Financial services firms’ offerings of digital investment advice—also known as ‘robo-advisers’—require sound governance and supervision, including effectively overseeing the suitability of recommendations, conflicts of interest, customer risk profiles, and portfolio rebalancing. That’s the warning in a new report released by the Financial Industry Regulatory Authority.

With global spending on digital wealth management services is expected to increase significantly, the report outlines lessons for investors, stressing that training and education are crucial for financial for financial professionals who use digital investment advice tools.

The report outlines regulatory principles and effective practices in five key areas: ensuring that algorithms at the core of digital investment advice tools are performing as expected and remain appropriate as market conditions change; ensuring the effectiveness of customer profiling, including assessing risk capacity and addressing contradictory or inconsistent responses in customer-provided information; governance and supervision of portfolios and conflicts of interest; rebalancing; and training that enables financial professionals to understand the assumptions and limitations of specific digital investment advice tools to determine when its use may not be appropriate for a client.

A variety of questions are offered in the report for firms that conduct needed reviews and assessments.

Are the tool's methodologies tested by independent third parties?

Can the firm explain to regulators how the tool works and how it complies with regulatory requirements?

Is there exception reporting to identify situations where a tool’s output deviates from what might be expected and, if so, what are the parameters that trigger such reporting?

What training or testing does the firm require before a financial professional may use the tool?

Does the firm review financial professionals’ recommendations that are inconsistent with the tool’s output?

What information is necessary to build a customer profile with sufficient information to make a sound investment recommendation?

How does the tool handle conflicting responses to customer profile questions?

What are the criteria, assumptions and limitations for determining that a security or investment strategy is suitable for a customer?

Does the tool favor any particular securities and, if yes, what is the basis for such treatment?

Does the tool consider concentration levels and, if so, at what levels?

Does the tool permit automatic rebalancing and, if so, what are the triggers for a portfolio rebalancing and how often does it occur?

Does rebalancing include the possibility of adding or removing a particular security, thereby requiring another customer-specific suitability analysis?

Would the rebalancing result in excessive commissions or lead to adverse tax treatment?

“As these services develop, firms need to ensure that the core principles of investor protection – such as understanding and responding to customers' needs and objectives – serve as the foundation of these new tools as well," Richard Ketchum, chairman and CEO of FINRA, said in a statement announcing the report’s availability.

Topics