Betterment's Jon Stein talks human-RIA coopetition but breathes fire about fellow online RIAs

Well, there is no doubt that there is a market for what he is offering, but I just spend the better part of several days not in setting up asset allocations or choosing investments, but in explaining to a series of clients why their portfolios need to be set up the way they are, and advising them on why pulling out a large lump sum from a portfolio designed to create income is not a good idea.

The “human factor” in investing, on the client’s side of the table, is perhaps the largest risk to a portfolio in an environment where asset allocation becomes generally accepted as the best method. As long as the media hypes specific investment schemes and salespeople are clamoring for investors to drop a big chunk of their money into something that will benefit the salesperson, members of the public will need professionals who understand why and how portfolios work.

We have well over 100 clients served by our firm, averaging just under a million dollars per portfolio and there is rarely a week when we don’t have to get involved to head off a serious mistake. Gold finally seems to have lost some of its appeal, but real estate is rising now as the flash de jour. Just as importantly, when there is a real need for a lump sum, or a family emergency creates a new income need, it is hard to get a software site to provide individualized advice on where to take the money and how the investor may need to compensate.

For whatever it is worth, the comparison to travel agents may be accurate. The more wealthy and busy family still have travel agents who understand the complexities of need for those families. That is generally who the professional investment advisory community serves.

This debate continues to be interesting. Two things pop out, based on the ADVs,Betterment has an average client of $12k and Wealthfront $85k so when you start talking about your market being from 0 to $10M it seems to be a bit of a leap. When I think of Wealthfront I always wonder how much of their traction comes from first $10k free from the “I’ll try you out” set of investors, not the most loyal as we all know. I think both these firms offer a great product up to the $250k range. We have always felt an investor in this area is best served by maxing out their 401k and taking any extra money to Vanguard. A point here, it seems to me that the area of differentiation here is in algorithms and tax optimization, because other than that I still can’t see what is offered that Vanguard can’t do as well for no fee.

NS Capital has a good point. We too tend to direct investors who we meet but don’t have sufficient invested net worth to make it reasonable for us or them to work together to Vanguard’s site. We then give them a short tour of what is available and suggest they get involved.

Now I want to venture a bit of a controversial point. ETFs are not as easy to use, understand, or as safe as a mutual fund, properly registered under the Investment Company Act of 1940. Dropping an inexperienced investor into a nest of ETFs has the potential to lead them far, far astray. When we work with low net-worth family members as part of our larger work with the family head, guiding them away from the flashy and quite risky narrow band ETFs is a continuing problem. My personal experience is that many younger investors believe that an ETF is an ETF and they are simply mutual funds that have low expenses and can be traded. As may of us know, there are ETFs that go far astray. There are others, heavily marketed, based on some pretty unrealistic assumptions about their ability to create a high return with little or no risk.

The number and complexity of ETFs has mushroomed since the panic of 2008-2009. The newer issues have not had their structure, premise or much of anything else tested in a serious market downturn. More, many of the lower net-worth investors have not experienced the effects of a serious correction or a bear market on a portfolio. As the dollar value of those portfolios rise, the need for a human being to talk investors off the ledge grows.

This debate continues to be interesting. Two things pop out, based on the ADVs,Betterment has an average client of $12k and Wealthfront $85k so when you start talking about your market being from 0 to $10M it seems to be a bit of a leap. When I think of Wealthfront I always wonder how much of their traction comes from first $10k free from the “I’ll try you out” set of investors, not the most loyal as we all know. I think both these firms offer a great product up to the $250k range. We have always felt an investor in this area is best served by maxing out their 401k and taking any extra money to Vanguard. A point here, it seems to me that the area of differentiation here is in algorithms and tax optimization, because other than that I still can’t see what is offered that Vanguard can’t do as well for no fee.

We spend most of our time with clients up front, discussing fees, where they add value and where they don’t, transparency to facilitate better investment decisions and most important time frames which for us have to be done eyeball to eyeball, “if you won’t commit that portion of your assets for a full market cycle we don’t want it”. Our smaller clients have around $250k and the larger ones between $5 & $6M. Here’s the interesting part, when the markets get dicey it is the clients with under $500 that we spend the most time with. Every investor has a tipping point when it becomes about having enough money that they become fearful of losing it, and that is where these on line providers are going to find things challenging.

