Wealthfront has courted controversy with risk-parity fund

Critics see a volatile product that has underperformed benchmarks and contains difficult-to-understand costs.

May 28, 2019 @ 9:25 am

By Bloomberg News

Wealthfront Inc. is known for doing the most boring type of investing possible — sticking clients' money in mutual funds and ETFs and taking a small fee.

But last year, the robo-adviser launched a new product that departed from that model. The Wealthfront Risk Parity Fund, announced in early 2018, was styled after the esoteric calculations of famous hedge fund manager Ray Dalio. Since then, the fund has amassed more than $860 million in assets under management according to Bloomberg data, and has become a lightning rod for controversy.

Wealthfront sees risk parity, a strategy that aims to diversify portfolios in order to protect from price swings in any one type of asset, as a way to compliment the holdings of its biggest customers. But critics see a volatile product that has underperformed benchmarks and contains difficult-to-understand costs, and a launch that automatically opted users into the fund, rather than allowing them to join of their own volition.

The tumult surrounding Wealthfront's risk parity fund comes at a pivotal time for the company, and for robo-advisers in general. Established competitors like Fidelity Investments and Charles Schwab Corp. are muscling their way into start-ups' turf with their own low-fee digital investing products. The heightened competition likely helped send Wealthfront's valuation down by almost a third, to $500 million, in its latest funding round announced early last year.

(More: The best robo-advisers for different investors)

One obvious solution would be to try to eke out a profit with more lucrative product offerings like proprietary funds, which could allow it to fork over less money to ETF makers like Vanguard. But if it goes that route, Wealthfront could wind up looking more like a regular Wall Street firm — in other words, exactly the thing it was created not to be.

Co-founded in 2008 by venture capitalist Andy Rachleff, now chief executive, Wealthfront has pitched itself to millennial consumers as an easy place to park cash, with a beautiful digital interface and annual fees of only 0.25%, or less.

The concept was a hit with investors, garnering roughly $200 million in funding, as well as with customers. It has more than $10 billion under management. Then, last year, the company became one of the first robo-advisers to launch a proprietary mutual fund, with the creation of the risk parity product, and almost immediately drew user outrage.

The idea behind risk parity was popularized by Mr. Dalio and his hedge fund Bridgewater, and aims to spread risk equally across different types of assets, based on the historical and expected price swings of stocks, bonds and commodities. The portfolio's balance is supposed to reduce volatility and provide smoother returns.

When Wealthfront created its own version of the fund, it wrote in a blog post: "Our research PhDs and engineers spent the past year effectively replicating Bridgewater's risk parity strategy," with the end result of a product that "aims to increase your risk-adjusted returns in a wide range of market environments."

But users balked at the management fees, which were 0.5% of the account's value each year — a shock to customers used to being charged half that. Two months later, Wealthfront backtracked, lowering fees for the risk parity product to 0.25%.

That management fee is today the lowest in the industry for a risk parity strategy, according to the company. Similar products from hedge funds and larger investment firms often charge significantly more. But questions about the fund's total costs linger. Because of its complex structure, it includes holdings like total-return swaps, which incur fees of their own. Most funds include some costs of this kind, though it's often difficult to figure out how much. Depending on the exact makeup of the fund and the fees associated with those products, which isn't public, this could bring the cost higher for Wealthfront customers.

The actual range of possible fees users are paying could vary. Given the swaps and bonds in the portfolio, Cullen Roche, an asset manager based in California, estimated the all-inclusive range to be anywhere from 0.5% to 2%.

"My guess is that it's high," Mr. Roche said.

Wealthfront did not respond to requests for comment on this story.

(More: Wealthfront introduces high-yield cash savings accounts)

Regulatory filings indicate that customers were likely paying closer to 1% in total fees, rather than 0.25%, for a large chunk of the fund's holdings for part of last year. According to the company's disclosures around risk parity, Wealthfront paid a spread of 55 to 65 basis points above Libor for its bond holdings, or about 0.55% to 0.65% beyond the international interest rate benchmark. Those fees would be taken out on top of the 0.25% management fee.

For Wealthfront customers, there were a few other reasons to be irked over the new fund. The company automatically put up to 20% of the holdings of accounts worth more than $100,000 into the product, meaning users had to specifically log in to the app to decline if they weren't interested. And just a few months out of the gate, its performance faltered.

The fund launched in late February of last year, but performance data is available starting in late January. From Jan. 29 through mid-May of 2018, it was down more than 9%, prompting more early criticism.

Wealthfront has published a blog post addressing the issue, which it updates from time to time titled, "What explains the recent performance of Risk Parity?" The fund, Wealthfront explained, has a higher allowance for volatility than its peers, causing swings in either direction to be larger than those of similar portfolios.

So far this year, the performance has been better as the market has climbed. The fund has returned about 11%, compared with roughly 9% for an S&P risk parity index. But it's still down about 5% since its inception.

In general, robo-advisers "are pushing the rest of Wall Street in the right direction" with their low fees, increased transparency and digital tools, said Mr. Roche. But as start-ups dabble in more traditional Wall Street products, they run the risk of eroding some of those advantages.

When it comes to the total fees in the risk parity fund, Mr. Roche said, "Because we don't have that transparency now, I think you'd be crazy not to opt out."

(More: SEC charges Wealthfront and second robo-adviser for false disclosures)

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