Wealthfront’s Hedge Fund: Why Should You be concerned?

By Nael Shahbaz, Wealth manager SAMT AG
Follow: @NaelShahbaz

Charles Darwin said that the species that are the most adaptable to change survive. But if a tiger starts eating flowers it will surely not survive.

Such an evolution will take thousands of years. Similarly, for an investment firm to shift its strategy from purely passive to active investing will take time. Radical shifts find success in slow transition.

Roboadvisors invest mostly in ETFs. If you’re thinking why the need for robos when BlackRock and Vanguard were already selling passive financial products, well, BlackRock is not cheap for the average investor, and Vanguard is notorious for bad customer service.

Which is why Wealthfront and Betterment found a niche. Both of these primarily invest in index funds. Here’s a quote from Wealthfront’s website;

“We believe parking your money in a diversified portfolio of low-cost index funds and having the patience to stay the course will always be a better approach to active investing. Why? Because active investing requires a judgment call every time the market moves. And even the experts aren’t immune to human error.”

Wealthfront has recently introduced an in-house hedge fund, following the strategy of Bridgewater Associates. Hedge funds follow active investing strategy, which goes against Wealthfront’s original vision.

So, why is a passive roboadvisor changing its path?

Wealthfront, as a startup, was backed by venture capitalists in 2008.

Since 2015, Wealthfront’s growth has been unsatisfactory, and the investors who backed the startup are showing concerns.

Enter active investing.

To generate the much needed revenue Wealthfront has introduced a hedge fund based on ‘risk parity’, “replicating Bridgewater’s risk parity strategy”, where 20% of investors’ funds (for portfolios of $100,000 and above) will be allocated to it. The company has implemented it on an ‘opt out’ basis, meaning that it applies to every investor unless he/she explicitly requests to be excluded from this fund.

Risk parity means to create a portfolio where each asset contributes equal amount of risk. Say, a portfolio of 50/50 stocks and bonds does not adhere to risk parity since stocks are generally riskier than bonds. So, increasing the weight of bonds and shedding from stocks to balance the risk will achieve risk parity.

Many consider risk parity an alternative to the Modern Portfolio Theory (MPT). Much like MPT, risk parity has its share of critique. For instance, risk parity technique focuses solely on risk management, while ignoring returns.

Wealthfront’s risk parity fund uses derivative instruments, such as investing in total return swaps, forward and futures contracts. It has also raised the average fee from 0.09% to 0.5%. The additional cost of swaps is on the customer, which could average at 3%. The 0.5% fee applies to 20% of investors’ portfolio, hence after tax, the total fee might end up somewhere around 0.33%, which is more than three times what investors used to pay.

Wealthfront is moving from active investing to passive investing, from cheaper to expensive fee. The new hedge fund is owned by the firm, which also raises the questions about their new role as a fiduciary.

Replicating Bridgewater’s hedge fund at this stage is quizzical but if you take into account the pressure from the VCs about company’s revenue, Wealthfront’s desperate shift to active investing makes sense.

Wealthfront could say that the investors can still choose between active and passive. The problem with that argument is that the majority of people who invest through roboadvisors don’t have the market knowledge to make such decisions.

Hedge funds are not designed for typical roboadvisors, and Wealthfront is a typical robo. Of course, every company has the right to adjust to change. However, if a business goes against its vision when the storm picks up, one should be concerned.

If you would like to learn more about WealthTech and FinTech please look at our video courses at FINTECHCircleInstitute.com