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'Big Charade' Seen in SEC's Handling of Robos

By Murray Coleman June 29, 2017

The rising popularity of robo-advisors is bringing increased scrutiny by regulators. At the same time, industry lawyers say they don't foresee any substantive changes coming in the form of new rules.

Even so, several legal experts are pointing to "gaping" holes in how these technologies are governed. Eventually, they argue, new regulations are going to need to be considered to keep up with evolving U.S. fiduciary standards.

But it's not like oversight authorities are ignoring an influx of robo services. This year for the first time, the SEC put online advice-giving on its list of examination priorities, raising concerns about “heightened risk to investors and/or the integrity of the U.S. capital markets.”

And this spring the SEC published updated guidance on robos to give advisors broad suggestions about how best to comply with disclosure and suitability issues raised by a wave of new automated investment services.

“Regulators are letting advisors know that robos are increasingly moving onto their radar,” says Todd Gibson, a Pittsburgh-based investment management lawyer at K&L Gates. “At the same time, nothing they’ve done so far suggests that the SEC or anyone else is considering anything that would rock the industry.”

Like other legal and wealth management experts surveyed by FA-IQ, he believes oversight authorities like the SEC and Finra are simply “restating the existing ground rules” for advisors. As Gibson puts it: “Regulators seem to realize they can’t prosecute machines.”

Instead, he views recent SEC moves as part of a pronounced push to “underscore what it takes to act as a fiduciary under current regulations.” That’s a starkly different message, Gibson says, than if the agency perceived a need to create a “whole new set of rules.”

Melanie Fein, a Washington, D.C.-based attorney who specializes in financial services, reads much the same in policymakers’ rising interest in the field.

While agreeing that robos do generally fall under the SEC’s current guidelines governing registered investment advisors, she adds: “Some gaps do exist.”

A central requirement of the Investment Advisers Act of 1940, Fein notes, is that fiduciaries provide recommendations to customers based on the “totality” of their financial circumstances. “But robo advisors don’t appear to me to do that – their questionnaires don’t elicit all of the information needed,” she says.

Another compliance red flag Fein's hearing some advisors raise relates to larger robos attracting more clients, but at the same time allocating a growing number of assets into a rather select group of investment “buckets,” or strategies.

“They’re giving packaged advice that doesn’t necessarily discriminate between large customer groupings,” she says.

With greater economies of scale offered by online technologies, robo managers often argue they’re able to refine client allocations more succinctly than mass-market fund manufacturers. In short, their argument is that automation allows for the development of a plethora of different risk-based model portfolios to divvy up money.

And that’s a point Fein doesn’t dispute. “But as robos grow in popularity and become a bigger part of the investment management market,” she says, “the concern is that these robo buckets will start to look and act more like mass-market mutual funds.”

A key issue securities lawyers and advisors raise is that if the SEC insists its current rules adequately apply to robos – yet there seem to be shortcomings in how some robos execute their fiduciary duty – then any perceived enforcement gap will only widen.

Scott MacKillop, chief executive at Denver-based First Ascent Asset Management, is concerned that regulators are giving robos “too much leeway” and creating a “double standard” by allowing algorithm developers to be judged in the same fiduciary manner as human advisors.

The ex-securities lawyer turned advisor does applaud the SEC’s efforts to encourage sound fiduciary operations by robos. But MacKillop, whose startup indie RIA manages about $50 million, scoffs at notions that computer-based investing can live up to the same sort of “best interest” standards for individual clients as brick-and-mortar advisors.

“Lumping human advisors into the same regulatory category as robos is nothing other than a big charade,” he says. “The technology just isn’t there yet – algorithms can’t recreate a truly sound fiduciary environment.”

Scott MacKillop

Even with artificial intelligence entering the market, MacKillop urges regulators to be “highly” skeptical about claims of “smarter” robo services. “The bottom line is that the SEC needs to create an entirely separate group of regulations to oversee robos,” he says. “Even brokers who adhere to basic suitability standards act in a more fiduciary manner than most robos.”

The current generation of robos are being put together by people who are “quite idealistic” and show “sound fundamental academic knowledge,” counters Tom Baker, a professor at the University of Pennsylvania Law School. “I don’t think there are any indications that current robos are poorly designed,” he says.

Baker, though, cautions that robos are still in their infancy and remain a “fairly unfamiliar and new entity” to regulators such as the SEC and Finra.

To help bring authorities, advisors and investors up-to-speed with such issues, he and a professor at Erasmus University Rotterdam in the Netherlands have written a new study, "Regulating Robo Advice Across the Financial Services Industry."

The authors make a case that today’s rules might be fine in the short-run, but longer-term more finely crafted regs will likely be needed to handle such an evolving wave of technologies.

“Robos now are primarily working through more strategic allocation strategies and index-based funds,” Baker says. “But what happens as more of these platforms start to branch out and try to actively beat the market?”

As a result, he predicts a time will come when regulators will need to step up oversight. “Eventually, robos are going to start touting enhanced performance in order to help justify any rise in fees,” Baker says.

Already he sees this happening in not only a new crop of actively managed robos, but also a surge in hybrid models that incorporate some sort of human intervention to supplement computer-generated model allocations.

Indeed, a new crop of robos are already here. Some offer different types of technical analysis and others employ hedging techniques as well as a diverse range of tactical trading strategies. Algorithms are also being created to cater to investors with a social conscious.

Also worth noting, low-cost and ETF-based provider Betterment has introduced a higher fee structure with an expansion into hybrid advice.

For his part, Baker concedes there’s an argument to be made that more regulation could prove “too burdensome for incentivizing true innovation” and too prohibitive in raising “cost barriers” to enter robo advice-giving.

“The big challenge in the future for the SEC and Finra is going to be finding a sweet spot between too much and too little regulation,” he says.

Even in the current environment – which he characterizes as “anti-regulatory” – Baker expects over time that many of the biggest players with roots in traditional asset management will wind up realizing the benefits to investors of updating old regs.

These are fund manufacturers like Vanguard, BlackRock and Schwab who stress, according to Baker, “evidence-based investing” through low-turnover and largely passive approaches to robo investing.

“I’d be surprised to see someone like BlackRock going to Washington and asking to be more closely regulated in the robo space,” he says. “Still, it seems doubtful to expect to see much in the way of industry resistance if regulators come up with new consumer-friendly rules in the future.”