Next step for robo-advisors is customisation of investment recommendations
Ex-SEC commissioner and founder of online brokerage Foliofn, Steve Wallman says that current robo-advisors are simplistic and offer one-size-fit-all solutions. He suggests that many digital financial advice platforms do not take into account granular individual circumstances which results in whole groups of people being invested in the same thing. The challenge now is to customise recommendations and avoiding institutionalising bad advice.
Steve Wallman prides himself on looking out for investors. After serving for three and a half years as Commissioner of the U.S. Securities and Exchange Commission, he founded online brokerage Foliofn Investing in 1997 to serve do-it-yourself retail investors regardless of their account size.

The firm has five core principles of investing – diversification, cost reduction, customization, consistent investment and tax minimization – which form the basis for “folios,” virtual baskets containing up to 100 stocks, ETFs and mutual funds.

Foliofn Investing claims to be one of the first brokerages to offer fractional-share investing. Wallman was among the first to anticipate the current robo advisor trend and claims that many digital brokerages are copying what his firm has been doing for the past 15-plus years.

Wallman, CEO of Foliofn Investing, discusses the state of the brokerage industry, where most robo advisors are falling short and why people should keep their expectations for a robo takeover in check.

Do you embrace the terms digital financial advice and robo advisor?

Automated digital financial advice results in lower cost. But you also wind up with whole groups of people being invested in the same thing. More granular individual circumstances are not taken into account. You may have a group of people who are the same age or making the same income, but that doesn’t mean their investing needs are the same. One might be expecting a big inheritance. One might be facing special worries. One may want to have four kids — others might not want kids at all. Maybe their age is the same and their salaries are the same for now, but their personal situations and investment needs are very different.

Too many of these automated systems are much too simplistic and offer one-size-fits-all measures. They don’t delve into other factors. Personal financial management is not where the robos are yet. They’ve tackled the easy part — automating part of the basic process — but not the hard part of customizing investment recommendations for each individual’s real-life situation. A real question is whether you end up institutionalizing bad advice instead of good advice.

The good news is that the offerings are still at a nascent stage; they will get better over time. The current robo offerings are not the best there could be, but they serve well for a certain cohort of people. They’re just not for everyone.

In addition to our retail brokerage, our institutional business, Folio Institutional, supports financial professionals with a brokerage and custodial platform. And through Folio Institutional, we pioneered the concept of flexible automated advised offerings with our Advisor Connexion platform.

Many of the RIAs using our platform are using that technology to provide a robo platform, but they’re doing it in a more thoughtful way. They are marrying a robo capability with the “live” advisor’s intellect and expertise so that they can offer good financial advice, but they can also offer it to a much larger cohort of investors with smaller account sizes.

This is where robos will eventually evolve, but we pioneered the concept, and we’re already there.

What is the current state of the financial advisory/brokerage industry? What factors will separate the winners from those that will lose market share?

First, we need to put this into perspective. Merrill Lynch, Morgan Stanley, Schwab and Fidelity each have over $2 trillion in assets. I understand that the cumulative size of all the robos — put together — is less than $20 billion. Saying robos are where the industry has evolved is like saying the oceans have evolved into swimming pools.

The media loves this idea of an evolving industry, and the attention has shifted. But the market is still based on the traditional broker-dealers and discount brokers. Make no mistake: Schwab and Fidelity will never put Merrill and Morgan Stanley out of business, and likewise, these newer models won’t put Schwab and Fidelity out of business. But there is a clear place for technology-enabled [brokerage] services.

This isn’t an industry that waits until it’s too late to react to new developments. This is an industry that will take a flier on something that could be great.

As an example, E*Trade and Fidelity both tried to offer basket trading, but they weren’t able to make it work in a way that made sense for them, so they didn’t pursue it. What we offered was too early for them. We were able to make it work — and we’ve now perfected it. The industry is now at a point where what we offer is seen as terrific and will make a difference. Other players are trying to copy what we do, because now they know it has legs.

There has always been a market for help and advice, so the application of technology to make it more efficient and better has been underway for decades. But getting investors to do the right thing is sometimes hard — just think about how investors keep being pushed to invest in a few hot stocks, or invest on whims, or [buy] baskets of stocks that aren’t diversified and make no sense.

Technology-enabled advisory services are here to stay and will get better and better. The question is not about the ability of the technology to pan out. We already know it does. Advisor Connexion, which is our next-generation robo capability, has already proven that it works.

The winners will be those who actually have something good to offer for the long run. That may not be the ones who sprint the fastest in the short term.

As for the investor-facing side of the business, what marketing tactics are you using to boost awareness and adoption of your platform?

Obviously, our marketing budget focused on individual investors isn’t at the same levels as Fidelity, Schwab, E*Trade and others, so we have to be more agile in getting our story out.

Customer referrals have been the main source of business for us so far. We have incredible customer loyalty, and many of our clients have been with us for a very long time. They are sophisticated investors who have been with advisors or other online brokerages before, and they get our message — customized, diversified, consistent, tax-aware, cost-efficient investing trumps stock picking or fad investing. They are our best and most credible evangelists, because they recommend Folio based on their personal experience.

