Digital Financial Battlefield

The digitization activities of established banks who dominate the market in wealth management are quite different from those of new entrants like robo-advisors. While robo-advisors go digital in the channel (web and mobile) and the content (origin of advice), the digitization efforts of banks are mostly focused on customer interfaces (channels) and cost-saving back-office automation. However, wealth management decisions – such as asset allocation, investment selection and portfolio/risk management – are done the traditional way, based on expert human judgement. The use of algorithms for running these core business processes is not something banks appear eager to do yet. However, by sticking to traditional wealth management methods, banks will lose ground vis-à-vis more data and innovation-driven new market entrants or early adapting trend-setting banks. Digitization of wealth management is in full swing now, and will change the landscape of the financial industry fundamentally.

Traditional Wealth Management Frameworks Under Attack

Forecasting market developments, as required by traditional wealth management concepts, turns out to be a challenging task and often has not met expectations. Human emotions – such as greed and fear, dynamic money flows, speed of information transmission and the complexity of financial markets often lead to misleading evaluations. The technology bubble of 2000, the financial crisis of 2008 and many other events have shown the limitation of financial professionals to foresee market responses. Because forecasting is so difficult, classical investment solutions from banks tend to be less active, which limits their ability to differentiate products. They usually stick closely to passive benchmarks to reduce the risk of “being wrong”. Nevertheless, such offerings are promoted as active solutions and thus expensive for end clients, as banks need to cover their high fixed costs. Serious digital competition and investors’ awareness of alternatives puts pressure on this product strategy now. Today, this model is attacked by disruptive players at the fund level (exchange traded funds (ETFs) and index funds) and at the asset allocation/portfolio construction services level (robo-advisors run by start-ups, but also by global giants such as Vanguard). They provide similar solutions at a fraction of the cost.

For this reason, it will not be enough to simply distribute traditional solutions over digital channels. In order to thrive in a digital world in terms of client satisfaction, profitability and competitiveness, banks will need new digital wealth management frameworks, integrating these into new business models and transforming their wealth management business.

Digital Wealth Management Frameworks: New Powerful Strategic Tools

Digital frameworks are based on algorithms and are fundamentally different from traditional concepts. As digital frameworks are free from emotions and do not rely on uncertain market forecasting, they are suitable for active investment solutions deviating from passive benchmarks. Such solutions protect, for example, capital in a crisis or profit from attractive conditions in bull market phases. To achieve this, digital wealth management frameworks must integrate strategic and tactical asset allocation, security selection, portfolio management and risk management. Portfolios can be created from simple building blocks such as ETF, single stocks or active funds where appropriate. This enables new applications and solutions well aligned with the needs of end-clients and banks. Such digital frameworks enable banks to provide clients with compelling solutions tailored to their needs. Production is highly scalable and costs can be kept low due to process automation and coverage of a broad investment universe within a single framework. Digital solutions can be offered for both self-directed and delegated client mandates. Therefore, they integrate well in today's landscape of banks’ products and services. Digital frameworks are beginning to take roots and they will eventually move into the mainstream of wealth management.

Survival in Wealth Management: Hybrid Transformation Options for Banks

If banks want to secure their position in the landscape of future digital wealth management or even shape the industry, they need to transform their wealth management core business processes and implement new digital frameworks and business models. Transformation will need to integrate not only the way advice and products are transported to the client (from classical to hybrid to digital), but also the origin and frameworks of how advice and products are created (from classical to digital).

Solutions with a digital origination can be integrated in a straight and value-adding way into a comprehensive wealth management business model (see Figure 1). Digital solutions can be distributed across client segments via traditional client-facing channels, digital (non-client-facing) mobile and web channels or, in advanced hybrid forms, by combining personal advice, digital aids and digital wealth management solutions. This will allow banks to provide prospects and clients with both traditional and new digital products and services via their preferred channels. The authors are clearly of the opinion that industry-leading banks will opt for an advanced and highly interactive model, covering both classical and digital content. Advanced hybrid approaches will become predominant, as machine-based advice will bring the client experience to new levels.

