Wealthfront's Passive Plus: A Low Cost "Black Box " Quant fund ?

From Passive Investing to Quant fund.

Wealthfront has now debuted the next state of the art investment strategy called Passive Plus. It is described as the next generation of indexing .

The strategy makes use of what is called "smart beta" meaning weighting the portfolio differently than the more common market cap weighting used in total stock market like VTI among others.

Wealthfront has now gone beyond claiming it offers a strategy to maximize tax savings to what it contends is a  market beating strategy. In other words the firm that claims in big bold letters on their website that:

when it comes to long-term investing, you can't expect to outperform the market.

Now it presents a  strategy that claims to do exactly that...Confused... so am I.

They also perform some intellectual sleight of hand by citing Warren Buffett (who favors a simple stock portfolio of an S+P 500 index fund) and their Chief Investment Officer Burton Malkiel who in his classic Random Walk Down Wall Street  endorsed a cap weighted index as endorsing Wealthfront's approach which has strayed far away from those strategies (which is why they call it "Passive Plus")

I am not alone in noting the irony

The company said Advanced Indexing is “an improvement on a strategy commonly referred to as ‘Smart Beta,’” and in a separate statement, noted that it was conceived by a team led by Wealthfront Chief Investment Officer Burton Malkiel and Vice President of Research Jakub Jurek...

Just a year ago, Malkiel reiterated his disdain of smart beta to the Wall Street Journal, saying they are riskier than index funds and just a new way for managers to justify fees. In a 2016 update of his book, “A Random Walk Down Wall Street,” he devotes a chapter to arguing why smart beta isn’t good for individual investors.

The next step for Wealthfront Passive Plus...an inexpensive quant fund.

Wealthfront's new strategy differs fundamentally from any kind of  traditional indexing strategy. It is a factor based strategy "optimized using backtesting with performance  presented based on using that backtested model on historical data. In plain English garbage in garbage out. While most of these factors have been shown to impact stock performance and in some cases increase return there is certainly no consensus on how to weight the factors

Here is their methoodology from their website:

Advanced Indexing blends five single-factor strategies (value, momentum, high dividend yield, low market beta, and low volatility) with the cap-weighted market index to generate a modified index. This index then serves as the benchmark for our stock-level tax loss harvesting algorithm (Direct Indexing), which seeks to maximize the quantity of harvested losses, while minimizing the tracking error from the supplied benchmark.

But we don't know the details of Weathfront's algorithm and unlike an ETF it doesn't have to disclose its holding.

The Passive Plus strategy is subject to the problems of data snooping/back testing and transaction costs and potentially difficulty in liquidating portfolios described my post on their tax harvesting strategy  Wealthfront says it uses a .20% estimate for transaction costs..a number that doesnt even come from backtesting..since the backtest is based on closing prices. Apparently the assumption is based on an academic paper but there is no full citation to track it down,

Investors with portfolios over $500,000 have the "privilege" of investing in this strategy. The strategy is untested in the real world.

Essentially Passive Plus is an optimized" strategy with a combination of stocks that make up a smart beta strategy. The strategy is presented as the single strategy that can be chosen for a portfolio of $500,000 or above.

 Is There A Better Way to Access The Smart Beta Factors ?

An alternative way to access the smart beta factor would be to use it in conjunction with a cap weighted total stock market ETF and separate allocations to the factor ETFS for Quality (Qual .15% management fee), Momentum (MTUM.15% mgmt fee )Dividend Growth (DGRO.08% mgmt fee) and Small Value (VBR .07% mgmt fee) Making use of this approach creates more transparency, has the potential to reduce transaction costs and the factors (although not necessarily the ETFs have a longer term data set that is publicly available (although the danger of data snooping still exists few of thse ETFs have been around more than 5 years. Additionally investors need not go all or nothing" they can create a portfolio combining a cap weighted index ETF with the factor ETFs

A strategy using the ETFs mentioned above might be to simply equal weight the factors or to use a reblancing strategy. Momentum tends to outperform in strong up markets value performs generally better in down markets. Portfolios looking for more income would put a higher weight on DGRO.

Another alternative might be to use funds from Dimensional Fund Advisors which has for many years been a pioneer in presenting passive funds designed to take advantage of the size and value premia and have recently added a quality screen, These funds are only available through a limited number of financial advisors (including me)and some 401k funds.

Goldman Sachs Asset Management offers a seruies of active beta ETFs which combine all of the factors in single ETF.

Finally is a new ETF that could be potentially interesting is a new one from Pimco: MFUS It makes uses of a number of factors of smart beta and holds them in equal measure but within those strategies constructs the holdings taking into account valuation.

With Wealthfront's passive plus the investor is presented with a single strategy for his entire portfolio with wealthfront. Combining it with other strategies would lead to the complication of opening a brokerage account aelsewhere and would require the investor to calculate appropriate tax management strategies.

Making use of factor ETs in addition to a total stock market index would create a portfolio with more transparency and personalization and the possibility of combining a cap weighted index with the other "factors".