How online investment advisers add value
A year ago, I wondered whether there was an easy personal investment strategy which is better than Vanguard, and looked at two intriguing products â the RealRetirement funds from Pimco, and an online asset manager called Wealthfront.
Then, last month, I saw a headline about Betterment, which is a competitor to Wealthfront. âBetterment’s Jon Stein talks human-RIA coopetition but breathes fire about fellow online RIAsâ, it said. An RIA is a registered investment adviser, and the âfellow online RIAâ that Bettermentâs Jon Stein was “breathing fire aboutâ turned out to be none other than Wealthfront.
Now Iâm familiar with Betterment: I wrote about the company a couple of years ago, calling it overpriced at 0.90% per year. Since then, its fees have dropped dramatically, starting at 0.35% for balances of less than $10,000, and falling to 0.15% for balances of more than $100,000. Those fees are assessed on top of the fees charged by the ETFs that Betterment puts you into, which will cost you an extra 0.13% to 0.16%. Thatâs a much more reasonable sum to pay for Bettermentâs service, and itâs similar to what Wealthfront charges, which is nothing for the first $10,000 and then 0.25% for the rest â plus about 0.17% in embedded ETF charges. (A Vanguard target-date fund, then, is still significantly cheaper than both, generally charging 0.17% or 0.18% per year in fees.)
So, what was Bettermentâs beef with Wealthfront? Hereâs Jon Stein, breathing fire:
Our platform is far more sophisticated. Our asset allocation is better because we donât have commodities, which are a poor asset to have in there. Our algorithm is better, because it invests all of your money down to fractional shares, because the tax optimization is actually better. I donât want to sort of pull it apart point by point but things like their tax-loss harvesting algorithm I think is a joke and not the way that it should be done.
Themâs fighting words, and so I started looking into the two offerings. And, frankly, theyâre both good. Betterment is sleeker than Wealthfront; itâs put more effort into design and user-friendliness, especially for people just starting out on a savings path. It has mobile apps, and itâs easier to move your money in and out of Betterment, or to change your asset allocation once youâre invested. (Although to be honest Iâm not entirely sure thatâs a good thing.) If you ask Stein what makes Betterment better than Vanguard, heâll basically tell you that itâs just much easier to use, and is designed from the ground up as an intuitive, web-native savings vehicle. Betterment has five times as many customers as Wealthfront, partly for these exact reasons. If you want to see what the future of investing looks like, then look to Betterment, not Wealthfront.
Wealthfront, on the other hand, just like Vanguard, feels more old-fashioned. Itâs not nearly as sleek, and in fact itâs quite nerdy. Its investors have significantly more money than Bettermentâs: while theyâre significantly outnumbered, they have invested 50% more money overall. The two companies seem to have a very different conception of what their product is: while Betterment concentrates on the how of investing, Wealthfront concentrates on the what.
The result is that Wealthfront has become something of a masterclass in how to squeeze extra basis points of return out of the basic stick-all-your-money-in-index-funds model. Just like Betterment, the Wealthfront team embraces the gospel of passive investing: theyâre not stock-pickers. But thatâs just their starting point. They then start geeking out, adding as many tweaks as possible to maximize total returns. The model is a bit like Amazon Prime: for your flat 0.25% fee, Wealthfront will provide an ever-expanding suite of services which in aggregate are worth much more than that.
This is where Steinâs criticisms of Wealthfront come in, and I think fall short. In terms of the sophistication of the investment product, Wealthfront beats Betterment. Wealthfront is built on the kinds of investment strategies which are normally available only to investors with well over $5 million, and which even then tend to be extremely expensive; itâs managed to democratize those strategies through software (and through more than $30 million in VC funding).
For instance, on asset allocation, Wealthfront uses no fewer than 11 different asset classes in its attempt to maximize risk-adjusted returns. (Most target-date funds toggle between just two: stocks and bonds.) Stein doesnât like the fact that one of those asset classes is commodities â but the point is that itâs important to look at the overall picture. Wealthfront isnât required to have much or even any exposure to commodities, but if it makes sense to do so, because of whatâs happening with correlations elsewhere in the portfolio, it can. (One of the big investment risks right now is that bonds alone might not give you much extra diversification: itâs very easy for both stocks and bonds to fall quite far at the same time, if and when rates start to rise.)
Wealthfront also does rebalancing the smart way â by using inflows to buy the asset classes which have dropped in value, rather than selling the assets which have risen in value and thereby generating capital gains. If you save a certain amount monthly, then that money doesnât simply get distributed evenly across your portfolio: it goes to rebalance your portfolio as necessary. And even if youâre not regularly putting extra cash into your account, Wealthfront will do the same thing with your dividend checks. Which seems obvious, until you realize that even highly-sophisticated passive investment shops like Dimensional donât do that.
