The world’s largest private sector manager by assets under management, New York City-based BlackRock has a stake in the robo-advisory or algorithm-powered automated investment platforms market, which consultancy KPMG says was managing about $60 billion in assets by the end of last year.
In August of 2015, BlackRock bought Future Advisor, a San Francisco-based retail robo-advisory, for a reported $152 million.
For as much ink that has been spilled on the robo-advisor movement, and for as rapidly as entrants are emerging in the market — more than 80 new automated investment platforms have been introduced in the past two years — robo-advisors represent a drop in the country’s $24 trillion retirement market bucket.
That is expected to change. By 2020, research analytics firm Cerulli Associates estimates robo-advisors will oversee nearly $500 billion in assets.
While regulators have periodically issued guidance and investor alerts relative to robo-advisors, BlackRock’s paper suggests a clearer regulatory framework is necessary.
In May 2015, the Securities and Exchange Commission and the Financial Industry Regulatory Authority issued a joint investor alert. The alert recognized the cost and accessibility value-adds of automated platforms, but also said, “Investors should be wary of tools that promise better portfolio performance.”
BlackRock’s paper mirrors investor alert
Several of the general concerns raised in the SEC’s and FINRA’s investor alert are incorporated in BlackRock’s report.
For instance, the regulators called attention to the underlying investment assumptions applied in the algorithms that power automated investment platforms.
“Be aware that an automated tool may rely on assumptions that could be incorrect or do not apply to your individual situation,” wrote regulators in the alert to investors. “If the automated tool assumes that interest rates will remain but, instead, interest rates rise, the tool’s output will be flawed.”
BlackRock calls for consistent oversight of algorithm designs, and says key assumptions in automated investment equations should be disclosed to investors.
The firm also emphasized the need for investment professionals to be closely involved in the design and oversight of algorithms and platforms, and said testing and control over algorithms should be its own oversight function, separate from those of compliance and internal audit teams. Moreover, when advisors use a third-party’s automated platform, they should be familiar with the investment assumptions built into the algorithms, BlackRock said.
BlackRock also says robos should be governed by clear and well-disclosed suitability standards, fully disclose the risks inherent in the platforms, as well as all costs to investors.
And the extent of discretion the platform has in managing assets, particularly during pockets of market turmoil, should also be disclosed. Some robo-platforms have tools to address liquidity and halt trading on accounts during market swoons or other unexpected events, according to BlackRock’s paper.
During the recent market turmoil following the Brexit vote in the United Kingdo., robo-advisory Betterment suspended trading on its platform for several hours, while other automated providers remained open for business.
BlackRock’s paper also calls for strong oversight of trade executions, and state-of-the-art cybersecurity protections, including data encryption and strict monitoring of third-party platform providers.
FINRA’s report shows potential chinks in robo armor
Last March, FINRA issued an independent report on the robo-advisory industry, which was considerably more in depth than the authority’s previous co-issued investor alert.
The report cited data from Cerulli showing that robos greatly vary in their approach to risk management.
The equity exposure for a hypothetical 27-year old ranged from 50 percent to 90 percent between seven platforms. One firm had 15 percent allocated to real estate, while two had zero real estate exposure. Another firm had 14 percent allocated to commodities; another had 8.5 percent allocated to cash. Five of the eight platforms had zero allocation to cash.
The FINRA report also showed that some of the questionnaires robos use to assess an investor’s risk tolerance fall short of existing rules governing the suitability standard for recommending investments.
Under rules governing brokers and advisors, FINRA’s “suitability” and “know your customer rule” lay out a minimum of nine questions advisors must ask regarding an investor’s risk tolerance and investment experience before determining if an investment is suitable.
The robo-platforms reviewed by FINRA in its March report showed platforms used between four and 12 questions, suggesting some platforms use too little information in determining an investor’s risk tolerance, according to the report.
Sometimes investors give contradictory answers to suitability assessments, noted FINRA’s report. In a traditional context, advisors can probe investors for further information in the event their answers contradict one another.
That can be more difficult in an automated context. FINRA noted instances of some robo-platforms averaging contradictory responses, which could potentially lead to putting investors in a portfolio that exceeds their risk tolerance, the report said.