The feds might be coming after the robots – finally.
Even here, as we start the New Year, I don’t have my hopes up. But I’ll take this good news.
On December 21, the SEC charged the country’s second-biggest robo-advisor, Wealthfront Advisers LLC, and a small defunct robo-adviser, Hedgable Inc., with misleading clients.
According to The Wall Street Journal, the two robo-advisors used “automated tools to create portfolios for clients, rather than relying on people to pick investments and councel customers through decisions,” misled clients by not monitoring accounts to prevent trades that created adverse tax consequences, illegally paid bloggers whose endorsements resulted in account openings, and, in the case of Hedgeable, used only 4% of client accounts to calculate company returns.
Here’s the $200 billion question (researchers at Backend Benchmarking say robo-advising makes up $200 billion of the investment and trading universe): Are do-it-yourself investors who rely on robo-advisors being shortchanged?
Today I’ll give you my answer
Plus, I’ll show you how to protect yourself.
“Washing” the Books
But before we get to what I think, here’s the SEC’s brief against Wealthfront and Hedgeable. Read it carefully – as it lays out exactly how their clients were at risk.
In the Matter of WEALTHFRONT ADVISERS, LLC, f/k/a WEALTHFRONT, INC., Respondent, here’s what the SEC’s ORDER INSTITUTING ADMINISTRATIVE AND CEASE-AND-DESIST PROCEEDINGS said, “The Securities and Exchange Commission (‘Commission’) deems it appropriate and in the public interest that public administrative and cease-and-desist proceedings be, and hereby are, instituted pursuant Sections 203(e) and 203(k) of the Investment Advisers Act of 1940 (‘Advisers Act’) against Wealthfront Advisers, LLC, formerly known as Wealthfront, Inc. (‘Wealthfront’ or ‘Respondent’).
The SEC goes on to allege that Wealthfront, a registered investment advisor that uses a software-based “robo” platform, “applies a proprietary tax loss harvesting program (‘TLH’) to clients’ taxable accounts.” And that Wealthfront assured clients it would “create tax benefits for clients by selling certain assets at a loss that, if realized, can be used to offset income or gains on other transactions, thereby reducing clients’ tax liability in a given year.”
That embedded program in Wealthfront’s software was supposed to prevent clients from violating so-called “wash sale” rules.
By SEC definition, “Generally, a wash sale occurs when an investor sells a security at a loss and, within 30 days of this sale, buys the same or a substantially identical security. A wash sale prevents the tax benefit of having sold the asset to realize a loss.”
Wealthfront posted “whitepapers” on its website for clients that explained and outlined how its tax-loss harvesting worked.
However, the SEC complaint alleges, “From October 2012 through mid-May 2016, Wealthfront falsely stated in its TLH whitepaper that it monitored all client accounts to avoid any transactions that might trigger a wash sale. In fact, until mid-May 2016, Wealthfront did not monitor client accounts to avoid any transaction that might trigger a wash sale. In Wealthfront’s TLH program, wash sales could occur, or were permitted, in certain circumstances relating to the management of a client account such as rebalancing a client portfolio or client directed transactions.”
That means clients who relied on their robo-advisor’s automatic programs to get the benefits of taking some losses on their taxes actually were allowed to violate wash-sale rules, most often without them knowing it. Therefore, they lost their beneficial deductions.
In addition, the SEC claims, “Wealthfront retweeted certain tweets from its clients on its Twitter account that constituted testimonials, which investment advisers are not permitted to publish without required disclosure.”
And that, “Wealthfront also paid bloggers for new client referrals, based on the amount of assets the new client initially deposited, without complying with applicable disclosure and documentation requirements.
“Wealthfront also failed to adopt and implement policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder.”
Of course, Wealthfront was allowed to settle the allegations without admitting or denying the charges and was ordered to pay a piddling fine of $250,000.
Clients weren’t so lucky. Those who violated the wash-sale rules ended up with higher tax burdens thanks to Wealthfront.
Now before we go any further, don’t think I’m casting out high-tech investing entirely. We use a “master algorithm” ourselves at The Money Zone to pile up some pretty big profits.
Then there’s my Money Morning colleague Tom Gentile. He just debuted a trading breakthrough that combines artificial intelligence-based neural networks with blazing processing speeds. It’s early days yet – but I think Tom’s innovation really could lead to a revolution of sorts for DIY investors.
Now the difference between what Tom and I do and what robo-advisors do is accountability. We put our name behind these systems – and we guarantee them.
For his part, Tom is guaranteeing that his new breakthrough will deliver 250 potential double-your-money trades every year. That’s one trade every day the market is open.
But don’t listen to me. Just click here for more – much more – on Tom’s latest innovation.
The Trap on the Horizon
Then there’s Hedgeable…
The defunct robo-adviser that only had $80 million in client assets settled charges that it advertised company returns based on cherry-picking only 4% of client accounts and paid an $80,000 fine.
What DIY investors should be scared of is being shortchanged by robo-advisors who offer automatic, robotic services that flat-out don’t do what they say they’re supposed to do.
They should be worried about being shortchanged when they rely on company-advertised returns and what paid-for bloggers say about how great they are.
Any time investors wade into untested waters, like robo-advisor services and even passive investing vehicles, they better understand how they can get shortchanged in the long run.
On Friday I’ll tell you how passive investors, some of whom do their investing through robo-advisers, are at risk in markets exactly like the one they’re trying to beat now as it threatens to drag them into a dark bear market trap.
I’ll see you back here then.
Meanwhile, I wish all of you a happy – and profitable – New Year.
Pop some Champagne tonight for me. It’s going to be a great year.