“JS: We don’t talk about profitability. Sorry.”

With $300M @ 25 bps, gross fees are $0.75M per year. With 34 people on this page alone: https://www.betterment.com/about/team/, a conservative estimate of salaries would be $3M…

The focus for both Wealthfront and Betterment is now firmly on scaling; not profitability. They are each early in building a brand and busy trying to slice up online business between the two of them. The service offerings are simple – but that’s how most high-growth businesses start. Good luck to them both; we’ll see you at the finish line!

When the dose of market downside reality is delivered and virtual RIA clients realize they have to tell their wives that their computer program lost a large portion of their stored earnings overnight, we will see the attitude of the technologist leadership of these firms.

Brian,
Recurring revenue from asset based fees are painfully slow. Where do you see the finish line and will the venture partners have the patience to keep funding these things. Does anyone remember Kaching.

Dear Steve,

Regarding the last question they clearly can’t be profitable. They have $303mm AUM and earn a 15bps fee, that’s only $454,500 of revenue per year for a 40 person company located in Manhattan. So there’s just no way they can be remotely close to profitable, they must be burning through cash, I can’t imagine that these employees are cheap, the legal fees must be staggering, office space in NYC, technology costs etc. It could easily cost $125k an employee if not more to run this show, right? That would be $5mm a year and to-date they’ve raised a total of $13mm. So somethings gotta give eventually.

Ok so lets stick with this, I’d like to talk about profitability. How in the world is this company ever really going to make any money? Let’s go through some simple back of the envelope numbers:

They currently have 25k users and a total of $303mm AUM so the avg account size is only $12,500. They’re trying to grow the business into running $100bb. Assume that the average account size stays the same (I know not a good assumption at all, but just to put some numbers / perspective on things lets do it anyway) that would mean they would need to grow their user base to 8.3mm users!! That seems like an impossible task, there are only about 100mm households in the US and I’m guessing a whole hell of a lot of them don’t even have 12.5k of savings.

So really the only way to grow the AUM to anything substantial is going to be by getting significantly larger account sizes. But can they really attract high-net-worth types to open accounts? My gut tells me no way. Certainly the guy who’s net worth is north of $25mm is not going to open a Betterment account and put his money there, he’s got a team of fancy people at GSAM or UBS or Credit-Suisse or Morgan Stanley that look over his stuff. They make him feel warm and fuzzy about how safe his money is and how he is getting access to the smartest, talented Ivy League MBAs to just sit around and think about his account. They want to be able to have access to alternative investments in CTA’s and hedge funds and it’s also a prestige thing, these guys want to stroke their egos right, they’re not driving around in Kias!!

Ok so maybe they can get some accounts in the low single digit millions, but again, is it really ever going to be enough to add up to something substantial? Like $100 bb substantial? It just doesn’t seem likely, Wealthfront seems to be targeting this higher end demographic with an average account size that is 7x Betterments, but it is still only $85,000. To get to $100 BB with that account size you would still need nearly 1.2 million users!! That number just seems insanely high. So the idea of this thing growing 300x in 5 years just seems way out of touch. I have no idea what the upside is but my guess is getting to something like $10bb would be pretty damn impressive and a more realistic best case scenario. In which case their 15bps fee is only bringing in $15 million in revenue per year.

Am I missing something?? Is the pie for small investment accounts really that large? (ps. I’m a total outsider, not from the RIA world at all, so I don’t have a good lay of the land) I’d love to know what I’m missing. Is there huge potential for IRA accounts or something?? Pensions and Endowments and Family offices seem like they are too sophisticated to just be using a “slider.” I’d love to know how in the world getting to $100 BB is anywhere near a realistic goal. Also do you think the whole venture is largely a bull market beta bet? I mean if things turn here at all and we go back to a down market do you really think people are going to be opening up new investment accounts?

