Rethinking The Proposition of Wealthfront in Index Investing

Index investing in today's fast paced capital markets

Here I’ll be reviewing an article regarding index investing recently given to me by one of my friends. It’s a blog post titled “Debunking The Myth of Magical Options Strategies”. The link is at the end of the post, you can read it later. 

The blog briefly talks about how options strategies work, and how investors use options to protect their downside, while having some of the upside returns. Also, the blog post shows two tables comparing options strategies, using Sortino Ratio and Standard deviation, vs the S&P 500. In addition to another table showing the average return of hedge funds, the S&P 500 with option strategies, and Wealthfront’s own portfolio allocation method, and detailing how Wealthfront beats them all by far.

What’s Wealthfront? It’s an online financial advisory company where you can invest your money with them, and they will manage it for you with advertised low fees.

The blog’s author goes on and on that:

We continually return to the idea that there is no magic secret to investing that will deliver consistently strong returns with little or no risk. The data show that, so far, all attempts to find this Goldilocks strategy end in heartache.

And then again:

there is no such thing as a free lunch in investing because we can’t control the market.

I, myself am a proponent of index investing and diversification, and I think it’s a very handy way of investing, but is it good everybody? Well, let’s find out.

Index Investing vs. Options Strategies

The author shows a table with the 20 year return of S&P 500 hedged with at-the-money puts (-0.26%), and out-the-money puts (0.02%), and shows how each of them failed to beat the 3.50% S&P 500 return for the same period. The author cites a University of Utah professor, Robert Dubil that published those findings in his paper.

There are several assumptions in the returns the blog post mentioned:

  1. Some sort of a commission fee?
  2. Whether the option contracts were European or American style?
  3. If the Sortino Ratio mentioned is against a unified Risk-Free Return or against a different benchmark?
  4. The most important one: That options strategies are for long investment horizons.

Beginning with assumption (1)

It is possible for the author to have assumed any commission fee, and that is a very important variable in determining the return of the investment. Based on what the author said and I agree, quote:

Instead, investors should focus their attention on controlling the things they can control: diversification, costs and taxes. By doing that, they can achieve the optimal result and maximize their net-of-fees, after taxes return.

Second

If the options were American style, then it is an order of magnitude more difficult to calculate the return since the owner of the option contract has the right to exercise before maturity, therefore can lock in potential returns before the expiration date. The author may reply back and say, well all major indices are European style and therefore they have to be exercised at expiration, and well it’s easy to refute that since you can have American options on ETFs that trade the S&P 500 index!

Third

I can’t go into much details of the Sortino Ratio because frankly I don’t know what data the author used, but it is possible for some people to use a risk-free return different from the Treasury, and therefore the results can be skewed. But from the table itself that the author posted, the standard deviation of negative returns in S&P 500 with OTM options had 11.92% vs. 20.48% of the S&P 500 itself. Keep that in mind and I’ll explain below!

Fourth

Options strategies are mainly for investors who require certain amounts of flexibility in their investments because of different capital requirements. Let me give an example to make it clearer:

A corporation may allocate a percentage of its cash reserves for capital market investment activities, but does not want this capital to be locked in for more than 6 months period due to its board’s requirements. Now such investor is basically trying to ‘if possible’ obtain some upside from a trend in the market if existed. We may debate if it’s right or wrong, but nonetheless, a considerable amount of investors ask for such requirements!

For that type of investor, options strategies are a MUST to protect their downside if a huge down trend hits them.

So for example, if you buy SPY (ETF tracking S&P 500) at $213, and 20 days later it is trading at $204, you have clearly lost $9/share. While if you have protected your down side by buying $213 puts at $2.50/contract + (assuming) $2.00 commissions, you would’ve lost $4.50.

Not beating the market by beating the market

Wealthfront advertises in the same blog post a 10 year annual excess return of 5.31% for its basic service, while it doesn’t include how much the S&P 500 was for 10 year (it’s only indicated for 20 years) but I’m assuming Wealthfront was not found just to tell people: Go buy an S&P 500 ETF and that’s it, clearly they have another way of managing investments.

And that is totally fine with me, but what is not fine is repeatedly saying “There Is No Magic Solution” and “… we can’t control the market.” and then right above it say that our methodology beats the market!

My question is: What’s the “market”? Is it the S&P 500? If yes, then Wealthfront is saying that they beat the market. Is it another index? Then the results shown have no value because they weren’t benchmarked against the market.

A note on hedge funds

I’ve seen numerous people comparing the returns of hedge funds to S&P 500 and be like: we outsmarted the smart guys like Paulson and Simons!

The blog post also does that by comparing the excess return of hedge funds (1.61%)  vs. Wealthfront basic service (5.31%) for 10 years.

Read this analogy:

The average acceleration time for all production cars from 0-60 miles is 11 seconds, and the acceleration of a Boeing 747-400ER from 0-60 is 4.9 seconds. Clearly, Boeing wins.

This is what the author is similarly doing, comparing apples and oranges, and averaging the apples (to get the rotten ones too!) vs. a good orange. For the past analogy, LaFerrari does 0-60 in 2.4 seconds, can we say LaFerrari is faster than Boeing 747? NO!

Averaging hedge funds is like averaging the 0-60 acceleration times for all cars in the world, and that’s not accurate. Plus, hedge funds are private and most of them are not subject to disclosure, and these indices are not reflective of the top performing ones at all.

Past results are not a guarantee of future results

Any investment professional would disclose that at the end of their statement/article/post etc. What I would expect from people who hold a doctoral degree in Finance to disclose such and believe in it even if not entirely by heart but to some good degree at least. What this means is that you can’t “Debunk” an entire set of financial instruments and investing strategies because you could achieve a 3% excess return in 20 years. As a matter of fact, the reason why options are existent is because we can’t predict the future and we’d want to be as agile as possible for what the future is holding for us.

Link to Wealthfront’s blog post.