Robo-Advisors: What They Mean for Investors and Financial Advisors

In this episode of Industry Focus: Financials, host Michael Douglass and Fool.com contributor Matt Frankel discuss Wells Fargo's (WFC 2.74%) recently announced "robo-advisory" platform. They also explain the general concept of robo-advisors, and what they've meant for investors, financial advisors, and the companies that offer them.

A full transcript follows the video.

This video was recorded on Nov. 13, 2017.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, Nov. 13, and we're talking robo-advisors. I'm your host, Michael Douglass, and I'm joined by Matt Frankel, as per usual. Matt, good to see you again.

Matt Frankel: Always a pleasure to be here.

Douglass: All right, fantastic. We thought we would talk about robo-advisors a little bit today because there's news. Wells Fargo is planning to use a robo-advisor. To be more precise, they're planning to create a robo-advisor. It's called the Intuitive Investor product. Clients are going to need to have a minimum of $10,000 to open an account. They'll be charged a 0.5% advisory fee. A little bit less in certain circumstances, and we'll talk about that a little bit further down the road. But what's interesting here is, Wells Fargo is following in the footsteps of a lot of small competitors, like Betterment, that you've probably heard of, and also some very large institutional competitors like Vanguard, Charles Schwab, Fidelity (FIS 1.04%), which has that product called Fidelity Go, and Merrill Edge Guided Investing by Bank of America. What's interesting about robo-advisors is, they're a big market. In fact, it's one that's growing pretty quickly. One estimate puts it at $385 billion in assets under management by 2021. Before anything else, let's talk a little bit about what a robo-advisor is. Matt?

Frankel: Before 2008, all you had were human wealth managers, I guess you would call them, where they would charge you a certain percentage of your assets under management in exchange for giving you financial advice and managing your investments for you. Generally, this was between 1%-2% per year, on top of all the fees charged by whatever mutual funds or ETFs they invested in for you. So, to solve that problem, I believe Michael actually told me he used one that charged him a lot.

Douglass: Yeah, it was something like 1.5% annually, again, in addition to the fees of the underlying mutual funds. So, I ended up paying something like 3-3.5% annually. Which, when you think about it, can be a lot of money long-term and can really damage your investing returns. When you think about the fact that the stock market historically returns about 6-6.5% after inflation, theoretically, that's eating about half of those returns.

Frankel: Right. I actually just published an article this morning that shows how you can lose hundreds of thousands of dollars over the course of a lifetime based on advisory fees alone. So, to solve this problem, this whole robo advisor concept was born. It started out in the form of what's called a target date fund that essentially invests in a combination of other mutual funds, and adjusts over time as you get older, lower your risk tolerance and make the prudent investing moves that a financial advisor would do.

Douglass: Yeah. And then, what's interesting is, the next step was, these formal robo-advisors. Betterment launched in 2008. The idea was essentially this automated solution that automatically rebalances your portfolio among different funds, at the time usually target date funds. Of course, since then, things have changed. So, you can kind of say, "Here's my risk tolerance, here's what I'm thinking about," and they'll recommend this allocation and work with it. Nowadays, of course, robo-advisors come in a variety of different shapes and flavors because it's been so popular. So, you actually see a move by some institutions toward hybrids, so, robo-advisors that charge low fees, but also provide some access to a human financial planner so that you can talk through some of the thornier tax issues that pop up from time to time when you're investing, and when you have a lot of complicated stuff, basically, in your financial life.

Frankel: Right. This would be a situation where, you still need some access to a person, you pretty much want your investments on autopilot for the most part, but there are some situations where, say, you inherit some money and you want to know the best thing to do with it, or you're faced with a big tax bill this year because you've sold some of your other investments and need to know what to do. It provides you access to an actual person where you can ask questions like that.

Douglass: Yeah. And as you can imagine, in most cases, that results in a slightly higher assets under management fee than for your typical robo-advisors. Now, just to be clear, to give you a sense of what robo-advisors are usually charging, it's usually pretty close to that 0.5%. Now, some of them are a little bit lower, some of them are a little bit higher, but to give you a sense, you're moving from a 1-2% assets under management fee for a traditional wealth manager down to around 0.5%. So, that's really a substantial savings for most investors. And I think that's one of the key upshots that everyone should be aware of. Robo-advisors are helping drive down fees across the board. That's objectively a good thing for investors, even if you don't personally invest with robo-advisors. And I don't. Because it just means, that downward pressure on fees is continuing across the board.

