The Perfect Storm. Over-regulation and the emergence of Robo-Advice
“Robo-Advice” is the use of automation to build and manage investor portfolios. This is not new, the use of digital techniques to manage portfolios has been around for a while. The emergence of more intelligent AI, advances in algorithms and the plunge in the cost of computing power have given a great tail wind to the nascent robo-advice sector. It is how the technology is being used and how it is affecting the large financial players that is now making people take notice.
I contend that it has been the convergence of three factors that have led us to this point.
3 factors why robo-advice is relevant now
1. A low interest rate environment combined with a crowded investor space has squeezed investment returns to the point where the management fees have become significant. This has necessitated margin compression and aided the growth in low cost ETF’s.
2. Regulation that was reactive rather than proactive, past policies increased the amount and cost of being compliant. This created great hesitancy around providing advice by the banks and in many cases made the customer experience a nightmare. Opaque guidelines and moving goal-posts made it expensive to invest in process automation with the old technology, and bureaucratic and timid internal policies made it difficult to approve changes with agility (see CYA).
3. Technological factors, AI, a vastly greater pool of data and algorithms and a simultaneous increase in power alongside a reduction in cost.
This has led to some major implications for the financial sector, I will explore two of these and suggest whats next below.
Man+Machine not Man vs. Machine
An Accenture report shows that while robo-advice will advance tremendously that there are enduring areas where humans will retain high value. The ability to explain, reason, persuade, validate on past experience and to customise solutions beyond the system capabilities will be areas where the human element will still be important. Of the wealth management clients “81% say that face-to-face interaction is important – the highest figure of all channels.”
So with access to all this technological support you would think that the Relationship Managers (RM) would be begging for these systems to help them gain an advantage over their competitors. Surprisingly (or unsurprisingly depending upon your viewpoint) RM’s are in general not immediately happy at the idea of the robo-advice intrusion into their world. One senior banker commented to me that the push back from the Front Office middle management was very strong, in fact went as far to say “as soon as you say Robo anything the passive resistance is off the charts.”
“as soon as you say Robo anything the passive resistance is off the charts.”
This fear that existing roles may change or become redundant is not an unfamiliar one and is emerging across a number of industries (see this article). The key for the wealth management companies according to Accenture is to do the following:
- Get the offering right
- Developing an effective distribution strategy
- Getting the advisor force on board
When the GFC occurred the regulators took a very predictable approach and applied the screws to all the financial institutions accompanied with opaque guidance. What resulted was a complete halt in innovation and seemingly all the resources were redirected to compliance and oversight. Much of the additional compliance was hastily implemented in manual processes, in the years following this the life of an RM (and virtually everyone else inside the financial institutions) became more administrative and tedious. Simultaneously the customer experience worsened as the procedures became convoluted and confusing to both the staff and the customer.
Something had to change
The emergence of FinTech is partly a result of the financial institutions lack of focus on innovation. In much the same way that other incumbent industries have been ‘disrupted’ the financial industry has been in line for a shock too, however, unlike these other industries the financial industry has a lot of regulation. This regulation has contributed to the financial industry’s lack of innovation, but at the same time I would argue that it has provided a barrier to entry and prevented significant inroads to their traditional markets and revenues. While the technologies that FinTech has been developing are undoubtedly desired by both the customer and the financial institutions themselves, the regulations previously have been ill-suited and one could argue actively discouraged their adoption.
A more collaborative approach is emerging where the regulators work with the financial institutions and FinTech to encourage the adoption of new technologies to better serve and protect the customers and keep these institutions relevant. We have seen this through supportive regulator programs, check out this report that shows just how much the Hong Kong and Singapore regulators have been doing to support these nascent players.
Singapore’s FinTech Office has the following charter:
- review, align and enhance FinTech related funding schemes across government agencies;
- Identify gaps and propose strategies, policies and schemes in industry infrastructure, talent development and manpower requirements and business competitiveness; and
- Manage the branding and marketing of Singapore as a FinTech hub through FinTech events and initiatives.
HK similarly has the FinTech Facilitation Office (FFO) which has a similar charter to help “facilitate the healthy development of the FinTech ecosystem in Hong Kong and to promote Hong Kong as a FinTech hub in Asia.”
The regulators have also created so called “sand boxes” in both Singapore and HK which “allow banks to experiment with new financial technologies that do not meet compliance standards.” This should allow your imagination to show you an image of all the financial institutions on the beach creating financial sandcastles that if they were to fall under the waves or an errant foot, can be rebuilt in a new formation without great disturbance to the ecosystem as a whole.
Financial institutions should take note, advances in Business Process Management (BPM) tools have massively reduced the cost and ease of implementation for these organisational changes. Now it is possible to map out the processes inside an organisation and automate them, this allows amazing oversight, control and the agility to modify the controls on very short timelines. Importantly these solutions also come with complete audit trail which the manual processes will always struggle to meet (see Bayes Digital Solutions).
Has there been much rollout yet? In Asia the answer is kind-of but not really. There have been some improvements on the back-end capabilities, certainly some wealth managers have powerful tools on hand for their RM’s but the key here is that they have yet to roll this experience out to where it really matters, the customer. I have heard that some of the biggest wealth managers will be rolling out Execution Only to customers on their platform in 2017, but the kind of changes we have come to expect from the tech industry have yet to materialise in the financial sector.
The life cycle shown here explains the continuous cycle whereby client needs are evaluated against solutions, in my mind clearly an automated solution will do this better than a human (selecting from a product shelf of approved and vetted investments). To be effective this will still require an accurate risk profile assessment of the customer, with a full understanding of the financial needs from short-term out to long term, matched to an investment outlook and a investment portfolio with a SAA reflecting the advisors view of the markets and the world. Ideally this will be done in a discretionary style investment that requires as little interaction as possible to minimise transaction costs. I have two issues with this:
- How to certify and then differentiate the robo-advisors, we can’t all play follow the leader.
- This is not exciting and sexy, ultimately investors want to have some emotional connection with their investments, fire-and-forget does not achieve this.
I am interested to see how the regulators work with the financial providers on the first point, on the second point I think that the addition of Tactical Asset Allocations (TAA) and Execution Only components to the service will enable this. This essentially would allow the personalised menu of investments that you would be attracted to invest in with a calculated risk, but the advisor can not advise you to buy as they sit outside your recommended (legally defensible/auditable) portfolio. Bringing the recommendation engines (think Netflix/Amazon) to the world of thematic investing could be quite exciting!
Reach out to me if you want to further discuss these ideas or if you think there is an opportunity to bring some of this technology to life in your business.