Most investment managers I’ve talked to believe that robo-advisors are the future. It’s easy to see why they think so. In many service industries, new entrants are pushing out old incumbents. The new entrants usually employ sophisticated
technology to cut costs and offer lower prices. The incumbents, for various reasons, are often slow to react, and the new entrants win out over the long run.
This exact scenario has been playing out in the wealth management industry. Over the past few years, dozens of robo-advisors have sprung up, offering cheaper investment advice. They aim to turn a profit by cutting the costs associated with employing human advisors.
Yet robo-advisors haven’t achieved the same smashing success as tech companies in other industries. It has now been 10 years since the founding of Wealthfront and Betterment, which are two of the most successful robo-advisors. A quick Google search reveals that their AUMs stand at $8 billion and $10 billion, respectively. While respectable, that pales in comparison to the AUMs held by large traditional wealth management firms, which generally run more than $100 billion.
It’s safe to say that robo-advisors haven’t driven any traditional advisors out of business, and on their current trajectory, they likely won’t. By contrast, Amazon’s presence was felt in the retail industry by its 10th year of operations, and it pushed Borders Group into bankruptcy by its 17th year.
There’s a good reason why robo-advisors have struggled to dominate. Let me explain that reason by first taking you through my own experience as a fintech entrepreneur.
In late 2012, I started a company called MoneyGeek, which I envisioned would one day become a robo-advisor. But faced with the enormous cost of starting a robo-advisor, as well as the difficulty of raising money, I decided to test the concept first. I set up a DIY service that offered model investment portfolio to see how many people would sign up.
I initially enjoyed decent success. At its peak, MoneyGeek had roughly 300 members who each paid $70 a year. However, I noticed something once I reached 300 users. Growth slowed down substantially, compared to how long it took for the site to go from 100 to 200 users. This alarmed me because it meant I wasn’t getting exponential growth.
All the top technology companies in the world have enjoyed exponential growth, at least early on. It took roughly the same amount of time for Facebook to double its user base from 150 million to 300 million users as it did to double it again from 300 million to 600 million users.
All of these internet giants have achieved exponential growth primarily through word of mouth. Think about how you discovered Google or Snapchat. Chances are, you heard about it through somebody you know. In fact, I can’t name one wildly successful internet product that didn’t succeed through word of mouth.
Unfortunately, word of mouth is very hard to generate in wealth management. Think about the last time you talked to your neighbour about mutual funds or ETFs. I bet many of us, even though we’re in the financial industry, would be hard pressed to remember.
That’s the challenge robo-advisors face in growing their business today. They have thus far grown their AUM through heavy advertising, but it’s unclear that they are getting any return on that investment. They’ve continued to spend those marketing dollars on the premise that once they become big, they’ll find it easier to become bigger.
But what happens if their venture capital investors find out that’s not the case? It’s unclear, but I believe we’re about to found out. Already, the value of Wealthfront is said to have dropped by a third since its last capital raise. Such ‘down rounds’ often spell doom for startups.
Unless robo-advisors solve the word-of mouth problem, I think it’s unclear whether they’ll even be viable. As for me, I decided to shut down my paid membership last year and concentrate on providing custom data and software for investment managers. I’ve found that to be a better business so far.
Jin Won Choi is the founder of MoneyGeek.ca and Enjine.ca, which provides custom data and software for investment managers. He has a PhD in financial mathematics.