RIA Compliance Blog
The Financial Industry Regulatory Authority (“FINRA”) recently released guidance on effective practices for financial services firms that provide digital investment advice services. While the report analyzed rules of the securities industry that relate to such services, it discusses effective practices that “may be valuable to financial professionals generally,” including registered investment advisers. With the increasing use of digital investment advice tools in the financial services industry, FINRA undertook to review a broad range of these tools to ensure broker dealers as well as investment advisers are complying with their legal obligations.
The digital investment advice tools FINRA is referring to include both financial professional-facing tools and client-facing tools. These tools typically perform the necessary functions involved in managing an investor’s portfolio, including customer profile development, asset allocation, portfolio selection, trade execution, portfolio rebalancing, and tax-loss harvesting. Client-facing tools which perform these functions are commonly known as “robo advisors.” Financial professional-facing tools usually include portfolio analysis capabilities in addition to those listed functions.
Many of these digital investment advice tools use algorithms to provide suggestions or advice customized to each investor. Algorithms are comprised of various financial models and assumptions that translate data inputs into suggested actions for each of the various functions mentioned above. FINRA recommends implementing adequate governance and supervision procedures over the development of these algorithms and the methodology by which they translate inputs into outputs. Poorly designed algorithms with incorrect coding can result in unintended outputs that will negatively affect investors. In addition, some methodologies may be inappropriate to use in certain circumstances. FINRA recommends that firms engage in initial reviews to assess the methodological approaches embedded in the algorithms they use and to ensure those approaches are consistent with the firm’s desired investment and analytic approach. Firms should also perform ongoing reviews to ensure that the models remain appropriate and are performing as intended.
Digital investment advice tools often match investors to certain portfolios based on their customer profile; therefore, it is extremely important that firms have effective governance and supervisory mechanisms over the customer profiles that digital investment advice tool may propose. FINRA recommends that firms establish criteria for including certain securities in each portfolio, oversee the development and implementation of the algorithm which will select the securities that are appropriate for each portfolio, monitor pre-packaged portfolios to ensure their characteristics are appropriate for the investors to which they are offered, and identify and mitigate any conflicts of interest that may result from including proprietary securities in a portfolio.
Similarly, in order to provide sound investment advice it is important to have a good understanding of an investor’s investment objectives and finances reflected in his or her customer profile. Firms should understand the customer profiling functionality of their digital investment advice tools and establish appropriate governance and supervisory mechanisms. Specifically, FINRA recommends that firms identify the key elements of information necessary to profile a customer accurately, assess each customer’s risk capacity and risk willingness, resolve contradictory or inconsistent responses in a customer profiling questionnaire, assess whether a suggested course of action is appropriate for an individual, and contact customers periodically to determine if their profile has changed. These are all sound practices that should be a part of an investment adviser’s or broker-dealer’s compliance system, whether or not digital trading tools are used. Among the questions firms should ask about their customer profiling tools is whether the tool favors any particular securities or whether the tool considers different concentration levels.
Digital investment advice tools are also often equipped to rebalance investment portfolios in order to maintain target asset allocations. FNRA recommends that firms using digital investment advice tools to achieve rebalancing should ensure that they have policies and procedures in place to establish customer intent regarding automatic rebalancing, to appraise the customer of potential cost and tax implications, to disclose to customers how rebalancing works, to define how the tool will act in the event of a major market movement, and to minimize the tax impact of rebalancing. In evaluating digital investment advice tools that engage in rebalancing, firms should consider whether the tool permits automatic rebalancing, the triggers for portfolio rebalancing by the tool, and how often rebalancing occurs, among other things. Automatic rebalancing could result in excessive commissions or adverse tax treatment.
Lastly, FINRA recommends providing training and education for firm personnel who engage in the use of digital investment advice tools. While the use of financial professional-facing tools can deliver sophisticated analytics, in order to use these tools effectively it is important that users have an understanding of the assumptions that go into the various algorithms and any potential limitations. Specifically, FINRA recommends that professionals that use digital investment advice tools receive training on the permitted use of digital investment advice tools, the key assumptions and limitations of individual tools, and when the use of a tool may be inappropriate for a client. Firms should also assess the adequacy of any training provided by third-party vendors.
The effective practices outlined by FINRA in its report are designed to ensure that the core principles of investor protection — understanding and responding to the needs and objectives of investors — are being met.
Parker MacIntyre provides legal and compliance services to investment advisers, broker dealers, registered representatives, hedge funds, and issuers of securities, among others. Our regulatory practice group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our website for more information.