©2015 Morningstar, Inc. All rights reserved.

Hal Ratner

Global Head of Research, Morningstar Investment Management, LLC

April 26, 2017

Replaced by Robots

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►A Lifecycle Investment Model

►Human Capital

►Replaced by Robots: A March Toward Obsolescence?

►Human Capital Repriced?

►Q&A

Agenda

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►Marginal player evolving from the institutional request for proposal (RFP)-oriented world of asset managers/consultants/institutional investors to advisors and individual households.

►Technology-enabled, holistic advice will be increasingly viewed as the real value-add, driving down traditional asset management fees (since there’s an upper bound on what people will pay for advice).

► Investment problems become more complex:

►Diverse & often ambiguous liabilities

►Heterogeneity of preferences

►Behavioral biases

►Lack of empirical verification of efficacy (the performance measurement conundrum).

Future of Investment Advice and Management in the US?

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►No agreed-upon definition: McKinsey & Co. “Digital Advisor: Delivering Personalized Advice in the Digital Age” (June 2015) argues for human advisors working through “digital hubs” sharing investment technology and distribution systems.

►Anything from “virtual advice hubs” to “standard DIY” web service (Wealthfront, Betterment, etc.).

►Ultimately we believe it means “increased integration of technology in the advice process, in terms of distribution, recommendations, and data aggregation.”

What is Robo-Advice?

Rules-Based (Index Fund) & Dollar Cost Avg

Program/Algo Trading

Robo AdviceMarket Model (e.g. CAPM)

AI/Machine Learning

Rote Tool (Adjunct to Human) Data Processing Self-Learning

► “Automation” in the investment world is not new.

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►Not in the near term. At least not for everyone.

►Most investors are more comfortable with a person when dealing with key issues impacting personal welfare.

►Financial economics is a social science and less amenable to quantitative methods than hard science is:

►Technological and methodological limitations increase as complexity increases especially for solutions requiring cross-disciplinary engagement (lawyers, tax planning, estate issues).

►However, technology will force advisors to become more sophisticated and rely on increased automation to help them deliver more comprehensive advice.

►It may also create fee pressure as big players with scale (e.g., Vanguard) dominate the scene. Likely put pressure on pure asset managers to lower their fees (e.g., ETFs, active strategies).

Robots on the March: Will Robo-Advice Replace Human Advisors?

Investors: Principles for Principals

gPeople invest to consume—they don’t derive “utility” from wealth, they derive utility from expected consumption

g Investors have subjective preferences (Risk Aversion, Time Preference, Substitution)

g Investors face budget constraints

gPeople would like to maximize the utility of lifetime consumption

Multi-Goal: Lifecycle Investing Using Simulation

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Simulation of Wealth Paths

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45

Extraordinary Cash Flows

Ongoing Cash Flows

Investor Attributions: A Representative Sample

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►Just as investments can be described by a weighted set of attributes, so can investors

Quantitative Qualitative

Retirement Benefit

Age PriorityOf Goals

Risk Aversion

LaborIncome

Tradable Wealth

Non-TradableWealth

Goals Time Preference

Investment Horizons

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Risk Capacity: Total Wealth

Human Capital Housing Wealth Pension Wealth

Total Economic Wealth=

+ ++

Financial Capital

Liquid Non-Tradable Illiquid Contingent

What is the true risk of any portfolio that exists to pay for a liability?

• It is NOT the standard deviation of the asset portfolio.

• It is NOT the performance of your asset portfolio relative to the asset portfolios of your peers.

• The TRUE risk is that it won’t be able to pay for the liability!

Risk Capacity: Investor Balance Sheet

Assets Liabilities

Financial Capital

Illiquid

Housing Equity

Human Capital

PV of Earnings Used for Pre-Retirement Expenses

PV of Earnings Directed Toward Savings

PV of Future Social Security and Pensions

Surplus (Deficit)

Future Expenses

PV of Pre-Retirement Expenses

PV of Post-Retirement Expenses

PV of Bequest

Ongoing Consumption

Debt

Mortgage

Revolving Debt

Risk Capacity: Human Capital

➢ Human Capital is the set of all attributes an individual possesses to create economic value.

