The Pomp Podcast - #381: Andy Rachleff on Wealthfront & The Future of Fintech

Episode Date: September 10, 2020

Andy Rachleff is a co-founder and Executive Chairman of Wealthfront. He also co-founded Benchmark Capital in 1995 and was a general partner until 2004. In this conversation, we discuss disruption theory, product-market fit, exponential organic growth, self-driving money, payment for order flow, and delight as the greatest form of virality. ============================= Athletic Greens is an all-in-one daily drink to support better health and peak performance. Even with a balanced diet, it’s difficult to cover all of your nutritional bases. That’s where Athletic Greens will help. Their daily drink is like nutritional insurance for your body that’s delivered straight to your door. You can get yours at https://athleticgreens.com/pomp ============================= EQUOS is a digital asset exchange built to institutional standards available to everyone. It is built with the highest-grade security and transparency principles to meet regulatory standards while paving the way for participation. Their diverse team brings together decades of experience building and operating global digital exchanges used by the world’s biggest financial institutions, including deep expertise in the design and implementation of low-latency matching engines and algorithms and strategies. https://equos.io/ ============================================================ Pomp writes a daily letter to over 50,000 investors about business, technology, and finance. He breaks down complex topics into easy to understand language, while sharing opinions on various aspects of each industry. You can subscribe at https://www.pompletter.com

What's up, everyone? This is Anthony Pompliano. Most of you know me as Pomp. You're listening to the Pomp Podcast, simply the best podcast out there. Let's kick this thing off. Andy Ratcliffe is the co-founder and executive chairman of Wealthfront. He also co-founded Benchmark Capital in 1995 and was a general partner until 2004. In this conversation, we discussed disruption theory, product market fit, exponential organic growth, self-driving money payment for order flow and delight as the greatest form of virality i really enjoyed this conversation with andy and i hope you do as well before we get into this episode though i want to quickly talk about our sponsors the first is athletic greens if you're

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Go check them out. Lastly, don't forget that I write a daily letter to over 50,000 investors about business technology and finance. I break down complex topics into easy to understand language while sharing my personal opinion on various aspects of each industry. You can subscribe at pompletter.com. Again, pompletter.com. All right, let's get in this episode with Andy. I hope you guys enjoy this one. Anthony Pompliano is a partner at Morgan Creek Digital. All opinions expressed by Pomp or his guests on this podcast are solely their

opinions and do not reflect the opinions of Morgan Creek Digital or Morgan Creek Capital Management. You should not treat any opinion expressed by Pomp as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of his opinion. This podcast is for informational purposes only. All right, guys, bang, bang. I've got Andy here with me. Thanks so much for doing this. Thank you for having me. For sure. So for the like two people who are watching this who don't know who you are, let's just start with your background and kind of what you did before you got to Wealthfront. Okay, well, I was a career venture capitalist for almost 25 years, the last 10 of which I co-founded and was a general partner

of Benchmark Capital. And then I retired the beginning of 05 to teach at Stanford Graduate School of Business, where I've continued to teach. And then in December of 2011, we launched the Wealthfront service. So that was quite an accident. And I'm the co-founder and CEO of Wealthfront. Awesome. So one of the things I'm personally interested in is what was the genesis for starting Benchmark? You'd already spent a bunch of time in venture, but what was the idea or the impetus for when you guys started that? Well, I needed a job. That's a pretty good answer. I had the good fortune to have been a partner at what was then a premier firm in the venture business called Merrill Pickard Anderson and I, or it was probably one of the top five or six firms

in the business. And two of our five partners had reached an age where they wanted to retire. And that left three of us. And we could either have taken the franchise forward, or we could start something new. And so two of, we decided on the latter. So we wound down Merrill Pickard. Our last fund, our 1989 fund was a 10X fund. And in 1989, that was a big deal. So in 95, actually New Year's Eve, 94, we, five of us shook hands to start Benchmark. So it was my partner, one of my partners from Merrill Pickard, Bruce Dunleavy, and I, and three other people. The other partner, the third partner from Merrill Pickard, teamed up with two other people and started Foundation Capital. And at the same time, another one of the top five venture firms,

TVI, had decided, had the same generational transition where the founding partner was going to retire. And one of their partners joined us, Bob Cagle, who was one of our co-founders. And that left two partners from TVI, and they teamed up with one other person and started August Capital. So from the two firms were created three. That's awesome. And then the name Benchmark. There's a lot of speculation. What was the idea behind the name? Well, we wanted something, we had read a book that we were heavily influenced by at the time that we had come together called Built to Last. And so we wanted a name that evoked something that was built to last. We were looking for an architectural term, and believe it or not, benchmark was initially the high point in a building. and we also wanted something that had a technology connotation and back in the days of hardware you always benchmarked your products against everyone else's so when we came upon that name we just

loved it because it had the the double entendre and that's and the best part of all was the domain name was available in 1995 that was you know you could get a name like benchmark.com so that was the final straw that led us to move forward. That's awesome. And obviously, the reputation speaks for itself in terms of you guys ended up going on and built one of, if not the number one venture capital firm in the technology industry. And you did it for about a decade, if I understand correctly. What was the fascination or kind of drew you to teaching? I think a lot of people said, hey, that is a natural progression. But what was it for you personally in terms of wanting to to do that? Well, I wanted to give back. I have a life beyond anything that I ever could have

imagined. And I wanted to give back to the institutions that made that possible. So I became a trustee of my undergrad alma mater, University of Pennsylvania, where I got to know Howard Marks, who we were discussing before we started very well. We actually served on the Endowment Investment Board together. And then I started teaching at Stanford Graduate School of Business, where I got my master's degree. And then my wife and I started an innovative cancer research funding initiative. And so they were all things to give back. And teaching just sort of came naturally. I TA'd a lot of courses, undergrad and grad. I was a guest lecturer for a number of classes. And I like coaching. So it was something that I wanted to try, and I absolutely

fell in love with. How similar was it coaching or teaching students to dealing with founders on a daily basis? You know, founders have always been young, but they were never as young as they are now. So they required more coaching than the founders that I work with. That might be a little bit. That might not be as true today, but I think the founders today want less coaching than the founders did 20 years ago, to be perfectly honest. Very fair point. And so obviously at some point you decide, I think you're actually still teaching now, correct? I am, yes. Okay. So you're going to continue to teach, but you ultimately end up starting a business.

