Malkiel: Cheap Money Advice For The Wired

December 10, 2012

In a wired world, could an online financial advisory firm end up ruling the roost?


Burton Malkiel, the Princeton economics professor and author of the index investing classic “A Random Walk Down Wall Street,” has a new gig that’s worth taking measure of. The legend of passive investing is now chief investment advisor of Wealthfront, a Silicon Valley-based financial advisory firm that is serving up a dirt-cheap online approach to money management.

Malkiel told Managing Editor Olly Ludwig that he sees the “wired” clientele at the core of Wealthfront’s business development plans as a crucial piece of the new company’s success. After all, what population could more readily embrace the virtual connectivity that allows Wealthfront to charge so little for its services? How little, you may be wondering? It’s free if you have less than $25,000 in assets, and just 0.25 percent for everybody else.

All the cutting-edge technological bells and whistles notwithstanding, Wealthfront is founded on the principles of index investing, which is why Malkiel is involved at all. But the technology makes some of those tenets—such as rebalancing and even tax-loss harvesting—much easier to implement. Moreover, lest you think taking humans out of the equation is a mistake, Malkiel argues Wealthfront’s algorithmic approach might be exactly what investors need to keep portfolio-destroying emotion at bay.


Ludwig: The whole money management business seems in some ways to consider only the wealthiest to be worthy of its time and effort. When I was at Smith Barney, I was discouraged from prospecting young associates at Boston law firms who were earning $250,000 a year—many of whom would end up being partners with substantial assets. That shocked me. I don’t mean to be blind to the realities of wire house economics, but I came out of that thinking there’s a flaw in the traditional business development model. Wealthfront seems to confront that flaw by not turning away even the smallest amounts.

Malkiel: I can understand why your sales manager would say: “Hey, wait a minute, these guys don’t have enough money to pay your bills; don’t worry about them, just worry about the big fish who might give you enough commission income so that you’re in good shape right now.”

But that’s been the mindset of Wall Street, and that’s been the mindset of a lot of business. But I think you had a terrific idea: These lawyers, who are associates and are busting their tails, at some point are going to be partners, and I’m sure they appreciated that you’d spend time with them, even when they didn’t yet have huge investable assets. But that’s a real blind spot that I’ve seen so often on Wall Street.

Wealthfront is taking this to a real extreme in that people with less than $25,000 are going to get the service for free. So this Wealthfront idea is not only doing good work for people, but I think it’s one that’s going to turn out very well in the long run. A lot of those people are going to have significant assets later in life. I think that’s a terrific way to build a business, and I really like your anecdote.



Ludwig: It seems to me that the traditional approach—the advisor sitting down with investors, holding their hands and explaining everything and taking care of everything—is actually stripped away in the Wealthfront model, is it not? Maybe the very wired population from Silicon Valley that Wealthfront is prospecting is OK with increasingly virtual connectedness, but Wealthfront is serving up John Bogle’s humble arithmetic of index investing and your notion that stock picking is a fool’s errand in a largely online experience. Is that really a viable way to build a business?

Malkiel: You’re on to something. I think you need a wired generation to make this work. I know my own son does more on the computer than I do, and his 6-year-old son sometimes shows up his dad in terms of what he can do. There’s no doubt that that’s a part of Wealthfront’s idea.

But let’s also talk about one thing that Wealthfront is going to do that I think is so important and maybe is easier to do in the Wealthfront context than in the advisory context.

I know a lot about advising in that I’m the informal advisor to all the Princeton widows. I remember so well in 2008, some of them coming into my office shedding buckets of tears, saying: “I can’t stand it anymore; tell me it’s OK if we just sell all my equities.” I did this pro bono, but it’s expensive in terms of time, and I’d feel so proud of myself when the widow would leave and she hadn’t sold her equities. But what I would never do at that point—and this is something Wealthfront is going to do—is to say: “Listen: not only should you not sell your equities, but this is the time to rebalance.”

Now I think that to the extent that you’ve got a wired generation, and they trust you and they think you really know what you’re doing, they will say, “OK, you do it for me at low cost, and when the next 2008 comes around, we’re going to rebalance, and in fact we’re even going to buy more equities.”

We’re just so emotional about investing, that by letting it go on automatic pilot is probably even better than what the advisor could do, even if the advisor was low cost and had the best motives in the world.

Ludwig: You’re saying the whole computer interface actually enhances the probabilities that you’re going to do the right thing—which basically means you’re less likely to do the wrong thing, like the widows you just spoke about. Is that a fair characterization of what you’ve just said?