Frankel: This is one of the reasons why you see a lot of the discount brokers drop their stock trading commissions. I know, personally, I use TD Ameritrade (AMTD), and they just dropped theirs from $9.99 to $6.99. Even human financial advisors are getting more toward the 1% of that 1-2% range. So, this has really had a lot of pressure across the board.

Douglass: And what's interesting, as well, is that robo-advisors still make up a relatively small percentage of the overall wealth management space. That means both that they have a lot of potential growth opportunity, but then also that there's a lot more disruption, perhaps, still to do with traditional wealth managers in terms of bringing down those fees. The question, I think, will be where we hit that final equilibrium. For some people, they're going to use human wealth managers long-term. For other people, though, robo-advisors often make a lot of sense, and particularly that's true for a lot of younger investors.

Frankel: Yeah, definitely. Like you said, it's a pretty untapped market at this point. The statistic you gave earlier, that by 2021 it's expected to be around $385 billion under management, to put that in perspective, Goldman Sachs alone has over $1 trillion in assets under management. So, this is still, and is expected to remain, a relatively small portion of the advisory business for the foreseeable future.

Douglass: Actually, this highlights a good question that I think a lot of people are going to be asking, which is, when might it make sense to use a human financial planner and not merely a robo-advisor?

Frankel: Basically, if you want your investments on autopilot, and your financial life is not very complicated, a robo-advisor might be a good idea. If you have a more complicated situation, let's say you need estate planning advice, like, the value of your estate is going to be over the taxable threshold, or if you have a really complex tax situation, or you want insurance planning advice, or something like that, that a robo-advisor is just not going to give you, in that case, if you're a very high net-worth individual and want access to other investment opportunities, perhaps, any of those situations where it's a little more complicated, you might want to look into actually talking to a person. Still, even if you do that, it's worth shopping around for the fees. Like I said, this is putting pressure on the whole industry to keep their costs in line.

Douglass: Right. Of course, there are the people in between for whom a hybrid model, a robo-advisor that's handling the day to day investing, but then a wealth manager who is perhaps checking in a couple of times a year and talking about specific tax issues and things like that, could be very useful. Anyway, the point is, everyone's financial circumstances are different. We can't tell you which one makes the most sense for you. But it's a really interesting, low cost option, and it's one that's made a tremendous difference in the broader space of wealth management. And that is an objectively good thing. 

Now, if everything we've talked about so far makes robo-advisors interesting to you and you want to learn more about what different robo-advisors charge, and thinking about the quantitative and qualitative ways of thinking about what robo-advisors might make sense for you, you're in the right place. We don't have time to get into the nooks and crannies of how each robo-advisor works and what fees you might pay in this episode. Fortunately, Matt is currently writing a great piece with that deeper background that we'll published by the time this episode hits iTunes, or wherever you get your podcasts. So, send us a note at [email protected] if you want to learn more about how you might benefit from robo-advisors, and how they work, and get a side-by-side comparison so that you can take that information, do a little bit more research and figure out what makes the most sense for you. I'll be happy to send that article to you. Again, that's [email protected]. Just make sure to let us know it's the article about robo advisors.

Frankel: Yeah, I'm going to try to do the hard work for you. I'll do the comparison shopping for you guys.

Douglass: And frankly, that's what we try to do here at The Motley Fool, in general, make things easier, take what is complex, make it simple, put it in a chart so that everyone can easily understand it.

We've talked a lot about why robo-advisors are really useful for investors, whether you invest personally with a robo-advisor or whether you're still using a financial advisor and they've lowered their fees as a result. But, let's also talk a little bit about why it makes sense for Wells Fargo specifically to be getting into this space.

Frankel: It's just the direction that customers are going. People are becoming more and more aware of investment fees. 20 or 30 years ago, before the internet became popular, if you asked the average person how much they're paying in investment fees, they would have no idea. There's still a lot of that, to some extent, but now people are getting more aware of what they're paying, it's easy for anybody to trade a stock online, so, you see all these E*Trade and TD Ameritrade commercials advertising rock-bottom commissions, advertising robo-advisory services with really low, like you said, 0.5% or below fees for assets under management. So, it's kind of just where their customers are going. And they said in their press release, there are a lot of their customers, I think they said 20 million millennials and Generation X-ers alone, currently do not have an investment account with the bank. So, this is their way to attempt to take customers who would otherwise go to Betterment, TD Ameritrade, Vanguard, Charles Schwab, and bring them into the Wells Fargo family.

