INTRODUCTION

Wealth management services have traditionally been offered by a variety of financial institutions, including banks, RIAs (registered investment advisors), and insurers. Historically, wealth managers have focused primarily on clients with a high net worth and ample capital available to invest. The services provided by a wealth manager can vary from assisting with analyzing and advising on potential investments and portfolio allocations to strategic advisory services such as advice on tax‐efficient wealth transfer strategies and retirement planning.

Banking and wealth management have intersected with a number of banks offering trust and wealth management services to customers through their trust and wealth management divisions. In the twelve months ended June 30, 2016, community banks (banks with assets between $100 million and $5 billion) collectively had $1.5 billion in fiduciary‐related revenues compared to $8.3 billion in fiduciary income for the Big Banks (banks with assets greater than $5 billion).

Despite the wealth management offering of a number of community banks, this is an area where community banks have historically underperformed the Big Banks.¹ Income from fiduciary activities comprised approximately 14 percent of non‐interest income for the Big Banks compared to only 8 percent of non‐interest income for community banks. Approximately 75 percent of the community banks reported no fiduciary‐related income compared to ∼35 percent of the Big Banks. Additionally, the majority of community bank trust departments are below $500 million in assets under management, which presents a significant challenge to remain consistently profitable.

Of those banks that did report wealth management revenues, the average assets under management was smaller for community banks compared to the Big Banks and fiduciary income approximated comprised a lower percentage of fiduciary assets under management, implying lower fee schedules. The overall contribution to profitability from wealth management services was lower among the community banks compared to the Big Banks, reflecting the lower AUM and fees as a proportion of assets (i.e., lower fee schedule).

Given the importance of wealth management services to traditional banks and the underperformance of community banks in this area historically, it is important for bankers to track emerging trends within wealth management and ascertain whether opportunities exist to improve performance and enhance profitability and value. Several trends have emerged in wealth management recently. As the wealth management industry continues to evolve, technology is increasingly intersecting with traditional advisory services and the traditional role of the advisor is beginning to shift. Managers have increasingly focused on a greater proportion of the population and shifted their focus from the high net worth to the mass affluent. Regulations for both non‐bank advisors and banks offering wealth management services have increased and impacted the industry, including the significant changes to wealth management in the United States following the implementation of the Department of Labor's (DOL) Fiduciary Rule (financial advisory firms have until January 2018 to become compliant). Greater transparency has also allowed customers to compare product offerings more easily. Lastly, there has been a general trend toward investors preferring passive strategies for a variety of reasons ranging from lower cost to economic uncertainty.

FinTech innovation within wealth management has also developed consistent with these trends. FinTech innovations are helping improve access to wealth management tools for a broader population segment, increase transparency, lower regulatory and compliance costs, and deliver robo‐advisory services with investment strategies that are more passive. These changes present community banks with a potential opportunity to reinvigorate their wealth management offerings or to expand their service offerings to include wealth management. For those currently offering wealth management services but seeing limited profitability from their offerings, FinTech and the development of robo‐advisory could help provide a way to enhance the profitability and growth prospects of their existing team. For those not offering wealth management services, the evolution of wealth management could offer opportunities to selectively begin offering this service and certain FinTech offerings may be attractive. Similar to other traditional incumbents exploring FinTech opportunities, banks are presented with strategic options ranging from building their own robo‐advisory to buying a robo‐advisory, partnering with an existing robo‐advisory, or not offering wealth management services. We suspect that partnerships will be the preferred route for those that choose to offer wealth management services although one might expect to eventually see acquisitions and internal builds among larger banks that have the scale to justify the higher costs of those strategies.

Despite the potential for FinTech innovation within wealth management, significant uncertainty still exists regarding whether these innovations will displace traditional wealth management business models. An example of industry evolution due to technological innovation is the online brokerage industry. It provides an excellent case study for the interaction among wealth management, technology, regulation, and customer adoption of new technology products.

THE EVOLUTION OF THE ONLINE BROKERAGE INDUSTRY

The discount broker traces its roots to 1975 when the Securities Act Amendments of 1975 abolished fixed‐rate brokerage commissions on May 1 (May Day). At the time of implementation, many industry participants and other pundits predicted commission revenue would shrivel for the industry as commission rates declined. Initial pricing at Charles Schwab & Co. (Schwab) was $70 or about half what a full‐service broker would then charge to execute a trade for several hundred shares prior to May Day.

