by Jack Waymire
Very few investors, individual or institutional, know there are two ethical standards for financial advisors and firms.
The higher ethical standard is known as “Fiduciary”. Financial advisors, who are Registered Investment Advisors (RIAs) or Investment Advisor Representatives (IARs), are held to this higher ethical standard. It requires advisors and firms to place the financial interests of their clients ahead of their personal interests (make more money).
The lower ethical standard is known as “Suitability”. Salesmen, for example stockbrokers, are held to this lower standard. They are supposed to make suitable recommendations based on their knowledge of the investors’ circumstances and goals. However, this lower standard is subject to interpretation. For example, three salesmen could have access to the same investor information and make three totally different recommendations.
Wall Street prefers a vague ethical standard that is difficult to enforce.
Investors are better off with a clear ethical standard that is easy to enforce.
Securities and Exchange Commission
The SEC is questioning whether Robos are financial fiduciaries.
This should be a relatively simple decision. The SEC is responsible for regulating financial service firms (RIAs) that provide advice and services for fees. Consider the following:
- Robos are Registered Investment Advisors (RIAs)
- Robos provide advice in the form of model portfolios
- Robo algorithms manage the portfolios
- Robos have discretionary relationships with their clients
- Robos are compensated with fees
Based on SEC regulations, RIAs are classified as financial fiduciaries. It does not matter if the RIA is a traditional, brick & mortar firm or a Robo that delivers advice and services over the Internet.
The Robo Exemption
Should Robos be exempt from fiduciary standards?
Absolutely not! They invest client assets in Exchange Traded Funds and other types of pooled investments. In this capacity a Robo is acting as a virtual financial advisor – the ETF is the money manager.
Financial advisors, who may be RIAs or IARs, are fiduciaries. Therefore, Robos are financial fiduciaries.
Department of Labor
The DOL also has some skin in the fiduciary game. It wants fiduciary status for all advisors who provide investment advice and services to 401k plans and IRAs. The DOL believes this requirement will protect American investors from unscrupulous business practices that jeopardize their chances for comfortable, secure retirements.
Robos are beginning to provide investment services for 401k plan assets. They also provide Robo services for assets in IRAs.
Therefore, this DOL mandated ethical standard would apply to Robos.
Robos did not invent model portfolios. Most financial advisors have used model portfolios to manage their clients’ assets for decades. In fact, the models of Robos and advisors are strikingly similar – based on age, risk tolerance, investment horizon, and return objective.
What is new is the sophistication of the computer models that run the Robos’ model portfolios. Computers are more efficient than humans.
Conflicts of Interest
- Models cannot be programmed to buy more expensive, under-performing products
- Turnover (buys & sells) have to benefit the investor and not the Robo
- There cannot be any hidden or unnecessary expenses
- The use of proprietary products must be fully disclosed to investors
- Robo portfolios should not be used as loss leaders