A Better(ment) Way to Invest?
Betterment is reshaping the wealth management industry. Are robo-advisors just a new fad, or here to stay?
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.
Student comments on A Better(ment) Way to Invest?
This is a fascinating article. As someone who uses Intelligent Portfolio, the Charles Schwab equivalent of Betterment, I was particularly interested in your analysis. I think another cause of concern for the robo-advisory model is the initial assessment of a client’s risk profile.
The survey that a client fills out to help Betterment come up with an optimal portfolio could be a limitation. I think it is hard for individuals to perfectly communicate their own risk tolerance to an application. I think that is where a conversation with a fund manager actually might be superior to a robo-advisory model. Without a more sophisticated risk assessment process (i.e. analyzing all of a customer’s financial data which is challenging for many reasons such as privacy), Betterment might be creating and managing portfolios that do not actually optimize an individual’s investments for their particular financial situation. Here’s an interesting article by a skeptic of the robo-advisory model who shares concerns about improperly assessing individuals’ risk tolerance (http://www.thinkadvisor.com/2016/02/17/why-robo-advisors-will-fail-finametrica).
I am also equally concerned about what Betterment will do in the face of competitors like Charles Schwab who are offering no fees at all. I think as the offering becomes more of a commodity, Betterment will have to figure out ways to deliver additional value. One option might be to give people the ability to customize or personalize their investments in some way without jeopardizing the target allocations required to create an optimal portfolio.
Very interesting article on the future of retail finance. While I agree with the above user that your average consumer may not have a very thoughtful understanding of their own risk, I believe that Betterment mostly accounts for that in generally conservative product mixes. What I think ends up being more important is whether roboinvesting’s simplicity adequately lower the barrier for more customers to shift from merely putting their money in savings to higher yielding products – one UK report believes that these FinTech startups could bring 2.5B consumers to these products (http://www.kuarix.com/single-post/2016/05/10/What-SMEs-can-learn-from-Fintech)
AlexShirley – Thanks for the article. In many ways, the robo-advisory trend is a continuation of the broad shift towards passive investment strategies by large investors. Pension funds, endowments, and 401(k) retirement plan have flooded into passive investment funds that track general market indices. In fact, according to Morningstar, over the last 3 years, investors have added ~$1.3Tn to passive mutual funds and ETFs while removing ~$0.25Tn from actively-managed funds. 
Robo-advisors represent the advisory equivalent of passive investments. Similar to advocates of passive investments, robo-advisors tend to cite superior performance over time (eliminating human biases and misaligned incentives), lower fees, and simplicity. But given these characteristics, why do only 1/3 of consumers say they are comfortable using an entirely digitized service as their primary investment advisor?  Do you think robo-advisors can completely replace the role of the financial advisor?
For me, the role of the financial advisor is more than just an allocator of retirement savings (which is easy to digitize). For many savers, the financial advisor also plays the role of life coach and planner. Robo advisors, for example, work great for simple savings plans, but what does a saver do it they need to balance the demands of a growing family, multiple savings goals, and development of an estate plan? I believe that the most successful digital platforms will recognize that technology isn’t the only solution and that there continues to be value in the balance between the efficiencies of technology and the personalization provided by the human touch.
Thanks for the article Alex! Betterment is a fascinating company operating in a rapidly changing industry. The other comments hit on some great points regarding the actual role of a financial advisor and some of the limitations of Betterment in the translation of client risk profiles into portfolio constraints. If more of the money in the capital markets shifts toward index funds and algorithmic investors such as Betterment, I wonder what impact it will have on returns overall and whether this creates a greater opportunity for active managers.
I would love to see how companies like Betterment and other robo-advisors craft their algorithms and investing rules. In the equity market, are they driven by the fundamentals of a business? Do they only look at historical performance or is there a quantitative assessment of future potential based on some analysis? What happens if most of the market behaves predictably or by a set of rules that may be decoupled from real business performance?
When I see companies like BlackRock buy a robo-advisor company, I wonder if they view the acquisition as their future or whether it’s just another offering. I tend to think that in the investing world (retail or otherwise), there will always be a divergence of opinion on the best way to manage money. Further, I think there is more than one way to generate attractive returns. My hypothesis is that robo-advising will grow but only up to a certain point. Traditional methods of management will always exist and play a significant role.
Thanks for the article. When looking at robo advisors, I have always wondered how to differentiate their product offerings on anything other than price. Given the product offering is passive, these algorithms are at risk of becoming a commodity – said another way, am I better off investing with Wealthfront over Betterment? I don’t believe that there is any real differentiation among the robo advisors; while lack of differentiation does not represent a problem during the “land grab” phase of growth, I agree with your view that the technology will likely represent an attractive acquisition target for a larger institution as growth slows. In that context, robo advisors are an interesting development in wealth management, but I do not believe that they pose a true threat to the incumbent players.
Great post. A huge advantage to robo-advisory is their ability to simplify the allocation process for individual investors. Many individuals are clueless when it comes to how much of their money needs to be allocated into stocks, bonds, commodities, emerging markets, alternative investments, or any other asset classes. Fidelity and Vanguard provide resources but the individual still needs to do his or her homework. Betterment, however, gets there by asking a few questions. One concern I have is whether the current performance of the market will affect the ability for robo-advisors to grow. Even though investors should not withdraw their money during economic downturns, it still happens, and I wonder if that will happen to these robo-advisors if the investors are not sufficiently financially literate.
