The Redwood City-based robo-advisor's CIO Burton Malkiel says his firm's robo-approach to factor investing convinced him to reverse his stand on passive investing as unbeatable

November 17, 2017 — 2:21 AM UTC by Brooke Southall

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Brooke's Note: The headline of this article could just as easily be: "Wealthfront goes smart beta by getting its chief investment officer to renounce the basis of his fame and put chimps with darts back in their place." The action in this story happened back in June. I worked on it over the summer but put it to the side and temporarily forgot it. But as Wealthfront pressed on with PassivePlus and Malkiel never recanted the blog post I revived my efforts at telling the story of a godfather of passive investing touting "smart" investing and also promoting his robo-advisor as "superior" to Dimensional Fund Advisors as a factor investor. 

Wealthfront Inc. threw shade at Dimensional Fund Advisors by attacking the effect its relationship to the 200-plus RIAs has on the investors with the assets in its mutual funds. 

The Redwood City, Calif.-based robo-manager of $8.2 billion of assets levied the criticism in an article on its blog in June titled "An optimal approach to smart beta." It was written by Burton Malkiel, whose name heretofore was synonymous with the idea that active management cannot beat passive management. See: Has indexing become too popular?

The esteemed economist who also holds down a job as Wealthfront's chief investment officer, wrote the piece to roughly coincide with his firm's launch of PassivePlus, a service "designed to deliver more returns without more risk, applied to individual, joint, and trust investment accounts at no additional cost."  The service is an orchestrated combination Wealthfront products for tax-loss harvesting, direct indexing, and "advanced" indexing.  See: Wealthfront's high-net-worth cat leaps out of the bag -- keeping it one robo 'pivot' ahead of Schwab.

In industry parlance, such an approach is known as "smart beta." 

Man smarter

Malkiel's cheeky conversion from relying on dart-throwing chimps did not go unnoticed when it was published as part of a New York Times profile of him in June: An index fund evangelist is straying from his gospel

Burton Malkiel: These advisors tend to be unconflicted, unlike other advisors. Nevertheless, they charge advisory fees that could range up to 1% or more.

"Now, at age 84, Mr. Malkiel has had a remarkable change of heart: Maybe the experts can beat the monkeys after all. That is, if the experts are software engineers writing sophisticated algorithms for computer-generated trading." See: The smart beta ETF industry gets blasted at swank Manhattan summit by an unlikely group of critics.

But Wealthfront comes out of the smart beta gate with an offering that is "superior" to Dimensional Fund Advisors, the Austin, Texas-based smart beta indexing giant. The smart beta ETF industry gets blasted at swank Manhattan summit by an unlikely group of critics

"Wealthfront’s approach is similar to DFA’s in that it is multifactor, but it is superior in two important respects," Malkiel writes. "First, the expense ratio of the Wealthfront “Smart Beta” portfolio is zero. While a 25 basis point fee is imposed for overall portfolio management, the “Smart Beta” portfolio is available at no additional fee. See: As Dimensional Fund Advisors' AUM nears half-a-trillion, David Booth yields his co-CEO duties to David Butler.

Malkiel's second point is that Wealthfront harvests losses to "offset" any rebalancing trades that trigger short-term capital gains. 

Unconflicted but pricey

The Malkiel analysis ignores both the value of an RIA in discussing a 1% fee, says Dave Butler, co-CEO and head of global financial advisor services.

"Having worked with advisors for almost 30 years at Dimensional, it is clear to us that an advisor brings an immense amount of value to the client experience.”

But Malkiel goes on to characterize RIAs as a middleman that can be cut out.

"The DFA portfolios are sold only through investment advisors," he writes. "...These advisors tend to be unconflicted, unlike other advisors. Nevertheless, they charge advisory fees that could range up to 1 percent or more, and therefore the extra returns that have been available from many DFA funds need to be reduced by these advisory fees." See: DFA and TD Ameritrade strike 'strategic' deal with potential to shift RIA custody power axis.

RIAs deliver value in myriad ways but also by one common measure, according to Butler.

Going long

But Malkiel goes on to characterize RIAs as a middleman that can be cut out.

