Why robo-advisors look set for malfunction

There has been a lot of noise about the provision of low-cost, automated strategic asset allocation portfolios to retail clients. But the economics doesn't add up, says Morningstar.
Why robo-advisors look set for malfunction

Fund research firm Morningstar has questioned the viability of robo-advisors, pouring cold water on their potential threat to wealth and asset managers.

In a recent research paper out of the US, the firm says few standalone robo-advisors will be materially profitable and many won’t be standing in a few years’ time.

It finds the economics of robo-advising challenging with low fee rates averaging 0.25%, given they will need to invest heavily in advertising or consolidate to gain scale.

“Robo-advisors need near industry-leading expense, efficiency and substantially more scale to be profitable,” said Michael Wong, Chicago-based equity analyst for Morningstar.

“The current legion of standalone robo-advisors will have to invest heavily in advertising, or consolidate to gain scale, be acquired or partner with established brokerages, or go out of business.”

However, Tao Jin, head of investment management in Asia for Morningstar, pointed out that robo-advisors might not be so overstated for Asia, given the difference between wealth management and distribution landscapes in the US and Asia. In the US, the fee-based financial advisory model dominates, although in Asia bank distribution and commissions are still the norm.

"Robo-advisors in Asia offer a low-cost alternative investment solution to the traditional bank-dominated advisory model," said Tao, nothwithstanding forecasts that the fee-based financial advisory model will be introduced in Asia before long.

Morningstar defines robo-advisors as offering automated, semi-tailored strategic asset allocation portfolios directly to retail customers. They are positioned between discount brokerage and full-service wealth managers. A risk-tolerance questionnaire usually algorithmically determines an appropriate portfolio composed of low-cost ETFs.

Using a range of comparable companies, Morningstar estimates the break-even client asset level for robo-advisors is between $16 billion to $40 billion – which it says is eight to 20 times the current level of leading robo-advisors.

“Robo-advisors will have to use much of the capital they raise to pay for the tens to hundreds of millions of marketing dollars needed to gather assets and reach a profitable scale,” noted Wong.

“Even after they become profitable, their slim operating margin and low average account size imply that it could take a decade or more to recoup advertising costs.”

He points to a competitive advantage for traditional wealth management firms, saying they should focus on their value-added services such as access to hedge funds and insurance, generating alpha and providing more holistic financial planning.

Nevertheless, Morningstar says the $16-$40 billion break-even point for robo-advisors is achievable given the addressable market of millennial and lower-net-worth households that full-service wealth managers don’t focus on.

At the end of 2014, the entire robo-advisor industry had assets of $20-$30 billion, and the leading independent robo-advisors assets of about $2 billion. That compares to the $2 trillion of firms such as Bank of America-Merrill Lynch and Morgan Stanley, and $2.5 trillion for investment services firm Charles Schwab.

However, to reach these investors robo-advisors will need to invest heavily in marketing. It estimates leading robo-advisors Wealthfront and Betterment would need to spend $60-$150 million and $240-$600 million in advertising to achieve $16-$40 billion of client assets.

“Once the robo-advisors break even, depending on their long-run operating margin, it could take years before any of the accounts they add become truly profitable,” said Wong.

Morningstar suggests Charles Schwab is one of the only companies with a viable business model delivering wealth management to the masses. The firm launched an online advisory solution, Schwab Intelligent Portfolios (SIPs), in the first quarter. It charges no advisory fees, account service fees or commissions.

Schwab’s expenses as a percentage of client assets are below 20% and it has access to more than nine million brokerage accounts and about $2.5 trillion in client assets.

“This means it can grow its online advisory solution to a profitable scale via low-cost promotion to current clients,” said Wong. “The company can also leverage its existing $250 million of annual marketing to simultaneously increase awareness of Schwab Intelligent Portfolios and its overall brand.”

¬ Haymarket Media Limited. All rights reserved.