3.1 Introduction

Banking, including investment management, facilitates many aspects of commerce and trade, the funding of governments and corporations, the financing of personal needs, and the settlement of all payments. Investment management relates to the origination, structuring, and management of financial assets. Personal wealth, owned by the richest few or the millions of retail bank customers is globally worth hundreds of trillions of US$ equivalent assets and contributes to most of its income. The industry targets to make profits by linking the offer-side to the demand-side: issuers of financial products (governments, financial institutions, or corporations) can access modern financial markets and meet the saving and investment demand of institutional and private investors. The supply-demand mechanisms are not straightforward but investors and issuers are typically intermediated by professional players: asset managers, investment banks, platforms, and wealth managers. In this game of finance, issuers search for the cheapest funding, investors look for the highest risk-adjusted return, and intermediaries make use of their professional knowledge to serve their clients and maximize intermediation margins. Conflicts of interest can easily arise as financial conglomerates often embrace a vast amount of services, which are directed to both issuers and investors. Therefore, banking and market regulation has been put in place to rein in the behaviour of all professional players, and safeguard the interests of final investors. Yet, the industry is not free from scandals. Greed and investment exuberance have often facilitated the building of large imbalances, which have grown into bubbles and burst into market downturns and painful recessions of real economies. Currently, the whole industry is hit by a perfect storm: while post-crisis regulation is threatening the main mechanisms of profit sharing among the players (e.g., the ban on retrocessions), social media and the internet are changing the behaviour of modern investors (e.g., acceptance of non-conventional investment services, any time, anywhere) and digital technology is facilitating the rise of disruptive entrants. The principles of innovation theory and the main characteristics of Robo-Advisors have been discussed. We can proceed to review the functioning of the industry in broader terms, and highlight how robo-technology can transform traditional wealth management relationships and the way taxable investors trade financial securities. This is of the utmost relevance, since the industry is struggling to move out of a product-orientated distribution framework and centre more on client/portfolio advice.

3.2 The Investment Management Supply-Demand Chain

The origins of the industry can be traced back to the Italian Renaissance, when banks thrived to serve the needs of wealthy families. Yet, only in the 20th century has investment management become a mass market industry, appealing to both customers of retail banking and ultra high net worth individuals. This became particularly evident in the 1950s, which saw the ranks of the middle class soaring in numbers and worth. The industry has transformed significantly ever since, particularly due to technology advances which have enabled the automation of back office processes and security trading. However, investment decision-making has been characterized by a conventional model, in which private investors have been largely assisted by human advisors or brokers. Yet, a process of progressive commoditization has been slowly eroding the dominant position of once established intermediaries, as presented in Figure 3.1. Discount brokers made financial advice accessible to the US middle class and have acquired a large portion of AUM since their appearance in the 1970s. Online trading was made available to an even larger public of self-directed investors in the 1990s, although in truth confined to a specialized group of trading-orientated individuals. Nowadays, Robo-Advisors seem to possess the potential to achieve what discount brokers did forty years ago and further downshift the costs and complexities of the investment experience.

The industry supply-demand chain is organized along three main branches: issuers (primary and secondary), intermediaries, and final investors (as in Figure 3.2). Business reality is more varied and features many more interdependencies. We can distinguish between issuers of direct and indirect investments. The first are issuers of debt and capital claims (bonds and stocks) which, helped by investment banks, fulfil their financing needs or meet their risk-management requirements. The second allow investors and their intermediaries to efficiently gain indirect exposure to the risk-return profiles of primary securities. Intermediaries are asset managers and wealth managers which serve final investors and advise them on suitable products or portfolios, by selecting among direct or indirect investments. Platforms allow intermediaries and final investors to trade securities within organized and transparent frameworks. Final investors can either be institutions (e.g., pension funds) or taxable investors (e.g., individuals), looking for yield and financial advice.

What follows is a presentation of the characteristics of these actors and some of the products they sell, and a discussion of the threats that they face due to progressive digitalization and robo-advice.

3.3 How Intermediaries make Money

The essence of investment management is to connect issuers and investors through distribution channels, and allow the latter to buy/sell financial securities to achieve their personal goals. Clearly, the change of approach from a product-centric to a client/portfolio-centric model can only be successful if the incentive schemes that regulate the behaviour of individual wealth managers to place financial securities in clients' portfolios are aligned. A financial instrument is a contract representing the right to receive future benefits under a stated set of conditions. Taxable investors can build direct exposure into any different type of claim on a financial, corporate, or government entity (e.g., bond). Alternatively, they can hold exposures through investment vehicles (e.g., mutual fund) that offer quotes in the portfolio of financial instruments they hold. Bonds, stocks, mutual funds, ETFs, structured notes, and certificates are all securities. Hedge funds are not offered to a broader retail public but only to wealthy individuals, while listed derivatives are negotiated by investors which are more trading-orientated. The hierarchy in Figure 3.3 represents a common way of classifying financial securities. Direct investments are straight claims on a financial, corporate, or government entity such as bonds and equities. Indirect investments are indirect claims on a financial, corporate, or government such as shares of investment funds. Derivatives are indirect claims on the performance of financial, corporate, or government-related securities, so that the investor receives or pays out according to a formula linked to the appreciation/depreciation of an underlying financial element which is itself a direct investment (e.g., an equity), an indirect investment (e.g., an investment fund), or an index.

