Silicon Valley Meets Wall Street: The Next Evolution of ETFs

Just this month, a new player on Wall Street announced that it has come up with a revolutionary idea that it hopes will change the exchange-traded fund industry.

Wealthfront, which states it’s the world’s largest & fastest-growing automated investment service, announced that it will be rolling out the “next evolution in index investing,” which it calls Tax-Optimized Direct Indexing.

This new product is the result of the work of “world-class financial experts, led by Dr. Burton Malkiel, renowned economist and author of A Random Walk Down Wall Street, with some of Silicon Valley’s best technology talent.”

What the company aims to do is allow investors to essentially cut out the middleman in ETF investing – the manager and Authorized Participant. To accomplish this, an investor will be able to hold individual securities that comprise an index in his or her account on a commission-free basis.

This means that instead of buying a pre-packaged portfolio of securities through a single ticker, an investor will act more like an Authorized Participant – where they themselves will hold the contents of the fund. To further clarify, the traditional ETF structure we see today is created by an Authorized Participant (AP) who buys shares of securities that will be included in the ETF. This basket of securities is then delivered to the ETF issuer in exchange for shares of the ETF. The shares that are delivered to the ETF issuer, however, are not kept as inventory, but instead the issuer “issues” new ETF shares in the primary market – this is where the exchange-traded fund is actually created.

What WealthFront is proposing is that by holding these securities directly, investors will be able to bypass management fees on the associated position, lowering the cost of the entire portfolio. Furthermore, this strategy will allow investors to harvest losses at the individual stock level. Simply put, if a number of stocks in the portfolio log in negative returns, these losses can be harvested and translated to tax savings, which then can be reinvested into similar securities that mimic the index and are compounded over time.

Currently, the exchange-traded fund structure does not allow issuers to pass on tax losses to investors, meaning the investor cannot use any losses in the ETF’s portfolio to reduce his or her taxes.

WealthFront believes its product will reduce the overall expenses of holding an ETF by essentially eliminating these nuances. According to their website, the Direct Indexing service is offered at no additional fee beyond its annual 0.25% advisory fee that is inclusive of all commissions.

Be sure to also read Tax Loss Harvesting with ETFs: 6 Ideas to Lower Client Liabilities.

WealthFront’s 0.25% fee seems quite steep compared to some of the popular ETFs that offer similar exposure to the broad equities market. The Total Stock Market ETF (VTI A+), for example, only charges 0.05%, while several Schwab funds charge even less than that. Furthermore, many of the cheapest ETFs are already available to trade commission free on several platforms. So what exactly is the difference?

According to the company’s white paper, its backtested results show how the after-tax price return of their methodology produces better results than traditional ETF investing:

According to this chart, the Wealthfront 500 and Wealthfront 1000 have outperformed VTI in 11 out of the last 14 years.

While these results are impressive, the question of whether or not this is actually more cost efficient remains. Making it more complicated, Wealthfront has some features that make it reminiscent of a mutual fund. One of these features is that investors must have a minimum account size of $5,000; the first $10,000 is managed for free and the rest for only 0.25% per year.

Where things get even more confusing, however, is that this fee is an “advisory fee” – but who exactly is this advisor and how good are they?

Without sounding to much like a science-fiction novel, what Wealthfront is basically selling is a completely automated, “software-based” financial advisor at an ultra-low cost.

According to its site, “Wealthfront takes the guesswork out of sound, long-term investing through effortless automation. Wealthfront manages a personalized online investment account for you that is fully diversified and periodically rebalanced – accessible anytime and anywhere from your desktop, tablet or phone.”

To put things as simply as possible: an algorithm will essentially be making your investment decisions. The reasoning for taking out the human element? Humans are not rational and therefor can make poor investment decisions.

It is very important to note, however, that most ETFs already use some type of computerized financial modeling system. Many of the “smart beta” and quant-based funds use highly intelligent algorithms to scour the investment landscape to pick stocks that meet a specific set of criteria.

Wealthfront CIO, however states that its company’s approach is “no different from a regular index fund,” except that it takes advantage of tax-loss harvesting.

The concept, essentially, is not a novel one. Wealthfront’s vision is just to make use of these computer-based models in a more efficient way than traditional ETFs do.

While the ETF industry’s history is a relatively short one, it’s not surprising to see so much innovation at such a rapid pace given the technologies available for financial institutions today. Whether or not Wealthfront’s Silicon Valley meets Wall Street approach is successful is yet to to be seen. Even more interesting will be twhether or not this new way of “ETF investing” will be a game changer for the industry.

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Disclosure: No positions at time of writing.