Lastly I don’t think you can even come remotely close to managing that type of money using ETFs. Below is the ETF basket that Betterment advertises on their website. The first column is the % exposure, then the ticker, next to it I’ve added the current market capitalization of each fund. If you add up the entire market cap of all these ETFs it’s $141 BB, so does betterment really think they are going to nearly double the entire market of these things that have been around for a hell of a long time in just 5 years! If half their portfolio is in bonds then at $100bb they would have to own $25bb of SHY, which is 3x it’s current market cap! It makes me think that Jon doesn’t really have a good understanding of liquidity in the market… again it’s likely I’m missing something and I’d love to know what.

Stock Basket:
25% VTI – $ 37B
25% IVE – $ 6B
25% VEA – $ 18B
10% VWO – $ 48B 8% IWS – $ 5B 7% IWN – $ 6B

FI Basket:
50% TIP – $ 13B
50% SHY – $ 8B

Dear Steve,

Regarding the last question they clearly can’t be profitable. They have $303mm AUM and earn a 15bps fee, that’s only $454,500 of revenue per year for a 40 person company located in Manhattan. So there’s just no way they can be remotely close to profitable, they must be burning through cash, I can’t imagine that these employees are cheap, the legal fees must be staggering, office space in NYC, technology costs etc. It could easily cost $125k an employee if not more to run this show, right? That would be $5mm a year and to-date they’ve raised a total of $13mm. So somethings gotta give eventually.

Ok so lets stick with this, I’d like to talk about profitability. How in the world is this company ever really going to make any money? Let’s go through some simple back of the envelope numbers:

They currently have 25k users and a total of $303mm AUM so the avg account size is only $12,500. They’re trying to grow the business into running $100bb. Assume that the average account size stays the same (I know not a good assumption at all, but just to put some numbers / perspective on things lets do it anyway) that would mean they would need to grow their user base to 8.3mm users!! That seems like an impossible task, there are only about 100mm households in the US and I’m guessing a whole hell of a lot of them don’t even have 12.5k of savings.

So really the only way to grow the AUM to anything substantial is going to be by getting significantly larger account sizes. But can they really attract high-net-worth types to open accounts? My gut tells me no way. Certainly the guy who’s net worth is north of $25mm is not going to open a Betterment account and put his money there, he’s got a team of fancy people at GSAM or UBS or Credit-Suisse or Morgan Stanley that look over his stuff. They make him feel warm and fuzzy about how safe his money is and how he is getting access to the smartest, talented Ivy League MBAs to just sit around and think about his account. They want to be able to have access to alternative investments in CTA’s and hedge funds and it’s also a prestige thing, these guys want to stroke their egos right, they’re not driving around in Kias!!

Ok so maybe they can get some accounts in the low single digit millions, but again, is it really ever going to be enough to add up to something substantial? Like $100 bb substantial? It just doesn’t seem likely, Wealthfront seems to be targeting this higher end demographic with an average account size that is 7x Betterments, but it is still only $85,000. To get to $100 BB with that account size you would still need nearly 1.2 million users!! That number just seems insanely high. So the idea of this thing growing 300x in 5 years just seems way out of touch. I have no idea what the upside is but my guess is getting to something like $10bb would be pretty damn impressive and a more realistic best case scenario. In which case their 15bps fee is only bringing in $15 million in revenue per year.

Am I missing something?? Is the pie for small investment accounts really that large? (ps. I’m a total outsider, not from the RIA world at all, so I don’t have a good lay of the land) I’d love to know what I’m missing. Is there huge potential for IRA accounts or something?? Pensions and Endowments and Family offices seem like they are too sophisticated to just be using a “slider.” I’d love to know how in the world getting to $100 BB is anywhere near a realistic goal. Also do you think the whole venture is largely a bull market beta bet? I mean if things turn here at all and we go back to a down market do you really think people are going to be opening up new investment accounts?

