveys to evaluate risk preferences and investment horizons greatly simplifies the investment process. Robo-advisors are differentiated from traditional financial advisory services by their constant monitoring and automated rebalancing, as well as their availability 24 hours a day, 7 days a week. Customers can log in to their accounts using user-friendly smartphone apps or the company’s website at any time of day to make changes to their portfolios and rebalance their investments.
Unlike traditional wealth management services, robo-advisors offer a broader range of services, such as risk alerts and opportunity, market update push notifications, and periodic portfolio reviews and dashboards, all of which improve the customer experience.
3. Non Personal service
The lack of understanding and the associated overconfidence is a prevalent problem among investors. As a result, the customer’s private and nonpersonal conversation with the robo-advisor can offer a safe platform for the client to realistically grasp their level of financial expertise without the fear and humiliation of sharing this information with a human advisor. On this note, robo-advisors can improve the process’ openness and, as a result, provide customers with more objective advice.
4. Conflict of interest
Human advisors are frequently accused of having a conflict of interest. This is due to the fact that their advice is influenced by their employer’s compensation, whereas robo-advisors’ compensation is product-neutral. Therefore, robo-advisors can be considered as a more ethical answer to investment counselling, since conflicts of interest are minimised, and the customer receives the truly best advice based only on the available knowledge about their preferences and the market and its fluctuations. Furthermore, robo-advisors give greater transparency by displaying the charges users pay through online fee analyzers and notify whenever new fees are charged.
Challenge for the customer
No personal contact
When it comes to their wealth and money, investors tend to be more cautious and alert when it comes to new technology. Furthermore, clients frequently seek personal and supportive interaction following big life events such as death or illness. Customers are often hesitant to use robo-advisory services during periods of high market volatility. According to studies, the wealthier a person is, the more valuable a human advisor is.
Robo-advisors provide investment recommendations based on an online questionnaire, which can result in recommendations that do not take into account all of the important components of an investor’s financial condition. This data could contain things like the customer’s contribution and withdrawal schedule, dependents, monthly spending, tax situation, expected larger expenses, and other sources of wealth from unique life events such as receiving a large inheritance.
Such an example is the Wealthfront investment app. This platform does not provide its users with the option of consulting a real financial advisor for personalised guidance on managing an irregular flow of funds. As a result, these retail investors must pay an extra cost for the external assistance.
Benefits and Challenges for the service provider
Robo-advisors are gaining traction in the wealth management industry, and they have the potential to transform investment advisory practices. To keep up with the competition, established financial service providers are developing their services and platforms in response to this rising trend.
Benefits for the company
1. Costs and efficiency
Currently, robo-advisory systems are mostly based on products that require little or minimal active portfolio management, such as ETFs. Because EFTs do not need active decision-making on the part of portfolio managers, their cost structure is straightforward and easy to administer. As a result, automated robo-advisors lower administration, human, and asset costs while also allowing them to serve a broader customer base due to lower service charges. This allows organisations that provide financial advising services to reach a larger market segment, resulting in increased earnings. Companies collect management fees on invested funds regardless of market fluctuations, ensuring a consistent stream of revenue.
Furthermore, the online questionnaires used to screen investors are very simple and less time-consuming compared to traditional personal face-to-face interactions. Traditional investment advisory methods are typically very administrative, requiring a lot of data entry and unneeded paperwork. To be viable, however, robo-advisors are thought to need near-industry-leading cost-efficiency and a sizable asset base.
2. Quality of the service
Customers may be assured of having access to information that is updated in real time by adopting automated investment advisory systems. Robo-advisors are much more efficient than human advisors at processing, utilising, and categorising information. Furthermore, automated systems standardise the services provided to clients, ensuring that they are treated fairly and consistently in specific situations while also decreasing human error . Because the algorithms deliver recommendations in a highly consistent and logical manner, the automated processes make it easier to track the rationale behind each investment decision. This simplifies the process of retaining online records of transactions and advice, as well as dealing with potential client complaints based on this data.
