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5 Reasons Most Robo-Advisors Are Not, in Fact, Advisors

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As regular readers of this blog might remember, I’m not nearly as enamored as some about the introduction of so-called “robo-advisors,” nor as concerned about their potential “threat” to human advisors (see, for instance, Who’s Your Robo?). For one thing, in the robos I’ve looked at, the algorithms for choosing investments and managing client portfolios are so rudimentary that competitive long-term performance is unlikely, while the potential for taking a large hit to the robo portfolios’ value in the next market “correction” is quite high.

What’s more, I envision that in the near future, most independent advisory firms will offer improved robo portfolio options of their own, for smaller clients and those who prefer a lower-cost solution.

Yet my concern about robos is that investors—and everyone else—don’t yet understand the business they are really in.

I’ve been covering the financial services industry far too long to believe that they are truly giving away portfolio management “for free,” or for a few dollars a month. To provide some insight into what robos are really up to, I recently found a June 30 white paper called Robo-Advisors: A Closer Look, by securities attorney Melanie Fein.

In it, she reveals that the situation is way worse than I feared.

Fein explores multiple issues, including investment costs, outside revenue sources, the standard of client care and conflicts of interest. She concludes that robo-advisors “do not meet a high standard of care for fiduciary investing, and do not act in the clients’ best interest.”

It’s an analysis that every independent advisor should be familiar with—and not a bad idea to hand out to, or summarize for, clients.

As for credibility, Melanie Fein is no financial lightweight. Before opening her own firm, she was senior counsel to the Board of Governors of the Federal Reserve, taught at Yale law school and wrote the Bloomberg BNA “Overview of the Dodd-Frank Act.” In this paper, prepared for Federated Investors, her legal eye finds robo-advisors wanting in many areas, including these five key areas: 

1. Data Collection
“The typical robo-advisor questionnaire allows investors to provide only limited information about their investment needs and risk tolerance,” she writes. “Critics argue that these questions elicit only superficial information that can result in no more than superficial asset allocation and investment recommendations.” 

As you’ll see, this isn’t nearly the worst of it. Yet it does suggest that robos are still a long way from offering financial planning, which means that financial planner RIAs still have a very large advantage.

2. Outside Compensation
“While some robo-advisors may not charge a fee to users, they do not offer their services without compensation. The compensation they receive ultimately is paid for by their customers in the form of higher fees embedded in investment products and services. Robo-advisors receive compensation from affiliated and non-affiliated broker-dealers, custodians, and clearing firms that handle their customer’s securities transactions, and who similarly do not act without compensation. Robo-advisor users typically bear the cost of brokerage, transaction, and other transaction fees and expenses, whether directly or indirectly, and thus contribute to the robo-advisor’s compensation. Accordingly, it is misleading to say that robo-advisory services are “free” or even “low- cost” to the user.” 

This, of course, is a major issue: especially as low robo fees are seen by some as potentially driving down advisory fees across the industry. As with brokerage commissions, which appear to provide “low-cost advice,” advisors have a powerful response, but they need to be proactive in educating the public about the realities of robos. 3. Self-Dealing
“Robo-advisors are affected with a number of conflicts of interest that enable them to engage in self-dealing transactions. Among other things, as noted, in providing services to customers, robo-advisors use affiliated brokers, custodians, clearing firms or other firms from which they receive compensation. They also use their own investment products.” 

Fein quotes one robo client agreement containing this disclosure: “Client recognizes that [Robo-advisor] or its affiliates may receive commissions, and have a potentially conflicting division of loyalties and responsibilities…” She also cites this disclosure: “[Robo-advisor] Securities reserves the right to receive remuneration (generally in the form of per-share cash payments or through profit sharing arrangements) for directing orders in securities to particular broker-dealers and market centers for execution.”  

And this disclosure: “[Robo- advisor] receives payments from the third-party ETF sponsors or their affiliates participating in ETF OneSource for recordkeeping, shareholder services and other administrative services that [Robo-advisor] provides to participating ETFs. In addition, [Robo-advisor] promotes the ETF OneSource program to its customers, and a portion of the fees paid to [Robo-advisor] offsets some or all of [Robo-advisor’s] costs of promoting and administering ETF OneSource… … ETF sponsors or their affiliates also pay [Robo-advisor] an asset-based fee based on a percentage of total ETF assets purchased by [Robo-advisor] customers after the ETF was added to ETF OneSource. The amount of the asset-based fee can range up to 0.20% annually.” 

Some people think I’m the most cynical financial journalist on the planet—but this is way worse than even I suspected.

4. Standard of Client Care 
“Robo-advisors do not meet the high fiduciary standard of care that normally governs the provision of investment management services by a registered investment adviser or ERISA fiduciary…One robo-advisor customer agreement emphasizes that it is the client’s responsibility to monitor his or her own accounts and that robo-advisor personnel will conduct only limited, non-periodic reviews of customer accounts.”

5. Acting in the Client’s Best Interest
“As one agreement states, the client—not the robo-advisor—is responsible for determining that investments are in the client’s best interests: Client is responsible for determining that investments are in the best interests of Client’s financial needs. Nowhere in the agreement does the robo-advisor obligate itself to act in the customer’s best interest.”

Even SIFMA would be red-faced about the kind of chutzpah exhibited in the last two points.

As you can see, robo-advisors are far from immune from the conflicts that are rife throughout the brokerage industry. Nor do they shy away from the industry’s ceaseless efforts to avoid a fiduciary duty to act in clients’ best interests. In fact, rather than “robo-advisors,” it would be far more accurate to call these websites “digital brokerage firms.” And therein lies fiduciary RIAs’ marketing advantage, if they can get their acts together enough to exploit it.

As Fein concludes: “The SEC and FINRA have issued cautionary advice to investors regarding robo-advisors. Their concerns appear justified, based on the robo-advisor customer agreements reviewed herein.”

— More by Bob Clark on ThinkAdvisor:

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