Regulatory Scrutiny of Investment Advisers’ Use of Investment Models and/or Algorithms

October 11, 2018

Investment advisers are increasingly leveraging technology as a part of their investment process to, among other things, identify sources of alpha, drive efficiencies, offer differentiated and innovative products and deliver investment management services to clients. While the ever-increasing utilization and reliance on technology by investment advisers is to be expected and is likely to continue to proliferate, it is not without risk. 

In response to the changing landscape, primary regulators of investment advisory functions, including the U.S. Securities and Exchange Commission’s (“SEC”) and the Office of the Comptroller of the Currency (“OCC”) appear to have taken a keen interest in the oversight and control infrastructure of investment advisers that are significantly and critically dependent on technology. 

In particular, ACA has observed that the document request lists submitted by the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) in recent examinations of investment advisers include lengthy and detailed requests related to the oversight and control of technology and the associated support infrastructure. Moreover, in situations where technology or a quantitative model/algorithm underpins the investment management process, examination teams are frequently comprised of subject matter experts. These experts have a deep understanding of technology and industry leading practices related to the development and maintenance of algorithmic driven investment management models. The targeted and timely focus is consistent with not only OCIE’s ever-evolving examination process, but also the staff’s goal of moving toward a more risk-based approach.

The increased regulatory focus on investment advisers’ reliance on technology has wide ranging implications. The impact will vary by the type of investment manager, but is likely to include, but not be limited to the following areas:

  • Quantitative Model Managers – Investment managers utilizing quantitative models will need to be able to evidence detailed documentation (e.g., flow charts, white papers and internal presentations) related to the initial development and validation of any algorithmic driven investment management models used. Similarly, to the extent there have been any model changes, such advisers will need to provide evidence to support the existence of robust oversight coupled with rigorous control and validation processes. Such advisers should also ensure written policies and procedures address model code read/write access, error identification, issue escalation and governance to provide regular and informed oversight.
  • Digital/Robo-Advisers – Robo-advisers also known as “digital advisers” and “automated advisers” are expected to develop customized policies and procedures around their use of technology. Such policies and procedures should address as applicable: the algorithmic code that automates an adviser’s provision of investment advisory services, testing of the code that includes ongoing validation of the algorithm to ensure it continues to perform as intended, and controls with respect to any changes to such code. Additionally, such advisers should ensure that appropriate cybersecurity safeguards have been put in place to protect all aspects of the digital platform, from access to algorithmic code housed on the adviser’s internal systems, to access to a particular client’s online profile, which is typically accessible through a public website.

    For any third party that develops, owns, or manages the algorithmic code or any technology utilized by the robo-adviser, the adviser must perform due diligence on the third party and ensure appropriate controls around its technology are maintained.
  • Bank Wealth Management Platforms – As noted above, the use of technology to support and/or drive the investment management process is a key focus area for the OCC. Wealth management platforms within banks are expected to have detailed and customized policies and procedures related to the development and maintenance of  active model risk management programs, which should encompass processes related to model construction, implementation and validation as well as governance and control mechanisms, such as board and senior management oversight. Similarly, to the extent smaller banks are utilizing third parties to leverage their digital wealth management platforms, oversight of such vendors should be deeply integrated into the bank’s third-party risk management program. 

ACA Guidance

ACA recommends that the investment managers mentioned above conduct a thorough review of their existing policies and procedures, disclosures, and related oversight to be prepared for a potential examination and to ensure consistency with increasing regulatory expectations.

How ACA Can Help

ACA can assist investment advisers in each of the groups referenced above with the following areas: 

  • Drafting and/or reviewing policies and procedures related to the development and monitoring of investment products and quantitative models;
  • Review of controls, processes and personnel involved in the oversight and management of quantitative models;
  • Independent testing of quantitative models, including a scrubbing of the code base;
  • Disclosure support;
  • Due diligence for third-party manager products; and
  • Processes to address errors and disclose errors to investors.   

For More Information

If you are interested in learning more about how ACA helps clients in mitigating these risks, please contact Todd Humphrey or your ACA Consultant.