Online Advisors: Stand-Alone Investment Managers or Tools for Portfolio Managers?
Online advisors are on the rise. Several well-known institutes predict that by 2020, they will manage between US$2.2 trillion to US$3.7 trillion in assets. Thanks to their relatively low cost and easy online accessibility, online advisors are seen to be closing the so-called “advice-gap” by appealing to millennials (ages 18-34) – the same group that is largely disconnected to traditional investment advisors but who are expected to control more than half of U.S. retail assets within the next 15 years[i].
Online advisors are becoming increasingly popular and are transforming the wealth management industry. However, while there has been much discussion about the threat posed by online advisors to traditional industry participants, the trend being witnessed is that online advisors are acting in a complementary manner to traditional investment management platforms. Indeed, the current regulatory framework for online advisors in Canada suggests that online advisors remain some way away from replacing traditional investment management. Rather, Canadian securities rules at present contemplate traditional investment managers using online advisors as tools in order to reach new clients and to simplify investors’ experiences.
What are Online Advisors?
Online advisors are digital wealth managers. They use information that an investor provides, usually through an online questionnaire, in order to create an investment recommendation. The information used can include such indicators like tolerance for risk, current financial circumstances or specific financial goals (for example, buying a home, saving for retirement or investing for a child’s education).
Different online advisors have different approaches to investing and offer different investment products. Some online advisors are programmed with a set portfolios, which cannot be customized, that are recommended based on an investor’s answers to a questionnaire. Other online advisors focus on a limited range of products, such as exchange-traded funds. Still others may recommend investing in emerging market funds or smaller companies – investments that could potentially be more volatile. Some online advisors have not been tested under stressed market conditions.
Regulation of U.S. vs Canadian Online Advisors
U.S. Online Advisors
In the United States, online advisors vary from models that require no human interaction to hybrid models that connect the investor with a human investment professional who can assist with the investor’s portfolio. Completely automated online advisors may be able to provide personalized investment services at a lower cost by limiting the expenses associated with a human portfolio manager (“PM”).
Firms that provide investment advisory services in the United States are generally registered as investment advisors with the Securities and Exchange Commission (“SEC”) and other state securities authorities. As a result, online advisors must comply with the same securities laws applicable to other investment advisors even though they provide an automated service. For example, online advisors, like traditional investment advisors, are required to file a Form ADV – a uniform form used to register with both the SEC and state securities authorities. A firm that offers an online advising service may also be affiliated with a broker that can execute the online advisor’s recommendations by buying or selling specific securities for the investor’s account. That broker may be subject to additional regulatory requirements. Ultimately, online advisors have several regulations with which they must comply before offering investment services in the United States.
As an example, investment advisors are required to meet certain obligations under the Investment Advisers Act of 1940 (the “Advisers Act”). On behalf of the SEC, Staff of the Division of Investment Management, in coordination with Staff of the Office of Compliance Inspections and Examinations, have been monitoring how online advisors meet the substantive and fiduciary obligations outlined in the Advisers Act. The SEC published an investment management guidance update in February 2017 describing statutory compliance requirements for online advisers, focusing in particular on requirements under the Advisers Act. In the guidance update, Staff pinpointed three areas in which most online advisors can improve in order to comply with these statutory requirements:
The substance and presentation of disclosure to clients about the particular online advisor and the investment advisory services it offers;
The obligation to obtain information from clients to support the online advisor’s duty to provide suitable advice; and
The adoption and implementation of effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice.
The update concluded that while online advisors have the potential to make investment advisory services more affordable to retail investors, online advisors must be mindful of their fiduciary and substantive requirements under the Adviser’s Act. In February 2017, the SEC also published an investor bulletin focusing on online advisers in order to “educate investors about [online advisers], and to help investors using [online advisers] to make informed decisions in meeting their investment goals.”
Canadian Online Advisors
In Canada, regulation of online advisors is arguably more strenuous than in the United States. Notably, regulators require online advisors to fulfill the same registration and conduct requirements as regular PMs, including know-your-client and suitability obligations. This means that Canadian online advisors must operate on a “hybrid” model in which an online program is used for efficiency but which ultimately leaves decision-making to a human advising representative (“AR”). This is because the registration and conduct requirements cannot be fulfilled by a purely automatic service – a human advisor has to assess the client. Moreover, online advisors are held to the same fiduciary like standard as traditional advisors.
