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Downside risk protection

After starting with tax-loss harvesting, Wealthfront then moved on to offer smart beta, followed by direct indexing.

Now Wealthfront is tackling one of the most common complaints about Modern Portfolio Theory (and, to a lesser degree, robo advisors, since they follow MPT): the lack of any downside risk protection.

While a robo-advisor will do great in a bull market, it might not perform well in times of stock market corrections, bear markets, high inflation or any decent amount of volatility. With the current batch of robo-investing services, until now, the only lever you could pull to decrease your beta (the volatility of your returns) was to increase your asset allocation to fixed income.

While this decreased your beta (which is good), it also reduced your returns (which is terrible).

That's now changing with Wealthfront's Risk Parity service. This is part of the PassivePlus collection of services that Wealthfront is using to improve upon existing passive investing strategies. The Risk Parity service will be available to investors who have taxable investments of $100,000 or more.

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Fees

Traditionally, most of your investment risk is tied up in the standard 60% stocks/40% bonds asset allocation. This means, unless we're in a bull market, your portfolio will perform poorly. Risk parity tries to solve this problem by equalizing risk and investing in opposing assets that will smooth out returns.

Ray Dalio made this style of investing popular with his hedge fund, Bridgewater Associates. Tony Robbins created a much-simplified version (minus any real hedging) of Ray's “All Weather” fund in his book Money: Master the Game.

Ray's hedge fund is not available to mere mortals. It is available only to institutional investors or the ultra-wealthy. So by Wealthfront offering this feature, it is democratizing this strategy for a much lower minimum investment and a lower fee to boot!

Wealthfront will achieve this risk parity via a mutual fund that has an annual fee of 0.50%. The risk parity part of your portfolio will take up 20% or less of your portfolio (depending on your settings). That equates to no more than a 0.05% increase to the existing 0.25% annual fee to use Wealthfront. So the new all-in fee will be around 0.30%.

Unfortunately, Risk Parity is currently available only in taxable Wealthfront accounts, but the platform does plan on rolling out this feature to IRAs in the future.

The Risk Parity mutual fund will use derivative instruments, such as total return swaps, to get exposure to global developed and emerging-market equities, global developed and emerging-market fixed income, real estate investment trusts and commodities. If you think this sounds like it will use a lot of actively managed techniques to invest, you are somewhat right. It is not passive in the same vein as Vanguard's mutual funds.

Typically, however, actively managed funds cost more than 0.50% per year. According to the Investment Company Institute, an actively managed mutual fund costs, on average, 0.84% annually. Wealthfront's portfolio is more in line with passively managed funds, although the large passive mutual funds are sub-0.25% per year. The Vanguard 500 Index Fund Investor Shares (VFINX) costs just 0.14% per year.

So while passive indexing devotees like those on the Bogleheads forum hate this new feature, is this service really a bad idea?

Drawbacks

Well, on the plus side, remember that Wealthfront's new service aims to solve one of the biggest complaints against robo-advisors (that lack of downside risk protection). Hopefully, it will decrease beta while not having too much of an effect on returns from a non-risk parity portfolio.

But at what cost — in terms of both annual fees and also any possible taxable drag from active trading? With this new mutual fund, we don't yet have any backward-looking metrics to see how it has performed.

Personally, I don't like the lack of transparency about this service being wrapped in a mutual fund. But unfortunately, I'm also not sure how else Wealthfront could offer risk parity without limiting the service to accredited investors. Because of changes to mutual funds, the platform can now offer some functionalities that were once available only in hedge funds. So the fact that Wealthfront created this as a mutual fund makes sense.

Plus, from the standpoint of Wealthfront's business, the platform needs ways to increase revenue per customer. It would be very costly for Wealthfront to replicate what Vanguard and iShares do at an already very cheap fee. Unlike Vanguard's, Fidelity's and Schwab's robo-advisor offerings — which use their own ETFs and mutual funds — Wealthfront has to find ways to add value to its customers but also generate more revenue.

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What does the future hold?

As the leading independent robo-advisors evolve, how they position themselves is becoming more apparent. Wealthfront is going the route of automated-only services and offering value-added products that are supposed to improve on what a traditional advisor may give. Wealthfront is offering more advanced asset allocation that once was available only to high-net-worth individuals.

Betterment, on the other hand, is focusing on more of the human element, but it's using technology to facilitate this.

I expect basic investment advice to go the route of the robo-advisor in the next 10 years. This model is cheaper to implement and can satisfy the needs of most individuals.

With current stock market evaluations, the length of this existing bull market run (currently the second longest in history) and previous low volatility, Wealthfront's Risk Parity offering might be the right service at the right time. Will it improve on the robo-advisor's existing passive investment options? The proof remains to be seen, and we'll have a better idea after the service has a few years of returns under its belt. Read the full Betterment Vs. Wealthfront comparison here

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Moneywise receives cash compensation from Wealthfront Advisers LLC (“Wealthfront Advisers”) for each new client that applies for a Wealthfront Automated Investing Account through our links. This creates an incentive that results in a material conflict of interest. Moneywise is not a Wealthfront Advisers client, and this is a paid endorsement. More information is available via our links to Wealthfront Advisers.

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About the Author

Larry Ludwig

Larry Ludwig

Freelance Contributor

Larry Ludwig is a freelance contributor for Moneywise.

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