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ETF investing is a little like stopping by your local bar on “Martini Mondays”…It’s fun, it’s cheap, and all your co-workers are doing it. When you add a menu of discounted automated advice offerings to the party it is easy to get carried away with the fun and forget what Tuesday morning can feel like. There will be another bear market, and I am not sure automated ETF programs will be the right tonic for the hangover. Robo-Advisers and Exchange Traded Funds can be fantastic tools for financial guidance but somehow both strategies have transformed into the girl you take home to mom after the first date. We are smitten.
While the fees and risks of other strategies receive constant attention, “Robos” and especially ETFs seem to get a pass. In my next few blogs I will address some misconceptions regarding Robo-Advisers and Exchange traded funds.

Misconception #1 A Robo-Adviser is able to provide uniquely conflict free guidance by employing passive ETF strategies and algorithms in place of human Advisors.
Not so fast.

There is no such thing as a conflict free Financial Adviser, and Robo-Advisers are no exception to the rule, mainly because humans are almost always very involved in all forms of automated guidance. A Robo-Adviser is often structured as a Registered Investment Adviser, and an Exchange Traded Fund is often structured as an Investment Company able to trade like a stock. For simplicity I will define an Exchange Traded Fund as either an ETF, ETN, or ETMF product, and include passive, active, and alternative beta strategies. For additional clarity I will use the SEC “definition” of a “Robo-Adviser”. According to February 2017 SEC Guidance a “Robo-Adviser” can operate as a standalone company or operate as a business unit of a larger “traditional adviser”; The SEC further clarifies that some Robo-Advisers enable their clients to access its services directly while other Robo-Advisers are “offered as digital portfolio management tools by traditional advisers that view these programs as components of their existing advisory practices.”

No matter how broad or narrow the definitions, ETF based automated advice has some specific conflicts of interest for investors to understand and consider:

1. ETF companies that own Robo-Advisers- This arrangement is the easiest conflict of interest to spot and understand. ETF companies will often acquire or create Registered Investment Advisors to serve as a distribution method for proprietary ETFs. While the Robo-Advisers will often have a different name than the parent ETF firm, the affiliation should be disclosed in SEC form ADVs. Many large well-known ETF companies have affiliated Robo-Advisers’ and this isn’t always all bad for clients despite obvious opportunities for conflicted advice. Investors or Consultants considering these structures must determine whether certain benefits such as lower Advisory management fees for using proprietary ETFs are worth the conflicts of interest in the guidance.

2. The relationship between a Robo-Adviser and the Algorithm- Advisers often use algorithms to provide direct financial guidance and investment advice to clients and institutions. The nature and scope of these conflicts depend on the ownership, development, and management of the advisory software and algorithmic codes. Information is vital for prospective clients to make the appropriate choices on who or what is providing her financial guidance. Some Robo-Advisers own proprietary algorithms in house, some contract with third parties that develop, own, and manage the algorithm, and some Advisers use different ownership and management arrangements for different algorithm based advisory functions. Information on software, algorithms, and potential conflicts should be fully disclosed and easily understood in ADV brochures, websites, and potentially through Advisory Personal. One of many conflicts of interest involving robo algorithms include a third party offering the Robo-Adviser software at a discount in return for the software directing investors to products where the third party receives a fee. Other conflicts of interest involving algorithms can involve issues with fees, trade execution, custodians, performance reporting, and advertising.

3. ETF Revenue sharing payments to financial intermediaries- This conflicted arrangement is one of the hardest to decipher if it is not fully disclosed. ETF revenue sharing payments involve fund affiliates making payments to select broker dealers, banks, and even Registered Investment Advisers for a variety of different services to benefit the fund. The third-party payments can be substantial and can lead to conflicted advice. For example, conflicts of interest emanating from Revenue Sharing can lead to Financial Intermediaries recommending certain ETFs over other ETFs for direct or indirect compensation. An investor may review an ETF prospectus to see language about payments to financial intermediaries for marketing, education and training, conferences, technology and reporting amongst other “services” to the ETF company; Conversely an Investor may see similar language in the ADV of a Robo-Adviser if that Adviser receives revenue sharing payments from ETFs or other entities. Many reputable firms including Robo-Advisers are compensated by ETFs as financial intermediaries, and these arrangements need not be a disqualifying factor for investors. Advisers must be transparent about all third party compensation arrangements that create potential conflicts and be able to answer questions about the nature of the arrangement.

Robo-Advisers and ETFs have conflicts of interest like all forms of financial guidance. Fortunately, Advisers have policies and procedures in place to mitigate conflicts involving various financial products, programs, and strategies. Many firms have voting structures such as Investment Policy Committees to enhance objectivity, reduce regulatory risk, and avoid serious issues. It appears that ETFs will continue to boom with popularity, new Robo-Advisers will pop up to meet demand, and many Traditional Advisory Firms will continue to add financial technology to become more “Bionic”. These exciting advisory and technology shifts provide opportunities for investor education, enhanced guidance, and require due diligence. I will address some opportunities and challenges with ETF trading in my next blog.

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As an Executive Vice President with Planning Solutions Group Paul leads a team of professionals serving affluent clients in the areas of investment, retirement, estate and tax planning. In addition to providing comprehensive planning to his clients, Paul serves as a member of the PSG Investment Policy Committee, where he helps shape firm wide investment policy.

Paul holds the CERTIFIED FINANCIAL PLANNER TM (CFP ®) designation and the internationally accredited CERTIFIED INVESTMENT MANAGEMENT ANALYST (CIMA®) designation, which he completed through the University of Pennsylvania-Wharton Certified Investment Management Analyst executive certification program. Paul graduated with a Bachelor’s degree in Political Science from the University of Richmond.