Intermediaries have built powerful distribution channels to place these financial products in the pockets of the broader public, learning to make money according to four major schemes:

• Commission only: they receive commissions for selling financial products to investors. Such commissions can be directly requested of investors or are embedded in the financial transaction. For example, embedded fees in structured products or retrocessions from asset managers.
• Commission and fee: they collect commissions for selling products to investors, but also ask for fees to provide investment planning assistance.
• Salary and bonus: investment professionals working for financial institutions (e.g., discount brokers or retail banks) get higher compensation for recommending or selling certain products and services.
• Fee-only: personal financial advisors (e.g., Registered Investment Advisors in the US) are paid by investors for their advice on ongoing investment management. They must have no financial stake in what they recommend.

Fees can be flat, performance-related, or a mix of the two. Performance fees might seem to incentivize wealth managers to do more, select better products, and provide better advice to their customers. However, they could also induce advisors to leverage too much risk on behalf of their customers, in an attempt to enhance the chances to harvest higher margins, especially in a downturn. Flat fees could instead induce advisors to do the minimum required and walk away, although they might facilitate a better alignment of the investment policies for more conservative individuals. A mix of the two, thus a waterfall model based on a flat floor and some participation in excess performance, might reconcile this dichotomy.

So far, the most common incentive plan has been the “commission and fee”, since institutions host more than one distribution model and intermediate a broad range of direct and indirect securities. Therefore, commissions and retrocessions have been traditionally harnessed as a percentage of private money traded or invested: a few basis points for stocks, more than one hundred for actively managed investment funds. With recent changes in market regulation, prompting the banning of retrocessions or fostering higher transparency on costs, this revenue model has been subjected to stress vis-á-vis more independent “fee-only” approaches. Clearly, this would be a Copernican revolution of the incentive skeleton of most financial institutions.

3.4 Issuers of Direct Claims (Debt Owners)

Bonds and equities are the building blocks of most investment opportunities: they are issued by debt owners and final investors can trade them directly or as part of investment funds. The main buyers are financial institutions (investment banks and insurance companies) and fund managers (pension funds and mutual funds). Although bonds and equities remain a very large component of private investors' portfolios, evidence shows that US households have already come to progressively favour investment funds, particularly in the aftermath of the GFC and following the growth of Individual Retirement Accounts (IRA) and Defined Contribution (DC) plans. Hence, their demand for directly held equities and bonds has started to fall, as can be seen in Figure 3.4 (source Investment Company Fact Book 2015). Yet, the global demand for bonds and equities has increased steadily together with the growth of global wealth, net of market fluctuations. Recently, this expansion has been fostered by a series of factors related to lower than average interest rates in major economies and stronger than ever demand in growth markets.

Table 3.1 reports the size of global debt and capital markets in US$ equivalents.

Recent behaviour of private investors in relying more on investment funds is a relevant shift for the wealth management industry, particularly for commercial banks. They might expect to report a reduction in commercial margins stemming from bond origination and underwriting and an increase in the relevance of investment funds. This trend seems to be a consequence of two factors. First, investors' reaction to the GFC, which has scared them, lowering their appetite for direct participation in debt and capital markets. Second, increasing investors' perception of the value of passive investments, which come with easier to achieve benefits of portfolio diversification. This shift seems to favour the acceptance of single minded Robo-Advisors' propositions.

3.5 The Institutionalization of the Private Banking Relationship

Private and retail banks play a central role in the wealth management relationship, and their distribution channels allocate the largest amount of AUM towards direct and indirect investment vehicles worldwide. Private banking primarily refers to the managing of patrimonies of wealthy individuals (e.g., investments and financial planning, securities, and real assets) whose known disposable wealth is typically more than US$ 1 million equivalent. Clearly, this is not a binding threshold and institutions apply a different tiering according to internal policy or market conditions (e.g., Eastern European banks set the entry point lower than their core Europe counterparts). Yet, the US$ 1 million cut is commonly used by market analysts to tell HNW and UHNW apart. Retail banking instead provides more off-the-shelf commercial services (e.g., investments, mortgages, loans, payments) and can feature more easily a combination of human types of relationship management (e.g., branches, call centres, branded financial advisors) and internet engagement (self-directed online banking). Seemingly, private and retail banks provide overlapping services (e.g., investments) but deliver them with very different content and format (e.g., buy and sell versus wealth planning), as private banking tends to be more personalized and human intensive so that only wealthy individuals can afford it. Their value proposition needs to stand out clearly in front of their target clientele. Therefore, private banks feature dedicated branding, processes, policies, and operations even when part of larger commercial banking groups.

