The good and the bad of technological disruption in the investment industry
“Computational power isn’t just changing the old literacies of reading and writing. It’s creating new ones.”
— Clive Thompson, Smarter Than You Think
There is no hiding from technological disruption these days which has spread quickly into every sector from health care, oil and gas, consumer discretionary, real estate, banking, insurance, legal, accounting — even to the investment industry.
The level of connectivity in devices is the reason why this period of technological disruption is different from prior periods such as the 1990s tech bubble. In particular, the subsequent build out of the internet of things has resulted in the acceleration and rapid adoption of new technologies that are using data to effectively drive down prices of products and services for consumers.
In the investment world, this level of connectivity has suddenly allowed equal and full access of information to the many chartered financial analysts out there willing to do the research. As a result, the level of efficiency in the markets has increased to the point where it is becoming nearly impossible to consistently outperform passive benchmarks — especially one in which there is little to no volatility. Looking ahead, imagine what will happen when more of these CFAs start using cognitive computing and artificial intelligence to start analyzing all of this data.
It isn’t surprising to see exchange traded funds (ETFs) do very well in this environment. They themselves have been a very powerful disruptive force to the high-fee mutual fund industry. Suddenly, the average investor can own the market at a substantial discount to an actively managed fund that is struggling to deliver alpha due to higher fees and greater broadermarket efficiencies.
While the fund industry is trying its best to adapt by lowering fees themselves, it is becoming a race to the bottom having to compete with ETFs that charge as little as 10 basis points. More so, it is competing against the banks and even insurance companies who have both the size and scale to be a low-cost and profitable manufacturer of ETFs.
Interestingly, ETFs have a lot in common with the network effect being used in other industries. This is where a product or service is nearly given away at cost to build out an internal distribution system which additional higher margin products or services are then layered on top of. This makes it tough for a single-service provider such as a mutual fund firm to compete against a multiservice financial institution.
Then there are the investment advisers who have finally begun using ETFs themselves in order to protect their margins in an environment where regulatory and administration costs are rising and investment fees are falling. From a value-add perspective, their role is still important in regards to asset allocation and ETF selection.
However, even this role is fast becoming disrupted with roboadvisers offering automated asset allocation solutions and ETF selection for a fraction of the cost. To make matters more complex, these robo-advisers are about to be disrupted by ETFs themselves who are offering tactical rebalancing strategies within a single ETF. We’ve even seen ETF’s utilizing artificial intelligence to rebalance holdings and weightings.
That said, these strategies have yet to be stress-tested given the market has gone up a record amount of time without a correction. A machine also cannot talk an active investor out of return-chasing, such as an overallocation to equities at market highs or loss aversion with an under-allocation at market lows — at least not yet anyway.
Additionally, there are some excellent actively risk-managed strategies out there that will outperform during periods of excess volatility. We think these funds are going to have to scrap their standard two-per-cent management fee and 20-percent performance fee though, in order to survive until the next correction. That said, it wouldn’t surprise us to see more of these funds become automated, especially those that are quant-based thereby driving their costs down so they can continue to compete.
In conclusion, while lower fees and ETF disruption are no doubt a great development for investors, it shouldn’t be the sole factor driving one’s process. Instead, we think pairing technology with asset diversification and professional advice is and will continue to be a prudent long-term way of managing money.
The disruption of new technologies in all industries is unprecedented today compared to prior periods, such as the 1990s tech bubble, says Martin Pelletier. The wise way to manage money in these daunting high-tech times, he advises, is to pair...