This article was orginally published in the February 2017 issue of Investment Advisor.
The question of whether a robo-advisor can be a fiduciary has become a hot topic. Recently, departing SEC Chairwoman Mary Jo White and outgoing DOL Secretary Thomas Perez, the Massachusetts securities regulator and two prestigious law firms have weighed in on the question. There is much at stake for the robos; there is little agreement on the answer.
A related question is whether robo-advisors are operating as unregistered mutual funds in violation of the Investment Company Act of 1940. The costs and burdens attendant to registration would cripple their business model. Again, there is little agreement on the answer.
Let’s examine these two questions and see if we can come up with some answers.
For purposes of our analysis, we define robo-advisors as firms that provide portfolio management services directly to consumers through the internet without the involvement of a human investment advisor. Wealthfront is an example. We are not talking about “hybrid” firms like Vanguard or Personal Capital that combine robo-technology with human advice. We are also not talking about firms like Jemstep that provide robo-technology to advisors for use in their firms. Our focus is on pure, online business-to-consumer robos.
In the Beginning
The fun started in May 2015 when the Securities and Exchange Commission’s Office of Investor Education and Advocacy issued with FINRA a joint Investor Alert discussing the “risks and limitations” of “automated investment tools.” These included the risk that the automated tools may rely on assumptions that are “incorrect” or “do not apply to your individual situation.” The alert also warned of robos’ questions for users that may be “over-generalized, ambiguous, misleading or designed to fit you into the tool’s predetermined options.” It cautioned that “an automated tool’s output may not be right for your financial needs or goals.” These warnings emboldened the anti-robo forces.
The following month, Melanie Fein, a Washington-based attorney with impressive credentials, issued a white paper entitled “Robo-Advisors: A Closer Look.” It questioned the fiduciary status of robos and argued that they were really unregistered mutual funds. She leveled other criticisms, too, including alleged conflicts of interest and questions about the perception that robos charge low fees. Fein’s white paper was prepared for Federated Investors, a non-robo.
Her broadside was followed in April 2016 by a policy statement issued by the Massachusetts Securities Division that openly questioned whether robos were fiduciaries. The division stated that robos “cannot fully satisfy their fiduciary obligations if they fail to perform the initial and ongoing due diligence necessary to act in the best interests of their clients.” The division was concerned that this failure “may render them unable to provide adequately personalized investment advice and make appropriate investment decisions.”
Feeling the heat, the robos issued a white paper of their own in October 2016 written by two attorneys from the global law firm of Morgan Lewis & Bockius, which represents the robo Betterment. The Morgan Lewis paper, “The Evolution of Advice: Digital Investment Advisers as Fiduciaries,” mounted a comprehensive defense of the robos, arguing both that they met applicable fiduciary standards and were not unregistered mutual funds.
Further contributing to this conversation were Mary Jo White and Thomas Perez, who made public comments supportive of the pro-robo forces. White said that robos offer retail investors “broader and more affordable access to our markets,” and that the SEC has “been considering how these so-called robo advisors […] meet their fiduciary and other obligations under the Advisers Act.” Perez was even more supportive, saying that robo Wealthfront has “a platform that enables them to lower fees, operate as a fiduciary and do well by doing good.” White and Perez also made general policy statements supporting the use of technology to expand the availability of advice.
Sorting It All Out
No one can argue with the policy of making advice more generally available to those who need it. Nor can one quibble with the other policy arguments made in the Morgan Lewis white paper. That is, robos give consumers more choice in how they access advice; they tend to have lower fees; and they use low-cost ETFs, which further keep costs down for consumers. These are all good things.
However, we should not look the other way and give the robos a pass on legal requirements that apply to everyone else based simply on these policy arguments. Sure, everyone loves a disruptor, and the robos of today seem harmless enough. Jon Stein, CEO of Betterment, looks more like a choirboy than a portfolio manager; not a whiff of Wall Street.
But what about tomorrow? Robos are getting gobbled up by the familiar faces of the financial services industry faster than you can fill out an online risk tolerance questionnaire. If you held a robo conference three years from now, there wouldn’t be a hoodie in sight — just pinstripes. Any of the original robo firms that might be left will be under such pressure from the venture capitalists who backed them that they won’t have time to be concerned about the little guy.