The opposite happened, though. As commission rates declined, more investors were empowered (or intrigued) to trade themselves without the support of a full‐service broker such as those then found at Merrill Lynch, Bache Securities, and the like. Trading volume grew significantly following the abolishment of fixed‐rate brokerage and offset steady declines in the costs of commissions per trade. For consumers, the evolution of discount brokerage served to expand access to trading markets and empowered them to trade more independently. For example, the average daily share volume in April 2016 on the NYSE was 1.2 billion shares compared to 20.3 million shares in April 1975, representing an 11 percent compound annual growth rate in daily average share volume over that 41‐year period. Today, online brokers advertise equity trades in the $7 to $10 range.

This evolution of discount brokerage is a unique example in the history of FinTech that provides guideposts regarding how future FinTech niches and companies may evolve. The change in regulation in May 1975 ushered in new players to provide discount brokerage services and also fostered changes in the incumbents as they ultimately began to offer similar services. This combination of newer, early‐stage companies and older, traditional incumbents and technology development ultimately led to increased innovation in the sector.

By the early 2000s, key larger established industry participants included firms that were founded in the 1970s and early 1980s, including Schwab (founded in 1971), TD Ameritrade Holding Corporation (TD Ameritrade, founded in 1971), E*TRADE Financial Corporation (E*TRADE, founded in 1982), and Interactive Brokers Group Inc. (Interactive, founded in 1978). Additionally, hundreds of other financial services companies with significantly longer corporate histories adapted to some extent and currently offer online brokerage services. For example, Fidelity Investments (Fidelity, founded in 1946) offers online equity trades for $7.95 and Merrill Lynch (founded in 1914) via Merrill Edge is presently offering $6.95 online equity and ETF trades or 30 commission‐free online equity or ETF trades subject to certain limitations.

As the discount brokerage industry has continued to evolve, companies in it have diversified beyond low‐cost equity trade execution services by expanding into banking, investment advisory, and trade execution for ETFs, options, futures, and other products. Services offered from discount brokerages immediately following May Day were initially limited to price quotes and trade execution. The initial revenue model entailed commission income and net interest income earned on customers' net credit cash positions. Diversification efforts first entailed offering more bank‐like products, which eventually led to bank acquisitions and formations by some firms. For example, E*TRADE acquired Telebanc Financial Corporation in 2000 to create the first pure‐play Internet company that combined brokerage and banking within one company. Schwab also subsequently chartered Schwab Bank in 2003 to provide customers with FDIC‐insured deposits, loans, and other banking products. TD Ameritrade does not own a bank; rather, the company has a formal agreement that establishes credit rates for customer funds that are swept to Toronto Dominion Bank—thereby obtaining most of the same benefits without having to hold the amount of capital that a wholly owned bank would require.

More recent diversification efforts by the industry have included the introduction of managed accounts, access to sell‐side research, enhanced trading platforms for active traders, and a growing partnership with independent registered investment advisors. Many RIAs have fled traditional brokerage operations to start their own firm or partner with an existing firm whereby services are provided for a fee. Independent RIA assets approximate $2.2 trillion and a number of online brokers actively seek to attract RIAs to their platform. As of September 2015, the Advisor Services group at Schwab accounted for $1.2 trillion of $2.4 trillion of client assets.

Expansion notwithstanding, the online brokerage industry is mature, which has resulted in periodic bouts of M&A as industry leaders have acquired to expand product offerings and increase the number of customers. M&A activity during the 1990s and early 2000s was largely geared to acquiring accounts and gaining economies of scale. The legacy predecessor company to TD Ameritrade was particularly active in acquiring online and discount brokers before combining with TD Waterhouse USA. Although Schwab did not pioneer online brokerage, Schwab built its online operation from its sizable discount brokerage operation. Fidelity did so by leveraging its mutual fund business.

