Embrace the technology, but be aware of the Regulatory Scrutiny
For years, financial industry observers have watched the pace of technological evolution in the industry with a mixture of trepidation and delight. Without question, these technological advancements have created new opportunities for both advisers and clients, including increased operational efficiency, analytical complexity and transparency. Some of these technological advancements have been accompanied by inherent disadvantages, thus necessitating the need for additional policies and procedures; the relatively recent need for cybersecurity plans is an example of a significant concomitant disadvantage that was not deemed onerous enough to prevent the use of the technology that warranted it. Although there have been many technological advancements that have been said to have revolutionized the industry and have since become ubiquitous, perhaps no technological development in recent years has been more debated, discussed or controversial at introduction than robo-advisers.
Simply stated, robo-advisers are online investment platforms that use algorithms and model portfolios to align a client’s investments with their objectives and risk tolerance. Portfolio construction naturally lends itself to an automated analytical process, as the often laborious task can be done more efficiently and cost-effectively by a computer than staff members, and at a cost that averages less than a quarter to a third of the average percentage of assets under management charged by traditional advisers. Although most robo-advisers limit their offerings to automated portfolio management functions while avoiding other advisory functions, they are still deemed to be investment advisers subject to the Investment Advisers Act of 1940. As such, robo-advisers, like traditional investment advisers, are regulated by the SEC and must be registered; because they are deemed to be internet-only advisers, they may register with the SEC regardless of assets under management. As registered investment advisers, they are subject to the same requirements as are traditional advisers. However, because of the robo-advisers’ unique business model, some of these requirements, such as the fiduciary duty to act in the clients’ best interests, the requirements of full disclosure of conflicts of interest, and client account reviews, for example, may prove challenging.
Robo-advisers operate in several different business models, and in various shades in between.
- Some robo-advisers work directly with clients, often citing the ostensible advantage of roboadvisers’ reduced interaction model, which is said to be increasingly favored by younger investors who came of age with social media, texting and virtual relationships as an alternative to traditional interaction. Additionally, because of their favorable fee structure, many consider them to be an ideal solution for those investors without significant investable assets who may be at risk of being overlooked by traditional advisers as their costs of doing business continue to rise.
- Some advisers use robo-advisers on an a la carte basis. These advisers, who may have conceded that the trend toward automation is inevitable, are either referring clients directly to robo-advisers for straightforward investing needs while continuing to work with the clients on the other aspects of their financial planning, or perhaps are following a lifecycle approach, in which they become more actively involved with the client’s investments as the client’s assets grow and their needs become more complex.
- Advisers are increasingly incorporating roboadvisers into their practices in order to avail themselves of robo-advisers’ competitive advantages in portfolio construction, automated tax-loss harvesting and portfolio rebalancing, thus enabling advisers to focus on the areas of their own inherent competitive advantage, such as financial planning, estate planning, relationship building, and other areas requiring face-to-face contact with clients. Some roboadvisory platforms allow advisers to white label their services, thus providing a more seamless client experience, preserving client relationships and helping to ameliorate some of the common robo-adviser-as-competitor concerns. Some of the adviser-facing robo-advisers allow interested advisers to customize the platforms and to build asset allocation models as well.
At any level of involvement with robo-advisers, advisers must remain cognizant of their compliance responsibilities as well as the ongoing fiduciary duty they owe their clients. The use of robo-advisers may lead to a false sense of security if advisers feel they are relieving themselves of liability with respect to those outsourced functions. The use of robo-advisers does not relieve an adviser of fiduciary duty owed to clients. Advisers utilizing robo-advisers are advised to be aware of the following:
Advisers that utilize robo-advisers within their practices must ensure they provide full disclosure regarding their use. Specifically, Form ADV Part 2 disclosures about an adviser’s use of robo-advisers should include information about advisory models and fee structures, brokerage and trading practices, account reviews and conflicts.
Fiduciary duty compels decisions that are in the best interests of the clients, including the decision or recommendation to use a robo-adviser. Advisers should thoroughly vet robo-advisers before deciding which to utilize. Factors to consider include the robo-advisers’ offerings, technology, costs, service, ease of integration with other technology and service providers, ability to white label, how much involvement the adviser can have in asset allocation and portfolio design if desired, and cybersecurity and business continuity plans, among others. It is also important to be aware of the conflicts of robo-advisers, and how those conflicts may affect an adviser’s clients. For example, if the robo-adviser is programmed to select from limited investment options from affiliated firms, or requires a minimum amount of assets to be in cash on which the robo-adviser’s banking affiliate profits, an adviser would need to be able to weigh these factors alongside other factors in determining which options are most beneficial for clients.