Douglass: Yeah. And that makes a lot of sense from a cross-selling perspective, as well. You could see these robo-advisors increasingly self-disrupting, particularly in the big institutions. It's not the case right now, but you could see a Wells Fargo one day offering its robo-advisor for free if you have a checking account or a credit card or something like that. So, it's basically this opportunity to cross-sell people, and then bring them further and further into your bank's ecosystem. In fact, although Wells Fargo is not offering its robo-advisor for free to anyone, or at least doesn't plan to right now, they are planning to offer a lower assets under management fee for people who have a certain amount of assets in your checking and savings accounts.

Frankel: Right. There are a few cases where it actually is free. I think Schwab is one of the big ones that offers a free robo-advisory service. They actually have two, they have one that's free and one that costs money in their hybrid platform. But, the reason they do that is, their customers' accounts are invested in Schwab mutual funds, or ETFs, I'm not sure which one, but it's invested in Schwab investment products, which, in turn, brings them into these. So, it's worth giving these advisory services away for free.

Douglass: Right. And essentially, they can use it as a loss leader, and put in the money a little bit further down the pipeline. Because, again, when you're thinking about fees that you're paying and investing, if you're working with a wealth manager or a robo-advisor, there's of course the advice, the management fee, which is that 0.5%, or for most human ones, in that 1%-2% range. Then, there's also the underlying fees for the funds. What that means is, Schwab can still make money even while they're offering something for free. So, it's a great way to just pull people in and get them further and further into the Schwab ecosystem.

Frankel: Eventually, it seems these are all going to trend down lower and lower to where people can invest for free, just pay the fund fees themselves.

Douglass: And that's one of the interesting things, for me, about institutions doing this. Institutions can both have the financial wherewithal to take some losses and also have the ability to, they've created their own funds, so they can take this initial loss anyways, go to the 0% fee and then make the rest on the funds and their expense ratios. For me, long-term, it begs the question, what will happen to the little guys?

Frankel: Right. There's no way of really knowing at this point, but it does seem like, especially the big institutions that offer their own line of funds, they definitely have a leg up on the smaller guys. And banks like Wells Fargo, too, that don't offer their own funds, but like you said, they have the cross-selling potential to offset the costs in other areas. Whereas a Betterment, if they can't charge a fee, how are they going to make money?

Douglass: Right. Long-term, perhaps this argues for greater vertical integration across all of finance. You could see, as banks continue to diversify, some of them really going fully into this idea of creating their own mutual funds, and doing all the different parts of someone's financial life so they can really do everything in one place. It'll be an interesting thing to see long term, whether that ends up panning out, and how our banks are structured five and 10 and 20 years from now, and also how the Vanguard of the world are structured as well as they try to compete on, at least so far, a really strictly fund and personal advice basis against some of these larger and more diversified institutions.

Frankel: Vanguard has the competitive advantage that their funds themselves are a lot cheaper.

Douglass: Oh, yeah.

Frankel: Which is their big draw. If you're paying a 0.5% of your assets with Wells Fargo, who has it invested in fees that charge you another 0.5%, but Vanguard charges, I think it's 0.3%, and the funds charge practically nothing, I think Vanguard's S&P 500 Index Fund is down to 0.4%.

Douglass: Something like that.

Frankel: Yeah. So, that's their big advantage, how they can stay competitive.

Douglass: And that's one of the reasons that, among robo-advisors, Vanguard personal advisor services has, as of this filming, the largest assets under management, around $65 billion as of May 15, 2017. Which, to give you a sense, No. 2 is Schwab Intelligent Portfolios at $16 billion as of March 31, 2017. So, a really big delta, and that's because Vanguard has, so far, at least, such an attractive platform. So, there's going to be a lot of different trends here to watch. Again, as you're thinking about what might make sense for you, having all the information at your fingertips makes a lot of sense. So drop us a note at [email protected]. Matt is finishing up that fantastic article which will really give a lot of that specific information that can be helpful in terms of head-to-head comparing robo-advisors, and figuring out what might make the most sense for you. Again, [email protected]. 

Folks, that's it for this week's Financials show. Question, comments, you can always reach us at [email protected]. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!