Over the years, skeptics of actively managed investment portfolios argue that over time a portfolio chosen by “a blindfolded monkey throwing darts at a newspaper’s financial pages” will do just as well or outperform a financial advisor’s pick.[1] Indeed, studies throughout the years, including a 2020 study done by the S&P Dow Jones Index, found that actively managed funds consistently underperform their benchmark index by wide margins.[2] Along with underperformance, actively managed funds can bake in outrageous fees that may cost hundreds of thousands of dollars to a retail investor over time.[3]
In 2017, we outlined recent market updates on robo-advisors generally and why it may look promising for an investor here.[4] As a recap, robo-advisors harness algorithms, as opposed to human financial advisors, to select and buy financial products on behalf of investors that fit with a client’s risk appetite.[5] Robo-advisors offer investment advising services with little or no human interaction at lower costs than traditional actively managed portfolios.[6] Also, robo-advisors like Wealthfront and Betterment offer automated rebalancing and tax loss harvesting in order to optimize client portfolios.[7] In response to the success of fintech investment companies, especially with younger investor demographics, traditional money managers such as Vanguard and Charles Schwab recently added robo-advising products and services.[8]
Robo-advisors are not going away. A Charles Schwab survey found that 58% of the participants believe they will use some form of robo-advice by the year 2025.[9] While robo-advisors offer promising investment tools, they are not perfect or immune from scrutiny of regulators. For example, in 2018, the SEC charged two robo-advisors, Wealthfront and Hedgeable, with false disclosures in violation of the Investment Advisor’s Act.[10]
Are investors putting themselves at risk by investing much of their lifetime savings at the mercy of an algorithm? Below, we investigate the investor vulnerabilities associated with automated financial products, recent updates in financial regulation, and outline regulation that may curb risk exposure.[11]
Suitability
Both robo-advisors and clients encounter risk in the business of automated investment advice. First, the client is at risk because the portfolio may not be suitable for her risk appetite and will not receive a bespoke financial plan.[12] A robo-advisor may ask for only limited information to make investment decisions for clients.[13] Also, clients may misunderstand the onboarding questions, input incorrect information, or not fully understand or interpret the advice given by the robots.[14]
A broker-dealer has a statutory duty to understand her client’s investment objectives and risk appetite while making investment recommendations, known as the “suitability obligation.”[15] Robo-advisors do not take into account the evolving nature and are not conducive to updating the current status of outside investments.[16] A robo-advisor does not validate the information given by the client or do a deep-dive into the client’s other financial circumstances outside of the robo-investment.[17] This can lead to a robo-advisor failing to account for an investor’s “experience, time horizon, cash needs and financial goals.”[18] The SEC advised that robo-advisor services can be too broad, “ambiguous, misleading, or designed to fit [a client]into the tool’s predetermined option.”[19] Scholars and regulators posit that without human interaction, clients are missing an imperative element of investing in their best interest.[20] They argue that robo-advisors are not able to properly advise clients during a market crash to “talk them through decisions so they do not take rash actions detrimental to their own long-term interests.”[21] Some have argued that robo-advisors should develop a more comprehensive, detailed questionnaire in order to gain enough information about the client, her financial goals, and financial risks in order to provide investment advice that is suitable.[22]
Due to greater regulatory scrutiny and new regulations, robo-advisors face reputational and regulatory risk. The suitability doctrine suggests that even if a client promises that they agree to the risks associated with the investment a client may still be able to sue.[23] A client’s agreement to the risks involved may not preclude a claim for damages based on the suitability doctrine if the client was not “sufficiently sophisticated to fully appreciate the risks of the investments in question.”[24] In 2019, the SEC adopted Regulation Best Interest which builds upon the broker-dealer standard of conduct to strengthen existing suitability obligations and ensures further alignment with a retail client expectations.[25] Because some dually registered broker-dealer and advisors offer robo-advisory services, the dual registrant must comply with Reg BI; the new regulation mandated compliance by June of 2020.[26] Some argue that Reg BI will magnify the suitability issues of robo-advisor’s one-size-fits-all approach, especially with inevitable oscillations in the market.[27]
Conflicts of Interests
While the automated nature of robo-advisors reduces misaligned incentives such as churning because the algorithm can be programmed to avoid churning, robo-advisors are not free from conflicts of interest.[28] However, the advisor tool harnesses opaque algorithms to make investment decisions. Robo-advisors can push investors to the same standardized investment products which could lead to excessive macro concentrations in specific financial products.[29] This is troubling from a regulatory and systemic financial risk perspective because concentrated financial markets can create “asset bubbles and vicious market spirals in poor market conditions.”[30] While the algorithms may be programmed to reduce the conflicts of interest between the robo-advisor and the client, the advisor may be programmed towards making decisions that prioritize the firm over the client.[31] The SEC should mandate the robo-advisors include more transparency on the makeup of their algorithms.[32] Also, the SEC should build up the capacity to audit the programs to ensure that the robo-advisor’s algorithms are fully understood.
