Robo-advisors are gaining in popularity. In fact, the financial media likes to predict that these online automated investment platforms will soon take over the entire investing universe, Skynet-style. But while there are compelling reasons why this might happen, it’s still early days for these online tools… early enough to question whether the “robo-advisor revolution” is here to stay or if the whole concept is subject to early termination.
Now, I’m not actually saying I necessarily believe this to be the case. But in this article, let’s take the skeptic’s view and consider some reasons why the future of robo-advisors may not be as rosy as everyone thinks.
The Five Reasons Why Robo-Advisors Could Disappear
1. Robo-Advisors Are Still ‘New’
Both Betterment and Wealthfront began operations in 2010. That makes the two leading players in the robo-advisor space just seven years old. Most of the other robo-advisors have come out even more recently, some in just the past year or two.
That’s hardly a basis for projecting that this technology will take over the entire industry in just a few years. Especially not since the seven-year period in question has been a single market — and a steady bull market at that. (We’ll delve deeper into this point in the next section.)
There’s even the thought that independent robo-advisors like Betterment and Wealthfront may just be the early players in the space and that it will eventually be dominated by large, established brokers. That trend is already taking place. Many large brokerage firms now have their own robo-advisor services. Instead of being an independent concept, robo-advisors may eventually blend into the bigger picture of the investment industry.
2. Won’t Prevent Losses in the Next Bear Market
It’s likely one of the drivers behind robo-advisor growth has been its association with the most recent iteration of the super bull market that began all the way back in 1982. The latest leg up began in the spring of 2009, just before robo-advisors began appearing.
Robo-advisors may be giving the unintentional impression that the combination of a reliance on technology, big data and the standby methodology of modern portfolio theory (MPT) makes large losses unlikely. But the reality is MPT has been around since the 1950s and it hasn’t overcome any bear markets since then.
No one has invented a crash-resistant widespread portfolio management system. When that becomes apparent in the next bear market, will robo-advisor investors “stay the course”? Or will they feel betrayed by the suddenly empty promise of eternal gains and jump ship instead?
No one has the answer to those questions because robo-advisors have yet to weather a bear market. But this needs to be considered, especially if you plan to use robo-advisors as your primary investment vehicle. Of course, the answers to these questions will be settled when the next bear market hits.
MPT May Not Be a Reliable Long-term Investment Strategy. Once again, MPT isn’t a new investment method. If it were truly superior to all other investment strategies, the other strategies would no longer exist.
It does seem as if MPT is well-suited to prolonged bull markets, which is exactly what we’re in right now and have been since before the inception of robo-advisors. MPT is all about asset allocation rather than individual security selection. But then again, nearly all investment strategies tend to work in prolonged bull markets. The investing public, particularly new and small investors, might be psychologically prone to buying into the MPT hype as if it’s bulletproof. But reality will eventually render that assumption hollow.
In bear markets, MPT is just another way to follow the financial markets down. At that point, investors may gravitate back toward more traditional investment strategies, such as value investing. As well, bear markets tend to favor individual security selection, which is the exact opposite of what MPT is all about. And individual security selection, in turn, tends to favor traditional human investment management or even self-directed investing.
This is yet another example of how we will have to wait for the next bear market to know how this will play out.
3. Young Investors Might Not Be Loyal
The evidence thus far is that robo-advisors are making progress in attracting Millennial investors. While that might be paving the way for the next generation of large investors, there’s an equal possibility they’re mostly riding the trend.
No offense to any Millennials reading this right now, but young people can be notoriously fickle. They’ll stick around until the next hot trend develops, and then they’ll jump on that bandwagon. The increasingly short shelf life of products and businesses in recent years testifies to this reality.
Right now, robo-advisors are the new “cool” thing in investing. But what happens when they are no longer new and the cool factor wears off? Only time will tell, but relying on the youth market is a slippery slope. It’s even possible some older investors, including baby boomers, could eventually tire of the robo-advisor phenomenon and decide to move on to other methodologies –- or even back to more traditional ones. It happens when investment cycles turn.
There is yet another possibility here, one in which the robo-advisor sector may contain the seeds of its own destruction. Since virtually all robo-advisors welcome small investors, sometimes requiring no upfront minimum deposit whatsoever, there’s a possibility investors will use robo-advisors to determine their portfolio asset allocations and then use the formula in their own self-directed investing. In this way, robo-advisors could become more of a model than a destination for big portfolios.
