Direct Indexing: The Next Generation of Index Investing

One year ago today, Wealthfront became the first and only automated investment service to offer direct indexing with the Wealthfront 500. Direct indexing allows you to own all the stocks that comprise a major index in your own brokerage account, which is far more tax efficient than owning the equivalent index fund. Our research indicated this could generate an incremental annual after-tax return of 2.46% over just owning the S&P 500®.

Frankly, we were overwhelmed by the amount of positive feedback from both clients and industry experts. It has been only one year since the launch of the Wealthfront 500, and already over $500 million has been invested in Wealthfront 500 accounts.

We thought we were launching a product, but it turned out we were launching a category.

Today, we are very excited to announce the expansion and improvement of our unique direct indexing technology. With this release, the Wealthfront Direct Indexing Platform will extend the benefits of direct indexing to broader sets of clients, with increased tax benefits and lower costs.

A Brief History of Index Investing

In 1973, our Chief Investment Officer Burt Malkiel published the first edition of A Random Walk Down Wall Street. In his groundbreaking book Burt argued that individual investors could achieve better net-of-fee returns than most professional money managers if they could just replicate a broad market index.

On December 31, 1975, Vanguard launched its first index fund. Investing was forever changed for the better. Dr. Malkiel teamed up with John Bogle to help make index investing available to individual investors, joining Vanguard as a Director. Investors now have invested over $2.5 Trillion in index funds.

In 1993, State Street Global Advisors improved upon index funds with the launch of the first Exchange Traded Fund (ETF), the Standard & Poors Depository Receipts (Ticker: SPY). SPY tracked an index, the S&P 500®, but unlike index funds it could be traded through any brokerage firm just like a stock throughout the day (index funds typically only can be purchased or sold from the issuer once a day at market close). Investors now have invested over $2 Trillion in ETFs.

In 2013, Wealthfront took passive investing to a whole new level with the introduction of direct indexing for individual investors. For the first time, retail investors could conveniently and affordably directly own all the stocks in a major index and harvest the losses they might generate. In other words, the overall index might be up, but you could harvest losses whenever an index component stock missed earnings and traded down. These tax savings could be reinvested and compounded over time into significant value.

Direct indexing offers value to investors that index funds and ETFs cannot structurally provide: funds are prohibited from distributing tax losses to their shareholders.

Announcing Our New Direct Indexing Platform

The Wealthfront Direct Indexing Platform uses a combination of individual stocks and ETFs to mirror the entire US stock market, while maximizing the tax benefit from harvesting tax losses within the index. Our new platform is optimized against Vanguard’s Total Stock Market ETF (Ticker: VTI), based on the University of Chicago CRSP index for US Stocks. Depending on how many stocks your account level utilizes, the Wealthfront Direct Indexing Platform uses completion index ETFs (including VXF and VB) to ensure your account is properly diversified across the entire US stock market with minimum tracking error.

With this new flexible platform, Wealthfront will be able to offer direct indexing to clients with accounts starting at $100,000. The larger the account value, the greater the number of stocks you will directly own in your account. The larger the number of stocks owned, the higher the expected tax loss harvesting benefit.

Our new research indicates that over six rolling 10-year historical periods, the average additional IRR that could have been generated by our new platform is up to an additional 2.03% per year over our standard service without daily tax-loss harvesting.

* Assumes 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.

Direct Indexing from Wealthfront will be available at three levels:

    • Wealthfront 100: Available in 2015 for taxable accounts of $100,000, the Wealthfront 100 will utilize up to 100 of the largest capitalization US stocks combined with specific ETFs to provide US stock market coverage equivalent to Vanguard’s Total Stock Market ETF (Ticker: VTI).
    • Wealthfront 500: Available now for taxable accounts of  $500,000, the Wealthfront 500 utilizes up to 500 of the largest capitalization US stocks combined with the Vanguard Extended Market ETF (Ticker: VXF) to provide US stock market coverage equivalent to Vanguard’s Total Stock Market ETF (Ticker: VTI). Based on our research, the Wealthfront 500 combined with daily tax-loss harvesting could potentially add an average of 1.88% to clients’ annual after-tax returns over our standard investment service.
    • Wealthfront 1000: Available now for taxable accounts of $1,000,000, the Wealthfront 1000 utilizes up to 1000 of the largest capitalization US stocks combined with the Vanguard Small-Cap ETF (Ticker: VB) to provide US stock market coverage equivalent to Vanguard’s Total Stock Market ETF (Ticker: VTI). Based on our research, the Wealthfront 1000 combined with daily tax-loss harvesting could potentially add an average of 2.03% to clients’ annual after-tax returns over our standard investment service.

Ready for 2015

As of today, you can sign up for Wealthfront and receive the option to take advantage of the new Wealthfront Direct Indexing Platform for accounts over $500,000.

If you are a current Wealthfront client, your account will be automatically upgraded to the new direct indexing platform if it is already invested in the Wealthfront 500. Clients with over $1 million will also be automatically upgraded to the new Wealthfront 1000 service. Our system has been designed from the ground up to minimize taxes as part of the migration to the new platform. Clients with at least $100,000 will be offered the opportunity to upgrade to direct indexing in 2015.

At Wealthfront, we hope to build a different type of financial service. Something new. Something different. Something better.

Join us.

 


Disclosure

This blog article was prepared to support the marketing of Wealthfront’s investment products, as well as to explain its tax-loss harvesting strategies. This white paper is not intended as tax advice, and Wealthfront does not represent in any manner that the tax consequences described herein will be obtained or that Wealthfront’s tax-loss harvesting strategies, or any of its products and/or services, will result in any particular tax consequence. The tax consequences of the tax-loss harvesting strategy and other strategies that Wealthfront may pursue are complex and uncertain and may be challenged by the IRS. This white paper was not prepared to be used, and it cannot be used, by any investor to avoid penalties or interest.

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.

When Wealthfront says it 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. Expected returns and risk characteristics are no guarantee of actual performance.

The various charts displaying simulated Tax Alpha from tax-loss harvesting are historical simulated returns based on backtesting and do not rely on actual trading using client assets. The results are hypothetical only. Several processes, assumptions and data sources were used to create one possible approximations of how Wealthfront’s tax-loss harvesting strategy might have benefited investors in the past, and a different methodology may have resulted in different outcomes. These results were achieved by means of the retroactive application of a model designed with the benefit of hindsight. The results of the historical simulations are intended to be used to help explain possible benefits of the tax-loss harvesting strategy and should not be relied upon for predicting future performance.

The chart showing the tax alpha and cumulative 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 August 2014. The chart 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 are based on IRR (Internal Rate of Return).

Different methodologies may have resulted in different outcomes. For example, we assume that an investor’s risk profile and target allocation would not have changed during the time period shown; however, actual investors may have experienced changes to their allocation plan in response to changing suitability profiles and investment objectives. Furthermore, material economic and market factors that might have occurred during the time period could have had an impact on decision-making. Actual investors on Wealthfront may experience different results from the results shown. 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.

 

 


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