JD Insider | Robo Advising

JD INSIDER | Robo Advising

Mona Chen

Robo Advisors and their Fiduciary Obligations

By Mona Chen

Robo-advisers, which are digital investment advisers that provide automated, algorithm-based services, emerged in 2008 and have since become a rapidly growing segment of the investment advisory industry. Accompanying this growth is uneasiness about robo-advisers' abilities to fulfill their roles as fiduciaries to their clients.

The Market for Robo-Advice

There are now over 200 robo-advisers operating in the U.S. The behemoths of the robo- advisers market are Vanguard Personal Advisor Services and Schwab Intelligent Portfolios, with $112 billion and $33 billion in assets under management (AUM), respectively. Aside from these two platforms, which were developed by incumbent financial services firms Vanguard and Charles Schwab, other leading players in the market are Betterment and Wealthfront, independent robo-advisers founded in 2008, with $15 billion and $11 billion in AUM, respectively.

The market for robo-advice is largely driven by the appeal of the generally low minimum account balances required and low annual management fees charged by robo-advisers. Betterment’sDigital plan, for example, requires no minimum account balance and charges an annual management fee of only 0.25% of AUM. In contrast, traditional — that is, human — investment advisers usually require higher minimum account balances and charge annual management fees upward of 1%. As such, younger investors who have not accumulated sufficient wealth to afford traditional investment advisers represent a target demographic for robo-advisers. In fact, over two-thirds of Betterment’s clients are millennials. Novice investors, too, are drawn to the accessibility of these platforms. Essentially, robo-advisers are seen as lower-cost alternatives to traditional investment advisers and therefore contributors to the democratization of investing.

Overview of Robo-Advisory Services

Typically, a robo-adviser will assess a client's investment needs by administering a questionnaire that prompts the investor for information relating to their financial circumstances, investment objectives, and risk tolerance. The robo-adviser uses the questionnaire responses to generate asset allocation recommendations across investment products, particularly Exchange- Traded Funds (ETFs), and subsequently manages and rebalances the portfolio over time.

Although these platforms tend to operate in a similar manner, specific features vary from one robo-adviser to another. A critical differentiation among robo-adviser models is the level of human involvement in the services they provide. Several models — such as Schwab Intelligence Portfolios, which offers "automated investing with human help when you need it" —supplement their services with traditional investment advisers. However, even though there are varying degrees of human touch incorporated by robo-advisers, there have been concerns about the risks arising from the ultimately automated, algorithm-based nature of these platforms.

The Role of Robo-Advisers as Fiduciaries

One concern about robo-advisers is the questionable extent to which they are capable of performing their fiduciary obligations in compliance with the Investment Advisers Act of 1940 (Advisers Act), which regulates activities of investment advisers.

Under the Advisers Act, an investment adviser is any person or firm in the business of providing securities advice for compensation. A Registered Investment Adviser (RIA) is an investment adviser which is registered with, depending on its AUM, either the U.S. Securities and Exchange Commission (SEC) or the securities regulators in the state of the RIA's principal place of business. The Advisers Act, while not explicitly stating that RIAs are fiduciaries, declares it unlawful for these advisers to "engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative." In view of this provision, the Supreme Court determined in the 1963 case SEC v. Capital Gains Research Bureau that the Advisers Act does indeed recognize the "delicate fiduciary nature" of an investment advisory relationship.

That being said, the impersonal online services of robo-advisers raises regulatory issues with respect to whether the structures of these platforms inhibit them from serving as fiduciaries. After all, robo-advisers rely extensively on questionnaire responses, which may not contain sufficient or fully accurate information, and they often cannot or do not collect additional information through proper due diligence. Consequently, certain robo-advisers may not be in good positions to act in their clients' best interests and provide their clients with suitable investment advice, both of which are fiduciary obligations.

