In last year’s Berkshire Hathaway annual report and shareholder letter Warren Buffett caused quite a stir by suggesting that upon his demise the assets he was leaving his wife, in trust, should be invested in index funds (see “Warren Buffett: ‘Investing Advice For You–And My Wife,’” “Will Warren Buffett’s investment advice work for you?,” “Warren Buffett’s 90-10 Rule of Thumb for Retirement Investing,” or “The Warren Buffett Guide to Retirement Investing“). The primary reason for the hubbub was probably the contradiction it represented in coming from Mr. Buffett. An endorsement of index investing from the man who is thought of as one of the greatest stock pickers of all time seemed to fly in the face of all that Buffett stands for. The advice probably also left many people questioning the various portfolio allocations and ratios their own financial advisors had put them in. Page 20 of his letter specifically said:
My advice to the trustee [of my wife’s assets] could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.
For regular readers of our blog a lot of this will sound very familiar as will some of the rest of this passage, which talks about the high transactional costs of active management and how investing in low-cost index funds on a long-term basis is the key to a strong risk-adjusted portfolio (a portion not reproduced here discusses the topic of not timing the market too, something we very often discuss as well) What we wanted to know though, is how Mr. Buffett’s simple 90/10 allocation might perform compared to a typical diversified Wealthfront portfolio.
The Buffett 90/10 Recommendation Is Not Quite as Good as Wealthfront
What we found was that someone implementing Mr. Buffett’s advice would have been better off investing in our average portfolio. To illustrate this point, let’s compare the average risk-adjusted return from a Buffett 90/10 portfolio over the past 15 years with what could have been expected from a typical Wealthfront portfolio over the same time period if it had existed. To evaluate the Buffett 90/10 portfolio we calculated returns on a portfolio that is 90% S&P 500® and 10% US 3-month Treasury Bills. For Wealthfront we used the returns for the asset allocation associated with our most common risk-level portfolio (7 on a scale of 0 to 10). To calculate risk-adjusted returns we used the Sharpe Ratio, the industry standard metric for such comparisons. The Sharpe Ratio was first proposed by Bill Sharpe, the co-recipient of the 1990 Nobel Prize in economics for Modern Portfolio Theory.
Taxes Make the Wealthfront Advantage Even Greater
Wealthfront’s portfolio has a higher average annual return and a much higher risk-adjusted return than Mr. Buffett’s portfolio. Why? Because Wealthfront’s portfolio is diversified globally across six asset classes, while Mr. Buffett’s is composed almost entirely of U.S. equities. As we explain in our investment methodology white paper, adding relatively uncorrelated asset classes to a portfolio almost always increases the return for a given level of risk. You begin to see radically diminishing returns when you attempt to broaden beyond seven asset classes. Mr. Buffett most likely suggested a very simple two-asset class portfolio because of its low fees and lack of familiarity with such new cost effective approaches as automated investment services.
The advantages of the Wealthfront portfolio become even greater when you take taxes into consideration. If you add the incremental benefits of tax-loss harvesting and Direct Indexing to our basic results, you could add as much as 2% to your annual after-tax return. Both of these techniques would be extremely difficult and time-consuming to implement and maintain as a do-it-yourself investor, but building them in software has made them practical.
As you can see from the chart below, adding tax-loss harvesting and Direct Indexing can have a huge impact on the relative Wealthfront advantage in both annual return and risk-adjusted return.
We agree with Mr. Buffett’s general recommendation that for most people a properly allocated, diversified portfolio of index funds is going to bring them the best long-term returns. As we discussed in Attempting to Maximize Your Return Isn’t Always a Good Thing we would also agree with his contention that very few people can resist the power of a down market and not buy and sell stocks at the wrong times. That behavior can lead to the offsetting of gains made in a portfolio composed of 90% stocks.
To be fair over the past 15 years Berkshire Hathaway significantly outperformed the average Wealthfront portfolio on both a return and risk-adjusted return basis. But Warren Buffett is a once-in-a-lifetime investor. It’s highly unlikely another Warren Buffett exists to manage his family’s money, which is probably why he recommended that his family choose index funds once he is gone.
* Wealthfront simulated the potential annual after-tax benefits of our Tax-Loss Harvesting services and found that asset-class Tax-Loss Harvesting as per our Daily Tax-Loss Harvesting service, combined with the stock-level Tax-Loss Harvesting per our Tax-Optimized Direct Indexing could add an annual benefit of 2.03% compared with an average Wealthfront account.
Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The information provided here is for educational purposes only and is not intended as investment advice. The analysis uses information from third-party sources, which Wealthfront believes to be, however Wealthfront does not guarantee the accuracy of the information. There is a potential for loss as well as gain. Actual investors on Wealthfront may experience different results from the results shown. Prospective investors should confer with their personal tax advisors regarding the tax consequences of investing with Wealthfront and engaging in these tax strategies, based on their particular circumstances. Investors and their personal tax advisors are responsible for how the transactions conducted in an account are reported to the IRS or any other taxing authority on the investor’s personal tax returns. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. The S&P 500 (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Wealthfront. Copyright © 2015 by S&P Dow Jones Indices LLC, a subsidiary of the McGraw-Hill Companies, Inc., and/or its affiliates. All rights reserved. Redistribution, reproduction and/or photocopying in whole or in part are prohibited Index Data Services Attachment without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.
