Robo-financial advisors, commonly known as robo-advisors, merge profound financial expertise with cutting-edge technological innovation to offer automated and sophisticated investment strategies. Since their inception, these digital platforms have transformed the accessibility of professional investment advice, extending it beyond high-net-worth individuals to a more diverse audience.
Several studies have indicated that the utilization of robo-advisors aids in rectifying behavioral biases frequently observed in investors. For instance, Back et al. (2023) suggests that the availability of investment advice from a robo-advisor can mitigate the disposition effect, a phenomenon where investors hold on to losing assets for too long and sell winning ones too early. Specifically, investors who can access investment advice from a robo-advisor are less hesitant to divest assets at a loss when compared to investors without such access. Nevertheless, it’s crucial to highlight that the influence of robo-advisors on investor behavioral biases constitutes a developing area of research with varying outcomes.
Robo-advisors, efficient at automating programmable tasks in investment management and financial planning, have notable limitations in handling non-programmable tasks. These limitations stem from their lack of cognitive abilities, emotional intelligence, and adaptability to unique or complex situations. Robo-advisors cannot engage in tasks that require subjective judgment, ethical considerations, or an understanding of human emotions. Additionally, they struggle with comprehensive financial planning and cannot provide the emotional support that human advisors can offer. While robo-advisors serve a valuable purpose in streamlining programmable financial tasks, they are complemented by human advisors who excel in addressing the intricacies of non-programmable financial challenges. Another limitation is that while robo-advisors offer diversified portfolios, they may not provide access to certain niche investments or alternative asset classes that can be part of a comprehensive investment strategy.
Regulation and Investor Protection
The discussion surrounding investor protection in the context of robo-advisors often centers on their ability to effectively fulfill fiduciary obligations. Fiduciary duties encompass acting in the best interests of clients, offering suitable investment advice, and disclosing any conflicts of interest. While robo-advisors bring accessibility and cost-efficiency to the table, concerns arise regarding their capacity to fully understand the intricacies of individual investors’ financial circumstances and provide personalized advice aligned with their best interests.
These concerns are substantiated by instances of fiduciary duty breaches. Notably, the Securities and Exchange Commission (SEC) charged New York-based robo-adviser Wahed Invest, LLC, with multiple violations, including misleading statements and breaches of its fiduciary duty. As per the SEC’s order, Wahed Invest falsely claimed the existence of proprietary funds and pledged rebalancing of advisory accounts, which it failed to execute between September 2018 and July 2019. The order also revealed that upon launching its proprietary ETF in July 2019, Wahed Invest utilized client advisory assets to seed the ETF without prior disclosure of conflicts of interest. Wahed Invest consented to a cease-and-desist order, a $300,000 penalty, and additional measures without admitting or denying the SEC’s findings.
While many argue that robo-advisors may struggle to fulfill the fiduciary obligations of an investment adviser, Ji (2017) contends that addressing robo-advisor duty of loyalty issues can be achieved through carefully programming algorithms and implementing heightened disclosure requirements. The key lies in ensuring that these algorithms remain impartial and unbiased, refraining from reflecting a firm’s inherent conflicts of interest. Human designers of robo-advisor algorithms may inadvertently be influenced by their firms’ incentives, potentially leading to subconscious biases in algorithm design that favor the firm’s interests over those of the client. Therefore, it is crucial to prioritize algorithms that are designed to serve the client’s best interests, safeguarding the integrity of the fiduciary duty.
There is also an emerging strand of research that delves into investor protection issues by examining the necessary regulatory changes in the future. For instance, Fein (2017) posits that the regulatory landscape for robo-advisors hinges on the actions taken by the SEC in line with the Dodd-Frank Act. Should the SEC not establish a uniform fiduciary standard, fail to reconcile existing regulatory frameworks for investment advisers and broker-dealers, or neglect to address how the robo-advisor model fits within these frameworks, uncertainties will persist concerning whether robo-advisors are receiving sufficient regulation in the best interests of investors.
Disclaimer: The Content is for informational purposes only. You should not construe any such information or other material as legal, tax, investment, financial, or other advice.
References:
Back, C., Morana, S., Spann, M. (2023) When do robo-advisors make us better investors? The impact of social design elements on investor behavior, Journal of Behavioral and Experimental Economics,103,101984
Fein, Melanie L., How Should Robo-Advisors Be Regulated? Unanswered Regulatory Questions (September 12, 2017). Available at SSRN: https://ssrn.com/abstract=3028266 or http://dx.doi.org/10.2139/ssrn.3028266
Ji, Megan, Are Robots Good Fiduciaries? Regulating Robo-Advisors Under the Investment Advisers Act of 1940 (October 12, 2017). Columbia Law Review, Vol. 117, No. 6, 2017, Available at SSRN: https://ssrn.com/abstract=3036722 or http://dx.doi.org/10.2139/ssrn.3036722
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