Key Notes:

Wealth management firms using digital advice tools should establish and maintain an investor protection foundation to ensure that:

  • They understand customers’ needs and whether the digital advice addresses those needs.
  • They understand the methodology used to generate the digital advice.
  • The digital advice reflects the firm’s investment approach.
  • They understand digital advice tools’ limitations.

In March 2016, the Financial Industry Regulatory Authority (FINRA) issued a report on its review of digital investment advice tools used by broker-dealers and investment advisers.[1] FINRA’s report notes the important role technology plays in financial services innovation and delivering investment advice to clients. It also reminds broker-dealers of their obligations under FINRA rules and identifies effective practices for managing technology, developing portfolios and mitigating conflicts of interest that firms should consider and tailor to their business models.

Digital Investment Advice Tools

FINRA defines “digital investment advice tools” as technology that supports core portfolio management activities such as customer profiling, asset allocation, portfolio selection, trade execution, rebalancing, tax-loss harvesting and portfolio analysis. The report notes that these tools fall into two groups: “financial professional-facing” tools, which a firm’s financial professionals use to manage client accounts, and “client-facing” tools, which are frequently referred to as “robo advisers” or “robos.”

Suggested PracticesAlgorithms

Algorithms, a core component of digital investment advice tools, use financial models and assumptions to translate data into client advice. FINRA notes that the methodologies algorithms use to produce advice at every step of the “advice value chain” (e.g., profiling an investor, rebalancing an account, etc.) should reflect a firm’s approach to a particular task. If an algorithm is poorly or incorrectly designed, it may produce results that are not indicative of a firm’s intended advice and may harm a client. As a result, FINRA believes that firms must effectively govern and supervise the use of algorithms. This includes understanding the methodology embedded in the algorithms, including the assumptions and biases underlying various scenarios, and ensuring that the methodology is consistent with the firm’s investment and analytic approach.

FINRA suggests that an effective governance and supervisory framework would include:

  • Performing an initial review of the methodology the digital investment advice tool uses to understand the data inputs and assumptions and test the outputs for consistency with the firm’s expectations.
  • Conducting ongoing reviews to determine whether the models the tool uses remain appropriate in light of market changes, test the outputs on a regular basis and identify individuals responsible for supervising the tool.
  • Developing compliance procedures that include exception reporting when a tool deviates from expected outputs, training in the use of financial professional-facing tools, controls relating to the use of assumptions and reviews of recommendations that differ from a tool’s expected output.

Portfolio Construction & Conflicts of Interest

FINRA notes that many digital tools match investors with pre-packaged portfolios of securities based on their profiles. As a result, decisions about characteristics that make a portfolio suitable for a given investor profile are very important. In addition, the FINRA report states that portfolio construction can give rise to conflicts of interest. For example, a firm may offer an affiliate’s products or services, or it may receive compensation or other benefits in connection with the use or sale of a particular product or service.

FINRA suggests that an effective governance and supervisory framework to ensure suitability and mitigate conflicts would include:

  • Determining in advance the characteristics of a portfolio recommended for a given investor profile.
  • Establishing criteria for including securities in a portfolio.
  • Monitoring pre-packaged portfolios to assess whether their performance and risk characteristics are appropriate for a particular investor profile.
  • Identifying and mitigating conflicts of interest that may arise from offering particular securities in a portfolio, e.g., adopting a policy of not offering proprietary products.

Investor Profiling

The FINRA report states that developing an investor profile (that is, “[u]nderstanding a customer’s objectives and the specific facts and circumstances of the customer’s finances”) is essential to providing sound investment advice and applies whether that advice comes from a financial professional or an algorithm.

To ensure that a member firm understands its clients’ needs and develops appropriate profiles, FINRA advises that the firm consider whether its digital investment advice tool is:

  • Collecting and analyzing the information necessary to make the determinations required by FINRA Rules 2090 (Know Your Customer) and 2111 (Suitability).
  • Assessing customers’ risk tolerance and risk willingness.
  • Resolving contradictory or inconsistent responses in a customer profiling questionnaire.
  • Assessing whether investing (rather than saving or paying off debt) is appropriate for a particular individual.

The report also suggests contacting clients to understand frequent changes in their investor profiles and to determine if an individual’s advice needs can be adequately met solely through a digital approach.

Rebalancing

Rebalancing an investment portfolio is necessary to maintain a target asset allocation as an investment portfolio naturally drifts away from its intended target over time, or the target itself changes. Understanding and disclosing how a digital investment advice tool rebalances an investment portfolio should be a priority for financial professionals. Effective practices include:

  • Requiring explicit customer consent to automatic rebalancing.
  • Disclosing the potential costs (e.g., commissions) and tax implications (e.g., capital gains or losses) of rebalancing.
  • Disclosing how a digital investment advice tool rebalances a portfolio, including the drift thresholds used to trigger rebalancing and frequency with which rebalancing occurs.
  • Developing policies and procedures that define how the digital investment advice tool will act in the event of a major market movement.
  • Developing methods to minimize the tax impact of rebalancing.

Training

FINRA emphasizes that training is crucial for professionals who use digital investment advice tools. To effectively use financial professional-facing tools and communicate with clients about their output, a financial professional must understand the assumptions, preferences and biases that go into the analytics and recognize the potential limitations of the results.