what was was it just pulling you out of bed every day and you said I got to go do this or was there some other reason to uh no it was really quite accidental so one of my responsibilities as a trustee at Penn was to sit on the endowment investment board and which I now chair and I was sitting through a presentation on how the endowment got its great returns I'm a big believer that the premier university endowments are the best managed pools of capital I mean that's how your firm got started. That's what Mark did before he started his own firm. And what I noticed was that a lot of what they did was all the premier endowments manage their money approximately the same way. You know, they were all investors in benchmark and friends of mine are on all of their

boards. So we all know what they do, but a lot of it is spreadsheet based and manual. And I thought, God, if you automate much of what they did, and if you actually implement it in software, you could deliver an 80-20 on the endowment experience. So it isn't quite as good, but it'd be radically better than what the average individual investor has available to them in the United States. And that struck me as an opportunity because when I was a venture capitalist, many of the people that I had recruited in my portfolio companies who went on to financial success would come to me for investment advice. And I could never tell them to do what I do because I was fortunate to be able to afford better services with higher minimums. And so by doing this, it struck me that it was yet another social good. And I had really committed myself to social good after I'd retired from venture capital. And little did I know how much work it was really going to take to build. That's awesome. And so talk us through in terms of as you guys got started, I was reading online, I actually didn't know this.

The company had a different name at first, and then kind of the Wealthfront story started in 2011. But what was kind of the, you know, the pivot or the name change and kind of how you navigated that? And then what was that initial launch under the Wealthfront name in 2011? Sure. Well, everyone pivots. The one thing that most people don't understand is that literally every single successful technology company ended up pursuing a business plan different than the one that they set out to pursue.

Now, they all revise history because consumers want to believe that you always intended to serve them. So we all change the story. And so when we started, what we were trying to emulate from the endowments was the way that they choose public equity managers. So we built a marketplace of managers from which you could choose, who you could access with as little as $10,000, and typically it took a million dollars at least to attract, to be able to get into a separately managed account, outstanding investment manager. And we use the methodology or algorithms that premier endowments use to vet the managers. So what we were trying to do is find people who are likely to outperform and make them accessible. That's the democratization. Now, what we picked were ultimately we got to a marketplace of about 50 managers, all of whom were U.S. public equity managers.

and in the year and a half that we operated the marketplace where we had performance post selection our managers outperformed the S&P by four percent net of fees so we did a great job and nobody cared and and what we learned when we dug in was that as I said we were really only appropriate for the U.S. public equity portion of one's portfolio and when we talked to people who chose not to open an account, the consistent message that we got, everyone used different words, but basically, we would rather that you manage all of my portfolio adequately and inexpensively than a portion of it superbly. And that was a lot easier to do. So we skinnied the marketplace down to one manager, us, and we offered a diversified and rebalanced portfolio

of low-cost index funds, and that immediately took off. Yeah, that's awesome. And so walk us through before today's announcement, kind of what the product itself looks like. So users come in under the promise that, you know, I think the popular terminology of robo-advisor, basically the computer and the algorithms are going to help me, you know, basically protect me from myself, right? It's going to do things that normally I would not do, or I wouldn't be disciplined to do, and I don't have to think about it, but what does that look like in a product format? Well, basically, what we've done is taken best practices in the financial advisory world and automated them. There's no proprietary algorithms. There's no quant element to what

we do. The way that we diversify your portfolio was first conceived in 1958, and it won the Nobel Prize in 1990. And it's the basis on which all well-managed large pools of capital diversify their holdings among asset classes. And there's a tremendous amount of research that's very consistent that shows that trying to pick managers to outperform the market is almost impossible over the long term. And you're better off picking index funds to represent each of the asset classes. So basically, that's what we do on people's behalf. The way that you'd select the portfolios based on their risk tolerance. And only that, most people overstate their tolerance for risk. And the problem is that the research is really clear that most individuals buy when

the market goes up and sell when the market goes down. It's the opposite of what you should do, but it's what feels right. And nothing about good investing feels right. So if we can keep you invested, then that's going to earn you another one and a half to three and a half percent per year based on the research of the way individual investors behave. So we want to make sure that we get a portfolio that's risky enough, but not too risky. It's sort of like Goldilocks. And if we can keep you invested in that diversified portfolio, you'll do well. So over the eight and a half years that we've offered that service, our gross return is about 8% per year. Now, certainly people can outperform that. But I don't think very many people over eight and a half years have earned

more than 8% compound. I really don't. And on top of that, we deliver a service called tax loss harvesting, which pays for our very modest fee of a quarter of a percent, anywhere from three to 13 times over. So amazingly, applying this methodology that typically has only been available to very wealthy people, that's selling an ETF when it goes down and replacing it with a similar one to maintain the risk and return characteristics of the portfolio, that adds after-tax for our average portfolio on the order of 2% of the portfolio value per year. but it ranges anywhere from three to 13 times the portfolio this year uh the tax loss harvesting will probably generate a value equal to 15 times our fee and it's free and it's deterministic it's

not there's no timing of the market there's no fancy algorithm and and so it's tremendous value So we just kept improving it and improving it and adding more features to that to the point that, you know, Dave Swanson, who runs the Yale Endowment, who's probably the most famous endowment manager, a large pool of capital manager in the world, said to me, I don't think there's anyone better than what you do other than maybe a few of the top endowments. And we make it available to people with as little as $500. dollars so over time the way that we expanded was we came to realize that our value added we started adding planning and advice to our suite of services and we came to realize that the investments that we had made in automation uh in in all the platform work because we won't deliver a service unless it can be completely automated and advice automation were the things that really stood out So we said that our vision was to automate and optimize all of your personal finances. And then one of our engineers said, well, that's self-driving money. And that's a lot pithier way of saying it. We said, actually, yeah.

