Robo Advisors Come of Age: Part Two
By: Barbara Novick, Vice Chairman of BlackRock, and Bo Lu, CEO of FutureAdvisor
This is the second post in a two part series on the implications of the rise of digital advice.
As we discussed in our first post, the financial services industry is undergoing a transformation in the way that advisory services are provided and delivered to individual investors. This transformation is being driven by several factors including changing demographics, technological advances, and new regulations.
In the face of these changes, regulators should be thinking about how to apply regulations on the provision of investment advice to digital advisors, in order to ensure that appropriate protections for investors’ futures are in place, while also ensuring that regulatory regimes encourage innovation. We have seen some progress on this front. For example, in the US, the SEC Division of Investment Management recently released a Guidance Update on Robo-Advisers, which provides suggestions on how digital advisors should address issues specific to digital advice as they seek to meet their existing regulatory obligations under the Investment Advisers Act of 1940.
Today, digital advisors represent a very small segment relative to more traditional financial advice providers. However, their recent rapid growth suggests a need for a focused analysis of the business and activities of these advisors. Over the next few years, the $490 billion dollar question will be: what protections are in place to safeguard your money at a digital advisor?
It is important to recognize that digital advisors are subject to the same framework of regulation and supervision as traditional advisors, although the applicability and emphasis of existing regulations may differ in some cases. As regulators think about where to focus attention in the digital advisory space, there are a number of areas they should consider:
1. Know your client and their suitability requirements: Like traditional advisors, digital advisors must make suitable investment recommendations based on their knowledge of clients’ circumstances and objectives. Whether or not this information is obtained through an online questionnaire or more traditional means, it should be used to make appropriate recommendations based on the clients’ goals.
2. Algorithm design and oversight: A key component of digital advisors’ service models is the use of optimization algorithms. Digital advisors should ensure that investment professionals with sufficient expertise are closely involved in the development and ongoing oversight of algorithms. Algorithm assumptions should be based on generally accepted investment theories that take into account the historic returns of different asset classes, and key assumptions of the algorithms should be made available to investors.
3. Disclosure standards and cost transparency: Clients should understand what services they are receiving and the potential risks involved. Digital advisors should clearly disclose the costs clients can incur (including fees), as well as other forms of compensation. In addition, advisors should disclose relevant technological, operational, and market risks to clients. This should include information on the tools the advisor can use to address these risks and when they would use such tools.
4. Trading practices: Like traditional advisors, digital advisors generally manage client assets on a discretionary basis and buy or sell equity securities, ETFs, and other broad-based securities. As part of these services, digital advisors should have reasonably designed trading procedures that include controls to mitigate risks associated with trading and order handling. Trading and portfolio management capabilities should be supervised by skilled investment professionals.
5. Data protection and cybersecurity: Digital advisors should view cybersecurity as a critical component of their business model and carefully safeguard sensitive client information. Digital advisors should use the strongest data encryption, conduct risk management of third party vendors, obtain appropriate levels of cybersecurity insurance, maintain business continuity management plans, and implement incident management frameworks.
In this age of technology, we should expect an ongoing evolution of the digital advice landscape. As business models continue to evolve, it is important that regulatory regimes encourage innovations that could be beneficial to consumers.
For a more detailed look at the evolution of digital investment advice and BlackRock’s recommendations on best practices for digital advisors as well as relevant disclosures, click here.