One of the hottest investment styles might be 'financially unviable'

Robo advising is one of the hottest trends in fintech. Over the last five years, hundreds of startups have launched digital platforms that use algorithms to manage investment portfolios — offering low fees and automated, user friendly, experiences.

While the excitement is real and the robo advisers fill an advice gap that millennials crave, it turns out that many are “financially unviable,” according to Alan Miller, Founding Partner and Chief Investment Officer of SCM Direct.

In a blog post for ETF Strategy, Miller wrote that SCM Direct researched robo-advisors based in the UK and their average fees, customer acquisition costs, and the rate at which they are adding more staff.

“As start-ups, most ‘robos’ do not have brands so require well-funded strategic marketing campaigns,” said Miller in his article. “We estimate a successful online campaign costs circa £3.15 per click. Based on a conversion rate of 1.75%, the customer acquisition cost is £180 (or $240) per account.”

Analyst estimates vary widely – from between $300-$1,000 per customer. At the highest end, Morning Star equity analyst Michael Wong estimates up to a decade to recoup marketing costs.

The future for many companies looks pretty grim. SCM Direct laid out the “defunct robo model” in their chart below, looking at the profits off of a £25,000 account:

SCM Direct Robo-Advisor graphicSCM DirectSCM Direct calculates the time it would take for robo-advisors to make a profit

The chart shows that it would take, on average, nearly 11 years to make a profit. Even by year 11, the projected IRR is only 1%.

High customer acquisition costs are by no means a doomsday scenario. In fact, this is a tale that is repeated over and over in the tech industry. The market will consolidate, leading to lower acquisition costs, and ongoing costs will come down as the technology and operating models become more efficient. Those robo-advisors that are gaining traction now, despite being “financially unviable,” will stand to come out ahead.

But right now, with hundreds of similar online advisories crowding the market, competition is fierce, and acquisition costs are steep. Advisors must do what they can to gain market share and come out on top.

Betterment, arguably one of the most well known advisors, has no account minimum and offers a promotion of up to six months of free management depending on the amount invested. Both Betterment and Wealthfront have invested in TV commercials, and Canadian firm Wealthsimple took it a step further with an ad in the Superbowl.

A huge market

Most robo advisors use low-cost, exchange traded funds (ETFs) to build the porfoltio, and then rebalance that portfolio on a regular basis. They generally only offer client portfolio management and don’t get involved with the more personal aspects of an investor’s situation, such as taxes, retirement, or estate planning.

Robo advisors represent a huge market. Global assets under management by robo-advisors is set to reach a staggering $8 trillion by 2020, according to BI Intelligence research.

While it’s true that millennials are more prone to using these online only advisors, the hype has hit all areas of the market. Wealth managers are increasingly acquiring or partnering with these firms, taking the best of what these more nimble startups have and offering it to their well-developed client base. Blackrock, for example, acquired FutureAdvisor, while Northwestern Mutual acquired LearnVest and UBS partnered with SigFig. Other companies, like Charles Schwab and Vanguard, have built their own in-house online wealth management services.

With all the hype, no one wants to get left behind.

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