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Key Regulator Doubts Robos Can Be Fiduciaries

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The highly anticipated Department of Labor fiduciary rule may not mean a fast track for robo advisors after all.

In Massachusetts, digital advice firms seeking to register as RIAs will face extra scrutiny from state securities regulators, who expressed doubts about their ability to act as fiduciaries.

“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 adviser," noted a policy statement released on Friday by the Massachusetts Securities Division.

The state regulator questioned the reliance of robos on questionnaires and lack of human interaction to determine risk tolerance and asset allocation.

"Until regulators have determined the proper regulatory framework for automated investment advice, robo advisors seeking state registration in the Commonwealth will be evaluated under the foregoing guidance on a case-by-case basis," the paper concluded.

The policy would not affect any federally-registered robo advisors, the paper notes.

While it is the first state regulator to formally issue policy on digital advice, is not the first authority to scrutinize the workings of robos. The SEC has stated it is reviewing its rules regarding automated advice, and earlier this month FINRA released guidance for broker-dealers considering the use of such tools.

Read more: FINRA Vows Keen Oversight of Digital Advice Tools

The paper cites the work of D.C.-based attorney Melanie Fein, who first raised these concerns in a paper of her own, titled Robo-Advisors: A Closer Look.

"The policy statement represents a significant recognition by a major securities regulator of the shortcomings of robo advisors as investment fiduciaries," Fein says.

She notes the policy's language goes further than the SEC or FINRA's pronouncements on robos to date. "They are certainly ahead of anybody else," she says. "Clearly they studied this issue perhaps more carefully than other regulators. 

"The Department of Labor, which has touted robo advisors as a source of fiduciary advice for retirement savers, should take note." 

Robo advisors are expected to reap the benefits of the fiduciary rule that will be released on Wednesday, considered by some to be the best positioned to collect smaller accounts collectively worth billions dropped by firms unwilling to service them due to cost or liabilities.

Currently, the digital advice space has gathered a combined $217 billion in AUM, up from $118 billion in 2012, according to Tiburon Strategic Advisors.  

Read more: Will the Fiduciary Rule be a Lifeline for Robos?

Robo advisory firms declined to comment on state regulator's policy paper.

They should be examining how well they profile clients in their initial interactions, notes Sean McDermott, senior analyst at industry consulting firm Corporate Insight.

"There are some significant differences between digital advice firms in terms of the depth of customer profile information they collect before delivering investment recommendations," McDermott says. "Some are very thorough, some are not. As a result, we imagine this announcement is triggering warning bells at some of these firms."

(The number of risk profile questions asked by robos in 2015 to obtain asset allocations ranged from Hedgeable's high of 16 to Betterment's and AssetBuilder's low of 4 questions, according to a recent study by Cerulli Associates.)

"That said, we do not think this development represents a significant barrier to the growth of digital advice," McDermott adds. "As for a digital advice platform being 'inherently unable to carry out the fiduciary obligations of a state-registered investment adviser,' this feels like a case where regulations may need to catch up to the technology."

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