Robo advisors are to a large extent a black box. While
the client can know his allocation he really has no idea how the transactions
are executed in the markets. The past week trading was very erratic with many
trading halts and large discrepancies between the trading prices of ETFs and
the "intrinsic value" (value of the underlying securities) and wide
swings in individual stock prices many transactions executed through any
automated basis had a high likelihood at being executed at unattractive prices
that didn’t represent "fair value" and were soon reversed.
August 24 was the most notable example with multiple
trading halts and wide swings of ETF values. Any human being (like me) could
look at a screen and know something was very wrong creating a trading
environment that was best avoided. For example several of the dividend ETFs
were trading at prices far lower than the drop in the S+P 500 Etf even though
there was a large overlap in the holdings of the two. The dividend etf price
simply couldn't represent fair value. And many stocks traded down close to 10%
at the open and quickly recovered a significant part of those losses.
Investors should have learned long ago not to place stop
loss" orders in the market as they are likely to be executed during
"flash crash" type events when markets take unusual short term moves.
A more sophisticated investor would also know that with the exception of a few
of the largest ETFs it is bad trading practice or place market as opposed to
limit orders. And in market conditions that prevailed most of the day on August
24 and at other times during the past week, the volatility and numerous trading
halts for stocks made it best practice to simply refrain from trading.
Many of the algorithmic traders and high frequency
traders that provide liquidity in normal markets simply did the same. Turning
off their computers or placing very wide bid ask spreads. Market makers in ETFs
unable to execute trades in many of the underlying stocks did the same. All of
this further complicated market conditions and left those with market or stop
loss orders literally paying the consequences.
It will be impossible to know how the robo advisors
performed in these markets. At some point a researcher far more capable than me
will measure the actual performance of the ETF portfolios of the
"robos" vs the performance of the ETFs in their allocations based on
market closing values. That would give some measure of any "value
added" or "slippage" because of the transactions of these robo
advisors.
The most interesting/complex test case of the impact of
robo advisors execution is the case of Wealthfront.
Unlike other robo advisors which make use of ETFs.
Wealthfront uses what it calls a" third generation tax loss harvesting
strategy" which makes daily
transactions which according to their description optimizes tax
savings.
Wealthfront makes use of what it calls a unique tax
optimizing strategy. There is a well-known strategy of tax loss harvesting of
replacing one etf with a short term loss with another essentially identical ETF
(for example two total US stock market ETFs) to realize a tax deductible loss
without changing strategy. This is a widely used tax management tactic used by
many individual investors and "non robo: advisors.
In order to avoid "slippage" a loss in
performance due to the trades in tax harvesting it is best to do this with tow
essentially identical ETFs in quiet markets .An example would be a sale of a
position in the Vanguard total stock market Etf when there was an imbedded loss and when
the ETF was down .5% for the day immediately executing the buy part of the tax
harvesting with a purchase of the ishares total stock market etf when it is
also down .5%. That would create the tax loss with no impact on portfolio
performance. Any slippage between the two trades would affect portfolio
performance. For instance in a volatile market the sale might be done with the one
ETF down .5% and the purchase made when the other ETF in the trade was down
only .2% the net "slippage" of .3% on the trade was the difference
between the sell price and the buy price.
Wealthfront claims it is unique in two ways. Not only do
they execute tax harvesting transactions on a daily basis they also do it with their own portfolios of
individual stocks rather than with listed ETFs, generating individual stock
trades. They call this "direct indexing"
As Wealthfront explains it:
Instead of using
a single ETF or Index Fund to invest in U.S. stocks, Wealth front’s
Tax-Optimized Direct Indexing directly purchases up to 1,001 individual
securities on your behalf — up to 1,000 stocks from the S&;P 500® and
S&;P 1500® Indices and an ETF of much smaller companies.
This allows us to take advantage of the countless opportunities for tax-loss harvesting presented by the movement of individual stocks, to further improve your investment performance. Combined with our Daily Tax-Loss Harvesting service, we believe this could add as much as 2.03% to your annual investment performance.
This allows us to take advantage of the countless opportunities for tax-loss harvesting presented by the movement of individual stocks, to further improve your investment performance. Combined with our Daily Tax-Loss Harvesting service, we believe this could add as much as 2.03% to your annual investment performance.
Wealthfront uses a similar strategy in which it
replicates the total stock market index with a smaller number of individual
stocks.
Wealthfront does these transactions on a daily basis. The
assumption is that this generates greater tax savings than for instance doing
the tax loss harvesting periodically based on the status of the individual
account simply swapping between two ETFs.
I am sure this "optimized" strategy works in back
testing on a computer, although Wealthfront claim of a single number for client
tax savings is questionable given the different tax status of individual
clients. Wealthfront notes http://www.quora.com/What-are-the-main-differences-between-Wealthfront-and-Betterment-3
But two other major questions remain:
There can be two drags on performance:
Does Wealthfront's replication strategy work? Since
Wealthfront doesn’t actually buy the ETF does its replication match that of the
corresponding ETF?