Rising costs of compliance, higher transparency in the disclaimers of costs faced by taxable investors, if not banning of the retrocessions between intermediaries and asset managers (e.g., fiduciary standards in the US) are forcing banks to rethink the foundations of retail and private banking investment relationships. Moreover, cooperation and greater openness among international tax authorities have levelled up the playing field in favour of on-shore investments, making off-shore tax advantages much less attractive if not unfeasible and have affected private banking advantages. This has reinforced the call to increase the effective added value of their offers, to retain AUM and better engage existing clientele. Customer engagement and experience have become the mantra in all industry talks, and have reinforced the strategic importance of the digital agenda. Digital technology is indispensable to achieve enough economy of scale in fast growing environments and penetrate new markets, characterized by different client behaviour and less branding legacy compared to mature economies. The fact is that existing business models might not allow the efficient servicing of clients, particularly mass affluent and affluent segments which cannot access private banking services but might be willing to engage in further investments should this become attractive and inexpensive. The upcoming retirement crisis is also fostering an increasing need for mass market financial advice and planning, since a large cohort of Baby Boomers is about to retire in the next decade and will take care of seemingly insufficient pension contributions sponsored by governments. Underserved mass affluent and affluent individuals represent 57.5% of world wealth, as indicated in the Credit Suisse (2012) wealth pyramid featured in Figure 3.5, which also shows that 7.5% of the world's population owns per capita between US$ 100,000 and US$ 1 million, which accounts for 43.1% of global wealth.

The institutionalization of the private banking relationship corresponds to the need to streamline operations and extend added-value services to affluent clients. It cannot be achieved without digital investments and automated money management. While banks have started to engage in a slow process of repositioning of their offers, the increasing use of the internet and smartphones has empowered individuals to disengage from traditional banking, segmenting themselves according to their tech-savviness, knowledge, and confidence. This has facilitated the penetration of Robo-Advisors in the upper tiers of the wealth pyramid, threatening the business model of established institutions and the incentive schemes behind them, creating internal political frictions about who should service whom and how. The process of institutionalization of the wealth management relationship is mainly driven by the following factors:

• On-shore versus off-shore: lack of tax advantages forces a reallocation of money from off-shore to on-shore accounts, and requires the provision of better services to justify existing fees.
• Market regulation: higher transparency on costs and sales incentives requires a broadening of the value proposition and clearer discussion of asset allocations and personal goals, instead of individual products, highlighting an educational gap in banks' personnel and need for intuitive portfolio management tools.
• Asian tigers: economic growth in Asia has opened up opportunities for local and international banks, which need to adopt automated tools and digital solutions to tackle the challenges of a different and fast emerging clientele.
• Independent advice: personal financial advisors have challenged banking ownership of client relationships (particularly in the US), as they can close the knowledge gap with final investors.
• Generational transfer: wealth is changing hands towards younger generations that are more digital-sensitive and less loyal to established brands.
• Robo-Advisors: the rise of automated investment solutions has helped investors to gain more confidence in judging the intrinsic value of traditional banking services.

Financial institutions need to transform, but existing incentive models seem to create a divide between the interest of internal stakeholders and that of their clients. “Changing the bank” is an expensive process, and has been attempted a few times in recent decades but with very different focus compared to today's revolution, which sees competition rising from outside the banking club. Traditional approaches have previously operated according to two principles aimed at enhancing operational efficiency: functional excellence and the uniqueness of resources. Functional excellence corresponds to the belief that efficient firms would generate value for both customers and shareholders (such as faster origination processes, bundling of services into one-stop shops, and new distribution channels like online offers). Yet, customers could not truly differentiate among these improvements which didn't necessarily result in lower costs or distinct features among competitors, as most of them could be imitated. Uniqueness of resources has been identified as a competitive hedge (e.g., a portfolio of better customers, broader risk diversification on balance sheets, access to more information, or richness of the product catalogues). Once more, customers could not truly appreciate and reward larger banks' capability to step into many different services, compared to local and smaller providers. Finally, the focus started to shift towards the customers themselves to anticipate, discern, and respond to their needs in a way that could be unique and difficult to imitate. This would move the emphasis from internal efficiency toward front-end design and building of customer-focus processes. Melnick, Nayyar, Pinedo and Seshadri (2000) have described this trend in detail and explained that value creation is the result of a smoothly running engine called Customer Value in Financial Services (CVFS), which is shown in Figure 3.6 as in their original publication. The CVFS engine has four key endogenous elements that must be carefully designed by banks to create customer focused value, and which this book discusses in the light of digitalization and robo-technology: strategies, services, systems, and measure of success. While strategies allow the shaping of the most appropriate services and aim to facilitate the best interaction between back-end legacy systems and front-end reporting tools, we can identify two other external factors which are not under the control of banks' management but interact with financial firms: customer behaviour and the broader environment.

