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The Evolution of Robo-Advisors

An updated look at the landscape of automated wealth management

Michael Wong, Morningstar Research Services LLC 

 

Back in 2015, robo-advisors were widely viewed as disrupters that could destroy the wealth management industry.  

We took the opposite viewpoint in a 2015 report called “Hungry Robo-Advisors Are Eyeing Wealth Management Assets.” At the time, we asserted that established financial institutions with economic moats, such as Charles Schwab and Morgan Stanley, would stay competitive. And we found that the stand-alone robo-advisors would “have to invest heavily in advertising, or consolidate to gain scale, be acquired or partner with established brokerages, or go out of business."  

Our dire assessment of the original robo-advisor business models has proved correct so far. Robo-advisors—which we defined as primarily digital firms that offer automated, semi-tailored investment portfolios direct to retail end customers—have failed to disrupt investment services incumbents and are still largely unprofitable. Many have sold themselves to established firms after realizing they can't count on investors giving them money. Robo-advisor costs also present a challenge to profitability. 

Overcoming 3 faults of the original robo-advisor business model 

The original robo-advisor model had three main challenges: high client-acquisition costs, ongoing costs of servicing clients, and low revenue yield on client assets. But new business models (and more aggressive digital-transformation efforts) are helping to address these faults.  

Lead-generation tools and strategic partnerships are reducing robo-advisor costs, while building for scale and operating leverage eventually solves service costs. Revenue-enhancement strategies underpin much of our optimism for select robo-advisors becoming profitable. Upselling to human advice, ancillary service offerings, and incorporating proprietary products in portfolios are key revenue drivers. 

We still don't see robo-advisors disrupting market-leading financial institutions. Instead, we expect established financial institutions to co-opt the technology of robo-advisors—along with the improvements to their user experience—and expand their own businesses.  

Our new report, “Robo-Advisor Upgrade! Installing a Program for Profitability: Digital Advice Raises Profits for Investment Services Industry” takes a deep dive into this corner of the financial services landscape. Here’s a look at some of the highlights. 

Download our full research paper to learn what robo-advisors need to do to be profitable.

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Key takeaways on robo-advisor wealth management  

We believe robo-advisors have three life-or-death choices: grow slowly and hope investors keep funding them, partner with an established financial services firm, or grow quickly with high-cost advertising. 
 
Betterment and Wealthfront have both raised capital in the last year, according to PitchBook data. We reasonably conclude that they've eaten through $100 million-$200 million of capital to reach $10 billion of client assets. 
 
We still assess that advertising cost per account acquisition at robo-advisors is approximately $300 per gross new account and $1,000 per net new account. At their presumably low operating margin after they become profitable, the payback period on advertising costs can be more than a decade.  

Strategies to lower robo-advisor management costs  

Four strategies can help reduce robo-advisor costs of client acquisition, but each approach has drawbacks. 

Robo-advisors need to build a high-operating-leverage business model to be profitable. We believe digital advice firms will spur growth in salaried financial consultants, as opposed to the traditional financial advisor compensation model of a percentage of revenue generated, to produce operating leverage. 
 
Expanded service offerings and higher revenue yields dramatically reduce the operating expense ratio and client asset hurdles to reach the goal of profitability. We estimate the break-even point for robo-advisors that sustain a 50-basis-point revenue yield could be $15 billion-$25 billion of client assets, 38%-63% lower than the break-even point for a robo-advisor that charges 25 basis points.

The landscape of automated wealth management 

Looking at business models, we see robo-advisors, discount brokerage firms, and full-service wealth managers have value propositions that target different customer bases. Additionally, many of the discount brokerage firms are well scaled with material cost advantages, while the reputation, relationships, and product offerings of the full-service wealth management firms create customer switching costs. We believe the economic moats of incumbent investment services firms can withstand the robo-advisor encroachment. 

This blog post is adapted from research that was originally published in Morningstar Direct’s Research Portal. If you’re a user, you have access. If not, take a free trial. 

Important Disclosure 

The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property of Morningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar. Investment research is produced and issued by subsidiaries of Morningstar, Inc. including, but not limited to, Morningstar Research Services LLC, registered with and governed by the U.S. Securities and Exchange Commission.​

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