So the vision is to get people to direct deposit their paycheck with us. We automatically pay their bills and then even pay down their debts and then take the remaining money and invest that in a way that's most appropriate for their situation and goals. And today, and so we launched initially a high-yield cash account, which was the minimum viable product of the account into which you would direct deposit. And then a couple of months ago, we added an entire suite of checking features, all of which are available for no fee and all much easier to use than a traditional bank app. It's a five-star rated app on the App Store and Google Play Store. And then today we introduced Autopilot, which you can think of as a software-based financial assistant that automates your savings. And so we actually are now implementing our vision.

Yeah. What's really interesting about this is much of, I think, personal finances, one, people just are very undereducated on it, right? A lot of people just don't have either access to the information. No one sat them down and said, you know, here's the basics. So I think that, you know, obviously being able to kind of impart that information to somebody's portfolio, whether you've got to tell them about it or you just do it for them is a huge value. But also the second piece is even the people who are educated on what to do, there's still a manual process, right? In terms of you've got to go into your account, you've got to do X, Y, and Z, you know, and it's very easy to kind of break discipline, right? Oh, the stock market's going up today. You know, maybe I should put a couple extra percentage points in there or take it out or do whatever. And so, to me, it seems like what you guys are really doing is just taking the best practice, writing it into code, and then preventing people from making all of the classic mistakes, right? That's all we do. It's really, really simple.

You know, it's really funny. I've seen many people write about us that it's ideal for beginners, which makes absolutely no sense because it's just as appropriate for really sophisticated people as beginners. And as a matter of fact, the early adopters of almost every one of our services are literally the most sophisticated people. So, for example, with Autopilot, this is a feature, our first self-driving money feature that unifies banking and investing. So what it does is that you choose the account that you want it to monitor. If the balance goes above a threshold that you set by more than $100, we will set up a transfer to an individual either savings or investment account. We'll then send you an email so that you have 24 hours to say no. So we want you to be in complete control.

That's what we call an assistant, not an advisor. You're in complete control of this thing. And it basically just automates what people, what sophisticated people normally do. And over time, we'll monitor more and more source accounts and we'll route to more and more destination accounts in parallel. And the beauty of it is if you bank with Wealthfront, all of this money transfer is immediate. We take all the float out of the system. And so there's a tremendous benefit from using both our banking and our investing. Yeah. And in that feature, it sounds like you guys are kind of start out with the minimum viable product, but you started to expand and there's kind of a greater vision there. I was told that you are the person who coined the term product market fit. I am.

Okay, so you're going to tell us the story of where that term comes from. And then I want to hear how you measure internally, you know, do each of these new features that you launch actually hit with product market fit? But where did that terminology come from initially? Well, as a venture capitalist, I always spent a lot of time trying to improve my craft. I always tried to get better. And one of the things that I did is I tried to study my competitors to understand what they did really well. And the firm that I most respected was Sequoia Capital. I just think they're unbelievable. And I think Don Valentine was brilliant. And Don had a methodology that that's very unique to sequoia don's point of view on don passed away in this past year and he was probably one of the two greatest venture capitalists of all time john door is probably the other from climate purchase anyway don had this philosophy that if a startup

can screw something up they will because you're under resourced you're understaffed it's not that you're not good. It's just that you have so little bandwidth to do so much, you're going to screw almost everything up. So the pull from the market has to be so strong for you to succeed that that's all that matters. And so Don was famous for asking this question, who cares? Everything he focused on was who cares about your product and why are they desperate? In order for a startup to succeed, consumers need to be desperate for what you offer, because if there's a good enough alternative from an incumbent, consumers will buy from the good enough alternative, because they trust it. Why would they buy from you? And so I tried to learn more and more about this. One of our partners, we recruited a partner to Benchmark who had Don as the chairman. He started a very successful digital video company, the first digital video company called CQ Microsystems. Don was his chairman. So I tried to learn from him about Don. Couldn't exactly call Don up and Don wouldn't tell you the secrets if you called him?

No. But I was on the board of a number of companies. We worked with Sequoia a lot back in the days when we used to syndicate, and I would talk with my colleagues because there was a lot of mutual respect. And so I basically put a name to what Don had been doing for decades. So the idea of the market pulling the product out of your hands, I thought of as product-market fit. And so I coined the term, and I really spent a lot of time working on the concepts with Mark Andreessen because I sat on Mark's board at Opsware, and he was really interested in this.

I actually gave them an idea. They pivoted from something called LoudCloud to Opsware based on some of the thoughts that I put together on what was important to product market fit. and so together we really tried to think that through. Mark wrote about it a lot which is why a lot of people think that he coined the term but he's always very kind to give me the credit and about 12 years ago I started teaching a course on it at Stanford. So every year I try to get a little bit better at trying to understand the issues. So back to your key question is how do you know if you have it? I think there are different heuristics for consumer companies and enterprise companies. For consumer companies, it's exponential organic growth. Because how do you know that people want your value proposition? Well, the only way that you can tell is if you

get word of mouth. And the only measure of word of mouth is exponential organic growth. It's not growth in general, because you can gain growth, you can buy growth uneconomically. And so a lot of people fall for that. But one of the things that you find if you talk to the premier venture firms is they're riveted on exponential organic growth. And then how about with the enterprise software? Well, there are two things. There are two heuristics that I've come to recommend for them. One of my teaching partners for another one of my courses, not the product market fit course, was a fellow named Mark Leslie, who founded a phenomenal company called Veritas Software that he grew to about a billion and a half dollars of revenue before he retired, which is an amazing accomplishment.

And Mark's a great leader. Well, he published a paper with a Stanford Graduate School of Business professor named Chuck Holloway called The Sales Learning Curve. And basically, it posited that sales has a learning curve, just like manufacturing, that there's an S curve to selling a product, it starts out slow, and then it ramps very quickly, and then it starts to slow down again. And interestingly, the first knee of the curve in that S, where things really take off, the sales yield is equal to one. So the sales yield is the contribution margin generated by a sales team as the numerator, and the cost in the denominator is the cost to field a sales team. So for an enterprise company, there's usually a direct salesperson. There is an SE, a sales engineer, who does the technical part of the sale. There's often an inside sales rep or a portion of an inside sales rep.

