Can Robo-Advisors Meet the Fiduciary Standard?

Saturday, March 25th, 2017 at 12:24 pm, by Mariam Kamran

The Emergence of Personal Investing Platforms

A robo-advisor is an online wealth management service that provides financial advice and portfolio management using algorithmic formulas, eliminating the need for human financial planners. These programs, the most popular of which include Betterment and Wealthfront, perform a multitude of mundane tasks such as portfolio rebalancing and tax-loss harvesting that have previously required human capital.

Distrust of the wealth management industry in the aftermath of the financial crisis coupled with rapid technological advances primed the landscape for the creation and advance of robo-advisory. The numerous benefits offered by these services as well as heavy interest and investment by venture capitalists and Fintech firms indicate that these programs will have a significant impact in the industry in the immediate short term.

Benefits of Robo-advisory

Robo-advisors offer numerous benefits. Their cost is minimized since decision-making is automated through algorithms and thus eliminates the expense of financial advice and portfolio management. This lowered cost has resulted in increased accessibility to a wider client base so that investment portfolios are no longer reserved for the financially elite. Online platforms and mobile apps such as Wealthfront and Betterment offer greater transparency, as customers are able to directly monitor the way their money is being managed. Finally, robo-advisory is convenient and enables clients to manage their portfolios on-demand and easily through their mobile devices.

Despite these benefits, this latest wave of technological innovation brings quite a few concerns, too. More worrisome than the declining value of human insight is that most robo-advisory services result in “cookie-cutter” approaches to investing. These programs are unable to truly provide users with personalized advice that fits their unique financial needs and objectives. This failure has important implications for these programs’ ability to meet the fiduciary standard.

The Fiduciary Standard

A fiduciary is someone legally required to act in the best interests of the client. The Department of Labor’s recent ruling, although currently delayed in implementation, “will automatically confer fiduciary status on a financial professional who works with or advises clients with retirement plans.” This means that advisors are obligated to disclose any potential conflicts of interest, as well as fees or commissions they receive from an investment company for using its products.

Although the DOL has recognized robo-advisors as a legitimate alternative to traditional advisors, whether these programs meet the fiduciary standard and offer truly unbiased advice is being called into question. This is because most robo-advisory services are affiliated with specific companies and often advertise those companies’ products and services. These inherent biases may impinge on the service’s ability to offer genuinely individualized assessments and financial planning.

Financial attorney Melanie L. Fine published a whitepaper commissioned by Federated Investors Inc. The paper found that robo-advisors fail to match up to their human counterparts when it comes to fulfilling the fiduciary standard. These services often fail to ask essential questions concerning the customer’s tax bracket, number of dependents, and other sources of assets and expenditures. Moreover, the services simply ask whether the user understands various kinds of investments such as stocks or mutual funds, and lack any safeguard to ensure that a client genuinely understands actions taken on the app or service. Beyond these disadvantages is a much simpler one: robo-advisors eradicate any human component to financial advising. Automated technological services lack the ability to empathize with clients and “have no interest in the personal details of their clients’ lives and will make no effort to get to know their clients’ children or beneficiaries in order to ensure a smooth transition of assets after they are gone.”

Law firm Morgan Lewis has published an opposing perspective. The firm has argued that robo-advisors are, in fact, able to meet the fiduciary standard. According to the firm’s whitepaper, “The Evolution of Advice: Digital Investment Advisers as Fiduciaries”, fiduciary standards, such as those that are incorporated into the Advisers Act, are flexible principles that robo-advisors are also capable of satisfying. Rather than being unique, products and services offered by robo-advisors are just technologically enhanced versions of advisory programs and services that have already been subject to this flexible regulatory framework for quite some time.

Remaining Questions

An additional concern regarding robo-advisory is the complication that results in answering the question of who is ultimately responsible. Who bears liability when the fiduciary standard is breached and a robo-advisor provides advice that proves not to be in the client’s best interests? One commentator provides a whole list of actors who may be found liable, including the investment managers that designed the portfolios on the backend, the team that formulated the algorithms suggestions in response to a consumer’s preferences, and the human advisors who regulate the algorithms to ensure they are performing correctly. The liability issue is further complicated in the case where a human advisor suggests a client invest according to a robo-advisor’s suggestions- who would be liable in that case?

These questions may soon be litigated heavily as today’s robo advisors are inexperienced and untested when it comes to managing assets during periods of market instability or turmoil. According to one commentator, robo-built portfolios are guaranteed to face obliteration within the next major financial crisis because “it’s in the very DNA (and history) of smart-sounding algorithms to get killed by angry financial markets.” Time will tell the extent to which robo-advisors will be held accountable in the years to come.

Conclusion

Robo-advisory has a long and promising future ahead as both its accessibility and consumer base continue to widen. However, it remains to be seen what will result when consumers begin running into some of these services’ limitations. There are still many unanswered questions regarding whether these services can ultimately satisfy the fiduciary standard and who will be held liable in case of breach.