FINRA Issues Report on Digital Investment Advice Tools

FINRA issued a report identifying effective practices that firms should consider when developing and using “digital investment advice tools.”

FINRA highlights five key regulatory principles and effective practices:

  • Governance and supervision of algorithms. This includes initially assessing the methodology of digital tools and the quality and reliability of data inputs, as well as ongoing evaluation such as testing the tools to ensure they are performing as expected, and determining whether models used by a tool remain appropriate as market conditions change;
  • Customer profiling. This includes assessing both a customers’ risk capacity and risk willingness, and addressing contradictory or inconsistent responses in customer-provided information;
  • Governance and supervision of portfolios and conflicts of interest. This includes determining the risk, return and diversification characteristics of a portfolio suitable for a given investor profile, and mitigating – through avoidance or disclosure – conflicts that can arise through the selection of securities for a portfolio;
  • Rebalancing. This includes providing descriptions of how the rebalancing works and procedures that define how the tools will act in the event of a major market movement;
  • Training. Training enables financial professionals to understand the key assumptions and limitations of individual digital investment advice tools, and determine when use of a tool may not be appropriate for a client.

In addition, investors should be apprised of (i) the soundness of the information gathered by the firm, (ii) the investment approach embodied in the digital tools, and (iii) the underlying assumptions used in such advice tools. FINRA cautioned that digital investment advice tools do not necessarily eliminate conflicts of interest, and that investors should understand the services provided by the tools, the costs of those services and how the services will be performed. FINRA stated that the report is not intended to create any new legal requirements or change the existing regulatory obligations of broker-dealers.

Lofchie Comment: This is a thorough and practical report. Although it focuses on providing e-advisory services to customers, much of the discussion is equally relevant to firms that provide personalized advice to customers (e.g., the section that pertains to asking customers about their objectives and potential risks: different results can arise from identical situations). This report should be reviewed by anyone (broker-dealer or adviser) who is responsible for providing advice to customers – or for supervising or monitoring that advice – regardless of how the advice might be delivered.