We also leverage our affiliate network, social media and earned media, as well as more traditional marketing programs.

But, based on the success of our platform for investment advisors and other broker-dealers that use it, we are now poised to re-launch our retail offering — and we’ll be doing a lot more.

What companies are doing interesting things in the digital financial advisory space?

I’m curious about Schwab’s recent Intelligent Portfolios release. They’re getting a lot of attention from folks claiming they are including an undue amount of cash and too many of their own products. Clearly, their intent is to make money, rather than just do it for lead-generation. But why create a reputational issue over an extra $30-to-$40 per account? Now people are saying it’s not what’s best for the client. It is interesting. Whether it’s good or not, I don’t know. I have great respect for Schwab so it will be interesting to see how this evolves.

Many of the companies that we’re compared to aren’t doing anything innovative. They’re just copying what we’ve already done and have been doing for the past 15-plus years. So I won’t say more.

Describe your transition from SEC Commissioner to founder and chief executive of Folio Investing. How does your past work experience inform your approach to your current role?

My SEC experience very much informed the genesis of Folio Investing. As a regulator at the SEC, you try to eliminate or mitigate the bad things that will hurt investors. But you usually can’t force innovations into the market place that will make things better. It’s up to the private sector to innovate and compete.

As SEC Commissioner, I had the opportunity to hear from and speak to many different groups, including my favorite — individual investors who were simply trying to learn how to invest better. And I noted some consistent themes.

First, these investors were constantly subjected to the notion that they should be investing in fads or hot stocks, or the winning mutual fund from last year.

Today, you see that barrage of bad advice continuing in the industry’s advertising with “trading like a pro” apps, one-second execution claims, heat maps and whole web sites devoted to the fad “portfolio of the month” or trade-on-a-whim functionality. For individual investors, that’s a disaster — it’s simply a bad way to invest, as so many studies have shown. But some in the industry make more money if individual investors buy and sell a lot and rack up commissions, or leverage a great deal, or do something else silly— as long as they keep doing it.

Second, the industry’s structure of charging by the trade frequently also encouraged bad investing. Not only does it result in brokers wanting to encourage lots of trades so they can make more, but it means it is actually hard for investors to take advantage of the one free lunch in investing, which is diversification.

Being under-diversified can cost investors 30% and even up to 50% over a lifetime. But most investors usually own only a small number of stocks, in part because buying 50 or 100 securities and reinvesting periodically was simply way too expensive a strategy to follow.

And so investors who did try to do the right thing — to be diversified — would buy a mutual fund or ETF. But such funds are one-size-fits-all. An index fund, for example, may be a great investment for some people, some of the time and for some of their goals. Jack Bogle is right in promoting diversification and low fees.

But a 27-year-old generally should not own the same fund as a 70-year-old, and your kid’s college tuition money should not be invested in the same fund as your retirement money. But that’s where people have been led — to one-size-fits-all funds — if they realize they shouldn’t just want to own a few stocks.

And today, personal values, like being socially responsible when you invest, also matter to many. But you have no control over what you own when you’re invested in an ETF or fund. Funds can be very expensive to own and most investors don’t understand the costs.

For example, an investor with $100,000 in an actively managed fund with a pretty typical 1.23% expense ratio pays over $100 a month in fees — I suspect most investors in that investment would have no clue they’re paying that much.

The other problem with one-size-fits-all solutions and being under-diversified is that investors panic. They end up with concentrated positions that are too risky for them, or they’re disappointed in their returns because they’re invested in funds that are too conservative for them. And so they don’t invest consistently.

That’s seen in the studies in behavioral finance. Investors buy high and sell low — not a great strategy. Morningstar estimates that buying and selling at the wrong time costs mutual fund investors 2.5% every year.

Lastly, taxes are an issue at any investment level, and investors don’t have many ways to control the tax impacts of their investing activities when they should.

So you can see that investors trying to do the right thing have had a really hard time, and the interests of financial institutions aren’t always aligned with investors doing the right thing.

I spoke a lot about these issues as an SEC Commissioner. But I couldn’t solve for them as a commissioner.

When I left government, I wanted to compete a solution into existence. So just over 15 years ago, I founded Folio Investing to create a brokerage that offered investors the ability to own customizable, diversified baskets of securities — what we call “folios.” And I made it so investors could do it inexpensively, while investing consistently and having control of their taxes.

And, along the way, we pioneered a number of other innovations — fractional-share trading, dollar trading, as opposed to only share-based trading, online one-click proxy voting and flat-fee commission-free pricing. We’ve been granted over 20 patents.

Today, we offer 2,000 commission-free window trades for a flat monthly fee of $29. Our customers can create and trade consistently entire diversified folios without worrying about racking up lots of commissions.

Our business model and functionality are different because we sought to align our interests with those of our customers.

Read more: