RiskTech Forum

Capco: What Robo-Advisors Should Expect From Regulators

Posted: 1 June 2017  |  Author: Steve Shin  |  Source: Capco

What to Expect as a Robo-Advisor

The sizable presence and rising trend towards automated digital advice has led to a disruptive shift in the ways investors and advisors receive and provide financial advice. The growing popularity of robo-advisors, however, has simultaneously intrigued various regulatory bodies.

Since the 2008 financial crisis, safeguarding the financial security of consumers has been a top regulatory priority as illustrated by the enacted Dodd-Frank Act and the DOL Fiduciary Rule. Interestingly, the Department of Labor Regulation drove several traditional wealth managers towards digital platforms as the Fiduciary Rule required heightened standards of documentation and fee transparency. Specifically, digital platforms provide advisors the necessary tools to streamline client onboarding and account opening via e-signature, improve client activity and decisions tracking, and better manage advisor activity and workflow processes –thus, enabling wealth managers to uphold their fiduciary responsibilities. Many Digital Platforms are DOL compliant “out of the box,” making them an inviting proposition for notoriously slow to change Wealth Management firms.

It is of no surprise that regulators are keeping a watchful eye on robo-advisors as studies show that $83 billion in client assets were managed by robos by the end of 2016. This number is projected to increase to $385 billion by 2021. To protect the vast amounts of client assets managed within robo-advisory accounts, regulatory bodies such as the U.S. Securities and Exchange Commission (SEC), specifically the SEC Office of Compliance Inspections and Examinations (OCIE), have placed automated digital advice as a top examination priority for 2017 and onwards. Though no official ruling specific to automated digital advice has been legislated yet, taking preemptive compliance measures is crucial for any robo-advisor to continue to drive growth and sustain client relationships.

To help robo-advisors better prepare, the SEC Division of Investment Management issued a guidance update in February 2017 that introduces the regulatory obligations and scrutiny robo-advisors may anticipate. This guidance update touches on the disclosure, suitability and compliance requirements that all robo advisors are expected to uphold under the Investment Advisers Act of 1940. In essence, robo-advisors are now viewed under the same light as all SEC-registered investment advisors, with the overarching responsibility of acting as a fiduciary.

Based on this guidance update, robo-advisors should focus on three distinct areas with respect to the obligations outlined in the Investment Advisers Act: 1) the substance and presentation of their disclosures to clients; 2) the provision of suitable advice; and 3) effective compliance programs.

The Substance and Presentation of Disclosures

As a robo-advisor, it is important to disclose any risks associated with the algorithms used to manage client accounts. Fees, degrees of human involvement in account oversight, third party involvement and the ways client information is used to recommend a portfolio should all be clearly outlined within a robo-advisor’s disclosures. The scope of its advisory service should avoid false implications in order to prevent misleading clients. For example, a robo-advisor’s tax-loss harvesting services should not imply comprehensive tax advice. The SEC may even monitor the design and placement of disclosures to make sure they are easily and readily located.

1“SEC Provides Robo-Advisor Guidance,” InvestmentNews, February 23, 2017. Access at: http://www.investmentnews.com/article/20170223/FREE/170229953/sec-provides-robo-adviser-guidance

The Provision of Suitable Advice

Just as traditional advisors are expected to act in the best interest of their clients, robo-advisors are expected to act in the same fiduciary capacity by providing suitable investment advice based on the client’s financial situation and investment objectives. Questionnaires are one of the primary means in which robo-advisors gather client information such as age, income, financial goals, investment horizon and risk tolerance. It thus makes sense from a regulatory standpoint that questionnaires are thoroughly designed and tested to ensure sufficient information is being obtained to provide suitable advice. This applies both during the initial portfolio recommendation process and with any ongoing advice that may be provided to the client. Inconsistencies with client responses should also be recorded and alerted to the robo and/or the client. The SEC guidance update recommends that robo-advisors consider whether their questionnaires provide additional clarifications or examples via design features such as tool-tips or pop-up boxes.

Effective Compliance Programs

The Advisers Act requires investment advisors to adopt, implement and annually review written policies and procedures. As suggested by the SEC’s guidance update, robo-advisors should consider the unique aspects of their business model when developing their respective compliance programs. Key policy and procedural considerations include the development and testing of their algorithm, disclosures of changes to their algorithm and third party oversight of the algorithm. Other considerations include the prevention and detection of cybersecurity threats, and the use of social media in marketing the robo’s services.

How the Move to Hybrid Will Shape the Future of Regulation and Digital Advice

Over the last few years, there has been a noticeable shift in the digital advice market away from direct-to-consumer (D2C) platforms and towards hybrid digital-human advice platforms. Specific cases include Merrill Edge Guided Investing, Schwab Intelligent Advisory and Capital One Investing. While the SEC’s expectations around a robo’s disclosures, suitable advice provisions and compliance programs will more or less remain analogous to the points made in the guidance update, it is likely that regulators will scrutinize the level of dependence human advisors will have on their automated digital tools. This will, in turn, affect how advisors interact with their clients. For example, with a robo’s automated capabilities on hand, human advisors can focus more on scaling their client base to investors across the age spectrum. As a result, the level of advisor-to-client interactions will vary between those with more investable assets that have more complex needs (retirees), and those just beginning to invest (millennials). The advisor will therefore need to closely monitor their clients’ changing financial needs to provide regulators sufficient reason as to why certain automated digital solutions were applied over others.

In any case, robo-advisory tools can quickly evaluate available investment products and present portfolio options, while disclosing any risks and associated fees. This is advantageous for the advisor, as well as the regulators who closely evaluate whether investors are supplied with suitable advice and clear fee requirements. End-to-end algorithm-based product shelf and risk analysis tools allow advisors to continually monitor the best options for investors while excising manual back office operations. This is a key selling point from a regulatory standpoint as advisors can then devote more time governing investor accounts to address changing needs and alleviate concerns.

Final Thoughts

The SEC’s guidance update along with the OCIE’s 2017 examination priorities affirm that regulators are continuing to observe and assess how robos fit into existing regulatory requirements. As new automated investment advice services continue to develop, it is clear that the structure, operations, disclosure and compliance programs of digital advice will face regulatory scrutiny under the Investment Advisers Act. While the legal obligations placed on robo and traditional advisors regarding fees and product offerings share many commonalities, a key distinction for robos is that they must be fully transparent with the use of their algorithms and questionnaires. Whether the digital solution runs on a D2C platform or supplements human advisors as a hybrid tool, it will prove absolutely critical for robo-advisors to audit and disclose how and why certain algorithms and questionnaires were used to provide clients specific investment portfolios.