Robo-advisers are investment advisers that utilize algorithms in order to generate an investment portfolio for clients. Because of their affordability, use of technology and minimal use of human interaction, robo-advisers initially targeted millennials. However, people of all age groups and income levels have come to enjoy the benefits of using a robo-adviser.
The Staff of the Division of Investment Management, in coordination with the Staff of the Office of Compliance Inspections and Examinations (“OCIE”) has been monitoring and engaging robo-advisers to evaluate how they meet their obligations under the Investment Advisers Act of 1940 (the “Advisers Act”).
Due to the unique nature of their investment advisory services and limited human interaction, robo-advisers should consider three distinct areas in order to comply with the Advisers Act.
1. THE SUBSTANCE AND PRESENTATION OF DISCLOSURES TO CLIENTS ABOUT THE ROBO-ADVISER AND THE INVESTMENT ADVISORY SERVICES IT OFFERS.
Because clients have limited, if any, interactions with a person, robo-advisers must keep in mind that the client’s ability to make an informed decision about whether to enter, continue or discontinue their investment advisory relationship may be dependent solely on a robo-adviser’s electronic disclosures. These may be made via email, websites, mobile applications or other electronic media. Accordingly, robo-advisers must ensure that they appropriately explain to potential and current clients their business model, menu of investment advisory services, conflicts of interests, risk disclosures and any other material information.
Robo-advisers should provide the following information:
· A statement that an algorithm is used to manage individual client accounts
· A description of how the algorithm generates recommended portfolios and that individual client accounts are invested and rebalanced by the algorithm
· 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 assets
· 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 that 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
· An explanation of how and when a client should update information he or she has provided to the robo-adviser
When presenting potential and current clients disclosures, robo-advisers should consider
· Whether disclosures are presented prior to sign-up process so that information necessary to make an informed investment decision is available to clients before they engage, and make any investment with, the robo-adviser
· Whether key disclosures are specially emphasized
· Whether some disclosures should be accompanied by an interactive text or other means to provide additional details to clients who are seeking more information
· Whether the presentation and formatting of disclosure made available on a mobile platform have been appropriately adapted for that platform
2. THE OBLIGATION TO OBTAIN INFORMATION FROM CLIENTS TO SUPPORT THE ROBO-ADVISER’S DUTY TO PROVIDE SUITABLE ADVICE.
Robo-advisers, as SEC registered investment advisers, must make a reasonable determination that the investment advice provided is suitable for the client based on the client’s financial situation and investment objectives.
Many robo-advisers utilize questionnaires, sometimes exclusively, to generate a recommended portfolio. The questionnaire should be designed to elicit sufficient information to support the robo-adviser’s suitability obligation. The questions should be clear and designed so that the client may provide additional clarification or examples as necessary. For best practices, the questionnaire should address any inconsistent client responses by, for example, incorporating a design feature or implementing a system that alerts the client or robo-adviser to inconsistent information.
Some robo-advisers also provide clients the opportunity to select portfolios other than those that have been recommended. In such cases, the robo-adviser should provide commentary describing why particular portfolios may be more appropriate for a certain investment objective and risk profile.
3. THE ADOPTION AND IMPLEMENTATION OF EFFECTIVE COMPLIANCE PROGRAMS REASONABLY DESIGNED TO ADDRESS PARTICULAR CONCERNS RELEVANT TO PROVIDING AUTOMATED ADVICE.
Robo-advisers must not only implement written policies and procedures relevant to traditional investment advisers, but must also consider policies and procedures to address:
· The development, testing and backtesting of the algorithmic code and monitoring of its performance
· The questionnaire eliciting sufficient information to allow the robo-adviser to make an appropriate suitability determination
· The disclosure to clients of changes to the algorithm that may materially affect their portfolios
· Oversight of any third party that develops, owns or manages the algorithm
· The prevention and detection of, and response to cybersecurity threats
· The use of social media and other electronic media for matketing
· The protection of client accounts and key advisory systems