How to invest in investors

Nvidia’s shares have almost quadrupled since last October. The maker of H100 semiconductors has been an obvious winner from investors’ excitement over artificial intelligence (AI) and large language models (LLM) such as ChatGPT. Yet the buzz is well and truly in the price, with Nvidia’s shares trading on 40 times sales, which seems expensive given the most obvious use case for LLMs is cheating on GCSE coursework.

Perhaps identifying some less obvious winners and losers from the AI boom could prove profitable. It has been suggested that LLMs could help automate financial advice. In February last year, Hargreaves Lansdown (HL) announced that it would spend £175m on strategic technology investment. The group intends to offer “augmented advice” – which Hargreaves Lansdown defines as “hyper-personalised guidance at moments that matter to you”. This spend may allow HL to target more of the wealth-management market, rather than just self-directed investors.

However, Peter Hargreaves, the founder who still owns 32% of the shares, has suggested that this is a waste of money. Historically, HL has done well by offering a lower-cost alternative to investors who don’t see why they should pay for advice they don’t need. Many MoneyWeek readers fall into the category of self-directed investors who know that a low-cost index tracker will outperform most active fund managers, but are also confident enough to invest in a self-selected portfolio of shares with attractive valuations. Other self-directed investments might be low-cost exchange- traded funds (ETFs) or investment trusts with an interesting theme, probably trading at a substantial discount to NAV.

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The reason Interactive Investor (II), HL and AJ Bell (AJB) are often referred to as “platforms” is that they share some of the attractive characteristics of technology companies that have relatively fixed costs but growing revenues, meaning increasing returns as the platform gains scale.

Uber connects drivers with passengers through its app, processing payments and managing ratings, but much of the real work is done by the self-employed drivers. Similarly, Airbnb and UK-listed Just Eat do not perform the physical work of owning hotels or running restaurants. HL, II and AJB provide a platform, with most of the work done by the self-directed investor choosing funds or shares based on their own research, without any need for hand-holding.

HL charges investors 0.45% a year and reports an operating margin of between 45%-65%, with management hoping to achieve the top end of that range by 2026 when investment expenditure begins to pay off. AJB, with a similar business model, charges 0.25% and reports an operating margin of between 30% and 40%.

II, now part of Abrdn, charges a flat monthly fee of £10 for Isas and £19 for a Sipp, which is more attractive to investors who have already accumulated large sums in their pensions. In the seven months of 2022 in which they were owned by Abrdn, II reported an eye-catching profit margin of 59%.

Hand-holding for the wealthy 

Bespoke wealth management, conversely, as offered by the likes of Rathbones/Investec, Brewin Dolphin, St James’s Place, Evelyn Partners or Lloyds Bank’s joint venture with Schroders, tends to be hand-holding for wealthier but less financially sophisticated investors.

There is a place for this type of advice: imagine a 70-year-old widow, whose deceased husband handled the financial affairs for their entire married life, suddenly having to make decisions about family wealth. Alternatively, many otherwise intelligent people have a mental block when it comes to finance. The celebrity mathematician Rachel Riley, for instance, seems to equate investing in shares with speculating in cryptocurrency.

It’s unclear, though, how AI would benefit wealth-management clients, who are looking for a sympathetic, well-spoken, competent human to support confidence in their decision making and tactfully prevent silly mistakes. The market for this sort of “advice” (a combination of financial coaching, needs-based selling and status symbol) is surprisingly large. Hargreaves Lansdown suggests that the total market size is £3trn of funds under management.

Although wealth management services cost more, from an investors’ perspective the sector is less appealing than investment platforms such as HL, II, or AJB. Wealth managers provide bespoke services such as portfolio construction, estate planning, tax planning and general financial good practice – helping older clients set up a lasting power of attorney (LPA), for instance, so that trusted relatives can look after their financial affairs if necessary.

These services are more personalised, but this comes at a cost. Rathbones charges 1.2% on customers’ first £250,000, 2.5 times more than HL and five times more than AJB. Yet as wealth managers, a bespoke service is more expensive to run, Rathbones reports an operating margin of between 20%-30%. Brewin Dolphin charges even more – 1.5% on a customer’s first £1m – but it has a lower profit margin at just over 20%. The typical wealth-management client has long-term savings worth well over £500,000 pounds, but the margins are lower because the cost of the service is higher.

Restaurateur Russell Norman of Polpo fame is fond of pointing out that if you own a restaurant with a Michelin star, you will lose money. If you have two Michelin stars, you will lose even more money. Domino’s Pizza on the other hand generates a return on capital employed (ROCE) of close to 30% and an EBIT (operating) margin of 20%.

Consolidating wealth management

Perhaps there is scope to improve margins in wealth management. Overseas banks and financial buyers have been acquiring firms and consolidating the industry, with the hope of increasing returns from economies of scale. Private-equity group Permira, which has owned Tilney for the last decade, recently merged it with Smith & Williamson to create a wealth manager with £56bn of assets under management. This deal was facilitated by £250m of cash from Warburg Pincus, another private-equity firm. In the middle of the pandemic US financial group Raymond James bought Charles Stanley, which had £26bn of assets under management, for £280m. Then last year Canadian bank RBC paid a hefty 60% premium to acquire Brewin Dolphin, valuing it at £1.6bn – 3.8 times sales, or 3.3% of the £49bn of discretionary funds under management.

Earlier this year Rathbones responded by acquiring the Wealth and Investment (W&I) division of Investec in an all-share deal worth £840m, which will make Investec its largest shareholder with a 41% stake. The deal has created the UK’s largest wealth manager with roughly £100bn of funds under management (FUM), and values the W&I division at 2.1% of FUM, or 2.5 times historic revenues. Rathbones is also rolling out a self-directed service for portfolios below £150,000, the area where AJB and HL have historically been the strongest players.