Updated: Dec 1, 2021
Summary: Robo-advisors are an exciting, high-impact fintech investment alternative. As the robo-advising industry matures, the industry participants appear to charge significantly different fees. In some cases, the fees lack transparency. We provide an example where the robo-advisor fees are hidden in required cash balances. We believe a “Truth In Investing”-like regulatory regime, modeled after the long-existing Truth In Lending Act, would be helpful to provide consumer transparency, consumer comparability, and a level competitive playing field. To help organize your robo decision criteria and robo-advisor alternatives, consider using a decision recommendation solution to help make the best robo-advisor decision.
In our Personal Finance Journey, The Stoic’s Arbitrage, we discuss the benefits of robo-advisors. We suggest robo-advisors should be an important part of your personal finance strategy. Robos are an effective way to get the most out of investing, at a lower cost and with lower minimums. Robos provide access to sophisticated investment strategies for a broader range of our society. According to Deloitte, a Global Advisory firm:
“By the year 2025 [the robo-advisor industry] is expected to rise to over $ 16.0 trillion assets under management (AUM), roughly three times the amount of assets managed by BlackRock, the world's biggest asset manager to date.”
To be fair, the Robo is not as friendly as a personal financial advisor. The Robo will not play a round of golf with you, nor will the Robo soothe your emotions when the market gets choppy. But for most fundamental investment needs, the Robo is an effective investment solution and at a much lower price.
The first movers in this space were monoline fintech robo firms, notably Wealthfront and Betterment. At first, the big investment banks considered the monoline robos as a small annoyance, then, as the robos got market traction, they saw them as an upstart competitor. Fast forward to today, robos are here to stay. The big investment banks have crossed the “If you can’t beat ‘em, join ‘em” chasm and have rushed in to stand up their own robos.
The big investment banks have natural advantages the monoline robos do not. For example:
Capital. Massive capital for investing in robo-advising and potentially competing for robos as a “loss leader.”
Diversification. The most important diversification benefit is that many large investment banks have commercial banking subsidiaries or affiliates. These entities have bank charters with the ability to take deposits and make loans.
The on-point questions become about the way in which the big investment firms leverage their natural advantages. Do they leverage their natural advantages:
In an way that reduces industry competition? - OR -
In a way that lacks transparency for its clients?
For this article, we focus on transparent advertising practices. We believe advertising practices lacking transparency, besides being inappropriate for clients, may lead to uncompetitive outcomes that benefit the large investment banks at the expense of the monoline robo-advisors.
Lending as a model for investing
As a long-time mortgage lender and consumer lending risk management leader, “Truth In Lending” or Regulation Z has been a high-impact part of my professional life. The Truth In Lending Act (or “TILA”) was enacted in 1968. According to the Office of the Comptroller of the Currency (the “OCC”), a national bank regulator, the purpose of TILA is:
“[The act] protects you against inaccurate and unfair credit billing and credit card practices. It requires lenders to provide you with loan cost information so that you can comparison shop for certain types of loans.” – (bold emphasis added)
The implementation of TILA occurs in multiple ways. Lenders must disclose all costs. For mortgages, costs are typically disclosed on the standard “Closing Disclosure” form. Also, costs are rolled up into a single, comparable, cost of credit metric called the Annual Percentage Rate (or “APR”). According to the Federal Reserve:
“The APR is a measure of the cost of credit, expressed as a nominal yearly rate. It relates the amount and timing of value received by the consumer to the amount and timing of payments made. The disclosure of the APR is central to the uniform credit cost disclosure envisioned by the TILA.” – (bold emphasis added)
Today, there is no “Truth In Investing” disclosure requirements like TILA.
So why wouldn’t investors have similar protections as borrowers?
Why the Robo-advising industry needs “Truth In Investing”
Robo-advising is a direct-to-consumer activity. This means there are generally no brokers to facilitate a transaction or otherwise help the client. Also, in the banking or broker-dealer legal environment, consumer-based clients have much higher protections than business-based clients. In effect, businesses are expected to have more capacity to fully understand investment agreement implications. Whereas consumers are generally expected to need more help understanding investment agreement implications.
By its nature, one could argue robo-advising is most in need of significant consumer protections. However, there is no “Truth In Investing” disclosure requirements like TILA. The following is a real-life example as we discuss in our Budgeting like a Stoic article.
In terms of comparable robo-advisor costs, there are 2 main costs to consider:
AUM fee – AUM is the investment industry jargon for “Assets Under Management.” Most robo-advisors charge a fee as a percentage of your assets they manage. Currently, the market is around .25% annually. (Or, $2.50 for every $1,000 they manage.)
The fee loads of the underlying funds the robo-advisor manages - Many robo-advisors use ETFs, which generally have very low loads (< .1%).
