SECTOR FEATURE WEALTH MANAGEMENT
Robo-advisory in Islamic investment management Robo-advisors are substituting their human counterparts in the investment and wealth management business in much the same way that Amazon and Netflix have taken a slice of the pie from retail stores and cinemas. Roboadvisors are digital platforms that provide automated, algorithm-driven, financial planning services with little to no human supervision. A typical robo-advisor collects information from clients about their financial situation and future goals through an online survey, and then uses the data to offer advice and/or automatically invests clients’ assets. AKASH ANAND analyzes how robo-advisory functions in Islamic investment management. Akash Anand is the chief marketing officer and the global head of strategy and sales at Credence Analytics. He can be contacted at [email protected]
credenceanalytics.com. Robo-advisors generally offer passive investment strategies focusing on three main areas: 1. Asset allocation and implementation 2. Portfolio monitoring, and 3. Portfolio rebalancing. Currently, there are two main types of robo-advisors: 1. Independent start-ups, and 2. Robo-advisory platforms of established investment companies. A quick survey reveals that roboadvisory is still at a very early stage of its potential. Client-profiling uses simple surveys to assess client needs. Asset allocation, portfolio monitoring and rebalancing are generally not rigorous. However, robo-advisors offer quick and easy account-opening processes and transfer of assets for management. Robo-advisors also offer their services at lower prices. However, current roboadvisors are not likely to meet the needs of sophisticated investors who have even moderately complex financial needs. Robo-advisors were built on the promise of offering wealth management expertise to the masses. Now those start-ups are turning their attention to different and much wealthier customers. Betterment, the largest start-up in the automated financial advisory market, is adding a tool for some clients to adjust investment allocations in more granular ways. The service is limited to those with at least US$100,000 under management by Betterment.
Figure 1: Phases of growth of robo-advisory
Generation 3 Conversation-based
Generation 4 Passive investment management
• Passive investment • Conversationmanagement Risk proﬁle-based based user • Self-learning • Active funds, asset allocation interface algorithms portfolio and • Built-in interface • Classiﬁcation investment wit robo-advisory based on machine • Client on-boarding management platforms learning • Risk proﬁling & • Manage • Interface with • Portfolio asset allocation rebalancing & various optimization & • Consolidated portfolio population automated portfolio view adjustments messaging portfolio • RSS feeds & daily • Goal & investment platforms like recommendation research content planning Facebook Messenger, Skype, etc. Source: Author’s own Goal & investment planning
In 2017, New York-based Wahed Invest started offering its automated investment services across the US after raising US$5 million in seed capital, making it the first robo-advisor to cater to Muslim investors through a Shariah compliant platform, according to its founder Junaid Wahedna.
Halal, socially responsible or ethical investing
The lack of the availability of Islamic investment options for non-high-networth Muslim investors has been a big boon to Islamic robo-advisory platforms. Halal investing requires investment decisions to be made in accordance with Islamic principles. As a faith-based approach to investment management, investors often consider Halal investing to be a category of ethical or socially responsible investing. Halal investment screens help assess whether a company’s business activities
are Halal or Haram. The screens facilitate the elimination of Haram investments from consideration. Typical Halal investing screens seek to eliminate: • bonds and other interest-based investments • stocks of companies that have high debt (sometimes referred to as highly leveraged) • securities of companies in industries that do not adhere to Islamic principles, such as liquor, gambling, pornography, pork, insurance, banks, etc, and • mutual funds or hedge funds that trade securities frequently (have high turnover rates) because frequent trading is seen as gambling by some Islamic scholars. Other financial screens seek to eliminate companies that have: • greater than 5% of their revenue coming from Haram sources
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• greater than 33% total debt as compared to their market capitalization (trailing 12-month average), and • greater than 45% accounts receivable as compared to their total assets (trailing 12-month average).
SECTOR FEATURE WEALTH MANAGEMENT Figure 2: Sample portfolio optimization methods – portfolio recommendation
Markowitz portfolio theory Black Litterman model
It is really interesting to see the rise and focus of Shariah compliant robo-advisory platforms as there is a huge market that is looking for avenues to invest in. A study by Deloitte estimated that ‘assets under automated management’ (including hybrid offerings) in the US will grow to between US$5 trillion and US$7 trillion by the year 2025 from about US$300 billion today. This would represent between 10% and 15% of total retail financial assets under management (AuM). At the end of 2016, Fitch Ratings estimated that all robo-advisors managed under US$100 billion in assets, and predicts double-digit growth in AuM over the next several years. Finally, AT Kearney predicts that assets under ‘robomanagement’ will total up to US$2.2 trillion by 2021. If artificial intelligence (AI)-guided investing can work for a person, can it also work for a company? Corporations buy and employ human advice from many advisors like consultants, lawyers and investment bankers in the same fashion that investors did in the past. Corporate strategy is complex, and the advice is expensive. However, the approaches advisors take are usually data-driven and guided by previous experiences. This is just the sort of problem that can benefit from machine intelligence. Robo-advisors’ AuM have risen manifold through competitiveness in pricing, transparency and services and betterthan-expected returns linked to the use of quantitative finance and technology with less subjective human intervention. Finally, it is becoming clear that serious AI adopters with proactive business strategies benefit from higher profit margins.
