Software can’t replicate a relationship, but it’s a good alternative for many investors. Illustration: Mark Fredrickson for Barron's
           
 
It’s a welcome change—though not without its problems. These so-called robo advisors use Websites backed by sophisticated software to put investors into asset allocation plans that meet their various financial goals.
 
Granted, the best financial advisors don’t just manage investments: They build relationships and help their clients negotiate all of life’s financial and emotional challenges. But the best advisors also don’t typically take on clients with less than $1 million in investible assets—and often require far more. The robos are bringing advice to the masses, for a fraction of what traditional advisors charge.
 
The change is being driven by technology, but it’s cultural in its roots. The advisory business is still relatively young; it’s grown rapidly, like so many other industries, on the backs of the baby boomers.

The boomers, the first generation for whom pensions weren’t a sure thing, embraced financial advisors. They wanted credentialed professionals who inspired confidence, which often came packaged with concierge-type services, and fees set at 1% of assets. Their kids, today’s millennials, have grown up understanding the importance of financial advice. But instead of human advisors, young investors are turning to software that provides the simplicity and speed they value.
 
THE INSURGENCY BEGAN in 2010, when Jon Stein, a 30-year-old entrepreneur launched Betterment at TechCrunch Disrupt, the prominent technology confab. “We were the voice in the wilderness,” says Stein, who remains Betterment’s CEO. It took New York–based Betterment a year to collect its first $10 million in assets; it now manages $2.2 billion for 85,000 clients. Its biggest rival emerged in late 2011 when Wealthfront launched. The Palo Alto, Calif., rival set its sights squarely on young Silicon Valley professionals and has since amassed $2.3 billion in 27,000 accounts.
cat
Wealthfront and Betterment aim to keep it simple; both Websites ask users just a handful of questions about their goals, risk tolerance, and investment horizon. From there, algorithms calculate a recommended asset allocation. After funding the account with an online transfer, a client’s assets are automatically split between several exchange-traded funds. (See the graphic.) The process takes less than 10 minutes and can be done with zero human interaction. Asset allocations are regularly rebalanced and both firms promise tax-loss harvesting, until now the domain of higher-end accounts.
 
“In general there’s been a lack of imagination about how far technology can go in helping investors,” says Wealthfront CEO Adam Nash. “In the next 10 years, everyone will be using some form of automated investment service. This is like e-commerce in the ’90s.”
 
Betterment and Wealthfront have sliding fee scales, but they essentially charge one-quarter of a percent for the service. That amounts to $19 a month for a $100,000 account, or “less than a night at the movies,” Wealthfront advertises. Wealthfront will manage the first $10,000 for free but has a $5,000 minimum. Betterment has no minimum but charges 0.35% for the first $10,000 invested.
 
Betterment says its assets are growing 400% a year, with each month stronger than the last. “We just keep accelerating, and I don’t see any reason that’s going to slow down,” Stein says.
 
The low fees mean revenues are also low—at least, for now. Neither of the start-ups disclose financial information, but based on an advisory fee of 0.25%, neither firm generated much more than $5 million in revenue over the last 12 months. Venture capitalists are nonetheless eager to invest in the businesses. Wealthfront and Betterment have raised $130 million and $105 million, respectively.
 
THERE’S BEEN a lot of Sturm und Drang around the notion of these firms encroaching on established advisors’ territory. That’s not likely. With their all-ETF portfolios, bare-bones advice, and low fees and account minimums, Betterment and Wealthfront are aimed at the smaller investor new to the world of financial advice. Investors with more money or complicated financial lives will still seek out traditional advisors. While Wealthfront and Betterment have $5 billion in assets combined, 55 of the top 100 advisors in Barron’s latest ranking each have $5 billion or more under management.
 
Perhaps that’s why the nation’s largest wealth managers, Morgan Stanley and Merrill Lynch, seem nonplussed when asked about the influence of robo advisors. Not only did the two firms decline to speak about the robo phenomenon, neither could even muster a comment on how the advisory business might look different in 10 years.
 
