Morningstar - Q2 2024 - 31

Spotlight: Artificial Intelligence
Advisors Await SEC Rule for AI
Proposal to tackle predictive data
analytics faces criticism.
REGULATION
Jasmin Sethi
The SEC has yet to directly address the use of
artificial intelligence by financial advisors.
Last summer, however, it issued a proposed rule
to prevent broker/dealers and registered
investment advisors from using " predictive data
analytics " and similar technologies, including
those that use AI, in a manner that results in the
firm placing its own interests above those
of its clients.
The commission said in its July 2023 proposal
that " the proposed conflicts rules would
require a firm to evaluate any use or reasonably
foreseeable potential use by the firm ... of
a covered technology in any investor interaction
to identify any conflict of interest associated
with that use or potential use. " [Italics added
for emphasis]
The SEC is concerned that firms could exploit such
technologies to optimize revenue and to use
behavioral prompts and social engineering to the
detriment of the investor.
We, and Others, Have Concerns
This proposal has been met with a slew of
industry criticism. In comment letters,
trade associations, including the Investment
Company Institute and the Securities Industry
and Financial Markets Association, have argued
that the requirements of the proposal
are impractical and would cause firms to avoid
adopting technological innovations. The
groups argued that the rule lacks clear limits and
could effectively ban certain technologies.
They also said that the definitions of covered
technologies, investor interaction, and conflicts
of interest are too expansive and could impose
onerous testing processes on firms and
stifle innovation, which would discourage the
development of products that would
benefit investors.
Morningstar shares the concerns of these trade
groups. In its own comment letter to the
SEC, Morningstar said that the commission's
definitions are overly broad and that the rule
would require burdensome testing. " We
believe a rule addressing emerging technologies
should be scoped to address those technologies
specifically, and we urge the commission
to revisit the requirements, guidance, and
enforcement around Regulation Best Interest ...
instead of promulgating new definitions
and approaches to conflicts of interest, "
Morningstar wrote.
Proponents of the rule, such as the Consumer
Federation of America and the North
American Securities Administrators Association,
assert that it would safeguard investors,
effectively tackling conflicts of interest arising
from technology-based platforms.
Implications for Advisors
If adopted, the proposed rule would become
important in virtually every aspect of an
RIA's or a broker/dealer's business. The
regulations would mandate that whenever an
investment advisor or broker/dealer used a
technology covered by the rule to engage or
communicate with an investor, the advisor would
have to conduct a comprehensive review
of the process to uncover any conflicts of interest.
If it were found that the firm's interests were
prioritized over the investor's, the conflict
would have to be eliminated. The rule states
that firms would have to establish policies
and procedures to prevent any violations and to
ensure adherence to the regulations. These
regulations would apply even in dealings
with investors that fall short of recommendations,
including, for example, using technology to
send news articles to investors about securities
on their watchlist.
An Expansive Definition: Covered Technologies
The proposed rules come into play when
firms employ covered technologies to communicate
or interact with investors. The SEC defines covered
technologies as any " analytical, technological, or
computational function, algorithm, model,
correlation matrix, or similar method or process
that optimizes for, predicts, guides, forecasts, or
directs investment-related behaviors or outcomes
in an investor interaction. "
This definition extends far beyond what is
commonly understood as predictive data analytics,
which uses machine learning, statistical
models, and data mining to identify business
risks and opportunities.
" Rather than addressing emerging concerns from
artificial intelligence, [the proposed rule] sweeps in
many older, well-established, and well-regulated
products such as quantitative equity or fund
ratings and robo-advice, " Morningstar said in its
comment letter.
In fact, Morningstar believes that the SEC's
definition is so broad that it would include
technologies designed to help firms mitigate
actual conflicts of interest that they may
face in making a recommendation. For example,
low-cost algorithmic investing through
managed accounts and robo-advisors has made
asset management accessible to the masses
in a way that mitigates conflicts of interest.
Retirement plan providers use managed accounts
programmed by third parties to avoid conflicts
that may arise if the plan provider has a
financial interest in recommending one fund over
another to retirement plan sponsors.
The rule could also include more-mundane tools,
such as correlation matrixes, which are
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