FINRA to Robo-Advisors: Human Touch is Critical

Why pay high advisory fees to talk to a wealth manager when a high-tech algorithmic system can provide advice for a fraction of the cost?

That’s the argument given by broker-dealers and investment advisors when convincing investors of the merits of robo-advice platforms. However, the Financial Industry Regulatory Authority (FINRA) apparently thinks that far more human intervention is needed to ensure investors understand the limitations of robo-advice and make the correct decisions. A recent 17-page guidance issued by the self-regulatory agency for broker-dealers entitled “Report on Digital Investment Advice” suggests that compliance managers will need to play a greater role in how robo-advice is marketed and monitored, a scenario which will generate plenty of consternation from their business and quant colleagues.

Ten compliance managers contacted by FinOps Report say they are in discussions with their trading surveillance, customer service and quant managers as to how and when they must interact to follow FINRA’s guidance. No one wanted to provide details on the compliance programs under consideration but agreed that FINRA-registered firms will need to ensure their investors understand just how robo-advice platforms work and whether they carry any conflicts of interest. Also required is a determination of whether the actual asset allocations will match investors’ risk appetites.

As automated online advice platforms, robo-advisors use algorithms designed by quant managers to handle initial portfolio management and rebalancing. Their decisions are based on responses to questionnaires answered by investors. In the US, robo-advisors must be registered investment advisors with brokerage Charles Schwab, and independent providers Wealthfront and Betterment leading the pack, according to a 2015 analysis conducted by the Sovereign Wealth Fund Institute, a global organization studying sovereign wealth funds. Asset managers have also entered the fray with Vanguard rolling out its robo-advisor service in May 2015 and BlackRock acquiring San-Francisco based FutureAdvisor three months later.

Not wanting to run afoul of regulatory requirements, compliance managers must create workable procedures, which business managers fear would add unnecessary costs to robo-advice, while quant managers dread any intrusion on their autonomy. “I’m envisioning a lot of internal arguments over how to balance conflicting needs,” a compliance director at US brokerage tells FinOps Report. Yet another compliance manager says, “We can only imagine how much more we will need to interact with the quant managers who have enjoyed a hands-off approach until now. I don’t think they will be happy with the additional scrutiny.”

Although the concept of robo-advice has been around for a few years, its recent exponential growth has FINRA and other regulators concerned. A study by Deloitte Consulting shows that the use of robo-advisors reached US$20 billion in managed assets at the end of 2014 and could skyrocket to US$5 trillion to US$7 trillion in assets over the next decade. Now popular with the younger Generation X and Generation Y crowd, robo-advice could eventually be more heavily marketed to retirees. A new report from Cerulli Associates says that the US Department of Labor’s decision to expand the definition of fiduciary to more instances of providing advice, such as to retirement plans, could make robo-advice platforms ideal for financial firms forced to disclose any variable compensation received for advice. Robo-advisors would comply with the rule, says the research firm, because of the flat fees they charge.

Although the new FINRA report doesn’t create any additional legal requirements or change current obligations, it does emphasize the need for FINRA-registered firms that offer investment advice to be aware of their legal obligations. Those include determining the suitability of robo-advice programs based on customer risk profiles, rebalancing the portfolios when necessary, disclosing any conflicts of interest, and testing the algorithms used. Conflicts of interest can occur in a hybrid platform that includes a role for actual financial advisors or any platform that offers products or services from an affiliate or receives payment or other benefits from such providers.

What’s Amiss

While the asset allocations made by robo-advisory platforms are based on customer risk profiles provided by investors, they differ in how much human interaction is available. Most offer a toll-free number or the possibility of a chat with a financial advisor. Still the communication is a far cry from the full-service level of direct human contact.

“Broker-dealers won’t be able to just create the algorithms and allow them to run rampant without any further communications with clients,” explains Gary Swiman, director of regulatory compliance for consultancy Eisner Amper in New York who serves robo-advisory platforms. “Market conditions change and customer profiles change. Clients might not understand how to answer the dozens of questions and respond incorrectly or inconsistently or even incompletely. Even if portfolios are rebalanced, it is on a larger scale involving multiple clients and it is unclear just how much that will affect the individual investor’s holdings.” Swiman predicts that FINRA will be far more concerned with broker-dealers and investment advisors who rely strictly on automation rather than those who include some personal contact.

Kathy Malone, managing director of regulatory compliance and consulting for global valuation and corporate finance advisor Duff & Phelps in Stamford CT, agrees that FINRA wants to ensure that the algorithms used by robo-advice platforms generate the correct portfolio allocations for investors. The limited investment selections of robo-advisors might also not be the best choice for certain risk profiles. Some have exchange-traded funds in the mix, which could have limited liquidity.

“How much human interaction the firm wants to provide customers might differ, although the principal review of the paperwork is already required. At the very least, firms will need trained staff to review each customer profile and sign off on the allocations,” say Malone. Additional communications with clients might be needed to either make changes to the portfolio allocations through the robo-advice platform or recommend it not be used at all. Other products not offered on the automated advice systems might also be far more suitable.

Role of Compliance

Just where do compliance managers fit into the equation? Naturally, they will have to design manuals as to how often the client is contacted, through what means, what additional disclosures will be required, how often the algorithms must be tested, who will monitor the results, how will deviations from the expected norm be handled, and who will decide when algorithms must be changed. Written policies that document how portfolios are created and modified will go a long way to appeasing FINRA’s concerns on investor protection, say legal experts. So will testing of algorithms which could prevent substantial investor losses during market upheavals.

Equally as important could be ensuring data security and privacy. Cybersecurity experts caution that robo-advice platforms could be ripe territory for fraudsters. Count on managing data breaches and redistribution to be included in the manuals.

One compliance manager at a New York brokerage tells FinOps that FINRA’s guidance has prompted his firm to consider hiring a dedicated compliance specialist for its robo-advice platform. The job description, he says, cites a background in broker-dealer compliance, wealth management and algorithmic programs as critical requirements. Yet another says that his firm will be adding a handful of wealth managers to contact investors on a quarterly or even more frequent basis during a market downturn.

Since robo-advice has been marketed as a cheaper alternative to full-service wealth management, it is unclear whether the additional expense will be absorbed by the brokerage or investment advisor or be passed along to customers in the form of higher fees. The latter option could robo-advice far less attractive. All of the ten compliance experts contacted by FinOps say that their firms will be evaluating the extra costs and determining how they will be priced for investors. Compliance consultants, such as Malone, believe that the additional costs should be absorbed by the brokerage or advisor.

Hopefully all of the preparatory work will help broker-dealers pass muster during a FINRA exam. It could also come in handy when the SEC comes calling. The SEC has suggested that it will also come up with guidance for broker-dealers offering robo-advice.