In this regard, in April 2016, the Massachusetts Securities Division released a Policy Statement asserting that robo-advisers "may inherently be unable to act as fiduciaries" if they are structured in such a way that they cannot truly perform their fiduciary obligations. The Massachusetts Securities Division additionally condemned robo-advisers' attempts to circumvent their structural limitations by burying disclaimers of various fiduciary obligations in their lengthy client agreements and demanding indemnification by their clients for any account losses.

Subsequently, in February 2017, the SEC released a Guidance Update on the obligations of robo-advisers. In the Guidance Update, the SEC confirmed that robo-advisers, like all RIAs, are fiduciaries. The SEC further acknowledged that, due to their unique business models, robo- advisers may need to bear in mind special considerations as they work on complying with the Advisers Act. Specific actions the SEC suggested that robo-advisers consider included, for example: (1) implementing design features, such as tooltips and pop-up boxes, to make the client experience more interactive; (2) automatically flagging for review inconsistent questionnaire responses; and (3) disclosing important algorithm changes that could affect clients' portfolios.

In the same year, the SEC also added robo-advisers to its annual examination priorities list. Interestingly, the SEC's recently published 2019 examination priorities list no longer identifies the robo-advisory space as a key area to be monitored by the agency's Office of Compliance Inspections and Examinations. Of course, this exclusion does not necessarily signal a major shift in the SEC's attention away from robo-advisers. In December of 2018, the SEC charged Wealthfront and Hedgeable with making improper disclosures to clients, which is significant, as employing reasonable care to avoid misleading clients is relevant to discussions on fiduciary duty. These charges marked the first instance of the agency bringing enforcement actions against robo-advisers.

Certainly, as more and more assets come under robo-management — S&P Global Market Intelligence has projected that, by 2021, assets managed by U.S. robo-advisers will reach $460.46 billion, up from $98.52 billion in 2016 — it becomes increasingly crucial for regulators to improve the regulatory framework for robo-advisers and ensure that these advisers fulfill their roles as fiduciaries their clients.

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1. Having emerged in 2008, Robo-Advisors are digital investment advisers that provide automated, algorithm-based service and they have become a rapidly growing segment of the investment advisory industry.
2. There are now over 200 robo-advisers operating in the U.S.
3. The behemoths of the robo- advisers market are Vanguard Personal Advisor Services and Schwab Intelligent Portfolios, with $112 billion and $33 billion in assets under management (AUM), respectively. Aside from these two platforms, which were developed by incumbent financial services firms Vanguard and Charles Schwab, other leading players in the market are Betterment and Wealthfront, independent robo-advisers founded in 2008, with $15 billion and $11 billion in AUM, respectively.
4. The market for robo-advice is largely driven by the appeal of the generally low minimum account balances required and low annual management fees charged by robo-advisers. In contrast, traditional — that is, human — investment advisers usually require higher minimum account balances and charge annual management fees upward of 1%.
5. As such, younger investors who have not accumulated sufficient wealth to afford traditional investment advisers represent a target demographic for robo-advisers.  In fact, over two-thirds of Betterment’s clients are millennials.
6. Essentially, robo-advisers are seen as lower-cost alternatives to traditional investment advisers and therefore contributors to the democratization of investing.
7. Although these platforms tend to operate in a similar manner, specific features vary from one robo-adviser to another. A critical differentiation among robo-adviser models is the level of human involvement in the services they provide. Several models — such as Schwab Intelligence Portfolios, which offers "automated investing with human help when you need it" — supplement their services with traditional investment advisers.
8. That being said, the impersonal online services of robo-advisers raises regulatory issues with respect to whether the structures of these platforms inhibit them from serving as fiduciaries.
9. After all, robo-advisers rely extensively on questionnaire responses, which may not contain sufficient or fully accurate information, and they often cannot or do not collect additional information through proper due diligence. Consequently, certain robo-advisers may not be in good positions to act in their clients' best interests and provide their clients with suitable investment advice, both of which are fiduciary obligations.
10. While Robo-Advisors continue to emerge in financial markets, there have been concerns about the risks arising from the ultimately automated, algorithm-based nature of these platforms.