The current strategic shift in financial markets post GFC is grounded on the search for advanced client/portfolio-orientated approaches to rebuild trust in the banking relationship. However, the recent transformational focus is not about design of client-orientated processes only, but rather taking clients' behaviour to centre stage of the supply-demand mechanism in terms of understanding their fears and ambitions and enhancing their experience and engagement. Therefore, the original exogenous and endogenous factors described in the CVFS engine can be enriched with respect to today's disruption, social mega trends, and the rise of behavioural analytics.

Exogenous factors:

• Customer behaviour: private investors' tastes and behaviour are transforming fast. This is particularly evident for younger generations, although wealthier Baby Boomers are also getting more engaged with digital. Peer-to-peer recommendations are becoming progressively more important. The retirement crisis, which is surfacing in mature economies, is requiring taxable investors to search for a breed of financial advice and financial planning to face the difficulties of long-term investments against personal goals.
• Environment: the globalization of international trade, growing interdependence among economies, and the consequences of the GFC have forced individuals, regulators, and tax authorities to tear down the barriers between on-shore and off-shore markets, with the aim of repatriating patrimonies or optimizing depleted public finances. Transaction costs have been reducing steadily, ETF trading is becoming mainstream, and automated portfolio indexing is emerging as a potential investment method. Regulators are asking for more transparency, hindering the asymmetry of information and the incentive schemes of banks. This is impacting the profitability of institutions and the economic rationale of open architectures.

Endogenous factors:

• Strategies: wealth management strategies need to be crafted around customer needs and can typically take two forms: cost reduction and revenue enhancement. Cost reduction is seldom achieved, while revenue enhancements are difficult to orchestrate as they often require changes in organization. Robo-technology and Goal Based Investing seem to allow banks to kill two birds with one stone, by automating the work of financial professionals (e.g., Robo-4-Advisors) to lower costs and gain operational efficiency, and tier new services with up-selling features (e.g., Gamification) by making clients' ambitions and fears the main focus, hence achieving true personalization and customer loyalty.
• Services: financial firms have become fairly complex over time, and so are the products that they sell. The rapid financial innovation which started in the late 1980s created operational problems and inefficiencies due to lack of back office standards, lack of defined responsibilities in the management of new services, and lack of defined responsibilities for compliance and risk management. Regulators and the successful experience of Robo-Advisors have been reinforcing the shift towards simpler investment solutions and services (e.g., passive investment strategies). This would allow us to simplify the complexity of existing services, streamline back and front office operations, reduce costs, and enhance the dialogue between advisors and clients.
• Systems: banks have continuously adopted new technologies, but markets and services have been changing faster. The priorities of technology officers are integration and simplification, which can be fostered by cloud computing, cognitive analytics, and digital platforms. Technology is also making customers more mobile so that digitalization is no longer a new channel, but the new normal. The whole bank is going digital.
• Measures of success: banks hoping to differentiate themselves need to focus less on incremental improvements in individual metrics and more on wholesale process change, to be able to fight disruption rationally and build sustaining innovation. The “moment of truth”, which is made up of the encounters with final investors, needs to be significantly improved. Behavioural analytics are the game changer, enabling banks to track social changes and stay tuned.

Clearly, Robo-Advisors' solutions pose opportunities and risks to established institutions, such as conflicts with existing channels or cannibalization of existing services. Financial institutions will therefore craft their robo-ambitions carefully and make sure that they fit current and prospective business strategy and brand.

