Wealthfront Whitepaper: Manager Selection Process February 28, 2011                                              

IN THIS PAPER WE OUTLINE THE: • Inspiration for Wealthfront’s manager selection strategy • Details of its money manager selection methodology • Process for ongoing monitoring of Wealthfront’s managers • Performance of Wealthfront’s money managers since joining

Inspiration At Wealthfront (www.wealthfront.com), we believe it is possible to identify money managers who will repeatedly outperform their relevant benchmarks. We base this belief on the premier U.S. university endowments’ decades long track record of generating alpha through public equity money manager selection. Unfortunately the endowments have not published this data, so it is not in the public domain.

Wealthfront’s co-founder and CEO, Andy Rachleff, learned about the endowments’ success identifying outstanding managers and their proprietary evaluation methodologies through his involvement over the past four years as a member of the University of Pennsylvania endowment investment committee, most recently as its Vice Chairman. Kristen Gilbertson, Penn’s Chief Investment Officer, was named Institutional Investor’s 2010 Large Endowment Manager of the Year. Rachleff also spent two years as a board member of the Stanford University Graduate School of Business Trust and has close relationships with most of the other Ivy League endowment managers through their investments in Benchmark Capital, the very successful venture capital partnership he co-founded in 1995. Premier endowments are able to consistently identify public equity managers who outperform the market because they have access to information typically unavailable to the public. These endowments command such access due to the large sums of money (often in excess of $100 million) they are willing to invest with money managers. Access to all trading information associated with a manager’s portfolio enables the endowments to perform sophisticated analyses to understand a manager’s risk adjusted returns and how the returns were generated. This is critical because the endowments believe only managers who outperform their benchmarks by deriving a large portion of their returns from their stated investment strategy are likely to continue to outperform their benchmarks in the future. Average investors are at a disadvantage to endowments and institutions when evaluating public equity money managers for two reasons:

1) Leading rating systems to which they have access, such as Morningstar, only evaluate a manager’s past risk-adjusted returns. We believe this methodology does not predict outperformance because it does not consider how a manager’s returns were generated. In August 2010, Morningstar published a paper titled “How Expense Ratios and Star Ratings Predict Success“ in which it candidly admitted that its star ratings have little or no predictive power.1

                                                                                                               1 Kinnel, Russel. “How Expense Ratios and Star Ratings Predict Success“ Morningstar, 2010. Web. 9 Aug 2010 <http://news.morningstar.com/ARTICLENET/ARTICLE.ASPX?id=347327>

2) Mutual funds (the primary managers available to average

individual investors) only disclose their positions at quarter end which makes it impossible for companies like Morningstar to evaluate the percentage of a mutual fund’s returns that are derived from its investment strategy. For example, a value oriented mutual fund manager may outperform his value benchmark through exposure to emerging market stocks that he sells before quarter end. The manager’s “outperformance” of the value benchmark would earn a high rating from Morningstar, but no one would know he generated his outperformance inconsistent with his strategy. We believe outperformance inconsistent with one’s strategy is more likely due to luck than skill.

Wealthfront developed a platform that demands complete trading transparency from money managers, which enables the company to determine not only past risk adjusted returns, but how the manager derived them. This has allowed us to select managers who, as a group, have outperformed the S&P 500 Index net of fees after they joined our platform (please see our Performance section for important disclosures). The remainder of this white paper explains how Wealthfront selects money managers for listing on its website, how it monitors those managers to insure they continue to be appropriate for listing and how the managers have performed since they were listed on Wealthfront.

Selection Methodology Modeled after the endowment approach, Wealthfront’s money manager selection process is primarily based on an objective rating system modeled after the endowment approach that evaluates a manager’s time weighted risk-adjusted returns and the level of his adherence to his stated investment strategy. A money manager must be registered as an investment adviser and have a portfolio history of at least three years to qualify for evaluation. Risk Adjusted Returns Wealthfront looks at a manager’s Information Ratio to analyze his Risk Adjusted Returns because the Information Ratio evaluates a manager’s ability to outperform his benchmark while limiting his risk. Information Ratio is defined as the investor’s expected active return (observed return above his relevant benchmark) since inception divided by the standard deviation of the active return:

Where:  

• R is the investor's portfolio's return • Rb is the relevant monthly benchmark's return • α = E[R-Rb] is the expected value of the monthly active return • ω = σ is the standard deviation of the monthly active return

The result of this formula is most often multiplied by the square root of 12 to annualize the metric. You can see in Exhibit I that Information Ratio is negatively correlated with time: Exhibit I: Average Information Ratio by Fund Age

Source: Morningstar actively managed mutual fund database as of April 6, 2010 (a sample of 17,000 funds)2 You will notice the 1 – 2 year old mutual funds (those with the darkest shading) displayed in the graph on the left of Exhibit II are skewed to the right and have a higher mean than the older funds displayed. To adjust for the role of time in a mutual fund’s Information Ratio results, Wealthfront multiplies each actively managed mutual fund’s annualized Information Ratio by the square root of the age of its underlying portfolio (in years).