Lastly I don’t think you can even come remotely close to managing that type of money using ETFs. Below is the ETF basket that Betterment advertises on their website. The first column is the % exposure, then the ticker, next to it I’ve added the current market capitalization of each fund. If you add up the entire market cap of all these ETFs it’s $141 BB, so does betterment really think they are going to nearly double the entire market of these things that have been around for a hell of a long time in just 5 years! If half their portfolio is in bonds then at $100bb they would have to own $25bb of SHY, which is 3x it’s current market cap! It makes me think that Jon doesn’t really have a good understanding of liquidity in the market… again it’s likely I’m missing something and I’d love to know what.

Stock Basket:
25% VTI – $ 37B
25% IVE – $ 6B
25% VEA – $ 18B
10% VWO – $ 48B
8% IWS – $ 5B
7% IWN – $ 6B

FI Basket:
50% TIP – $ 13B
50% SHY – $ 8B

NS Capital: I remember Kaching (aka Wealthfront)..that was a service offering that didn’t work for the general population – ie) people didn’t want it, and it just never took off. I think Andy was wise enough to recognize this early enough that they could pivot into what Wealthfront has become today.

The difference here is that people do want what Wealthfront is now selling. Both Wealthfront & Betterment have significant traction and that traction is telling VCs to “just grow it”. It’s all about scaling the business now.

WRT asset based fees being a painfully slow business – it’s not the fees that are painfully slow in growing, it’s client acquisition that has been historically slow to grow. Fees grow as fast as the clients are added, no? So the online guys are adding clients at a clip of maybe 500% per year. They’ve probably got a ways to go now.

Ultimately, I don’t find the business compelling for the reasons you’re all citing, but I’m not sure that’s really the endgame – ie) automatically managing (what are essentially target-date) accounts at 15-25bps annually. There are plenty of business opportunities that open up when you grow a business to multi-billion of AUM.

The big wildcard imo is the “stickiness” of these assets. Given that they can be added and removed with the click of a mouse, we really don’t know what client retention will look like in a downturn. I think we’ll see within a couple of years. My personal hunch is that many people view these accounts as alternatives to low-yield bank accounts…something they clearly are not.

Kevin – the amount outstanding of ETFs expands and contracts with investor interest…just because the “market cap” is a couple billion now doesn’t mean the ETFs can’t grow to $10 billion within a couple of quarters. ETF shares are issued and purchased back, by their sponsor agents on a daily basis.

Brian,

I am well aware of the creation / redemption processes involved in the ETF market. But this doesn’t change the fact that Betterment would effectively have to become one of the largest holders of ETFs in the world to be managing a $100 BB portfolio in them.

Let’s look at IVE. Betterment’s allocation is 25%, I’m going to guess since their clients are largely small account mom and pop types that they have a strong equity tilt, let’s call it 65%. Therefore if they were at $100 BB then they would have to be holding $16 BB worth of IVE. At today’s price that’s 19 million shares.

If you look at the current market the top holders of IVE and the amount of shares they hold are:

Morgan Stanley – 7mm
Wells Fargo – 4mm
Bank of America – 2.5mm

and then it drops off pretty quickly… and the list is filled with a variety of household name financial advisory / asset management type of shops.

Ok sure of course the product can expand to satisfy more demand for the ETF by the banks creating more units… but still are you telling me that Betterment is going to be on the top of the list in 5 years time ahead of Morgan Stanley! And not just even ahead of them, but more then 2.5x their size!! I seriously doubt it.

Just look on your bberg yourself and you’ll see the same is true if not even worse off in the other ETF’s. You simply can’t manage $100 BB in only ETFs. If there is someone out there doing it at that size please tell me who, I’d love to be corrected.

@jonathan & ns capital,

Don’t forget betterment decided to go ahead and open their own broker dealer and self custody their assets. Wealthfront didn’t do this and built their product clearing and custodying through apex. Having a broker dealer is an expensive proposition, and it also invites scrutiny and compliance costs to self custody assets.

Not only must the compliance be an incredible headache, but try explaining to a sophisticated $10M client (or his or her lawyer) that you are taking their money and they are going to be taking your word and only your word on how much you have. No reason to believe that any funny business is going on given the transparency, but it seems an odd choice that may bite them when they try to move to higher dollar accounts.

