Finance is an industry that despite its success is rife with challenges.
For top hedge funds, the minimum buy-in excludes most potential investors. However, investors with significant capital that don’t meet the typical minimum buy-in are still clamoring for sophisticated investment advice. The proliferation of online investment vehicles like Wealthfront, which targets mostly below accredited investors (meaning less than $300,000 in annual or less than $1million net worth excluding your primary residence) are a testament to this pent-up demand.
However, these companies lack a sustainable competitive advantage, as more and more “robo advisors” come onto the market.
There is a mismatch between the way the market is allocating capital and the availability of high-quality investment advice and opportunities.
Typically fees for financial advisors are broken down into two categories. The first type is traditional asset management (wealth management) that take between 1-3% annual to invest your funds in traditional assets classes (bonds, equities, commodities). These funds are usually open to anyone, no financial requirements needed. But Wealthfront and Betterment, along with a number of other robo advisors, are using smaller teams, and artificial intelligence to manage these assets for a fraction of the cost, typically between 0.25% – 0.75%. In both cases, the goal of these advisors is to stay at or near the market returns.
On the other hand you have investment vehicles like hedge funds. These investment vehicles are considered to be higher risk by regulators and require accredited investors. Additionally, these funds typically have heavy minimum investments. For their market beating returns they charge a ~2% annual fee, the same as asset managers, but they also take 20% of the profit.
Why? These funds invest in traditional investments like the asset managers, but they also invest in high frequency trading, derivatives, foreign currencies, bankruptcies, high-yield bonds (sometimes called junk bonds), mode- based speculation, quant trading, and the list goes on.
However, an increasing number of hedge funds have set up bots built by quants that handle much or all of their trading. Investors are paying fees for the expertise of the whole fund when much of the decision-making is done algorithmically.
Many of these quant traders and analysts might be perfectly willing to manage small sums of capital if they could start their own fund. However, these investment managers are typically unskilled at fundraising or lack the network to do so. Since they’re unable to raise the capital, they cannot feasibly break away from the traditional model of working at a hedge fund or larger wealth management firm.
Fundamentally, there is a mismatch between the way the market is allocating capital and the availability of high-quality investment advice and opportunities. The barriers to entry are simply too high for many investors, on the demand side, and for many traders, on the supply side.
A platform will solve this capital resource allocation mismatch, but the real dagger to the heart of the current hedge-fund industry is the erosion of fees. A platform could easily charge 0.25-.75% annual fee, plus 10-15% of returns. In this model, the trader (producer of value) would get 8-13% for doing what they love while the platform takes the rest for handling back office operations and sourcing the capital.
The answer to this problem is simple. Remove the unnecessary complexities, enable small-size transactions, and provide better service and returns, all while substantially growing the market.
Currently, there is a heap of untapped wealth-management opportunities in the market. On one side, there are traditional retail advisors who’ll take a few dollars from anyone off the street that’s looking to save for retirement. On the other are hedge funds that typically require millions of dollars as a minimum investment from their customers.
Between these two segments sits a highly underserved market. Investors with access to significant amounts of capital and wealth, but not enough for the minimum buy-ins to top funds. These investors have historically been left out in the cold.
These individuals and entities certainly want to take high-value risks and seek the same kind of returns as those who have access to top hedge funds and wealth managers. Some conservative estimates approximate this segment of the market to be worth around $1 trillion. Whether that estimate is perfectly accurate or not, there still exists a tremendous pool of capital that merely needs an outlet.
Additionally, there is an army of quants, investment analysts, and other financial services professionals who would be perfectly willing to manage smaller sums of capital if given the opportunity.
The greatest platform businesses resolve pain points on all sides of their respective markets. Resolving pain points should be the goal of any new platform business because doing so builds strong growth and platform loyalty, low churn, and very little platform leakage.
A platform approach to investment, one that connects these independent investment managers with underserved investors, does just this.
On the platform, investors would back investment managers whose quantitative models and analysis have been proven to work in the market, without the large minimum buy-in requirements typically mandated by top funds.
This approach to fundraising can eliminate the need for high minimum buy-in requirements by corralling the capital and positioning it all in aggregate. Investment managers would benefit because their validated analyses can win them access to capital. Investors would benefit because they’d easily be able to identify the top performers and diversify their investments across multiple funds.
Eventually, large funds will join in as well, attracted by lower fees and more visibility than typical investment vehicles they allocate their money to.
Finally, a platform can standardize and automate much of the back office processes for traders and investors, such as reporting and compliance, much like Wealthfront and Betterment have done. However, in a platform investors won’t be tied to a single set of financial products. Investment managers will compete with each other directly for capital and the most successful funds will win.
By Drew Moffitt