Rise of the Machines: Is Betterment a Better Business for Wealth Management?
Betterment leads the fray in a group of financial technology (FinTech) companies known as Robo-Advisers who seek to use automated investment platforms to disrupt the wealth management industry as we know it.
Industry Background
To appreciate the effectiveness of Betterment’s model, it is important to understand it within the context of the wealth management industry. Historically, wealth management involved three parties: the client, asset management firms, and banks. Clients paid financial advisers (employed by asset management firms) an annual management fee (usually a fixed percentage of the assets managed for the client) to assume fiduciary responsibility for the client’s assets. The adviser’s responsibility was simply to make pragmatic investment decisions that would best satisfy the client’s investment goals by selecting the appropriate securities and investment vehicles, which were often created and sold by banks. However, the industry changed as the Glass-Steagall Act of 1933 was repealed, allowing for massive consolidation within the financial industry (Malkiel, 2014). As banks and asset management firms consolidated, perverse incentives arose for financial advisers. Banks pressured advisers to bias their security selections towards in-house products rather than those best suited for their clients. The public became aware of these perverse incentives following the financial crisis of 2007-2008, creating skepticism of financial advisers. Today, asset management firms are becoming increasingly aware of what consumers are demanding:
“One big dynamic we see if the growing demand for truly objective advice. Investors want advisers who are free from bias” – Mark Casady, Chairman and CEO of LPL Financial
Conventional Wealth Management Operating Model
Asset management firms pay an extraordinary amount in compensation to its financial advisers; the annual compensation of the average Vice President FA at JPMorgan was $340,000 in 2014 (PayScale). Their value to the firm is the revenue they generate from their clients. In order to ensure that its advisers justify their hefty expense, banks typically create net worth minimums that a client must satisfy in order to be covered by the firm – they better be able to afford the expensive products if they are going to consume the adviser’s expensive time. At the top banks, these minimums are often $10m in net worth (Barrons). By maintaining such high standards, banks exclude the vast majority of the population from receiving its services; the scale of the business is capped at the population of multi-millionaires, a group over whom all of the banks compete aggressively. Winning these prospective clients over often forces the bank to assume significant client acquisition costs in prospective client entertainment and the research/due diligence conducted to earn their business.
At the end of the day, volumes of academic research suggest that “actively managed” investment portfolios – or those managed by financial advisers, rarely (if ever) outperform “passively managed” portfolios – or those which merely track an index – net of fees (Malkiel, 2015).
Enter Betterment
Betterment leads the fray in a group of financial technology companies known as “Robo Advisers” who seek to disrupt the wealth management industry by using various investment algorithms to manage client assets through proprietary technology platforms. It offers a low-cost, low-hassle solution relative to what is offered by conventional asset managers.
In order to be sustainable, Betterment’s business model relies on achieving substantial assets under management (AUM) to offset the discounted fee it charges clients relative to financial advisers. Its business model is made possible by (and relies completely upon) its operating model.
Why Betterment’s Operating Model is… Better
Automation – By automating the investment process, Betterment has removed financial advisers from its business model, reducing the sizable costs associated with adviser compensation shouldered by conventional asset management firms. Furthermore, its investment process is completely transparent, and is without a financial adviser of whom to be skeptical, addressing the conflict of interest issue of discussed above.
Scalability – Betterment’s technology-driven investment platform allows its business to be incredibly scalable. Each additional customer’s assets are added to the pool and are invested automatically as per Betterment’s algorithms. Consequently, Betterment has nearly eliminated client acquisition and servicing costs (aside from the occasional billboard advertisement), allowing it to charge clients a fraction of what they are charged by the big banks without eroding margins; Betterment charges 0.35% of AUM vs. the 1%+ top private banks charge their multi-millionaire clients (Barrons). With little cost or labor intensity added with each incremental client, Betterment can open its doors to clients with as little as $10 to invest, one one-millionth the size of the minimum account requirement at Goldman Sachs Private Bank (Barrons). By alleviating client minimums, Betterment can target a considerably larger population for potential clients, removing significant limitations in growing its assets under management.
In summary, Betterment’s product offering is a cheaper, more trustworthy solution to wealth management than what is currently available through financial advisers. The success of its business relies completely on its assets under management, which must be vast as it charges a fraction of what competitors charged. Betterment’s operating model removes major inhibitors to achieving that AUM by reducing client acquisition and ongoing service costs. Betterment’s operating model enables a cycle of exponential growth in assets under management – a comparative advantage that threatens the current wealth management industry as we know it.
Sources
Barons, “Top 40 Largest Wealth Management Firms,” http://online.barrons.com/public/resources/documents/BARRONS_TOP_40_LARGEST_WEALTH_MANAGEMENT_FIRMS_2013.pdf
Forbes, “Wealthy Clients Should Beware of Private Banks” http://www.forbes.com/2010/05/24/private-bank-trust-personal-finance-conflict-of-interest.html
Malkiel, Burt. A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (Eleventh Edition), Jan 5th 2015.
PayScale, “Average Salary by Job for J.P. Morgan Chase & Co,” http://www.payscale.com/research/US/Employer=J.P._Morgan_Chase_%26_Co._(JPMCC)/Salary/by_Job
Peter, thank you for sharing. My key issues with the business model are the following: i) no algorithm can ever replace the skill of certain investors, to whom financial advisors play a key role in allocating capital; ii) there are few barriers to entry in creating a portfolio of low cost ETFs (said differently, wealth managers like Schwab and Fidelity are starting competing services already); and iii) roboadvisors only work for individuals without complex investments. I have no doubt roboadvisors can win AUM, but I do not see them taking significant share of fund flows from asset managers.
Insightful points on the scalability of the operating model.
I am an unsophisticated investor with a small amount of wealth. With that out there, I believe Betterment’s model can capture a significant amount of value from users like me, and/or those new to investing money in public markets. As a first mover in this field, Betterment will have to continue to invest aggressively in acquiring new users – there is a significant potential upside in network effects for this business.
It will be interesting to see if Betterment can continue to be successful with their 0.35% fee, in the face of similar, even lower priced offerings with institutions like Vanguard or Schwab’s Intelligent portfolios (which charge no fee, but keep an above-average amount of wealth in cash).