Software Based Companies Should Be Judged On Their Rate Of Innovation

Software is eating the world and it’s pretty clear why. Unlike their people-intensive predecessors, software-based businesses have the ability to improve their offerings at a rapid rate.

But software is not a commodity, and not all companies are able to innovate at the same rate. Understanding that matters, because committing to a software-based vendor that is not the innovator in its space will likely lead a customer to incur significant costs in the form of lost opportunity – and that opportunity cost is usually quite tangible.

Not All Automated Investment Services Innovate At The Same Rate

Allow me to illustrate this with automated investment services. To the uninformed observer, all the players appear to offer the same service – a diversified portfolio of low cost index funds managed by software. Dig deeper, however, and you will find some significant differences, particularly around the rate at which different automated investment services improve their offerings.

Wealthfront launched its service in December 2011, one and a half years after the first entrant. Despite our late start we were able to grow into the largest player in our space by consistently being the first company to offer what ultimately became industry standard services. The timeline below displays when Wealthfront began to offer a new capability and how long it was available before one of our competitors launched something similar:

The Value of Innovation Adds Up

Prior to our entry, the biggest player in our space charged an annual advisory fee of 0.90%. This seemed crazy to us given that a software-based solution could be offered at an extremely low marginal cost. As a result we launched with a 0.25% annual advisory fee. As you can see our competitor responded within three months. A client who chose our competitor would have incurred an extra 0.16% fee for that year ((0.90 – 0.25%) * 3/12).

In October 2012, we became the first automated investment service to offer tax-loss harvesting. It took our competitors 20 months to come up with an alternative.

In March 2013, we became the first automated investment service to offer what is commonly known as optimized asset location. It looks at your portfolios across both taxable and retirement accounts and puts the least tax-efficient assets into the tax-protected retirement accounts. Our competitors didn’t offer this capability until June 2014, 15 months later.

In December 2013 we launched our Stock-level Tax-Loss Harvesting service. It allowed people other than private wealth management clients to access tax-loss harvesting within an index for the first time. No automated investment service has been able to replicate what we do even after 18 months.

Finally, in January 2015 we introduced tax minimized brokerage account transfers. This new capability allows our clients to minimize the taxes due if they transfer their current holdings at another brokerage firm to us rather than sell everything and transfer cash. We have not seen any other automated investment service offer this capability.

The cumulative benefit of these advances is significant.  There is a wealth of additional improvements in the pipeline that we look forward to introducing in the coming months.

Software Based Market Leaders Are The Innovators

But really, in this framework, Wealthfront is no different than any other software based market leader. As I explained in When It Comes to Market Leadership, Be the Gorilla, the leader is almost always the innovator in its space, because there is a virtuous circle of innovation. As you lead the market, your customers do better. As your customers do better, you attract a bigger market share. As you get a bigger market share, you attract better talent and raise money more easily. As you attract talent and raise money, you can continue to accelerate your pace of innovation.

You’ve seen this in popular companies like Amazon. Amazon was the first to sell books on line. Barnes & Noble followed Amazon into the market with great fanfare, but Amazon’s market-leading position allowed it to invest in continual improvements and innovations that both saved people money and added convenience: reviews. recommendation engine, next day shipping, additional categories, Kindle, Prime. The list keeps growing. Today, it has a truly dominant position.

Rate Of Innovation Should Drive Your Decision

Pundits and market analysts often ignore the role of innovation because they are used to evaluating people-intensive business where execution, not innovation, plays the biggest role in differentiation. Software-based businesses need to be evaluated very differently from traditional businesses. Choosing the innovator means you are likely to continue to be rewarded with incremental benefit for many years to come.

 

Disclosure

Nothing in this blog should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront Inc. clients pursuant to a written agreement, which investors are urged to read carefully, that is available at www.wealthfront.com. All securities involve risk and may result in some loss. For more information please visit www.wealthfront.com or see our Full Disclosure. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront does not guarantee the accuracy of the information.

This blog is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.

When Wealthfront replaces investments with “similar” investments as part of the tax-loss harvesting strategy, it is a reference to investments that are expected, but are not guaranteed, to perform similarly and that might lower an investor’s tax bill while maintaining a similar expected risk and return on the investor’s portfolio. Wealthfront assumes no responsibility to any investor for the tax consequences of any transaction. Tax loss harvesting may generate a higher number of trades due to attempts to capture losses. There is a chance that Wealthfront trading attributed to tax loss harvesting may create capital gains and wash sales and could be subject to higher transaction costs and market impacts. In addition, tax loss harvesting strategies may produce losses, which may not be offset by sufficient gains in the account and may be limited to a $3,000 deduction against income. The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any.

Wealthfront’s investment strategies, including portfolio rebalancing and tax loss harvesting, can lead to high levels of trading. High levels of trading could result in (a) bid-ask spread expense; (b) trade executions that may occur at prices beyond the bid ask spread (if quantity demanded exceeds quantity available at the bid or ask); (c) trading that may adversely move prices, such that subsequent transactions occur at worse prices; (d) trading that may disqualify some dividends from qualified dividend treatment; (e) unfulfilled orders or portfolio drift, in the event that markets are disorderly or trading halts altogether; and (f) unforeseen trading errors. The performance of the new securities purchased through the tax-loss harvesting service may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes.

Wealthfront only monitors for tax-loss harvesting for accounts within Wealthfront. The client is responsible for monitoring their and their spouse’s accounts outside of Wealthfront to ensure that transactions in the same security or a substantially similar security do not create a “wash sale.” A wash sale is the sale at a loss and purchase of the same security or substantially similar security within 30 days of each other. If a wash sale transaction occurs, the IRS may disallow or defer the loss for current tax reporting purposes. More specifically, the wash sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale, and the 30 days after the sale. The wash sale rule postpones losses on a sale, if replacement shares are bought around the same time. The effectiveness of the tax-loss harvesting strategy to reduce the tax liability of the client will depend on the client’s entire tax and investment profile, including purchases and dispositions in a client’s (or client’s spouse’s) accounts outside of Wealthfront and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term). Except as set forth below, Wealthfront will monitor only a client’s (or client’s spouse’s) Wealthfront accounts to determine if there are unrealized losses for purposes of determining whether to harvest such losses. Transactions outside of Wealthfront accounts may affect whether a loss is successfully harvested and, if so, whether that loss is usable by the client in the most efficient manner. A client may also request that Wealthfront monitor the client’s spouse’s accounts or their IRA accounts at Wealthfront to avoid the wash sale disallowance rule. A client may request spousal monitoring online or by calling Wealthfront at 844-995-8437. If Wealthfront is monitoring multiple accounts to avoid the wash sale disallowance rule, the first taxable account to trade a security will block the other account(s) from trading in that same security for 30 days.


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