Wealthfront, one of the industry’s leading robo advisors, now has the dubious distinction of being among the first robos to settle an enforcement action with the SEC.
In what could be the beginning of greater surveillance of digital investment platforms, the SEC stated Wealthfront made false statements about a tax-loss harvesting strategy it offered clients and didn’t fully disclose that it paid bloggers for client referrals,
A separate SEC investigation into Hedgeable found it made false statements about investment performance on its now shuttered robo advisor.
“Technology is rapidly changing the way investment advisors are able to advertise and deliver their services to clients,” says C. Dabney O’Riordan, chief of the SEC Enforcement Division’s Asset Management Unit, in a release. “Regardless of their format, however, all advisors must take seriously their obligations to comply with the securities laws, which were put in place to protect investors.”
Wealthfront disclosed that their proprietary tax loss harvesting software would monitor all client accounts for transactions that could trigger a wash sale — selling a security at a loss and buying a substantially identical security within 30 days. However, wash sales occurred in at least 31% of Wealthfront accounts that employed the tax loss harvesting software over a four-year period, according to the SEC.
The Redwood City, California-based firm with more than $11 billion in client assets also improperly retweeted prohibited client testimonials, paid bloggers for client referrals without disclosing the information and failed to maintain an adequate compliance program, according to the order.
“We take our regulatory duties seriously at Wealthfront and are happy to have reached a settlement with the SEC,” says a Wealthfront spokeswoman in an email. “The settlement order addressed Wealthfront’s retweets of clients’ positive tweets from our corporate account and compensation to some bloggers for client referrals without proper disclosures.”
The second largest independent robo advisor by assets under management also owned up to improper disclosures regarding its tax-loss harvesting program.
“Additionally, Wealthfront did not have proper disclosure in its tax-loss harvesting whitepaper concerning monitoring for any and all wash sales that could occur in client accounts,” says the spokeswoman.
“For example, a wash sale can be triggered by infrequent events outside of tax-loss harvesting trading including a client changing their risk score or a withdrawal. During the period January 1, 2014 to December 31, 2016, wash sales made up approximately 2.3% of tax losses harvested for the benefit of clients. Therefore the average Wealthfront client received 5.67% in total annual harvesting yield versus 5.8%.”
Hedgeable, which had approximately $81 million in client assets under management, also made a series of misleading statements about its investment performance, the regulator said. The New York City-based robo posted misleading performance comparisons on its website and social media that included accounts with higher than average returns and made up only 4% of all client accounts, according to the order.
The firm’s co-founder Mike Kane declined to comment on the SEC order.
Without admitting or denying the findings, Wealthfront agreed to pay a $250,000 penalty. Hedgeable agreed to an $80,000 penalty without admitting or denying the findings.
One industry executive was surprised by the SEC’s charges, considering Wealthfront kept strict standards regarding republishing customer testimonials. “They are extremely meticulous about that,” the executive says. “Something must have fallen through the cracks.”
“Whether you’re a big company or a tech startup, you can’t selectively choose performance,” says Grant Easterbrook, cofounder of the 401(k) provider Dream Forward. “Client testimonials are tricky and failing to disclose relationships is definitely a no-no. There are a lot of gray areas here, but most of this you just can’t do in the investment space.”
Also unclear was Wealthfront’s tax strategy at issue in the SEC’s charges. The robo advisor employs two types of strategies. One is very typical among robo advisory firms that offer tax-loss harvesting.
A portfolio carries several asset allocation classes, and each class will have usually two ETFs. If an asset class drops in value from the time of its purchase, typically one of the ETFs in the class is sold and another similar ETF is bought to replace it. This process avoids wash sales because the ETFs are officially tracking different indexes. The portfolio is served as the ETF provides a similar exposure.
The other is an index replication strategy, which is a more sophisticated approach offering potentially higher returns after taxes. This only applies to the U.S. stock portion of a portfolio. Wealthfront has made this strategy available for accounts with a minimum of $100,000.
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Instead of buying funds, the portfolio holds individual stocks that make up an index it is trying to track. The benefit being if individual stocks drop in value, they can be sold to harvest losses, and then the portfolio can buy other stocks that are correlated. Being that it isn’t an exact replacement of stocks, the portfolio can maintain its exposure.
The sheer popularity of digital advice in the past few years could be catching the eye of the SEC, Easterbrook says. Robos are expected to grab
“You’re starting to see the SEC pay a little more attention to these guys,” Easterbrook says. “If Wealthfront wasn’t really on their radar screen in 2011, they certainly are now.”
The burden of running a successful startup may have gotten the better of the two firms, says industry consultant Timothy Welsh. “When you know your business model is under pressure and you owe your investors and creditors hundreds of millions of dollars, there is a strong temptation to cut corners,” Welsh says.
Wealth management is a complex business, which makes compliance exceedingly important, he says.
“Hopefully they will learn their lessons from these SEC sanctions to better protect consumers and use it as a mandate to fix their culture of over-hyping capabilities,” Welsh says.
