The Trap of Wealthfront’s Direct Indexing

A moat that keeps you in

Wealthfront’s direct indexing is one of the most significant differentiators between Wealthfront and Betterment, the two most visible competitors in the robo-investor space. It’s also a bi-directional moat. Not only does it act defensively, keeping competitors from reaching feature parity, but it also keeps customers inside.

The latter part is what I’d like to talk about—How Direct Indexing keeps customers from moving to a competing product.

Direct Indexing?

The standard playbook for a robo-advisor is to invest customer’s money into a series of indexed funds. Based on historical data, buying and holding an index of the overall market is shown to yield reliable returns over a 15+ year period. The indexed funds that robo-advisors typically purchases are managed by larger financial players such as Vanguard or Schwab. These indexed funds are called Exchange Traded Funds, or ETFs. An ETF is a great investment vehicle and while the maintainers do charge for their trouble, the costs are generally very low.

Wealthfront Direct Indexing flips the script—instead of purchasing ETFs from another firm, Wealthfront creates their own index. They invest customer’s money into a series of individual stocks which they believe will index of the market.

An Expensive Move

ETFs being a “standard playbook” turns out to be important. Because many companies utilize the same underlying assets for investing, moving from one provider to another is a simple matter of moving control of those assets. This type of transaction is called an “in-kind transfer”.

With an all ETF portfolio, in-kind transfers are simple. While a company will have a unique mix of ETF preferences, they have the capacity to onboard customers whose holdings differ.

For customers, in-kind transfers are important for tax purposes. In-kind transfers don’t involve a sale. Control moves from one broker to another but the same customer retains ownership. This kind of move, one where no sale occurs, has no tax implications. So far as the federal government is concerned, the investment is Schrodinger’s cat—it’s change in value can’t be known until it’s sold.

With Direct Indexing, Wealthfront isn’t investing customer’s money in a small hand full of ETFs. They are buying stock in hundreds of individual companies. In order to move to a competitor, the only choices are to move to a standard brokerage account like E-Trade and manage all of those stocks yourself or to sell them all and move the cash.

Moving becomes a massive expense, effectively creating a significant disincentive from moving from Wealthfront to a competing product.

Glass Half Full

The upshot of Wealthfront’s strategy with Direct Indexing is that their customers pay a slightly lower cost basis on the portion of money that’s directly managed. If you’re able to stick with Wealthfront for the long term, this could yield positive results.

This requires making a few bets:

  1. That Wealthfront is as good at crafting an index as the more established firms behind common ETFs.
  2. You’re betting that Wealthfront stays around for the long term and that the product maintains a satisfactory state for that same term.

I’m not particularly enamored by typical ETFs. They are great investment vehicles with a very low-cost basis but the chance that there is a critical insight at play in an ETF is very low. I think Wealthfront can do this job just fine.

Is Wealthfront is a 30-year company? It seems likely that it will exist in some form for that duration. Finance isn’t exactly a high-churn industry. I am however, unconvinced that I’m going to want Wealthfront to hold on to my retirement savings forever.

Wealthfront has a profit motive, this means change. They might choose to focus on customer growth and great product, they might decide to up prices. In a world where competitors exist who are likely to create similar investment outcomes but also allow me to maintain greater optionality, that’s the direction I’m going.