There is the management overhead. And when you add it all up, it adds up to about $600,000 per team. So that says once a sales team is able to generate a gross profit in excess of $600,000, you know you've hit the recipe. You know you've figured it out. And the paper on sales learning curve, which you can easily Google, makes the point that the biggest mistake enterprise companies make is they ramp up their sales teams before they know whether or not their sales yield is greater than one. And they do it thinking more sales reps means more sales. Well, it doesn't work that way. First, you have to figure out the recipe, and then you can ramp it. And that's where you waste most of your money. So that's one. And then the other one I learned from Doug Leone, who's the managing partner at Sequoia, not surprisingly, and that is when an enterprise company starts, it usually has to do a trial as a proof of concept.

And what you find is in order to qualify the prospect, you make them sign a contract that says after 30 days, if the product does what you say it will do, what you represent, they'll buy the product. No one ever lives up to that contract. So what Doug does is he tells the CEO, pull the trial after 30 days. Now, most companies don't start the trial until one or two weeks into the stated 30-day period. But Doug's point is, if they don't scream and pay you, they were never going to pay you anyway. Because if they don't scream, they weren't desperate.

And if they're not desperate, they're not going to pay you. So pull the trial. Now, this drives entrepreneurs nuts, because the worst word in the English language for entrepreneurs is maybe. Maybe is no with hope. When someone says maybe, they're never going to say yes. But you want to believe it's hope. You want to believe they're going to say yes. So if you pull the trial, you learn whether it's yes or no. And if it's no, then you don't just keep trying more trials. You try to figure out why was that customer not desperate? What are the characteristics that would cause someone to be desperate? And you test the new hypothesis. And that's where you apply the Lean Startup methodology. Yeah. One of the things that's really interesting, again, you've co-founded one of the absolute best venture capital firms in the world today. You've built a very big business with Wealthfront. But what you're talking about when you're talking about formulas and algorithms and things like that is you were talking about the decision-making of the endowment pool managers or financial advisors. But venture capital and company building has many of those same either formulas or decision-making processes and kind of lessons learned over the years. They just might not be as clear because they're not as quantitative, right? They're clearly not as quantitative, yeah.

Yeah, but very similar in terms of if you understand this stuff, it is very easy, one, to recognize. And then two, as the founder of a company, it's easy to focus on here are the important things, right? The exponential organic growth is much more important than going and sinking a bunch of money into digital ads, for example. I wish that knowing how to judge made a difference to actually creating a product that succeeded at those things. Those are two very different issues. So, yes, I think I have an unfair advantage in knowing what to look for, but unfortunately, that doesn't help you conceive compelling products. I love the honesty. One of the things that has happened over the last six, seven months is obviously COVID-19, a very large impact to the public markets, and then a macro environment that

I think a lot of people are just scratching their heads. We don't have to get into why has a lot of this happened, but there's obviously been a lot of volatility in the market. Talk a little bit about the impact that that volatility has had on Wealthfront users, and then maybe some of the positive things that Wealthfront has allowed people to do that data is suggesting, for example, a lot of older clients in the financial advisor world sold stocks at the bottom of the market in March because of short time horizons. So maybe just talk kind of the macro environment and COVID-19 and how that's impacted Wealthfront. Okay. Well, first of all, as context, you should know that we target young professionals as our customers, so millennials who save.

And so today, millennials are 25 to 40. They like us because, as they tell us, we pay you not to talk to us. We don't have any advisors. Our customer support reps are licensed as financial advisors, but you don't need them. And their job is actually more focused on figuring out what to do to the product to keep someone from reaching out to them than it is providing technical support, even though they provide great technical support. So the thing that's most surprising about our customer base is our withdrawals are not at all correlated with market performance. This shocks people. Now, I don't know if that's because we offer a passive investing solution, an index-based solution. And maybe to use us, you've already bought into passive investing. And if you

understand passive investing, you know you can't time the market, so you shouldn't try. So our withdrawals are much more impacted by life events like getting married or buying a home than the state of the markets. Now, the add-on deposit rate is affected by the performance of the market. And that thing that I referenced earlier about how people chase the market up and down. So they don't withdraw, but they can't quite bring themselves to add more money when the market goes down. So we're going along just fine. I mean, we're growing at our normal pace. But I would say that right now, the day trading is exploding. And you see that in companies like Robinhood. Now, every 15 years or so, something happens that causes an explosion in day trading.

And then people lose their money, and then they learn their lesson. But, you know, it's like kids, teenagers with parents, no amount of telling someone the research that you shouldn't day trade is going to get them to not do it, because it's also a lot of fun. So we see people, and it's really funny that we, because people link all of their accounts to us so that we can automate the movement of money and such. We see where the money is going and they're allocating, our clients are allocating a bunch of more money to trading, which literally makes no sense, but it's what they want to do and they're welcome to do what they want to do.

What's so interesting to me is you get the market volatility, right? To your point, there's probably some longer term trends, just now's about the right time for day trading to come back because people who, you know, learn their lesson back, uh, 10 to 20 years ago, they've kind of aged out of the phase of wanting to do it. And so there's a whole nother crop of people that need to learn the lesson. Exactly. But, but the other thing that's really interesting is, um, sports completely disappeared. Right. And so one of the things that is fascinating to me is many of my friends who were, uh, always betting on sports right through what, whether it was kind of the fantasy stuff, like the draft Kings of the world, et cetera, uh, or just, you know,

kind of more amateur what's the name of the guy from barstool sports who's promoting day trading that you can't lose money trading what's his name dave portnoy yeah dave portnoy you know the thing that reinforces it too anthony is that you know if you look at the s&p since the bottom what are we up 50 or 60 percent something like that so so if you started investing then post shelter in place and you're up 30%, you think you're brilliant. Because historically, if you're up 30% in six months, you're a god. But if you're up 30% in the last four or five months, you're terrible. I mean, you would have been far better off buying a market index. But it doesn't feel that way. I mean, you can brag to your friends, I'm up 30%. I'm really good at this. And so I think that has reinforced this idea that the other periods of great day trading coincided with very large increases.

