Automated online advice platforms, the so-called robo advisors, have long said that the use of algorithms eliminates the kinds of conflicts of interest that can exist in more traditional brokerage firms. It’s a premise that’s gained traction with both consumers and regulators as the Dept. of Labor prepares to unveil new rules for brokers to retirement accounts, demanding they limit conflicting business arrangements.
But a new report by the Financial Industry Regulatory Authority, the self-regulator funded by Wall Street, casts doubt on the ability of robos do just that.
With robo advisors managing billions of dollars, FINRA released a report Tuesday that investigated the users of these digital platforms to evaluate several key service areas including governance and supervision, the suitability of recommendations, conflicts of interest, customer risk profiles and portfolio rebalancing.
FINRA found that while digital advice will likely play an increasingly important role in wealth management, investors should be aware that conflicts of interest can exist even in risk profiles and asset allocations powered by algorithms. Specifically, the advice consumers receive depends largely on the digital advice provider’s investment approach, as well as the underlying assumptions and financial products that they use.
“Digital investment advice tools do not necessarily eliminate conflicts of interest,” the report says. “Since conflicts of interest may exist in the investment advice they receive, investors should evaluate whether those conflicts compromise the objectivity of that advice.”
FINRA points out that conflicts within some digital advice platforms could include the same that plague human advisors. “Conflicts could include, for example, commission payments and other incentives for a registered representative in a financial professional-facing context, and revenue sharing or sale of proprietary or affiliated products for a firm in a client-facing context,” according to the report.
Additionally, the regulator says consumers should ask about all the costs associated with investing on a digital advice platform, including costs incurred from mutual fund management fees.
This comes after Labor Secretary Thomas Perez threw his support behind digital advice models as a viable solution for mass affluent investors, which the industry has argued will be priced out of financial advice under the impending fiduciary rule. The rule would require advisors to act in their clients' best interest and aims to reduce conflicts of interest, which the Council of Economic Advisers has controversially estimated is responsible for over $17 billion in losses every year for IRA investors.
“Smart leaders will and can adapt to changing market conditions,” Perez said in October. “Successful firms like Wealthfront, the Garrett Planning Network, Financial Engines and Personal Capital are there to occupy this important market niche. They already do so quite profitably, and they do so while embracing and adhering to a fiduciary standard.”
FINRA's report makes a distinction between automated investment platforms used by human advisors to more efficiently serve lower-threshold accounts (platforms that may be owned by asset management firms with incentives for advisors to use their products) and direct-to-consumer platforms that often pair investors with model portfolios of low-cost ETFs for a fraction of the fees charges by traditional advisors.
In a statement Tuesday, Betterment spokesman Joe Ziemer said it has been the company’s mission since day one to provide quality and cost-effective advice that is aligned with their customers’ interests. “We look forward to working with our regulators to ensure that investors understand and benefit from these exciting developments,” he added.
In response to the report, Wealthfront CEO Adam Nash noted that his firm strongly agreed with the core message in FINRA’s findings: Consumers should have a full understanding of the investment strategy of their investment provider, a concept that applies equally to both digital and traditional services. But he added that it’s important to remember that ‘digital advice’ is a very broad term and can refer to a range of service models.
“Today there are companies out there that are referred to as ‘digital’ who use software as a tool to complement a human advisor. There are also digital services out there that use software for active trading strategies—even those that mimic hedge funds or complex quantitative strategies,” he said, adding that Wealthfront is a fully automated investment service registered with both FINRA and the SEC as a fiduciary.
Updated on March 16, 2016 at 12:30 p.m. to remove the impression FINRA was naming any particular provider in its report.