In the past year, the asset management industry warmed up to the idea that robo advice could provide a new distribution channel for their products, and some of the biggest providers made multi-million dollar acquisitions and investments into digital platforms as a result.
But new regulatory guidance on the fiduciary rule may have cast doubts on the viability of a business strategy centered on robos and proprietary products, according to legal experts and industry executives.
The Department of Labor stated Thursday that automated investment advice delivered online without any human interaction is not covered under the fiduciary rule's full best interest contract exemption, which permits firms to continue offering clients commission-based retirement accounts.
The same guidance notes, though, that a separate exemption allows for computer generated investment advice, provided it follows several requirements. The exemption could be used to cover recommendations to rollover assets into a digital platform, and human advisers recommending portfolios on digital platforms should be able to qualify for level fee exemptions — also known as BIC lite.
The newly released guidance, however, also notes "that level fee provisions are not available for commission or transaction-based compensation arrangements, or for compensation structures that are limited to the sale of proprietary products."
Quote"There is a big difference between independent robos and robo advisers attached to fund companies," says Betterment's legal counsel, Seth Rosenbloom.
If an adviser or institution is only recommending proprietary products, the Labor Department's guidance adds, "they need to comply with the more stringent provisions of the full BIC exemption to safeguard the investor from biased advice."
This complicates plans for asset managers that own or launched robo platforms and sought to use them to primarily sell their own funds, says Kristina Zanotti, an ERISA attorney and partner in Washington-based law firm K&L Gates.
"If the whole point in having a digital platform is to distribute your own proprietary funds, then you will be hard-pressed to use the level fee streamlined exemption," Zanotti says.
'UNCLEAR HOW THIS WOULD WORK'
Credit Suisse analysts raised additional concerns in a note summarizing the new guidance.
"Human-directed robo advice may need the [BIC lite]," wrote analysts Christian Bolu and Richard Fellinger. "It's unclear to us how this would work for product manufacturer-owned robo advisers given the ultimate compensation earned could vary depending on which/if proprietary products are used."
As an example, Bolu and Fellinger suggest, "a human-directed robo advised wrap product with proprietary products is more likely to earn the product manufacturer higher compensation, which raises conflict of interest and is at odds with the [BIC lite]."
Reaction to the department's new guidance has been markedly different between mutual fund firms and independent digital advice providers, with the latter celebrating what they describe as a win for their model and an easier path to securing 401(k) assets.
"We let out a huge sigh of relief," says Michael McDaniel, chief investment officer of Riskalyze, which also announced it received an additional $20 million in capital investment to further develop its robo adviser technology.
"We’ve made few decisions, such as not aligning with a big asset manager last year, that are looking like they will pay huge dividends. If you are tied to an asset manager, you're going to have a higher bar to prove you’re objective."
The language is clear, says Betterment's legal counsel Seth Rosenbloom.
"There is a big difference between independent robos and robo advisers attached to fund companies," he says. "Are you independent and choosing the best and cheapest of otherwise interchangeable funds, or are you beholden to funds otherwise associated with your firm?
"Even if you do fee leveling on top — say the ultimate client fees are 30 basis points — if you are recommending your own funds, you are not a level fee fiduciary."
'THE DISTRIBUTION STRATEGY YOU WANT?'
The restrictions don't mean platforms tied to proprietary products can't exist, Zanotti says. But it does mean they will have to meet higher standards.
"You'd have to consider, first of all, is this the distribution strategy you want?" she asks.
An easier route would be to provide robo advice that follows the requirements of the separate ERISA exemption, Section 408(g), Zanotti notes, referring to the law that enables the Labor Department to regulate advice in the retirement space.
"But you're going to have to rethink the strategy a little," Riskalyze's McDaniel says. "There's a need, even for in-house robo advisers, to actually provide shelf space to other asset managers' funds."
Several asset management firms with robo platforms or investments in robo platforms declined to comment on the regulatory changes.
“The best interest standard is such a seismic change in business and operating models, and traditional business practices need to be reviewed," said Next Capital, which recently announced its collaboration with State Street to provide RBC Correspondent & Advisor Services with a robo advice platform built on underlying SPDR ETFs, which State Street manages.
McDaniel says an example of a platform that fits with the new guidance is BlackRock's FutureAdvisor, since it offers a variety of funds and does not specify BlackRock funds be included in the underlying portfolio of the platform offered to institutions.
For instance, one of its broker-dealer clients, LPL Financial, relies on its own research team to select which ETFs go into the portfolios, with no stipulation from BlackRock on the use of its funds.
The asset management giant has advocated for greater transparency and disclosure in digital advice in a recent white paper it released.
"Like traditional advisers, digital advisers should clearly disclose costs, fees, and other forms of compensation prior to the provision of services," the paper stated.
THEY LIKE ROBOS
The Labor Department did not make the full best interest contract exemption generally available for computer-only robo advice "based on its view that the marketplace for robo advice is still evolving in ways that appear to avoid conflicts of interest that would violate the prohibited transactions provisions and that minimize cost."
K&L Gates' Zanotti notes that stance is markedly different from other regulators who have debated whether robo advisers can act as fiduciaries at all.
"It sounds like they generally like robos and like the way the robo advice market looks," Betterment's Rosenbloom says.
The Credit Suisse analysts summed up the perspective on how the industry will approach the new guidance and digital advice. "We will be watching for how these robo adviser platforms comply with DoL rules," they wrote.
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