3.6 The Digital Financial Advisor

Personal financial advisors are professionals who render financial services within a mandate regulated by local financial authorities and common law (e.g., FCA in the UK, FINRA in the US, ASIC in Australia), which set the tone in terms of type of services, transparency of disclaimers, and form of remuneration that they are allowed to propose. There are differences among regulations, but also common principles. This book does not provide a detailed discussion of these differences, but drafts their main attributes and discusses the international trends of advisory practices. Direct references to specific cases are provided whenever necessary. “Personal financial advisors” has been elected as generic appellation and refers to the work of those practitioners or small firms owning the rights to provide financial advice or financial planning (as the case may be) by working directly for their clients rather than representing a financial institution. Personal financial advisors can be independent or restricted (the terminology is adopted from the UK regulation, but it is used here as a general definition irrespective of the regulatory framework in which the personal financial advisor operates). The distinction between independent and restricted refers to the form of remuneration they receive for the services they provide: independent financial advisors do not receive any rebate from any third party for the advice provided to final clients (e.g., sales loads), but depend solely on the advisory fees they ask their customers to pay. In some jurisdictions financial institutions can provide independent (e.g., fee-only) and restricted advice within the same banking perimeter (e.g., the MiFID II Regulation).

Personal financial advice is a fairly recent practice, which appeared in the late 1960s with a focus on US stock brokerage and insurance sales. Elicitation of clients' goals and monitoring of the progress of investments were not common. Following the oil crisis and the recession of the 1970s, individuals became more aware of the relevance of planning instead of solely buying and selling, and the industry started to transform. In particular, the favourable economic conditions of the 1990s facilitated the industry's expansion and prompted the first clear divide between commission based and fee-only services. Financial institutions began to see the value of using financial advisors to promote their investment products and services. The distinctive value proposition of personal financial advisors compared to traditional retail banks and online services resides in their direct and familiar relationship with taxable investors, which should enable them to anticipate, understand, and respond to their needs in a way that appears to be very personalized.

The emphasis on client relationship management restricts de facto the capability of traditional practitioners to manage a scaled up number of customers. Their daily workflow requires them to deal with a large amount of red tape, make decisions about money management, perform accounting tasks, research financial markets, and report investment performance. Their role seems to have gained further momentum in the aftermath of the GFC, due to a substantial loss of reputation of main street banks. Robo-Advisors have also profited from this window of opportunity and started to gather AUM at an impressive pace from 2014 to 2015. Although most of the early adopters might have come from the pool of self-directed investors, they are now pitching within the ranks of the advised clientele. However, Robo-Advisors are also transforming and have started to target institutional relationships (i.e., Robo-4-Advisors). This trend has been followed by both FinTechs and established institutions. The adoption of Robo-4-Advisors allows tech-savvy human advisors to streamline and verticalize their tasks by means of automation, and hence institutionalize the asset management aspects which are becoming somewhat commoditized (e.g., portfolio construction and portfolio rebalancing with passive investments). They can leverage automated investment services on behalf of their clients and focus their time and expertise on so-called “gamma tasks”: prospecting and on-boarding new clients, following up on investment performance, engaging and amplifying on social media. Gamma tasks are particularly relevant for new entrants in the professional community of personal financial advisors, especially those targeting new generations which are more digital and social media native.

The upcoming retirement crisis will also give advisory practices a significant opportunity to strengthen and extend their businesses. Since government sponsored pension plans appear to be insufficient to fulfil the financial needs of post-retirement Baby Boomers and younger generations, legislators are progressively transferring the burden of planning for adequate retirement income directly onto the shoulders of individuals (e.g., Australian superannuation plans) who need to be adequately advised to make decisions for long-term financial goals. Yet, the quantitative aspects related to building long-term asset allocations with income stream perspectives are not insignificant and are forcing financial advice (portfolio management) and financial planning (cash flow management) to come together in integrated solutions. The complexities of these tasks can be solved and efficiently demonstrated by extending the reach of robo-technology to treat all aspects of Goal Based Investing, as demonstrated in the second part of this book. The institutionalization of automated investment services can provide more lifeblood to high-level advisory practices as well, such as family officers and multi-family officers. They typically possess financial investment skills or reach out to financial advisory practices for all aspects of portfolio management. Yet, they still struggle to automate a large part of their investment management processes due to the multiplicity of goals and highly bespoke requirements that they have to handle. The new generation of Robo-4-Advisors also has the potential to look into these needs.

Broadly speaking, financial advice is compensated by fees or commissions:

• hourly fees for the advisory services rendered (less frequent);
• flat fees for periodic investment reviews or financial planning (e.g., advice-only practices without the responsibility of money management);
• sales loads based on invested amounts (e.g., restricted or branded practices);
• fees for assets under management (e.g., independent fee-only practices and Robo-Advisors).

To conclude, performing portfolio rebalancing of individual clients' portfolios comprising passive investments requires time and this effort might not be perceived by final clients as a differentiating element among different financial advisors. Therefore, financial advisors could use institutional robo-solutions to perform these tasks, save time, and establish branding for their clients. Institutional robo-services also provide vertical services (e.g., reporting) which would further enhance the efficiency of human advisory practices. More time can be dedicated to increasing revenues by added-value discussions with clients, goal elicitation and tracking, and complementary planning services. Robo-technology will not replace human advice altogether, but personal financial advisors and Robo-Advisors might well team up to empower independent advisory relationships and ultimately individual investors whose characteristics, needs, and transforming behaviour are discussed in the next chapter.

