By Max Biesenbach, Director, Simon-Kucher & Partners Strategy & Marketing Consultants and
Alfons Gudmundsson, Consultant, Simon-Kucher & Partners Strategy & Marketing Consultants
Robo-advisors are gaining momentum with exponential asset growth forecasted in coming years. Increased price transparency under MiFID II (Markets in Financial Instruments Directive II) will reinforce the threat robo-advisors pose to traditional advisors. To respond effectively, private bankers and wealth managers need to develop more differentiated propositions to better communicate the value they offer and thereby better justify their fees.
“Adoption of robo-advisory services is accelerating.”
The number of robo-advisory firms has increased in the last two years. Their combined market share has grown even more rapidly, in line with increased trust for digital banking services. Their simple, transparent and low-cost business models have gone beyond the “advisory gap” to attract assets from more affluent segments, disrupting the traditional wealth management business. Since 2016, the robo-advisory market has nearly tripled in size, reaching $600 billion this year. By 2020, the market is expected to expand to $3,700 billion assets worldwide.
Before assessing the threat, it is important to understand the role robo-advisory plays within the wealth management industry and what services it aims to disrupt. When evaluating business models of established robo-advisors across Europe (such as Nutmeg, Wealthify or Scalable Capital), it is arguable that the term “advisory” is misleading. Existing robo-advisors do not advise clients on their investments but take full discretion over investment decisions using automated algorithm-based investment processes, accounting for clients’ risk profiles and investment objectives. Therefore, the business model is more comparable to a traditional discretionary management solution – more specifically, modelled portfolios aimed at addressing defined risk classes. Here, digital investment manager would be a more appropriate term.
However, hybrid business models for which the term advisory is more accurate do exist. Sigmastocks, a Swedish fintech company, also applies an algorithm-based approach to identify investment opportunities. However, instead of executing trades for its clients, Sigmastocks provides recommendations on how investors can construct their own diversified single-line equity portfolios. Investors then decide whether to follow the advice or not. Since discretionary solutions do not appeal to everyone, more hybrid solutions such as Sigmastocks will likely emerge as advisors pursue new markets and segments.
The desire of robo-advisors to tap into wealthier segments to grow their assets under management (AUM) more quickly is a trend already seen in the United States, with the likes of Betterment, Charles Schwab and Wealthfront. These firms have enhanced their business models beyond “digital only” and brought human intervention back into the game. These new hybrids combine the benefits of automated investment solutions and traditional financial planning, enabling them to cater to more complex financial needs. This confirms that human interaction is still fundamental in establishing sustainable business models for the future. This development increases the threat that disruptors pose to traditional advisors beyond discretionary services.
“New regulations put pressure on banks’ margins.”
The main competitive advantage of robo-advisors is their low, simple and transparent pricing, facilitated by their low-cost business models. In contrast, the pricing of services provided by banks and wealth managers is still perceived as vague by many investors.
The introduction of MiFID II in January 2018 aims to improve client protection through increased transparency on both investment performance and fees. This will force banks and wealth managers to “expose” their charges to a greater extent than today. Not only will service fees (such as management, transaction and custody fees) become more accessible, but product fees of underlying mutual funds and ETF (exchange-traded fund) holdings will have to be reported as well. Currently, since asset managers’ product fees are deducted from the returns of the underlying investments, they are not clearly visible to the investor holding the assets. As a response, there is an industry fear that funds flowing into robo-advisors will accelerate as more clients realise the actual price they currently pay for services with their traditional providers.
Simon-Kucher & Partners conducted a pricing study (Figure 1) on the average annual service and product fees (TERs) for a £500,000 example portfolio charged by robo-advisors and traditional providers in both the United Kingdom and Switzerland. It revealed a price difference of up to 178 basis points—a gap which widens when compared to classic and bespoke discretionary mandates offered by traditional providers. Furthermore, some mutual funds charge TERs that exceed 200 basis points, extending the gap even further. As awareness of fees increase, this substantial price difference will ultimately create downward pressure on fees and squeeze margins for traditional providers as more clients begin to anchor the cost for obtaining investment “advice” to robo-advisors’ price levels.
However, with the right strategy in place, traditional providers can respond effectively to the threat of robo-advisors, both in regard to protecting and acquiring new assets while maintaining margins—even in a post-MiFID II world.
“The solution to combatting low-cost disruptors is a three-step strategy to identify, deliver and communicate value.”
As a response to the growing threat, several banks and wealth managers have already launched or are about to launch their own robo-solutions. However, just introducing a robo-proposition will not solve the problem, only create issues elsewhere. Adding a low-cost proposition to a traditional service portfolio bares the risk of cannibalising margins and diminishing the value of customer relationships due to the limited engagement required by an automated service.
The many complexities surrounding wealth management services often makes it challenging for clients to fully realise the value they receive from their private banker, financial planner or investment manager. Therefore, to successfully respond to the threat of low-cost disruptors in a time of increased transparency requirements, traditional providers should follow this three-step approach to adapt their commercial strategy:
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Develop a differentiated service offering: A robo-advisory solution should be part of a wider proposition overhaul, where a well-differentiated and harmonised proposition should be designed around a client’s “real” needs. A Good, Better, Best structure with clear distinction of the value offered in each service level will make it easier for clients to what proposition most accurately reflects their personal needs. Today, banks often include too many service features, several of which are perceived as redundant by some client segments. A targeted focus on key value drivers and deemphasising the rest will make it easier for clients to understand the proposition, and realise its value.
Apart from targeting digital-savvy individuals, the role of a robo-solution should primarily be to provide an emergency exit for the most price-sensitive clients. Those migrating to a robo-solution will benefit from lower prices, but at the expense of receiving a highly restricted service, a price-value trade-down that clients should not be willing to make.
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Align price with value: With mounting price pressure following MiFID II, it is increasingly important for wealth managers to justify their fees to protect current price levels. To achieve this, a sustainable price model, including both existing and new price points, must be developed.
An aptly differentiated service proposition with appropriately calibrated price points will create a clear price-value relationship that clients understand. As a result, clients’ willingness to pay will increase as they realise the value that they receive is more in line with their personal needs.
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Enhance value communication: Investment management, investment advisory and financial planning are all complex terms, terms clients generally struggle to differentiate between. This is partly due to the industry’s poor value communication. Developing a unified and client-friendly value message through which RMs (relationship managers) have value-based arguments for every price point charged, combined with an internal peer-pricing scheme, will promote RMs’ abilities to offer clients the right services while reducing discounting pressures. Improved value communication and value selling play an integral part of future business success.
By successfully implementing this three-step strategy of identifying, delivering and communicating value, traditional providers will be able to both protect and grow assets, while preserving profit margins, even at a time when humans compete with robots to manage the assets of the rich.
Appendix: Robo-advisory benchmarks
References: Meola, A. (2016). “Robo-advisors have a $2 trillion opportunity in front of them”. Business Insider (2016). “Robo Advisors vs. Human Financial Advisors: Why Not Both?” uk.businessinsider.com