SEC’s Gensler takes aim at robo-adviser investing strategies

The Securities and Exchange Commission chairman raised questions about the effect that behavioral prompts — like encouraging clients to trade more often or using algorithms to steer them into high-risk, high-fee products — might have on investing outcomes.

Robo-adviser platforms are coming under the gun again as the latest tech advances attract increased scrutiny from regulators and raise concerns about the possibility of conflicts.

New tools, like artificial intelligence and predictive analytics, have helped robo-advisers better manage money for investors by suggesting personalized financial plans or by recommending new products. The advances also represent areas of conflict and raise important public policy questions, Securities and Exchange Commission Chief Gary Gensler said last week.

The remarks were just one of a handful of recent instances in which Gensler has addressed conflicts in robo-advice platforms specifically. The remarks could signal an increased willingness to bring enforcement actions.

Gensler raised questions about the effects behavioral prompts — like encouraging clients to trade more often or using algorithms to steer them into high-risk, high-fee products — might have on investing outcomes.

“When do behavioral nudges by broker-dealers take on attributes similar enough to recommendations such that related investor protections are needed?” he said during remarks to the agency’s Investor Advisory Committee last week. “The nature of certain steers may create gray areas between what is and isn’t a recommendation — gradations that could be worth considering through rulemaking.”

The main goal for regulators is finding out exactly what these tools are designed to achieve. “Are they solely optimizing for the investor’s benefits, including risk appetite and returns? Or are they also optimizing for other factors, including the revenues and performance of the platforms?” Gensler added.

These algorithms have become a major area of concern for regulators. The SEC recently issued deficiency letters to almost every robo-adviser under the sun, citing shortcomings in how those companies are managing portfolios and disclosing conflicts of interest. The citations could potentially point toward future enforcement actions.

The problems stemmed from robo-adviser compliance policies that didn’t test whether the investment advice they provided matched their clients’ investment objectives, according to the alert.

“Chair Gensler certainly voices a number of valid concerns,” said Scott Smith, director of advice relationships at Cerulli. “It comes down to the terms of engagement and setting rules of engagement on each platform.”

While setting the AI algorithms to maximize firm revenue would be a cut-and-dry violation, other decisions robo-advisers make for their clients can get murkier. For example, should a firm be able to offer investment solutions that include only proprietary options if that information is disclosed? How would algorithms choose between very similar funds if one was created in-house and another by a competitor?

A focus on compliance could be a likely starting point for regulators that take future actions based solely on the grounds of inadequate policies, even if there was no underlying customer harm, said Susan Schroeder, former head of enforcement at the Financial Industry Regulatory Authority Inc. and current vice chair of securities at WilmerHale.

After years of playing catch-up and giving digital upstarts room to develop, regulators are ratcheting up their examination of digital platforms. In February, Wahed, a robo-adviser that operates under Islamic Shariah law, was charged by the SEC with making misleading statements and breaching its fiduciary duty, as well as with compliance failures. In 2019, Wealthfront and the now defunct Hedgeable were the first robo-advisers to ever be sanctioned by the agency.

While compliance is a first step for any firm, the laundry list of problems the SEC identified in its risk alert in November is a warning shot to digital advice platforms and may force firms to make a concerted effort to focus on those areas. The agency could make an example of the worst offenders, Schroeder said.