Update: On April 18, 2018, we cut the expense ratio of the Risk Parity mutual fund in half from 0.50% to 0.25%. As the assets in the mutual fund continue to grow, we want to share our success with our clients.
At Wealthfront, our goal is to constantly deliver new financial services with either a lower cost or higher value than can be found anywhere else. As we explained in last month’s blog post, when it comes to investing we look for time-tested, academically proven, rules-based strategies that can be implemented through software. That focus led us to build PassivePlus®, our signature suite of rules-based investment strategies that includes Tax-Loss Harvesting, Stock-level Tax-Loss Harvesting, and Smart Beta. Fortunately we’re not done building.
Today we’re excited to introduce our newest PassivePlus strategy, Risk Parity. Risk Parity aims to increase your risk-adjusted returns in a wide range of market environments through an enhanced asset allocation strategy.
The empirical underpinning for Risk Parity has existed in academic literature since the 1970s.1 Bridgewater Associates, the world’s largest hedge fund, first offered its risk parity strategy through its All Weather Fund to institutional investors (endowments, pensions, life insurance companies, etc.) more than 20 years later in 1996 due to the operational challenges of executing the strategy.
We would love to add Bridgewater’s risk parity fund to our clients’ portfolios, but unfortunately they require a $100 million account minimum. So our research PhDs and engineers spent the past year effectively replicating Bridgewater’s risk parity strategy, delivering our version exclusively through software. This new strategy will be available as part of a diversified portfolio for our clients with taxable investment accounts starting at $100,000.
Off to the Races
The key benefit of Risk Parity is the way it balances the risk of an investment portfolio. Wealthfront’s Chief Investment Officer Burt Malkiel offers an effective analogy to illustrate this point:
“Imagine you’re at a horse racing track. There are long-shot horses (considered by most to be unlikely to win, but with the largest winning payout), horses that are middle of the pack, and favorites (considered most likely to win, but with smaller winning payouts). What is your optimal betting strategy? Sure, the significant payoff of the long-shots is enticing enough to lure some into throwing their money at them, but a more prudent bet is the favorite. Why? Well, it turns out that over time if you consistently bet the long-shots you lose 40% the amount of your bet to pay taxes and operational expenses since the track takes 20% of each bet. However, over time, if you stuck with betting the favorites, you’d only lose about 5% of your bet over time. Risk Parity aims to give you the probability of the favorites with potentially the larger payoff of the long-shot.”
In the world of asset classes, there are also favorites and long-shots. A favorite is an asset class with relatively low risk, but also lower expected returns (e.g. bonds). Other asset classes, such as the stocks, have higher expected returns, but also higher risk. Risk Parity aims increase your risk-adjusted returns in a wide range of market environments through an enhanced asset allocation strategy. If you want to dig in more to how we do this, please see our Help Center section on Risk Parity.
Minor Cost, Major Value
Risk Parity is the first investment product we’ve built that will increase your portfolio’s average annual expense ratio. This was driven by our need to structure our Risk Parity implementation as a mutual fund in order to preserve the value we offer through our Tax-Loss-Harvesting and Portfolio Line of Credit. Just as the ETFs we use have an associated expense ratio, the Wealthfront Risk Parity Fund has an expense ratio of 0.25%. Fortunately your weighted average annual expense ratio will only increase by 0.03%.
It’s important to us to be transparent about what we charge to invest your money. Risk Parity is designed to increase your long term net-of-fees, after-tax, risk-adjusted returns, but you have a two-week period to opt out if you don’t want to use the strategy for any reason.
The Wealthfront Standard
At Wealthfront we’re focused on maximizing your financial fitness so you can focus on what’s most important: living your life. So when it comes to adding any new service, we have simple criteria: it must deliver significant value; have lower fees than the alternatives; and provide access to something you can’t get anywhere else. Like our other PassivePlus strategies, Risk Parity checks all three important boxes. We can’t wait for you to start benefiting from this time-tested, academically proven, rules-based strategy.
1 Black, Jensen and Scholes (1972) shows that low (high) beta stocks outperform (underperform) the general market on a risk-adjusted basis, suggesting that leveraged exposure to low beta stocks have the potential to outperform investing in high beta stocks. Risk Parity is based on a similar idea but applied across asset classes.
PassivePlus® is a registered trademark and property of CSSC Investment Advisory Services, Inc. (“CSSC”) and is used under license. CSSC and Wealthfront are not affiliated companies.
The views expressed reflect the current views as of the date hereof and neither the author nor Wealthfront undertakes to advise you of any changes in the views expressed herein.