Both Wealthfront and Betterment, as of the writing of this article, have an AUM fee of .25%. However, Schwab does not charge any stated AUM fees. Your initial response may be “Yea! Great news.” Why would you use less known robo-advisors when a better-known brand like Schwab does the same thing and for no cost? Upon reflection, you may be skeptical, as I was. You may then ask, “If they do not charge anything, how do they stay in business?”
How Schwab makes money is the premise for why we need “Truth In Investing”-based regulations. Based on their website example, Schwab sweeps about 8% of client AUM into a low-interest-bearing bank account. Schwab uses this very cheap, FDIC-insured money to make loans and other investments for itself. In today's world, the bank account deposit rate they pay customers is extremely low or zero. If the long-term average annual yield on the investment strategy is 11.5%, that means the effective AUM fee is .92%. [(long-term yield – deposit yield)*cash sweep %] Please note, we use Schwab as an example. Other large investment banks, with affiliated commercial banks, utilize a similar strategy.
Here is the important part - this AUM fee difference between the monolines and some big investment banks, known as the opportunity cost value, is not available for the long-term time value of money customer benefit. (We discuss the opportunity cost impact in the next section.) Other robo advisors invest 100% of client funds in the investment strategy. This practice is concerning because:
The effective AUM fee is hidden in the cash account and is over 3x monoline robo-advisors.
From a liquidity standpoint, an investor would not use a robo-advisor to hold cash because the investment strategy, by definition, is illiquid in the short term. It is like getting the worst of both worlds --> a) getting a super low or no yield on cash AND b) not having direct access to cash liquidity.
Sweeping cash, intended for an investment account to an FDIC-insured bank account, is not the intent of the FDIC. Investment money is “at-risk” and is not intended for the FDIC to insure. The use of the FDIC-insured bank deposit in this way --> a) puts the nonbank robo monoline at a competitive disadvantage and b) creates an unintended liability for the FDIC.
David Goldstone, CFA is from the Backend Benchmarking firm. They publish "The Robo Report" and provide robo-advisor benchmarking services. Mr. Goldstone noted:
“I agree, even if it is disclosed that a robo is using a cash sweep to generate revenue (Schwab does disclose it) I still think it is a hidden cost and creates a real transparency issue.”
The cash sweep impact
At this point, you may be thinking:
“OK, I get it. The robo cash sweep lacks transparency. But is it material? The difference between .92% and .25% seems really small.”
In a long-term investment strategy, like for our retirement, the investment value difference is huge. We model the investment value difference after our career-focused persona named Liam. Liam is a college-educated worker that actively manages his career. Liam can choose either a) a higher cash sweep effective AUM fee robo-advisor like Schwab or b) a lower effective AUM fee robo-advisor like the monoline robos. For Liam, the modeled difference between the two different AUM fee strategies is $4.5 million at retirement. Please note: The model is available for download and found at the end of this article.
The assumptions are that Liam will steadily invest with robo-advisors, starting in his 20s. Liam will consistently increase the invested amount as he progresses through his career. The assumed average annual yield is 11.5%. The $4.5 million is the retirement difference between a robo that charges .25% of AUM v. a robo that sweeps cash in a way where their effective AUM cost is a higher .92%. A seemingly small difference in AUM fees creates a very large difference in long-term value.
Making a good robo-advisor decision
Over time, as the industry and legal environment evolve, robo-advisor information will continue to improve. As mentioned earlier, "The Robo Report" and the Backend Benchmarking website contain data for cost, risk, and return criteria and across most robo-advisor alternatives. The question then becomes, what is important to you? How do you weigh the criteria and the alternatives in a way that provides the "best" robo recommendation, tailored to your preferences? It is one thing to have the information from "The Robo Report" but another thing entirely to calculate all the criteria and alternatives in a decision-informing way.
Definitive Choice is a smartphone app decision solution for robo-advisors and many other life decisions. It provides a straightforward user experience. The number-crunching occurs in the background by time-tested decision science algorithms. It uses a proprietary "Decision 6(tm)" approach that organizes the criteria (what is important to you?) and alternatives (what are the choices?) in a series of bite-size ranking decisions. Since it is on your smartphone, you can use it while you are reviewing research from "The Robo Report" or other sources. It is like having a decision expert in your pocket. The results dashboard provides a rank-ordered list of recommended "best choices," tailored to your preferences.
Also, Definitive Choice comes pre-loaded with many templates, including the Investment Type Selection. You will want to customize your own investment criteria and robo alternatives, but the preloaded templates provide a nice starting point.
Robo-advisors are an exciting, high-impact fintech investment alternative. As the robo-advising industry matures, industry participants appear to charge significantly different fees. In some cases, the fees lack transparency. We provide an example where the robo-advisor fees are hidden in required cash balances. We believe a “Truth In Investing”-like regulatory regime, modeled after the long-existing Truth In Lending Act, would be helpful to provide consumer transparency, consumer comparability, and a level competitive playing field. To help organize your robo decision criteria, criteria data, and robo-advisor alternatives, consider using a decision recommendation solution to help make the best robo-advisor decision.