➢ From an economic perspective, human capital is the present value of future labor income. Can be extended to include labor-accrued benefits such as public and private pensions.

➢ Typically, an investor’s largest asset.

➢ Typically non-tradable. Convertible and consumable only through time.

➢ Human Capital has no intrinsic value. It is continually repriced by the labor market. But because it’s not marked-to-market this rarely shows up in earnings patterns.

➢ Value depends on age, gender, education, as well as general economic factors, interest rates (cost of capital), labor-force participation, etc.

Human Capital (cont.)

➢ Can be modeled as a self-amortizing bond with an embedded “call” that can be “sold” to another employer.

➢ Old Concept—Adam Smith (1776), Ricardo, Marx, Pigou,(1935), Mincer (1958), Becker(1964)

Human Capital: Risk associated with Human Capital differs by occupation

/Artist

Earnings Curves (Real Earnings)

Source: Morningstar.

Human Capital Stylized Model

Source: Morningstar.

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The March Toward Obsolescence?

Replaced by Robots: Is Human Capital Under Threat?

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“We are being afflicted with a new disease of which some readers may not have heard the name, but of which they will hear a great deal in the years to come—namely technological unemployment. This means unemployment due to our discovery of means of economizing the use of labor outrunning the pace at which we can find new uses for labor.” [emphasis in the original]

J.M. Keynes (1933) “Economic Possibilities for our Grandchildren”

“The evaporation of thousands of skilled information technology jobs is likely a precursor for a much more wide-ranging impact on knowledge-based employment.”

Martin Ford (2014) “Rise of the Robots: Technology and the Threat of a Jobless Future.”

Replaced by Robots: The March Toward Obsolescence?

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Automation’s Increasing Impact on Workers

Data: Federal Reserve Bank of St. Louis (FRED)

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Automation’s Increasing Impact on Workers

Data: Federal Reserve Bank of St. Louis (FRED)

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Automation’s Increasing Impact on Workers

Data: Federal Reserve Bank of St. Louis (FRED)

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►The question is whether we are moving toward a sort of Singularity, in which self-replicating and self-sustaining robots render human labor as we know it obsolete, or whether we’re moving toward the Creative Destruction of the “Fourth Industrial Revolution” (WEF) in which such machines, while displacing many workers and destroying many types of jobs, also create new, as-of-yet-unimaginable occupations and modes of labor.

Replaced by Robots: Core Question

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The Arrow of Economic Time: Looking at Economic History

Agrarian

Economy

First Industrial

Revolution

Third Industrial

Revolution

Second Industrial

Revolution

Introduction of steam power.

Advances in agriculture and

textile production.

Digital Age: Transition of

analogue to digital

technology. Information age.

Steam-powered transport

(shrinking time). Increased

mechanization and atomization of

large-scale manufacturing.

“De-skilling” (Bravermann, 1974)

Brawn- and artisan-

based economy

1870-1914Pre-1760

1760-1830 1950-1980

Substitution of Technology for Brawn Substitution of Technology for Non-Creative Cognitive Tasks.

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World Economic Forum: Fourth Industrial Revolution?

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Looking Into the Future: Two Possible Paths

►Creative Destruction School: Historical Argument

►Not different this time.

►New technology begets new jobs.

►Creative Destruction (Schumpeter, 1942) .

►Creation of new, as-yet-unimaginable professions. In the past (e.g., industrial revolution) workers were displaced (from field to factory), but new jobs arose.

►Singularity School: Futurist Argument

►This time is different.

►Machine intellectual capital replaces human capital.

►Significant displacement up to an “underemployment equilibrium.”

► We don’t actually hit a singularity (Ulam, 1958, Ratner 2016) since full-on capital replacement implies a “market singularity” and cannot exist in an economy.

►Necessity for “universal” subsistence wage to support a small minority of “super-capitalists.” Likely emergence of “artisan” class. Homogeneous composition of goods market. Very different composition of “labor market.”

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►Replication of human intellectual capital—not just brawn or repetitive uncreative tasks (e.g. solving a large set of simultaneous equations).