Recently, Reg BI has mandated that broker-dealers disclose material information related to the conflict of interests associated with any recommendation which include fees and compensation methods.[33] Reg BI mirrors the principles in the Advisers Act of 1940. However, some have argued that there should be more stringent disclosures industry-wide, including clear warnings regarding the narrow service provided by robo-advisors.[34]
Other issues that the current SEC and FINRA regulations do not take into account include cash investments and use of affiliate broker-dealers. Where the robo-advisor has an affiliated broker-dealer, a trade executed on behalf of clients can be brokered exclusively though that broker-dealer.[35] This leads to an inherent conflict of interest because the affiliated broker dealer may not quote the client with the best execution price.[36] Also, if an advisor exclusively uses an affiliated broker-dealer, it is an invitation to increase commission rates that then can be imposed onto the client or could lead to less cost savings for the client. Some argue that the SEC should require disclosure of commissions received by the robo-advisor on behalf of the trades done by the advisor.[37] Advisors, in fact, disclose this information, but it is too general, and therefore inadequate.[38]
Finally, a robo-advisor can choose to allocate a certain percentage of the client’s portfolio to cash.[39] The advisor can profit off this allocation because, if it partners with an affiliate bank, it can take the cash and loan it out at a much higher rate than the client’s interest rate.[40]
Conclusion
Robo-advisors offer lower fee investment advice and discretionary services. However, robo-advisors are not immune from maligned incentives that can affect investors. Due to opaque algorithms, generalized onboarding questionnaires, and conflicts of interest, robo-advisors may pose threats to producing the best and most transparent outcome for small investors. While the SEC and FINRA have taken a greater look at robo-advisors within the last few years, more regulation and inspection is required to protect investors and ensure a competitive environment.
[1] S.H., No Monkey Business, The Economist, https://www.economist.com/free-exchange/2014/06/04/no-monkey-business (last visited Oct. 12, 2020). This phrase was coined by Dr. Burton Malkiel, a professor Emeritus and Senior Economist at Princeton University and also the Chief Economist at Wealthfront. Expertise, Wealthfront.com, https://www.wealthfront.com/expertise; see generally Burton Makiel, A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (1973).
[2] SPIVA Statistics and Reports, S&P Dow Jones, https://www.spindices.com/spiva/#/reports (last visited Oct. 26, 2020). For example, measured over one year, large-cap actively managed funds underperform their benchmark index, the S&P 500, by 63.17%. Id. In a recent study, a computer program’s buy recommendation outperformed the human analysts’ picks. Braiden Coleman, Kenneth Merkley, and Joseph Pacelli, Man Versus Machine: A Comparison of Robo-Analyst and Traditional Research Analyst Investment Recommendations (Feb. 2020), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3514879.
[3] See Dayana Yochim and Jonathan Todd, How a 1% Fee Could Cost Millennials $590,000 in Retirement Savings, NerdWallet, https://www.nerdwallet.com/blog/investing/millennial-retirement-fees-one-percent-half-million-savings-impact (last visited Nov. 2, 2020).
[4] See Fidelity Learning Center, Robo Advisors: Affordable, Professional Investment Management, Fidelity, https://www.fidelity.com/learning-center/tools-demos/planning-guidance-tools/robo-advisor-vs-hybrid-robo-advisor (last visited Oct. 4, 2020).
[5] See id.
[6] See id.