One source of guidance for online advisors is a notice published by the Canadian Securities Administrators (“CSA”) – CSA Staff Notice 31-342: Guidance for Portfolio Managers Regarding Online Advice (“CSA Notice 31-342”). CSA Notice 31-342 notes: “[t]here is no “online advice” exemption from the normal conditions of registration for a PM”. The CSA explains that before implementing an investment service, the firm operating the online advisor must file substantial documentation. The AR behind the online advisor then needs to ensure the portfolio proposed by the software for the client is in fact suitable. Once the portfolio is selected, a PM then needs to ensure that the client’s investments are in line with the initial model portfolio that had been approved. This could include manually rebalancing the client’s portfolio where appropriate. These guidelines suggest that Canadian securities regulators view online advisors to be an online platform through which PMs can provide investment services and not a stand-alone wealth management service.
Only online advisors with a “current registration” with the CSA are allowed to advise or deal in securities in Canada. For such registrants, the CSA delineates “custom” terms and conditions that are meant to ensure the registrant’s compliance with securities regulation. For example, in Ontario, Wealthsimple Inc. is subject to custom terms and conditions as an advisor, including restrictions on the use of margin, short-selling, or a leveraged investment strategy in a client’s managed account when the know-your-client questionnaire does not include discussions between registered ARs and clients. Wealthsimple is also subject to custom terms and conditions as an advisor in the portfolio manager category including:
a requirement to retain, at its own expense, the services of an independent consultant to carry out the terms and conditions specified;
the implementation of a plan approved by the Ontario Securities Commission (“OSC”) to: (i) strengthen Wealthsimple’s compliance system; (ii) prepare and assist Wealthsimple in transitioning to implement the restrictions noted above; and (iii) ensure that clients of Wealthsimple existing prior to the effective date of the terms and conditions have had meaningful discussions about what the terms and conditions entail; and
a requirement for the independent consultant to submit progress reports to the OSC related to the implementation of the terms and conditions.
Another source of guidance for some online dealers is the Investment Industry Regulatory Organization of Canada’s (“IIROC”) Notice 18-0076 which applies to “order execution only” (“OEO”) services offered by its dealer members. OEO services are different from other online dealer services: OEO firms provide clients with an online trading platform that allows them to trade in securities independently without any recommendations or suitability assessment from the OEO firm itself. In fact, IIROC OEO regulations prohibit OEO firms from providing any recommendations to clients. As long as OEO firms comply with this prohibition, IIROC rules exempt the OEO firm from certain regulatory requirements applicable to other dealer members. OEO firms are still subject to some IIROC requirements such as certain know-your-client requirements. Notice 18-0076 sets out guidelines to assist OEO firms in complying with regulatory requirements, such as guidelines on what constitutes a “recommendation”. For example, recommendations could include actions on social media such as re-tweeting, “liking”, or sharing a third-party post.
Do Canadian Online Advisors Comply with the Regulatory Guidelines?
In early 2016, the OSC began a series of compliance reviews of Ontario-based online advisors. The reviews were meant to determine, among other things, whether the registrant complied with relevant provisions of Ontario securities law, terms and conditions of registration (if applicable) and CSA Notice 31-342. The OSC summarized its findings in a July 2017 report, the Annual Summary Report for Dealers, Advisors and Investment Fund Managers.
Among the findings were various deficiencies among online advisors including:
inadequate know-your-client questionnaires;
failure to maintain evidence that the model portfolio had been reviewed and approved;
failure to maintain evidence of meaningful discussion with clients prior to opening an account; and
failure to provide notice to the OSC when there was a material change to the online advisor’s business model.
As a result of the compliance reviews, the OSC issued deficiency reports, warning letters, and imposed terms and conditions on several registrants. The OSC reminded potential online advisors of their obligations to comply with CSA Notice 31-342 and to submit their plans to the OSC for review prior to launch.
These compliance reviews indicate that online advisors are not immune to regulations applicable to regular investment management services. So long as these regulations apply, online advisors in Canada may continue to rise in popularity but will not completely replace traditional portfolio management.
Regulatory Implications of Technological Innovation
While the use of technology can lower the cost of investment advisory services, the introduction of algorithmic technology or other forms of artificial intelligence into the investment advice process introduces new risks to investors which raise questions such as:
Do the creators of the technology have adequate understanding of security analysis and drivers of the capital markets?
Do the registered advisors have adequate training and understanding of the how the technology works?
Do investors understand how to properly provide the informational inputs?
Is the technology free of bias or has it been programmed to make decisions that improperly benefit conflicted parties?
It remains to be seen how regulators respond to the role of the technology in the investment decision making process and whether the introduction of technology as an integral element of the investment decision making process requires refinement to existing licensing and operational regulations.
For more information about our firm’s Fintech expertise, please see our Fintech group’s page.
[i] Deloitte, “The Digital Wealth Manager of the Future”, p. 3: https://www2.deloitte.com/us/en/pages/consulting/articles/the-digital-wealth-manager-of-the-future.html