Brian, I just realized I forgot a zero! So again if Betterment’s AUM was $100 BB they would have to hold roughly $16 BB worth of IVE. The current price is $83.96, so that’s 190 million Shares!!! When the current biggest holders, all the largest banks and advisory firms and asset management shops are all holding 1-7 million Shares at most! Are you telling me that Betterment is going to be 27x larger then Morgan Stanley in this market. Ha!!

As I said in my first post. This debate continues to be interesting. Great stuff from everyone. NS Capital

Here you go further proof from a recent report:

“Bank of America Merrill Lynch is the largest institutional investor of ETFs with over $50 billion in the financial products, according to a report.

BofA Merrill Lynch, Wells Fargo, Morgan Stanley, Goldman Sachs, UBS, BMO, JPMorgan and Citi together hold about $166 billion of ETF assets, according to independent consultancy ETFGI. “

This is what I mean when I say they don’t understand the liquidity in the market. How in the world does Betterment honestly think they are going to grow to $100 BB in 5 years by managing a basket of ETFs. That’s like saying they are going to be as big as all of Merrill Lynch and Morgan Stanley / Smith Barney and JP Morgan’s massive army of retail brokers, investment advisers, private client wealth guys etc. It’s insane! That’s like some guy with a few burger shops in town thinking he’s going to be bigger then Mc Donald’s, Burger King and Wendy’s combined in 5 years.

They’re clearly smart guys behind this whole thing, and savy investors backing it, so I’m sure they no something I don’t. But at such a basic level the numbers just don’t seem to add up.

http://www.etftrends.com/2013/09/bank-of-america-harvard-among-largest-etf-investors-report/

Been enjoying reading all of the interesting and insightful comments here. No question, Betterment and Wealthfront are hemorrhaging money, so it’s really a question of whether their VC backers will keep investing for years hoping they reach profitability, and what is the real upside for doing that?

Airlines fought competition by inventing their own small airlines, and I suspect Vanguard, Fidelity will do that if they feel at all threatened by these tiny (at this point) competitors.

What is really missing is a different investment approach or strategy alternative. They all offer the same thing. Diversification that failed to protect during the financial crisis.

So, this competition is about the same technology everyone has…unless someone is going to start sending disappearing account statements and trades on SnapChat.

Jermey Stevens,

I think their target market is small accounts, who don’t know any better, seeking betterment.

But it is a leap of faith after Jon Corzine, MF Global—I-don’t-know-how-the money-disappeared-from- brokerage-accounts, for more aware potential customers.

Kevin, you seemed caught up on the liquidity aspect of managing that much in ETFs at large scale. We get it. Whether their projections are correct or not ($100billion by Betterment, $1+ Trillion by Wealthfront), we pretty much agree that what they’re offering now is a money-losing model until way, way down the road. The interesting point is that they have investors who are drinking the cool-aid with them. They must be some envisioning an exit strategy – sell to a broker, or bank? Who knows, but it will be fun to watch.

I have to guess that Betterment’s low average assets ($12k or something like that) is testament to low rates at savings institutions, and that was how it was pitched for awhile. We’ll see how it all plays out in a downturn (providing the Fed ever takes their feet off the gas pedal – which itself is highly questionable).

This discussion has generated some systemic thoughts in me. In the aftermath of Bernie Madoff, etc. the regulatory fiduciary requirements for an investment adviser have mushroomed. From my reading of the “guidelines” and rules, an investment adviser, unlike a broker, has to truly advise a client, not just process orders or use some automated system to line up investments. There seems to be a very strongly implied requirement to “know your client” in order to provide investment advice suited to the needs of that client. I cannot imagine how a mass produced system like the one Mr. Stein has created can meet that requirement. Perhaps this is a change and the SEC will treat mass production differently from the standard to which they hold the rest of us, but the very definition of “fiduciary” implies acting in the best interests of the beneficiary. If a firm does not even know the client, how can that take place? It will certainly be interesting to see if a “bot” can replace a person in this role, but I do see that those who believe in an efficient market and pure indexing could arrive at that conclusion.