Algorithms or machines will therefore not replace finance experts and relationship managers in wealth management; however, their roles will have to adapt using their expertise for developing and governing processes and for explaining and communicating with clients and other stakeholders.

The “digital” element in the business model covers new client needs and thus offers growth opportunities. Due to the scalability effects from process automation, it also enhances the cost–income ratios of banks, which strengthens their profitability and competitiveness. Furthermore, this is well beyond what today's robo-advisors have to offer – focusing solely on low-cost passive digital solutions and distribution – and thus is clearly differentiated. Such a transformation also puts banks in a strong position to compete with innovative new market entrants.

Digital transformation of business models is always challenging. However, banks are in a very good starting position as they have essential ingredients such as a large client base, capital and established brand recognition already. All that fuels a powerful start to the required transformation, making their position sustainable.

Building Digital Wealth Management Frameworks: Dealing With the Complexity of Financial Markets

The sheer complexity and dynamic, ever-changing nature of the financial markets makes successful investing very challenging. For building digital frameworks, “rule-based” approaches are the option of choice. It is a rapidly growing investment category, where investment decisions are taken based on clear and evidence-based rules (i.e. what has proven to work). This approach fulfils three key requirements:

• Automation. Rules can be coded into algorithms.
• Robustness. Unlike complex quant models (where model parameters are continuously (re-)calibrated with historical data) or AI approaches (where investment decisions are determined by algorithms based on unknown criteria), rules are fixed, simple by nature and can be well understood. Thus, they are no “black boxes”. Counter-intuitively, the simplicity of rules makes them also more robust to cope with the highly complex financial markets.
• Cost efficiency, transparency and liquidity. Portfolios can be composed from the huge universe of available ETFs, index funds or single stocks and bonds.

Three Steps to a Digital Wealth Management Framework

A suitable framework must be able to produce a wide range of active, value-adding and tailor-made investment solutions (see Figure 2). Furthermore, suitable frameworks must be modular and scalable. A framework can be built in three steps:

• access to financial/news data
• extraction of valuable information out of data (noise filter)
• construction of portfolio solutions.

The first step when building a framework is to source financial markets data. In the second step, data gets used as input for rule-based investment strategies. These strategies must cover all portfolio levels and collectively steer long-term strategic asset allocation, tactical asset allocation (under- and overweighting markets to manage risk and return) and, if desired, security selection (e.g. high dividend or momentum stocks). Strategies must be purely rule-based to take out emotions from the decision-making process. Testing and ensuring the validity of strategies over different market phases is critical during the development phase. At the third step, strategies are combined into portfolio solutions. The weight of the single strategies depends on and must be aligned with the investment objectives (strategies are used as portfolio “building blocks”). For example, if capital preservation is an important objective, then strategies which tactically reduce risk in phases of market stress should be given a high weight. The combination of different strategies means that the portfolio is managed according to different rules (“multi-strategy”) and, thus, is diversified beyond asset classes, which enhances robustness. An integrated risk management process ensures that portfolios adhere to desired levels of risk (e.g. concentration limits or volatility). Lastly, ongoing management of portfolios covers regular adjustments from strategy outcomes and, at times, rebalancing.

Keeping the “Time-to-Market” Short is Important

The time to develop and build digital frameworks must be kept as short as possible to make progress quickly in executing the transformation strategy. According to the authors’ experience, after having gained insight and collaborated with many financial institutions, two critical levers drive the “time-to-market”. Initiatives must be driven from the top down. Bottom-up innovations do not work, due to the need to integrate such initiatives into a proper business-wide strategy. Furthermore, fear from competing approaches can cause political resistance in the organization. Secondly, it can take even well-resourced banks a few years to develop digital frameworks and the necessary IT systems. Specialized sourcing providers can help accelerate this process significantly.