The Wealthfront Risk Parity Fund (the “Fund”) is managed by Wealthfront Strategies LLC (the “Adviser” and formerly known as WFAS LLC), a registered investment adviser and a wholly owned subsidiary of Wealthfront Inc. Wealthfront Strategies LLC receives an annual management fee equal to 0.25% of the Fund’s average daily net assets. Northern Lights Distributors, LLC, a member of FINRA and SIPC, serves as the principal distributor for the Fund. Wealthfront Inc., is not affiliated with Northern Lights Distributors, LLC.
Before investing in the Wealthfront Risk Parity Fund, you should carefully consider the Fund’s investment objectives, risks, fees and expenses. This and other information can be found in the Fund’s [prospectus]. Please read the fund prospectus or summary prospectus carefully before investing. Investing in securities and mutual funds involves the risk of loss.
All investing is subject to risk, including the possible loss of the money you invest. In addition, an investment in the Wealthfront Risk Parity Fund (the “Fund”) would also subject you to the following principal risks, among others: The Fund’s principal investment strategy requires the use of derivative instruments, such as investments in total return swaps, forward and futures contracts.
In general, a derivative instrument typically involves leverage, providing exposure to potential gain or loss from a change in market price of the underlying security or commodity in a notional amount that exceeds the amount of cash or assets required to establish or maintain the derivative instrument. Adverse changes in the value of the underlying asset or index, can result in a loss to the Fund substantially greater than the amount invested in the derivative itself. These derivative instruments provide the economic effect of financial leverage by creating additional investment exposure to the underlying instrument. Financial leverage will magnify, sometimes significantly, the Fund’s exposure to any increase or decrease in prices associated with a particular reference asset resulting in increased volatility in the value of the Fund’s portfolio. While such financial leverage has the potential to produce greater gains, it also may result in greater losses, which in some cases may cause the Fund to liquidate other portfolio investments at a loss to comply with limits on leverage and asset segregation requirements imposed by the 1940 Act or to meet redemption requests. If the Fund uses leverage through the purchase of derivative instruments, the Fund has the risk that losses may exceed the net assets of the Fund. The net asset value of the Fund while employing leverage will be more volatile and sensitive to market movements.
Investments in total return swap agreements also involves the risk that the party with whom the Fund has entered into the total return swap agreements will default on its obligation to pay the Fund. The Fund’s use of derivatives may cause the Fund to realize higher amounts of short-term capital gains than if the Fund had not used such instruments. The Fund may also be subject to overall equity market risk, including volatility, which may affect the value of individual instruments in which the Fund invests. Factors such as domestic and foreign economic growth and market conditions, interest rate levels, and political events affect the securities markets. Markets also tend to move in cycles, with periods of rising and falling prices. If there is a general decline in the securities and other markets, your investment in the Fund may lose value, regardless of the individual results of the securities and other instruments in which the Fund invests. When the value of the Fund’s investments goes down, your investment in the Fund decreases in value and you could lose money.
In addition, the Adviser relies heavily on models and information and data supplied by third parties (“Models and Data”). Models and Data are used to construct sets of transactions and investments and to provide risk management insights. The Fund may be exposed to additional risks when Models and Data prove to be incorrect or incomplete. The Adviser is also newly established and has not previously managed a mutual fund. The Fund is a new fund and as such has limited performance history. The Fund is not suitable for all investors. The Fund should be utilized only by investors who (a) understand the risks associated with the use of derivatives, (b) are willing to assume a high degree of risk, and (c) intend to actively monitor and manage their investments in the Fund. Investors who do not meet these criteria should not buy the Fund. An investment in the fund is not a complete investment program.
The Fund is non-diversified under the 1940 Act and may be more susceptible than a diversified fund to being adversely affected by any single corporate, economic, political or regulatory occurrence. For more information regarding the risks of investing in the Fund, please see Principal Investment Risks section of the Fund’s prospectus. Past performance is no guarantee of future results.
The information provided here is for educational purposes only and is not intended as investment advice. The analysis uses information from third-party sources, which Wealthfront believes to be accurate; however Wealthfront does not guarantee the accuracy of the information. There is a potential for loss as well as gain in investing. Wealthfront does not provide personalized financial planning to investors, such as estate, tax, or retirement planning. Investment advisory services are only provided to investors who become Wealthfront Clients (“Clients”) pursuant to a written Client Agreement, which investors are urged to read and carefully consider in determining whether such agreement is suitable for their individual facts and circumstances.