A new report takes a look at the issues raised by FINRA’s “Report on Digital Investment Advice.”
The FINRA report addresses the various features of robo-advisors and highlights investor protection concerns and regulatory issues that may arise from their use by investment professionals and individual investors, and at least implicitly raises the question of whether robo-advisors meet the fiduciary standard of care applicable to broker-dealers and investment advisers when they give investment advice.
In fact, the report suggests that on a stand-alone basis, robo-advisors do not meet a fiduciary standard of care when they advise individual investors, rather that human judgment by a trained financial professional is a necessary element of the fiduciary standard.
The analysis says that the failure of robo-advisors to provide portfolio analysis, as found in the FINRA report, raises the question of robo-advisors can fulfil the role of a fiduciary in giving prudent investment advice to individual clients. The implication of the FINRA report is that if a robo-advisor cannot not perform overall portfolio analysis, it cannot perform a critical function of an investment fiduciary.
The report thus raises the corresponding question of whether robo-advisors, which are required to be registered as investment advisers (because they give investment advice), can comply with the fiduciary obligations applicable to investment advisers, and whether they are entitled to be registered under the Investment Advisers Act of 1940.
The Key Fiduciary Duty?
According to the analysis, the overriding question that needs to be answered is: Does a registered investment adviser, which has the status of a “fiduciary” under the Investment Advisers Act of 1940, comply with its fiduciary obligations if it provides investment advice in all respects except the one key function necessary to provide prudent advice based on modern portfolio theory — i.e., portfolio analysis? In other words, what is the scope of an investment adviser’s fiduciary duty and does it include portfolio analysis? A question that the analysis says that the FINRA report does not answer, and that the Securities and Exchange Commission, the agency that the analysis says has clear authority to address the question — hasn’t yet.
One agency that has, the Massachusetts Securities Division, said in a policy statement issued on April 1, 2016, that robo-advisors may not be able to register as investment advisers in Massachusetts due to their deficiencies as fiduciaries. Among its reasons, the analysis notes that the Securities Division stated that robo-advisors do not perform comprehensive portfolio analysis necessary to act in the best interests of their clients.
Turning back to the FINRA report, the analysis says that it strongly suggests that, absent intervention by a trained professional, the investment advice given by a robo-advisor is likely to be deficient. Among other things, the report says, robo-advisor questionnaires alone do not adequately profile investors and may elicit contradictory responses – contradictions that it says are more accurately resolved by human interaction.
Additionally, the FINRA report notes that while a financial professional can help ensure that the resulting investment recommendations are appropriate for the investor, a robo-advisor lacks the ability to go beyond its algorithms.
Not To Be Used ‘Alone’?
The FINRA report emphasizes that robo-advisors should not be used by financial professionals without training and education, and similarly, that individual investors should not use digital investment tools on their own without education and training.
The analysis concludes that, while the FINRA report does not preclude the use of robo-advisors by financial professionals in providing investment advice to their clients, it emphasizes that robo-advisors are not a substitute for the suitability analysis required when broker-dealers provide investment recommendations. A corresponding implication, according to the report, is that robo-advisors are not a substitute for the portfolio analysis required of an investment fiduciary under the fiduciary standard of care.
