{"id":2857,"date":"2015-12-08T14:23:57","date_gmt":"2015-12-08T19:23:57","guid":{"rendered":"https:\/\/digital.hbs.edu\/platform-rctom\/submission\/rise-of-the-machines-is-betterment-a-better-business-model-for-wealth-management\/"},"modified":"2015-12-08T14:25:29","modified_gmt":"2015-12-08T19:25:29","slug":"rise-of-the-machines-is-betterment-a-better-business-for-wealth-management","status":"publish","type":"hck-submission","link":"https:\/\/d3.harvard.edu\/platform-rctom\/submission\/rise-of-the-machines-is-betterment-a-better-business-for-wealth-management\/","title":{"rendered":"Rise of the Machines: Is Betterment a Better Business for Wealth Management?"},"content":{"rendered":"

Industry Background<\/strong><\/p>\n

To appreciate\u00a0the effectiveness of Betterment’s model, it is important to understand it within the context of the wealth management\u00a0industry. Historically, wealth management\u00a0involved three parties: the client, asset management firms, and banks. Clients paid\u00a0financial advisers (employed by asset management firms) an annual management fee (usually a fixed percentage of the assets managed for the client) to assume fiduciary responsibility for the client’s\u00a0assets. The\u00a0adviser’s responsibility was simply to make pragmatic investment decisions that would best satisfy the client’s investment goals by selecting the appropriate securities and investment vehicles, which were often created and sold by banks. However,\u00a0the industry changed as the Glass-Steagall Act of 1933 was repealed, allowing\u00a0for massive consolidation within\u00a0the financial industry (Malkiel, 2014). As banks and asset management firms consolidated, perverse incentives arose for financial advisers.\u00a0Banks pressured advisers to bias their security selections towards in-house products rather than those best suited for their clients. The public became aware of these perverse incentives following the financial crisis of 2007-2008, creating skepticism of financial advisers.\u00a0Today, asset management firms are becoming increasingly aware of what consumers are demanding:<\/p>\n

“One big dynamic we see if the growing demand for truly objective advice. Investors want advisers who are free from bias” – Mark Casady, Chairman and CEO of LPL Financial<\/em><\/p>\n

Conventional Wealth Management Operating Model<\/strong><\/p>\n

Asset management firms pay an extraordinary amount in compensation to its financial advisers; the annual compensation of the average Vice President FA at JPMorgan was $340,000 in 2014 (PayScale). Their value to the firm is the revenue they generate from their clients. In order to ensure that its advisers justify their hefty expense, banks typically create net worth minimums that a client must satisfy in order to be covered by the firm \u2013 they better be able to afford the expensive products if they are going to consume the adviser\u2019s expensive time. At the top banks, these minimums are often $10m in net worth (Barrons). By maintaining such high standards, banks exclude the vast majority of the population from receiving its services;\u00a0the scale\u00a0of the business is capped at the population\u00a0of multi-millionaires<\/strong>, a group over whom all of the banks compete aggressively. Winning these prospective clients over often forces the bank to assume\u00a0significant client acquisition costs<\/strong>\u00a0in prospective client entertainment and the research\/due diligence conducted to earn their business.<\/p>\n

At the end of the day, volumes of academic research suggest that \u201cactively managed\u201d investment portfolios \u2013 or those managed by financial advisers, rarely (if ever) outperform \u201cpassively managed\u201d portfolios \u2013 or those which merely track an index \u2013 net of fees (Malkiel, 2015).<\/p>\n

Enter Betterment<\/strong><\/p>\n

Betterment leads the fray in a group of financial technology companies known as “Robo Advisers” who seek to disrupt the wealth management industry by\u00a0using\u00a0various investment algorithms to manage client assets through proprietary technology platforms. It offers a low-cost, low-hassle solution relative to what is offered by conventional asset managers.<\/p>\n