Your Robo-Advisor May Have a Conflict of Interest

Algorithms are designed by humans - or even by other algorithms designed by other humans. Those humans have strategies to support, goals to meet and bosses to please. Technologically driven or not, there is no such thing as the proverbial 'honest broker' of investment ideas. JL

Hugh Son reports in Business Week:

Some of the big banks’ new algorithmic programs may favor funds from companies that pay the banks millions of dollars for access to their wealthy clients. The payments, according to (internal) disclosure, “present a conflict of interest to the extent they lead to focus on funds from those fund families that commit significant financial and staffing resources to promotional and educational activities.”
Robo-advisors offer the promise of impartial investment guidance, but the newest ones may not be totally immune from Wall Street’s ways. Wealth management units at big U.S. banks including Morgan Stanley and Bank of America Corp. have rushed to build so-called robo-adviser services. The products, which were pioneered by online upstarts Wealthfront Inc. and Betterment LLC, use algorithms to pick investments tailored to a customer’s appetite for risk. They cut out a lot of the costs of working with flesh-and-blood financial advisers, and, it would seem, some of their biases.
But it turns out that even software-based financial advisers can have conflicts of interest. Banks still employ armies of advisers and get payments from fund companies that want access to those advisers’ clients. There’s a risk that the banks’ robo programs could favor mutual funds and exchange-traded funds from companies that make such payments, according to disclosures by the banks.
The practice is known as revenue-sharing, or paying for shelf space. It includes sponsoring conferences for bank employees at luxury resorts and lavishing top brokers with gifts and entertainment. Vanguard Group, whose popular low-cost ETFs are the main funds used by Wealthfront and Betterment, refuses to make such payments. Morgan Stanley in May dropped Vanguard from the lineup of funds its advisers offer; it said at the time it was weeding out funds that were less popular with its clients. Many other asset managers, including BlackRock Inc. and Legg Mason Inc., choose to pay.

Some fund companies pay Morgan Stanley up to $550,000 for expenses such as sponsoring seminars

The trend started about two decades ago, according to John Strauss, chairman of FallLine Securities LLC and a former wealth management executive at UBS Group, JPMorgan Chase, and Morgan Stanley. “When I’m a client of one of those firms, I think I’m seeing the best ideas,” says Strauss, whose business helps advisers go independent from big brokerages. “Really, what you’re seeing are the ideas they have arbitrarily decided they can make enough money on to show you.”
In June, Morgan Stanley, which calls itself the world’s biggest brokerage, released details about its robo-adviser ahead of a planned launch later this year. Its version of the service has a layer of human decision-making: A global investment committee will set asset allocations for model portfolios; other employees will pick funds that go into them. Morgan Stanley said in the disclosure that some fund companies provided it as much as $550,000 per year for such things as sponsoring seminars or paying the meal, travel, and hotel expenses of brokers attending sales events. Companies may also pay the bank as much as $500,000 a year for data about mutual fund sales and as much as $550,000 for ETF data. More than 120 companies participate in revenue-sharing with the bank, according to a separate filing.
The payments, according to the bank’s disclosure, “present a conflict of interest for Morgan Stanley to the extent they lead us to focus on funds from those fund families that commit significant financial and staffing resources to promotional and educational activities.” Morgan Stanley said it would provide objective investment advice, and that this conflict is mitigated because employees don’t get extra compensation to recommend funds from favored providers.
Bank of America, a big player in wealth management under the Merrill Lynch brand, made similar disclosures for its digital advice service in March. While it didn’t say how much investment management companies paid for training meetings and client events, it disclosed a laundry list of charitable donations and other gifts and payments companies make to the bank. It said it adopted policies to prevent the payments from affecting its advice. The bank’s robo service picks low-cost ETFs similar to those in other robos, including some from Vanguard. Wells Fargo & Co., which is also planning a robo-advising service, made a similar disclosure. Wells Fargo, Morgan Stanley, and Bank of America declined to comment for this story.
Strauss has a dim view of the industry training events, which he says are mostly perks banks use to reward their top brokers. “I don’t need a boondoggle to some resort in Palm Beach to help me understand the value of a money manager,” he says.

Why would a practice rooted in rewarding human brokers bleed into services driven by algorithms? It may be hard to cleanly separate one business from another. Brokerages building robo-services are piggybacking off their existing infrastructure, says Kendra Thompson, a managing director at consulting company Accenture Plc. Even as some clients shift their money toward robos, she says, big brokerages are going to be conservative about shaking up their existing, profitable business model—using people to sell investments to other people.