equationWith the deadline for the annual update to Form ADV closing in at the end of March, let’s examine one aspect of Form ADV disclosure which impacts a majority, if not all, robo-advisory firms – algorithm related disclosure.

Your firm likely utilizes a proprietary algorithm to automatically determine client asset allocation among a limited set of investment products. Typically, this is done after a client has provided certain personal information (e.g., personal income, risk tolerance) through an intake questionnaire. While this process is an effective and efficient business model for both your firm and the client, it is critical that you fulfill your fiduciary and regulatory obligations.

One of your primary fiduciary and regulatory obligations is disclosure. As we previously discussed, your firm must register, either federally or with any applicable state, by completing and submitting Form ADV. General Instruction 3 of Part 2 of Form ADV requires you to disclose your obligations as a fiduciary, including all material facts relating to your advisory relationship with your clients and any potential conflicts. For a robo‑adviser this consists of disclosure regarding your algorithm, including, at a minimum:

  • A general statement that an algorithm is used to manage client accounts;
  • A description of how the algorithm is used (e.g., that client accounts are initially invested and periodically rebalanced, if applicable, by algorithm);
  • An explanation of the underlying methodology of the algorithm; and
  • Any involvement by a third-party in the design, maintenance, or ownership of the algorithm (e.g., if the algorithm directs client assets to third-party investment products for which the third party earns a fee).

While much of this disclosure is straightforward, publicly disseminating the underlying methodology of your algorithm presents a potential issue – you don’t want to give away proprietary trade secrets. However, you can meet your fiduciary duty and protect the proprietary nature of your algorithm design at the same time. In describing the methodology of your algorithm, focus on its assumptions and limitations. For example, if the algorithm is based on modern portfolio theory, a description of the assumptions and limitations of that theory would adequately fulfill your fiduciary obligations without disclosing the particulars of investment selection.

Moreover, focus your algorithm disclosure on potential risks, such as any instances when the algorithm may rebalance a client’s account without regard to market conditions. Also consider disclosing any level of human involvement in the management of the algorithm, for instance if there are dedicated personnel overseeing the algorithm but not monitoring individual client accounts.

When preparing your ADV updates this year, take an extra moment to review your algorithm disclosure. And don’t hesitate to reach out if you have any questions.

As always, we thank you for your continued readership. Please check back next time when Craig will discuss tips for making sure, on an ongoing basis, that your algorithm continues to serve your clients the way you intend it to.

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