The global wealth management industry is a US$30 trillion business, with managers charging up to 1-2% despite frequently failing to beat the market. And although the Islamic sector accounts for a tiny proportion of the whole, fees are even more of a challenge in this high-competition, low-volume market. As a new trend starts to tread on the heels of traditional managers, LAUREN MCAUGHTRY asks if machine could ever truly overtake man as a preferred choice for cost-effective asset allocation?
Robo advisors are one of the biggest trends in the conventional wealth management space this year, with claims of major disruption to the industry as online firms charging significantly lower fees deliver electronic, software-based investment options that offer transparent model portfolios and allow the middle market investor to maximize their returns.
So what do robo advisors actually do? In essence, almost anything. They can provide automated assessments of a user’s risk appetite, and automated portfolio creation, services and products. They can offer electronic advice to replace that of a traditional wealth advisor, as well as services such as diversified portfolio allocation, electronic portfolio management and rebalancing. They can be accessed from anywhere simply using a smartphone or laptop, they are available 24/7 and they charge a fraction of human managers — typically around 15-35bps.
A key point to highlight is that robo advisors do not aim to beat the market. They do not even aim to beat the best managers. Instead, they aim to exploit the current inefficiencies in the existing system to smooth and improve overall performance — delivering returns very close to the market and thus outperforming most human fund managers who, data suggests, are less successful.
A report from S&P Dow Jones Indices in 2014 found that 86% of active large-cap fund managers failed to beat their scorecards in 2014, while nearly 89% had underperformed benchmarks over the past five years and 82% over the last decade. While specific data is not available for the Islamic fund management industry, there is no reason to believe that the trend would significantly diverge from the wider market — making robo advisors a compelling attraction especially for the large mass affluent market seeking cost-effective and relatively simple investment advice.
A growing trend
And the market is expanding fast. Research from MyPrivateBanking estimated robo advisory assets under management of up to US$14 billion in 2014 in the US alone, and expected to grow to US$255 billion within five years. More than 200 robo-advice platforms now exist in the US with activity also picking up in Europe, as the biggest players in the world look to gain first-entry advantage.
Blackrock recently bought US robo advisor FutureAdvisor while Aberdeen Asset Management (which has an Islamic arm) was pipped at the post by Schroders to acquire online wealth manager Nutmeg in 2014, and in late 2015 retaliated with the purchase of Parmenion Capital Partners, a UK firm providing risk-graded portfolios to UK financial advisors through a digital platform.
Charles Schwab has developed its own low-cost exchange-traded fund (ETF)-based service, while Vanguard offers a hybrid ‘robo-human’ model that already has over US$21 billion in assets under management and charges just 33bps for investors with portfolios of over US$50,000.
It is clear that the conventional industry is embracing the trend — perhaps to mitigate the disruption that this new technology has the potential to cause. But what effect could robo advisors have on the Islamic space?
“The impact could be profound,” predicted Muneer Khan, a partner at Simmons & Simmons Middle East. “As the technology develops, which will happen rapidly, more and more aspects of the wealth management service life cycle will be covered. This technology will be particularly useful for the ‘mass-affluent’ segment.
A possible trend
Currently, there is limited activity in the Islamic space. “It’s still very much in the planning stage,” agreed James Stull, a partner with King & Spalding Middle East. “The people I have spoken to who are interested in this are currently talking to partners about development or looking at examples in the US or UK — I am not aware of anyone in the region who is actively doing this yet on an Islamic level.”
Yet there is certainly plenty of potential. “It should be easy enough to set up a robo advisor that can select stocks on a Shariah compliant basis that meet Shariah standards, and this could open up the universe to a broader range of Islamic investors,” he continued. “This could absolutely have an impact on Islamic funds — and a similar impact as it has had on the conventional space: by bringing costs down and allowing access for people who might not otherwise have been able to invest.”
It could also have positive implications for portfolio diversification and wider market access. “Robo advisors could be very applicable to the equities asset class, particularly when you are looking outside the region,” pointed out Stull. “For someone sitting in the Gulf who wants exposure to wider markets, this is cost effective, quick and easy so there is a big opportunity for growth.”
So why has this growth not yet occurred? One reason is because currently robo advisors are concentrated in the ETF space, and this has simply not yet taken off in the Shariah compliant market. Schwab Intelligent Portfolios for example, the online advisory service from Charles Schwab, combines robo advice with smart beta to beat the market: allocating around 60% to alternatively weighted ETFs.
“One of the things that makes robo advisors work is the low fee structures in their ETF models,” explained Monem Salam, a director of Saturna Capital and the president of Saturna in Malaysia. “However, there is currently a dearth in ETFs in the Shariah space out of which you can actually build a model portfolio, so fees will remain high just because of the fund structures throughout most of the Muslim world.”
