For the Future of Financial Advice, Look to Mutual Funds

Upsetting Tradition For years, the industry charged its customers an annual fee of 1% of their assets. Few complained. The levy seemed reasonable, and the financial markets were rising, thereby boosting portfolio values. Those who stayed invested for several decades became wealthier than they would have imagined.

Then came a new competitor, which priced its services far below the norm. Its initial sales were modest. Existing firms argued that cost was but one factor of many that customers should consider, and far from the most important. After all, buyers generally get what they pay for.

This argument was aided by the industry’s revenue model. Whereas businesses in most sectors must prod their customers for payment, thereby prompting ongoing purchase decisions, this industry needed only to collect its money but once. After that, its payments would be collected automatically. Better yet, that charge was expressed as a small percentage—only one cent in each hundred!—rather than as a large dollar amount.

Over time, customers began to believe the newcomer. As time passed and the evidence mounted, customers could judge whether the old guard was correct when asserting that its higher fees led to better services. For the most part, the answer was no. Cheaper did not mean shoddier. Quite the contrary; that which cost less tended to deliver more.

As this lesson permeated, customers began to change their buying habits. No longer was cost one of many items to weight. It became the factor to consider. Consequently, new sales disappeared almost entirely for the highest-priced 80% of the industry. Some of its existing customers defected as well. All the action lay with the cheapest 20%. The traditional pricing model was thoroughly, irrevocably busted.

From Funds to Advice I write, of course, of the mutual fund industry, and of Vanguard as the disruptor. (In that endeavor, Vanguard now has several rivals, including some of the traditional companies, who have reluctantly opted to compete against their existing businesses by offering extremely low-cost funds.) That story has been well told. The cycle is complete; the hypothesis has become demonstrated fact.

The question now is whether financial advisors will follow funds’ lead. I believe that they will, albeit with some significant differences.

To begin with the similarity: Every word in this column’s first three paragraphs applies just as well to financial advisors as to mutual funds. Advisors, too, charge about 1% per year, with that request supported both by rising financial-market prices that have padded portfolio values, and a revenue-collection scheme that avoids asking customers to write checks. Until recently, that fee structure went unchallenged.

High Tech, Low Touch Over the past decade, so-called “robo-advisors”—entities that create portfolios via computer programs, and which connect with clients through the Internet and telephone, rather than through personal meetings—have entered the fray. Now advice is available at a fraction of its traditional price. If the new services do not exactly match those that they seek to replace, well so with funds: Passive management is not the same as active management. No matter. Tens of millions of American investors have concluded that passive is plenty good enough.

Eventually, I believe, many will think the same about robos. After all, robo-advisors enjoy the advantage over their human rivals that Vanguard had over its competitors. Just as Vanguard invested in the same stocks and bonds as did the other fund companies, so do robos buy the same funds as do traditional advisors—and through the same process of strategic asset-allocation. The performance difference comes down to price. On average, over time, robo portfolios will beat those created by human advisors by about 75 basis points per year.

True, robo-advisors don’t benefit from the transparency that benefited Vanguard. The net asset values (and distributions) for all mutual funds are publicly filed, which permits companies like Morningstar to calculate and publish their total returns. The same does not occur in the advice industry. Even if the robos were to make their results available to third parties, human advisors certainly would not. There will be no Morningstar Rating for funds, nor performance rankings, for advisors’ portfolios.

However, unlike when Vanguard came to market in the 1970s, investors now possess a deep appreciation of the logic of investment math. Every cent that leaves a portfolio to pay expenses is a cent that would have improved the portfolio had it stayed. This principle is well known. Also understood is the difficulty of generating “alpha.” Over time, investors will no more believe that the average financial advisor’s portfolio outgains a cheap solution than they will believe that the typical actively run fund beats index funds.

The Limits of Technology Thus, to answer the headline’s question, the financial-advisory business will indeed follow funds’ lead – to a point.

That point being where investment selection stops and personal advice begins. It’s one thing to construct a generic portfolio that serves Sally as well as Tom. One 35-year old investor who has a job, checking account, and 401(k) plan is much the same as another 35-year old investor who owns the same. They need no customized solutions. Drop them into a target-date fund, and they will be served just fine. They require diversification, strict cost controls, and the force of time.

It’s quite another to take into consideration investment lives that have become messier, with multiple accounts and tax issues and withdrawal needs. Technology can help to address those issues, but it cannot replace the iterative, back-and-forth learning that comes from extended conversations – and the relationships that come from discussions. Those who possess more financial assets than human capital, and who seek professional help (do-it-yourselfers being another breed altogether), will likely use traditional advisors.

Which is perfectly good news for such advisors, as those clients are the ones with the most money. To be sure, fee pressures will continue to build as the wealthier customers push for steeper volume discounts. (After all, they have all heard arguments that advisory firms should pass along economies of scale, as applied to mutual funds.) But there will be an understanding that as human advisors’ services are not the same as those of the robos, that their charges can and will be higher.

Thus, the analogy between what has already happened with funds, and what will happen with financial advisors, is imperfect. Pricier funds carry no special appeal to wealthier investors, while pricier advisory services might. Nevertheless, the parallel is sufficiently strong that I feel confident in predicting that robo-advisors have only just begun. They will not conquer all, but they will expand greatly over the next couple of decades.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.