FINRA Issues a Report on Digital Advice

As digital investment advice platforms gain traction in the marketplace, it should come as no surprise that FINRA is taking a closer look at how these platforms operate, as well as what potential regulatory concerns may arise as a result of their proliferation.

FINRA recently released a report entitled “Report on Digital Investment Advice.” The report does not create any new legal requirements, nor does it change any existing broker-dealer regulatory obligations. It does, however, provide some insight into FINRA’s current thinking and concerns regarding digital investment advice.

Clearly, FINRA wants to make it clear to firms falling under its regulatory purview that digital investment advice requires the same type of supervision that any other type of investment advice does. In other words, firms would still be responsible for ensuring that recommendations are suitable and conflicts of interest are disclosed and addressed in a manner consistent with FINRA regulations, as are customer risk evaluations and other investment related practices.

In the report, FINRA highlights five key areas of concern:

  • Governance and supervision of algorithms, including initially assessing the methodology of digital tools and the quality and reliability of data inputs, as well as ongoing evaluation such as testing the tools to ensure they are performing as expected, and determining whether models used by a tool remain appropriate as market conditions change
  • Customer profiling, including assessing both a customers’ risk capacity and risk willingness, and addressing contradictory or inconsistent responses in customer-provided information
  • Governance and supervision of portfolios and conflicts of interest, including determining the risk, return and diversification characteristics of a portfolio that is suitable for a given investor profile, and mitigating – through avoidance or disclosure – conflicts that can arise through the selection of securities for a portfolio;
  • Rebalancing, including providing descriptions of how the rebalancing works and procedures that define how the tools will act in the event of a major market movement;
  • Training that enables financial professionals to understand the key assumptions and limitations of individual digital investment advice tools, and determine when use of a tool may not be appropriate for a client.

Let’s briefly explore these issues. In my experience, broker-dealers and independent RIA firms have an investment profession or a committee examine the algorithms underlying any digital tools they contemplate using. They assess the methodology, understand the data inputs being used, and test the output to see if it conforms to a firm’s expectations. I’m sure there are firms that are not performing the proper due diligence, and FINRA should rightly be concerned about them, but I think reputable firms have this one covered.

FINRA cites a Cerulli Associates study that compares the asset allocations suggested by various digital tools for a fictional 27-year-old saving for retirement. Equity allocations ranged from a low of 51% to a high of 90%. This should come as no surprise to anyone who has looked at these tools, but that alone does not appear to be a problem to me. Depending on what financial professional an investor deals with at a given point in time, it is likely that they would also receive vastly different portfolio allocations from a range of human advisors as well. There are other potential issues that seem more deserving of attention. For example, if an established firm generally constructs portfolio comprise of active investments, including alternatives, and it begins offering a low cost service targeting millennials with portfolios consisting solely of passively managed ETF’s, some people familiar with the firm might assume that the millennial service constructs similar portfolios for all clients. Advisors will need to potential clients what each service offering includes, and how the different services differ from one another. Since this is uncharted territory for advisors, lapses may occur.

There are other legitimate concerns regarding portfolio construction tools. What training and testing is required before an advisor can use the tool. How much discretion, if any, does the advisor have in displaying multiple scenarios and assumptions to the client? The more discretion an advisor has, the greater the supervisory burden, one would assume.

The next area is an interesting one: Customer profiling, including assessing both a customers’ risk capacity and risk willingness, and addressing contradictory or inconsistent responses in customer-provided information. According to FINRA, a key question is: What information is necessary to build a customer profile with sufficient information to make a sound investment recommendation? Here, the report points out that a digital tool asks a discrete set of questions. It seems to imply that human advisors have the discretion to ask for additional information where appropriate to arrive at suitability. I’m sure that some advisors do strive to obtain additional information, but in many cases they don’t. Furthermore, it is likely that many investors who are looking for a digital solution currently have no advisor, so they are getting no information regarding suitability.

Having said that, it seems clear that many digital platforms could do a better job of assessing investor risk tolerance as well as their need to assume risk. Assessing risk is a multi-faceted problem that the industry still has not totally solved. Digital platforms can do a better job, but so can human advisors.

Yet another issue with risk assessments in general is inconsistent answers. I’ve written about this in the past. If an investor on a scale of 1-10, answers 50% of the questions with a 9, and the other half with a 1, to give an extreme example, their risk profile is likely not a 5. Further probing is necessary. Not all applications report on the consistency of a user’s answers, but they should.

Conflicts of interest almost always exist, but they are not always addressed. Here’s a simple one: Should the investor be opening an account at all, or would the investor be better off paying down debt or building an emergency fund. A digital platform could ask a few questions than might indicate a need to pay down debt or save first. Should that be required of a digital platform? FINRA seems to think so. Do registered reps typically do this today? I wonder. Do mutual fund firms ask on an account opening form? I’ve never seen it.

Another obvious one is the types of securities that go into the portfolio. As would be the case with a non-digital platform, the use of proprietary products, or any financial incentives to the firm for using a specific product should require substantial disclosures.

FINRA has what appears to be some legitimate concerns around rebalancing. Experienced practitioners understand that rebalancing methodologies and practices vary widely across the industry. Any firm using a digital platform should understand the methodology, and be able to explain it to clients. My guess is that this will present somewhat of a challenge. Most end investors don’t understand the finer points of tax sensitive, location aware rebalancing.

Training, or lack thereof, is a legitimate concern as well. Our experience over many years indicates that firms tend to underinvest in technology training. Lack of training could become a regulatory liability in the future.

In summary, my take on all of this is that there are some area of concern surrounding digital advice, but they are essentially the same ones surrounding advice from a human. A difference may be that FINRA has no way of knowing what each individual advisor is actually doing or discussing with an investor. In the case of a digital platform, everything is being captured and archived within the system. As a result, digital tools may be easier to monitor allowing FINRA to implement necessary changes in a timely fashion if it chooses to do so.

One thing is for certain, we have not heard the last from regulators regarding digital platforms.

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