But just because these services are rapidly gaining popularity, does not necessarily mean they pass muster with all regulatory agencies. And although they appear capable of meeting fiduciary duties outlined by the SEC, not all do, meaning that investors should think twice before saying goodbye to their human financial advisers, or at least be mindful in choosing among robo-adviser alternatives.

Robo-advisors, like traditional financial advisors, are required to act in the best interests of their clients.⁵ The Investment Advisers Act of 1940 and analogous state statutes lay the groundwork for these fiduciary duties. While the SEC has not specifically defined the “contours of the fiduciary duty of investment advisers,” acting in the best interests of a client means to conduct “some degree of portfolio analysis when providing investment recommendations.”⁶ The Act defines an investment advisor as any person engaged in the business of advising others as to the value of securities or as to the advisability of investing in, purchasing, or selling securities. To satisfy the “best interest” standard, three conditions must be met: (1) the advisor must disclose any conflicts of interest that may prejudice his advice; (2) the advisor must seek the lowest-cost execution of securities trades; and (3) the advisor must provide “suitable” recommendations that have a reasonable basis in the client’s specific financial situation. Most, if not all, robo-advisors are registered investment advisors and therefore subject to these fiduciary standards.

1. The Debate: As Fiduciaries, Can Robo-Advisors Meet Their Obligations?

a. Do Robo-Advisors Disclose Conflicts of Interest?

Investment advisor conflicts are governed through a “disclosure-based” regime rather than a “merit-based” one, meaning that the “SEC can compel disclosure about transactions…but…it cannot evaluate their economic merits or require them to be restructured in accordance with some legal conception of fairness.”⁷ This means that investment advisors can have interests not in line with their clients’ interests – e.g., salary, bonuses, or personal relationships, provided such interests are disclosed.⁸

Robo-advisors are capable of meeting this aspect of their fiduciary duty, and some experts have even argued that, because of the automated nature of these services, robo-advisors can more easily avoid conflicts of interest when compared with their human counterparts who may “push investments that pay the highest commissions.”⁹ One indicator that a robo-advisor is not conflicted is if they sell products that are not their own. For example, Betterment, an online investment company, does not make their own products and uses this fact to promote their services.¹⁰ Jon Stein, Betterment’s CEO said, “[w]e believe that independence from the funds that we recommend is an important part of being a fiduciary, being aligned with our customers and doing what’s in their best interest.”¹¹

b. Do Robo-Advisors Identify the Lowest-Cost Services?

Seeking the “lowest-cost execution” means that an investment advisor must seek to ensure that the client’s total costs are the most favorable under the circumstances.¹² These considerations can include transaction costs, execution capacity, financial solvency of a brokerage firm, and the value of any research.¹³ According to the SEC, “the determinative factor is not the lowest possible commission cost but whether the transaction represents the best qualitative execution for the managed account.”¹⁴ Because this is a continual duty, if the robo-advisor is periodically reviewing its method for executing client transaction, it is capable of fulfilling this duty.¹⁵ Notably, the SEC does not strictly enforce this element, and it generally will not take action unless advisors are failing to best execute in order to benefit themselves.¹⁶

c. Do Robo-Advisors Provide “Suitable” Recommendations?

In 1994, the SEC proposed a rule on suitability that could have clarified the suitability requirement, and while the rule was never formally adopted, it does provide some insight into the requirement. To fulfill their fiduciary duty to provide suitable advice, advisors have to “make a reasonable inquiry into a client’s financial situation, investment experience and investment objectives”¹⁷ This “inquiry” can include obtaining a client’s current income, investment assets and debts, marital status, insurance policies, and financial goals.¹⁸ The SEC’s February 2017 IM Guidance Update reiterates that an “investment adviser’s fiduciary duty includes an obligation to…provide only suitable investment advice...based on the client’s financial situation and investment objectives.”¹⁹

To create personalized investment portfolios, robo-advisors ask consumers their age and other questions relating to risk tolerance, goals, and time horizon. The answers are then run through an algorithm, and a risk level ranging from conservative to aggressive is assigned. Based on that, the robo-advisor presents the consumer with a variety of investments meeting the consumer’s criteria.²⁰

Critics argue that the electronic questionnaires utilized by robo-advisors to gather client information cannot satisfy this fiduciary function, because only limited information about investors’ investment needs and risk tolerance is obtained. But the same can be said for human advisors, where it is incumbent upon them to elicit the proper information from their clients. If the robo-advisor asks the proper questions, it’s as capable of fulfilling the suitability requirement as humans. In fact, the Investment Advisers Act does not direct how much information must be obtained from a consumer in order for an advisor’s recommendation to be deemed appropriate. Also, because robo-advising platforms are based on computerized algorithms, some argue that they cannot be induced to make illegitimate deals.²¹

2. The Verdict: Robo-Advisors Meet the Fiduciary Requirement But May Not Be The Best Option

Although many critics may feel threatened by the new technology, robo-advisors are capable of meeting fiduciary duties. However, just because robo-advisors can meet fiduciary standards doesn’t mean they always do. In fact, as recent as December 21, 2018, the SEC settled cases against two robo-advisors — Wealthfront Advisers LLC and Hedgeable, Inc. — for making false statements about investment products and publishing misleading advertising. These actions were the first enforcement actions against automated investment advisors to date.²² While the companies neither admitted nor denied the accusations, Wealthfront is being forced to pay a $250,000 penalty and Hedgeable must pay $80,000.

So, although on its face a robo-advisor may seem like a more convenient and less expensive option, it is just as important to do your research before investing your money with an automated investment advisor as it is when investing with a human financial advisor.