Regulation and Robos

Betterment CEO Jon Stein sees robo-advice as remedying an "industry problem — the old way of managing money is broken."

When investing for the future, he told me in a recent email, "People have been limited in their options. They could either do it themselves, or they could hand it off to an investment manager. The first is tedious, time-consuming and error-prone; the second has historically meant tolerating outdated technology and potential conflicts of interest."

Stein co-founded Betterment and was named an industry frontrunner in the May issue of Investment Advisor. He says that "people's money should work as hard for them as they worked to earn it, and that is the future of investing. The future of investing is more advised and more transparent, and automation helps make that all possible."

Indeed, Stein says that capital will continue to flow into fintech, with assets under management by robo-advisors estimated to increase 68% annually to about $2.2 trillion in five years, according to a forecast from consultancy A.T. Kearney. "About half of that [AUM growth] is expected to come from money that's already invested and the rest from non-invested assets," Stein said.

As noted in the May IA profile of Stein, Betterment has accumulated more than $8 billion since it launched in 2010 and currently serves nearly 210,000 clients with its ETF-based portfolios; it rolled out a platform for advisors in 2014. Stein says he anticipates more consolidation in the fintech space "as incumbents look to more aggressively enter spaces where the new players are getting substantial traction."

Here They Come

While no formal fintech/robo-advice regulations are in place yet, the Securities and Exchange Commission recently addressed the issue of portfolio risk in robo-advisors' offerings and is boosting its oversight of such advice in its exams, according to "Looking Under the Hood: Robo Advice, Portfolio Risk, and Regulation," a report released in mid-July by Celent, a fintech research and consulting group that is part of Oliver Wyman.

As Celent's report notes, the SEC stated in guidance released in February that robo-advisors should be able to "make clear to clients" the following:

The frequency with (or situations in) which clients should update their profile information;
Risks around the ongoing maintenance of the portfolio inherent to the algorithm; and
Circumstances that would lead the robo-advisor to override the algorithm.

In June, the securities regulator announced an update to its annual exam process, "whereby robo-advisors would be subject to levels of review similar to those applied to real-life advisors," the Celent report says.

The SEC highlighted compliance, marketing, data protection and the management of potential conflicts of interest as areas of focus. "In particular, the commission indicated it would scrutinize the way in which investment advice is generated, as well as the compliance processes in place for monitoring these recommendations," Celent explained.

Similar concerns expressed by state regulators and the broker-dealer regulator, the Financial Industry Regulatory Authority, "suggest that supervision will only grow tighter," Celent opines. SEC staff explained in their guidance that they have been monitoring and engaging with robo-advisors to evaluate how these advisors meet their obligations under the Investment Advisers Act of 1940.

While the SEC guidance focuses on robo-advisors that provide services "directly to clients over the internet," the agency notes that it could also be helpful for other types of robo-advisors. Robo-advisors, like all registered investment advisors, "are subject to the substantive and fiduciary obligations of the Advisers Act," the SEC says in its guidance. "Because robo-advisors rely on algorithms, provide advisory services over the internet, and may offer limited, if any, direct human interaction to their clients, their unique business models may raise certain considerations when seeking to comply with the Advisers Act."

Clayton's Comments

Even SEC Chairman Jay Clayton said in his first public speech in mid-July at the Economics Club of New York that "technology and innovation are constantly disrupting — in mostly positive ways — the manner in which markets work and investors transact." Clayton noted that the SEC "must recognize this and strive to ensure that our rules and operations reflect the realities of our capital markets," but added that "while this dynamic atmosphere presents challenges, it also provides opportunities for improvements and efficiencies."

Technology "is not just the province of those we regulate. The SEC has the capability to develop and utilize it, too," he explained. "We apply sophisticated analytic strategies to detect companies and individuals engaging in suspicious behavior," and are "adapting machine learning and artificial intelligence to new functions, such as analyzing regulatory filings."

As for FINRA, the self-regulatory organization recently announced the creation of the Innovation Outreach Initiative to help it get a better handle on how advances in financial technology affect the industry. The BD regulator also launched a website with resources to help financial professionals understand emerging fintech areas like distributed ledgers and digital advice.

William Trout, head of Wealth Management Research at Celent, told me that he doesn't see the SEC or FINRA likely issuing "explicit rules" or more guidance than they've done already, mainly because "their focus is principles-based regulation; actual implementation (and to a degree, interpretation) is left to the discretion of the advisor."

FINRA, "as an industry-controlled watchdog, has not surprisingly been less explicit in terms of expectations, but it has made noises about wanting greater transparency around investment decision-making, as have certain state regulators," Trout explained. "But again, I'd expect any further pronouncements from these bodies to be at most directional, and not take the form of conduct-based rules."

The Role of Robos

The benefits — or not — of robo-advice also have been a big debate as the Department of Labor's fiduciary rule has unfolded, and there's been lots of talk that increasing numbers of mass-affluent individuals likely will be driven to such services. For his part, Stein said in his email message that Betterment, as a supporter of DOL's fiduciary rule, is "excited to see a more transparent, customer-aligned market developing."

As for the robo-advisor's approach, "We're going to keep doing the same thing we always have," Stein explained. "We're going to keep providing independent fiduciary advice and fight for the right of investors regardless. As a fiduciary, existing and prospective clients can be sure that Betterment acts in clients' best interests at all times."

Fitch Ratings' analysts say that automated investment advice has the potential to drive "significant long-term change" for retail wealth manager platforms, and may assist wealth managers in addressing new required fiduciary standards for retirement accounts.

"We believe that the wealth-management divisions of large banks will increasingly adopt the technology, following similar moves from traditional investment management firms such as Vanguard, retail brokers such as Charles Schwab and internet-based companies such as Betterment," explained Fitch Senior Director Justin Fuller and Justin Patrie, a senior analyst, in a recent commentary.

Fuller told me that he sees the robo-advice trend as a net positive for wealth managers, as the automated advice "should allow for better client interactions and better client segmentation."

But he and Patrie warn that automated products "come with operational and implementation risks" and challenges like "maintenance of portfolios within stated risk tolerances, communication with clients, ensuring suitability of investments (i.e., maintaining the fiduciary standard for retirement accounts) and maintaining strict cybersecurity."

— Read Fitch: Robo-Advice a Net Positive for Wealth Managers on ThinkAdvisor.