Controlling Trading Behavior Is a Slippery Slope for Advisers

On Friday, 24 June 2016, the robo-adviser Betterment suspended trading between 9:30 am and noon. The reason? The firm didn’t want its clients trading blindly into extraordinary Brexit-related volatility until order and liquidity returned to the market.

Some investment professionals were critical, calling Betterment’s actions impulsive and overly paternalistic. Others felt that the firm’s behavior was both sensible and prudent.

Trading Restrictions

The New York-based company’s decision has sparked a discussion on the role of automated financial advisers. It also has the investment community questioning whether any financial adviser should exert such wide-ranging control over client accounts. How much influence should investment advisers exercise over their clients’ trading activity if it is perceived to be in their clients’ best interest? Should any firm be able to limit the ability of clients to trade without first receiving explicit authorization?

During the suspension, Betterment informed its institutional clients about the trading halt and the rationale for it but never advised its retail clients. Although there has been some criticism about the firm’s failure to keep their retail customers in the loop — a situation that CEO Jonathan Stein, CFA, admits needs to be rectified in the future — Betterment’s client agreement does not “guarantee access to the website and account management . . . all the time.” Moreover, that access may be “limited or unavailable during periods of market volatility, peak demand, systems upgrades, maintenance or for other reasons.”

In fact, the firm is often praised for suspending trading every day during the first hour of trading, the so-call “amateur hour,” which is often characterized by increased volatility and bid-ask spreads.

Inconsistent Actions

Whether Betterment’s decision was impulsive or prudent, none of its competitors halted trading, nor had Betterment suspended trading before, not even on days characterized by similar or perhaps even greater volatility than 24 June.

The company’s actions underscore several issues. Since Betterment’s client agreement does not specifically spell out the factors that would cause a trading halt, clients have no way to judge what sort of conditions could trigger one or would indicate that a suspension was to be lifted.

In what situations would Betterment provide clients with liquidity during a period of continued market declines? What happens when clients are adamant about liquidating all or a portion of their portfolios in order to ride out perceived increases in market risk?

Clients’ Interest

Much to his credit, Stein appeared on CNBC’s Fast Money to explain the reasoning behind the trading suspension, noting that Betterment’s clients are long-term investors and that protecting them from volatility, increased market risk, and bad trade execution should be in their best interest and part of the firm’s fiduciary duty.

During the show, however, the hosts also mentioned that allowing clients to buy during a market decline may have also been in the clients’ best interest and pushed back on what could be construed as inconsistencies with Betterment’s approach in other trading situations. Since the firm is trying to protect clients from selling into volatility and a significant down market, shouldn’t they also protect clients from buying into volatility and a significant opening rally?

Determining whether Betterment’s actions were correct may depend on what you believe the firm’s role to be. Does Betterment provide a suggested investment strategy and course of action? Or is it a professionally managed investment vehicle, like a target date fund (TDF), over which the investment professional has full control of all strategic and transaction decisions?

Professional Opinion

For some sense of how much control investment advisers should assume over client accounts, we asked readers of CFA Institute Financial NewsBrief for their input.

Should financial institutions limit the trading activities of clients in response to market events without first receiving explicit authorization from clients?

Of the 644 readers who responded to the poll, the overwhelming majority (66%) believe that advisers should never limit the trading activities of their clients without their permission.

Slightly more than a third (34%) of respondents felt that there are situations when advisers should limit their clients’ trading behavior either because of an extraordinary situation (15%) or when they feel that it is in their clients’ best interest (19%).

Setting Limits

The results of the poll highlight how importance it is that both clients and investment professionals have a solid understanding of each other’s needs and desires and the requirements and limits of their service agreement. Conflicts can arise and trust can be broken when advisers assume rights and responsibilities that have not been authorized or when clients fail to ask questions about how their account will be managed.

To help investors conduct due diligence on their investment advisers and to spark honest and upfront discussions that can limit conflicts and misunderstandings, CFA Institute and the Future of Finance initiative created “Realize Your Rights: Using the Statement of Investor Rights to Find the Right Financial Professional.” The guide provides suggested questions and considerations to help investors determine the ethical commitment of their financial professionals and outline their own investment needs and constraints.

Whether clients choose to work with an automated or a flesh-and-blood investment adviser, it is paramount that they select one that has a similar investment philosophy, recognizes what the client will and will not abide by in specific investment situations, and is committed to working as a trusted partner in achieving the client’s long-term investment objectives.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.