Robo-advisors are actually one of the better inventions of our 21st century. Making professional financial advice available to the masses and doing at a minimal cost. What could be better? But there is a darker side to all of this. Likely, many robo-advisors will not make it and fail. Why robo-advisors will fail is a more complicated issue. However, the bottom line is this:
Robo-advisors will fail because most of them are not profitable. In order for a robo-advisor to be profitable at a 0.25% fee, they would need to have somewhere between $15-20 billion assets under management (AUM). Needless to say, many of the smaller robo-advisors are not meeting that threshold and will likely fail within the next years.
In this post, I will dive a bit deeper once again into the topic of robo-advisors and examine why many of them will fail. I’ll give you a brief overview of what robo-advisors are and how they operate before looking at some of the reason why robo-advisors will fail.
In the second part of this blog post, I will go through whether robo-advisors are a good idea or not based on the likelihood of failure. Conclusively, I will give my personal opinion concerning robo-advisors.
What are robo-advisors?
Robo-advisors are brokers that manages portfolios and executes trades using algorithms. The brokers usually provide their clients with an easy-to-use, visually appealing platform to determine their broad investment goals.
The robo-advisor will then regularly propose various portfolio strategies according to the above-mentioned investment objectives. The options offered appear to differ according to risk and usually include portfolios with varying exposure to bond funds.
If the portfolio plan is chosen, the robo-advisor will do all of the research that follows. It will position the necessary trades to achieve the optimal allocation of the portfolio, auto-rebalance the portfolio to ensure that those allocations remain, invest in fractional shares, and reap tax-losses.
Much of this occurs unknown to the end-user in the background. Thus these kinds of brokers are called robo-advisors. An algorithm performs all actions; no human intervention is needed.
Will robo-advisors fail?
Robo-advisors may fail. In fact, it seems likely that most robo-advisors will fail and only a select few will ever operate sustainably. Which brings me to my main point: sustainability.
As of now, most robo-advisors do not have a sustainable business model. Rather, they incur losses to be able to attract more clients at lower fees and secure a bigger market share while the robo-advisor market is still relatively new.
Since the most well-known advisors such as Betterment and Wealthfront offer their services at 0.25% fees, most of the less-known robo-advisors follow suit. However, as pointed out above, a 0.25% fee would require between $15-20 billion in AUM at current market conditions in the US.
Needless to say, not many robo-advisors hit that threshold. As a result, they are operating at a loss year after year. It is only a matter of time until writing red numbers every year will lead to collapse and failure.
Furthermore, attracting new clients in the financial industry comes at a significant price. While the better-known brokers can easily market their algorithmic trading services to their existing client base, newly formed robo-advisors will have a much tougher time acquiring customers.
This is also due to the fact that transferring from one broker to another is quite a hassle! Even through the ACATS has made things easier on a process level, transferring your funds that are reserved for retirement from one broker you trust to a completely new and unknown robo-advisor will some convincing and a leap of faith. Especially if you have read that robo-advisors will fail.
How robo-advisors could fail
So, let’s look at some of these reason in more detail. I have elaborate on the financial reasons why robo-advisors will fail, however, there’s more: regulation.
Even well-established robo-advisors frequently run into regulation issues with the SEC due to their wide array and combination of various financial instruments. For instance, what should a pie that you invest in that contains stocks, bonds, real estate, TIPS and other miscellaneous products be classified as?
Nobody really knows, which means the legal fees will add up and the process will be long and costly for robo-advisors. Thus, in addition to robo-advisors already struggling to attract new clients and break even, they are burdened by regulatory hurdles. This could be another reason as to why robo-advisors will fail.
Can Robo advisors survive a bear market?
When a sustained bear market hits, typically a lot of wealth is lost. However, brokers do not necessarily struggle. Traditionally, brokers made their money by charging a commission for buying and selling stocks. This means that as long as people kept buying and selling, brokers were just as happy in a bear market as they were in a bull market.
However, robo-advisors are a different ballgame. Since all they charge is an annual fee, the more trades they actually have to execute the more costly it will be for them.
With this in mind, let’s imagine the scenario of a sustained bear market. Typically what happens is that many investors get scared and start pulling their money out of stocks and bonds. Money needs to be liquid and available in a recession.
Since robo-advisors were already struggling to begin within a bull market, the additional loss of assets under management in a bear market could pose a real dilemma. Thus, I feel fairly confident in saying that most robo-advisors will not survive a bear market and will likely fail.
Are Robo advisors a good idea?
Robo-advisors seem to have a lot of issues. Financially they are not set up well and could easily collapse. From a regulatory perspective, robo-advisors currently have to jump through a lot of hoops to get most of their financial products approved.
So with all this going on, are robo-advisors a good idea?
The simple answer is, it depends. What is most important here for us as retail investors, is that the advisors can offer sustainable services at a low to moderate fee. I myself have stayed clear of services like Betterment and Wealthfront and prefer the more flexible and hands-on approach that M1 Finance offers.
The wealth of services and products that robo-advisors currently offer and the competitive environment of an entirely new market segment come at a price. Low to non-existent margins for robo-advisors.
It seems more than likely that many robo-advisors will fail within the coming years or when the next bear market hits.
However, the concept of robo-advisors will not go away. Automating basic or even complex investment processes will become a cornerstone of all investment activity. When it comes to your personal investing strategy it simply remains a matter of preference whether you’d like to make use of such algorithmic automation or not.
Everything has its pros and cons. And so do robo-advisors.