A Blog by Jonathan Low

 

May 25, 2018

When Your Investing Robot Has a Mind Of Its Own

The client's idea of long vs short term or rate of return - or risk - may be very different from that of the computerized system and the algorithm that runs it. JL


Jason Zweig reports in the Wall Street Journal:

The whole point of using an automated online firm is that you don’t intend to actively monitor and manage your investments. You want its computers to do that for you, using exchange-traded funds that track the markets, minimize your costs and maximize your after-tax returns. (But) hiring a robo-adviser instead of a human adviser doesn’t mean you no longer need to pay attention.
Not many people would keep adding money to a brand-new investment that has lost 9% in its first four months. But a robot will.
That’s what has been happening at Wealthfront Inc., the automated online investment manager, or robo-adviser, that manages about $10.5 billion. In January, the firm launched Wealthfront Risk Parity, a mutual fund that invests across stocks, bonds and commodities around the world. For many clients with at least $100,000 invested at Wealthfront, the firm has been automatically moving as much as 20% of their assets into the fund — unless they stipulated that they don’t want it to.
Wealthfront has amassed $690 million in the fund and says it expects to hit $900 million soon. Some $440 million came in last month, according to Morningstar Inc., even as the fund lost 2.6% while the stock market and comparable risk-parity funds were up slightly.
As Wealthfront’s vice president for research, Jakub Jurek, rightly points out, four months is “just noise,” far too short a period to draw any conclusions about the success of a long-term investment strategy. And ​a similar approach has worked reasonably ​well in the hands of such leading investors as Bridgewater Associates, the world’s largest hedge-fund manager, and AQR Capital Management, which oversees $30 billion in similar strategies.
Even so, as Wealthfront continues frog-marching investors into the fund despite its poor initial performance, confusion reigns.
Its prospectus says the new fund should be used only by investors who understand complex securities, are highly risk-tolerant and who “intend to actively monitor and manage their investments in the fund.”
The whole point of using an automated online firm like Wealthfront, however, is that you don’t intend to actively monitor and manage your investments. You want its computers to do that for you, using exchange-traded funds that track the markets, minimize your costs and maximize your after-tax returns.
Unlike Bridgewater and AQR, the Wealthfront fund won’t own the underlying assets directly — and that could lead to some gaps.
As one of its hedges against inflation, it may own an ETF that holds energy stocks. So far this year, the Energy Select Sector SPDR Fund is up ​9.7%, whereas crude oil has surged 18.3​%.
As of its latest available regulatory filing, the Wealthfront fund was paying financing rates between 1.88% and 2.18% for its total-return swaps, the contracts it exchanges with banks to replicate the performance of various assets. Under accounting rules, those costs aren’t reported in the fund’s expenses, but they do come out of its net return.
That means the fund, which reduced its annual expenses to 0.25% from 0.5% last month, will need to earn better than 2% a year just to break even — a high hurdle.
The prospectus also says the fund may trade rapidly and could produce higher short-term capital gains than other strategies, potentially raising investors’ tax bills. Using swaps that mature in 13 months should enable realized profits to be taxed at the lower long-term capital-gains rate, Mr. Jurek says.
It isn’t clear that everybody wants the risk-parity approach. At its heart, risk parity is simply a way of diversifying not by how much money you have in each type of asset, but by how much risk you are taking overall.
Stocks are far riskier than bonds. If you have 60% in stocks, they could account for 90% or more of your portfolio’s total riskiness. Under risk parity, you borrow money to buy more bonds, commodities and other assets that reduce the risk of holding stocks — and may well make your overall portfolio safer.
Still, that makes sense only for people who are comfortable investing with borrowed money — and a lot of folks would rather take a nap on a bed of nails.
“It may be presumptuous to roll investors automatically into a new product like this without making sure they first have a reasonable understanding of what to expect,” says Adam Butler, chief investment officer at ReSolve Asset Management Inc., which manages approximately $300 million in Toronto.
Clients come to Wealthfront not just for its automation and low cost, but “because of the sophistication we are able to offer them,” says spokeswoman Kate Wauck. “So to us, offering risk parity is consistent with our clients’ expectations and our ethos as a firm.”
Still, she says, “we could have done a better job rolling this out and explaining it to clients.”
Mr. Jurek says the new fund squares with Wealthfront’s traditional automated approach because the firm will manage the portfolio with a “rules-based strategy” rather than subjective judgment.
Looking back at decades of data, Wealthfront tested the hypothetical results and found the strategy would have produced a “very attractive risk-adjusted, long-term rate of return,” Mr. Jurek says.
That multi-decade test, he says, “speaks much more loudly to us than any one month.”
In the long run, this fund might turn out to be a decent idea. In the short run, it’s a reminder that hiring a robo-adviser instead of a human adviser doesn’t mean you no longer need to pay attention.

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