SEC Offers Guidance on ‘Fast-Growing Trend’ of Robo-Advisers

The Securities and Exchange Commission (the “SEC”) recently published guidance for the financial services industry on the “fast-growing trend” of automated advisers, more commonly known as robo-advisers.

Although these registered investment advisers – which use computer algorithms to provide investment advisory services online, often with limited human interaction – initially targeted the younger millennial demographic, the SEC notes their popularity has since expanded across all age groups and investor classes. The guidance covers a range of issues and includes suggestions on meeting disclosure, suitability and compliance obligations under the Investment Advisers Act of 1940 (the “Act”). While robo-advisers are subject to the same substantive and fiduciary obligations of the Act as other registered investment advisers, the SEC sought to raise certain considerations that could arise from their specific business models. To that end, the guidance focuses on three distinct areas and provides suggestions on how robo-advisers may address them.

First, the guidance examines the substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers. In this regard, the SEC reminds advisers of their duty to make full and fair disclosure of all material facts to, and to employ reasonable care to avoid misleading, clients. However, due to robo-advisers’ reliance on technology and relatively low level of in-person client interaction, the SEC suggests they “may wish to consider the most effective way to communicate to their clients the limitations, risks, and operational aspects of their advisory services” when designing their disclosures. This should include adequate disclosures regarding such topics as (i) an explanation of their business model, including a discussion of the inherent risks in the model, a description of the algorithmic functions used to manage client accounts, an explanation of the degree of human involvement in the oversight and management of individual client accounts, and the involvement of any third parties in client accounts; (ii) the scope of the advisory services provided (e.g., indicating whether the robo-adviser is expected to provide the client with a comprehensive financial plan); and (iii) the presentation of disclosures, including measures to make disclosures effective (e.g., are they understandable and not buried within the document) in online and mobile formats.

The second subject covered is the obligation to obtain information from clients to support the robo-adviser’s duty to provide suitable advice. The SEC indicated that it has observed that robo-advisers may provide investment advice “based primarily, if not solely, on client responses to online questionnaires” of varied length and content, such as recommending an investment portfolio based on a client’s age, income and financial goals. However, the SEC noted that some such questionnaires do not allow clients to provide additional information or context with respect to a client’s selected responses that may be relevant. As a result, it suggests advisers consider certain factors in order to determine whether such surveys alone provide sufficient information to offer clients suitable investment advice. To ensure the questionnaires are meeting this goal, it recommends robo-advisers consider:

• Whether the questions elicit sufficient information to confirm initial recommendations and ongoing investment advice are suitable and appropriate for the client.
   
• Whether the questions are sufficiently clear and provide additional clarification or examples to clients, when necessary.
   
• Whether steps have been taken to address inconsistent client responses.

In addition, the guidance suggests that, where a client wishes to select a portfolio other than what the adviser has recommended, the adviser “consider providing commentary as to why it believes particular portfolios may be more appropriate for a given investment objective and risk profile” in order to fulfill its obligation to act in its client’s best interests.

Finally, the guidance discusses adoption and implementation of effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice, as required under Rule 206(4)-7 of the Act. Due to robo-advisers’ reliance on algorithms and limited human interaction with clients, the SEC suggests the adoption and implementation of specific measures in their compliance programs, including, among other things:

• The development, testing and backtesting of the algorithmic code and the post-implementation monitoring of its performance.
   
• The disclosure to clients of changes to the algorithmic code that may materially affect their portfolios.
   
• The appropriate oversight of any third party that develops, owns or manages the algorithmic code or software modules utilized by the robo-adviser.
   
• The prevention and detection of, and response to, cybersecurity threats, including the protection of client accounts and key advisory systems.

The guidance also notes that there may be a range of strategies for a robo-adviser to meet its obligations to clients under the Act and that not all of the issues addressed in the guidance will be applicable to every robo-adviser.

Investor Bulletin

The SEC’s Office of Investor Education and Advocacy also published an Investor Bulletin to provide information to individuals using robo-advisers and help them make informed decisions regarding their investment goals. It covers several issues investors should consider when dealing with robo-advisers. For example, since the amount of human interaction varies among robo-advisers, the SEC recommends investors think about how much interaction and support they expect from an adviser. The investor’s level of financial literacy should be part of this deliberation, as an investor may not always be able to ask a robo-adviser questions about strategy or other market events.

The bulletin also recommends investors consider the information the robo-adviser uses in formulating its recommendations, the robo-adviser’s approach to investing, and the fees and charges associated with its services. As it does with respect to all advisers, the SEC encourages investors to educate themselves in order to make informed decisions.