Your question on how quickly robo-advisors need to grow is important given the recent fundraising environment. Betterment and Wealthfront took venture money at high valuations. In order to justify those valuations, they need to grow their assets under management (AUM) rapidly. $6 billion in AUM at 0.25% fees amounts to $15 million in annual revenue. Betterment’s March 2016 fundraising placed the company at a $700 million valuation, or 47x revenues. That’s a high multiple for even a tech company. The only way Betterment can grow their AUM this rapidly is if they reach institutional investors. Pension funds, for example, oversee billions in assets; Betterment needs to convince them to invest at least a part of that in robo-advisory.
If Betterment is unable to do this, then, as you mentioned, they would be an acquisition target. In addition to BlackRock’s acquisition of FutureAdvisor, Northwestern Mutual acquired LearnVest — which was founded by an HBS student — in March 2015. The larger money managers could not only expand the reach of these robo-advisors, but also they would have the reputation and clout needed to get the institutional investors on board.
Alex, great article. I have followed the growth of Betterment very closely (you may have notice me sporting a Betterment t-shirt every now and again) as my cousin runs their legal and biz development teams. We have had many discussions over the business models, and you article has certainly picked up on some of the main benefits and challenges the company itself thinks it faces. In particular, the low barriers to entry to replicated Betterment’s value proposition seems to be a particularly salient challenge to future Betterment customer acquisition and market share growth.
Another concern I have identified is the changing perception of the value proposition over time. Passive investment strategies such as those provided by robo-advisers are certainty seeing an increase in popularity. In my mind, this is related to the historically poor performance of actively managed portfolios as well as the recent turbulence in financial markets. Over time, it has been show that actively managed portfolios under-perform market indexes and other passive strategies. However, almost all of Betterment growth has taken place in a period of high returns in equity markets. As a result, customers have recognized immediate returns from the investment strategy. I wonder if, however, the next market downturn will lead an exodus away from passive funds and market index ETFs as short term returns become negative. While long term performance would not be effected, I wonder how consumers would reactive to negative returns in their passive investments, and whether they would stick out the downturns or withdraw their money. Would love to hear your thoughts on this.
Alex, thanks so much for sharing this. I understand the appeal of Betterment, particularly for younger folks who have wealth but enough amassed to retain a financial advisor through a high net worth client advisory business. But, I definitely have some concerns around a standalone robo-advisor model.
For one, my understanding is that financial advisors do so much more than just allocate their client’s assets between classes of securities. FAs advise on planning for taxes, retirement, paying for your kids’ college expenses, and more. I would almost argue that in the best advisory-client relationships, the FA serves as a sounding board not just on financial matters but also on life. How do you manage your finances if you’re planning to have a child? What if the markets are tanking, and, with no one to stop you, you react in a knee-jerk fashion and sell everything at the very bottom? What if you don’t eve know what questions to ask? Betterment and Wealthfront simply allocate money between investments and provide little or no context around those decisions – and many times, a little bit of handholding and a personal touch can make all of the difference.
I also share concerns around commoditization of robo-advising. The actual economics of the business model aren’t great. Per the CNBC article linked below from a few months ago, Betterment sports an average account size of $27k and, due to its fee structure, makes less than $100 per account every year. A Morningstar equity analyst, Michael Wong, believes that, given a customer acquisition cost of ~$1k per client implying the need to retain a customer for over a decade to break even, Betterment’s economics aren’t promising. The flow of venture capital into the robo-advising space in the last year also speaks volumes about how sentiment has changed around the concept. I think that large wealth management firms like Schwab, Fidelity, and Morgan Stanley Wealth Management already have the scale. And, if they can successfully embed components of the robo-advising experience into their current human-based financial advisor relationship, they will emerge the ultimate winners.
Great article. As the article and a number of comments have pointed out, it’s hard to tell what the value proposition of a specific offering is in this space versus their competitors. One thing that has surprised me in this space is that raters have not started reviewing and posting about the performance of these products. I envision a system sort of like what is done for mutual funds, hedge funds, etc. Where a user could see how the algorithms a specific company uses compare, and provide easy access to annual reports and such.
Great article. I think that there is definitely a space for algorithm investments for retail investors since some Hedge Funds currently use algorithm investing as their primary method of investing. I do agree with you, I wonder how they can differentiate their product? Since most investors deploy similar strategies to investing, is it possible for them to truly create and edge for their customers? Also, I was skeptical about the automatic adjustments to the portfolio because I know that some investors try to keep their security for longer than one year to take advantage of the long term capital gain tax, but I was please to read that the Betterment algorithm takes taxes into account (https://www.betterment.com/resources/investment-strategy/taxes/investment-switching-costs-calculate-your-costs-and-benefits/).
I’m also curious about their ability to keep their cost structure low if they start looking to grow the company and acquire more customers. I wonder if the need to grow will force them to spend more on marketing, leading them to operate with smaller margins?
Great article, and this is a topic I’m very interested in as well. I do agree with the above questions about the long term viability of Betterment. Betterment really doesn’t offer anything much different than an index fund does, except the index fund charges lower fees. The concern for me over Betterment is it just seems too vulnerable to competition – there are other robo-advisors that do the same thing, potentially for lower fees, and customers could easily choose to DIY the offering. I do wonder if this is a case where digital disruption went too far to the extreme, and Betterment could benefit from more of a human touch.
Betterment has a rather interesting value proposition. It is great that they simplify investing and I think for younger less sophisticated clients that works. The question is then, do those clients have enough money to invest, and over what time horizon. I imagine that by the time such investors become higher net worth clients they will want to have a human adviser. I think the robo-adviser model works for people who are rather unsophisticated investors but I would imagine that as one has more money to invest they would move away from such a model. At best I see Betterment as a tool which works for the younger generation, but expect that they would turnover clients at a high level.