Approaches to Automated Investment

The overwhelming number of financial products on the market has given rise to two innovative FinTech firms. Wealthfront and OpenInvest provide a service that automatically selects the most suitable investment option based on the client’s preferences, goals, and social and ethical values.

In this video, Christopher Malloy, a Course Convener in the Harvard VPAL FinTech online short course, discusses how robo-advising has made it easier and more affordable for clients to invest and manage their portfolios.

But with a product that’s easy to replicate, how will these companies remain competitive in the long run? And how does this service impact the future of financial advisers?

Transcript

In this video, we will talk about the emergence of a new phenomenon in asset management, which is the idea of robo-advising. And we’ll focus in on two particular companies, Wealthfront and OpenInvest, who are pioneers in this space.

The simple reality of why this industry became into existence is because the wealth management industry is too complicated, it’s too opaque, and it’s too expensive. And those facts paved the way for the emergence of these firms. So now, on the expensive piece, a company called Vanguard, has been a pioneer in wealth management and making products that are very, very inexpensive. And so, Vanguard is now one of the largest wealth management firms in the entire world. But the problem with Vanguard is if you go to their website, you still have to decide which products to choose. And so, that search problem is actually quite hard, and I would encourage you to go onto their website and look at the thousands of products that they have on offer, and try to figure out what you would want to invest in.

And so, because of that problem, which we call the search problem, these robo-advising firms came into being. Wealthfront and OpenInvest basically grew right after the financial crisis, and the idea is quite simple, which is: Could you offer a product totally online, where someone could come onto the site and type in their risk preferences, things that they’re interested in, and goals, and could you then, as a firm, design a very automated product that would go and invest in cheap securities, like exchange-traded funds, and then automatically rebalance that portfolio such that the investor wouldn’t have to keep going and logging in, and they would in one click basically have their entire investment policy set by an automated firm?

So Wealthfront took that idea and designed a very appealing interface, targeted some younger investors, and grew dramatically since 2014, and became a big player in this robo-advising space. And then, seeing the success that Wealthfront had had, other firms began to enter. And one such firm was OpenInvest, which had a refinement of the idea of robo-advising based on this notion that, perhaps, investors had more preferences other than just risk and timeline, but maybe they cared something about, the environment, or maybe they cared about gun control, maybe they cared about some other social issues. So, they design an interface where people could screen out particular types of companies and particular types of investment, and that’s sort of capitalizing on this, the idea of socially responsible investing.

Now, the challenge of socially responsible investing, of course, is how do you define it? Because, for example, say you wanted to invest in environmentally friendly companies, well, then of course, naturally you’d think you would screen out Exxon and BP and these large oil stocks. And the problem with that is those are the very companies that are spending the most amount of resources and doing the most amount of R&D in the area of sustainable energy.

And so, the problem of how to measure social preferences and how to measure firms and investments that are socially responsible is actually quite difficult. And if there’s one thing we know from finance is that if you take a universe and you constrain it and make it smaller, and try to then pick the best investments within that, you are ultimately going to be sacrificing returns. And so, that’s this trade-off that OpenInvest is always having to think about, which is: Can I offer a product that delivers good returns while still screening out the things that people might not want to invest in?

Now, the other big challenges that both OpenInvest and Wealthfront face going forward is, because their products are so easy and transparent, they’re actually quite easy to replicate. You put in a couple parameters, and then they put you into some exchange-traded funds, and then there’s a machine that will automatically invest and automatically rebalance. And you can imagine this would be quite easy to replicate by larger, big financial firms, and so that’s an issue that they’re quite worried about.

A second issue is if we get to the point where all investment is done in a robotic way, what happens to all the financial advisers who are out there, and is it a good thing to get rid of all these financial advisers? So you might say it is, because they’re quite expensive, but at the same time, if you have machines trading with machines by machines, there’s almost no one at the end of the day who’s looking at the actual stocks, and pricing them, and doing the correct research to make sure that the prices are right. And so, you worry about a scenario where all humans are removed from the investment process. Will the prices be right, and what will happen to the returns on your investments going forward?