MGT415: Fintech

FinTech In Wealth Management

Topic:

Pre-requisite for wealth (for most people): save money

many facets

Wealth Management

income/expense management
retirement savings advice
investment advice
tax advice

many facets

Questions we are interested in

What tools have people come up with?
Do they work?
What are the larger implications for the financial industry and for markets?

Areas and topics

investment advice

consumer finance advice

What's there?
Why matters?
Does it work?

What's the problem with (current) advice?
What's there, what's new?
Does it work, and does it matter?

In 2015, underserved consumers spent $140.7 billion on fees and interest across five financial product categories that serve the "under-banked"
Service fees for under-banked
- high cost check cashers $2 billion
- small dollar ‘pay day’ lenders $7 billion
- bank overdraft fees $24 billion
Poor people also pay credit card fees and debts etc
Banks "optimize" fee collection, e.g., on overdrafts

Source: Schmall & Wolkowitz (2016), Center for Financial Services Innovation (2016) "Financially Underserved Market Size Study"

Banking in the U.S. - Fee Collection Business

Source: Schmall & Wolkowitz (2016), Center for Financial Services Innovation (2016) "Financially Underserved Market Size Study"

Why and how? - People have a) little money and b) spending habits

Source: Schmall & Wolkowitz (2016), Center for Financial Services Innovation (2016) "Financially Underserved Market Size Study"

Canada has its own set of problems

Bottom line: tools that help consumers spend better could have high social value

Consumer Finance Advice

Status Money (an income aggregator) used a Peer Comparison Device

elicits characteristics of customers
uses US representative micro-data on transactions
shows customers the spending profile of similar group
assesses the reaction of customers (transaction level)

A FinTech firm's experiment

Source: D’Acunto, Rossi, and Weber: Crowdsourcing Financial Information, 2019

A FinTech firm's experiment

"over-spenders" reduced spending

most people reduced spending

Bottom line: seems to work well in terms of helping people manage their spending

Why we should be skeptical of untethered AI

https://assets.dynamic.ca/content/dam/klick/Article-Reprints/SUFA_sareport.pdf

With a finer comb: components of Financial Advice

available investment products
fee transparency
regulatory changes
mobile (&tech) savvy users

several developments in recent years

Our main focus: Investment Advice

The founding father of portfolio optimization is still with us, his name is Harry Markowitz
Won the Nobel prize in 1990 for work he did in the 1950s
His insight is the engine of robo-advising
- How to take the least risk for the expected return

Detour: theory behind the advice
Portfolio Choice

Want higher expected return, lower risk
- For a given expected return, want the lowest risk
- For a given risk, want the highest expected return

Industry terminology is "efficient portfolio"
- Portfolio with the minimum risk, for its expected return
- Efficient in the sense of bearing only the risk necessary for the expected return

Portfolio Choice for Risk-averse People

You do the work
$\to$ (DIY)-portfolio of securities
Delegate portfolio selection
$\to$ invest in a fund

Two basic approaches

First one: March 21, 1924 (Massachusetts Investors Trust)
An investment program funded by shareholders that trades in diversified holdings and is professionally managed
Active management
- Pay 1-2 percent a year for the manager to pick the stocks your money goes in
Passive management (Index Fund) (from Dec 31 1975)
- Fund simply gives you access to a defined index
- Not paying for stock picking, just the logistics of getting the index return (may pay 1+%)
- Google: Jack Bogle ...

