This post was originally published by Michael Blanding for HBS Working Knowledge.
Millennials are a disruptive bunch. The first generation to grow up with the internet, consumers born after 1980 are used to relying on technology and engineering to do almost everything—including shopping (Amazon), listening to music (Spotify), communicating with friends (social media), and hailing a cab (Uber).
It seems as if millennials would prefer to avoid face-to-face business interactions when there exists a more efficient way of getting what they want accomplished.
“HAVING GONE THROUGH THE GREAT RECESSION, THEY TEND TO BE MORE CONSERVATIVE WITH THEIR MONEY. THEY ARE GOING TO BE THE ASSET ACCUMULATORS OF THE FUTURE”
A new breed of financial technology companies, known collectively as fintech, has taken advantage of these traits to disrupt an unexpected industry: personal investing. Just as manufacturing companies have replaced assembly line workers with robots, these companies have replaced financial advisors with robo-advisors, which use big data and algorithms to determine the best places to put clients’ money—and appeal to a whole new generation of investors.
Technology replaces the financial advisor
“They have a firm belief that the insights of modern technology can be competitive with someone who is personally advising you, and at a fraction of the cost,” says Luis Viceira, George E. Bates Professor and Senior Associate Dean for International Development at Harvard Business School. Viceira explores this phenomenon in the recent HBS case, The Wealthfront Generation.
Traditional financial advisors cater to baby boomers with substantial savings, requiring minimum amounts for investment upwards of $100,000 to access their services. By contrast, industry-leading Wealthfront and similar firms such as Betterment, Vanguard Personal Advisor, and Acorns have tapped into an underserved market by allowing clients to invest as little as $5,000. Wealthfront doesn’t even charge a fee for assets of less than $10,000—and even after that charges a 0.25 percent fee, as opposed to fees of 2 to 3 percent by traditional firms.
The reason Wealthfront is able to do that, says Viceira, is by keeping costs low. Traditional financial advisors are all about establishing a personal relationship with their clients, understanding their financial situation and walking them through their options. By pursuing a “one-size-fits-all” approach to investing, robo-advisors can eliminate a huge amount of operating costs.
“They have a phone number and an email for customer service, and that’s about it,” says Viceira. “The main way they communicate with customers is through a blog.”
Secondly, much of the cost for traditional financial advisors comes from client acquisition—chasing down leads and making personal visits with potential clients. They also spend considerable resources in traditional marketing, especially the large firms. Those setup costs must be recovered over time through fees. Wealthfront keeps those costs low by finding clients through social media—either through direct ads or referrals by early adopters who post about their services. “Their way to capture clients is through viral acquisition,” says Viceira.
Lastly, fintech firms save costs by outsourcing money management expertise to technology rather than to experienced money managers. “They come from the culture of the Silicon Valley, which is a culture of believing in engineering as a way of solving consumer problems,” says Viceira.
Millennials meet the robo-advisor
That’s where millennials come in. This cohort is ideal for a robo-advisor firm in many ways—first and foremost, because they have faith in the power of technology to solve their problems. (In fact, the Occupy Wall Street generation may be more likely to trust a fintech company than a big New York banking firm.) Moreover, millennials are heavy users of social media, and apt to recommend services they enjoy to their contacts.
Studies also show millennials are financially responsible, with two-thirds of them putting more than 5 percent of their paychecks into savings, the highest rate of savings of any current generation.
“Having gone through the Great Recession, they tend to be more conservative with their money,” says Viceira. That means that they have been accumulating savings, even if they are not yet large enough to be served by traditional brokers. “They are going to be the asset accumulators of the future.”
Lastly, millennials show a “set it and forget it” attitude towards money management, desiring to delegate the responsibility elsewhere so they have more time for their passions, whether that’s their careers, hobbies, or travel.
Despite the big differences in operations, the investment strategy Wealthfront pursues is not dissimilar from a mainstream financial investor. Its portfolio emphasizes a diversification of assets, managed through a portfolio of exchange-traded funds (ETF’s) that track market indexes. “It’s a great way to invest cheaply in a diversified basket of stocks, bonds, and other securities,” says Viceira.
If anything, Wealthfront’s offering is more diversified than typical balanced mutual funds, with 11 categories of investments, including global stocks, corporate and municipal bonds, real estate, natural resources, and treasury bonds. The fund also automatically rebalances itself over time just as mainstream financial advisors and brokers do for their clients—if for example, stocks do very well over a period of time relative to other asset classes and become too large a percentage of the portfolio, the robo-advisor automatically reinvests in the other asset classes to control investment risk, frequently through the reinvestment of stock dividends or the investment of new contributions.
Financial copy cats move in
Most of the strategy Wealthfront pursues is identical for each client; however, it does provide some amount of individual customization through a process known as tax-loss harvesting and asset allocations tailored to the tax status of the client. For example, tax-loss harvesting aims at realizing capital losses that help offset realized capital gains to reduce the amount of capital gains tax paid. Capital gains are computed based on when each individual made contributions to her account and in this sense efficient tax loss harvesting requires customization.
The strategy Wealthfront has pursued has resulted in growth of assets under management from $100 million to over $3.7 billion by September 2016, placing it in the top 100 independent registered investment advisors in the United States. Their diversified portfolios have outperformed the S&P 500 by 40 percent on a risk-adjusted basis. (There have been challenges, too. CEO Adam Nash stepped down in October, replaced by founder Andy Rachleff returning as CEO. Nash retained his seat on the board of directors.)
But regardless of their growth, Viceira argues that perhaps the biggest indication of the success of these firms is the fact that mainstream investment firms have decreased their fees and added their own robo-funds with lower minimum asset amounts in an effort to compete directly with Wealthfront and its ilk.
“They have been clearly disruptive. Most of the big brokers, such as Vanguard and Schwab, have seen that there is a way to address this segment of the market, and developed similar offerings,” says Viceira. “That’s brought this to the attention of not just millennials who have thousands of dollars to invest, but also Gen-Xers who have tens of thousands.”
The bigger issue is whether, as millennials get older and develop more sophisticated investing, tax and estate planning needs, firms like Wealthfront will continue to keep them as customers, or lose them to more traditional firms.
“They are hoping that as millennials grow, the technology will grow with them to continue to offer sophisticated portfolio advice with technological solutions,” says Viceira. “Whether that will happen or not is an open question.”
If it does, then expect more disruption in the financial advising industry in the next generation.