It wasn't so much about volatility. It was about a large increase in a short period of time, which led people who had historically reasonable performance to think that they were doing a good job. We were talking about Howard Marks before, and in one of his recent letters, he pointed out that if the S&P 500 is up 50%, the six biggest tech companies are up more, and the other 494 companies that comprise the S&P 500 are down 10% or 15%. What does that tell you? So if you invested in one of those, a momentum investor to me is not a brilliant investor. They're a lucky investor. Yeah. Well, and I think also it goes to this belief that human nature is whenever something happens, whether that means prices go up or down, just something is happening.

The feeling of control, unfortunately, comes from people doing things, right? So it's like, oh, I see a price movement. I need to buy or sell because that's how I almost convince myself I'm in control. And what obviously all the research shows is maybe being in control is not the thing that needs to happen, right? We're the boring choice. But all we can do is encourage people to limit their play money to a reasonably small percentage of their total net worth. Go have fun. Bert Malkiel is our chief investment officer, and Bert invented the index fund and wrote the seminal book on the subject called A Random Walk Down Wall Street. He was a professor for many, many years

at Princeton University. And I'll never forget, soon after we launched, we had an event for our local clients in the Bay Area, and we invited Bert to a fireside chat, and then we opened it up to questions. And a wise ass in the audience said, Bert, do you own any stocks? And Bert said, as a matter of fact, I do. And I also love going to the dog track. He said, but I consider that entertainment. I don't consider that investing. And I keep it to less than 10% of my net worth. I enjoy it. And I do it. But I know exactly what it is. So yeah, that's a great way. We're the boring alternative. That's awesome. Obviously, there's a lot of questions now about 6040 portfolio construction,

passive investing, how do you think about kind of shifts in the modern portfolio theory, like a lot of these core concepts that financial advisors for sure built, have built a lot of their business on and done very well over the years. Do you think that any of that is changing? Or is a lot of that conversation just people basically, they're wishing that something would change because they don't like the idea that the same principles have worked decade after decade after decade and that's going to continue? Well, practically speaking, I think the latter. I think that's a very good question. Technically speaking, there have been advances in factor-based analysis. And that's led to products like smart beta. And there was a Nobel Prize awarded for that

in 2019, or 2013. So 23 years after modern portfolio theory. So there are more modern ways to construct a portfolio. There are limitations to modern portfolio theory. And as I said before, we view ourselves as an 80-20 on the university endowment portfolio. We're not quite is good. But for someone who doesn't have the money to invest that way, who isn't worth hundreds of millions of dollars, I think net of fees after taxes, nothing can come close. So yeah, it is really boring to have a portfolio with maybe not 60-40, but maybe six asset classes in it. And the thing that we can really add value on is the tax savings that a traditional financial advisor can't do because it's too complicated. If you think about all the tax lots, especially

with dividend reinvesting from the index funds, that's too hard for an advisor to perform other than at year end. But computers don't care about number of clients or number of tax lots, so we can do it dynamically every day. And that leads to far greater value creation, not because we're so much better, just because computers are better at doing things like that. So, you know, why don't advisors use really inexpensive index funds? I think they need to try to justify their fees to their clients. You know, we only charge a quarter of a percent and nothing for the tax loss harvesting, but the average financial advisor charges 1%. And if you outsource some of the portfolio for tax loss harvesting to parametric associates,

they charge another half a percent. So people have to justify the fees with more action. The problem is more action leads to destruction of portfolio value, not addition, not creation of portfolio value. But that's not a fun narrative. For sure. And one of the things in the university endowment, so many people listening to this are probably not familiar with endowment investing, obviously, having a partner in Mark Yusko, who spent a lot of time doing that. Very well. Exceptionally well, yes. Yeah, I've gotten the crash course many, many times. And for the people who can go, Andy mentioned Dave Swenson. He's written a great book about portfolio allocation and

construction. But one of the key pieces to the endowment model is the use of alternatives. And so how do you think about that in a world where you can use quantitative models and algorithms and software really to, again, just help people do the good things, right? Not necessarily do anything crazy special, but just the good things. Where do you see the alternatives fitting into that? Well, the dirty little secret is almost no quant funds make money. And by saying almost no quant funds outperform the market. renaissance has for decades and everyone holds them up as an example and maybe two sigma has as well but i can't name more than five that outperform the market net of fees so logically

one should be able to create a quant fund that that can do the things that you say but they can't And that's why the plain vanilla makes sense. So look, if you have access to the premier hedge funds and private equity firms, then there are a few that are two sigma from the mean. You know, in the venture business, something like 20 firms or 3% of the venture capital firms generate 95% of the realized returns of the industry. Now, there have been a bunch of studies of late how they don't represent nearly as much of the returns of the industry, but the only thing that matters are the realized returns. Markups don't matter. So if you can get access to those 20 firms, man, by all means, you should. But none of those firms want you as an investor. They want people who are going to be there for decades and where there's continuity of management and the people are just going to say yes. And they have extremely long time frames and they are not worried at all about the state of the public markets.

So they don't want investors who, when the markets go down, worry about whether or not they should make a new commitment. So if you can't get access to the premier hedge funds or private equity firms, you shouldn't do it. Because investing in the others are value-destroying exercises. And the number one thing that private wealth managers sell to justify their high fees is access to alternatives. The problem is the old Groucho Marx line, never join a club that would have you as a member. If a brokerage firm can get access to an alternative asset, the only reason they can get access is because they can't raise money through the best investors. Why would they accept individual investors as investors? That's stupid. So be careful what you're being offered. it's uh it's funny to hear you say uh the realized returns because that only comes from somebody who has been around long enough to see the realized returns and understand that that's actually the the ultimate goal of this game is that you have to get the money back exactly and markups are great but you know there's a lot of unicorns that won't ever return a penny we've definitely seen that already uh and something tells me there are more to come uh talk a little bit about the uh there's

a counter argument to basically what you guys are doing uh there's um kind of a critic who would say oh there's just this massive passive investing bubble now there are tons of um what i'll call uh the uneducated critic which is just a kind of a you know a swipe of the um of the brush and just say it's all bad. Then there's very educated kind of critiques. But how do you see whether there could be a passive investing bubble or not, and how you think about kind of navigating that? You know, I draw an analogy to climate change. If you look at the peer-reviewed research, something like 90%, 98% of the scholars who do research agree that there is a problem with climate change. Now, if you go online, it's not 98%. I remember in John Oliver's first season,