3.7 Asset Management is being Disintermediated

Mutual funds are managed by professional investment managers, who trade securities (typically stocks, bonds, commodities, or deposits) for the most effective growth of a well identified portfolio. Each fund can be managed by an individual fund manager or a team of people, all working for the mutual fund company whose shareholders are the institutions and private individuals who have invested in the mutual fund itself.

Mutual fund companies typically include the following activities:

• Asset research and selection: a team of financial analysts and economists makes statistical and econometric analysis to assess the expected earnings/values of individual stocks and asset classes, to estimate the volatility and the correlation among risk factors, to envisage the economic outlook, to provide recommendations about buying or selling potentially undervalued or overvalued stocks and bonds.
• Investment planning and implementation: portfolio managers optimize the asset allocation according to a mandate, which restricts portfolio exposures to certain markets and strategies, or enforces the tight tracking of benchmarks.
• Rebalancing of the fund: realignment of the fund's exposure to the benchmark or the mandate, execution of required trades in an attempt to minimize trading costs.
• Monitoring and risk management: ongoing verification of the risk profile of each fund and its compliance to the mandate.
• Marketing and reporting: periodic reporting to market regulators, institutional and private investors, and management committees.
• Internal audit and compliance: ongoing auditing of operational compliance and adherence to local and international regulations.

Mutual funds are, by definition, diversified portfolios meaning they are made up of a lot of different securities whose combination complies with a mandate reflected in the strategic asset allocation. The fund allocation can deviate from the strategic view, for macro or tactical reasons, yet within the limits stated by the mandate. Fund managers trying to tame the market might leverage on their financial analysis and research experience to position portfolios more tactically, hence deviating tactical asset allocations from strategic long-term views, as represented in Figure 3.7.

The most common mutual funds policies fall into four categories, according to the nature of their strategic asset allocation: Money Market, Fixed Income, Equity, and Balanced. Money Market funds invest in liquid and short-term highly rated debt and commercial paper. Equity funds invest in common stocks and can be riskier (possibly earning more money) than other types. Fixed Income funds are made up of government and corporate securities that provide a fixed return and are usually lower risk than most equity funds. Balanced funds combine both stocks and bonds in their investment pool and offer moderate risk and return. Mutual funds can be open-ended (the most common case) or closed-ended. An open-ended fund is open to new investments without limit and new shares are reinvested in the portfolio (or sold back to the fund). Mutual fund shares are not sold in the traditional sense, but they are redeemed by the fund management company. With respect to closed-ended funds in contrast, only a certain number of shares can be issued for a particular fund. These shares can only be sold back to the fund when the fund itself terminates. Yet, existing shares can be sold to other investors on the secondary market. Fund managers typically distribute their fund shares through intermediaries, such as retail banks, private banks, or financial advisors.

Open architectures have been the most common distribution model, allowing wealth managers to offer their clients a broad selection of competing mutual funds. Therefore, fund managers have had to reward the intermediaries for their role in placing their shares to final investors. The costs that final investors face are called fees and can be broken down into two categories. Ongoing fees (expense ratio) are yearly costs required by fund managers to reward the work of portfolio managers (management fees), administrative costs (e.g., accounting and customer services), and marketing costs (e.g., so-called 12B-1 fee in the US). Loads are transaction fees paid when buying (front-end) or selling (back-end) shares in a fund and that mutual funds use to reward brokers and sales people; deferred fees allow them to reward investors, which do not dispose of their shares for longer periods, with lower transaction costs. No-load funds are mutual funds which distribute their shares directly without the need of third parties. Hence, they do not feature sales charges and can be seen on the internet platforms of those mutual funds selling to final investors directly.

Asset managers face three types of threats following digital solutions and robo-technology:

• Commoditization: the rise of Robo-Advisors has started a process of further commoditization of asset management propositions, as portfolio diversification can be conveniently built by means of inexpensive ETFs. The industry shift towards inexpensive passive management, particularly in the US, has ignited downward competition of fee levels and forced fund managers to reconsider their full cost structure.
• Inefficient open architectures: as regulation features the ban on retrocessions or requires much higher transparency of the embedded costs that individuals face, traditional business models are changing to favour a realignment between the propositions of asset management companies (typically product based) and private banks (typically portfolio and client based). By working much more closely, they can achieve higher cost savings and rebuild financial advice more clearly around portfolio management expertise. This convergence might affect the fate of open architectures and pose a serious threat to smaller or independent asset managers, which do not have direct access to final investors. Therefore, asset managers have started to embrace robo-technology as a way to lower operating costs (e.g., automated rebalancing of existing funds) and add B2C capabilities.
• Client awareness: the awareness of individual investors about the limitations of active investment management has been increasing since the GFC, particularly in the US, as well as the perception that mutual funds and ETFs are not very different in terms of potential harnessing of gross returns, while they do differ in terms of final costs. This has increased individuals' appetite for ETFs and forced institutions to rethink their revenue structures.

