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‘A call to action’: What advisors need to know about the SEC, robo-advisors and compliance

The Securities and Exchange Commission noted widespread compliance problems among advisors using robo-advice tools in a November risk alert.

Beth Haddock (1)

It was the latest in a series of alerts from examiners about the use of robo-advice, notes Beth Haddock, chief legal officer at AdvisorEngine®.

As robo-advice becomes more common among RIAs, firms can take several steps to avoid the deficiencies the SEC found in its examinations, Haddock says. She adds the messaging from the regulator indicates this is a top priority, and advisors should act accordingly.

The following transcript has been edited for length and clarity.

What’s your general take on the SEC’s findings and the importance of this guidance for advisory firms employing robo-advice technology?

BETH HADDOCK: These are observations, not enforcement cases. It's a call to action, to pause and make sure that whatever digital advice tools you're using, you're just as careful about your fiduciary obligation with them as if it were old-school face-to-face human advice.

Having reviewed the SEC’s risk alert, are there any takeaways for advisors?

HADDOCK: At a high level, it’s very important to conduct due diligence before you use any digital advice tool. It's not just a plug-and-play exercise; if you're using a tool to deliver investment advice as a fiduciary, it’s important that you do initial and then ongoing due diligence.

The second takeaway is that you need to understand the tool’s methodology, including algos and assumptions used to calculate forecasts and projections and provide investment advice. This goes along with the first takeaway; as you conduct your due diligence and calibrate the tool for your client base, you need to understand the methodology. You’re going to understand which assumptions you agree with and which ones you want to tinker with. It’s important to document the methodology of the advice as well as your due diligence.

Lastly, we can't just set it and forget it. Like any RIA program, you need to check in periodically and make sure it's working as you would like it to work. That means auditing. Having independent testers, having your compliance group and your IT and portfolio managers get together and ensure that the tools are doing what they are supposed to do. There are going to be lots of upgrades. There will be changes in how you use it, so advisors could adopt a review process the same way they have a process for their investment committee or best execution. They could just bake this review of the tools into the best execution committee.

Is this different from having to assess traditional advice? Because there's an algorithm involved, there are digital tools, does this review require specialized expertise, especially for a firm that hasn’t used this type of tool before?

HADDOCK: It's a great question it could. There's a continuum of digital tools and how are you as an advisor going to use one. Are you using a tool for order management or rebalancing versus providing financial planning advice? It just depends. But if you're going to have an algorithm and your vendor says, ‘We can't tell you about the algorithm because that's our proprietary intellectual property,’ then I would say as an advisor you should get an outside expert to help you to make sure that the algorithm is working in the way in which you think.

If you have a vendor that gives you their methodology paper or whitepaper, you have to have a good relationship to ask questions about how the tool works; you may not need to hire an independent expert. You need to understand the assumptions used and the methodology, and you may be able to do it in-house if you have that transparency and support. Even then, potentially every three years, or even every year, depending on the risk and the type of tool, you could have an outside expert examine and test the tool to ensure it's working as intended.

Could this account for the widespread compliance deficiencies reported among advisors using robo tools?

HADDOCK: It does [speak to] the resources they need to have on hand. You want to have the same sort of screening process and understand how the arrangement will work. If you’re an advisor, I don't think you would hire a portfolio manager without making sure that he or she was a good fit for your advisory firm and that you were feeling comfortable that they were representing your firm. It’s arguably the most strategic practice management takeaway from the SEC’s Risk Alert.

Were there any surprises in the findings you examined?

HADDOCK: The only surprise I would say is despite all the advice from 2017 to date, there really weren’t any claims about bad intent or willful misconduct. It's more along the lines of what you were describing, which is advisors using technology and not enough due diligence and care [rather] than intentional fraud or bad intent. As I mentioned, it's important at the end of the year to adjust your compliance program and make sure you’ve addressed your testing plan for all the guidance so that there are no surprises.

There were two enforcement cases and some guidance and 2017 and 2018, with Wealthfront and Hedgeable. And then, in  2019, there was a risk alert for investment advisors. As the SEC does each year, they list their exam priorities at the beginning of the year. Digital advice was on their priority list. When SEC Chair Gary Gensler spoke in the October ‘SEC Speaks’, he also mentioned this topic. Almost every year, you can point to these basics, and it seems as though advisers have forgotten. So that was a little bit of a surprise that advisors haven’t already understood the SEC’s message.