The more I look at the numbers and the concept the more I see something coming that may not be pretty. ETFs are designed to “track” but when the tracking device provides a huge input to the thing it is supposed to be tracking, that changes the target. I mentioned earlier that ETFs have yet to stand a major test in the market. If this concept gets as large as the claims, it will effectively “become” the ETF market. Offering ultra low-cost allocation is effectively a form of leverage. As the assets become sufficiently large to create feedback, it is very likely that the allocation algorithms will become self-following. That, in effect, is what happened at Long-Term Management. If these guys are successful they either will have to place hold times on investments or risk imploding the ETF market.

A simple solution that I use is eMoney’s client web portal. I can aggregate all of my clients accounts, save important documents in a vault, see a clearer picture of all their investments, plus spending and budgeting as well as build a financial plan for them if needed. This gives me an advantage over these online tools such as Betterment, Learnvest, Wealthfront and Personal Capital. They will be successful. The transfer of wealth over the next eight years is around $20 trillion. Gen X&Y do almost everything online. I give my clients the ability to do the same along with my professional experience/knowledge to help them reach their financial goals. Times are changing.

There is a simple reason these guys have to make outlandish, ridiculous $100 billion asset goals —— because the model doesn’t work at lower amounts. Do the math, $1 billion is still losing money. $5-$10 billion is very marginal.

The only way the model works is if they eventually move into charging fees for other products —- ie, upselling their big list of small clients into higher priced products.

Maybe a silly question but what would be the downside for Betterment of raising prices by 50% after hitting $10 billion? It would be hard to imagine people would move for such a low absolute increase and the profitability, such as it is, would shoot up.

Brooke

“After they hit $10 billion”. Given that they have less in total assets ever gathered than a firm like Windhaven gathered last quarter, I would say $10 billion is a long way off. Windhaven charges fees closer to 1% and its not hurting them one bit.

Eventually, the online brokers will have to do something to generate revenues. Your point is a good one and maybe something like that is in the cards. Lose money while gaining accounts, then raise fees later to try to get to breakeven.

I am not sure profitability really ever gets that good on this model so there must be some type of plan for how to leverage all these new accounts.

How many RIAs in the world lose money when they have hundreds of millions in assets? These guys have figured out how to lose money on what is a great level of business for everyone else. Congrats guys.

“I think our platform is the best way to invest for anyone with $10k to $10 million.” I think that isn’t true. These are two different customers with very different needs. I don’t think that Betterment is taking into account the human side of the business. This is a product for people with less than 100k in account size or maybe somewhere a little bit above that. They should really start to see if they are getting any bigger accounts, and maybe change directions. They aren’t offering much value to the client.

I find it fascinating that Mr. Stein is now considering working with financial advisors a year plus after his firm published this piece https://www.betterment.com/blog/2012/04/12/financial-advisors-are-bad-for-your-wealth/. Perhaps his investors invoked the “P” word aka profitability? While Betterment did issue what in my opinion is a pretty half-baked apology this advisor is pretty skeptical of Mr. Stein’s motives on this issue.

We who are becoming more successful in the RIA business have largely figured out that what we bring to the table is a personal relationship. That is not to say that being compliant, fiduciary, and competent is not a requirement, but what sets us apart is personalization. That is the polar opposite of what the corporate advisers are doing. My advice is to stay as far away from big corporate RIAs as possible. Their purpose in existence is so adverse to ours that working together is potentially deadly.

Personal relationships are surely valuable but what if personalized know how is made scalable which resolves the limitations of Robo-advice.

As prudent process and more modern, lower cost approaches to portfolio construction become universally available, how advisors add value becomes more daunting. Essentially the value of human advice is uncovering an unaddressed need and managing it.

Human advisors will default to robo advice to maximize their value proposition, streamline cost, optimize their margins and achieve professional standing in ways not supported by either brokerage or custody formats. It looks like ultimately cost and value are on the side of the Robo advisor, unless there is a terrifically complex problem which is beyond the typical advisor in any event.

The problem is Robo advisors do not understand prudent process, advanced technology, work flow and conflict management that lead to both scale and expert technical competency. When they figure it out (b/ds and custodians want no part of it) it will reorder the entire industry around expert prudent process and technology not expensive packaged investment product.

SCW