SEC Updates Guidance on Robo-Advisers

The Securities and Exchange Commission has published information and guidance on what it termed the “fast-growing” use of robo-advisers.

Because of what it described as the “unique issues” raised by robo-advisers, the Commission’s Division of Investment Management issued guidance for investment advisers with suggestions on meeting disclosure, suitability and compliance obligations under the Investment Advisers Act of 1940.

This guidance focuses on three distinct areas identified by SEC staff, including suggestions on how robo-advisers may address them:

  • the substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers;
  • the obligation to obtain information from clients to support the robo-adviser’s duty to provide suitable advice; and
  • the adoption and implementation of effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice.

Business Model

With regard to the first point, the SEC says that a robo-adviser should consider providing the following information as part of its explanation of business model:

  • a statement that an algorithm is used to manage individual client accounts;
  • a description of the algorithmic functions used to manage client accounts;
  • a description of the assumptions and limitations of the algorithm used to manage client accounts;
  • a description of the particular risks inherent in the use of an algorithm to manage client accounts;
  • a description of any circumstances that might cause the robo-adviser to override the algorithm used to manage client accounts;
  • a description of any involvement by a third party in the development, management or ownership of the algorithm used to manage client accounts, including an explanation of any conflicts of interest such an arrangement may create;
  • an explanation of any fees the client will be charged directly by the robo-adviser, and of any other costs that the client may bear either directly or indirectly;
  • an explanation of the degree of human involvement in the oversight and management of individual client accounts;
  • a description of how the robo-adviser uses the information gathered from a client to generate a recommended portfolio and any limitations; and
  • an explanation of how and when a client should update information he or she has provided to the robo-adviser.

Effective Compliance Programs

Regarding compliance, the SEC notes that in addition to adopting and implementing written policies and procedures that address issues relevant to traditional investment advisers, robo-advisers should consider whether to adopt and implement written policies and procedures that address areas such as:

  • the development, testing, and backtesting of the algorithmic code and the post-implementation monitoring of its performance;
  • the questionnaire eliciting sufficient information to allow the robo-adviser to conclude that its initial recommendations and ongoing investment advice are suitable and appropriate for that client based on his or her financial situation and investment objectives;
  • 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;
  • the use of social and other forms of electronic media in connection with the marketing of advisory services; and
  • the protection of client accounts and key advisory systems.

A second publication, an Investor Bulletin issued by the SEC’s Office of Investor Education and Advocacy, is intended to provide individual investors with information they may need to make informed decisions if they consider using robo-advisers, including the level of human interaction, the information the robo-adviser uses in formulating recommendations, the robo-adviser’s approach to investing, and the fees and charges involved.

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