Wealthfront simulated the potential annual after-tax benefits of our Tax-Loss Harvesting services and found that asset-class Tax-Loss Harvesting as per our Daily Tax-Loss Harvesting service, combined with the stock-level Tax-Loss Harvesting per our Tax-Optimized Direct Indexing could add an estimated average annual benefit of 2.03% to a Wealthfront 1000 account compared with an average Wealthfront account. The tax alpha and cumulative hypothetical return for Tax-Optimized Direct Indexing clients is based on Wealthfront’s estimates from existing client data since we launched our asset-class tax-loss harvesting in October 2012 through December 2014. The return was based on the subset of our clients with tax-loss harvesting enabled in their accounts and the returns and tax alpha were estimated for their accounts only. The return estimates were based on IRR (Internal Rate of Return). The cumulative returns were calculated by taking the composite’s daily return based on its daily balance series, where the composite’s balance is the aggregated value of all the accounts under our Tax-Optimized Direct Indexing strategy. We then compound the daily return series to get the compounded return over the period. The monthly tax alpha was calculated using the net tax benefit/liability and dividing by the aggregate balance. The net tax benefit over the period includes the liquidation of positions transferred in and sold to invest the client account in the Wealthfront portfolio. We assumed a married client, age 37, in California with the Wealthfront taxable investment mix set to risk score of 7.0. Full detailed assumptions for this research located in the Direct Indexing Whitepaper.
Backtested performance is not an indicator of future actual results. Backtested results are calculated by the retroactive application of a model constructed on the basis of historical data and based on assumptions integral to the model which may or may not be testable and are subject to losses.
Wealthfront assumed we would have been able to purchase the securities recommended by the model and the markets were sufficiently liquid to permit all trading. Backtested performance is developed with the benefit of hindsight and has inherent limitations. Specifically, backtested results do not reflect actual trading or the effect of material economic and market factors on the decision-making process. Actual performance may differ significantly from backtested performance. There is a potential for loss as well as gain that is not reflected in the hypothetical information portrayed. Investors evaluating this information should carefully consider the processes, data, and assumptions used by Wealthfront in creating its historical simulations.
Backtested results are adjusted to reflect the reinvestment of dividends and other income and, except where otherwise indicated, are presented net of fees.
This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.
When Wealthfront replaces investments with “similar” investments as part of the tax-loss harvesting strategy, it is a reference to investments that are expected, but are not guaranteed, to perform similarly and that might lower an investor’s tax bill while maintaining a similar expected risk and return on the investor’s portfolio. Wealthfront assumes no responsibility to any investor for the tax consequences of any transaction.
Tax loss harvesting may generate a higher number of trades due to attempts to capture losses. There is a chance that Wealthfront trading attributed to tax loss harvesting may create capital gains and wash sales and could be subject to higher transaction costs and market impacts. In addition, tax loss harvesting strategies may produce losses, which may not be offset by sufficient gains in the account and may be limited to a $3,000 deduction against income. The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any.
Wealthfront’s investment strategies, including portfolio rebalancing and tax loss harvesting, can lead to high levels of trading. High levels of trading could result in (a) bid-ask spread expense; (b) trade executions that may occur at prices beyond the bid ask spread (if quantity demanded exceeds quantity available at the bid or ask); (c) trading that may adversely move prices, such that subsequent transactions occur at worse prices; (d) trading that may disqualify some dividends from qualified dividend treatment; (e) unfulfilled orders or portfolio drift, in the event that markets are disorderly or trading halts altogether; and (f) unforeseen trading errors. The performance of the new securities purchased through the tax-loss harvesting service may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes.
Wealthfront only monitors for tax-loss harvesting for accounts within Wealthfront. The client is responsible for monitoring their and their spouse’s accounts outside of Wealthfront to ensure that transactions in the same security or a substantially similar security do not create a “wash sale.” A wash sale is the sale at a loss and purchase of the same security or substantially similar security within 30 days of each other. If a wash sale transaction occurs, the IRS may disallow or defer the loss for current tax reporting purposes. More specifically, the wash sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale, and the 30 days after the sale. The wash sale rule postpones losses on a sale, if replacement shares are bought around the same time.
The effectiveness of the tax-loss harvesting strategy to reduce the tax liability of the client will depend on the client’s entire tax and investment profile, including purchases and dispositions in a client’s (or client’s spouse’s) accounts outside of Wealthfront and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term). Except as set forth below, Wealthfront will monitor only a client’s (or client’s spouse’s) Wealthfront accounts to determine if there are unrealized losses for purposes of determining whether to harvest such losses. Transactions outside of Wealthfront accounts may affect whether a loss is successfully harvested and, if so, whether that loss is usable by the client in the most efficient manner.
A client may also request that Wealthfront monitor the client’s spouse’s accounts or their IRA accounts at Wealthfront to avoid the wash sale disallowance rule. A client may request spousal monitoring online or by calling Wealthfront at (650) 249-4250. If Wealthfront is monitoring multiple accounts to avoid the wash sale disallowance rule, the first taxable account to trade a security will block the other account(s) from trading in that same security for 30 days.
The S&P 500® (“Index”) is an index of 500 stocks seen as a leading indicator of U.S. equities and a reflection of the performance of the large cap universe, made up of companies selected by economists. The S&P 500 is a market value weighted index and one of the common benchmarks for the U.S. stock market.
The S&P 500 (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Wealthfront. Copyright © 2015 by S&P Dow Jones Indices LLC, a subsidiary of the McGraw-Hill Companies, Inc., and/or its affiliates. All rights reserved. Redistribution, reproduction and/or photocopying in whole or in part are prohibited Index Data Services Attachment without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.
Nothing in this blog should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront Inc. clients pursuant to a written agreement, which investors are urged to read carefully, that is available at www.wealthfront.com. All securities involve risk and may result in some loss. For more information please visit www.wealthfront.com or see our Full Disclosure. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront does not guarantee the accuracy of the information.