It’s About Automation, Not Fees
Automated investment services are successful because they are automated, not because they are low priced. They are low priced because they are automated, but that’s not why most people choose them.
Broadly, preference for automation is a generational thing, much like music. Baby Boomers who grew up on rock ‘n roll didn’t transition their musical taste to classical when they got older. They were conditioned as a generation to like a particular style of music, and stuck with it. We believe the same is true for the way people interact with the Internet. While older people like the convenience of the Web, they also like talking to people “in person.” In contrast young people who grew up “digitally native” prefer 24/7 electronic access to all of their services over the opportunity to interact with salespeople. Financial services are no different.
The misunderstanding of automation’s relative importance leads most financial service market analysts to label all investment management services with a web front end as “robo advisors.” As we explained in Not Everyone Wants to Manage Their Own Investments, there’s an enormous difference between an investment service that only uses software to help you sign up for an account (what we call a “technology-assisted financial advisor”) and a service that does everything in software (an “automated investment service”). Just because you sign up for an investment management service via the web doesn’t mean it’s automated.
There are five primary ways in which automated investment services automate investment management:
- Account creation
- Account funding
- Portfolio management
- Managing deposits & withdrawals
- Tax minimization
Account creation: It is now very common for investment management and brokerage firms to enable clients to open their accounts online. All you have to do is fill out an online form and hit “Submit.” While this basic function should be standard, many old line brokerage firms like Merrill Lynch still require you to print the completed application, physically sign it and then physically mail or fax the application in. They don’t even offer email as an option! This is a complete non-starter for young people, who may not even own a printer and certainly don’t use stamps. But it makes sense for their audience, who are not digital natives. Mailing in a form is completely natural to clients who are older than 50.
Account funding: You would think every investment management service would allow you to arrange the funding of your account electronically. But surprisingly, that’s not the case. Even Vanguard, which is often mistaken as competing with automated investment services, requires you to attach a cancelled check to your physically signed application and mail it in before they will send micro deposits to your bank account to verify it. Vanguard also requires that you call one of their advisors if you want to add or withdraw funds from your account. This might sound like a small issue, but it’s a big deal to young people who are used to instant gratification from their mobile applications.
Portfolio management: Automated investment services use software to determine your risk tolerance, assign the proper asset allocation and then periodically rebalance your portfolio. In contrast, technology-assisted advisors perform all these functions manually, which inevitably leads to errors and high cost. Computers are much better at performing these kinds of repetitive tasks.
Most articles that describe automated investment services only refer to portfolio management. More specifically, they usually focus on the use of algorithms to allocate portfolios. Interestingly, the algorithms used by almost all automated investment services (also known as Modern Portfolio Theory) were awarded the Nobel Prize in 1990 and are the exact same ones used for decades by the vast majority of the financial advisory industry. It’s the least innovative part of what an automated investment service does.
The Changing Definition of Automated Investment Service
These first three capabilities comprised the initial service offered by Wealthfront when we launched in December 2011. Today they represent the bare minimum of what is required to be considered an automated investment service. Most of the traditional investment management providers who entered the automated service market have delivered these three capabilities, but not much else. They would like prospective clients to believe all automated investment services are alike. But unlike traditional investment services delivered through advisors, automated investment services are based on software and the beauty of software is it should constantly improve over time. As the innovator in the automated investment service space, Wealthfront has continued to advance the state of the art of what can be delivered via software. As a result of our efforts, two new categories of capabilities are beginning to be offered by others:
Managing deposits & withdrawals: Often overlooked by analysts, making simple deposits and withdrawals can involve complicated decisions that automated investment services have eliminated for their clients. When making a deposit, whether small or large, there is a question of what percentage of the deposit should be allocated to which asset class, based on the current state of the portfolio. Even 401(k) plans set a rigid set of percentages, while automated investment services use every deposit to automatically rebalance the portfolio. Withdrawals can be even more complicated without automation. Which shares do you sell to minimize gains and taxes? What assets do you sell to keep your portfolio balanced? Automated investment services automate all of these decisions, so clients can focus on the most important thing: saving regularly.
Tax minimization: This is the area where automated investment services add the most value, but it’s also the area where you see the most variance in capabilities. All 11 automated investment services that we have identified(1) employ tax-efficient index based ETFs, but two incumbents also use their own expensive “smart beta” ETFs or actively managed mutual funds to enhance their revenues.
