portfolioIn a previous blog post, we discussed an adviser’s fiduciary duty to provide advice based on the client’s financial situation and investment objectives. In today’s post, we’ll examine the practical implications of this requirement from a compliance prospective.

Craig noted in our last entry that Advisers Act Rule 206(4)-7 (the “Compliance Rule”) requires that every investment adviser adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules. The adopting release for the Compliance Rule includes a list of the critical compliance policies that the SEC expects each adviser to address. The first of these critical policies relates to an adviser’s portfolio management processes.

The most important consideration in developing your portfolio management compliance policy is developing procedures that ensure adherence to the investment profile of each of your clients, including each client’s investment objective, restrictions, and risk tolerance. Moreover, your firm must address how your firm allocates investment opportunities among its clients.

As a robo-advisory firm, you likely have little to no in-person contact with your clients and your firm also likely utilizes a proprietary algorithm for portfolio selection. Given this scenario, your portfolio management compliance policy should focus on:

  1. ensuring that your client intake process is adequately designed to capture each client’s investment profile, including the client’s investment objective and risk tolerance (see our fiduciary duty post on this topic above for more information on this process);
  2. that investment opportunities are allocated equitably among all clients (this not typically an issue for robo-advisory firms given the general availability of offerings, e.g., ETFs, mutual funds, etc.), and
  3. developing procedures for a periodic review of your algorithm to ensure that its security selections remain consistent with each client’s investment profile, as well as any applicable regulatory disclosures or restrictions, especially in light of any relevant market or profile changes that may have incurred since the client’s initial intake.

At minimum, your portfolio management compliance policy should clearly articulate your understanding of the duty to only select securities that are suitable for each client’s specific investment needs, which is accompanied by procedures that detail a regular review and documentation of your investment methodology to ensure compliance with your policy. A best practice would be to conduct periodic sampling tests on the results produced by your algorithm to ensure that they are consistent with each client’s investment profile.

It’s important to note that the compliance procedures designed for any policies related to your portfolio management process need not be rigid. Instead, consider designing your policies and procedures in a manner that allows for necessary flexibility. Market conditions are ever changing. Designing a policy that mandates a yearly review of your algorithm to ensure that it is producing portfolios consistent with client expectations may be adequate in periods of less volatility.  However, in a less stable market environment a more frequent review process to ensure consistency may be required. Your compliance policy should account for such a contingency.

We hope you’re finding our examination of critical compliance policies helpful. Please don’t hesitate to reach out if you have any questions. We continue with this topic series in our next post when Craig discusses trading practices. As always, we thank you for your continued readership!

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