Markus Schuller, founder of Panthera Solutions
The OECD Financial Roundtable on October 27 gathered together 20 representatives from the banking industry, fintech companies, and other financial services, as well as trade unions and other experts, in addition to the OECD delegations. The topic Fintech: Implications for the shape of the banking sector and challenges for policy makers allowed for an intense debate, especially among the 20 mostly private sector participants.
Ironically, both Fintechs and big banks lobbied for level playing fields, arguing that the respective “other” benefits from a regulatory advantage. It also became evident that the big banks try to justify their existence by highlighting their large capital and client base, expressing interest in cooperating with Fintechs by offering scalability. The latter is claiming to add a moment of disruption to financial services, opening it to a wider audience by democratising financial services. Whether the race is decided through competition or cooperation, regulatory “sandboxes” were presented as appreciated tools to level the playing field for both.
At Panthera, we are asset allocation specialists. As such, the Fintechs named Robo-Advisors in the field of asset management are of most interest for us. Inspired by the OECD FRT, we looked at whether Robo-Advisors deliver on the promise of adding a disruptive moment to our market segment. For that purpose we introduce two asset allocation penalties as indicators of disruption.
As we concluded in our article “Man at the centre of the investment decision”, the underperformance of professional investors versus the market portfolio is dominated by two structural factors, cost penalty and behavior gap penalty. Cost penalty is defined as the amount of under-performance caused by transaction costs, management fees, distribution fees, etc. Behavior gap penalty is the contribution of the human factor to a biased perception of reality caused by cognitive dissonances. Indicators of the penalty along the investment process can be certain market timing techniques, the application of flawed portfolio optimisation techniques, minimising career-risk as primary objective, and other expressions of cognitive biases.
As highlighted in a previous article, professionals managing other people´s money like regional banks, private banks, wealth managers, investment companies, (multi-) family offices, etc. are confronted for the first time in decades with a situation that forces them to:
- either grow aggressively in size to play a shaping role in the industry´s concentration process
- take on the competition with Robo-Advisor Fintechs in offering low-cost, fully automated wealth management solutions
- position themselves as leaders in an investment management niche via an innovation-driven competitive edge
- or accept to be squeezed out of the market.
Options 1 and 2 are out of reach for most of the investment service providers listed above as they are too small, too conservative, and/or too loaded with overhead costs. Assuming they want to survive, Option 3 is the only one left for the vast majority of professional money managers.
If Option 3 it is, getting trapped in pseudo-innovations like risk parity will be insufficient. Consequently, a learning organisation with a continuous improvement cycle is a prerequisite for establishing and maintaining the innovation-driven competitive edge of an investment process in the chosen niche. Many will not manage to reinvent themselves.
Like Big Pharma during the 2000s, which benefitted of windfall profits due to rent-seeking oligopolies, the asset management industry is increasingly dominated by a handful of multi-trillion-dollar players like Vanguard, BlackRock or State Street. Big Pharma was compensating its lack of innovation ability by re-investing its windfall profits into biotechs, refilling its product pipeline with the ideas of promising start-ups.
We see similar patterns occurring in the asset management industry, where Robo- Advisors convert from stand-alone B2C (business to consumer) providers to either white-label B2B2C providers or useful take-over candidates for the big players. With Vanguard launching its Personal Adviser Service already mid 2014, Charles Schwab following with its Schwab Intelligent Portfolios in 2015 and BlackRock taking over FutureAdvisor shortly after, the big players benefit from the momentum of digitalisation.
Here, the weakness of the Robo-Advisory start-ups become obvious. Their offering is lacking the disruptive element. All they offer is a more compelling user interface as improved distribution channel, lower production, and end-consumer costs compared to traditional money managers. In that, they are powerful enough to put pressure on the small-to-medium sized money managers, but have no leverage on disrupting the industry’s oligopoly. The explanation lies in four reasons:
- Robo-Advisors help investors to minimise their cost penalty. By still relying on traditional portfolio construction techniques of the first generation (Mean-Variance Optimization, MVO, etc.), they are offering identical services like thousands of established money managers. As such, they don’t offer disruptive innovation at the head of the asset management industry, but simply an evolution of presenting those methods – user interface – and distributing them differently – cheaper fee-model and no intermediaries along the distribution channel. Having talked to several Robo-Advisor executives, their responses can be summarized as: “we definitely have other issues than the portfolio construction methods used”. They consciously ignore, that, although their traditional techniques have been performing well since 2009 through a historical anomaly, they failed in raising significant assets under management because they lack competitive edge in portfolio construction.
- Related to reason 1 – neither the big players nor their emerging rivals are significantly reducing the behaviour gap penalty. Their rebalancing and cost average techniques are helping investors to apply some self-discipline. Though this does not hold investors back from overruling those techniques in times of turmoil, when the pro-cyclical temptation is shown to be the highest. This blind spot on the behaviour gap penalty is explained by the first generation portfolio construction models used, as for those, the human factor in investing does not exist. Unsurprisingly, this is less of a problem for the big players, given that the start-ups are not challenging them with taking the lead.
- The big players remain more competitive than Robo-Advisors because, while applying identical portfolio construction techniques, they can offer their advisory services even cheaper by still making money on the investment products chosen or through transaction fees. Charles Schwab, for instance, manages to charge zero fees for their Robo-Advisory service. It cannot get cheaper than that. Furthermore, the big players can scale their Robo-Advisory business through their enormous asset base.
- Both the big players with their Robo-Advisory front-end and the Robo-Advisor start-ups acknowledge in the meanwhile that retail and institutional investors need to have a human client advisor as back-up. By responding to that need, both are either hiring client advisors themselves or offering white label solutions of their platforms to RIAs/IFAs (registered investment advisors/independent financial advisers). Given the stronger balance sheets and better scalability of brand and existing customer base, the big players with Robo-Advisory front-ends enjoy a competitive edge.
In short, Robo-Advisor Fintechs are currently not revolutionising the asset management industry as they lack a disruptive element, but are helping accelerate the concentration process to produce even larger players.