Challenges for the company
1. No acceptance by users
Despite the cost advantages that robo-advisory services provide, these services have a hard time gaining user adoption. Customers appear to favour hybrid models in which they can research and compare products online while still being able to speak with a human advisor before making a final decision. This is according to the findings by Zhang et al. (2021) which suggest that consumers favour human financial advisors with great experience over robo-advisors. As a result, significant marketing and advertising expenditures are required, as well as less expensive marketing methods like word of mouth and social media. A problem may be that the investor group that has amassed sufficient wealth to be interested in investing and saving is unwilling to forego personal face-to-face advisory services for new technologies.
2. Competitive environment
New technological advancements have made it easier for new firms to break into the wealth management industry. This competition is not limited to banking institutions; it also includes firms in other industries, such as insurance and asset management, that have added online investment advisory to their services. Furthermore, new robo-based technical advances are helping tech-based start-up enterprises gain market share.
Consequently, traditional financial service providers must be prepared to adapt their services in response to new technology and customer demands. However, when traditional financial service companies begin to offer robo-advisory services, the competitive environment for FinTech start-ups will become more difficult, as they often lack a significant customer base.
In these circumstances, it is expected that robo-advisory start-ups will shift their focus from consumer to business-to-business services, and partner with existing asset management companies or banks. This new robo-advisor trend will have a significant impact on firms serving a mass client base, whereas enterprises targeting high-net-worth individuals who prefer personalised advice may be able to wait for the industry to mature and their customers to adjust to new technologies.
Robo-advisors and inclusive finance
Financial inclusion is one of the most crucial promises of the fintech revolution. Offering financial services generally entails high fixed expenses, making it unattractive to serve low-income customers. New technologies provide for a significant reduction in transaction costs. New technology can reach those who have been previously underserved by lowering these prices. This promise can be seen in the form of robo-advisors.
To begin with, they usually require less money to open an account. For example, Bank of America requires US$25,000 to open a new private financial advisor account, but only US$5,000 to open a robo-advisor account. Some robo-advisors, like Betterment, have no minimum investment requirements.
Similarly, they are usually less expensive than human consultants. The automation of the advisory process lowers the fixed expenses associated with guidance. For example, in the United States, a fully automated robo-advisor costs between 0.25% and 0.50% of assets managed (between 0.25% – 0.75% in Europe), but traditional human advisors’ fees rarely fall below 0.75% and might even reach 1.5%.
An analysis of the effects of the reduction of the account minimum from $5,000 to $500 by a major U.S. robo-advisor depicted that there was a 59% increase in the share of ”middle class” participants (with wealth between $1,000 and $42,000), but still no rise in participation by households with wealth below $1,000. The bulk of new middle-class robo-advice users are also unfamiliar to the stock market, and they took higher risks than upper-class investors.
These findings show that having access to a robo-advisor may be especially crucial for individuals who are less likely to be given traditional assistance, and that it can thus be viewed as a key tool for financial inclusion.
REFERENCES - PART 1
Ganatra, M. (2021). What Is A Robo-Advisor And How Does It Work? [online] Forbes Advisor INDIA. Available at: https://www.forbes.com/advisor/in/investing/what-is-a-robo-advisor-and-how-does-it-work/.
Robo-advisors as a form of artificial intelligence in private customers’ investment advisory services. (2019). [online] Available at: https://core.ac.uk/download/pdf/224802905.pdf.
The Tokenist. (n.d.). What is a Robo-Advisor? (2022): Step-By-Step Guide. [online] Available at: https://tokenist.com/investing/what-is-a-robo-advisor/
LEHNER INVESTMENTS. (2019). Robo Advisor – Introduction to automated investing with innovative FinTech companies. [online] Available at: https://www.lehnerinvestments.com/en/robo-advisor-introduction-automated-investing/#robo-advisors-automated-investing
Robo-Advising: Less AI and More XAI? Augmenting algorithms with humans-in-the-loop. (n.d.). [online] Available at: https://www.icmagroup.org/assets/Uploads/Robo.pdf.
REFERENCES - PART 2
NerdWallet. Robinhood Review 2022: Pros, Cons and How It Compares. [online] Available at: https://www.nerdwallet.com/reviews/investing/brokers/robinhood#:~:text=The%20bottom%20line%3A
Who Do You Choose? Comparing Perceptions of Human vs. Robo-advisor in the Context of Financial Services (2021) [online] Available at:
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