What is a robo-advisor and should you use one?

A recent trip to the US proved very worthwhile in getting the lay of the land as far as robo-advisors are concerned. The new term in use, by the way, is ‘digital advice’ rather than ‘robo-advice’.

Undoubtedly digital advice is seen as the wave of the future. Digital advisors, which use a combination of a simplified client experience, lower and transparent pricing and seamlessly integrated technology to offer automated advice, are seen as the most effective way of accessing the investments of the mass market.

Interestingly, this advice does not typically come for free. Most robo-advisors charge between 0.20% and 0.50% per annum in advisory fees on assets managed using their advice. Most robo-advisors guide investors to passive or index-tracking strategies to contain costs. In the US, those are usually managed as ETFs rather than unit trusts.

There is also a big schism developing between robo-advisors and simple calculators (more on this in the next article).

Many large asset management firms, particularly those offering passive investments such as Vanguard, are gearing themselves for the change in the advisory landscape by launching their own robo-advisors. Other firms, such as BlackRock, are buying robo-advisory firms at ridiculous valuations. Some are entering into partnerships with known robo-advisor firms.

Everyone acknowledges that a world where digital advisors dominate is a certainty. However, this is not envisaged to happen for some years yet.

In the short term, as one would expect, robo-advisors have found most appeal with the millennial generation rather than with established investors, as evidenced by the average account size of between US$20 000 and US$100 000. Hence they do not currently pose a material threat to independent financial advisors, as their South African counterparts will probably be relieved to hear. On the other hand, most robo-advisors provide back-up ‘human’ contact via either a chat function or an option to call a financial advisor.

Although millennials make up a quarter of the world’s population, and one third of the US’s population, they are not, as yet, a massive ‘savings’ force. In fact, they delay becoming significant savers by virtue of the fact that they tend to stay single for longer and have children later in life. Millennials are the most educated generation to date and currently experience the highest levels of unemployment. They are also technology-savvy, confident, quick results-oriented and amazingly cost-conscious.

Consequently, the money that has actually been invested through robo-advisors remains small, although the actual numbers of investors are large, a little bit like South Africa’s tax-free savings accounts. It is estimated that robo-advisory firms currently manage about US$19 billion in assets.

Although the asset size is expected to grow over time (Cerulli Associates predict that the digital advice market will grow to US$489 billion in assets under management by 2020), in the short term profitability is being eaten away by administration costs. Unfortunately, it is difficult to make money out of the administration of a large number of small accounts when you only charge 0.20% to 0.50% per annum.

Part of the problem – and the reason why start-ups are being bought out by established firms – is the business model. By investing in third party ETFs, the robo-advisory firms have no other source of revenue but advisory fees.

Struggling for critical ‘asset’ mass in the short term has left many robo-advisors eyeing the institutional market where, similarly to South Africa, many stand-alone defined contribution funds are collapsing into umbrella funds, and where individually-customised savings accounts are all the rage. The US umbrella funds remind me more of South Africa’s group retirement annuity structures, than of our standard umbrella funds. The appeal of robo-advisors in that world is therefore obvious.

Robo-advisors are also evolving and expanding their business models with more features and more flexibility being launched. Once again, as development takes time, those quick to market have a distinct advantage over companies only now looking at the robo-advisory space.

It was very interesting to see how many of the trends found resonance with our own thinking and with the developments at Sygnia. Sygnia has just launched its umbrella fund, SURF, to complement its Group Retirement Annuity offering and we are launching the Sygnia RoboAdvisor in May 2016. These will work hand-in-hand to offer investors the proposition envisaged by National Treasury in its draft default regulations for retirement funds.

A digital advisor is a perfect ‘retirement benefits counsellor’. However, Sygnia’s business model is more supportive of robo-advisors in that, by offering index-tracking funds managed by ourselves, our asset management fees can cross-subsidise the administration of the umbrella fund and the robo-advisor.

Despite what the advertising billboards have you believe, the financial services industry is shifting. Umbrella funds, robo-advisors and index-trackers all provide a significant threat to the active asset management industry and to the high-cost/high-fee business models adopted by many financial services firms.

You have been warned.

ADDITIONAL NOTES

CEO, SYGNIA GROUP**

Magda qualified as a Fellow of the Faculty of Actuaries (Edinburgh) in 1994. She has over 20 years’ experience in the South African asset management industry and has published widely in the field. She has also served as a board member of the Actuarial Society of South Africa.

She started her career as a product development and investments actuary at Southern Life in 1993, where she designed and managed index-tracking funds, followed by two years at Alexander Forbes as an investment consultant. In 1997 she joined Coronation Fund Managers as Head of Institutional Business and a director. While at Coronation she was responsible for growing the institutional assets under management of the company fivefold. Magda left Coronation in 2003 to start IQvest, a fund of hedge funds company. Later that year, after selling IQvest to the African Harvest group, she was appointed to the position of CEO of African Harvest. Under her stewardship the assets under management of the company grew from R10 billion in 2003 to R35 billion in 2006. After negotiating the sale of African Harvest Fund Managers to Cadiz Financial Services in 2006, she led the management buy-out of the remainder of the African Harvest group which resulted in the formation of Sygnia. Since 2006 she has headed Sygnia as its CEO.

Sygnia Newsletter May 2016