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Robo-Advisors, Massachusetts and the Fiduciary Rule-A Peak into the Future?

Robo-Advisors Are the Wild West of Financial Advising

Are robo-advisors beyond the the Fiduciary Rule?, Massachusetts SEC thinks so!

Robo-advisors have taken the investment world by storm. Most of the Betterment, Motif, Personal Capital, Wealthfront, TradeKing Advisors and more have sprung up within the last 10 years. Promising to be an investment management panacea for the individual investor, these new platforms are sparking controversy among the regulators. The automated advisory robos’ claim to provide the average Jane and Joe with top notch investment portfolios, informed by modern theory along with low-fees. By cutting customer expenses and implementing systematic investing, portfolio rebalancing and tax-loss harvesting, these robo-advisor model portfolios offer low cost professional management.

Welcome the Fiduciary Rule; Robo-Advisor’s Beware

There’s been some concern that all financial advisors may not be acting primarily in the best interests of their clients. The Department of Labor is putting the finishing touches on the Fiduciary Rule which will require all financial advisors to act in their clients best interests. For example, if there’s a fund in which the advisor receives a fat commission and there’s a similar one with a lower commission payable to the advisor, then under the fiduciary rule the client needs to be offered the lower fee alternative. The advisor must base their investment recommendations on what is best for the client. This pertains to robo-advisors as well.

Massachusetts is Challenging the Robo-Advisors

The Massachusetts Security Division (SEC) is taking the robo-advisory field on with their recent policy statement. The Massachusetts SEC is alleging that as currently structured, the robo-advisors may not be able to comply with the fiduciary rule.

Here’s how the Massachusetts SEC is looking at the fully automated robo-advisor:

  1. They don’t meet individually  or perform due diligence with clients.
  2. Their investment advice is only minimally personalized.
  3. The robo-advisors may not accept the obligation to act in a client’s best interests.

In response to the Massachusetts concerns it’s important to understand that all robo-advisors won’t fit into the above categories. Several robo-advisors offer clients individual human financial advisors. Some automated services, such as Vanguard Personal Advisor, require a meeting with an advisor. Personal Capital‘s higher net worth clients receive access to licensed advisors.

Not only Massachusetts, but the U.S. Securities and Exchange Commission (SEC) expressed concerns over the robo-advisor’s ability to put the individual clients needs first.

The SEC cautions investors to  “Be aware that an automated tool may rely on assumptions that could be incorrect or do not apply to your individual situation.  For example, an automated investment tool may be programmed to use economic assumptions that will not react to shifts in the market.  If the automated tool assumes that interest rates will remain low but, instead, interest rates rise, the tool’s output will be flawed.

In addition, an automated investment tool, like other investment programs, may be programmed to consider limited options.  For example, an automated investment tool may only consider investments offered by an affiliated firm.”

Personally, we believe that all investors need to be aware when working with any financial advisor; robo-advisor, human advisor or a combination advisor.

Analysis of the Fiduciary Rule’s Applicability to the Robo-Advisor Model

First off, it’s a mistake to lump all the robo-advisors into one category. It would be similar to lumping all financial advisors together. There are vast differences between the investing strategies, models, number of investments available, types of funds and services. For example, Motif offers funds grouped according to type. Whereas Betterment constructs an investment mix based upon the users responses to risk tolerance questions. An initial risk quiz is implemented by other robo-advisors as well.

There are many differences between the robo-advisors. Their risk quizzes are different. The asset allocation models are distinct among robo-advisors. The available investments vary, Betterment offers corporate and international bond funds but not real estate investment trusts (REITS). Whereas, Wealthfront gives clients access to both energy and real estate sector funds.

Here’s additional data that suggests that at least one robo-advisor is attempting to supersede the automated approach in order to protect their clients. The day after Britain’s citizens voted to leave the EU, Betterment decided to suspend trading for a few hours. In spite of conflict from various stakeholders, Betterment claims that they were acting in their client’s best interests. Isn’t this exactly what the Fiduciary rule requires?

Robo-advisors aren’t as uni-dimensional as the SEC implies. Most, if not all robo-advisors, give clients the freedom to vary their asset allocations. Additionally, the robo-advisory managers aren’t benefiting in a special way from their recommendations. In fact, their fees are generally much lower than those of typical human financial advisors.

In sum, investors need to be prudent with their money. That means, educating themselves about how various financial assets perform, the historical investment market returns and the differences between stocks, bonds and funds. Further, whenever an investor chooses to pay another human or firm to manage their money, it’s their responsibility to understand what they are doing, the terms of their relationship and how their investment manager will be compensated. To assume that because robo-advisors have an automated investment portal is no reason to believe that they are not upholding the fiduciary standard. Additionally, the SEC’s claim, from the previous quote, that robo’s are basing their investing strategy upon future market conditions doesn’t jive with what we know about the robo-advisors. In general, the robo’s tend to design diversified portfolios that will transcend the market gyrations not capitalize on them.

In the last analysis, it’s important to make sure investors are protected from unscrupulous advisors or those that tend to select investments that benefit themselves ahead of their clients. But to assume that all robo-advisors can’t comply with the Fiduciary rule due to their structure may be short-sighted.

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Barbara A. Friedberg, MBA, MS

Barbara A. Friedberg, MBA, MS

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