While industry participants have diversified revenues over the past decade, the key revenue drivers for online brokers are customer accounts, customer assets, daily average revenue trades (DARTs), and the spread on client deposits and free credit balances. Also, the trading mix (e.g., the number of options) also influences revenues. Several of these revenue drivers are influenced by the condition of capital markets and trading activity. The performance of the U.S. economy in terms of the level and trend in corporate profits, employment, and U.S. monetary policy, which impacts investors' view of equities and other financial assets, are all important factors influencing trading activity and market conditions. Monetary policy also impacts the spread between the yield banks and other financial intermediaries earn on interest‐earning assets and the cost of funds for deposits and borrowings used to finance the assets.

In the last few years, the Federal Reserve's zero‐interest‐rate policy (ZIRP), in which short‐term rates are maintained near zero, has negatively impacted spread revenues for discount brokers and other financial institutions. In its 2015 annual report, Schwab management noted that the then‐seven years of ZIRP had caused Schwab to waive $4.0 billion of money market management fees during 2009–2014 so that clients would not receive negative yields to cover the cost of offering the funds.² Schwab also noted that client assets had grown 120 percent since the onset of ZIRP while revenues had only grown 24 percent largely due to the rate environment as its spread was 1.60 percent in 2015 compared to 3.84 percent in 2008.³ During this period, client assets more than doubled to $2.5 trillion from $1.1 trillion, yet it took until the end of 2013 for revenues to return to the 2008 level.⁴

The other key activity driver is market volatility, which has been lacking in recent years. According to Bloomberg, U.S. equity trading volume averaged approximately 7 billion shares per day in 2015, up slightly from 2013 and 2014 levels, yet well below the approximately 10 billion shares per day posted in 2009.⁵

THE RISE OF ROBO‐ADVISORS

Robo‐advisory has the potential to significantly impact traditional wealth management. It represents a FinTech niche that is similar to the transition from full‐service traditional brokers to discount online brokers. Robo‐advisors were noted by the CFA Institute as the FinTech innovation most likely to have the greatest impact on the financial services industry in the short term (one year) and medium term (five years).⁶ Robo‐advisory has gained traction in the past several years as a niche within the FinTech industry offering online wealth management tools powered by sophisticated algorithms that can help investors manage their portfolios at low costs and with minimal need for human contact or advice. Technological advances making this business model possible, coupled with a loss of consumer trust in the wealth management industry in the wake of the financial crisis, have created a favorable environment for the growth of robo‐advisory startups meant to disrupt financial advisories, RIAs, and wealth managers. This growth is forcing traditional incumbents to explore their treatment of the robo‐advisory model in an effort to determine their response to the disruption of the industry.

While there are a number of reasons for the success of robo‐advisors attracting and retaining clients thus far, we highlight a few primary reasons.

• Low Cost. Automated, algorithm‐driven decision making greatly lowers the cost of financial advice and portfolio management.
• Accessible. As a result of the lowered cost of financial advice, advanced investment strategies are more accessible to a wider customer base.
• Personalized Strategies. Sophisticated algorithms and computer systems create personalized investment strategies that are highly tailored to the specific needs of individual investors.
• Transparent. Through online platforms and mobile apps, clients are able to view information about their portfolios and enjoy visibility in regard to the way their money is being managed.
• Convenient. Portfolio information and management becomes available on‐demand through online platforms and mobile apps.

Consistent with the rise in consumer demand for robo‐advisory, investor interest has grown steadily. While robo‐advisory has not drawn the levels of investment seen in other niches (such as online lending platforms), venture capital funding of robo‐advisories has skyrocketed from almost nonexistent levels 10 years ago to hundreds of millions of dollars invested annually the past few years. The year 2016 saw several notable rounds of investment not only into some of the industry's largest and most mature players (including rounds of $100 million for Betterment and $75 million for Personal Capital), but also for innovative startups just getting off the ground (such as SigFig and Vestmark).

Table 7.1 provides an overview of the fee schedules, assets under management, and account opening minimums for several of the larger robo‐advisors. The robo‐advisors are separated into three tiers. Tier I consists of early robo‐advisory firms that have positioned themselves at the top of the industry. Tier II consists of more recent robo‐advisory startups that are experiencing rapid growth and are ripe for partnership. Tier III consists of robo‐advisory services of traditional players that have decided to build and run their own technology in‐house. As shown in Table 7.1, account opening sizes and fee schedules are lower than many traditional wealth management firms. The strategic challenge for a number of the FinTech startups in Tiers I and II is generating enough AUM and scale to produce revenue sufficient to maintain the significantly lower fee schedules. This can be challenging since the cost to acquire a new customer can be significant and each of these startups has required significant venture capital funding to develop. For example, each of these companies has raised over $100 million of venture capital funding since inception.