he did a bit where he said, all of these point counterpoint news shows have debates on the subject where they have one person representing each side, which makes you believe that it's a 50-50 argument. He said, that totally misrepresents it. So I'm going to populate my desk in the relationship of the actual research. And so he had 98 scientists sit on one side of the desk and one scientist sit on the other. So among academics, there's no debate on this topic. It's very, very clear. There's tremendous debate among individual investors because they don't want it to be true because no one wants to believe that they can't do it. You know, it's really funny to me that you'd never pick up a scalpel and think, I could perform heart surgery. But you can

look at a Yahoo Finance page and think, I can pick stocks, both of which take years and years of apprenticeship and learning to do exceptionally well. But for some reason, people think they can they can pick up investing very, very quickly. And I've never understood it. I'm a pretty good investor. I don't invest my own money because I'm not doing it all the time and I'm not totally on top of it. So I'm going to delegate it to people who know what they're doing. Bert, now to address the specific point you made about, is there a bubble in passive? You know, I think just last year, passive funds, total capital passed actively managed funds, total capital. You know, and that's after, and I think Vanguard sold their first index fund in 1974.

So it's taken a long, long time to get to 50%. percent. Burt Malkiel's point of view, and he actually wrote a blog post about this on the Wealthfront blog, is that until passive is 90 or 95 percent, we don't have any problems. Because as long as there's 5 percent of the market that's actively investing, you can accurately price securities. Think about it. If you have $40 trillion invested in equities, do you need more than $2 trillion to accurately price a security? I don't think so. So that's why we are a long, long way from passive getting in the way of accurately pricing securities. Because as long as there's $2 trillion of money chasing it, if something gets mispriced terribly,

someone's going to jump it. Yeah. It's funny to hear you talk about the individuals who are debating passive versus active, because I think you are right that people want to believe that they can- I don't blame them, but I don't think I can pick up a scalpel and perform heart surgery. Absolutely. Talk a little bit about how you overcome that psychology, right? So obviously- You don't. You preach to the converted. Explain that a little bit more. So the first rule of entrepreneurship is you can only sell to people who want to buy, that startups can't educate. I have to let Vanguard educate people on passive investing, and then they come to realize that we offer a better form of passive because our tax loss harvesting more than pays for our fees. So if you like Vanguard, you'll love Wealthfront. But I let Vanguard do all of that work.

I can only preach to the converted. I can't do missionary work. I have to leave that to big companies. And that's not just true of Wealthfront. That's true of all startups. Is that a resource constraint or what exactly is driving? It takes too much time. Time, okay.

Just time and effort. Got it. Talk a little bit about the fee-based model. So I saw a couple of people tweeted at us asking, basically saying, how do you grow AUM? Is there things you can do with the business model that could help or hinder that growth? And how you just think about an AUM-based fee versus maybe some of the other business models that people are trying. But like what? Well, so mainly in the more active stock brokerage, right?

So they'll go no fees and kind of try other things. In passive, it's a little bit harder, right? But I hope that your viewers and listeners realize that Robinhood makes a rather large multiple of revenue relative to us annually. They get more revenue from you than we do for their free trading. And that's just because it's hidden. It's called payment for order flow. The exchanges are paying them to place the trade. And the reason the exchanges pay Robinhood to place the trade is because the exchanges then sell that data to high frequency traders who front run your trade and make a penny a transaction. auction. Now, I don't understand why this is legal, but it is. But to me, it's insider trading. It's enabling insider trading. And just so I'm clear, because actually, I've never heard anyone

make that argument. It's the idea that the exchange is selling it is the part that you don't like, or the part where Robinhood's selling it to the exchange, or just the whole thing? I didn't say I don't like, I'm just saying that if you, let's say I'm a brokerage firm, And you say, I want to sell 100 shares of Netflix with Netflix at $500. That's a lot of money. So I'm just trying to make this easy. So as the broker, I then electronically place that on an exchange for someone to buy. Instead of me having to pay the exchange to make the trade, the exchange pays me to place the shares on their exchange to be purchased. So instead of me paying the marketplace, the marketplace pays me. And the reason that the exchange is willing to pay me is they then take the data, the information, and they don't know that it's Andy Ratcliffe. They just know that an individual wants to sell 100 shares of Apple, and they sell that to a high-frequency trader.

So if the market for Netflix is a bid-ask spread of $501.50 and $501.75, they'll jump in and buy it at $501.50 and sell it at $501.75. so before you have a chance to sell it they know you want to sell they buy they jump in and then they sell it to you and they do this in milliseconds and so the high frequency trader every year they get a smaller and smaller time period to front run your trade so what's the name of the guy who wrote Blindside and Moneyball Michael Lewis

so he wrote a great book on this called Flash Boys if you really want to understand it so that's why and so Robin Hood makes all of this money and then it really is a commission they just don't call it a commission And today, the Wall Street Journal published a report that the SEC is likely to fine them more than $10 million for not disclosing that they do this. So what we do is we charge a percentage of

assets, which actually is a lot lower than the fee that you're paying to Robinhood. It's just overt. People don't like overt fees. And as I've said before, we feel good about what we do because the value of our tax loss harvesting more than pays for that fee many, many times over. And the reason that we're able to do this is if you delight your customer, they tell their friends. So we grow through word of mouth. So I was on the board of Reed Hastings' previous company, Pure Software, and he taught me that virality is the greatest form, that delight is the greatest form of virality.

So if you delight people, they keep giving you more money. And one of the unique things about Wealthfront is that our average customer generates 30% more revenue to us each year by, one, giving us more deposits, and, two, adopting more of our services. If we were a SaaS company, that would be in the top quartile. They call it dollar-based net expansion ratio. And you only do it if you really delight your customers. and the highest valued companies are the ones that do this. For a consumer company net of churn to generate more than 100% of last year's revenues

is exceptionally unusual. Yeah. And is this where you see something like a Netflix being able to increase the price and not have increased churn? Yeah, because they delight their customers. They give you more and more value. Yeah.

