For years, financial institutions have used the same formula for attracting new customers. Be at the right place at the right time, and you’ll likely have a customer for life. The “right time” meant having the right set of products to serve a person at major life inflection points. When someone is looking to buy a house, be there with a mortgage at competitive rates. The “right place” meant having branches in as many places as economically feasible, as people value face-to-face interactions when conducting important financial transactions.
This formula is being disrupted, putting the traditional financial service industry at an inflection point of its own. First, the financial crisis of 2008 created an enormous rise in the distrust of traditional banks. In fact, even 7 years removed from the crisis, only the media is less trusted than the banking industry1. Second, due to the proliferation of digital technology, the “right place” now means a mobile app available on demand. Given these circumstances, people are willing to give Financial Technology (FinTech) startups a chance – and they have grown rapidly. For example, Venmo, a peer to peer payment app, handled $7.5 billion in transactions in 20152.
Betterment is another such FinTech startup, and has taken a chunk out of the wealth management industry, currently managing over $6 Billion in assets for customers3. On the surface, $6 Billion does not represent an existential crisis for traditional wealth managers. What has traditional wealth managers scared is that Betterment has dramatically undercut management fees by using computer algorithms to manage money.
Betterment’s Value Proposition
Betterment’s business model has two components, each being conceptually similar to historically available options. First, investors set their risk tolerance, and Betterment will create a portfolio to provide optimal returns given the level of risk desired. Second, as the market shifts, Betterment adjusts the portfolio to retain desired risk levels. Alone, these offerings are not entirely dissimilar from passively investing with a low-cost provider such as Vanguard, or using a traditional advisor to make portfolio changes.
The innovative component is the blending of these two models. Using a set of complex algorithms, Betterment automatically reallocates a portfolio so that investment objectives are maintained. The usage of algorithms – or robo-advising – has a variety of benefits over traditional wealth management:
- Lower Fees: Traditional wealth management advisors typically charge between 1-2% on the overall account balance. Betterment has a significantly lower fee structure, charging between 0.15-0.35%. In an account with a $100,000 balance, this accounts to nearly $2,000 in one year.
- Enhanced Precision: Compared to a traditional broker executing transactions, robo-advising has a higher level of precision. Automatic reallocation is just that – automatic. Additionally, the element of human error is removed once the algorithms have been perfected.
- Scale Benefits: Betterment’s business model results in a negligible marginal cost to serve additional customers. While not a consumer-facing benefit, this scalable business model allows Betterment to keep fees low as it adds more customers.
Outside of the algorithms, Betterment has a very intuitive and easy-to-use mobile platform that fits nicely with their target segment – investors who are comfortable using technology for important activities. A best in class mobile app is a necessity for this group.
Cause for Concern
It is difficult to question Betterment’s initial success given its rapid growth. There are, however, valid questions to the long-term sustainability of the business.
How large will the demand for robo-advisors grow?
- Regardless of the benefits of robo-advisors, many people feel more comfortable having a person that they trust manage their money. The flash crash of 2010 offers a precedent for computer-driven market swings, which limits the number of investors that feel comfortable putting their money in the hands of a computer.
How defensible is Betterment’s value proposition?
- There is nothing stopping other FinTech players from replicating the business model and competing on cost. Not surprisingly, Wealthfront offers a similar set of services as Betterment, and charges a flat fee of 0.25%4. As the industry matures, there will be margin pressure, restricting profitability and growth.
The Future of Robo-Advisory
The established wealth management industry is already reacting to the threat of robo-advisors. Charles Schwab, with $2.65 trillion in assets under management, has created a similar offering that already manages $5.3 billion6.
Larger retail banks, such as Chase, have been slower to act. As later players to the game, some will seek to acquire FinTech players versus embarking on the time-consuming task of building the capabilities internally. This process has already started, with BlackRock acquiring FutureAdvisor in late 20157.
Betterment will likely be one such acquisition. Being a component of a larger financial institution will help further drive scale, potentially enabling further fee reduction in an increasingly competitive industry.
 De Cremer, David (3 March, 2015). “Why Our Trust in Banks Hasn’t Been Restored”. Harvard Business Review. https://hbr.org/2015/03/why-our-trust-in-banks-hasnt-been-restored. Retrieved 17 November 2016.
 Del Rey, Jason (27 April 2016). “Venmo is growing ridiculously fast”. Recode. http://www.recode.net/2016/4/27/11586488/venmo-is-growing-ridiculously-fast-q1-2016. Retrieved 17 November 2016.
 Betterment Company Website. https://www.betterment.com/. Retrieved 17 November 2016.
 WealthFront Company Website. https://www.wealthfront.com/. Retrieved 17 November 2016.
 Charles Schwab Company Website. https://aboutschwab.com/investor-relations. Retrieved 17 November 2016.
 Hunnicutt, Trevor (6 Jan 2016). “Schwab ‘robo adviser’ grows to $5.3 billion in its debut year”. Reuters. http://www.reuters.com/article/us-charles-schwab-automation-idUSKBN0UK2GA20160106. Retrieved 17 November 2016.
 Sharf, Samantha (26 Aug 2016). “BlackRock To Buy FutureAdvisor, Signaling Robo-Advice Is Here To Stay”. Forbes. http://www.forbes.com/sites/samanthasharf/2015/08/26/blackrock-to-buy-futureadvisor-signaling-robo-advice-is-here-to-stay/#2593320d2294. Retrieved 17 November 2016.