Robo-Advisors Are Not for the Faint of Heart

On this exciting episode of The Long View podcast, Michael Kitces, the head of planning strategy for Buckingham Wealth Partners, discusses his journey with financial planning, portfolio consolidation, and the state of the financial advice business.

Here are a few excerpts from Kitces’ conversation with Morningstar’s Christine Benz and Jeff Ptak:

Benz: You referenced, Michael, that this fee compression that many people had warned would happen in the advice space has yet to really materialize. So, I’d be curious to get your thoughts on why that hasn’t happened? That the Jack Bogle revolution in terms of asset-management products has not come to the advice business.

Kitces: I think there’s a couple of different reasons for this, and in part you have to look at the underlying drivers, even of where the fee-compression discussion came from in the first place. If I look over the past 10 years, certain people of the industry have been pounding the table around fee compression. It primarily comes from two places. It was either robo-advisors are providing this low-cost solution, so all advisor prices are going to have to come down, or it’s been look at all the fee compression that’s happening in the product space, advisors are the next inevitable domino to fall in that chain.

So, if you start drilling into each of those, though, you get a little bit of a different perspective. If you start on the robo-advisor and why will consumers keep paying the proverbial 1% to advisors when you can get it from a robo-advisor for 25 basis points? Well, what you really find when you drill into that is, you think who chooses a robo-advisor? Because there’s a certain pressure that’s still on you if you’re going to choose a robo-advisor. You have to choose the right robo-advisor. You have to do an analysis of the different robo-advisors to figure out the pros and cons of each one and their investment performance, and their allocations, and their services, and their capabilities. You have to do all this analysis to figure out what the right robo-advisor is and whether they are going to manage your assets well—which, frankly, is not that different than how a lot of investment selections looked historically.

Right now we look at robo-advisors and how they manage ETFs. Ten and 20 years before that we were looking at mutual fund managers and how they’re going to manage their portfolio. There’s a segment of consumers that like doing that. Rolling up their sleeves using the available resources—now a lot of online resources, including from Morningstar—to analyze their own portfolios. We have a label for them: they’re called do-it-yourselfers. They’re also known as people who don’t hire advisors and never have and never will.

The whole robo-advisor movement at the end of the day was built to serve do-it-yourselfers. I don’t think that’s what the robo-advisors thought they were going to do when they began. They thought they were going to be competing with individual advisors, but who showed up in practice were do-it-yourselfers, and that’s why the primary platforms that launched competing options were do-it-yourselfer platforms like Vanguard and Schwab’s retail offering.

And so, at a core level, robo-advisors were never in competition with human financial advisors because human advisors by and large tend to work with delegators, people who don’t want to make these decisions and figure it out. They’d rather hand it off to someone and pay them for that service. Robo-advisors were appealing to do-it-yourselfers who wanted to do it themselves and don’t want to pay advisors and so, of course, if you want to do it yourself and don’t want to hire someone else to do it for you, it’s going to be cheaper. That’s what I would logically expect in that situation, but that doesn’t mean robo-advisor fee compression translates to financial advisors because the people who buy robo-advisors don’t hire financial advisors, or alternatively and ironically, the version even that we see in some places now has consumers that literally do both—like I’m comfortable with my investment stuff, I can pick a robo-advisor. I want to hire a financial advisor to give me financial planning on all the other stuff besides the investment portfolio, because I still want and need help with that and I’m willing to pay an advisor for that. But that’s a separate service from it allocates my portfolio for me. I might be good with that part.

And so, there are even advisors who have thrived with clients who use robo-advisors for their investments. But this whole idea that robos were in competition with financial advisors, I think was a misunderstanding of consumer psychographics and who buys what and engages with what. To me, sure enough financial advisors didn’t end up getting fee-compressed by robo-advisors because we weren’t competing with them and their offerings and the fees that they charge. I do think there’s been pressure on advisors to, I’ll call it value-add, our way up; there is still a price gap. If all you’re going to do for me for 1% is asset-allocate my portfolio, I could just hire a robo-advisor to do that for a fraction of the fee.

There has been pressure on advisors to value-add their way up to justify what services, capabilities are you delivering for me to justify this fee? I think by and large, the advisor community has stepped up, and I’m not saying that to pat ourselves on the back. I’m saying that by look at the actual growth of advisors relative to the growth of robo-advisors. Advisors have stepped up and consumers are voting accordingly with their feet. That’s deeper financial planning and better client communication, and proactivity, and tax services, and estate services that are showing up—lots of different ways that advisors are value-adding their way up. So, you get a lot more for your 1% fee than you did 10 and certainly 20 years ago.

