We have shown in prior blogs how do-it-yourself investors can achieve reasonable investment returns through the use of low-cost highly diversified passively managed funds. How can non-do-it-yourselfers obtain these same benefits? There are financial advisors who specialize in these services, but often not at an acceptable level of cost. Recently, a marriage of technology and financial theory has resulted in a number of online wealth management services that provide automated, algorithm-based portfolio management advice at very low cost (these services are known as “Automated Investment Services” or AIS). One of these is Wealthfront, a company started just two years ago and already managing nearly $3 billion in assets. The founders include technologists and financial economists.
Wealthfront is targeting the tech-savvy millennial generation; people who grew up with technology and arguably would be more comfortable with turning their portfolios over to an automated process. The company offers a set of diversified portfolios, each using low-cost passively managed index funds (in the form of Exchange Traded Funds). The funds represent major asset classes including US equity, international equity, emerging markets, dividend stocks, corporate bonds, municipal bonds, inflation-indexed bonds, real estate and precious metals. A recommended allocation across these asset classes is derived from user answers to a brief set of queries that are aimed at assessing a client’s tolerance for risk and investment horizon. The company offers a very competitive fee structure: zero percent on the first $10,000 and then 25 basis points (.25%) on the remaining balance. This fee is in addition to the expense ratio on the funds (roughly 10 basis points). For large accounts (greater than $1 million), Wealthfront will create a personalized “index fund” consisting of a portfolio of individual stocks designed to match market indexes. The benefit of this service is that you save the 10 basis point fund fee (and only pay the 25 basis point Wealthfront fee).
In return for their fee, Wealthfront takes over management of your portfolio. The portfolio is automatically rebalanced at no cost in order to maintain the desired asset allocation. Capital losses are automatically “harvested” (realized) in order to optimize tax efficiency (to offset realized gains and maximize deductible losses), again at zero cost. The Wealth Front website claims their process offers a total value added of roughly 300 basis points (3%) of return per year, based on their low fee structure and the benefits of rebalancing and tax loss harvesting. Not only that, but by turning your portfolio over to an automated process, you are at least partially prevented from making monumentally bad timing decisions. This might be the biggest benefit of all.
The website is very user friendly, even for an aging baby boomer. The risk tolerance measure is on a scale of 0.5 (very low risk tolerance) to 10.0 (huge risk tolerance). You can toggle the measure and see instantly changes to the recommended portfolio. The total allocation to equities is 90% for the 10.0 risk lover and 33% for the 0.5 risk hater. There is a screen showing projected portfolio performance over a five year period, based on the recommended asset allocation. You can see the range of probable values of the portfolio in five years, and the probability that it declines in value.
What is the downside to AIS? One potential downside is for some reason (perhaps a decline in the overall stock market) you lose confidence in the process and decide to intervene. That is, you still have the opportunity to make monumentally bad timing decisions. Second, portfolios are tailored to the individual customer only in a fairly coarse way. The series of questions put to a client are aimed at assessing the client’s tolerance for risk and investment horizon, but do not attempt to assess the client’s overall financial position. For most people who are not in or near retirement, the amount of financial wealth they have is small relative to their “human capital” or the present value of future earnings. Ideally, the nature of this earnings stream should be taken into account when determining the financial portfolio. For example, a tenured college professor has an income stream which is very safe, like a Treasury bond. It would be appropriate for the college professor to concentrate her financial portfolio in riskier assets, like equities. On the other hand, a serial entrepreneur has an extremely volatile earnings stream and should concentrate her financial portfolio in less volatile assets, like bonds. It is possible that a financial advisor would take these factors into account and come up with more appropriate portfolios.
I see three broad groups of investors. First are the people that are comfortable with handling their own portfolios. Financial theory and innovations have provided this group with the tools to obtain market returns at very low cost so that do-it-yourself is a viable strategy.
The second group consists of people who are comfortable with turning their portfolios over to an automated process. This is the target market for AIS, but to this point does not comprise a large portion of the total market. Of an estimated $27 trillion of financial wealth being managed by somebody, the share of AIS is a fraction of one percent. Wealthfront’s bet is that a large portion of young people will eventually fall into this second bucket. As described above, the AIS approach offers the benefits of low cost funds along with further benefits of automated rebalancing and tax loss harvesting. Do these benefits more than offset the (modest) AIS fee? I don’t know the answer, but surely the AIS approach is also a viable strategy.
The third group, comprised of people who demand a personal touch, is today by far the largest group. It encompasses a wide variety of different types of relationships from fee-only financial planner to discount broker, full-service broker, active mutual fund manager, separate account manager, etc. It is certainly possible that an advisor can add value through developing a customized plan or a market beating portfolio. In the next blog, the final chapter in this series, we’ll review some specific strategies aimed at achieving market-beating returns.