As robo-advisers continue to grow in popularity with investors, especially millennial investors, at least one regulator is taking a closer look. On July 14, 2016, Massachusetts Secretary of the Commonwealth William Galvin issued a policy statement addressing the use by investment advisers under his jurisdiction of third-party robo-advisers. This follows a similar policy statement by Secretary Galvin in April 2016 addressing fully-automated robo-advisers. The more recent guidance urges IAs to provide highly-specific disclosures to clients about a firm’s relationships with robo-advisers, the purported benefits and limitations of using a robo-adviser, and, perhaps most importantly, the multiple layers of fee structures.
A robo-adviser provides an automated service, without the need for traditional advisor relationships, by employing asset-allocation models and algorithms to invest client portfolios. According to the Massachusetts policy statement, robo-advisers have experienced significant growth “based in large part on their perceived simplicity, their ease of accessibility, and their ability to service investment advisory clients who may not have sufficient assets to establish a relationship with a traditional investment adviser.” Massachusetts has stressed that robo-advisers are investment advisers, and that they owe the fiduciary duties of loyalty and care to their current and prospective investment advisory clients.
The state’s guidance makes clear that, to satisfy their fiduciary obligations, investment advisers registered in Massachusetts have a high disclosure burden any time they enter into a sub-advisory relationship with a robo-adviser. This includes the following:
- The IA should identify the proposed robo-adviser to its clients and provide a detailed explanation of its services. Specifically, the IA should explain: (i) why it chose the proposed robo-adviser as opposed to others; (ii) any conflicts of interest that may arise; (iii) any additional fees that may be incurred; and (iv) the perceived advantages and disadvantages of the robo-adviser relationship. These disclosures should be made to the client before the robo-adviser relationship has been established.
- The IA should inform those clients, such as retail investors, who can receive robo-adviser services directly that such services can be obtained without an intermediary, and without paying an additional layer of advisory fees.
- The IA should explain the ways in which it provides value to its client over and above the value provided by the robo-adviser. This might include, for example, assisting the client in establishing financial and investment goals, providing financial planning services, or evaluating the client’s overall investment portfolio. These investment adviser services should be distinguished from those services that will be provided by the robo-adviser.
- The IA should explain the services that it does not provide when it uses a robo-adviser. Most robo-advisers use proprietary algorithms to make asset allocation determinations in the client’s account, and most of them—or their broker-dealer affiliates—effect trades in the client’s robo-adviser account. These services typically would not be provided by the IA.
- The IA should explain the type of investment products used by the robo-adviser in its portfolio structure. It is common for robo-advisers to use a pool of ETF securities for client portfolios, the weightings of which are adjusted and rebalanced algorithmically over time. The IA should consider, consistent with its fiduciary obligations, whether such investment products are appropriate for its individual clients.
- The IA should avoid boilerplate disclosures that are not tailored specifically to its robo-adviser relationships. Many IAs use the services of compliance consultants to assist in preparing regulatory disclosures—but they cannot delegate those regulatory responsibilities, and bear the full responsibility of satisfying their disclosure obligations, when they engage robo-advisers.
The guidance provided by Secretary Galvin applies to investment advisers under his jurisdiction in Massachusetts, but IAs not registered in Massachusetts should also be aware of these issues and prepare for the inevitability of similar guidance from other state and federal regulators. Massachusetts is ahead of the pack on this issue, but will not be alone for long. We expect this to be a harbinger of things to come.
The Massachusetts Policy Statement can be found here: https://www.sec.state.ma.us/sct/sctpdf/Policy-Statement-State-Registered-Investment-Advisers-Use-of-Third-Party-Robo-Advisers.pdf
A version of this blog post appeared in Compliance Reporter on Aug. 8, 2016. It can be accessed here.