And as attorney Fein pointed out, current robo practices aren’t nearly as praiseworthy as the robos’ squeaky-clean public image would suggest. Conflicts of interest exist. Fees aren’t always low. Investment options are often limited and may include proprietary products. Although today’s robo portfolios are relatively benign, focusing on buy-and-hold ETF strategies, tomorrow’s robo portfolios may, and probably will, include all manner of high-fee products and could even utilize hair-trigger market timing strategies.
For now, we should put aside the sweeping policy considerations and forget about how the robos look today. Whatever rules we settle on now we should be willing to live with for years to come.
So let’s take a quick look at some sticky legal issues that will help us answer the two important questions with which we began this discussion.
The Fiduciary Question
Investment advisors who are registered under the Investment Advisers Act of 1940 owe a fiduciary duty to their clients. This fiduciary obligation is not actually spelled out in the Advisers Act itself, but was breathed into the statute in 1963 by the U.S. Supreme Court in SEC vs. Capital Gains Research Bureau.
There are two parts of an advisor’s fiduciary obligation. The first is the duty of loyalty, which is the obligation of the advisor to act in the client’s benefit and to place the client’s interests ahead of the advisor’s. The second is the duty of care, which is the advisor’s obligation to act with the care, competence and diligence that normally would be exercised by a fiduciary in similar circumstances.
The key to satisfying these obligations is knowing the client.
Robos collect basic data about the client, such as name, age and address, and then run the client through what is essentially a short risk-tolerance questionnaire. Astronomer and computer scientist Clifford Stoll famously said, “Data is not information, information is not knowledge, knowledge is not understanding and understanding is not wisdom.” The robos collect data, but have very little knowledge about — and certainly no understanding of — the needs or interests of the client. How can you meet your fiduciary obligations to someone you don’t know?
I’ve written before about the challenges of using conventional risk tolerance questionnaires to gain an understanding of a client’s investment needs. On a stand-alone basis they are essentially worthless. Only in the hands of a skilled advisor do they become valuable tools.
It is simply not possible to understand the goals, experiences, preferences, risk profile and other relevant information about a client without talking to them. Anyone who has worked with clients knows this. The answers to a 10- or 15-item questionnaire provided in an online environment cannot even begin to scratch the surface. There may come a day when artificial intelligence has advanced to such a state that a human advisor does not need to be a party to that conversation, but that day is far in the future.
The Morgan Lewis paper acknowledges that fiduciary obligations require an advisor to have “a reasonable basis for its advice.” The Morgan Lewis lawyers do not directly argue that the meager data collected by the robos is sufficient to form a reasonable basis. Rather, they argue that the robos and their clients may agree to limit the scope of the fiduciary duties owed to the client and the amount of information the robo must collect. In effect, they are saying that by using the robos’ services, the client is agreeing to the limited nature of the interaction between the robo and client.
The implications of this argument are frightening. It says that an advisor can disclaim as much responsibility as the client will agree to. This is particularly distressing in light of the fact highlighted in Fein’s paper that at least one robo client agreement is 140 pages long!
This essentially turns the robo advisor into a self-help platform for do-it- yourself investors. Morgan Lewis argues that “goal-based” investors — those with very specific investment objectives like accumulating assets for retirement, college funding or saving for a vacation house — do not want or need to engage in a comprehensive financial planning process. For them, collecting less information is perfectly appropriate since the Advisers Act does not dictate the quantity of information that must be collected.
This is absolutely true. But what about the quality of the information? First of all, there is very little established science behind most risk tolerance questionnaires. Moreover, research has shown that a person’s risk tolerance changes over time and that people are notoriously bad at assessing their own tolerance for risk.
Then there is the problem of properly identifying a client’s goals. What if a client isn’t really sure about her goals or has a problem articulating her goals? What if a client has multiple goals? What if the client has conflicting goals? What if there’s a gap between an investor’s tolerance for risk and the amount of risk he needs to take to reach his goal? What if the investor simply doesn’t understand some of the 10 or 15 questions on the questionnaire? What if they think they understand the questions, but really don’t?