4. Most Robo-Advisors Aren’t Available for 401(k) Plans
Most individuals have their money in their employer’s retirement plan. It’s not clear yet whether robo-advisors will be successful in penetrating the all-important 401(k) market. This is significant, because 401(k) plans hold at least $4.8 trillion in personal wealth.
Late last year, Betterment rolled out its Betterment for Business 401(k) robo-advisor service. It gathered 300 medium-sized “professional services firms like medical and dental practices, law firms and architecture firms, as well as technology companies.”
That’s certainly a good start for a brand-new business venture. But we’ll have to see if Betterment and other robo-advisors are successful in penetrating the 401(k) plans of Fortune 500 companies and other large employers. Right now it’s simply too soon to tell. At this point, the Betterment 401(k) push is more an experiment than anything else.
If Betterment is successful in capturing a large chunk of 401(k) business, the future of robo-advisors is assured. But if they don’t, for whatever reason, the future will be less than certain.
5. Requires Large Amounts of Capital To Kickstart The Business
It’s hard to go anywhere on the web and not see ads for robo-advisors. Those ads cost money. Michael Kitces at Nerd’s Eye View provided a virtual white paper on the topic of robo-advisor marketing costs outstripping their customer revenue. It’s a point well taken.
Much of the growth of robo-advisors is a result of aggressive (and expensive) marketing campaigns. But as Kitces points out, how much marketing needs to be purchased in order to bring in a single customer, whose $20,000 account might generate only $50 per year in fee income (at 0.25%)?
Right now, venture capital is largely supporting the marketing budgets of robo-advisors. But eventually, those investors will be looking to see a return on their investments and may pull the plug if they don’t. Will robo-advisors continue to draw in a flood of new customers absent costly marketing campaigns? Again, we’ll have to wait and see.
Where Will the Robo-Advisor Investors Turn?
Even under the worst-case scenario, it’s unlikely robo-advisors are likely to go away completely. The concept is solid, and it’s just a matter of who will survive and how the sector will evolve in the process. And it will evolve, perhaps drastically.
Let’s dare to consider where the safe ground will be if and when a robo-advisor shakeout happens.
- Some robo-advisors will adapt and thrive. Among the actual standalone robo-advisors, we like Wealthfront. It has a strong combination of low fees and tax-efficient investing for all portfolio sizes, as well as having recently rolled out Direct Indexing managed portfolios for larger investors. In those managed portfolios, Wealthfront is moving even beyond strict reliance on a small number of exchange-traded funds — which is the standard investment procedure of all robo-advisors — to include large numbers of individual stocks.
- Discount brokers. Despite the development of robo-advisors, it’s way too soon to even think about abandoning discount brokerage accounts. These accounts will always serve the interests of self-directed investors in a way that is fundamentally contrary to the robo-advisor model.
We should probably also suspect that the discount brokers will eventually add a tool for self-directed investors that will replicate what robo-advisors do in regard to developing portfolio allocations (if it doesn’t already exist somewhere in the quiet corners of the sector). And once the robo-advisor model is reduced to a tool, the purpose for robo-advisors even existing will be permanently compromised.
- Full-service brokers won’t disappear. While we should fully expect robo-advisors to continue to eat away at the business of higher-priced traditional investment advisors, the latter is not likely to go away entirely. There will always be investors, particularly large ones, who prefer the human touch with their investments. Robo-advisors are already adding more customer contact to their product mix, but there’s a limit to how far they can go with that before higher employee costs threaten their low-fee structures and undermine the whole program. (Vanguard Personal Advisor services is one robo-advisor we’ve reviewed that offers a mix of human-assisted and automated advice.)
So What Do I Think Will Happen?
Perhaps the most likely outcome is going to be some sort of meeting in the middle. Robo-advisors will ultimately force traditional investment advisors to lower their fee structures. And they will likely be able to do that by borrowing on the robo-advisor concept. They’ll use algorithm-assisted investment strategies that do exactly what robo-advisors do but with a human face.
In the end, robo-advisors may be less of a distinct “thing” and more of a disruptive force that causes the entire investment industry to streamline its processes and reduce its fees even more. But that’s where the entire industry seems to be headed anyway.
Where do you think the future of robo-advisors will lead us? Do you think they’ll take over the investment universe or merely reform it before they disappear as a unique concept?