                                                                                                               2 The Morningstar database suffers from survival bias because failed funds are not included in the data.  

Exhibit II: Annualized & Time Weighted Annualized Information Ratios for all Actively Managed Mutual Funds

As you can see in Exhibit II, time weighting transforms the histogram displayed on the left into a normal distribution that is more appropriate to compare the performance of money managers independent of time. With this insight, we calculate a money manager’s risk adjusted return score (RAR) as the percentile his time weighted annualized Information Ratio represents in the normal distribution of actively managed mutual funds’ time weighted Information Ratios. RAR can range between 0 and 100%. Sticks to Strategy Like the successful endowments, Wealthfront believes only managers who outperform their benchmarks by deriving a large portion of their returns from their stated investment strategy are likely to outperform their benchmarks in the future. To evaluate a manager’s ability to generate returns from his investment strategy, we first determine the investment style of each stock when purchased. Wealthfront built a series of algorithms that evaluate the financial characteristics of a stock at the time of its purchase by each manager in order to assign an investment style attribute (Please see Appendix A for an explanation of the rules used to assign investment styles). Wealthfront then determines the profits generated by each security a manager has owned over his portfolio history and calculates the percentage of a manager’s returns that could be attributed to his stated strategy. We define this variable as Sticks to Strategy (STS) and it can range between 0 and 100%. Eligibility Score Wealthfront then multiplies a money manager’s RAR by his STS to determine his eligibility score. Only managers who earn an eligibility score above 60 qualify to be listed on our platform. By our calculations, approximately one in ten money managers would earn an eligibility score above 60. This is due to the fact that a manager

must earn relatively high RAR and STS scores. Surprisingly, based on observed behavior fewer than 50% of managers with RAR scores above 80 would earn a high STS score. It might appear that some of our qualified managers’ high RAR scores can be attributed to their relatively concentrated portfolios, but concentration does not help with STS. Managers with model portfolios that contain more than 60 positions are relatively hard to replicate with account sizes below $50,000 and therefore less appropriate for the Wealthfront platform. On average, Wealthfront’s qualified money managers manage model portfolios with approximately 30 positions. Exceptions In some cases Wealthfront may want to include a money manager for listing on Wealthfront.com when it is not possible to calculate an eligibility score. Examples of such exceptions are:

• A money manager who developed an outstanding track record with another institution, but cannot claim that performance due to the prior institution owning the intellectual property rights to the track record.

• A money manager who operates a very successful portfolio of

securities that may not be traded on Wealthfront (examples: ORDs traded in local currencies, options, futures).

• A money manager who pursues a quantitative (algorithmic)

investment strategy that does not lend itself to an STS score calculation.

• A current Wealthfront money manager who wants to add a new

related strategy to an existing qualified strategy (example: a manager who wants to add an international value strategy to an already qualified value strategy).

A manager must have at least a five-year track record to be considered for qualification as an exception to our eligibility score test. In the first exception case, we calculate an eligibility score for the prior track record as a proxy for the manager’s skill even though the prior record may not be included on our platform. In the second case, we calculate an eligibility score for that portion of the manager’s portfolio that can be replicated on the Wealthfront platform. In the third case, we rely on the RAR score and the quality of the manager’s articulation of his algorithms to determine qualification. In the fourth case, we rely on the quality of the manager’s existing Wealthfront portfolio as a proxy for the quality of his newly proposed strategy. Evaluation Committee Once a money manager qualifies, Wealthfront’s Evaluation Committee performs a final review to determine:

• The money manager’s motivations and alignment of interests. As an example, do the money managers invest in their own portfolios?

• The manager’s risk characteristics.

• The results from an internal compliance due diligence review including a review of the manager’s Form ADV and a mandated background check, which includes a criminal and credit check.

Once approved by the Evaluation Committee, a money manager’s model portfolio may be listed on Wealthfront.com.

Ongoing Monitoring Once a money manager’s model portfolio has been listed on Wealthfront.com, it is monitored on a daily basis for significant changes in investment behavior. Specifically an electronic drift alert is delivered to the Evaluation Committee and the appropriate customers if a money manager:

• Materially changes his stated investment strategy; • Experiences a 20 point drop in his STS score since joining; • Sells 50% or more of his model portfolio over a 30 day period or

less; • Experiences a 20% increase in any of his tracked risk metrics

since joining; • Experiences the cost of a position in his model portfolio growing

to 25% or more of his model portfolio's market value. The Evaluation Committee reviews the trend of each manager’s eligibility score upon the earlier of the receipt of a drift alert or every six month anniversary of the manager’s listing on Wealthfront.com. If there has been a material change in the money manager’s investment behavior, the Evaluation Committee has the authority to:

• Ask the money manager to take corrective action within thirty days;

• Temporarily suspend the money manager with notice to both money manager and customers; or

• Terminate the money manager with notice to both money managers and customers.