Surprisingly only 6 out of the 11 automated services offer tax-loss harvesting and not all tax-loss harvesting services provide the same amount of benefit.
Wealthfront took tax-loss harvesting to a new level when it introduced Stock-level Tax-Loss Harvesting, the ability to harvest losses within an index, in December 2013. Surprisingly no other automated investment service has yet been able to offer a Stock-level Tax-Loss Harvesting service.
It is also possible to minimize taxes through dividend-based rebalancing, optimizing asset location in taxable and tax-deferred accounts and intelligently selecting which investments should be sold to fund withdrawals, but only 2 out of the 11 automated investment services, including Wealthfront do.
For more details on the benefits of each of the aforementioned tax minimization capabilities, please see Minimize Your Investment Taxes.
But that’s not all…
Wealthfront is also the first and only automated service to offer what is likely to become a sixth major category: the automated disposition of transferred assets. By this I mean the ability to manage a transferred account in a way that minimizes the taxes incurred when the old portfolio is sold (our Tax Minimized Brokerage Account Transfer Service). You’re not likely to find these at a traditional brokerage, since they are extremely time consuming and costly when performed manually.
Automation makes it possible to provide access to premium investment services that were previously only available to the very wealthy. As we explained in Why Wealth Managers Have High Account Minimums, individual traditional advisors only have the bandwidth to serve 50 to 100 clients. Their fees and account minimums must be high for them to generate the high salaries to which they have become accustomed.
The only way to deliver high-end services to the masses is through software. And software makes far fewer errors at the repetitive tasks advisors need to do on behalf of their clients. Consistent academic research has shown that any attempt to customize clients’ portfolios based on judgment leads to worse returns. There simply isn’t any value to it.
Financial planning is the next service to get automated
At Wealthfront, we believe there are still a number of other important financial services offered by private wealth managers that can be automated. A great example is financial planning. Most people don’t realize that a vast majority of independent financial advisors use packaged software (like Money Guide Pro) to deliver financial planning. The advisor’s primary value added when using this software is inputting the numbers on your behalf. But it’s now possible to automate the collection of your inputs by electronically accessing your financial accounts (with your permission of course).
Data from your financial accounts is much more likely to reflect your actual spending practices, as opposed to what you are willing to admit to your financial advisor. Advances in machine learning will allow us to automatically identify opportunities for you to improve your behavior and offer insights that even a traditional advisor might have missed (please see Introducing Wealthfront 3.0 for more details). But more importantly it will now soon be possible to offer young people an important and valuable service they would prefer to access via software.
Delivering financial services through automation will lead to much lower cost services, but as we noted at the beginning, that is not the point. Younger people much prefer a fully online/mobile experience, one where they can avoid having to talk to someone. The fact that the service is offered with much lower fees and account minimums is icing on the cake. Automation isn’t a “nice to have” for young people. It’s the most important thing.
(1) Acorns, Betterment, Charles Schwab (Intelligent Portfolios), Covestor (now owned by Interactive Brokers), Ellevate Financial (Ellevest), E*TRADE, Fidelity Go (beta), Future Advisor (now owned by BlackRock), SigFig, Wealthfront, WiseBanyan
The information presented here, including but not limited to research, calculations or estimates obtained from Wealthfront and/or other sources is believed to be correct, but Wealthfront does not warrant its accuracy or completeness. Wealthfront does not provide tax advice, and none of the foregoing should be construed as such. Investing carries risk. Past performance is no guarantee of future results.
About the author(s)
Andy Rachleff is Wealthfront's co-founder and Chief Executive Officer. He serves as a member of the board of trustees and chairman of the endowment investment committee for University of Pennsylvania and as a member of the faculty at Stanford Graduate School of Business, where he teaches courses on technology entrepreneurship. Prior to Wealthfront, Andy co-founded and was general partner of Benchmark Capital, where he was responsible for investing in a number of successful companies including Equinix, Juniper Networks, and Opsware. He also spent ten years as a general partner with Merrill, Pickard, Anderson & Eyre (MPAE). Andy earned his BS from University of Pennsylvania and his MBA from Stanford Graduate School of Business. View all posts by Andy Rachleff