Enhancing the proposition of robo-advisory
Investment advisory and asset management Product suitability is the most important criterion. Helping a client to design and execute an investment portfolio relevant to his or her life situation and
Monte Carlo simulation Fama – French Factor tilt
Source: Author’s own Figure 3: Robo-advisory platform – passive investment management Step 2 Automated investment allocation Use artiﬁcial intelligence to allocate investment automatically unlike traditional model portfolio
Step 1 Clasiﬁcation based on machine learning Use of advanced machine learning algorithm to classify investors based on the risk proﬁle
Step 3 Factor-based investment allocation Using wide variety of security classiﬁcation called ‘Factors’ to allocate investments Robo advisorysteps involved Step 4 Portfolio optimization Many optimization methods to use to arrive at an optimum investment recommendation
Source: Author’s own
risk appetite is the overriding concern. In addition to product suitability, other factors such as expenses and liquidity needs are embedded in the solution. Retirement planning For affluent clients, retirement planning is an important requirement. This is the most challenging area within wealth management. Wealth managers who generally assist clients in retirement planning have to contend with: (1) Actuarial life expectancy (2) Lifetime income (3) Potential inflation (4) Market outcomes (5) Product returns, and (6) Utility of income. Robo-advisors may help in managing some of these factors by using data analytics and simulations. Preliminary solutions such as the lockbox spending
strategy based on allocation between assets like treasury inflation-protected securities, shares and funds of stocks and bonds to meet a range of future-year needs can play a useful role in providing future income. Estate planning services For high-net-worth individuals (HNWIs) and ultra-HNWIs, a key function of wealth management is to help clients pass on their assets to their heirs and loved ones. This is an emotional area for a client. Again, simulation and data analytics may help the client to decide on appropriate intergeneration asset transfers. Shariah compliance filters and selection The Shariah compliant selection of stocks is automated in the case of Islamic asset and wealth management. Islamic investment products use filters to adhere
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SECTOR FEATURE WEALTH MANAGEMENT
to religious guidelines such as bans on tobacco, alcohol and gambling, in much the same way as socially responsible funds. Tax planning Some robo-advisors are already helping clients to manage taxes. There are three likely types of mismanagement of taxable assets: • unnecessary realization of capital gains • failure to harvest losses, and • failure to prefer lower-dividend stocks. Tax harvesting needs to be fully incorporated in portfolio recommendations. Insurance management A robo-advisor may also add insurance products as a solution for clients who need wealth and/or income protection. Insurance management can be used to mitigate issues of mortality and health risks. Client education Retail investors do not always have time to research opportunities for making money. Robo-advisors would do well to provide more client education and online training to help individual investors make more informed investment choices. Mobility platforms With the increased use of smartphones and personal digital assistants as a communication and personal planning tool, these tools can be the device for financial planning, investment advice,
payments as well as investment execution. Built-in data mining and AI tools The use of data analytics and AI can lead to a better matching of investment opportunities with the needs of clients and lead to improved investment outcomes, including satisfying behavioral preferences. With better analytical tools, clients may avoid some human judgmental errors and behavioral biases. The use of such software may allow investors to have enhanced capabilities to compete with institutional investors. Enhanced client servicing This is another area in which roboadvisors can do more. Data chatbots, which are artificial intelligence tools, can provide intuitive answers to generic customer questions, thus freeing up relationship managers to focus on complex requests and products. Chatbots would allow robo-advisors to enlarge the client base, catering to another market segment that embraces technology and social media. This is consistent with the function of robo-advisory to rely more on technology and to use less a human interface. In a typical Islamic robo-advisory software solution, the following functionalities are a must: • Seamless connectivity to the user interface layer of the robo-advisor • Straightforward portfolio management functionalities • Setting up and managing model portfolios
• Choosing the Shariah board with widely accepted principles as per AAOIFI or IFSB standards. • Shariah filters and selection • Automatic rebalancing, trade order management and fee calculations • Compliance function to ensure that all applicable laws and regulations are followed seamlessly • The customer relationship management system to gather and store all relevant data (such as know your customer, anti-money laundering, politically exposed persons, etc) for efficient and competent customer relationship management • Automate and digitalize strenuous error-prone reporting processes regarding authorities, customers and other stakeholders • Connections to market data providers and trading platforms for automated information flow and up-to-date values • Bank and custody connections for automated reconciliation and sending or receiving payments (such as monthly deposits) • Transaction aggregation to automatically import transactions from a third party such as a broker, custody or asset manager, with the functionality to validate transactions and automatically save them to correct portfolios to prevent human error, and • Accounting function to translate transaction data into accounting entries for your accounting system.
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