Burton Malkiel and Weathfront’s Fancy New Approach to Passive Indexing

Burton Malkiel has been champion of passive index fund investment longer than many of you have been alive. He has played an important role in communicating academic investment knowledge to professional and non-professional investors, and has generally been a voice of reason in American investing for decades. Guy’s got cred.

More recently, Malkiel became chief financial advisor to Wealthfront, the robo-advisor investing company. Until recently, Wealthfront has been more or less indistinguishable to competitor Betterment (highly diversified ETFs and index funds > wait 30 years > $$$$). Within the past few days Wealthfront has introduced a novel idea called Advanced Indexing. And Burton Malkiel is making the rounds selling it to Wealthfront’s wealthiest clients.

What is “Advanced Indexing”?

First let’s talk about what it’s (sort of) not.

Conventional Passive Indexing: You put your money into a cheap fund that is made up of hundreds or thousands of little pieces of company stocks. The stocks reflect the exact composition of a specific market (S&P 500, for example). The money you gain or lose reflects the exact value motion of that market.

Stock Picking: You put your money in individual company stocks, hoping they’ll gain enough value to “Beat the market”.

Advanced Indexing is more or less a combination of the two. Wealthfront uses algorithms to create new indexes, based on companies that meet certain criteria, rather than simply mirroring an entire market.

What are these criteria, you ask? Here’s the list I had to dig out of the Advanced Indexing White Paper:

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.”

In other words, Wealthfront it trying to give its clients better-performing funds by cutting out the crap that weighs down returns on conventional funds.

Will This Actually Work?

Nobody knows. It’s one of those ideas that “seems to make sense”, and is certainly based on rich academic groundwork. The concept has been backtested with excellent results. But because this offering is brand new, no one has actually made money this way yet. So what do I think is going to happen?

I Don’t Totally Buy It

“Advanced Indexing” is still stock picking, at its heart. Currently the service is only available to people with at least $500,000 invested in Wealthfront, who will receive 500 stocks based on the above criteria. Clients with at least $1,000,000 in Wealthfront accounts will get 1000 stocks. Any decent portfolio of 1000 company stocks is bound to closely resemble one or more existing, dirt cheap ETFs.

Wealthfront and Malkiel emphasize that the company’s standard Tax-Loss Harvesting opportunities will be greater this way because, you know, stocks are more volatile than funds. That’s not a zero-sum game exactly, but it’s not far off.

I think Wealthfront is trying to find a real value-proposition to distinguish it from Betterment and increase its market share. I’m guessing Advanced Indexing will outperform market indexes sometimes, other times not, and in the end it won’t be worthwhile enough to switch your business over to an expensive (when compared to the passive model) robo-advisor.

I think Wealthfront and Malkiel are currently testing the waters to see if this should be a feature to market in a big way. That’s why it’s only offered to a relatively small group (those with $500k – $1M invested). If it doesn’t work for them, they can take it off the table without having pissed off the majority of users.

I say all this because the service is poorly explained in Wealthfront’s general marketing. You have to dig into a dense White Paper to find out how it works. For me, the same downsides still apply to Wealthfront: more expensive than passive indexing, only useful for taxable accounts, doesn’t do anything you can’t do yourself.

I don’t blame Burton Malkiel for pushing this new method. Maybe it’ll pay out and become a new industry standard. But that’s a tall order when the old model you’re trying to topple is as proven and efficient as conventional index funds. I’ll keep an eye on this issue, but my expectations are not high.