What is the appropriate level of regulatory oversight for a robo-advisor? As federal agencies struggle with the question, the Financial Industry Regulatory Authority (FINRA) published a new report reminding companies offering digital investment advice that the agency's rules still apply to new technology.

What happened

Technology has been a driving force in financial services innovation, FINRA recognized, with digital investment advice tools a growing product in the industry. Leveraging regulatory experience and discussions with a range of financial services firms, the regulator published a Report on Digital Investment Advice to guide companies using the new technology.

"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. "We trust that the report will provide information and guidance for FINRA member firms and investors about key aspects of the rapidly growing arena of digital investment advice."

The report discussed two forms of digital investment advice tools: financial professional-facing tools (used by a firm's professionals) and client-facing tools, also known as robo-advisors. The robo-advisors create an automated portfolio after a client responds to a detailed questionnaire, answering questions about its risk tolerance and investment objectives.

While not establishing any new legal requirements, the report offered guidance to financial institutions in five key areas of regulatory principles and effective practices.

Of great importance: the governance and supervision of algorithms, FINRA said. Algorithms are "core components" of digital investment advice tools and their use must be evaluated at every stage of the process, from an initial assessment of the methodology of digital tools and the quality and reliability of data inputs to an ongoing evaluation (testing the tools to ensure they are performing as expected, for example) and determination of whether the models used remain appropriate in light of market changes.

The individuals responsible for supervising the tool should be identified as part of an effective governance and supervisory framework, the report suggested. Firms should also be able to explain to regulators how the tool works and complies with regulatory requirements, FINRA said.

Customer profiling also raised concerns for FINRA. "Understanding a customer's investment objectives and the specific facts and circumstances of the customer's finances—developing an investor profile—is essential to providing sound investment advice," according to the report. "FINRA believes that core principles regarding customer profiling apply regardless of whether that advice comes from a financial professional or an algorithm."

Effective practices with regard to customer profiling include identifying the key elements of information necessary to profile a customer accurately, assessing both a customer's risk capacity and risk willingness, resolving contradictory or inconsistent responses in a customer profiling questionnaire, assessing whether investing (as opposed to saving or paying off debt) is appropriate for an individual, and contacting customers periodically to determine if their profiles have changed.

While interaction with a financial professional can help resolve issues, the report advised consideration of whether the digital advice tools are designed to collect and sufficiently analyze all of the required information about customers to make a suitability determination, resolve conflicting responses to customer profile questionnaires, and match an investment profile to a suitable securities or investment strategy.

For firms, the next area of focus for digital investment advice tools should be the governance and supervision of portfolios and conflicts of interest, FINRA said. The construction of portfolios may raise concerns about conflicts of interest, including the risk, return and diversification characteristics of a portfolio that is suitable for a given investor profile.

How to mitigate such problems? Establish a review mechanism to determine the characteristics (such as return, credit risk, and diversification) of a portfolio for a given investor profile with criteria for including securities in the firm's portfolios, selecting the securities that are appropriate for each portfolio (keeping an eye on the algorithms), monitoring pre-packaged portfolios to assess if they are appropriate for the investors to which they are offered, and identifying and mitigating conflicts of interest that may result from including particular securities in a portfolio.

Rebalancing portfolios should be a priority for firms, FINRA said. The most effective practices include a written description of how the rebalancing works, accompanied by a description of the procedures that define how the digital investment tools will act in the event of a major market movement. Explicit customer intent should be expressed for automatic rebalancing, the regulator added, with customers informed of the potential cost and tax implications.

Digital tools may execute numerous rebalancing trades depending on threshold limits and the frequency of rebalancing reviews, the report noted. Firms should assess potential issues by understanding the triggers for a rebalancing by the tool and whether the rebalancing includes the possibility of adding or removing a particular security that would require another customer-specific suitability analysis.

Finally, FINRA discussed the need for training, which is "crucial" for individuals who use digital investment advice tools. "Some of the financial professional-facing tools FINRA observed can deliver sophisticated analytics, but using them effectively and communicating with clients about their output is dependent on the financial professional understanding the assumptions that go into the analytics and the potential limitations on the results," the report cautioned.

Financial professionals should receive education on the permitted use of digital investment advice tools, the key assumptions and limitations of individual tools, and when use of a tool may not be appropriate for a client, the regulator advised. Most firms require their professionals to undergo training before they are permitted to use a digital investment advice tool, and third-party vendors often offer training sessions for financial professionals, FINRA said.

Why it matters

"Digital investment advice tools will likely play an increasingly important role in wealth management, and investor protection should be a paramount objective as firms develop their digital investment advice capabilities," FINRA concluded its report. "Firms need to establish and maintain an investor protection foundation that accounts for the considerations raised by digital investment advice. One key element of that foundation is understanding customer needs. Another is using tools with sound methodological groundings, and a third is understanding those tools' limitations. FINRA trusts that the effective practices outlined in this document will help firms advance investor protection objectives in their use of digital investment advice tools." Firms using digital investment advice tools should look to the report for guidance and track the best practices set forth by the regulator or face the potential for examination issues or enforcement actions.

To read FINRA's Report on Digital Investment Advice, click here.