Advisers utilizing robo-advisers should consider their fees carefully. Robo-advisers bring increased efficiency and cost savings to many firms, and it is imperative that advisers are able to demonstrate that the fees they are charging clients are not excessive in light of the services they are providing. Advisers should fully disclose the fees they are charging clients in Form ADV Part 2 and in Advisory Contracts, if used. Disclosure language should also describe any other fees clients will be assessed as a result of implementing recommendations, such as product fees and expenses, transaction fees, and custodial fees.
Conflicts are highly scrutinized and should be fully disclosed to clients. Advisers are encouraged to review the disclosures provided by the robo-advisers they utilize within their practices to determine the conflicts of the robo-adviser, and to do a comprehensive review of their own conflicts as well. Conflicts vary by adviser, robo-adviser, and the specific situation, but common conflicts include the varying fee structures and/or additional services provided to the adviser based on amounts invested with the robo-adviser and whether it receives any form of compensation for offering, recommending or selling certain services or investments.
Policies and Procedures:
Advisers’ policies and procedures must be updated to reflect the incorporation of robo-advisers. Staff must be trained and well-versed in workflow and administrative changes resulting from the robo-adviser addition. As with any newly adopted change in business practices, procedural adjustments are often necessary while the firm acclimates. Advisers should review their policies and procedures regularly to ensure they are in alignment with actual firm practices and amend as needed.
- The importance of protecting client information cannot be overstated. Advisers utilizing robo-advisers are advised to investigate the cybersecurity plans and any previous information security breaches of prospective robo-advisers prior to engagement. Cyber incidents involving robo-advisers could have far reaching consequences, including unintended trading if algorithms are affected or a compromise of client data. Cyber insurance terms of coverage, limitations and exclusions should be examined and continually evaluated as the cybersecurity insurance and robo-adviser markets and offerings continue to evolve.
- Advisers whose business model involves sharing client data with robo-advisers must ensure their privacy notices allow for the scope of data sharing required under such an arrangement, and should update and deliver revised privacy notices if needed. Further, advisers must be diligent about sharing only such information as would be reasonably necessary to facilitate stated investment purposes and nothing more.
- Advisers that utilize robo-advisers within their practices are advised to remain involved in the client fact-finding process, rather than simply relying on the robo-advisers’ automated data-collection questionnaires in order to understand crucial information about their clients. Computers excel in areas in which they are programmed, but they are only as competent as the data entered. Those in client-facing positions know that it often takes probing questions, explanations, and even the ability to read body language to fully ascertain a client’s investment objectives, risk tolerance, and other crucial information about a client’s financial and personal situation, so it does not require a great cognitive leap to understand how an online questionnaire without the ability to engage in such could lead to less than optimal outcomes. Advisers with insufficient information about their clients lack the requisite knowledge to ensure that they are acting in their clients’ best interests.
- Advisers that utilize robo-advisers within their practices are advised to review the robo-adviser-invested accounts periodically to ensure client needs are being met. Through the process of annual account reviews or otherwise, advisers can best determine if the technology is meeting the needs of the clients. If an inherent limitation in the technology, such as the inability to predict or react to political events or global economic changes, for example, causes an outcome that is not best suited for the client’s needs, the adviser can discover it during a review and address it as necessary. Account reviews could also uncover other unintended outcomes that could be harmful to clients as well. What may be a minor system “glitch” can result in unsuitable trades or other anomalies. Skepticism of computer-based automated systems is generally quite low, and when this same blind faith is applied to robo-advisers with the high suitability standards and fiduciary duty incumbent upon advisers, this blind faith can lead to a serious blind spot. Advisers have a fiduciary duty to ensure that they are acting in their clients’ best interests, and this also includes a review of the performance of all third party vendors and service providers with whom they choose to work.
Although the robo-adviser industry will continue to evolve rapidly in the months and years to come, the use of advanced technology is here to stay. Both investors and advisers will increasingly acknowledge the many advantages of robo-advisers and will seek to utilize them more fully in the future in variations not even contemplated at present. However, regulation in this area will evolve and adapt to keep pace with the new issues robo-advisers will present as well. In a possible foreshadowing of regulatory interest in the area, on May 8, 2015, the SEC issued an Investor Alert about automated investor tools, including robo-advisers. The alert outlined due diligence investors should perform before investing, including understanding relevant terms and conditions, limitations of the technology and key assumptions, safeguarding personal information shared online, and a warning that output generated solely by a robo-adviser may not be right for the investor’s needs and goals as a result of the inherent limitations. Advisers should not be afraid to embrace the new technology, but they should be cognizant of the increased regulatory vigilance that will be required of those involved in what is likely to be an initially active area. NRS can help navigate through the complexities of this new area of regulation.