"The DFA portfolios are sold only through investment advisors," he writes. "...These advisors tend to be unconflicted, unlike other advisors. Nevertheless, they charge advisory fees that could range up to 1% or more, and therefore the extra returns that have been available from many DFA funds need to be reduced by these advisory fees."

RIAs deliver value in myriad ways but also by one common measure, according to Butler.

“While each relationship between an advisor and a client is different, a common theme that has shown itself repeatedly over the years is the ability to help the client maintain the long-term view and discipline necessary to investment success.

Missing the point

Dave Butler: Having worked with advisors for almost 30 years at Dimensional, it is clear to us that an advisor brings an immense amount of value to the client experience

Butler is being far too kind to Wealthfront in failing to mention the deepest potential failing its aproach, says Mark Matson, CEO of Matson Money Inc., a Mason, Ohio-based RIA and TAMP that manages several billion of AUM using DFA mutual funds.

"They've gone from: Smart beta is stupid to we're the ones that can pull it off," he says. "It's hypocritical at best and they're applying it completely wrong." See: Mark Matson's $7.6-billion DFA TAMP exits Schwab custody as it sets $100-billion AUM goal.

He adds: "Where you get the bang is by applying factor investing to small cap and international and they haven't applied it to that."

Malkiel allows that his whole career has been based on the idea that a passive portfolio can't be improve upon, whether it's called active investing or factor investing.

But Wealthfront's approach allows him to think differently, he says.

"It is possible to offset the disadvantages noted above by creating an offering with specific characteristics," he writes. "First, an optimal offering would have an expense ratio of zero or as close to zero as the existing broad-based capitalization-weighted ETFs have. Second, it would diversify its weightings so that several factors would be used rather than a single factor. Third, it would offset the capital gains that may be realized during rebalancing trades by harvesting tax losses in other parts of the portfolio."

Tax-loss conundrum

But even the tax-loss harvesting claims are dubious, Matson says. 

"This tax-loss harvesting is the exact opposite of what you want to do," he says. "I don't want to sell my stocks when they're down, unless there's an exact match, which is difficult, or wait 30 days. Their own disclosures basically say that it's a gamble." See: The three big defects in Andy Rachleff's theory of robo-advisors' ineluctable destiny of domination.

Wealthfront declined to respond to an RIABiz request for comment but offered the New York Times a nuanced message about Malkiel and the sudden embrace of smart beta.

“Burt Malkiel is still the high priest of passive investing,” Jakub Jurek, vice president for research at Wealthfront told the Times. “To be absolutely clear, we’re not stock pickers. There are decades of research on active investors, which show they underperform.”

Yet he added: “there are small adjustments you can make to improve after-tax returns.”

To Matson, Malkiel and Wealthfront are on shaky ground.

"They took a shot at DFA," he says. "The whole thing stinks of desperation -- a Hail Mary." Andy Rachleff blasts flesh-and-blood advisors -- even planners -- as Wealthfront returns to offense in robo game after losing ground under former QB Adam Nash


Mentioned in this article:

Wealthfront
Portfolio Management System
Top Executive: Andy Rachleff



Share your thoughts and opinions with the author or other readers.

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Paul Damon said:

November 17, 2017 — 7:45 PM UTC

And not to mention DFA sub-advises multi-factor strategies available to anyone via relatively low cost ETFs by John Hancock.....
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Randy Bullard said:

November 21, 2017 — 4:33 PM UTC

The sum total of this issue or disagreement comes down to whether an investor should or will pay the typical 1% fee that an advisor charges vs. the 25bps that Wealthfront charges. The difference between the multi-factor smart beta approaches utilized by DFA and Wealthfront are so minor as to be irrelevant. Tax loss harvesting within a sampled SMA portfolio vs. using pooled vehicles has greater opportunity to create usable losses, but comes at a cost of incremental trading and is ultimately of limited value. So again... this really comes down to an argument from Wealthfront that investors shouldn't pay 1% to an RIA. The 75bps advisory fee differential is real, but the arguments around that fee differential aren't based on the merits of one smart beta approach over another. This is about cheaper digital advice vs. more expensive traditional full service advice.

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