I recently read with interest Melanie Waddell’s Oct. 7 story, “Under ’40 Act, Robo-Advisors Are Fiduciaries: Morgan Lewis Lawyers,” about a new white paper by that New York-based international law firm titled “The Evolution of Advice; Digital Investment Advisers as Fiduciaries.” Like most folks in the advisory industry these days, I suspect, I’m curious about so called robo advisors, and the role that they will eventually play in retail advice giving. And having written over the past couple of years a number of articles about the potential and shortcomings of today’s robos, the paper’s title caught my eye, since it contradicts conclusions made by other observers.
The paper’s authors, Jennifer Klass and Eric Perelman, do a nice job of detailing why robos qualify as investment advisers under the Investment Advisers Act of 1940 and therefore are, in fact, fiduciaries for their clients. “The fact that digital advisers do not interface with their clients in the same way as traditional advisers does not mean that they are not fiduciaries to their clients,” they wrote, “or that they cannot fulfill the fiduciary standards that govern an investment advisory relationship.”
Yet I have to admit to being a bit puzzled by some of their descriptions of how robos meet those duties. “One of the positive features of digital advisers from a fiduciary perspective is that they typically present fewer conflicts of interest. As fiduciaries, all advisers owe their clients a duty of loyalty. At common law, this involves refraining from acting adversely or in competition with the interests of clients, and not using clients’ property for the adviser’s benefit or for that of a third party. The duty of loyalty consists of the principles that advisers deal fairly with clients and prospective clients,” they wrote.
“By emphasizing transparent and straightforward fee structures, prevailing digital advice business models inherently minimize conflicts of interest associated with traditional investment advisers,” they continued. “Digital advisory offerings are typically comprised of ETFs that, in comparison to mutual funds, offer little room for revenue streams and payment shares that would otherwise create a conflict of interest for investment advisers (e.g., 12b-1 fees, subtransfer agent fees). The absence of such compensation factors means that comparatively fewer conflicts of interest are present even where digital advisers are affiliated with some of the ETFs that they recommend. […] Moreover, digital advisory solutions eliminate the representative-level conflicts of interest typically present in the nondigital advisory context because there is little or no role for financial advisors who receive incentive-based compensation in an online offering.”
My confusion comes from a blog I wrote back in October 2015 about a survey conducted by securities attorney Melanie Fein titled “Robo-Advisors: A Closer Look,” in which she combed through robo-advisors’ Form ADVs and client agreements. Here are a few highlights of her findings:
- “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 bps annually.”
- “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.”
- “Another 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.”
Based on these and other findings, Fein offered this conclusion: “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…“[Consequently] 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…”
Now, I’m not a securities lawyer, but that doesn’t sound to me as if at least some robos don’t even meet the standards of brokers—let alone Registered Investment Advisors. What do you think the chances are that one client/user in a thousand will be able to tell the difference?
The authors of the Morgan Lewis paper had not answered my request for comments at the time of this writing.