CONCLUSION

The proliferation of robo‐advisory services across the financial landscape carries many potential outcomes for the wealth management industry and traditional players in the space like banks. Up to this point, the initial success in attracting assets by robo‐advisors indicates that there exists a broad base of customers that demand holistic financial management and online investment and portfolio management platforms with the ability for programmed decision making. While we cannot predict the future, one possibility sees large incumbents continuing to snatch up and leverage the capabilities of robo‐advisor startups, leaving only the largest and most established online robo‐advisory platforms able to continue to operate on their own. Smaller wealth management firms and RIAs may look to partner with robo‐advisor platforms as well or return to focusing exclusively on high‐net‐worth clients and offering more personalized services.

Beyond robo‐advisory, FinTech innovation within wealth management may also broaden access to wealth management tools, increase transparency, and lower regulatory and compliance costs. These changes present community banks with the chance to enhance their wealth management and trust divisions or to develop one that leverages FinTech innovations.

Similar to other traditional incumbents exploring FinTech opportunities, banks are presented with strategic options ranging from building their own robo‐advisory, buying a robo‐advisory, partnering with an existing robo‐advisory, or not offering wealth management services. While we suspect that partnerships will be the more preferred route, one might expect to eventually see acquisitions and internal builds among larger banks that have enough scale to justify the higher costs of those strategies.

For large incumbents, the trend of acquiring robo‐advisory startups and adopting the technology behind robo‐advisory through other means is already well underway. As previously mentioned, some of the industry's largest players such as Goldman Sachs and BlackRock have acquired smaller robo‐advisory startups and are integrating these startups' capabilities into their online platforms. Partnerships and in‐house builds are also occurring across the financial landscape as financial institutions begin to recognize not only this evolving consumer preference, but also the efficiency that programmed portfolio management decision making can bring. As incumbents continue to integrate robo‐advisory capabilities into their wealth management and financial advisory divisions through acquisitions, partnerships, and in‐house buildouts, they will continue to gain scale and increase their already massive presence within the financial ecosystem.

In the frenzied wake of traditional institutions' acquiring or partnering with robo‐advisory startups, startups operating on their own will likely begin to fade as they join with more established players in efforts to gain better access to funding or a larger platform to promote their products. As the technology behind robo‐advisors becomes more accessible, the importance of scale will likely increase, leaving many smaller startups with no choice but to sell to or be acquired by a larger player. This mass consolidation of the market could then leave only the most established and largest robo‐advisors, such as Wealthfront, Betterment, and Personal Capital, able to stand alone and continue to operate independently.

Finally, as large institutions can more readily offer low‐cost, automated investment advice and portfolio management services, smaller wealth management firms and divisions of banks and RIAs may be forced to move into more specialized areas, such as intergenerational wealth transfer and tax planning. Smaller firms will also have to focus on retaining high‐net‐worth clients that represent the largest section of their customer base, as greatly lowered costs may lure clients toward working exclusively with large institutions offering robo‐advisory services. Unless small wealth management firms and RIAs can respond to changes in customer preference by adopting some aspects of robo‐advisory services, there is the potential for their business model and role within the financial landscape to be greatly disrupted. While it still remains to be seen whether high‐net‐worth clients will begin to move away from traditional, people‐centric firms, the proliferation of robo‐advisors has certainly created the potential for it. Large institutions can now leverage robo‐advisory services to offer a complete snapshot of a client's financial status in a clear and transparent manner through online platforms driven by algorithm‐based, programmed decision making.

While all of these outcomes are certainly possible, there are still a number of factors that could inhibit the continued proliferation of robo‐advisors, including government regulation and a renewed investor realization of the value of investment advice and portfolio management that includes a human element. Although the days of completely relying on robo‐advisory for all of our financial advisory and wealth management needs are still a long way off (if they ever come at all), robo‐advisors have made inroads into the financial landscape and have shown just how innovative and disruptive the technology can be. However, it may only serve as a complementary piece to the financial landscape rather than one that overhauls the entire system.