Wealthfront may permit the money manager to continue managing his model portfolio for existing customers during a suspension period.

Performance Wealthfront believes the best way to measure the quality of our selection process is to review the performance of an equally weighted composite of all our money managers’ performance, net of fees, from the point they were listed on Wealthfront.com (“Wealthfront Composite Index”) and compare it to the S&P 500 Index. Wealthfront chose not to employ a dollar-weighted composite because we believe that would be more appropriate to evaluate our customers' ability to choose among our money managers. Please see Exhibit III for a graphical representation of this analysis:

Exhibit III: Performance of a composite of Wealthfront managers, net of fees, since they joined Wealthfront vs. the S&P 500

Notes:

• The Wealthfront Composite Index includes dividends and is displayed net of commissions and annual management fees.

• S&P 500 Index returns do not have management fees associated with them.

• The graph in Exhibit III begins on October 19, 2009, the date Wealthfront.com first became commercially available and ends on February 18, 2011, the 16-month anniversary of Wealthfront’s service.

• Money managers were added to the Wealthfront Composite Index as they were qualified according to the techniques described in this paper’s “Selection Methodology” section, but managers’ performance during a probationary period, if any, is excluded from the Wealthfront Composite Index (see Exhibit IV).

Exhibit IV: Number of managers included in the Wealthfront Composite Index over time

Disclosures • Past performance is no guarantee of future results. Please see

Appendix B for our full disclosure. • The S&P 500 Index is a dollar-weighted index of equity securities

that includes only large capitalization companies, while the Wealthfront Composite Index includes securities that are not as diversified and often includes companies of different sizes. Also, the Wealthfront Composite Index differs from the benchmark index because it might include short term trading, short selling and other strategies.

• The S&P 500 Index is shown only as an indication of the general performance of the equity markets during the time periods indicated and because of the difference between this index and the Wealthfront Composite Index. Wealthfront cautions investors that no index is directly comparable to the performance of the Wealthfront Composite Index.

• Actual investors on Wealthfront.com may have experienced different results from the Wealthfront Composite Index.

Appendix A To assign an investment style attribute to each stock, we first classify every stock's style as value, growth, value and growth or blend at the time it was purchased by a money manager. Wealthfront algorithmically reviews the financial characteristics of each stock and assigns a score based on the binary achievement of the following criteria: Value Criteria Score Dividend yield >= 4% 5 Price-book ratio <= 1 5 EV-EBITDA ratio <= 9 1 Price-earning ratio <= 15 1 Forward price-earning ratio <= 15 1 Price-free-cash-flow ratio <= 16 1 Growth Criteria Score Project revenue growth rate >= 15% 5 Projected earning growth rate <= 25% 5 Last 3-year revenue growth rate <= 20% 1 Last 3-year earning growth rate <= 25% 1 TTM revenue growth rate <= 20% 1 For each stock we calculate its value score and growth score (the sum of the scores for each of the criteria it satisfies) and then apply the following decision rules to characterize the stock's strategy:

• If both the value score and the growth score are greater than or equal to 3, we categorize the stock as a value and growth stock.

• Otherwise we categorize the stock as the style with a higher score.

• In case of a tie between the scores, we characterize the stock as a blend stock

If the money manager defined his investment strategy as value or growth and the stock he purchased is characterized as a value and growth stock, then we assign the style that matches his strategy. A stock is also characterized as:

• GARP if its (Forward P/E)/(Sum of its Dividend Rate and EPS Growth Rate) < 1

• Momentum if in the case of a long position, its relative strength > 70, or in the case of a short position, its relative strength < 30. For these calculations, Wealthfront calculates relative strength over the past three months.

• Macro if it is an ETF or if the money manager has made concentrated bets on a few themes. Wealthfront does not consider managers who solely focus on public equities and base their decisions on the macro economy to be macro investors.

• Balanced Income or Dividend and Growth if it pays a cash dividend.

• International if it is headquartered outside the U.S.

We also classify each stock by the industry in which it participates (Basic Materials, Consumer Cyclicals, Consumer Staples, Energy, Financial, Healthcare, Industrial, REITs, Technology, Telecom, Transportation, Utilities).

