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Getting Active-Investment Advice to Market Cheaply

August 6, 2015

With robo-advisors putting downward pressure on wealth-management fees, advisors need to develop a cost-effective investment strategy that has a diverse mix of actively managed securities providing adequate market exposure and risk control. This approach also has to cover portfolio implementation, middle- and back-office, and manager-of-manager costs.

The issue, however, is that when distributing investment advice at scale — assuming that returns are in the vicinity of market performance — the differentiating feature is technology. It affects product, service and profitability. But as of now, technology in the full-service private-wealth space has fallen short.

With the average expense ratio for actively managed domestic equity funds above 120 bps, and client charges for a single separately-managed-account manager approaching 50 bps in some cases, the fee differential compared to robo-advisors can be stark — with the gap likely to widen as robos become even more price-competitive.

Currently, the institutional channel is exploring multi-factor and smart beta investing. This makes sense from the standpoint of finding ways to inexpensively gain adequate market exposure, true diversification and risk control while still accessing the factors that tilt the portfolio toward alpha. An important first step in this process is viewing the total allocation as a bundle of factors. In this process, the portfolio manager or manager-of-managers has to be able to look through the individual securities to their underlying factors such as market capitalization and price to book.

But this requires a lot of intellectual capital in the areas of market data, portfolio construction, implementation and supporting technologies. Managing this process is more readily achievable in the institutional channel, because of the relatively smaller number of accounts that have to be managed. This fact alone saves institutional managers from many of the challenges of implementing new strategies.

This is not true in the private-wealth arena, however. Assuming all other conditions to be equal, the major problem is dealing with the operational scale created by thousands of accounts. Portfolio customization at scale is an even bigger challenge. This will require a specialized technology platform to provide low-cost active management of these more-complicated portfolios. Such a platform could also increase the likelihood of allowing a customized, or restricted, portfolio to replicate the alpha produced by the model.

Unfortunately, it is an implicit assumption in the industry that private-wealth investors can’t understand more sophisticated strategies. This is not necessarily the case if the portfolios can be described to the client in a report that presents the portfolio in a simple and elegant fashion. Creating this view may be the biggest challenge in bringing multi-factor investing to the private-wealth sector. This challenge presents issues in engineering and design.

From an engineering perspective, the bulk of the securities will need to be held in a single custody account; but the portfolio accounting and performance-measurement systems will require the ability to handle subaccounts that are variously defined — all of which can be rolled up into a variety of customizable report views.

The design challenge will be in constructing an intuitive user interface to diverse client views of the portfolio’s performance. Also, the advisor dashboard controlling this reporting service will have to be highly configurable within compliance-approved constraints.

The final challenge, of course, is to be able to provide all of these services at a reasonable price. Especially in the independent channel, many of the wealth-management technologies in place today are not capable of supporting such a platform cheaply enough and at scale.

But it is still obvious that the observable trend toward increasing automation to lower fees is in place. Labor Secretary Thomas Perez refers favorably to certain robo-advisors by name in congressional hearings. Luckily, the technologies to provide much of what’s described above at scale are available in the market today. But they are yet to be integrated from the perspective of providing a simplified view of a fairly complex investment process.

There are reasons for this deficiency. First, private wealth usually trails behind institutional-investment strategy trends. Second, the private-wealth industry is still struggling with scaling and integrating more conventional strategies such as separately and unified managed accounts. Third, absent immediate and overwhelming pricing pressure, there is an understandable inertia regarding automation in anticipation of lower fees. Finally, outside of portfolio-manufacturing support, core infrastructural technology is still an afterthought in much of the investment-management industry. The idea that downstream-processing technology could be any kind of contributor to alpha at the individual-account level is a transformative thought.

The first firm to deploy this more-sophisticated product platform will gain a significant competitive advantage by offering more service at lower fees. The right product vision coupled with an intuitively designed infrastructure could deliver this platform relatively quickly.