Here's a quick checklist for using a robo-advice tool
in your practice to help you remain complaint:

The SEC has weighed its oversight role in encouraging innovation and supporting more people to gain access to financial planning.

HADDOCK: It is such an interesting time to have an advisory practice because you're right at the crossroads of needing to do things more efficiently and differently, but you may not have grown up understanding how to use technology and how to know when you don’t know, and when you need to get outside help. Rest assured, regardless of an acknowledgment that innovation and efficiencies are going to help the integrity of the market; they’re also going to help the end-users. It's going to create a better investor experience because as a client of an advisor, one has the access to see the advice at work through digital tools. Basically, end-users or investors have better transparency into how their money is being managed. 

The observations through this risk alert about providing this advice just hits home. If you haven't already studied up and weren’t curious enough to understand the methodology of the advice, now is the time to do that. Innovation will just keep progressing; the tools are just going to get more complex. It’s a good reminder to have an infrastructure around your due diligence process that includes keeping pace with how the tools work overtime.

Is this risk alert a helpful nudge by the SEC or a prelude to more enforcement?

HADDOCK: This is a call to action. I do not think that this is a helpful nudge; I do not think if an advisor was subject to a routine exam and they didn't have all these items buttoned up, they would get a pass from the SEC exam team. We just went through multiple years with multiple nudges and it's a very clear theme. Generally, the way securities regulators work in the U.S. is that these alerts are your time for action and then there's not going to be a lot of helpful nudging after that. If there's an error, a whistleblower complaint, or some sort of for-cause exam that comes your way or even a routine exam, the examiners are going to be hyper-focused on this. I don't think this is a helpful message, and I think this is, ‘Please take action now because you should already have been up to speed and you should get there ASAP.’

Another risk alert and a case involving a large institution and its automated investing offering have attracted legal and regulatory attention because of how cash was allocated within client portfolios. Would that same level of scrutiny be applied at a smaller firm level?

HADDOCK: For all firms, including smaller and mid-size advisors, this is a message about going back and doing a reality check as to where your program is against this risk recently. If you hit a threshold to be regulated by the SEC, you need to have the same compliance program and attention to detail, regardless of your AUM. Many state regulators either directly or indirectly follow the SEC's lead, so even if you're a small advisor, this is an important message for you to take as a priority.

A large portion of the risk alert talked about making sure your digital advice isn't so out-of-the-box that it could be treated as a mutual fund. That's an interesting conversation to include in your due diligence with your vendor to make sure you as an advisor want to take the tools and customize them [to deliver] personalized advice for your clients. If your vendor won't allow that, that's potentially a regulatory red flag as well as something you'd want to know upfront. Suppose you have a vendor that understands their tool and methodology so well that they can educate you and [help you] fulfill your fiduciary duties a little bit easier. In that case, I think that is incredibly valuable.

This blog is sponsored by AdvisorEngine Inc. The information, data and opinions in this commentary are as of the publication date, unless otherwise noted, and subject to change. This material is provided for informational purposes only and should not be considered a recommendation to use AdvisorEngine or deemed to be a specific offer to sell or provide, or a specific invitation to apply for, any financial product, instrument or service that may be mentioned. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor. Opinions and forecasts discussed are those of the author, do not necessarily reflect the views of AdvisorEngine and are subject to change without notice. AdvisorEngine makes no representations as to the accuracy, completeness and validity of any statements made and will not be liable for any errors, omissions or representations. As a technology company, AdvisorEngine provides access to award-winning tools and will be compensated for providing such access. AdvisorEngine does not provide broker-dealer, custodian, investment advice or related investment services.

Suleman Din

Suleman Din

Suleman Din is AdvisorEngine's Advisor Intelligence Lead. Previously he oversaw technology coverage for American Banker and Financial Planning. At Financial Planning, Din launched ReinventWealth, the first newsletter dedicated to covering the evolution of digital wealth management and helped establish its INVEST conference. Previously, Din was a contributing editor to Knowledge@Wharton, the online business journal of the Wharton School of Business, and reported for the Newark Star-Ledger, where his coverage of the Asian tsunami in 2004 earned him a finalist nod for the Livingston Awards.


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