Perspectives: Opinions from our network of advisors, investors, operators and analysts on the risks and opportunities they see.
The extent to which robo-advisory is either a boon or threat to the traditional wealth management industry has been a major question on the minds of financial advisors since the emerge of the tool set right after the 2008-09 financial crisis. Early movers like Betterment and Wealthfront have attracted clients and capital, and legacy players from Charles Schwab to Morgan Stanley have launched their own offerings — often through acquisitions or partnerships with pure players. But many traditional wealth managers argue that the idea of replacing human advisors entirely is a pipe-dream, and a dangerous one, at that.
Scott Moss is a Partner at the New York-based law firm Lowenstein Sandler, where advises P/E, hedge fund and family office clients on regulatory compliance matters. He says the robo-advisory space poses unique risks to the century-old model of credible human advisors helping people make potentially life changing decisions about their assets. But these risks, he says, are manageable if handled carefully. He spoke with Karma Contributor Editor Michael Moran.
Michael Moran: What are the SEC requirements for reporting conflicts of interest for robo-advisors?
Scott Moss: Now a lot of robo-advisors have a Research Affiliates Fundamental Indexation (RAFI) program, where the commission for execution is wrapped together with the advisory fee. This streamlined some conflicts of interest, but the SEC highlighted things that maybe the robo-advisors didn’t think of.
For example, if the third-party algorithm maker drove investments to, say, affiliated ETFs. That was a conflict of interest that they wanted the robo-advisor to disclose to its clients.
If the services that the robo-advisor gave was not a comprehensive financial plan, the SEC wanted that to be explained to the client. If there was a tax law harvesting component, whatever the components of the algorithm or the actual services, the SEC wanted a lot of specificity, particularly in ADV.
They also wanted that to be understandable and in plain English, which can be very hard to do, especially if you’re in a robo-advisor fintech platform with no human interaction.
The SEC suggested things like Frequently Asked Questions, interactive tools or pop-up boxes to help a retail client understand in plain English what those services were about. And they also wanted it to be simultaneous with decisions or before decisions were made. So before a client signed up for the robo, they had to have all the material information about the services.
For the suitability of the investment advice, the SEC focused a lot on any questionnaires that were used by the robo-advisors that led to the advice.
So they look at how thorough the questionnaire was. They considered if it solicited enough information to make a recommendation that was suitable for the client. They wanted the questionnaire to be clear and understandable. They wanted it to use examples to help the user.
They wanted it to flag inconsistencies. So if in one part of the questionnaire the client responded with a low net worth or low income, but yet responded with a very high risk tolerance, it wanted the questionnaire to flag those inconsistencies and provide commentary if there was a self-directed component, where the client would direct the robo-advisor to do something through its interactive website or app that was not maybe suitable for the client.
Lastly, the SEC focused on the compliance program. Now every investment advisor that’s registered with the SEC has to develop a compliance program tailored to their operations and the same advisors, that rules apply to all investment advisors but the application can defer to the role of advisors.
So similar to the other three things they focused on, prior two things they focused on, the compliance program; and focused on how the algorithm was developed and tested; how the questionnaire was developed and used; what disclosures were made; how cyber security was protected; and in particular the SEC focused on the marketing and advertising procedures.
Now that guidance dovetailed very nicely into two recently published settlements against robo-advisors in December of 2018. And really, all of the claims against those two robo-advisors can fit into categories that were in that February 2017 guidance.
One of those recent enforcement actions that got settled was against Wealthfront Corp., that had about $11 billion in regulatory assets under management. The second was against Hedgeable Inc., which has about $81 million in regulatory assets under management. So not particularly small firms. Firms with developed compliance programs with significant assets.
Against Wealthfront, the SEC focused on false statements about a tax-loss harvesting strategy. They focused on retweets of prohibited client testimonial. They focused on Wealthfront paying bloggers, but not properly treating them as cash solicitors under the cash solicitation rule. They focused on the record maintenance, and they felt that because things weren’t caught that Wealthfront didn’t have adequate policies and procedures.
For Hedgeable they focused on misleading statements in a performance advertisement, again record retention, and again because they felt that performance advertising misstatements or misleading statements should have been caught. They felt they had an inadequate compliance program.
Now all this leads to where we stand in 2019, which is the Office of Compliance Inspections and Examinations (OCIE) of the SEC named robo-advisors or digital advisors, cybersecurity, and advisors to retail clients as top priorities in a 2019 national exam program.
Also, states may jump in the fray, especially focused on solicitors like bloggers, which may need to be licensed as investment advisor representatives or registered with the states.
So combined with the current market volatility, the high priorities of OCIE and possible state enforcement actions should lead to a very fun-filled 2019 or at least an interesting one for digital advisors.