Automated advisors only know you so well -- but it's enough and you know exactly what you're getting, says a paper written by Morgan Lewis attorneys

October 7, 2016 — 2:11 PM UTC by Brooke Southall


Brooke's Note: About 270,000 of the 300,000 human financial advisors out there are not legally worthy of calling themselves fiduciaries. In other words, it is deemed by federal and state laws that they cannot hold themselves out as the kinds of people who can be trusted to put the interests of clients ahead of their own. It is presumed that these individuals -- i.e. stock and insurance brokers -- will reliably put the interests of their broker-dealers ahead of investors. In that context, Morgan Lewis, a Philadelphia law firm, endeavored to write a paper explaining why robotics, so to speak, are more trustworthy than 90% of the humans who make a living in the financial "advice" business. Yes, I had to put "advice" in quotes to encompass brokers for whom advising is supposedly "solely incidental" to their value proposition as product pushers. The Morgan Lewis argument here relies on the idea that robo-advisors don't make wild promises about how much they care for clients. The idea is that the promises they make -- creating a risk-factored portfolio that is rebalanced properly and tax-harvested meticulously -- get fulfilled to a T. The white paper opinion recommends robos get brownie points for high transparency, 24-hour availability, low minimums and other factors that give clients more access. Once you get over the fact that some of these and-then-there's-this arguments (no, not as far as transparency goes) sound a little like what FSI says about why the DOL rule should be tossed on its ear, they sound halfway reasonable. I think.

Robo-advisors can be fiduciaries -- as long as a sliding scale is introduced that scores them on their ability to hit for a high average on a low number of absolute promises, according to a white paper released today.

A prominent law firm is putting its reputation on the line by stating unequivocally that, yes, a robo-advisor can meet the legal standard of a fiduciary. Morgan, Lewis & Bockius LLP of Philadelphia, endorsed by one of its clients, New York-based Betterment says that robo-advisors can deliver a portfolio complete with rebalancing, about which it may give tax harvesting advice and provide other ancillary services that can add value, by rote automation. See: Betterment wins Uber account from under the nose of its Silicon Valley robo-rivals

The point is hardly an academic one as venture capitalists and other investors pour hundreds of millions of dollars into building a new financial advice industry where automation is the key differentiator. Of all the players, Betterment may have the most to lose -- and gain -- given that it is backed by $200- million-plus of committed capital, is tops in its field among free-standing ventures, and also has the lead in managed assets, hence market leadership. Betterment manages about $5.8 billion.

Industry watchdogs have staked out differing positions on the crucial point of whether a robot can put humans first. The Department of Labor seems to see them as potential boons to retirement savers thanks to their low fees, while the SEC frets that the automated component inherent in the very name of the sector may lead to incorrect assumptions that generate subpar advice -- basically, that you get what you pay for. 

"Fiduciary is a term getting thrown around a lot," says Morgan Lewis partner Jennifer Klass, co-author of the paper -- along with Eric Perelman -- and former associate general counsel for Goldman Sachs Asset Management. "It isn't a concrete inflexible thing. It's applied based on the scope of services. That's the thesis of our paper." See: Robo-deal catapults Goldman Sachs into defined contribution business that's as down market as it gets.

Jennifer Klass: [The term 'fiduciary'] It isn't a concrete inflexible thing. It's applied based on the scope of services.

Betterment's legal counsel, Seth Rosenbloom, says the paper, entitled The Evolution of Financial Advice: Digital Investment Advisors as Fiduciaries, comes down to two aspects of fiduciary care -- duty of loyalty and duty of care.

"People don't spend enough time on loyalty," he says. "It reframes [the concept of loyalty] a bit and says there are, and always have been, levels and that none of them are not fiduciary." See: How 10 top groups define 'fiduciary'

'Inherently unable'

As the paper puts it: "Under both common law and the Advisors Act [of 1940], the applicable standard of care may be defined by contract, and the concepts of reasonable care and skill that are at the heart of any standard of care necessarily must be judged in relation to the scope of services agreed to by the client."

One attorney, who asked not to be named, opined: "They are arguing, in essence, that robo customers don't want the best advice, they want the cheapest. Based on that contractual relationship, the robo delivers what it is promises."

The white paper puts it this way: "One of the central themes advanced by critics of digital advisors is that they do not collect sufficient information to provide personalized investment advice and thus are not meeting their fiduciary obligations. We disagree .... Under established regulatory principles the information captured in the client-profiling process must be evaluated in relation to the nature of the advice that is provided." See: Amid hail of DOL questions, Walt Bettinger calls RIAs' draining OneSource 'identified' risk, and explains away LPL/ RBC/BBVA picks of BlackRock FutureAdvisor over Schwab robo

The paper comes in the wake of a pessimistic assessment of whether robos are capable of acting as fiduciaries by the Commonwealth of Massachusetts. "It is the position of the Division that fully automated robo-advisors, as currently structured, may be inherently unable to carry out the fiduciary obligations of a state-registered investment advisor," reads a portion of the introduction of a policy statement issued by by the Massachusetts Securities Division in April.

