My Robo Advisor was an iPod – Applying the Lessons from Other Sectors to FinTech Disruption
By Paolo Sironi
Thought Leader, Wealth Management Investment Analytics, IBM
FinTechs are hitting the headlines for their potential to disrupt banking services, unbundle financial institutions, and tear down barriers to entry by means of digital weapons.
Within the FinTech ecosystem, robo advisors have gained momentum to advise or manage private wealth at the expense of established institutions and are poised to become the new price-makers of the banking relationship. They first appeared around 2010, and leapt to the top of the chart of disruptive innovation a few years later due to a set of concurrent factors:
- A change in market regulation to favour fee-only advice, which is affecting global markets;
- A significant growth in assets under management that robo advisors could harvest in a relatively short time;
- The recognition of appealing not only to low-margin clients, but also to affluent and high-net-worth investors, which were previously thought to be an exclusive target segment of traditional more expensive advisory firms.
Yet, not all FinTechs addressing personal finance can be classified as robo advisors, and not all robo advisors are pure FinTechs.
“What is a robo advisor?”
The terminology “robo advisor” is quite journalistic: they are not always robotic, nor do they always provide advice.
Robo advisors (1.0) are automated investment solutions which provide automated portfolio rebalancing using trading algorithms based on passive investments and diversification strategies, which engage individuals with digital tools featuring advanced customer experience, to guide them through a self-assessment process and shape their investment behaviour towards rudimentary goal-based decision-making. It follows that robo advisors must display at least some of these four elements, if not all of them:
- Provide full digital access;
- Perform automated portfolio rebalancing;
- Adopt indexation or passive management;
- Personalize to customers’ goals and behaviour.
“Is robo technology truly disruptive?”
We will answer this question by referring to the theory of innovation, which enables us to establish a parallel between the iPod’s disruption of the music industry and the game-changing nature of robo advisors in banking.
First of all, we do not confine technology to a concept linked to the usage of algorithms or digital instruments (e.g. tablets), but we define technology as any process by which a firm (e.g. a bank) transforms information and data, human labour, or economic capital into products or services of greater value. This is of the utmost importance because most banking transactions are essentially “immaterial” and we can ascribe to the technology concept the three elements of digitalization, automated portfolio rebalancing, and goal-based investing (GBI) principles. We will explain why the latter plays a key role in the evolution of robo advisors.
Second, technology evolves continuously inside and outside individual firms. The introduction of new technology modifies the way firms operate and the way consumers access services and products. Therefore, we use the term innovation to indicate any change of existing technology used by a firm and recognize that such a change can take two forms: disruptive innovation or sustaining innovation:
- Sustaining innovation refers to any improvements in product performance, being of incremental nature or more radical, that allow a firm to increase the quality of its offer, to fend off competition, or to increment commercial margins, by operating either at lower costs or with higher affordable prices. Structured finance or hedge funds would be some examples.
- Disruptive innovation instead might well result in worse product performance, at least in the near term. Such revolutionary products are usually cheaper, simpler, or more convenient to use and appeal to new customers or create new needs in existing clientele.
Robo advisors classify as disruptive technology because they are cheaper than traditional advisory services, they are simpler to access, they appeal to new customers, and create a new need among existing clientele.
Goal-based investing, which robo advisors represent in a rudimentary fashion, is instead a case of sustaining innovation, which will grant the smarter robo advisors the opportunity to move outside the disruptive though unpleasant corner of low margin businesses and achieve margin-driven growth over time.
Traditional firms typically face two challenges in their lifetime: deciding how much investment needs to be dedicated to sustaining innovation and, most importantly, recognizing which disruptive innovation can be the main reason for failure or success of established brands, although such innovation might seem to be anti-economical in the near term. Banks are not excluded from the need to solve this dilemma.
“How do sustaining and disruptive innovation interact to shape the future of banking?”
According to Clayton M. Christensen,1 there is a relationship between innovation and industry/product performance over time (i.e. the quality of banking services): there seems to be a fixed amount of innovation that a regular customer can absorb, all industries being equal, hence a capped amount of money that investors are willing to pay to receive better products or services. Clearly, not all investors are equally constrained, which permits banks to tier their offers across different segments: retail, affluent, high-net-worth (HNW) and ultra-high-net-worth (UHNW). This is represented in the following Figure.
