Robo-advisory firms often build client portfolios with exchange-traded funds (ETFs) and mutual funds.  This makes practical sense – these instruments allow advisers to efficiently meet a wide range of client investment objectives.  Nevertheless, as mentioned in our last post, the SEC’s Division of Exams (EXAMS) has made it a priority this year to focus on advisers’ recommendations of these assets.  Why?

EXAMS recognizes the widespread use of mutual funds and ETFs by advisers for retail client portfolios.  Due to this prevalence, the associated risks are, in the eyes of the Division, elevated.  Here are some of the key concerns voiced by the SEC in its 2021 Examination Priorities Report:

  • Investors may not understand the risks associated with a particular fund. The risk profiles of mutual funds and ETFs vary widely.  Some funds are widely diversified across industries and asset types, while others may be very focused.  Some funds use relatively simple strategies, and others use very complicated or technical strategies.  Robo-advisers, like all investment advisers, have a duty to ensure that investors receive adequate disclosure of the risks involved with these instruments.
  • Funds used in client accounts may not be suitable. As you might recall from Josh’s previous post, all investment advisers, including robo-advisers, must recommend investments that are suitable for a particular client based on the client’s unique financial situation and investment goals.  EXAMS noted that the Division will make it a point to review an adviser’s basis for selecting investments, highlighting that higher risk investments like niche or leveraged/inverse ETFs will be particularly scrutinized.
  • There may be financial conflicts in the selection of certain mutual fund share classes. The report emphasized the Division’s continued focus on an adviser’s selection of mutual fund share classes for retail client portfolios. As many of you remember, the SEC launched an initiative a couple years ago that resulted in settlements with nearly 80 advisers that the SEC found had (i) placed clients in higher cost mutual fund share classes (such costs generally stemming from 12b-1 fees paid to the adviser or an affiliate) when lower-cost share classes of the same fund were available and (ii) failed to adequately disclose that the higher cost share class would be selected.  EXAMS’ report notes that this practice, and the conflicts caused by it, continue to be areas of focus for the Division.

So what does this mean for your robo-advisory firm?  Now is a great time to review the risk disclosures you provide to investors in your firm brochure, on your website, and in other communications you provide to your clients.  Ensure those disclosures are clear, use plain English, and are robust.  In addition, make sure you are adequately assessing a client’s risk tolerance and investment objectives and making recommendations based on that assessment – clients with a conservative risk profile should not be served higher risk investments.  Moreover, recognize that a particular client’s risk profile is likely to change over time, so you should be making this assessment on an ongoing basis.  Finally, if your client portfolios use mutual funds, fully understand the share classes you’re using and select the one that is best for your client.

We hope you’ll join us next time, when Josh will discuss another 2021 focus for EXAMS – advisers’ use of strategies that focus on sustainability, social responsibility, and environmental, social and governance (or ESG) factors. Thanks for reading!