Scalability is a huge issue for robo-advisors

By Dan Hallett | September 2016

Much of the media coverage of robo-advisors (a nickname for online investment advisors) has been devoted to whether or not they will replace some segment of today's traditional advisors. Certainly, some advisors are vulnerable, but robos are likely to have their share of challenges.

Any advisor with too many clients and offering too little service has always been vulnerable to replacement. But this weakness is heightened with the emergence of robo-advisors and new transparency rules such as the second phase of the client relationship model (CRM2).

Compared with most retail advisory firms, robos boast a superior registration category (i.e., portfolio manager), more consistent portfolio-building processes, lower costs and efficient systems for managing and rebalancing client portfolios. But there is a wrinkle.

Scale is both robos' biggest attraction and their biggest challenge. As the Canadian Securities Administrators (CSA) detailed in Staff Notice 31-342: Guidance for Portfolio Managers Regarding Online Advice, robos operate on a hybrid model. An online questionnaire and interface facilitates much of the "know your client" process, but a live, licensed portfolio manager must review this information and the recommended portfolio to ensure suitability. This review has to be done through what the CSA calls a "meaningful discussion" between a licensed portfolio manager and each client. This process need not be in person, but the definition of "meaningful discussion" ultimately may determine the robos' scalability.

This situation raises interesting questions. Do robo discovery processes address suitability for specific risk levels - and specific return requirements? If so, are return requirements simply client-provided inputs or the result of an interactive process whereby the robo (or its software) offers analysis to support the return target? How is this updated?

The more one-on-one contact that is required - and the standard is higher for registered portfolio managers than for registered salespeople - the less scalable the business model. Like all "client-facing" firms, robos need some minimum level of assets under management (AUM) to be viable longer-term. The magic number might be something like $500 million - with desired AUM targets in the $1 billion-$2 billion range.

As robos target smaller accounts, these online services need a whole pile of clients to hit their targets. One robo had an average AUM of $30,000 per client when it hit its first important AUM threshold. (The average client size was $60,000 just six months earlier.) The same firm then set its sights on $2 billion in AUM threshold. If its average AUM stayed at $30,000, the firm would need about 67,000 clients to hit its target.

If this robo is able to attract greater AUM per client - $50,000, for example - we're still talking about at least 40,000 clients. I wonder if the scalability assumptions of robo firms - and the regulatory tolerance for automation - will be challenged.

I don't doubt that robos will survive, both as a stand-alone offering and as a platform for segmentation by traditional, full-service firms. But before traditional advisors face extinction, robos first will have to live through their share of growing pains.

Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.

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