Then thereâs the way that Wealthfront constructs different portfolios depending on whether the money is in a taxable account or in a tax-sheltered account like a 401(k). Initially, Wealthfront just did this the simple way: it would put the highest-income products, like REITs and taxable bonds, into the tax-sheltered accounts, and the rest of the portfolio into the taxable accounts. But then they ran some mean variance optimization analysis, and found a better way: what they call âdifferentiatedâ rather than âsegregatedâ asset allocation. It isnât for everybody: it works best for younger investors with most of their wealth in taxable accounts. (Thatâs the investor base Wealthfront is starting with; as the company expands, Iâm sure that they will find a way to give you segregated allocations if that makes sense for you.) Again, the differences might seem small, but in the world of index investing, all differences are small. Which doesnât make them any less important.
Finally, thereâs Wealthfrontâs tax-loss harvesting. Here, Stein is wrong: itâs not a joke, itâs a very sophisticated way to boost returns by a noticeable amount, especially in down years. Wealthfront has published a very detailed white paper explaining how it works, but at heart what happens is that the companyâs algorithms are constantly scanning your portfolio, looking for positions which have declined substantially in value. When that happens, those positions get sold, generating a loss which you can claim against your income when you do your taxes. And the proceeds get put into a similar investment, with similar risk characteristics, for at least 31 days. After that time, the second-choice investment can be sold, the first-choice investment bought again, and youâre back to your optimal allocation.
Again, tax-loss harvesting isnât some amazing rocket fuel for your portfolio. It works best for long-term investments, since in reality all it does is defer your taxes until the point at which you liquidate your portfolio. But it can give you a nice extra slug of cash to play with until you do liquidate â and that adds up. In the Wealthfront analysis, tax loss harvesting produced an annual “tax alpha” of 1.14%, on average, between 2000 and 2013 â and was over 5% in both 2000 and 2001. Especially when markets are falling, it can give you significant outperformance. And because Wealthfront does its tax-loss harvesting continuously and opportunistically, rather than just once at year-end like most financial advisors, it can make more money from it. This year, for example, nearly all of the 0.71% Wealthfront generated in tax alpha came in the single month of June.
Still, if you only have 11 ETFs in your portfolio, that means you only have 11 securities which give you the opportunity to sell at a loss. What if, instead, you had hundreds of such securities, all moving in different directions? Thatâs what Wealthfront has announced today: for investors with more than $500,000 in taxable accounts, Wealthfront will stop investing in a broad stock-market ETF, and instead will buy each of the 500 components of the S&P 500, plus one more ETF which represents smaller-capitalization companies. That gives Wealthfront the ability to do tax-loss harvesting at the level of individual stocks, rather than just broad index ETFs.
Being able to use hundreds of different securities in a tax-loss harvesting system can make a big difference: it would have generated tax alpha of more than 10% in 2000, and almost 8% in 2008. Of course, if youâre selling some stocks and buying others, youâre not going to track the S&P 500 perfectly: on average, the performance of the Wealthfront portfolio in any given year is going to differ from the performance of the S&P 500 by about 0.72%. (That tracking error might be in your favor or against you; over time, it will probably work out to be zero.) But in return for that tracking error, Wealthfront says that it can deliver extra tax alpha of more than 3% per year.
These kind of iterative improvements in the way that Wealthfront invests do add up, and Iâm sure that Wealthfront hasnât stopped yet. It could take a leaf from Bettermentâs book, for instance, and offer fractional shares for investors with lower dollar amounts of savings. It could tweak its tax-loss harvesting algorithm so that rather than automatically switching back to the original allocation after 31 days, it waits for the perfect time to do so. It could try to lend out its stocks into the repo market, and get a bit of extra income that way. And Iâm sure there are other tweaks I havenât thought of.
It will even, at some point, start putting more effort into user-friendliness, much as Betterment has done. (Iâm less convinced that Betterment is going to start adopting all of Wealthfrontâs investment tweaks, just because its CEO is so rude about them.) Betterment, I think, has a superior understanding that while people might tend to say that theyâre investing for the long term and have the stomach to withstand large market gyrations along the way, in reality life happens and thereâs a good chance that the money is going to be withdrawn sooner rather than later. That diminishes the value of things like tax-loss harvesting, while increasing the value of more behavioral approaches, which make use of smart defaults, segregated goal-based accounts, positive feedback about whether youâre meeting those goals, and even observed behavior. The Wealthfront approach, by contrast, relies much more heavily on old-fashioned risk questionnaires, and does much less to automate the kind of hand-holding where human investment advisers add most of their value.
The big picture here is that none of these products are bad. Vanguard is the elephant in the room: it has massive economies of scale, it is certainly going to be around for decades to come, and itâs the gold standard which any other investment product should be judged against. Itâs never a bad choice. Betterment and Wealthfront both have higher fees than Vanguard, but give you real value in return for those fees. Wealthfrontâs value is more quantifiable, and the company makes an extremely strong case that it delivers more than 25bp in value for the money that itâs charging. But Bettermentâs value is also important. Thereâs a large and distressing difference between investment returns and investor returns: investment returns assume a perfectly rational buy-and-hold investor, but humans donât behave that way. Thatâs one reason why Pimco spends a lot of money hedging tail risk in its RealRetirement products. If Bettermentâs behavioral-finance based user focus can substantially narrow the gap between investment returns and investor returns, that could be just as valuable as all of Wealthfrontâs bells and whistles.