At a glance
- Robo advice includes a set of digital financial technologies that leverage mathematical modelling to provide automated personal advice.
- Millions of investors worldwide have already shifted close to US$1 trillion (A$1.4 trillion) in assets onto various robo-advice platforms.
- Some financial advisers have begun using robo-tools to offer low-cost solutions to those consumers who can’t afford higher-end advice.
By Gary Anders
The 2003 movie Terminator 3: Rise of the Machines, starring Arnold Schwarzenegger, pitted humans against cyborgs in an epic struggle to save humanity from annihilation. Thankfully, the human race came out on top, but not without suffering substantial casualties.
Almost two decades later, the battle between humans and machines is erupting on another frontier.
This time, it is pitting financial advisers against sophisticated computer algorithms designed to deliver financial advice and portfolio management solutions at a very low cost. Unlike the science fiction battles against cyborgs, the exponential rise of “robo-advisers” seems to be both unstoppable and unwinnable.
In fact, millions of investors worldwide have already shifted close to US$1 trillion (A$1.4 trillion) in assets onto various robo-advice platforms.
What is robo-advice?
At its heart, robo-advice is another way of describing digital financial technologies that leverage mathematical modelling to provide a level of automated personal advice.
Some robo-advice platforms are more sophisticated than others. A common aspect is their use of computer algorithms to determine an individual’s investment risk profile based on entered financial information. Platform offerings can include producing personalised statements of advice, recommendations around asset allocation and financial products, and even active portfolio management.
Financial adviser ratings and customer review service Adviser Ratings maintains a register of Australian robo-advisers, which it defines as “online smart tools”. Its register incorporates 45 companies offering online financial tools that provide financial advice, automated investing and post-retirement services, as well as personal budgeting calculators.
These types of services have been launched to fill the growing demand for financial advice from individuals unwilling – or unable – to engage human financial advisers and incur what can often be substantial ongoing costs.
Despite a huge growth in the number of Australian investors, Adviser Ratings estimates that 86 per cent of Australians remain unadvised by fellow humans.
Best of both worlds
Angus Woods CPA, Adviser Ratings’ founder, says COVID-19 has been partially responsible for both an explosion in investor numbers and a surge in advice interest.
“What we have found is that the generation that is actually more interested in advice about their wealth and more interested in speaking to someone and getting a handle on their money is that millennial/Gen Y segment,” he says.
“The increase in people wanting to speak to an adviser in that younger generation has basically increased exponentially.
“So, what does that mean for robo-advice? The expectation from that younger generation is that advisers will have access to those specialty tools.”
Underscoring this has been a lot of recent activity involving financial advice groups partnering with robo-tools developers in order to provide a combination of human advice and automated advice solutions.
“What we are starting to see is that a lot of these tools that were launched three or four years ago, that were once considered robo-advice, are being rebadged to assist advisers to offer low-cost solutions to those consumers who potentially can’t access that higher-end advice,” Woods says.
“I think that is going to blow out over the next two to three years, especially as that younger generation comes through.
“I’m seeing a whole bunch of solutions. What we get is a lot of the new players coming and wanting to access advisers. Is there a way we can rebadge or ‘white label’ our solution to consumers coming through your [the Adviser Ratings] platform?”
Learning from the machines
Willingly or reluctantly, a growing number of financial advisers are adopting an “if you can’t beat them, join them” attitude.
Dr Luis Filipe Goncalves-Pinto, who heads the Master of Financial Technology program at the University of New South Wales, says robo-advisers have been driving the disruption in the financial advice sector and helping inexperienced investors overcome cognitive biases.
“Traditional human advisers could help overcome these limitations, but they are expensive, generally ineffective and they cater mainly to wealthier individuals,” Goncalves-Pinto says.
“This leaves room for robo-advisers to improve the effectiveness of financial advice and increase the number of people who receive advice.
“However, many potential clients are algorithmic-averse, and many algorithms used by robo-advisers do not work very well.”
The main algorithm used by robo-advisers is the mean-variance optimisation model developed by American economist and 1990 Nobel Memorial Prize winner Professor Harry Markowitz.