Mutual Funds

Trading directly with the fund
- If you invest $10,000, your money goes into the fund, making it trade
One trading time a day
Can access from only some platforms
Minimum investment (used to be a few thousand dollars, much smaller now)

Mutual Funds

Investment program funded by shareholders that trades in diversified holdings and is professionally managed
- typically a much lower fee (will revisit this point)
- First ETF: January 23, 1993 (State Street's SPY)
Typically: follow an index.
To invest: buying shares of the fund on the open market
- Your money goes to the person selling shares
  - Your trade doesn’t directly affect the fund, doesn’t make it trade
  - Pay the market transactions cost
- Trade any time the market is open
- Minimum is just 1 share (maybe a hundred dollars)
- Access from any brokerage account

"new" product: Exchange-Traded Funds (ETF)

New Investment Products: Exchange Traded Funds (ETFs)

US data: https://www.seeitmarket.com/what-are-etf-and-mutual-fund-flows-trends-telling-investors-now-14449/

New Investment Products: Exchange Traded Funds (ETFs)

For an extensive review of ETFs (U.S. Markets), check out:

SIFMA Insights:

US ETF Market Structure Primer

https://www.sifma.org/wp-content/uploads/2018/09/SIFMA-Insights-US-ETF-Primer.pdf

New Investment Products: Exchange Traded Funds (ETFs)

https://www.sifma.org/wp-content/uploads/2018/09/SIFMA-Insights-US-ETF-Primer.pdf

ETFs are mostly passive

Based on

Lasse Pedersen's book plus
an academic paper "Efficiently Inefficient Markets for Assets and Asset Management" (Journal of Finance, 2018) (Nicolae Garleanu & Lasse Pedersen)

Detour: theory behind the advice
active vs. passive

Capital Asset Pricing Model

market portfolio is efficient

Theory & Empirics Behind "Active vs. Passive"

market portfolio is "value-weighted"
- investment in each security is proportional to its market capitalization

Property of "value-weighted": "equal-ownership"
- if I hold a value-weighted portfolio & it turns out that I hold 0.00045% of all outstanding TD shares
- => I hold 0.00045% of all outstanding shares in other securities (0.00045% of AC, 0.00045% of BBD, etc.)

Doesn't matter if prices change
Don't need to re-trade unless the number of shares outstanding change
=> passive portfolio

Value-weighted portfolios are passive

$\to$ Old consensus: one cannot beat the market by being active

But ... empirically this isn't quite true

Where does the basic arithmetic go wrong?

When passive trade, they are typically uninformed and lose money to the informed (hence, the latter can make money!)

Detour: theory behind the advice

Predictions on Active vs. passive

Skilled/informed active asset managers: outperform passive investing before and after fees
Unskilled/uninformed active asset managers: underperform after fees

Sophisticated investors: higher expected returns with active managers before and after fees (which compensate them for the "search costs" for finding the "good managers"!)

In theory, investing is easy...

Theory:

risk free asset
market portfolio
maybe additional risk factor exposure

Practice: Investing is complex...

$\to$ most people need or look for help
$\to$ investment advisor

From Lecture 1: Finance as % of GDP

Advice ain't free: Fees & Fee Transparency

What fees do investors pay?

Account management (to the bank)
Investment adviser
- typically fee based (annual, based on AUM)
- Front end (0-2%):
  - by customer to advisor
- trailer fees
  - paid by fund per year that the customer holds the fund; roughly 1%
  - implicitly paid for by customer
- commission
  - get paid by the fund that they are "reselling" to you
  - often: "deferred sales charge" (client pays if liquidates the fund too early)
fund expenses (MER)
- 0.1-4% of funds under management (to the fund)
  - 1+% for mutual funds

But still not easy ...

... and it's also hard to get people to invest

Advice given fifty years ago

100 minus your age = percentage of equity allocation
- Out of college, close to eighty percent in stocks
- Near retirement, more like forty percent
- Over your career, gradually tilting stocks to bonds
Still pretty much the conventional wisdom

Solvable ... Basic Advice is: more risk at longer horizons

The question: do they act in client's best interest?

The problem: all evidence points to them not acting in clients best interest

2015 (!!) report

Trailer fees are illegal in ...

Britain
Continental Europe
Australia

BMO Canadian Equity ETF Fund

BMO S&P/TSX Composite ETF

What to suggest?