But we didn’t get fee-compressed. We got value-challenged, and firms have reinvested to step up on the value. When you get to the product end of where this prediction was, well look at all the fee compression that’s happening from products. Isn’t that inevitably going to happen to financial advisors as well? To me, what most of the industry just fundamentally missed is the product fee compression--it’s not products compressed fees and then advisors get their fees compressed. We, as the advisors, we’re the ones causing the fee compression in the products. It’s not coming at us; we’re causing it to everyone else and it’s because of that fundamental shift that’s happened in the advisor world.

If I go back 20 years ago, virtually all of us worked for insurance companies or broker/dealers. We wrote “financial advisor” on the business card, but the truth is, literally, legally we were in the product sales-distribution business. We sat on the product side of the table and our job was to sit across from a client and pitch that product to the client, and the product companies paid us for that in what we know as commissions. As the advisor business has shifted from products to the actual advice business, by and large from the brokerage side of the industry to the RIA side of the industry, and we take on those things like fiduciary duty and different obligations. If you think of this like a table where it used to be I sat on one side of the table with my product lineup behind me, and I tried to sell things to my client sitting on the other side of the table.

What’s happened now is as an advisor I got up, I walked around to the other side of the table. I now sit next to my client on the client side of the table. And my job is to look at all those product companies coming at me, trying to sell stuff to me and my clients, and defend my client, and gatekeep my client to protect them and make sure they’re getting a good deal. And, frankly, we have a lot of incentive to do that as advisors, because one of the easiest ways to make my fee look good is to strip out the costs of everybody upstream and get lower-cost products for my clients, because that can recover some or all of my fee, depending on how expensive the client’s portfolio is.

And so, what you’re seeing happen over the past 10 and 20 years is not like product fee compression is magically happening and advisors come next. Its advisor stood up, got to the other side of the table, sit next to their client to protect the clients, and go back to the product companies and say you got to get me a cheaper version of this that makes me look good in front of my client or I’m going to fire you and find someone else who gives my client a better, cheaper offering. Advisors aren’t experiencing the downstream effects of fee compression, because we’re the ones causing the upstream effects of fee compression in the first place.

Likewise, there’s been all this discussion of advisors going passive with the growth of ETFs. We’re not going passive. If you literally look at the industry trend data, we’re not going passive at all. What’s happening is we used to sell a mutual fund to a client in a C share that was 2% to 2.5% all in, between my 12b-1 trail as the advisor, plus what went to the fund manager, plus what went for distribution to my platform. Now I sit on the other side of the table next to my client and say, here’s the deal. I’m going to save you 40% on your investment cost. And here’s how it’s going to work. Right now, you pay 2%-plus in that C share mutual fund, but what you’re going to do instead, is you’re going to pay me 1%.

And then I’m going to build you a portfolio of asset-allocated ETFs that I will manage on your behalf, which I can do super-efficiently thanks to the growth of rebalancing software and portfolio management tools. I’m going to manage all this stuff on your behalf. The average expense ratio of these ETFs was 20 basis points. Now we’re probably getting down to 10 to 15 basis points, even lower for certain funds. So, you used to pay 2% all in. Now you’re only going to pay 1.2% all in. But as advisor, my cut didn’t go down. I used to get 1% from the C share. Now I get 1% on the advisory fee, but the product side went down from 1%-plus to 0.2%. And I manage the client’s ETFs on their behalf, because, frankly, it’s a little bit more manageable for us to manage ETFs than it is individual stocks. And we have tools and technology to be able to do that well and efficiently.

And so that’s the trends that you’re seeing. We’re not going passive; we’re proactively managing ETFs, as the new stock, as the new building block for clients, and saving clients 40% of their all-in costs to do it, which is why you’re seeing so much growth in that direction. But again, if I want to look even better in front of my clients, I don’t necessarily have to cut my fee. I just say well, instead of 1.2, I found a new thing that’s only 1.1. I got a lower cost out of the product manager, and I drove that down even further. So, just all these predictions around fee compression were mostly built around robo-advisors are going to compete with us, except it turns out they’re not. Or product compression is going to come down on us, except it turns out that we’re the cause of the fee compression in products.

At the end of the day, the pressure is certainly on us advisors to do more than we did before, and I look back to even what our firm did 10 years ago and certainly what we did 20 years ago. And we do so much more than we did before. There’s more advice, more expertise, more training, more knowledge, we hire people who have more degrees and designations. There has been a lot of pressure on us to up our game to justify what we do for that 1%. But the industry has been stepping up, and that’s why the advice business is doing so well despite, and notwithstanding, product fee compression and the rise of robo-advisors.