Editor’s note: Bo Lu is the founder of FutureAdvisor.
Shane Leonard recently wrote a doomsday post on this site about robo advisors, whose rapid growth has made the behemoths of finance take notice.
Now that robo advisors have shown there’s a market for low-cost, online investment management, Leonard predicts that the industry’s incumbents will copy robos’ technology and offer similar services at little to no cost, essentially wiping out their nascent rivals.
While that has happened in sectors like online banking, a close look at wealth management shows Leonard is wrong for three reasons: incumbents are slow to start because digital financial advice cannibalizes their existing businesses; they face deep conflicts of interest as advisors; and not enough human experts exist for them to serve middle-class families, where robos dominate.
Leonard cites two examples: One is Charles Schwab, the discount broker and asset custodian, which said last July that it would offer online investment management for free sometime this year. Another example is Vanguard, which came out with its Personal Advisor Service last year, and plans to make human financial advisors available for inexpensive webcam consultations.
Schwab and Vanguard are both great companies, but several structural issues prevent them from competing effectively.
Racing for Product and Killing a Golden Goose
Let’s take Schwab: It mooted its free robo-advisory service in July. Three months later, it formally announced the same service. Seven months later, no service.
Every day that Schwab doesn’t launch demonstrates the disadvantage large companies have competing against startups in the short-term. It’s not the product or engineering ability that slows them down, but the dissonance within an organization acting against its own interests.
Creating a great robo-advisory service undercuts human advisors. That puts incumbents like Schwab at odds with the human advisors who custody assets with them (if those advisors leave, Schwab loses money). So incumbents must manage an internal conflict, and Schwab’s strategy will need all the careful attention of their very smart CEO, Walt Bettinger. They’re walking a very fine line.
In the short run, Schwab is trying to sidestep the conflict by announcing direct-to-consumer robo advice and a re-brandable version for human advisors. That could work. Early disruptive products are always worse than the incumbents by some measures. But as the disruptive product improves and closes the gap between low-priced robo advice and human solutions, a company providing both will be more and more at odds with itself.
Startup engineers don’t have incumbent problems. Their very newness preserves them from internal conflicts such as these and the structural traps of established businesses.
When a Service Is Free, What’s Being Sold?
Both Schwab and Vanguard have investment funds to sell. An advisor who looks at all available options and suggests the best to her clients is objective. An advisor who looks at 5 percent of all available options (say, in-house funds) and suggests only those is a salesperson. If Pizza Hut owned Yelp, or if Marriott owned TripAdvisor, would you trust them to give neutral advice?
As with Google and Facebook, when the service is free, the users are being sold. A free service like Schwab’s can give away advice only because users are being sold Schwab funds at a profit.
In the short-term, startups’ advantage is speed; in the long-term, it’s flexibility. In five years, the killer personal finance app may not be robo advice at all, but a service that crosses sectors and combines many other services. A neutral startup acting as a third-party aggregator of financial products has a better chance of building that all-embracing solution.
Too Few Human Experts
The financial advice industry has never served the American middle class because not enough human financial advisors exist, and those that do make much more money serving millionaires than “thousandaires.” What’s worse, traditional advisors are failing to reproduce themselves as a profession: they simply can’t fill seats in the firms.
So where will Vanguard find all these cheap experts on webcams to serve the middle class? Why didn’t someone think of this before? Because young advisors can make more money serving the super wealthy and charging 1-3 percent, as they always have. (The industry minimum is half a million dollars just to take a client.)
The average human advisor can serve between 75 and 125 clients per year. Our firm has 40 employees and 200,000 users (about 5,000 per team member). That’s scaling, and human experts just can’t do it like software can. That’s why a team of advisors cobbled together by an incumbent can’t compete for less wealthy investors: the overhead is too damn high, the human capital too scarce.
Robo advisors exist because only software can serve the middle class and break even.
Leonard shows a lot of misconceptions about the robo advisory space. He’s saying we’re all competing fiercely with each other. In fact, robo advisors are all racing across the green field of clients that have never been served by the incumbents. This is a vast, untapped, multi-trillion-dollar market. Our main competition is simply the fact that most people don’t know that low-cost financial advice is accessible.
Why Startups Are Eating Finance
Finance, like the media, is made of bits. Other sectors make cars or washing machines or porcelain, which the Internet can’t copy and algorithms can’t generate, but the products of finance travel over wires and live in databases. More than any industry besides publishing, finance is ripe for disruption.
In fact, software companies have already tackled one financial vertical after another. E*trade and Scottrade disrupted discount brokerage online in the 1990s. PayPal, Square and countless others have disrupted payments. Lending Club and Kickstarter are disrupting consumer loans by helping individuals raise capital.
A bunch of structural constraints in wealth management hobble incumbents. It’s in these situations that disruptive startups have a chance to thrive.