In this lecture, we will explore FinTech developments in the wealth management industry. We begin by looking at how these FinTech firms operate and the factors that are contributing to their early success. Before moving on to examine the associated risk, we will conclude by discussing the legal and regulatory framework applicable to FinTech wealth management firms. The wealth management industry is massive and has historically been very profitable. PWC estimates at the end of 2016, the amount of assets under management by wealth management firms around the world was approximately $85 trillion. The industry has traditionally been labor-intensive, with scores of advisors and retail brokers across the country meeting with clients face to face on a periodic basis. Given the industry size and lack of technological sophistication, it's no wonder tech startups have began to put their own spin on the very old business of managing other people's money. These new FinTech firms, commonly called robo-advisors, provide automated algorithm-driven financial planning services based on investors' data and risk preferences. Some robo-advisors provide investment advice directly to the client with limited if any direct human interaction with investment advisory personnel, while other robo-advisors provide advice by having investment advisory personnel, use the interactive platform to generate an investment plan that is discussed and refined with the client. It's estimated that robo-advisory firms currently hold $200 billion in assets under management, with that amount expected to grow dramatically over the next few years. One research firm estimates that robo-advisory firms will have as much as one trillion dollars in assets under management by 2020 and as much as four trillion by 2022. Some of the more prominent robo-advisors include Betterment, Personal Capital, and Wealthfront. Let's take a look at how robo-advisors work and practice. It all begins when the customer goes to the robo-advisor's website and enters in personal information such as their age, income, investing goals, risk tolerance, investing time frame and their current financial assets. Information pertaining to an investors' risk tolerance is often obtained through the use of a questionnaire, designed to identify the investor's willingness and ability to take risk. Once this information is collected, it is fed into the robo-advisor's proprietary algorithm, which then spits out one or more recommended investing strategies for the client. Once the customer selects their preferred strategy, the platform will automatically execute trades and periodically re-balance the customer's portfolio in response to the performance of the portfolio of assets and the customers goals. Finally, the customer is free to periodically adjust the information they originally provided should their financial circumstances or risk tolerance change. The platform will adjust the investor's portfolio accordingly. Robo-advisors are growing in popularity for several reasons. For starters, they are cheaper than traditional financial advisers, who triply charged each client an annual fee anywhere between one and two percent of their assets under management. In contrast, robo-advisors charge between 0.15 and 0.5 percent in management fees. Customers are also flocking to robo-advisers because they offer the same or higher performance as traditional advisers. According to the Financial Times and CNBC, between 80 percent and 90 percent of the active managers underperformed their state of benchmark over a period of 10-15 years. Why pay active managers if they perform worse than the market? By utilizing passive investment strategies, robo-advisors can beat active managers, providing higher returns to their customers at a lower price. Finally, robo-advisors are attracting customers who did not meet the minimum net worth requirements that most traditional wealth management firms require. Many robo-advisors don't require a minimum amount to invest, allowing more people to use their services in a take on less financial risk. Now, let's talk about some of the risk associated with robo-advisors. As with any type of financial advice, whether it's provided by a robo-advisor or a traditional financial adviser, consumers face risk of receiving unsuitable investment advice. While human adviser maybe able to mitigate this risk by probing consumers for more information to assess needs, risk tolerance or other important factors, a robo-advisor's ability to mitigate this risk may be based on a discrete set of questions to develop a customer profile. Financial advisers of all kinds can also make inaccurate or inappropriate economic assumptions, perhaps due to a failure to factor and changing economic conditions, which could result in flawed investment recommendations. While human advisers maybe able to mitigate this risk to some degree, based on their ability to adjust to economic conditions, a robo-advisor's ability to mitigate those risks is based on whether it's algorithm has been updated to reflect the most recent economic conditions. Robo-advisory firms can be investment advisers or broker dealers, both of which employ licensed professionals to assist investors with their financial goals. Brokers are paid through commissions for the trades they make on behalf of their clients and are governed by financial industry regulatory authority or FINRA rules. FINRA is a self-regulatory organization that regulates member brokerage firms and exchange markets. Investment advisers are paid either a straight fee for their time or percentage of the assets under management and are governed by Securities and Exchange Commission rules. I should note that many FINRA registered broker dealers are also registered as investment advisers. Investment advisers are held to a higher legal standard than brokers. Specifically, investment advisers owe a fiduciary duty to their clients, which requires advisers to act in the best interests of their clients and put their clients interests above their own. Brokers, on the other hand, are held to a suitability standard, which means that as long as an investment recommendation meets the client's defined need and objective, it is deemed appropriate. In 2016, the Department of Labor proposed a so-called fiduciary rule, which automatically elevated all financial professionals who work with retirement plans or provide retirement planning advice to the level of fiduciary. The rule would effectively hold brokers to the same standard that is currently applied to investment advisers. The fiduciary