Financial “advice” is the latest area where technology seeks to strip humans of personal responsibility – to free us of the “burden” of thinking for ourselves. (Wait, doesn’t government already do that for us?)

These so-called “robo advisors” are investment programs constructed through algorithms. Human involvement is not part of the package. The Department of Labor touts them as a source of low-cost personal investment services with minimal conflicts of interest.

Is this true? Are robos acting in the best interest of their users? Is there a fiduciary standard?

The answer is a resounding NO. The robo business model and user agreements make this clear. Here’s why:

PERSONALIZED ADVICE

Robos simply do not provide it. Their advice is generated programmatically by computers based on user responses to online questionnaires. These questionnaires do not elicit all relevant information. Many ignore key facts including a user’s contributions and withdrawals, dependents, outside sources of wealth, monthly expenses, tax situation, anticipated expenditures (i.e. 2nd home purchase, college tuition), etc.

STANDARD OF CARE: FIDUCIARY VS. SUITABILITY

The fiduciary standard is much more stringent. It requires advice to always be in the best interest of the client. The distribution model of financial advice (i.e. retail brokerage) escapes this responsibility using the watered-down suitability standard. Robos are another notch below as user agreements explicitly state clients are left on their own to assess whether recommended investments are appropriate for their needs.

The Uniform Prudent Investor Act requires an investor’s total financial circumstances be considered. All relevant factors must be accounted for. Facts must be verified. Robos do just the opposite – they make isolated investment decisions that do not necessarily account for a user’s total portfolio. They require users to monitor their own investments for suitability on an ongoing basis.

To avoid being held to a fiduciary standard robos intentionally avoid providing their services to 401(k) and other ERISA-governed plans. Why? They cannot meet the Department of Labor’s proposed best interest standard requiring investment advisers to acknowledge their fiduciary status, commit to give only advice that is in the customer’s best interest and agree to receive no more than reasonable compensation.

In sum robos want users to believe they’re doing what’s in their best interest yet not actually provide such a service while simultaneously avoiding any liability if what a user thinks differs from what they actually receive.

CONFLICTS OF INTEREST

The claim that robos are “free” or “low-cost” is misleading. There’s no such thing as a free lunch. Users are paying – they just don’t see it. In addition to a user fee (i.e. investment management) robos earn money through revenue sharing from affiliated broker-dealers, custodians and clearing firms (as opposed to shopping for the lowest cost broker-dealer through which to execute trades). These costs are imbedded in the price of the products sold.

What’s more robos engage in self-dealing (selling their inventory to users), receive payments from stock exchanges for order flow, use affiliated banks for cash sweeps and often sell proprietary investment products.

Clients must consent to these conflicts of interest as a condition of use!!!

DEPARTMENT OF LABOR WARNING

In May 2015 the SEC and FINRA issued an investor alert cautioning that robos:

  • may give advice based on incorrect assumptions, incomplete information or circumstances not relevant to the user
  • use questionnaires that may be ambiguous, misleading and programmed to generate preset options
  • may use economic assumptions that do not react to market shifts
  • may be programmed to consider only limited investment options such as those offered by an affiliate
  • do not offer the benefits of human judgment and oversight
  • do not provide access to value-added personalized service

While the warnings by the SEC and FINRA – two agencies charged with protecting investors – seem valid and justified it’s curious the DOL so strongly endorses robos.

In the end it is as always – you get what you pay for and it’s up to you to determine if you ought to be buying what they’re selling. Peel back the layers and make sure you understand if a robo is right for you given your needs and wants. Caveat emptor!