On October 10th, the Wealthfront Risk Parity fund, internally built, imploded versus other risk parity funds created by professional quantitative investors. It seems like a small blip in the world of markets, so why is this important?
Over the last several years, “robo-advisors” and other fintech companies claiming to “disrupt” the financial industry have made enormous inroads into attracting investors and growing AUM. The benefits espoused have primarily focused on a reduction of fees and enforcing behavioral limitations to prevent investors from exercising their human emotion in an actively managed portfolio.
And this good! The problem is that they are also startup companies, with large cash burn rates, big valuations and a need to big or go bust. Which means that while their mission is important, revenue generation is existential. Which means that sometimes the mission takes a backseat, naturally, at the expense of its customers.
In this case, Wealthfront had the option of using third party risk parity funds, but the fees they could generate by attempting to create their own in-house fund that matched the performance of third-party funds was incredibly alluring. But that’s not their core competency, they’re technologists, not quantitative investors! Of course anybody can hire some PhDs and call themselves proficient, but that’s not how it works. Investing is hard, and for the best investors it takes years and years of experience and internalization. If anybody could just hire investing talent, everyone would do it.
Backtest vs in sample risk parity performance comparison… Wealthfront vs AQR pic.twitter.com/NQ7LLxkUGH
— Jake (@EconomPic) October 10, 2018
And the result was a disaster. The S&P dropped over 3% on a single day, treasury yields increased, and the Wealthfront Risk Parity fund dramatically under-performed similar funds. The worst part is that they didn’t have their investor base OPT-IN, rather, for many investors, they had to OPT-OUT. But the whole point is that it’s a “robo-advisory”. You’re signing up for Wealthfront because you don’t want to actively manage. As a result, a bunch of investors took it in the teeth because a technology company, trying to find creative ways to generate revenue, strayed way outside their lane and crashed into a tree.
My pet thesis is this Risk Parity Fund came about BECAUSE their business model is terrible: Raise oodles of VC money for a low fee commoditized product with no exit strategy or even produce high yield income from the business. Uh Oh, better get creative . . .
— Barry Ritholtz (@ritholtz) October 10, 2018
Why, is this relevant to Streitwise? Because we see the same thing happening in the commercial real estate crowdfunding sector. Do you know, have you researched, have you questioned the incentives and the alignments of the actual people making decisions as to which properties become available on the crowdfunding platforms or the investment decisions made through other Reg A+ REITs? These are technology companies primarily, hiring real estate professionals secondarily. Streitwise is a real estate company first, using technology to make the investment process cheaper and process, second.
Our REIT, sponsored by an independent real estate investment company, exists and will exist whether or not the move to online real estate investing becomes an entrenched trend. We have our money it, our family’s money in it. For us, it’s about finding quality, long term investments, determined by a team that has decades of commercial real estate investment experience. We want the entire sector to succeed, but many deals get capitalized because of shiny “projected returns” and the informational asymmetry of raising money online. We see properties acquired because money is available and the fees to the sponsor leaves little skin in the game, not because a particular opportunity has a good risk adjusted return profile. And when the Wealthfront phenomenon hits real estate crowdfunding, it won’t be pretty either.
Doing your homework on any investment is not “active management”, it’s essential to compounding returns over a long time horizon. Startup fintech mission statements make for great marketing collateral, don’t let it become collateral damage to your portfolio.
Mr. Karsh is a Partner and Co-Founder of Streitwise. His primary responsibilities include sourcing and executing new investments, managing corporate operations, and overseeing investor relations and reporting.
Prior to forming Streitwise, Mr. Karsh was an Acquisitions Analyst for Canyon Capital Realty Advisors and the Canyon-Johnson Urban Funds, where he was responsible for underwriting, structuring and executing value-add and opportunistic transactions. He holds a Bachelor of Arts degree in Political Science from the University of Pennsylvania. Mr. Karsh is a member of ULI and is also a Real Estate & Construction member of the Jewish Federation of Greater Los Angeles.