Yeah. It's fascinating, I think, that when you start to use comparisons on the consumer side with the SaaS, very quantitative model too, right? You can really start to unpack, I think, hey, is this working, right? And it goes all back to the product market fit. Well, it all goes back to Debner. It all goes back to this dollar-based net expansion ratio. You know, Datadog is something like 1.7 or 170%. That means a customer that they acquired last year, it's like same-store sales. The same-store sales are 1.7x what they were last year. Can you imagine a retailer with same-store sales of 170%? They're happy if they get 104%. And so Datadog does something like 170%. Snowflake, which is coming public, is something

like 160%. The top quartile of SaaS companies are 125%. And we're at 130. I challenge you to find another consumer company above 100. Yeah. Well, and what's interesting too, is your model, like you're talking about here, right? So Netflix has to go and make a corporate decision to raise prices, right? Or they give you more services, but in the case of Netflix, they don't have more services. Yeah. But it's just hard to do that year in, you're out right there's fatigue for the customer etc for you guys it is based on you make more money as the user deposits more money with you and therefore we make more money with you not from you exactly by by automating it by only delivering services that we can automate we lower the cost

of delivering the service and we share the economics with our customer and they really really value that. So, you know, first we offered investment services, and then we offered the fastest, easiest, and cheapest way to borrow money with our portfolio line of credit. Our customers who use that are our most satisfied customers. Then we offered a high-yield cash account that's free. We make a little net interest margin on it, but we make money that way. Then we offer checking services with a debit card. So we make interchange revenues on the debit card. And then in the future, we'll offer mortgages. Again, we'll share the economics with our clients so they'll get better rates than they would from any other bank, but we'll still make a spread.

We can do just fine with much lower prices because of our automation. Yeah, I love that. And the nice thing is the autopilot brings it all together. That imagine, you know, you don't have to learn how to drive a manual transmission or a stick shift car before you learn how to drive an automatic, do you? You do not. But you never see anybody online say, well, before you drive an automatic, you better learn how to drive a stick. But for some reason, earlier you talked about financial education. With Wealthfront, you don't need any financial education. We do it all for you. We literally do it all for you so you don't have to learn how to drive that stick shift car.

That's awesome. The last thing I want to talk about before we get into some rapid fire questions to finish up is you are very well versed and spend a lot of time in the endowment world. So these large pools of capital, one of the more, I'll call it controversial or debated topics has been there are a couple of managers. I think one of the Nevada pension managers has basically said, nope, I'm not going to play this game of managing the endowment. I'm instead going to go into all low-cost indexes, right? Basically, he walked in and I'm paraphrasing, but I think he basically fired like 90% of the staff and he put it all on low-cost indexes,

shows up every day and like reads the newspaper, right? It doesn't do too much. Do you think one, that trend will become more popular at the large pools of capital? And two, do you think that maybe some portion of what they do can be automated? So you guys are doing this for consumers today, but can this kind of go upstream

to the larger pools of capital as well? Sure, it's exactly what we do. And it makes a tremendous amount of sense. Remember I said earlier that if you can't get access to the premier alternatives, you shouldn't try. Well, guess what? The non-premier limited partners, the non-premier endowments or pension funds can't get access. So it's sort of a fool's errand for them to continue to try. For most of them, it doesn't stop them from still investing, from getting an allocation to hedge funds or private equity or venture capital. But they shouldn't. The average return of the venture capital asset class is horrible. It's really a dumb asset class to invest in if you can't get into one of the top 20 firms. That doesn't stop people from doing it for ego reasons.

So as a matter of fact, we have a debate at the Penn Endowment about whether or not we should index U.S. public equities. Because one of the things the endowments are good at is figuring out how to choose managers. They're in that two sigma from the mean group. There are always an unusual set of outliers who are able to identify managers who outperform the market. Those were the algorithms that we used when we started Ka-ching, the predecessor to Wealthfront. And we're still really good at picking international managers and generating alpha that way, but we haven't been at U.S. And so it's a really controversial decision, should we index? Because, you know, real investment managers don't index. So if the discussion is going on at the seventh largest endowment in the university world and one of the best managed ones, I think it should go on in one of the lesser endowments.

It's so fascinating to me because for the most part, when you bring most money managers into a room, they're incredibly intelligent. They're very, very focused on kind of truth-seeking and generally have sound decisions. Except about themselves. Well, that's what I was going to say is basically when it comes to their decision, it ends up being they completely throw math out of the window, right? All the research, it's so fascinating to me how somebody can be so intelligent and completely, from an emotional standpoint, write off certain conversations or certain options, and it's just a human thing. You know, the best explanation I've heard for why it's so hard to outperform the market came from a member of our advisory committee who's a legend in the investment world named Charlie Ellis. Charlie founded the premier financial services consulting firm called Greenwich Associates. And for many years, he was the chairman of the Yale Endowment, which I think is the best managed pool of capital. He's been an instructor at Harvard and Yale schools of management. And he was on the Vanguard board for 20 years as well.

And so the way that he describes the challenge is he said, look, 40 years ago, the vast majority of the money invested in the stock market was invested by individuals. And as I mentioned earlier, individual investors consistently buy when the market goes up and sell when the market goes down. So he said, you can think of it like a poker table. the one institutional investor at the poker table with a bunch of individual investors was like playing poker with a bunch of rubes all you did was take the other side of that trade and by taking the other side of the trade you could outperform by one and a half to three and a half percent this you know it's a zero-sum game the amount by which the individuals were losing by by chasing the market well fast forward 20 years and almost all the money is now in the hands of

institutions not individuals so now everyone at the poker table is a really good poker player well it's really hard to win consistently if everyone at the poker table is a really good player but it's really hard to admit when you used to be the star at the table that you're now one of many stars at the table and i think that's what leads to that cognitive dissonance Yeah, that's a fantastic explanation. I never thought of it that way. But it makes a whole lot of sense. Charlie is, I mean, people love Charlie, because he explains complex issues so simply. Yeah. And I also think it's, you know, the other part of the endowment model that's so fascinating to me is, you know, you don't sit at Penn by yourself making decisions, right? There's a room full of intelligent people.

And I love to always ask the individual stock investor, who's your, you know, kind of your advisory board? Who's on your board, right? Who's on your investment team? And the dog doesn't count. And so it's just, you know, naturally we get lost in our own thoughts. We're very emotional.