These high fees make robo advice difficult to launch — because no matter how low the robo advisory fee might be, it is still an addition to the existing fund cost. “Yes there is potential there, but there are steps along the way that need to be taken first,” warned Monem. “The fee structures have to come down on the funds, then you have to have an explosion of ETFs and then the cost bases on these ETFs must be so low that you can justify having a robo advisor. I think it is a good thing, and it should happen — but right now there is just not enough product out there yet to do it in the Shariah space. The first step toward a robo advisor is to be able to go on your website and have a survey that finds out your goal, time horizon and so on. Then you move on to asset allocation, and here you can even recommend certain allocations. That’s already there, but that is not a fee model: that is a straightforward process that you don’t need to charge a fee for. The next step is a robo advisor, and that advisor does charge a fee, and makes recommendations on ETFs with an active rebalancing on a regular basis. ”
A question of fees
It will come as no surprise that fees are the major stumbling block to the growth of the Islamic funds sector — this has been a challenge long recognized by the industry. And although most Shariah screening is done electronically already and several fund managers (such as UK-based Arabesque) already use a computer-based quantitative strategy for stock selection, this has not yet had an impact on fee reduction. Until that happens, little is likely to change.
“There is currently a debate within Islamic investment whether to have a small amount of assets and charge a lot, or charge a little and let the assets grow. Right now I don’t think anyone is willing to take the risk and let the assets grow — they are pretty comfortable charging high and keeping the assets where they are,” commented Monem. “That’s one of the reasons why Islamic investment assets have plateaued over the last few years, and a lot of the growth is market growth rather than real asset growth.”
A positive outcome
However, others are more positive as to the potential impact of the online revolution. “If something becomes more cost-effective, then it opens the doors up and I think it’s good for the industry and good for growth,” noted Stull. “We will see investors come in who weren’t willing to invest at the higher prices and this could be a boon for the Islamic funds industry.”
Islamic funds might charge higher fees for advice now, but if the entire process could be mechanized then what reason would there be to charge these fees, other than a deliberate choice to maintain high barriers to entry? “I am a lawyer not a banker, but I would like to think that robo advisors could bring fees down to be equal to conventional counterparts,” said Stull. “It is essentially a computer, an algorithm, picking securities and making adjustments. It is a program, and I would think there would be no difference in price, as you are not relying on extra active expertise. It might take more expertise to create or launch that algorithm with the Shariah element but once it is up and running there is no reason why it could not be comparable.”
And if the application is currently concentrated on ETFs, it has the potential to apply to a wider range of funds and assets. “This technology could certainly help to streamline processes and enhance efficiencies, and Shariah compliance processes could be built in,” agreed Muneer. “With the right collaboration between the asset managers, technology developers and Shariah advisors, robo advice could be adapted to deliver many Islamic wealth management services.”
A disruptive influence
It seems inevitable that this new segment will disrupt the industry — not least because the growth of stand-alone robo advisors will force incumbents to react fast to launch their own offerings or risk losing customers. The conventional industry has already jumped on board — when will we see the Islamic industry follow?
If Shariah compliant fund managers fail to follow this trend, they could lose out on even more customers as the market congregates toward the best price and the most efficient service. And after all, with the increasing sophistication in online and electronic services, what is to stop a conventional wealth manager from offering a simple Shariah robo advisory product and drumming the existing players out of business altogether?
The target market for robo advisors is not high-net-worth-individuals or family offices, but the mass affluent, mid-career professionals with little time and low tolerance for high fees, yet a reasonable quantity of investable assets. With a rapidly growing middle class and increasing sophistication in financial services, the trend applies perfectly to the developing Muslim world.
“Enhanced efficiency and productivity must be key objectives for the growing Islamic wealth management sector, as they are in the wider industry,” pointed out Muneer. “This technology, if deployed in the right way, could help to achieve these goals. This could in turn help to make the Islamic wealth management sector more competitive.”
A slow burn
So why has no one yet taken the plunge? “Some of the smaller first-time managers have mentioned robo advisors as something they might look at, perhaps in partnership with someone else,” said Stull. “It is the smaller players who are exploring it, because they are looking for any kind of advantage they can get in terms of cost.” And while the barriers to entry may be high, they are no higher than in the conventional space.
“A lot of the interested parties I have come across aren’t so worried about the impact on compliance of robo advisors,” Stull pointed out. “Most of them will have a Shariah board that approves the process — while the manager of the fund itself may not be a Shariah scholar. So in the case of robo advisors it would be a similar situation — the Shariah board would review and approve the underlying algorithm or program and then investors would be comfortable with that approval.”
However, as with human advisors, robo advisors will need control, oversight and audit. “This will especially be the case for Islamic wealth management services, due to the additional Shariah compliance requirements,” warned Muneer. “For the time being, and while the technology develops, there will remain a significant level of human advisor interaction in the Islamic wealth management space, with complementary robo advice services being added as they are developed.”
There is always a challenge with something new that people don’t understand. As people learn more about it the trend will grow, but it might have a slow start. “We are still in a wait-and-see phase, we haven’t yet seen anyone take the plunge,” confirmed Stull. But surely, if the Islamic asset management industry wants to survive, it can only be a matter of time?