While the tax harvesting may create tax losses what is
the impact on portfolio performance?
The large number of transactions increases the
possibilities of slippage. The buys and sells in the accounts may not be executed
at zero cost. The transactions may not be executed such that the net result of
the buys and sells does not create an outcome lower than the movement in the
S+P 500. So the tax savings may potentially be higher...but the large number of
tax harvesting strategies may actually be a negative for portfolio performance.
Wealthfront uses this strategy on accounts with
balances as low as $10, 0000 meaning daily tax harvesting numbering possibly
several hundred trades a year of tiny size. Is it necessarily true that
the net result of 100 individual stock trades generating $1000 a year in tax
losses in a $10,000 account (a high number since it would be 10% of the account
value) in tax harvesting losses produces a better outcome than one trade
between ETFs generating that same $1000 in tax losses And of course the more
trades particularly since they entail purchases and sales of individual stocks.
The more opportunity for slippage. In fact with that number of trades the
cumulative impact of the bid ask spread could add up significantly. And as
Wealthfront grows. In assets its tax harvesting trades will have greater impact
on the market, making it even more difficult to avoid slippage
Did the strategy that worked in computer research work in
highly volatile markets? The history of markets is full or automated strategies
that worked on research based on years of data. Until the markets hit a highly
volatile period. When these strategies run into illiquid markets. Those
outcomes predicted by computer modelling disappear. A notable example was
"portfolio insurance" in 1987. As noted many algorithmic traders and
high frequency traders have their own "circuit breakers" when markets
get too volatile and/or valuations across securities seem to be far away from
fair value they turn off the computers and watch the market chaos. Humans both
professional and some nonprofessionals have learned the same thing: to sit back
and wait under such market conditions.
But Wealthfront was active in the markets on August 24.
Wealthfront CEO
proudly told Bloomberg that Wealthfront's tax loss harvesting did over $200
million of trades on August 24...the most volatile trading day in years.
And this anecdotal article reports on a client notes
The account had been easy enough to set up—skim a
few questions, assess a few options, and voilà—all within a few
minutes from the comfort of our couch. But, on Monday, as the Dow
tumbled more
than 1000 points, he watched as the service rapidly
rearranged his account on the fly. “I’ve been constantly refreshing,” he
texted, “and it’s a roller coaster.”
He was startled, concerned, and a little bit
confused. But the service was doing exactly what it was supposed to
do. Betterment, Wealthfront, and FutureAdvisor say their services not only take
the headache out of investing, but offer real opportunities when the market
dips. The question is how well this will work—and how well the services
can retain their clients—in the long-term, especially when the market
takes a turn for the worst, or, one day, heads into a recession.
Wealthfront may have generated tax losses and as seen in
the above quote rapidly adjusted portfolios (with account size as small as
$10,000).but was what the impact on the performance. Wealthfront’s tax strategy
entails buying and selling individual stocks. For the strategy to work there
should be minimal "slippage" the down movement on the stock should be
equal to the decline on the stock purchased. If not the net gain or loss will
cause the portfolio return to differ significantly from the index performance.
Call me skeptical that Wealthfront was able to execute
its tax loss harvesting strategy which involves buying and selling individual
securities without significant slippage and thus drags on performance. On
August 24 over 1200 stocks and ETFs had trading halts which are put in place
when there are swings of 5% or more in the stock. Numerous stocks had volatile
swings particularly at the open of trading. How did Wealthfront's optimized tax
harvesting manage in these markets executing $200 million worth of trades ?
It certainly wouldn’t
have been easy given the market environment. To give just two examples of the
market environment on August 24 that would have been faced by Wealthfront's
direct indexing consider he performance of two widely traded SP 500 stocks.
Citigroup opened trading on August 24 at 48 traded 6% higher an hour later the
spread between high and low for GE was even larger trading at the open at 19.87
before recovering to 23.87.
As Wealthfront actively traded on August 24 it isn’t
hard to imagine that their trading got them caught taking "tax
losses" at extreme lows and buying back other stocks that didn’t have
similar losses. Buying a stock down 10% and replacing it with one that had
fallen only 8% would result in a loss vs the index far in excess of any tax
savings.
August 27 was another roller coaster as the Dow
opened 200 points higher dropped 300 points mid-day and recovered 300 points at
the close. It is reasonable to assume that Wealthfront’s tax harvesting trading
was active throughout and also found it difficult to avoid slippage.
Analyzing Wealthfront’s tax management
trading and its impact on performance vs the index it is trying to replicate
would be extremely difficult if not impossible.. Most likely Wealthfront will
keep that information proprietary and it will be difficult to ever discover.
But it is clear that tax harvesting strategy
through replication is not as simple as it sounds. And in fact may produce little
if any benefit compared to a far more simple strategy of periodically swapping
between ETFs when there are "harvestable" tax losses that are significant.
And to wait until markets are orderly to execute the trades.