So we’ll tell you: Morgan Stanley, Merrill Lynch, UBS, and their ilk will still cater to the uber-wealthy, where most of their profits already exist. But every advisor—from the powerhouse firms to the small independents—will be forced to justify their fees, which typically run 1% of assets under management. “We used to get paid to be toll keepers on a highway that consumers couldn’t navigate,” says Steve Lockshin, who founded Convergent Wealth Advisors, an independent advisory, in 1994. He’s now an investor in Betterment and a founder of AdvicePeriod, a full-service financial planning firm. “Now highways have been open for very little cost or free but advisors still want to charge a toll.”
 
The differentiator, advisors say, is financial planning, the kind of customized advice that computers struggle to provide.
 
“If you’re with a robo advisor, are you going to put in there that you have a special-needs child?” asks Marvin McIntyre, a longtime Washington, D.C., advisor, now with Morgan Stanley, who has been ranked on Barron’s list of Top 100 Advisors since it began in 2004. “Are you going to put in there that you need to protect these assets because your daughter married someone you’re not comfortable with?”
 
Ron Vinder is a UBS advisor who has also frequently been included in Barron’s annual ranking. For years, he has been building client portfolios using just ETFs. In that sense, his portfolios look like the ones built by robo advisors. But Vinder says security selection and asset allocation are a small part of his job. “I’m talking about asset allocation for maybe five minutes of my meeting,” Vinder says. “Most of the meeting with clients is talking about estate plans, education plans, whether to buy or sell a company, how to give more money to the kids.”
 
Fund giant Vanguard has researched what it calls “advisor’s alpha” for 14 years, and has found that the standard 1% of assets that many advisors charge is low compared with the potential benefits that arise from a human advisor., which can add 3% to a client’s annual return. Half of the overall effect comes from what Vanguard calls “behavioral coaching”—basically, stopping clients from making bad decisions.
 
TECHNOLOGY IS TURNING asset allocation models into a commodity service, which could allow many firms—not just Betterment and Wealthfront—to profitably serve the masses.
 
In promoting his company, Nash has frequently referred to Wealthfront as a new kind of Charles Schwab (ticker: SCHW). Forty years ago, it was Schwab that disrupted the financial services world, bringing discount brokerage services to young baby boomers. Nash sees his firm doing something similar for the new wave of millennial investors, though Schwab is not yet willing to cede the innovation mantle.
 
 
This spring, Charles Schwab launched its own automated platform, called Intelligent Portfolios.
 
Schwab’s established presence gives it a leg up: It amassed $1.5 billion in the first six weeks, primarily from existing customers. That’s already two-thirds of what Betterment and Wealthfront each have under management.
 
Schwab’s massive scale allows it to offer the robo service without a management fee; investors pay only for the cost of ETFs, many of which are Schwab funds. “This is an evolution, not a revolution for us,” says Naureen Hassan, Schwab’s executive vice president for investor services segments and platforms.
 
There’s no free lunch, of course. Schwab’s portfolios are costly in other ways. The firm mandates that all portfolios have at least 6% in cash at all times, its most conservative portfolios can have as much as 30%—an unusual construction for an investment portfolio. Schwab claims that cash is a necessary ballast. Fair enough. But the parent company also profits by depositing the cash at its banking subsidiary.
 
Wealthfront and Betterment are flattered by the imitation, but the start-ups contend that the legacy players are hampered by outdated technology and old-fashioned thinking. “We’ve built from the ground up,” says Betterment’s Stein, adding that Schwab’s product is “bolted together.”
 
It certainly seems that way. Schwab’s robo product feels like it was created for the Web of a decade ago. It lacks the polish and modern design of Betterment and Wealthfront, and its attempts at simplicity feel more like limitations. “I don’t envy them,” Stein says of Schwab’s attempts to remake its consumer-facing Websites. “Legacy code is incredibly expensive to deal with.” Stein notes that Betterment has worked hard to surface only important details, but the site allows impressive customization under the hood.
 
The technology the robos boast about isn’t just about a slick Website and asset-allocation modeling. Both Betterment and Wealthfront say they can automatically sell securities after a selloff to capture a loss, while buying a similar ETF, so asset allocation stays unchanged. Wealthfront says that its tax-loss harvesting can improve returns by one percentage point annually, even more if clients allow Wealthfront to directly buy all the stocks in the S&P 500, instead of using an index.
 