Rosenbloom says any such timing is coincidental.

"They have nothing to do with each other," he says. "[The Morgan Lewis report] was in process long before the Massachusetts stuff came to light."

Unbalanced discussion

Klass says that her firm did, however, take notice of -- and issue with -- a paper written by Melanie Fein of Fein Law Offices in Washington D.C. in September, which stated: "Robo-advisors do not live up to the DOL’s acclaim. They are not designed for retirement accounts subject to ERISA and should be approached with caution by retail and retirement investors looking for personal investment advice."

'[Robos] are not designed for retirement accounts subject to ERISA and should be approached with caution by retail and retirement investors,' wrote Melanie Fein in a September paper.

Fein specializes in banking, securities and trust law. See: What exactly to make of the big robo-advice deal that, according to Reuters, Financial Engines and Wells Fargo are nearing

"We were convinced there wasn't balanced discussion going on regarding fiduciary duty," says Klass. "We were interested in presenting counter arguments."

Staking out a middle ground, in September, New York-based BlackRock Inc. published a study which concluded that robo-advice done well is a good thing -- but that not all robos are created equal.

"Digital advice is not all the same, with many digital advisors pursuing different business models and investment philosophies, as well as offering varying degrees of sophistication in the services provided," the study stated. See: What exactly are robo-advisors, why did they steal the 2014 show and what will a 2015 repeat take?

'Reasonably available'

The upshot of the Morgan Lewis report is that providing financial advice is an endless, tiresome, multitasking job best done by a tireless machine. See: Trade publication critiques the inhumanity of Schwab's robo advertising

"In many respects, digital advisors permit far more customization than the traditional approach of simply giving clients the ability to impose reasonable restrictions on the management of their accounts by designating certain ticker or security limitations," it reads. "Digital advisors offer many features and tools that a client or advisor may use to personalize portfolios, including financial planning tools to inform portfolio selection; portfolio allocations that clients may customize to their desired asset class mix; the ability to retain legacy positions; sophisticated, technology-driven portfolio rebalancing based on market changes, cash in-flows and out-flows, and risk parameters; and asset placement and tax-loss harvesting services."

The paper continues:  "The result is that clients receive investment advice that is customized to their particular investment goals and needs. Moreover, digital advisers are 'reasonably available' to clients consistent with Rule 3a-4. In fact, they are arguably more available than traditional advisors." See: Six ways that human advisors kick robo-advisor butt

To read the full Morgan Lewis report, click here: The Evolution of Financial Advice: Digital Investment Advisors as Fiduciaries


No people referenced

Mentioned in this article:

Betterment Holdings Inc.
Financial Planning Software
Top Executive: Jon Stein

Share your thoughts and opinions with the author or other readers.


FAA said:

October 7, 2016 — 7:27 PM UTC

A number of things I do not understand. One of the fundamentals of ERISA type fiduciary structure is the development of an investment policy statement including any types of restrictions, policies etc. the investor has. Robos don't do that. Without that as a foundation- I'm not sure how anyone can defend they are acting in the best interests of the clients. Also, packaged product may or may not be in the best interest of the client...the Robo decides it is and the reason they do is because that is their business model. Gee what happens if active management shines again (it has before). Finally, you don't really manage taxes at the ETF or Mutual fund level- the only way you really manage taxes is in an SMA context, at the underlying security level, if done properly. Robos don't do that. One other thing- Betterment is one of Morgan Lewis clients?

On the money said:

October 7, 2016 — 7:43 PM UTC

I guess the comment scuttles the "talking my own book" article. Done and Dusted. Hope Betterment did not pay for it or was it soft dollars?

Tad Borek said:

October 7, 2016 — 9:46 PM UTC

Sure, one can make the case that an automated process can do client intake, pigeonhole them into a risk and tax profile, and match that to some mix of index funds in a manner consistent with fiduciary duty. But it's all automated, right? Doesn't that raise a unique liability issue? Selecting securities by "formula or device" gets special mention in the rules - just advertising the service improperly can constitute fraud: 17 CFR § 275.206(4)-1 Advertisements by investment advisers (a) It shall constitute a fraudulent, deceptive, or manipulative publish, circulate, or distribute any advertisement...Which represents, directly or indirectly, that any graph, chart, formula or other device being offered can in and of itself be used to determine which securities to buy or sell, or when to buy or sell them; or which represents directly or indirectly, that any graph, chart, formula or other device being offered will assist any person in making his own decisions as to which securities to buy, sell, or when to buy or sell them, without prominently disclosing in such advertisement the limitations thereof and the difficulties with respect to its use Is this rule going to be the doorway into fiduciary liability claims? What would need to be prominently disclosed to avoid having your device run afoul of this rule?

FAA said:

October 7, 2016 — 11:59 PM UTC

Agree with Tad- the crux of this article is a legal opinion written by a law firm which, as reported, has business ties to one of the Robo advisors. The merits of the opinion are meaningless- their business relationship with Betterment is meaningful. They are conflicted- and opining on fiduciary duty. Whoaaaa

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