You don't have somebody there to kind of talk with and stuff. So I think that, you know, it's pretty clear. It's just, do people buy in? I love your idea of kind of only preach to the converted. yeah makes a lot of sense and people want they want an advantage if they're only you know i have a a friend who's a professional poker player and he only plays in tournaments in out of the way

places now the the pot's much smaller but he wants an advantage he wants to play against a bunch of rooms so he goes to oklahoma city and he goes to and he goes to uh you know champaign illinois he goes to all these weird places but he doesn't go to the world series he plays in the world series of poker just because everybody does but that's not where he makes his money he makes his money by playing against a bunch of rubes i have a couple of friends who uh who do the same thing they're very good at poker uh have played professionally or online um in kind of a full-time basis and i was shocked when i heard that's what they were all doing and basically they were like look all the money to be made is to basically find these big fish that want to play

private games. Right. And they said, cause they got a lot of money and they're not very good at poker. And so, you know, there's a true combination. Only, only if you're the guy who's good at poker, right? Andy, before I let you go ask everyone the same two questions, and then you'll get to ask me one to, uh, to end it. But the first question is just, what is the most important book that you've ever read? The one that changed my perspective on technology was The Innovator's Dilemma. I think the disruption theory from Clay Christensen is worthy of a Nobel Prize. Explain a little bit more why that was so foundational or kind of mind-changing for you? Well, disruption is perhaps the most commonly misused term in

technology. Clay Christensen, who passed away last year, was a professor at Harvard Business School. And he coined the term disruption theory. And it had a precise definition. Unfortunately, reporters and others have come to represent disruption as anything that's new or different. But what Clay found from his research was that if a company can come along and deliver something that's simpler, cheaper, and more convenient than the incumbents, such that it is uneconomic for the incumbent to address, it's an almost impossible advantage to overcome. And there are two forms of disruption, new market disruption and low-end disruption. So an example of new market disruption is where you serve non-consumers, that people cannot consume the incumbents' services.

So think Sotheby's and eBay. You couldn't sell, you know, your leftover items from a garage sale at Sotheby's because they only sold things for $30,000 or more. Now, eBay was able to build a profitable business facilitating the sale of $20 items. Now, over time, they were able to move up market. And because of the breadth of their market, they really ate into the profitability of all other retailers. So that's an example of a new market disruption. Now, it's called an innovative, and then a low-end disruption is when you serve the over-served.

In every market case, people start adding more and more features to the point that people can't use them all. You know, think about office phones. You know, there are all these features on an office phone that you've never used. So there's an opportunity to come up with something simpler, cheaper, and more convenient. A great example of that was Dell versus Compaq. When Dell got started, Compaq sold computers to resellers who then sold it to companies and individuals. Compaq had a 40% gross margin, and the retailer had a 20% gross margin, you know, resale margin. Dell sold direct to consumers at a 25% gross margin. Now, their cost of goods sold was higher than Compaq, which was a multibillion-dollar company, but not that much higher.

So Dell was selling computers directly to individuals at a price lower than what the retailer was paying for Compaq. Now, Compaq could not—so the problem with a disruption is it's uneconomic for the incumbent to address. So if Compaq tried to sell direct, they would have pissed off their channel and lost their channel. Now, as a company with $5 billion of revenue and publicly traded, that would have destroyed their stock price. So it's called an innovator's dilemma because you're damned if you do and you're damned if you don't. If you ignore the innovator, they move up market like eBay did and Dell did. And if you go after them, you kill your economics. So you're screwed either way. And so a truly disruptive company that's able to deliver something simpler, cheaper, more convenient,

either to the over-served or non-consumers, is almost impossible to stop. that's what netflix did to cable companies so that's why it's so powerful and and so uh i wish i under the book came out in 97 i i retired in 2005 i would have been a radically better venture capitalist that i understood these issues i think you did it right for yourself andy no worries uh the second question is a little bit more fun uh aliens are you a believer or a non-believer non non what what is the rationale for not believing i haven't seen any proof so uh i've asked hundreds of people this question and the two most popular answers are either uh the world is you know the universe is so big

just probability wise i'm gonna uh throw a flyer and say that there's something out there that's reasonable and the most uh popular no answer is basically i'll believe when i see one so it's so funny there's very few questions you can ask hundreds and hundreds of people and get the same answers depending on yes or no but uh i think i'm a data driven guy so i want to see the data i love that you could ask me one question to finish up what's the one question you for me. What was most different from what you expected in today's discussion? Most different. I don't think that I've ever heard somebody talk as much about... Obviously, your background as a venture capitalist, you're going to understand a lot of data points in terms

of things to look for in companies, measuring growth, sustainable growth versus something that it's more manipulated. All of that is kind of expected and to be good at it, you've got to really, really understand it. I've never heard anyone talk about the consumer metrics benchmarking and no pun intended against the SaaS metrics. What do you mean? It is a pun intended. No, but I think that this idea of like the same source sales, right? That margin expansion or the dollar expansion that you talked about, but applying that to consumer businesses. I just had never thought of it that way. And as we were kind of talking, I started to think of, you know, Netflix is one example,

but there's actually a lot of businesses where when you align... Amazon. Amazon's net expansion ratio is phenomenal. Yeah. And it's just aligning incentives, right? It's the true measure of if you can align your incentive with your user, that user or customer is going to use your product more, you'll make more money, but it will actually become much more valuable to them, right?

And it almost kind of digs them deeper and deeper in and the retention goes through the roof because they'll never leave. Yeah. So this was a lot of fun. Thank you so much for hosting me. Listen, thank you so much for spending the time. If people walk away from this and they didn't learn something, they weren't listening. So I appreciate your time.

And obviously, you've had a stellar career. And hopefully, that will continue. Where can we send people to find either you on the internet if they want to ask any questions or if they want to learn more about Wealthfront? Well, my Twitter handle is A-R-A-C-H-L-E-F-F and Wealthfront is at W-E-A-L-T-H-F-R-O-N-T.com. Awesome. Thank you so much, Andy. Plenty of information there.

We'll have to do it again in the future. Thank you.