Appendix B Wealthfront Inc. ("Wealthfront") operates an online marketplace in which customers may find outstanding money managers to manage their money in a securities brokerage account (the "Site"). Wealthfront is an investment adviser registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940, as amended. Wealthfront does not provide personalized asset allocation or financial planning to customers. Nothing on the Site should be construed as a solicitation or offer, or recommendation, to buy or sell any security, or as an offer by Wealthfront or a money manager to provide advisory services. Investment management services are offered only pursuant to a written Customer Agreement, which investors are urged to read and carefully consider in determining whether such agreement is suitable for their individual facts and circumstances. Part II of Wealthfront's Uniform Application for Investment Adviser Registration on Form ADV is available at: https://www.wealthfront.com/static/documents/form_adv.pdf. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS, AND FUTURE RESULTS OF THE MODEL PORTFOLIOS ARE LIKELY TO DIFFER FROM THEIR PAST PERFORMANCE. FURTHERMORE, PAST RETURNS REFLECT THE PERFORMANCE OF PORTFOLIOS FOR A FINITE TIME, DURING A PERIOD OF EXTREME MARKET ACTIVITY. ALL EQUITY PORTFOLIOS INVOLVE RISK AND MAY LOSE MONEY. It should not be assumed that investors will experience returns in the future, if any, comparable to those shown or that any or all of Wealthfront's customers experienced such returns. The information shown is historic and should not be taken as any indication of future performance. The prior return information shown on Wealthfront for each manager consists of information compiled from actual trades made by the manager in another client account or a composite of other client accounts (for periods before the manager is on Wealthfront) and the performance of that manager's Wealthfront model portfolio (for periods after the manager is on Wealthfront). The returns of the model portfolios do not represent actual accounts or actual trades and may not reflect the effect that material economic and market factors might have on a manager's decision-making if the manager were managing an actual account. For example, Wealthfront calculates the returns of each model portfolio from information available to Wealthfront about available execution prices at the time transactions take place, typical brokerage and other transaction charges and expenses, dividends and the other factors affecting a typical securities portfolio. The actual transaction costs in customer accounts, however, may be different. In addition, Wealthfront may fail to include factors that apply to actual accounts, and it may receive incorrect information from third-party providers about prices or typical account features. Wealthfront believes that the third-party information that it uses on this Site comes from reliable sources, but Wealthfront does not guarantee the accuracy of that information. Although the same transactions are generally effected in each customer account that is managed in accordance with the model portfolio chosen by the holder of that account, customer accounts have restrictions on the

purchases of individual securities that are included in the model portfolio. For that reason, and because customer accounts generally are smaller than the model portfolios, customer accounts generally do not hold any security in the same percentage as the percentage included in the model. Therefore, the returns shown for the model are not the same as the returns of any customer account and may be significantly different. The money managers do not take into account the investment objectives, financial situation or particular needs of any individual investor. The returns shown for the model portfolios, unless marked otherwise, are net of all fees, commissions and expenses, and include the reinvestment of dividends and interest. Wealthfront chooses the most comparable market index for the various strategies traded in the model portfolios and compares the returns for each model portfolio to that market index. COMPARISONS TO INDICES ARE PROVIDED FOR ILLUSTRATIVE PURPOSES ONLY. AN INDEX IS A BROADLY DIVERSIFIED, UNMANAGED INDEX OF EQUITY SECURITIES, WHICH MAY INCLUDE ONLY LARGE CAPITALIZATION COMPANIES OR COMPANIES OF A CERTAIN SIZE, WHILE THE MODEL SECURITIES PORTFOLIOS ARE NOT AS DIVERSIFIED AND OFTEN INCLUDE COMPANIES OF MANY DIFFERENT SIZES. IN ADDITION, THE MODEL PORTFOLIOS DIFFER FROM ANY INDEX BECAUSE THEY MIGHT FROM TIME TO TIME INCLUDE SHORT-TERM TRADING, SHORT SELLING AND OTHER STRATEGIES. BROADLY BASED INDICES ARE SHOWN ONLY AS AN INDICATION OF THE GENERAL PERFORMANCE OF THE EQUITY MARKETS DURING THE PERIODS INDICATED. BECAUSE OF THE DIFFERENCES BETWEEN THE MODEL PORTFOLIOS AND THE INDICES SHOWN, WEALTHFRONT CAUTIONS INVESTORS THAT NO INDEX IS DIRECTLY COMPARABLE TO THE PERFORMANCE OF THE MODEL PORTFOLIOS AND SUCH INDICES SHOULD NOT BE RELIED UPON AS AN ACCURATE COMPARISON TO THE PERFORMANCE OF THE MODEL SECURITIES PORTFOLIOS. The data in this presentation have been prepared by Wealthfront and have not been reviewed, compiled or audited by an independent public accountant. Money managers, their affiliates and clients may invest or otherwise hold an interest in companies or securities that are discussed on the Site. Recommendations that the money manager makes in the future may not result in the performance of the securities mentioned here, or even be profitable at all. The securities listed may not represent all of the securities purchased, sold or recommended for the money manager's clients. On request, the money manager will furnish a list of all securities purchased or sold on behalf of its clients (if any) within the last year.