On February 23, 2017, the staff of the SEC's Division of Investment Management (the Staff) issued a Guidance Update addressing the unique issues raised by automated investment advisers, i.e., "robo-advisers," and offering suggestions on meeting disclosure, suitability and compliance obligations under the Advisers Act. As the Staff notes, robo-advisers operate under a wide variety of business models and provide a range of advisory services with varying levels of human interaction. Although the Guidance Update focuses on robo-advisers that provide services directly to clients over the internet, the Staff notes that the guidance may be helpful for other types of robo-advisers as well as other registered investment advisers generally.
Substance and Presentation of Disclosures
The Guidance Update notes that since client relationships with robo-advisers may occur with limited, if any, human interaction, robo-advisers should be mindful that the ability of a client to make an informed decision about whether to enter into, or continue, an investment advisory relationship may be dependent solely on a robo-adviser's electronic disclosures made via email, websites, mobile applications and/or other electronic media. Accordingly, the Staff offers several suggestions for a robo-adviser to consider in explaining its business model, the scope of advisory services offered and the manner in which it presents material information to clients.
Explanation of Business Model
In explaining its business model, the Staff recommends, among other things, that robo-advisers provide:
- a statement that an algorithm is used to manage individual client accounts and a description of the algorithmic functions used for this purpose (e.g., that the algorithm generates recommended portfolios);
- a description of the assumptions and limitations of the algorithm;
- a description of the particular risks inherent in the use of an algorithm to manage client accounts (e.g., that the algorithm might rebalance client accounts without regard to market conditions or on a more frequent basis than the client might expect);
- a description of any circumstances that might cause the robo-adviser to override the algorithm;
- a description of any involvement by a third party in the development, management or ownership of the algorithm, including an explanation of any conflicts of interest such an arrangement may create; and
- an explanation of the degree of human involvement in the oversight and management of individual client accounts.
Scope of Advisory Services
The Staff cautions robo-advisers to "consider the clarity of the descriptions of the investment advisory services they offer and use reasonable care to avoid creating a false implication or sense about the scope of those services which may materially mislead clients." For instance, the Staff states that robo-advisers should be careful not to mislead clients by implying that:
- the robo-adviser is providing a comprehensive financial plan if it is not in fact doing so;
- a tax-loss harvesting service also provides comprehensive tax advice; or
- information other than that collected by the questionnaire (e.g., information concerning other client accounts held with the robo-adviser, its affiliates or third parties) is considered when generating investment recommendations if such information is not in fact considered.
Presentation of Disclosures
In presenting their disclosures, the Staff recommends that robo-advisers consider:
- whether key disclosures are presented prior to the sign-up process so that information necessary to make an informed investment decision is available to clients before they engage, and make any investment with, the robo-adviser;
- whether key disclosures are specially emphasized;
- whether some disclosures should be accompanied by interactive text or other means to provide additional details to clients who are seeking more information; and
- whether the presentation and formatting of disclosure made available on a mobile platform have been appropriately adapted for that platform.
Provision of Suitable Advice
The Staff, which, in coordination with the Staff of the Office of Compliance Inspections and Examinations, has been monitoring and engaging with robo-advisers to evaluate how these advisers meet their obligations under the Advisers Act, observed that robo-advisers may provide investment advice based primarily, if not solely, on client responses to online questionnaires. In making this observation, the Staff notes that an investment adviser's fiduciary duty includes an obligation to act in the best interests of its clients and to provide only suitable investment advice reasonably determined based on the client's financial situation and investment objectives. Consequently, the Staff suggest that a robo-adviser consider whether its questionnaire is designed to elicit sufficient information to support its suitability obligation. In particular, the Staff recommends that a robo-adviser consider factors such as:
- whether the questions elicit sufficient information to allow the robo-adviser to conclude that its initial recommendations and ongoing investment advice are suitable and appropriate for that client based on his or her financial situation and investment objectives;
- whether the questions in the questionnaire are sufficiently clear and/or whether the questionnaire is designed to provide additional clarification or examples to clients when necessary; and
- whether steps have been taken to address inconsistent client responses.
The Staff also observed that some robo-advisers allow investors to select alternatives to the recommended portfolio, but do not give investors an opportunity to discuss with investment personnel the suitability of the selected portfolio in light of their stated investment objectives and risk profile. To address this issue, the Staff recommends that roboadvisers provide clients with commentary supporting their recommended portfolio, as well as incorporate features that alert clients when their selected portfolio conflicts with their stated investment objectives.
Effective Compliance Programs
The Staff recommends that robo-advisers tailor their compliance programs to address the unique features of their business models; namely, their reliance on algorithms, the limited human interaction with clients and the provision of advice over the internet. In particular, the Staff suggests that robo-advisers consider adopting policies and procedures that address the following:
- the development, testing, and back-testing of the algorithmic code and the post-implementation monitoring of its performance;
- the questionnaire eliciting sufficient information to allow the robo-adviser to conclude that its initial recommendations and ongoing investment advice are suitable and appropriate for that client based on his or her financial situation and investment objectives;
- the disclosure to clients of changes to the algorithmic code that may materially affect their portfolios;
- the appropriate oversight of any third party that develops, owns, or manages the algorithmic code or software modules utilized by the robo-adviser;
- the prevention and detection of, and response to, cybersecurity threats;
- the use of social and other forms of electronic media in connection with the marketing of advisory services; and
- the protection of client accounts and key advisory systems.
The Staff indicates that it will continue to monitor robo-advisers and other innovations in the provision of advisory services and implement safeguards, as necessary, to help facilitate such developments and protect investors.
The Guidance Update is available at: https://www.sec.gov/investment/im-guidance-2017-02.pdf.