All these forces combine to expose asset managers to the highest risk of disruption among all of the investment management intermediaries, because robo-technology has reinforced the ETF momentum and helped to augment investors' awareness about final investment costs, as advocated by new market regulation, creating a downward spiral on operating margins. This has affected cost/income ratios and threatened their long-term profitability. The way out is twofold: asset managers need to build up better economies of scale, by merging existing practices to increase AUM per portfolio manager; they need to adopt automated portfolio rebalancing techniques (robo-technology) to replace the work of human portfolio managers, and reduce the cost structure to manage the funds. Passive asset managers have the most to lose but active asset managers will also be under significant pressure because algo-trading can embed active management rules into automated investment mechanisms. Is this all good news for ETF providers in the long term? Not really: index replication is also becoming commoditized by means of automated portfolios that can be sold directly to wealthier investors instead of ETFs.

3.8 ETF Providers and the Pyrrhic Victory

An ETF is a pooled investment vehicle with shares that can be traded throughout the day on a stock exchange at the prevailing market price, as opposed to mutual funds which can be bought and sold at their forward price (NAV) calculated at end of day. There are two types of ETFs: passively managed ETFs are index based and seek to track the performance (directly or inversely) of a specific index or a multiple of indexes; actively managed ETFs are created with a unique asset allocation to meet a particular investment object and policy. The way they are engineered and their trading features on stock exchanges, just like publicly available companies, make them cheaper investment opportunities compared to traditional mutual funds. Moreover, ETF providers can pass on most of their administrative and operating costs to brokerage firms (e.g., client services, statements, notifications, tax reports). The process of origination and distribution is referred to as the creation/redemption mechanism and sees the interaction of two actors, the sponsor and the authorized participant, as in Figure 3.8. The sponsor issues the ETF shares and lets the authorized participant buy and sell the underlying securities for a profit in order to manage the fund and receive/redeem the ETF shares in the market. This process keeps the ETF trading price in line with the fund's underlying NAV, although their price fluctuates through the trading day due to simple supply and demand. When this happens, the authorized participant can earn a risk-free arbitrage profit by buying up the underlying securities that compose the ETF and then selling ETF shares on the open market, or vice versa, and drive the price back toward fair value. Moreover, the mechanism is a very cost efficient way to acquire the securities they need compared to mutual funds. When investors want to buy a mutual fund, the fund manager has to go to the market and buy securities, hence pay trading spreads and commissions which affect the expense ratio. In contrast, the authorized participant does most of the buying and selling for the ETF, paying all expenses and costs stemming from new money into or out of the fund.

The sponsor is a company or financial institution whose dedicated investment advisors choose the objective and policy of the investment vehicle, for example their benchmark and which method to use to track their returns (if index based) or which discretionary trading strategy (if actively managed). Passively managed ETFs need to track the returns of indexes, which use different methodologies of portfolio construction: weighting based on market capitalization or fundamental factors (e.g., sales or book value), factor based security selection (e.g., they screen securities according to their value, growth, or dividends), or statistical approaches (e.g., tracking error volatility). Passively managed ETFs are not necessarily a 100% replication of their benchmark, but can approximate their index by investing in a representative sample of securities in the target index to reduce operating costs or circumvent trading limitations (e.g., restrictions on ownership of certain foreign securities, or unavailability of certain fixed-income products due to low trading volumes). The authorized participant on the other hand is typically a large institutional investor, such as a market maker or broker-dealer that has entered into a legal contract with the sponsor, whose role is to facilitate the creation/redemption mechanism of ETF shares and support market demand. The authorized participant creates the basket of securities for each trading day, which are the specific quantities of securities and cash in the fund, and transfers it to the ETF so that the sponsor can issue or redeem the required number of shares, which varies based on market activity. The interaction between sponsor and authorized participant is categorized as primary market activity. The sponsor creates new shares only when the authorized participant submits an order for one or more creation units, which consist of a specified number of ETF shares. The value of the creation basket and any cash adjustment equals the value of the creation unit based on the net asset value at the end of the day on which the transaction was initiated. The authorized participant can either keep the ETF shares that make up the creation unit or sell all or part of them to its clients, or to other investors on the exchange. These sales by the authorized participant, along with any subsequent purchases and sales of these existing ETF shares among investors, are referred to as secondary market activity.

