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Are robo-advisors risky?

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Should robo-advisors have to follow a First Law?

A new paper says they might not be all they’re cracked up to be.

In science fiction author Isaac Asimov’s futuristic tales of robots, all robots must follow the Three Laws—the first of which is, “A robot may not injure a human being or, through inaction, allow a human being to come to harm.”

And while the Department of Labor says that robo-advisors are good for people saving for retirement, since they minimize costs and aren’t subject to conflicts of interest, the SEC and FINRA have basically said, “Not so fast.”

Robos, say the latter two agencies, can present a different set of risks for investors: they may work on incorrect assumptions or make their recommendations based on data that are incomplete or irrelevant to an individual’s personal finances.

Therefore, robos’ recommendations may not be appropriate for the individual for whom they are made.

In “Robo-Advisors: A Closer Look,” a paper prepared for Federated Investors, Inc., by Melanie L. Fein, an attorney who advises on banking, securities, and trust law and has served as an adjunct at Yale Law School, robos don’t come off looking so well.

The paper looked at the user agreements for three main robo-advisors to see whether they “provide personal investment advice, minimize costs, and are free from conflicts of interest” and to “evaluate whether robo-advisors meet a high fiduciary standard of care and act in the client’s best interest.”

Upon examination of the user agreements, the paper concluded that robos fail to elicit sufficient information, particularly significant data on clients’ current financial situations and needs.

In addition, it found that they do not provide personal advice, but instead allow the client to use online tools to figure out his own risk tolerance, then follow an investment strategy “based on asset allocation formulas recommended for investors with similar preferences.… similar to mutual funds.”

In addition, the paper said services provided by robos are not free, since their compensation is paid by customers “in the form of higher fees embedded in investment products and services.”

They’re not free from conflicts of interest, either, since “robo-advisors typically use an affiliated broker-dealer or a broker of their choice, which may not always obtain a favorable price for the user.”

That can also result in conflicts of interest.

And since robos do not consider an investor’s total financial picture in light of the Uniform Prudent Investor Act, they fail to meet fiduciary standards.

They “[a]re not designed for ERISA retirement accounts and would not meet the DOL’s proposed ‘best interest’ contract exemption.”

The paper concluded that robos “are not designed for retirement accounts subject to ERISA and should be approached with caution by retail and retirement investors looking for personal investment advice.”

Now, maybe if they had a First Law…


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