Also known as the “modern portfolio theory”, mean-variance is a mathematical framework for assembling a portfolio of assets such that the expected return is maximised for a given level of risk.
“Human financial advisers continue to have an important role to play in this area. This is why we observe a tendency for financial advisers for convergence to a hybrid model allowing for collaboration between robo and human advisers,” Goncalves-Pinto says.
Regulating the robots
The rapid growth in the number of robo-advice providers offering various financial tools presents challenges for regulators.
In November 2021, the US Securities and Exchange Commission (SEC) flagged compliance concerns following a series of examinations focused on how advisers were using digital advice tools.
In a risk alert, the SEC says its Division of Examinations recently observed a “significant increase” in the use of robots among advisers working with retirement plans and retail clients.
“On the one hand, automation can offer significant benefits, including providing convenient, accessible and lower-cost services for investors, and enhancing operational efficiency for advisers,” the SEC says.
“When robo-advisers fail to comply with their regulatory obligations, however, investors may experience poor outcomes.”
The regulator notes that, if a robo-adviser is programmed to act on conflicts of interest that raises the costs or decreases the quality of the services provided, a client may be harmed as a result of an adviser putting their own interests ahead of its clients.
“That could entail product recommendations where the adviser has an undisclosed conflict of interest, excessive trading or placing clients into costly, complex or risky products based on an insufficient assessment of the client’s goals and risk profile.”
In 2019, concerns expressed by the Australian Securities and Investments Commission (ASIC) saw a Sydney-based financial services licensee close down two its robo-advice subsidiaries.
The subsidiaries provided automated advice to consumers on self-managed superannuation fund establishment, life insurance, budgeting and tax issues, using a proprietary algorithm.
At the time, ASIC said it was concerned about the quality of advice provided to users, and that the due diligence conducted by the online tools into client circumstances and objectives was insufficient.
As a member of the Australian Government’s FinTech Advisory Group, established in 2016, ASIC believes robo-advice does have an important role to play.
“On the advice process side, there is potentially opportunities for technology to introduce efficiencies into the advice process,” ASIC says.
“As part of a consultation paper, we canvassed the concept of digital advice. And, while there wasn’t an overwhelming response of people wanting to go down that business model, there was a considerable level of interest in adoption of technology to the extent that it might introduce efficiencies in the advice process.”
Federal Financial Services Minister Jane Hume says that, while “no one has yet cracked the nut” of full robo-advice service, it does not harm financial advisers or their businesses.
“When someone puts together a fantastic product, I also don’t think robo-advisers are going to replace the 18,000 or so financial advisers practising in this country.
“What robo-advice and other digital tools will do is offer an alternative for people who don’t currently have access to an adviser, or who wouldn’t pay for an adviser.
“It will get young people more engaged with their finances, and it may act as a gateway to full-service financial advice.”
Woods agrees and says robo-advice tools are becoming smarter by focusing on niche segments rather than trying to be all things to all clients.
“They are really trying to build out their solutions by capturing a niche segment and then having building blocks on top of that.”
On regulation, Woods says companies that have been in the robo-advice market for a while can see how aggressive the regulator can be and how legislation can change quickly.
“To a certain extent, ASIC has got its own sandbox to try and increase innovation and offer these new sorts of solutions. But it’s a fine line to when does it encroach on best interests, and whether a provider starts offering advice, as opposed to just a platform.
“In the UK, they are testing algorithms to ascertain whether they are providing actual advice and should be regulated more than they are.
“ASIC is likely to take a similar approach, while it also looks at the innovation agenda being promoted by the federal government and the relaxing of rules to allow people to look after their money.
“That said, I think ASIC see issues in terms of the speed at which some of these players have come into the market over the last 12 months, especially on the trading side.”
Goncalves-Pinto adds that household budgets are not limited to investments in stocks and bonds, and involve decisions around housing, the trade-off between consumption and saving, choices of insurance, mortgages and management of debts.
“Robo-advisers have an important role to play in these other areas as well. They can help provide understandable rules of thumb for day-to-day decisions, as well as provide motivation and reinforcement to individuals.”