But Vanguard senior investment strategist Francis Kinniry says the robos are “trying too hard to validate” even their low fees. He’s complimentary of the robos’ efforts and says he would recommend an automated service to his 18-year-old son. But: “I haven’t found anyone in the financial community who agrees with their tax-loss harvesting and self-indexing.”
 
VANGUARD IS STRIKING its own middle ground. Earlier this month, the firm officially launched its own new retail service that’s part robo and part traditional advisor. The hybrid service, called Personal Advisor Services, carries a fee of 0.3% and a minimum initial investment of $50,000—a tenth of the firm’s prior threshold for personal advice. Thanks to a lengthy pilot program and the shifting of some existing advisory client assets, Vanguard has more than $17 billion in its new product, $7 billion of which is new money.
 
The service features a robo-type Web interface, but an advisor controls all activity. It’s a role the firm likens to an “emotional circuit breaker,” forcing investors to stick to preset goals and asset allocations. “This is more akin to a traditional advisor relationship with a heavy tech element,” says Karin Risi, who heads Vanguard’s retail investor division.
 
Vanguard is clearly thinking about how their customers will react in the next stock market correction—an environment the robos haven’t faced yet. “It’s a lot easier to renege on a machine than someone you’ve made a personal bond with,” Kinniry says. He likens the situation to scheduling a workout with a friend. “It causes me great pain to cancel on my running partner,” he says. “It’s a lot easier to turn the Fitbit off.”
 
THE ADVISORY BUSINESS is still a young one, and this disruption is even younger. Betterment and Wealthfront don’t have much of a track record—Barron’s requires advisors have at least seven years to even be a contender for our rankings.
 
Wealthfront and Betterment hope to make up for their inexperience by relying on some of the best academic work to create their portfolios. Wealthfront CEO Nash spends a lot of time talking about the “efficient frontier,” for instance. That’s the concept introduced by Nobel Prize-winning economist Harry Markowitz that refers to structuring a portfolio’s asset mix to maximize return with the least amount of risk. For an aggressive 30-something investor with $100,000 in investible assets, that leads to a six-ETF allocation at Wealthfront, with 95% stocks and 5% in bonds. Betterment and Schwab’s algorithms lead to more products in the portfolios, 10 and 15 funds, respectively.
 
In the past, those complex portfolios would have drawn criticisms because of the transaction costs. That’s no longer a concern with the robos, which offer unlimited trades. “Transaction costs have gone to zero, so you think about investing in a different way,” Betterment CEO Stein says. For instance, “We’ll take a $100 deposit and divide that across 12 ETFs. You wouldn’t do that in a world where you have transaction cost in each of those trades.”
 
But there’s still a question of efficacy. There’s significant overlap in terms of the stocks held in the various ETFs in the Betterment and Schwab portfolios. Spreading the money around too much doesn’t help, either. While the efficient frontier makes theoretical sense, it’s hard to see how a 2% allocation to anything will move the needle, or why a $10,000 portfolio needs such fine parsing.
 
That’s why Vanguard—no stranger to rigorous academic research—puts the same young, aggressive investor in just two funds, a total-market U.S. stock fund and its international counterpart. Vanguard, of course, isn’t a start-up trying to promote a groundbreaking service. No matter what they say about the need for diversity or the value of the efficient frontier, Betterment and Wealthfront simply couldn’t launch a firm that offered a two-fund solution.
 
THE DEMOCRATIZATION OF ADVICE is a noble one, and the appeal of an easy-to-open account with a full investment plan will no doubt succeed despite its obstacles. Silicon Valley is leading the way, but it’s still Wall Street that holds the cards. “We can do this in a far more scalable way that delivers value to investors,” Schwab’s Hassan says. “It’s all backed by a company with 40 years of stability and proven experience.”
 
Nash argues that Schwab’s experience has become a liability not an asset. “I think that frankly most investors in their 20s and 30s are not happy with the status quo,” Nash says. “They’re not happy with pricing gimmicks. A lot of the traditional brands are increasingly damaged. Most of our clients choose Wealthfront because they’re looking for something different.”