The U.S. Securities and Exchange Commission’s Division of Investment Management (SEC) recently issued a guidance update regarding robo-advisers and the increased use of robo-advisers by investors. Robo-advisers use algorithmic programs to generate an investment portfolio for a client based upon the information that client provides to the robo-adviser. In response to the increased interest in using robo-advisers to provide discretionary investment management services, the SEC identified three areas that robo-advisers should focus on in providing services to investors: (1) the disclosure of information about the robo-adviser and its services to clients; (2) the obligation of the robo-adviser to obtain information from clients in order to fulfill the robo-adviser’s duty to provide suitable investment advice; and (3) the establishment of effective compliance programs to address issues specific to a robo-adviser’s automated advice.
Disclosure to Clients
Like all investment advisers, robo-advisers have a fiduciary duty to fully and accurately disclose all material facts and to take reasonable steps to avoid misleading clients. Given the unique way in which robo-advisers provide investment advice, robo-advisers should consider how to best provide information to clients (e.g., via email, websites, mobile applications, etc.).
The SEC guidance provides that robo-advisers should consider making the following disclosures in describing their services to clients:
- a statement that an algorithm is used to manage client accounts and that the algorithm generates and rebalances the client’s portfolios
- a description of the assumptions and limitations of the algorithm
- a description of the risks of using an algorithm (e.g., portfolios might be rebalanced regardless of market conditions or more frequently than expected by a client)
- a description of the circumstances that would cause the robo-adviser to override the algorithm
- a description of any third-party involvement in the development or management of the algorithm and any conflicts of interest related to a third party
- fees and other costs and expenses to be charged by the robo-adviser
- an explanation of the level of human involvement in the oversight and management of client accounts
- a description of how the robo-adviser uses client information to generate portfolio decisions
- an explanation of how and when a client should update his or her information provided to the robo-adviser
The SEC guidance also cautions robo-advisers to accurately describe the scope of the services they provide and not to mislead clients by implying that they are providing other services such as tax advice or comprehensive financial planning if they are not, in fact, doing so.
The SEC guidance also describes certain factors that a robo-adviser should consider in gathering information from clients, as such information is important in fulfilling the robo-adviser’s obligation to provide suitable advice to clients.
The factors suggested by the SEC are:
- whether questions elicit sufficient information from clients to allow robo-advisers to provide suitable advice based upon each client’s financial situation and objectives
- whether questions are clear or require additional clarification
- whether inconsistent client responses can be taken into account and flagged for follow-up or review by the robo-adviser
Because a robo-adviser may allow a client to select a portfolio other than the one recommended by the robo-adviser, the SEC also suggests providing disclosure to the client as to why a certain portfolio was selected and why another portfolio may not be consistent with the client’s financial situation and objectives.
Due to the unique way that robo-advisers provide investment advisory services, the SEC notes that they need to address certain compliance issues specific to their business. The SEC suggests that robo-advisers consider the following areas in adopting and implementing compliance policies and procedures:
- the development and testing of the algorithm and monitoring of its performance
- the questionnaire used by clients and whether it allows the robo-adviser to gather sufficient information to generate suitable portfolios for clients
- the disclosure of changes to the algorithm to clients
- the oversight of any third party involved with the development and management of the algorithm
- the prevention and detection of cybersecurity threats
- the use of social media and other forms of electronic media in connection with marketing the robo-adviser’s services
- the protection of client accounts and key advisory systems
Given the proliferation of robo-advisers, the SEC guidance is helpful in reminding robo-advisers of their fiduciary duties as registered investment advisers. The SEC notes that it will continue to monitor changes in the industry and will implement safeguards, as needed, to help protect investors.