The price of an ETF share is influenced by the forces of supply and demand throughout the trading day. Therefore, imbalances in supply and demand can cause the price to deviate from its underlying value. Yet, substantial deviations tend to be short-lived due to portfolio transparency and the ability for authorized participants to create or redeem ETF shares at the NAV at the end of each trading day. Full disclosure of the portfolio enables institutional investors to observe and attempt to profit from discrepancies between the ETF's share price and its underlying value during the trading day. As indicated, they are the most convenient form of pooled trading which is currently available to individual investors and their financial advisors. Yet, their penetration among individual investors' accounts is still far from its long-term potential, due to the incentive mechanisms based on sales loads which have created an information asymmetry in favour of traditional mutual funds. This is typically defended by referring to the professional effort of intermediaries to select the best investment opportunities for their respective clients. Academic research has shown that such effort might not fully justify the costs borne by final investors (as historical performance of mutual funds is not statistically different from that of equivalent ETFs). At the same time, regulators have asked internationally for higher transparency standards on investment costs and in many cases also prescribed the full ban on retrocessions. Thus, ETF demand by private investors or their fee-only advisors soared.

However, ETF providers should be wary as well, because their advantage can soon turn into a Pyrrhic victory. Robo-technology has been exploiting diminishing trading costs of most traded securities, particularly stocks, and tax code advantages in such a way as to potentially disintermediate ETF providers as makers of convenient pooled investments. The more advantageous treatment of capital gains and losses, stemming from trading a broader set of underlying securities as opposed to a few ETFs or mutual funds, has enabled some Robo-Advisors to propose fully automated portfolios as investment solutions that track the return of indexes directly, although the debate about the long-term economic advantages of these practices is still open (besides, so far they are restricted to larger patrimonies and higher tax brackets).

3.9 Vertically Integrated Solutions Challenge Traditional Platforms

Brokers came into existence after the 1929 crash with the scope to execute stock trades on behalf of customers and quickly evolved into brokering bonds and mutual funds in return for a selling fee. In essence, brokerage firms conduct financial transactions on behalf of a client and derive their profit from commissions on orders given, although their role shifted to the oversight of sales processes and the collection and allocation of the sales commissions paid. Typically they collect a percentage of the value of each transaction, though in some cases flat fees can be charged, but some also started to provide forms of advisory services. They handle two main types of brokerage accounts: advisory and discretionary. They are only allowed to conduct transactions on advisory accounts on the explicit orders of the account holder, or under very specific instructions. On the other hand, they have much more leeway over discretionary accounts, conducting transactions not prohibited by the account holder in accordance with the holder's investment goals and the prudent man rule. In practice, most brokerage houses are in fact broker-dealer firms which provide custodian services to their clients. Clients may give orders to broker-dealers in a variety of ways: they may meet with a broker (very seldom), call on the telephone (less and less frequently), or execute orders using trading tools referred to as platforms (market practice). Trading platforms are digital tools and services that can be used to place electronic orders for financial securities with a financial intermediary (e.g., market makers, investment banks, or exchanges). Typically, they stream live market prices on which users can trade and may provide additional trading services, such as charting packages, news feeds, and account management functions. Some platforms have been specifically designed to allow individuals to gain access to financial markets that could only be accessed by financial institutions such as margin trading on derivatives (e.g., contract for difference).

The strengthening of the fiduciary standards would require them to support financial advisors with a broader set of back-office and middle-office functions, beyond traditional services offered by custodians and brokerage firms. In fact, they need to perform tasks related to portfolio account management, performance reporting, rebalancing, and client relationship management. Some Robo-Advisors have raised the competition bar, to provide vertically integrated solutions: Business to Business offers for financial advisors (i.e., Robo-4-Advisors and Robo-as-a-Service). Established platforms noticed and some responded by adding institutional robo-solutions alongside traditional custodian and brokerage services. Although robo-technology could potentially cannibalize their online trading offers, this move will give them the chance to diversify their business model at the very time change is happening, and position them to profit from the advantages of digitalization.

3.10 Conclusions

The whole supply-demand chain of the investment management industry is transforming due to new technologies (e.g., digital platforms, robo-technology, smartphones), changing investors' behaviour (e.g., social media, lower brand loyalty, peer-to-peer recommendations), tighter regulation (e.g., transparency principles, ban of inducements), and Big Data analytics. In particular, Robo-Advisors have demonstrated that disruptive innovation is at play and affects all professional supply-side actors: issuers, passive and active asset managers, ETF providers, platforms, discount brokers, private banks, retail banks, and personal financial advisors. The next chapter will review the characteristics of the demand-side, which is made up of taxable investors, and how technology can influence them or help to discern their investment behaviour.