CONTACT US
In the asset management world the SEC provides guidance for risks involving robo-advisors, covering social media, cyber-attacks and due diligence.

Robo-Advisers: The Supervisory Challenge

Download

Overview

We hear many stories these days about robots taking over jobs traditionally performed by humans.  In the asset management world, this technological advance takes the form of automated advisers (a.k.a “robo-advisers”).  Generally speaking, a robo-adviser uses technology, such as computer algorithms, to provide discretionary investment advice by collecting investor information regarding financial goals, income and asset information, and investment horizon and risk tolerance through online questionnaires.  Younger investors seem to prefer robo-advisers to human beings primarily due to greater convenience and lower costs associated with automated advice. 

Asset managers, however, should not assume they can sit back, relax and let the robots do their work; robots require human supervision.  Automation does not eliminate a registered investment adviser’s (“RIA’s”) fiduciary duty or potential liability in the event of a robo-adviser failure, and may introduce additional risks.

The U.S. Securities and Exchange Commission (“SEC” or the “Commission”) has noted this change in the competitive landscape of investment advice and the attendant risks.  In February 2017,1  the Commission’s Division of Investment Management and Office of Compliance Inspections and Examinations identified special considerations for asset managers when using algorithms instead of humans to provide investment advice.  When deploying a robo-adviser, the fiduciary duty requires RIAs to consider the following issues:

  1. What happens if the algorithmic code does not account for changing market conditions? (Note: RIAs should always consider Long-Term Capital Management in the late 1990s as a cautionary tale of how models can spectacularly fail.)
  2. Do RIAs have adequate staffing to address investors who prefer humans to robots?
  3. How do RIAs protect the robo-adviser from cyber-attacks?
  4. Are investors adequately informed about the robo-adviser strategy and methodology to make investment decisions?
  5. Is the “secret sauce” in the algorithm robust enough to meet all investor needs?

Robo-Adviser Compliance Programs

To address these risks, the SEC guidance addresses 4 primary areas:

  1. Effective Compliance Program – Robots or not, the Investment Advisers Act of 1940 (“Advisers Act”) mandates an effective compliance program pursuant to Rule 206(4)-7.  Robo-adviser policies and procedures should cover:
    1. Development, testing and backtesting of algorithmic code, and post-implementation of its performance;
    2. Investor questionnaires, which should elicit sufficient information from investors regarding their investment objectives and financial information to provide suitable advice;
    3. Disclosures to clients regarding material changes to the algorithmic code;
    4. Oversight and due diligence of third-party vendors that develop or manage the algorithmic code or software;
    5. Prevention and detection of cybersecurity threats;
    6. Use of social media;
    7. Compliance with the Custody Rule under the Advisers Act in safeguarding client accounts; and
    8. Protection of key advisory systems.
  2. Content Standards for Disclosures – RIAs must provide information to investors critical to their ability to make informed investment decisions.  As it relates to the use of robo-advisers in managing client accounts, such disclosures may cover:
    1. Business practices and scope of advisory services;
    2. Information gathered from and the use of electronic investor questionnaires;
    3. Risks and limitations of the algorithm;
    4. Use of third parties in developing, managing and owning the algorithm;
    5. Fees and expenses for use of a robo-adviser;
    6. Degree of human involvement in advising clients;
    7. Changes robo-advisers make to the algorithm; and
    8. Clear explanation of how and when investors should update information provided to robo-adviser.
  3. Presentation of Disclosures – In addition to content standards, robo-advisers should consider the methods of client and investor disclosures, such as:
    1. Timing of disclosures (e.g., whether prior to an investor signing up for the robo-advisor’s platform);
    2. Adaptation of disclosures for various mobile platforms (e.g., social media sites, mobile devices); and
    3. Emphasis of key disclosures (e.g. though pop-up boxes, frequently asked questions, other design tool tips).
  4. Suitability of Investment Advice – Robo-advisers must consider a client’s financial situation and investment objectives, and consider the following issues:
    1. (Over) reliance on investor questionnaires, and whether they are sufficiently clear to elicit adequate information for an RIA to meet its fiduciary duty;
    2. Opportunities to consult with RIA personnel (i.e., humans); and
    3. Use of client alerts when client questionnaire responses are inconsistent.  

Conclusion

Robo-advisers will bring significant changes to the asset management industry, but will also introduce new risks for investors.  RIAs need to adapt their Adviser Act regulatory framework to the changing landscape and ensure they can adequately supervise the robots.  Human beings will still be critical to that task.


 1  SEC Division of Investment Management, IM Guidance Update No. 2017-02:  Robo-Advisers, February 2017.


Asset Management Intelligence – Q2 2017

Venkat Rao is a Director in the Compliance and Regulatory Services Practice. He works with hedge funds, private equity funds, commodity pool operators, registered investment advisors, broker-dealers, investment banks and insurance companies.

* Required