Figure: Innovation and industry/product performance over time
Yet, time goes by, industries evolve, technology changes, and so does investors’ behaviour. Thus, markets or segments can saturate: no further innovation can lead to higher commercial margins. This is when disruptive innovation, such as robo advisors, has the highest chance of succeeding. Initially, disruptive solutions are seen as a phenomenon confined to less appealing low margin clients (e.g. retailers) or distant markets (e.g. emerging economies). But disruptive innovation can downshift the product paradigm globally, across markets and segments, so that customers start favouring the new solutions and move en masse towards new offers. This can displace established players who have no time to adjust their traditional workflows or business models. Market leaders become laggards (e.g. Nokia) and new entrants gain momentum (e.g. Apple) and start climbing the hall of fame of successful brands. Thereafter, the cycle of sustaining innovation re-ignites and successful firms can achieve higher commercial margins by improving once very simple disruptive products.
To exemplify why robo advisors have all the potential to be disruptive technology, we can briefly discuss what happened in the music industry, when the iPod was first launched.
The first Compact Disc (CD) player was sold in Japan by Sony in 1982. The CD levelled up the music industry by setting a higher standard and inducing fierce industry competition by means of sustaining innovation. A period of tech spending involved a large number of consumers who were buying new appliances offering higher levels of sophistication. Within a decade, many households were equipped with advanced High Fidelity sets (Hi-Fi) featuring equalizers, subwoofers, powerful amplifiers, and fancy head-sets that parents were willing to buy to reduce noise late at night. Soon, individuals reached a peak point in consuming satisfaction, and in the late 90s they could not possibly justify paying higher prices for a declining marginal improvement in music quality. The music market saturated.
Steve Jobs grabbed this chance and in 2001 launched the Macintosh version of iTunes and the first Apple iPod (think of a robo advisor). The key selling point of the iPod was not better music quality compared to existing CD players. The fact is that the product was cheaper, more portable, and certainly cooler than CD players. Those who thought that it would have been a phenomenon confined to young consumers, walking up and down the streets with white cables in their ears, were proved wrong. The era of the Hi-Fi was over, the traditional way of buying and listening to music was disrupted and changed forever. Most importantly, today the dependence of Apple’s revenues on iPod sales is very limited, as Apple entered a new wave of sustaining innovation to release higher margin services and devices, such as iPhones and iPads up to the Apple Watch in 2015 (think of GBI).
“What does this tell us about the fate of wealth management?”
Digital trends are a mix of technology advances and changes in consumers’ behaviour which are facilitating the creation of new entrants to compete with traditional banks. Robo advisors are FinTechs which attempt to democratize advisory services that have always been an exclusive privilege of private banking institutions. They started to target retail investors needing financial advice, but lacking the resources to pay for the required services. With an entry level investment of around US$5,000, robo advisors were meant to appeal to low-margin customers and mostly to a very young clientele whose needs remained unheard by traditional bankers, as they did not account for a large contribution to their balance sheet figures. Yet, robo advisors proved to be very attractive solutions not just for low-income customers, but also for affluent and high-net-worth individuals. Banks, already reconsidering their focus on wealth management operations due to increasing cost of capital in investment banking, yet challenged by tighter market regulation, were quite abashed to see that new entrants were threatening their once dominant positions, filling the headlines of newspapers, and attracting within a short time a considerable amount of venture capital funding.
We can conclude that robo advisors possess all the elements to be a disruptive technology and relegate the banking industry to simpler and low-income business models. Clearly, although new entrants use digital weapons and dump incumbent businesses, neither robo advisors nor the financial institutions willing to invest and transform have any interest in engaging in a huge transformation effort to corner themselves in low-income shops.
Goal-based investing will provide a way out for all the players that master the battle of disruptive innovation. GBI principles are already present in robo advisors’ propositions, but to a level of simplicity that cannot afford them any leverage and increase commercial margins. Yet, the tendency will be for financial advisory and financial planning to converge within robo models. This will allow robo advisors to tier their offering to appeal to a more diversified client base and will enable them to price up their services by competing on more added value services. The sustaining innovation that GBI can provide is supported by high-end technology advances, such as cognitive computing and risk-based portfolio management.
“Will banks be extinct or will they transform?”
We cannot predict the future of an industry nor of an individual firm, and we cannot say if today’s banking will become extinct or will transform under market and consumer pressure. The latter is the more likely outcome, given the unique characteristics of banking as a regulated and, to a point, a protected industry. However, the industry landscape is truly changing fast. What lies ahead is not a one-sided competition, FinTechs versus traditional banks and advisors, but rather a likely situation where a handful of digitally transformed firms will become new dominant players, while traditional institutions unwilling or not able to embrace change will become laggards.