(Bloomberg Businessweek) -- Wealthfront Inc., an online money manager, attracted a following in Silicon Valley and expanded its assets under management to $10 billion by offering a simple proposition. Instead of telling clients which stocks to buy or which supposedly brilliant money manager to pick, Wealthfront charges a low fee to help people spread their assets among exchange-traded funds that passively track the market. It adjusts that allocation to stocks, bonds, and other assets according to a client’s tolerance for risk.
Customers loved Wealthfront’s passive investments. In February, however, the company added something new. The Wealthfront Risk Parity Fund is automatically included in accounts with more than $100,000 in taxable assets unless the client opts out. The fund is supposed to follow an approach taken by hedge fund manager Ray Dalio of Bridgewater Associates. Only a portion of clients’ money would be invested in it, the rest going into more traditional fare such as low-cost Vanguard funds. Rather than cheering at the opportunity to invest like an exclusive hedge fund, some Wealthfront clients expressed puzzlement about an unusual strategy with added expenses. “I’m not bailing on Wealthfront yet, but I am opting out of Risk Parity until someone can better explain to me why I should have it over passive investing,” tweeted Austin Johnsen, head of corporate development at the game streaming site Twitch Interactive Inc.
Wealthfront’s plunge into risk parity represents one of the biggest attempts yet to take the strategy into the mainstream. A handful of other mutual funds offer some version of the approach, but it’s largely been the domain of hedge funds and institutional investors. There may be as much as $500 billion invested in risk parity, making it common enough that it’s sometimes singled out as a likely suspect—fairly or not—for unexplained bouts of volatility in stock and bond markets. Last year, Paul Tudor Jones II, the billionaire founder of Tudor Investment Corp., said risk parity could act as “the hammer on the downside” when turmoil returns to equity markets as managers rush to adjust their strategies.
So what the heck is it? The strategy begins from a premise familiar to many investors: diversification. For example, in addition to stocks, you want to have some bonds, which won’t necessarily fall in value at the same time as equities. The problem, risk-parity advocates say, is that even if you’re split pretty evenly between stocks and bonds, most of the volatility in your portfolio will come from the equities. In a bear market, holding even a little bit in stocks can expose you to losses. You can equalize this by tilting more heavily to bonds, but then you end up in a low-risk portfolio that gives up potential return.
Many risk-parity funds try to solve this with leverage. A manager might create a portfolio heavily exposed to the bond market but do so using derivatives that increase the value of the fund’s bets, magnifying potential gains as well as potential losses. The hope is that the fund will provide some protection when the stock market drops but deliver higher returns than a simple bond-heavy portfolio. Throw in exposure to other asset classes, such as commodities, real estate investment trusts, and emerging-market bonds, and the risk is even more spread out.
Risk parity looked really good during the financial crisis, when stocks fell sharply. A long stretch of strong bond returns also helped. But lately bond yields have been rising, with the benchmark 10-year Treasury at about 3 percent. (Bonds fall in value as yields and interest rates rise.) JPMorgan Asset Management, Jeffrey Gundlach of DoubleLine Capital, and others say a bond bear market is on the way. If so, some risk-parity strategies could be in for a bumpier ride.
The approach varies in terms of how complicated or simple it is, with each firm having its own spin. Wealthfront’s fund gets leveraged exposure to asset classes using derivatives called swaps. The fund reweights investments to try to keep the portfolio at a set level of annual volatility, but that’s just a target. The prospectus says actual volatility could fall above or below the fund’s goal. Wealthfront’s website says it doesn’t consider this active management, because it’s a “rules-based” approach.
Risk-parity elements such as leverage and other complicated inputs have historically been confined to quantitative money managers working with sophisticated investors. There’s a reason for that. Individual investors shouldn’t be putting money in strategies they don’t understand well, says Maneesh Shanbhag, who, after five years at Bridgewater, co-founded Greenline Partners. “The issue isn’t that it’s a bad strategy. It’s that investors don’t know when they’ll underperform and outperform and why,” he says. “They’ll sell at the bottom, while an informed investor stays in.”
Wealthfront has acknowledged some investor qualms, specifically about costs. The risk-parity fund originally had an expense ratio of 0.5 percent of assets per year. That compares with expenses averaging 0.15 percent for other ETFs in Wealthfront’s portfolios. Because of the backlash, the company cut its expense ratio to 0.25 percent just a couple of months after the fund’s launch. Andy Rachleff, a co-founder of Wealthfront, told Bloomberg News in April he was caught by surprise when customers were upset about the higher fee. “We thought continuing our policy of always delivering existing services at better prices than available would be compelling,” he said, adding that if he could launch the product over again, he would have chosen the lower fee to begin with. “Most of our clients shared our excitement on the launch of Risk Parity, and we have significant assets committed to the fund,” says Wealthfront spokeswoman Kate Wauck. About $900 million is committed, although some is still in the process of being moved to the fund in a tax-efficient way.
Investing by and large has been getting simpler for individuals, who can diversify broadly across markets at a very low cost. But fund companies and advisers still want to be able to offer an edge to justify even low fees in an increasingly cost-competitive market. “I look at it as this race occurring to add more strategies, more capabilities,” says Devin Ryan, an analyst at JMP Securities LLC. In short, complexity isn’t dead.
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