►Automation has hit the manufacturing sector and is working itself into the professional class (tax preparation, medicine, software development, investment management).

• Automation of professional services and displacement of middle- and upper-middle-class (all but significant holders of capital), social unrest (too many people, too few jobs), only certain types of jobs will be more or less immune to automation.

• Attributes such as education, hard work, intelligence, are repriced by factor markets due to competition from AI.

• Attributes such as persuasion, social perceptiveness, empathy, originality (in the colloquial sense), become more valued and are repriced upward.

Robots on the March: Why This Time Could Be Different

Manufacturing Administrative Professional

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►Wage and education level as a function of the probability of computerization (“The Future

of Employment: How Susceptible are Jobs to Computerization.” Frey & Osborne, Sept 2013)

Robots on the March: Potential Wage Impact

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►Technical innovation destroys old jobs and creates new ones

Creative Destruction

►Capital-Labor Complementarity

►ATMs vs. Bank Tellers (Bessen, 2015): Introduction of ATMs lead to proliferation of bank tellers. Put to higher-better use as sales people

►Financial Advisors: With robo-capabilities, less asset management, more counseling, coaching and education.

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►We’ve got problems.

Creative Destruction

►Healthcare: We haven’t conquered disease

►Degenerative process associated with aging

►Congenital disorders

►Disorders due to injury

►Environment: Global Warming

►These are areas which demand massive investment in human capital and in which robot complementarity will help to create much needed jobs.

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►Capital is concentrated in the hands of a few “Super Capitalists” who control nearly all production.

►In order to maintain ROI, they need to supply tax revenue to the “government” which is redistributed as a universal basic wage.

►The optimization problem is determine the optimal tax rate that maximizes ROI through distribution of the universal basic wage.

►Consumers have needs met, but are still social competitive social animals concerned about status and endowed with a massive time surplus. Technology makes cost of many services trivial through virtual reality-type services.

► Reemergence of an artisan class to provide specialized goods/services for which the super capitalist’s cannot make a worthwhile ROI

►“Artisan Made” confers status on a good or service.

Economic Singularity: Artisan Economy

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►Artisans provide specialized goods/services for which the super capitalist’s cannot make a worthwhile ROI

►The “authenticity attribute” sheer knowledge that service or object was created by a specific person (or just any person) confers a “premium” to the buyer.

►A service can pass the Turing Test (Turing, 1950) but price below one with a human origin.

Economic Singularity: Artisan Economy

$10

MM

$100

Artist: Anonymous Forger Dealer:

Salvation Army. Transaction Date :??

Artist: Franz Halls, Dealer: Mark Weiss

Transaction Date 2011

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► Increase in unemployed and underemployed prime-age males may be due to increase in their “reservation wage” due to low cost and huge utility of gaming (Hurst, 2014) and social media

Virtual Reality Economy: Beginning?

Source: U.S. Bureau of Labor Statistics

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What are the HC Attributes that may be most valued in robot the economy?

Dexterity

Originality

Persuasiveness

Programming/Computational

Reference Knowledge

Waning

Waxing

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►Talent Stack Concept (Except you have to be good but not great)

►Knowledge acquisition is increasingly easy in the internet age

►Wikipedia

►Stack Overflow

►R-bloggers

►Free textbooks

►YouTube

►Complementarity with technology allows you to devote your time to “content” not “production”

►Specialist vs. Renaissance Person?

Moving back toward broader skill set requirements?

Closing Slide

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gMore than at any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other to total extinction. Let us pray we have the wisdom to choose correctly.

• Woody AllenMy Speech to Graduates (1979)

Thank You

Questions?

Hal.Ratner@Morningstar.com

+1 312 696-6606

Becker Path (use another Title)

Source: Morningstar. Based on Chart 1 of “Human Capital: A Theoretical and Empirical Analysis with Special Reference to Education” 2nd Ed. (1975).

Multi-Goal Advice: Cascading—Investing Optimally Through Time

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79%Expected Shortfall

$157,872

81%Expected Shortfall

$945

81%Expected Shortfall

$1,506

78%Expected Shortfall

$691