The clock is ticking towards April 10, when the Department of Labor’s new fiduciary rules go into effect, and firms are still grappling with how best to comply.
Some advisors are deciding it’s simply a good time to retire, sell their practices or merge with larger firms. Thanks to passive products, like exchange traded funds, the value of investment management is falling and firms are eliminating commissions and migrating to a fee-based service model. Amidst all this upheaval, technology vendors are pitching their products as solutions to help advisors successfully navigate the new world order.
For advisors making the transition, one product is being pushed particularly hard: white-labeled versions of automated asset allocation platforms, or so-called robo advisors. The promise is that they will help advisors compete against direct-to-consumer investment platforms, appeal to elusive millennial clients, build scale to their practices and serve smaller accounts profitably, all while remaining compliant with the fiduciary rule. Use of low-fee funds, transparency and instituting a uniform, repeatable process for opening, funding and investing in a portfolio aligned with a client’s risk tolerance will help advisors comply with fiduciary requirements to ensure advisors are acting in their clients’ best interests.
That’s the sales pitch, and many advisors buy it. Upon closer inspection, the reality is not so tidy.
What if an advisor embeds a robo advisor into their business and brings in a client who, given a bit more individual scrutiny, shouldn’t really be investing in the first place? What if a recent college graduate with no emergency funds and large college debt is being automatically “onboarded” into an aggressive investment model, or an elderly retiree with held-away assets, unseen by the robo platform, gets put into a portfolio that takes a much safer approach than is ideal for her? Are the advisors who use these robo services to scale their practices and service these more “hands-off” accounts being true fiduciaries?
“Investing is not always the best answer, especially if someone has a high debt load. At least, that’s what a great fiduciary will tell their clients,” said Aaron Klein, the CEO and co-founder of Riskalyze, whose Autopilot product allows advisors to add such automated functionality to their practice. While it’s helpful to offer objective advice, Klein says algorithms can’t yet factor in enough to determine whether or not a person should receive portfolio advice at all. “Life is not a spreadsheet.”
“An advisor who thinks that automating everything and taking themselves out of the decision-making process can still be considered a fiduciary is taking a massive risk,” Klein added.
Steve Dunlap, president and COO of FolioDynamix, said that while technology will be necessary to achieve the sort of scale needed to survive under the DOL, it cannot replace a human being or give that advisor air cover for fiduciary scrutiny.
“A lot of people have said robo is the hot new thing … so they rush out and sign a deal with a robo advisor and bolt it onto the side,” Dunlap said. “If it’s not an extension of your core abilities, those customers are going to be gone.”
As more and more asset management firms buy or build their own robo platforms, either for advisors or for DIY investors, there’s also the question of the firms utilizing the automated products to sell their own products. For example, Schwab’s Intelligent Portfolios, as well as its for-advisors product, Institutional Intelligent Portfolios (IIP), automatically direct investors towards investment models using Schwab products. This could create a conflict of interest both for Schwab and for an advisor custodied with Schwab using IIP to serve clients.
Schwab declined requests for an interview. Seth Rosenbloom, the associate general counsel of Betterment which creates a competing institutional service "Betterment for Advisors", would not comment on a specific company’s business model, but he expects to see changes from those offering proprietary products.
“At a high level—once you’re classified as giving fiduciary investment advice under the DOL fiduciary rule, then you’re basically prohibited from benefiting from that advice,” Rosenbloom said, though the best interest contract exemptions can be used if enough hoops are jumped through. Because Betterment has a level-fee business model, it is considered to be acting in the client’s best interest when offering IRA rollover accounts; but this likely wouldn’t be available to Betterment if it sold its own investment products, he said.
“It’s a really interesting distinction,” Rosenbloom added. “It will be interesting to see how it plays out.”
In 2015, a white paper written by attorney Melanie Fein, commissioned by an asset management firm, stirred the pot by questioning whether robo advice could at all satisfy the requirements of a registered investment advisor, regulated under the SEC and held to a fiduciary standard. Michael Kitces, an industry analyst and co-founder of the XY Planning Network, goes a step further and argues that investment advisors adopting automated technology also may also not meet the requirements if they aren’t mindful. He suggests firms using automated processes and standard investment models without much client interaction could raise the same regulatory concerns over fiduciary care that the stand-alone robos could face.
The debate was rekindled in October when Morgan Lewis, a Philadelphia-based law firm that represents robo advisors, including Betterment, published a white paper arguing that digital advice is indeed fiduciary advice with fewer conflicts of interest than traditional advisory firms. The paper predictably ruffled feathers, not in the least because it disputes arguments made by Fein’s paper often used by industry analysts and regulators arguing that robos require more scrutiny and that the human element in advice is sacrosanct.
“These critics tend to proceed from misconceptions about the application of fiduciary standards, the current regulatory framework for investment advisers, and the actual services provided by digital advisers,” authors Jennifer Klass and Eric Perelman, both partners at Morgan Lewis, wrote in the report. The paper contends that digital advisors actually offer clients far more customization and “do far more than simply provide online tools that allow self-directed investors to determine their own risk tolerance and investment preferences and then subscribe to a model portfolio designed for investors with similar preferences.”
The authors declined to comment or answer questions about white-label robo products built for advisors.
According to Knut Rostad, the president of the Institute for the Fiduciary Standard, the Morgan Lewis paper takes too narrow of a view of what it means to be a fiduciary. Rostad says the legal analysis is technically sound and agrees that robos can be a helpful tool for both retail investors and financial advisors, but they do not qualify as advisors; therefore, they most likely would not give an advisor using the platform air cover for the fiduciary standard.
“[The authors are] conflating giving product recommendations, which robos do, with advice, which human advisors do,” Rostad said. “Robos don’t have judgment.”
Rostad echoes points made by people like Klein and Kitces: that while automated functionality is beneficial for advisors, and even become borderline mandatory under DOL constraints, it still isn’t enough to replace human judgment when determining a client’s best interest.
Whether or not the Department of Labor will make that distinction when the first wave of “fiduciary-or-not” disagreements comes down the pike remains to be seen.