3. Regulatory Changes

over past 20-25 years: regulations become more assertive
- => compliance expenses
(upcoming -- announced in Dec 2019) ban on trailing commissions for investment advisers & ban on DSC everywhere but in Ontario
- reduced incentive to push mutual funds
for funds: separation of research fees and commission charges (no more hidden charges) when dealing with sell side
- likely funds will have to do research themselves
- => reduced demand for them
best interest vs suitability
- best interest is often seen as low fees
  - => reduced demand for mutual funds
- SEC is further ahead than OSC on this ...

But the concern is: how do people get financial advice?

Fact 1: People need advice
Fact 2: Advisors face conflict of interest.

How do people get financial advice?
$\to$ There is an app for that: Robo Advisors!

4. Robo Advice

https://www.theglobeandmail.com/business/article-the-grim-reality-for-wealthsimple-and-its-peers-robo-advisers-are/

Globe and Mail Feb 2020

What are the challenges (& costs) if you wish to enter the market?

What does it mean for the future of robo-advice?

Challenges & Options?

Customer acquisition
- Marketing directly to consumers vs. partnering with an FI
- Total customer portfolio size must be sufficiently large to offset the costs!
- Low fees? => Need a lot of AUM!
- lots of competition & captive customers

Baby-boomers are retiring ...
- outflow of funds!

Rise of ETFs
- => decreased willingness to pay for "advice"

Recent development:
"active" ETFs with the usual fees

Challenges & Options?

Regulatory challenges
- fewer fees => fewer sources of income
- increased compliance requirements
  - paperwork!!!

Trust
- face-to-face contact
- familiarity with the "banks"

Scaling vs. profitability
- Researchers at Morningstar estimate robo-advisers in the U.S. need US$16-$40 billion in assets to break even.

Is robo advice is inevitable?

Robo-advisors mostly recommend ETFs
On average mutual funds don't deliver value for the money
- decades of finance research ...
many financial advisers don't act in their client's but in their own best interest
- would you code this in?
most financial advisors actually use generic, algorithmic scoring tool anyway
- why pay a person to type number on a website?

BUT: this all means 100,000 middle class jobs are at risk ...

Gen X

Millenials

How does one scale?

An alternate path: add a B2B option (SaaS)

partnering with the wealth-management industry to license online technology to those investment firms who want to bring robo-adviser capabilities in-house for their financial advisers to use directly with clients

Human vs. Robo-Advice: What’s Better? For Whom? Giving Robo-advice to investors that already access Human Advice

Source: D’Acunto, Prabhala, and Rossi: The Promises and Pitfalls of Robo-advising, RFS 2018

Setting: large full-service brokerage house in India more than 800,000 retail accounts
In July 2015, introduced a Portfolio Optimizer Tool
- obtains existing portfolio holdings from account
- performs Markowitz mean-variance optimization
- proposes optimal weights, analysis
- immediate execution by clicking a button

The Promises and Pitfalls of Robo-advising

$\to$ reduction in risk/better diversification

The Promises and Pitfalls of Robo-advising

$\to$ people with diversified portfolio trade much more

Who Benefits from Robo-advising?

largest US robo-adviser, Vanguard Personal Advisor Services (PAS)
Robo-advice reduces investors holdings in money market mutual funds and increases bond holdings. Bond=higher yield for same risk
Reduces holdings of individual stocks and US active mutual funds, and moves investors towards low-cost indexed mutual funds. avoid useless fees
Increases investors' international diversication and investors' overall risk-adjusted performance. combat home bias
Biggest benefit to clients with little investment experience & those with high cash-holdings and high trading volume pre-adoption. helps less sophisticated
Clients with little mutual fund holdings and clients invested in high-fee active mutual funds also display significant performance gains.

Source: Rossi & Utkus (2019) Who Benefits from Robo-advising? Evidence from Machine Learning

Who Benefits from Robo-advising?

Source: Rossi & Utkus (2019) Who Benefits from Robo-advising? Evidence from Machine Learning

$\to$ evidence clearly points to robo-advice being a positive development

FinTech in Wealth Management

By Andreas Park

FinTech in Wealth Management

This deck of slides is on WealthTech

Andreas Park PRO

Professor of Finance at UofT

MGT415: Fintech