The Future Of Investing

October 15, 2015 | By Neil Howe

This editorial originally appeared in Forbes.

To the dismay of traditional brokerage firms, Silicon Valley robo-advising startups are now handling $6.7 billion in assets—up from almost nothing a couple of years ago. These blows to the investment industry old guard have been coming for decades: In the 1970s and ‘80s, it was the passive investment model popularized by Boomers and Generation Xers—which was followed by the exchange-traded funds (ETFs) and online brokerages that rose to prominence in the ‘90s. Now it’s robo-advisors. These waves of generational change have upended the retail investment industry, threatening the profitability of brokerages unless they can revamp their offerings—or their identities—entirely.

It’s an open secret that most retail-oriented brokerage firms spend a lot of their time playing bait-and-switch. On the low-profit end of the brokerage service spectrum are single trades, which earn brokers only a microscopic fee per trade. A step up from that are “passively managed portfolios,” which yield a fee of around 0.1% of assets invested. These are groups of assets that don’t rely on specialized market knowledge—from the simplest and cheapest (like a cross-section of S&P 500 stocks) to something more sophisticated (like an ETF drawing from a high-dividend index). The real moneymakers are “actively managed” portfolios, which are handcrafted, expertly picked assets that earn brokers anywhere from 1% to the very high-end “2-and-20” options available to the super-affluent.

During the early postwar era, most of the activity in the retail investment industry was on the high end. During the ‘50s and ‘60s boom years, retail firms like Fidelity and Merrill Lynch promised that their actively managed portfolios could “beat the market.” These institutions were embraced by the G.I. and Silent investors then nearing retirement age, who relished the opportunity to put away some extra savings—and later by Boomers, who enjoyed the investment autonomy they offered.

But then several waves of innovation began hitting the investment industry. The first hint of a seismic shift came in the 1970s, when John Bogle founded Vanguard, the world’s first index mutual fund, based on research he once did as a Princeton undergrad showing that a portfolio of stock invested in the S&P 500 would outperform three-quarters of all existing mutual funds. This initial wave gained momentum in the ‘80s and ‘90s with the rising popularity of ETFs (which Vanguard was slow to jump on) and online brokerage firms like E-Trade, which offered clients ways to more accurately track and analyze market prices in real time.

Boomers and Xers fully embraced this wave of low-cost investment services. Late-wave Boomers could no longer count on defined-benefit pension plans as a main source of retirement income—and saw the guaranteed returns of passive portfolios as their only nest egg. Young DIY Xer investors used these services to cut out the middleman. They could now build their own custom packages that only included volatile assets, highly diversified portfolios, or anything in between.

Today, the low cost and sophistication of these passively managed portfolios makes them more attractive than ever. ETFs automate in real time to show the most up-to-date asset price. And with“smart beta” passive management, investors can stay on the cutting edge, beating other passives with a formula that weights assets based on their volatility. In a post-Great Recession world where 48% of Americans believe that “it’s hard to know which sources of financial advice to trust, why shell out big bucks for a pricey actively managed product with a comparable hit rate?

Over the last year in particular, robo-advising startups have further “tech-ified” the low end of the market. Companies like Wealthfront and Betterment offer algorithm-based investment platforms that generate smaller returns to brokers and lower the costs even further for investors. Consulting group A.T. Kearney predicts that robo-advisory will become a $2.2 trillion market by 2020—a ridiculous compound annual growth rate of over 200% from today.

These “robo” services resonate with Millennial investors in particular who see robo-advising as the simplest path to guaranteed savings: Risk-averse Millennials are much less inclined to try to beat their peers with actively managed portfolios—and are instead happy “following the market.”

In the aggregate, these waves of low-end innovation have started to play out in the industry itself. On the surface it appears that full-service brokers are doing as well as ever: At the beginning of 2015, Morgan Stanley, Merrill Lynch, and Wells Fargo each reported multibillion-dollar increases in assets under management (AUM). But this dollar growth in AUM conceals a decline in market share: Prior to the recession, full-service firms boasted about half of all AUM—but that share fell to 41% by 2011. According to the Financial Industry Regulatory Authority, there were just over 4,000 total firms as of May 2015—down by more than 500 since 2010.

With their most profitable services under fire, full-service brokers face a two-pronged challenge going forward. The first is figuring out how to manage all of these different generational preferences seamlessly. According to research firm Corporate Insight, only 30% of financial advisors are actively looking for clients under 40. The reason is simple: Not only are these clients much less affluent than the older investors that firm serve, but the firms also earn less per dollar of investor wealth. However, that old line of thinking is changing: According to Fidelity broker David Canter, “Financial firms can no longer wait for the emerging affluent to appear at their doorstep when they have enough assets.”

The second challenge, of course, is the most fundamental of all—figuring out how to survive in a world where young investors are embracing zero-profit services. Innovators should understand that just because Millennials are flocking to high-tech brokers, it doesn’t mean they’re abandoning high-touch ones. Millennials’ risk aversion means that they crave whole-life advice—which creates an opportunity for firms willing to expand beyond mere money management, into challenges like taxation, insurance, and inheritance. If firms can offer hands-on, non-algorithmic advice to their help-seeking young customers, they’ll have them for life.


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