Software is eating investment management

Some trends seem like no-brainers in retrospect. Two-plus years ago in the concluding chapter of my book, Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere, I talked about the rise of algorithmic investment managers:

Of late we have seen some tentative steps taken to provide investors with algorithmic investment services. This represents a natural evolution for the investment business because much of the everyday work inherent in investing can be done algorithmically. And it represents another way in which algorithms have become a part of our lives, oftentimes without our knowledge. More sophisticated, automated investment plans will make life easier for a wide swath of American investors who would be happy to take routine, everyday investment decisions off their plate. Automation or not, investors need to educate themselves along the way. It will allow us to spend more time thinking about the bigger, more impactful questions surrounding money.

A great deal has happened since then. It has taken a little time but it is becoming increasingly clear that “Online financial startups are starting to take root with investors.” We have even discussed the possibility that investing in a few years will be virtually free. Startups, albeit well-financed, have been driving this trend. Now the big boys are paying attention.

Vanguard Investments, the world’s third largest money manager, has now gotten into the game in a significant way. Vanguard’s Personal Advisor Services is now offering to manage client portfolios for a 0.30% per year. When you take into account that fact that Vanguard’s fund (and ETFs) are already low it makes for a compelling package.

Vanguard is not alone in this space but their entry validates what the other companies are doing. In surveying the bevy of companies trying to provide low cost financial Ron Lieber writes:

..Vanguard is all but admitting that the start-ups were right in identifying an enormous advice gap in the financial services industry…Not all of these players will survive, but their sheer number will probably bring prices down even further or force established advisers to do more to justify their existing fees.*

Competing against robots, or in this case, robo-advisors, is not easy. This trend toward “tech-sourcing” has been going on for a long time and is now coming to areas of finance that many thought were untouchable. Daniel Nadler writes:

Like outsourcing, tech-sourcing jobs does not replace a set of tasks; it simply replaces the people who do them with an alternative process that is cheaper, faster and more efficient – and often less American, whether the sourcing comes from Bangalore (as it did for the customer service sector) or from bits and bytes, as it did for the financial sector.

The most immediate impact of low-cost algorithmic investment management services will be for consumers who either couldn’t access (or afford) such services or those investors who get a cost benefit from increasing competition. Cullen Roche writes:

..the good news is that these low fee providers are driving down costs, automating processes (portfolio management is all about process, process, process) and driving out bad advisors. I also think they’re perfectly positioned to help the lower income investor which is great news for people who are hesitant to pay up for something they might not need.  Those are huge wins for everyone who’s an investor. But the Vanguard product is cool because it takes Vanguard’s low cost platform, embeds automation AND offers you the personal touch that is often necessary with financial planning and portfolio advisory.  As Erik Brynjolfsson says, we have to learn to work with the machines, not against them. Vanguard seems to have gotten the message.

That message is going to be a bitter pill for some to swallow. For those advisors who were earning high fees without providing value added services this trend will be a wake-up call. There are a number of ways that advisors can add a great deal of value for investors but it doesn’t come from the fruitless pursuit of alpha. It comes largely from preventing investors from being their own worst enemies.

Much has been written in the past week or so about the cost of high-frequency trading on investors. Which may very well be true, but less talked about is the high (net) cost of portfolio management. As Cullen notes the potential for algorithms to help investors is vast and we are just beginning to see it take shape. Software is eating the world and now it is coming to manage your portfolio.**

*I would also recommend checking out the table that accompanies this article comparing the cost, balances and services of the dozen or so most prominent algorithmic advisors.

**Clarification: As the Vanguard white paper notes there is an important role for human advisors. The reality is that is not in the management of portfolios. Michael Kitces at Nerd’s Eye View has a piece up talking about the importance of real human financial advisors in the process. Important financial decisions still require a dialogue that is not yet replicated by software. However that bifurcation of portfolio management and “real” financial planning will still radically transform the industry.

Items mentioned:

Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere  (Amazon)

The rising challenge of robo-advisors.  (Abnormal Returns)

Robo-advisors gobbling billions in assets.  (ThinkAdvisor)

If investing were free how would it change what you do?  (Abnormal Returns)

Wealthfront raises $35 million.  (TechCrunch)

The world’s largest money managers.  (24/7 Wall St.)

Financial advice for people who aren’t rich.  (NYTimes)

Michael Lewis and the tech-sourcing of white collar jobs. (Institutional Investor)

Robo-advisors – awakening the giant for the benefit of all.  (Pragmatic Capitalism)

Putting a value on your value: Quantifying Vanguard Advisor’s Alpha.  (Vanguard)

Everything you need to know about high frequency trading.  (The Atlantic)

As software eats the world, non-tech companies are eating startups.  (TechCrunch)

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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  • Tadas ViskantaAbnormal Returns has over its seven-year life become a fixture in the financial blogosphere. Over thousands of posts we have striven to bring the best of the financial blogosphere to readers. In that time the idea of a “forecast-free investment blog” remains as useful as it did six years ago. More »

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