Malkiel: That is certainly a fair way of looking at it. And, in Wealthfront, you’ve got someone that’s looking at the universe of index funds and ETFs and knows exactly where to go. And the other thing that is so attractive to me is—that to the extent we have taxable accounts—one of the things we’re going to do is tax-loss harvest. If you’ve got a Vanguard Total Stock Market Fund, and this was ’08 and you’ve got a loss, well, we’ll sell it and buy a Schwab fund.

I’m using those two as examples because in both cases we’re talking about expenses of 5 basis points or less. We tell people we know where the good low-cost funds are; we’re going to do the rebalancing for you; we’re going to do the diversification for you—including into emerging markets. And for taxable accounts, we’re going to tax-loss harvest for you. Tax-loss harvesting is the only sure way I know of generating alpha.



Ludwig: I’d be remiss if I didn’t ask this: The ETF is at the center of all this, isn’t it?

Malkiel: I think there’s no question that the ETF could be at the center of it, but that doesn’t mean that one wouldn’t use mutual funds. I would say there will probably be a tendency going toward ETFs because they’re lower-cost instruments, and I think I’ve told you before, that all of us need to be modest about what we know and don’t know about investing.

I think I’ve told you before that the only thing I’m absolutely sure of is—and there’s not a lot I’m absolutely sure of—is that the lower the price I pay to the purveyor of the investment product, the more there will be for me. And that will, in many cases, lead to ETFs.

Ludwig: Now, Wealthfront is very algorithmically driven and is trying to take the emotion out of investing, and you are one of the legends of the indexing movement. And that makes me wonder: What are you doing over there as chief investment officer, and how much is there to do in such an automated environment?

Malkiel: Well, I’ve been talking to the people who have been doing the portfolio allocations, and have been coming up with portfolios. Yes, it’s algorithmic—but it makes a great deal of difference what kind of inputs you put into the equation. And the inputs of covariance and expected return are extremely important.

Let’s take one particular example: I’m extremely worried about the bond market. The 10-year Treasury note yields 1.56 percent, and if you hold that to maturity, that’s precisely what you’re going to get.

Ludwig: The 1.56 percent?

Malkiel: Yes. You’re not going to get what Treasurys have done in the past. And this then also leads to the fact that it makes a difference what the time horizon is for the individual. There’s a different way to do Markowitz portfolio theory when you’re talking about a 20-ish engineer working at Google who is just getting into the game and who has an enormously long horizon compared to a 70-year-old who’s looking at a risk and return from the standpoint of someone with a shorter horizon.

All of these things are important, and while they are algorithms, the parameters that you put in place matter. So there’s a lot that’s behind this, and I would say to you—and this is one thing that people at Wealthfront do understand—that there’s also a good deal of judgment that’s involved. Again, even though these are algorithms and are computer-driven, there isn’t anything you get out of something that’s computer driven that you don’t want to look at very carefully and ask, Does this make sense, or not?

And that’s exactly what we’re doing: What do we do about bonds? And if we’ve got the 70-year-old who wants income; who wants low expense; who wants less volatility—are there things like dividend-growth ETFs that can substitute in part for some of the traditional bond portfolio? Should we look, for example, at emerging market bonds? Are they as risky as their past risk and return parameters suggest?



Malkiel (cont'd.): Let’s look at their fiscal balances as of today; let’s look at their debt-to-GDP ratios today, and then maybe what we ought to say is that it’s not the history of some of the Latin American countries that have defaulted that matters, but rather, where they are now. So maybe holding Spanish debt is maybe riskier than holding Brazilian debt.

I’m trying to give you a flavor of the kind of things we’re talking about, and those are exactly the kinds of discussions we’ve been having.

Ludwig: What you’re describing sounds like contemporary tools plugged into the timeless verities of index investing, no?

Malkiel: I think that’s fair, yes.

Ludwig: Does what you’re doing at Wealthfront at all affect what you’re doing at AlphaShares; or, looked at from another angle, might you integrate some of the AlphaShares products into what you’re doing at Wealthfront?

Malkiel: What I’m doing with AlphaShares creating China products would in no way affect this, and if we did have some China allocation to think about, I’d be happy to point out that YAO is a much better China product than FXI.

But I would point out that the people at Wealthfront should be well aware that that’s a conflict of interest from my standpoint. And that’s so important, because Wall Street is so full of conflicts of interest, and if there’s one thing I would always want to do is that if there was even a suggestion of a conflict of interest, I want to make sure that everyone knows it.



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