[7]See What is Tax-Loss Harvesting?, Wealthfront, https://support.wealthfront.com/hc/en-us/articles/209348486. (Last visited Oct. 3, 2020). Tax lost harvesting is an investment tool that uses security losses to offset ordinary income or investment gains to reduce taxes. Id. When market fluctuations may divert asset portfolios from its originally intended allocation, automated rebalancing uses an algorithm to re-allocate assets back to its specified allocation. See How Often Do You Rebalance My Portfolio?, Wealthfront, https://support.wealthfront.com/hc/en-us/articles/209353766-How-often-do-you-rebalance-my-portfolio- (last visited Oct. 31, 2020).
[8] See Anne Tergesen, Vanguard Seeks to Draw Younger Investors With New Robo Service, Wall St. J (June 16, 2020), https://www.wsj.com/articles/vanguards-new-robo-service-offers-low-cost-financial-and-retirement-advice-11591873200?mod=searchresults&page=1&pos=4.
[9] The Rise of Robo: Americans’ Perspectives and Predictions on the use of Digital Advice, Charles Schwab (Nov. 2018), https://content.schwab.com/web/retail/public/about-schwab/charles_schwab_rise_of_robo_report_findings_2018.pdf.
[10] See Press Release, SEC, SEC Charges Two Robo-Advisers with False Disclosures (Dec. 21, 2018), https://www.sec.gov/news/press-release/2018-300.
[11] This blog is an excerpt of a larger essay written for a Fall 2020 Fordham University School of Law course.
[12] Iris H.-Y. Chiu, The Regulatory Implications and Limitations of Robo-Advice, 38 Banking & Fin. Servs. Pol. Rep. 11, 19 (2019).
[13] Id.
[14] Philipp Maume, Regulating Robo-Advisory, 55 Tex. Int’l L.J. 49, 70 (2019).
[15] See 5 Thomas Lee Hazen, Treatise on the Law of Securities Regulation § 14:138 (7th ed. 2020).
[16] See Maume, supra note 14, at 70.
[17] See id.
[18] Id.
[19] See Megan Ji, Are Robots Good Fiduciaries? Regulating Robo-advisors under the Investment Advisors Act of 1940, 117 Colum. L. Rev. 1543, 1565 (2017).
[20] Id.
[21] Ji, supra note 19, at 1567 (citing Michael Wursthorn & Anne Tergesen, Robo Adviser Betterment Suspended Trading During ‘Brexit’ Market Turmoil, Wall St. J. (June 24, 2016), https://www.wsj.com/articles/robo-adviser-betterment-suspended-trading-during-brexit-market-turmoil-1466811073).
[22] Robo-Advisors: SEC Steps Up Scrutiny, PWC (Oct. 2017), https://www.pwc.com/us/en/financial-services/regulatory-services/publications/assets/sec-and-robo-advisers.pdf.
[23] Hazen, supra note 15, at 3.
[24] Id.
[25] 17 C.F.R. § 240.15l-1 (2019).
[26] Public Statement, Jay Clayton, Chairman, SEC, Confirmation of June 30 Compliance Date for Regulation Best Interest and Form CRS, (June 15, 2020), https://www.sec.gov/news/public-statement/clayton-compliance-date-regulation-best-interest-form-crs.
[27] Jeff Nash, In the New Reg BI Environment, Robo-Advisors are Finished, Wealth Mgmt. (Nov. 15, 2019), https://www.wealthmanagement.com/technology/op-ed-new-reg-bi-environment-robo-advisors-are-finished.
[28] See Tom Baker and Benedict Dellaert, Regulating Robo Advice Across the Financial Services Industry, Vol 103:713 Iowa L.R. 713, 732 (2018).
[29] See Chiu, supra note 12, at 20.
[30] Id.
[31] See id.
[32] See Baker and Dellaert, supra note 28, at 735-36.
[33] See Ethan Silver, Lauren Schwartz, and Alexander Zozo, SEC and FINRA Provide Reg. BI and Form CRS Guidance as the Implementation Date Approaches, Lowenstein Sandler (Apr. 21, 2020), https://www.lowenstein.com/news-insights/publications/client-alerts/sec-and-finra-provide-reg-bi-and-form-crs-guidance-as-the-implementation-date-approaches-investment-management.
[34] Chiu, supra note 12, at 20.
[35] Ji, supra note 19, at 1563.
[36] See id.
[37] Ji, supra note 19, at 1564.
[38] See id.
[39] See id.
[40] See id.