rule has been controversial from the beginning and it has gone through a lengthy legal challenge. The Department of Labor is currently not enforcing the rule, and it's unlikely it ever will, but this does not mean broker dealers are entirely off the hook. In April of 2018, the SEC released a proposed rule that establishes a new best interests standard of conduct for broker-dealers when recommending a securities transaction or investment strategy to a retail customer, including that the broker-dealer act without placing its own interests ahead of the retail customers interests and disclose and mitigate certain conflicts of interests. If this rule is finalized, it will significantly close the gap between the fiduciary standard that is currently applied to investment adviser and the current suitability standard that applies to brokers. Under the Investment Advisers Act of 1940, in state securities laws, any entity or individual that offers investment advice for compensation generally must register as an investment adviser with the SEC or the states and adhere to various reporting and conduct requirements. Robo-advisors offering wealth management advice would generally be such as the same state federal and state oversight as traditional investment advisers and customers of robo-advisors received the same protections as those of traditional advisers. As mentioned, when providing advice, investment advisers, traditional or FinTech, are considered fiduciary to their clients, which means they owe a duty of care and loyalty to their clients, and they must disclose all actual or potential conflicts of interests and act in their client's best interests. Recognizing that robo-advisors utilize a unique delivery mechanism compared to traditional advisers, the SEC issued guidance to the robo-advisors in 2017 that offered suggestions for how they can meet their obligations under the Investment Advisers Act. This includes suggestions on substance and presentation of disclosures, the provision of suitable advice and effective compliance programs. For the substance and presentation of disclosures, an investment adviser has a duty to make full and fair disclosure of all material facts and to employ reasonable care to avoid misleading clients. This information must be sufficiently specific so that a client is able to understand the investment advisers business practices in complex and interests. Because most robo-advisors interact with their clients solely online with limited human involvement, they need to think critically about how they communicate this information electronically. The SEC knows that robo-advisors, like all registered investment advisers, need to disclose information regarding their particular business practices and related risk, which includes a description of the algorithmic functions used to manage client accounts. These disclosures should be made prior to the sign-up process and easy to understand. For the provision of suitable advice, all investment advisers must make a reasonable determination that the investment advice provided is suitable for the client based on the client's financial situation and investment objectives. Robo-advisors typically acquire this information through the use of a questionnaire and the SEC recommends the following factors to be considered when designing the questionnaire: whether the questions elicit sufficient information to allow the robo-advisor to conclude, that it's initial recommendations and ongoing investment advice are suitable and appropriate for that client based on his or her financial situation and investment objective; whether the questions in the questionnaire are sufficiently clear; and whether steps have been taken to address inconsistent client responses. Finally, the SEC's guidance says that each registered investment adviser is required to establish an internal compliance program that addresses the adviser's performance of its fiduciary and substantive obligations under the Investment Advisers Act. Robo-advisors should incorporate the unique aspects of their business model into their compliance program. For example, robo-advisor's reliance on algorithms they are limited if any human interaction with clients in the provision of advisory services over the internet may create or accentuate risk exposures that should be addressed through written policies and procedures. Similar to the SEC, FINRA recognize that many of the broker-dealers it supervise are beginning to adopt digital investment advice tools. So in 2016, they issued a report reminding broker dealers on other obligations under FINRA rules in sharing effective practices related to digital investment advice, including with respect to technology management, portfolio development and complex of interest mitigation. The FINRA report on robo-advisors focused on the governance and supervision of investment recommendations in two areas: first, the algorithms that drive digital investment tools; and second, the construction of client portfolios, including potential conflicts of interests that may arise in these portfolios. FINRA recommends that robo-advisors should be able to answer the following questions about their algorithms: one, are the methodologies tested by independent third parties? Two, can the firm explain to regulators how the tool works and how it complies with regulatory requirements? Three, is there exception reporting to identify situations where tool's output deviates from it what might be expected to do? If so, what are the parameters that triggers such reporting? FINRA also encourages robo-advisors to have governance and supervision structures in place to review both the customer profiles and pre-packaged portfolios that maybe offered to clients. Robo-advisors are examined just like traditional advisers. In 2018, National Exam Program Examination Priorities document that SEC noted that it will continue to examine investment advisers including robo-advisors that offer investment advice through automated or digital platforms. These examinations will focus on registrants' compliance programs including oversight of computer program algorithms that generate recommendations, marketing materials, investor data protection and disclosure of conflicts of interests. Finally, I should note that state regulators are responsible for conducting examinations of investment advisers that operate in fewer than 15 states. The whole client assets under management are less than $100 million. However, as at the end of 2017, no robo-advisor met these criteria and was therefore regulated solely by the states.
