Introducing a New Level of Tax-Loss Harvesting

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Today we are proud to announce a significant enhancement to our breakthrough tax-loss harvesting service — the ability to harvest losses on stocks that comprise an index.  We call this new service the Wealthfront Tax Optimized US Index Portfolio.

A little over one year ago, Wealthfront became the first service to offer daily tax-loss harvesting across asset classes.  Since then, Wealthfront has become the largest and fastest growing software-based financial advisor, with over $450 million in assets under management, up over 350% in 2013 alone.

With today’s announcement we go one step further by taking advantage of the volatility among stocks that comprise the S&P 500 to look for tax losses at the individual stock level without straying from the index or adding any additional fees. Combining stock level tax-loss harvesting with our current asset class level tax-loss harvesting could add 1.6% to your annual after-tax returns.  This represents a significant improvement from the 0.9% improvement to your after-tax return that could be possible from our daily asset class level tax-loss harvesting.

The Disruptive Power of Software

Wealthfront constantly looks for opportunities to leverage our world-class financial expertise through software. Markets rise and markets fall – that’s not something you can control.  We focus our efforts on improving the three areas you can control:  diversifying your portfolio, minimizing fees and minimizing taxes.

Earlier this year our Chief Investment Officer, Burt Malkiel, suggested there was significantly more value we could deliver through tax-loss harvesting. He observed that Aperio Group and Parametric have attracted more than $100 billion by extending tax-loss harvesting to the individual stock level within an indexed portfolio. Aperio and Parametric only make their service available to accounts in excess of $5 million. This seemed like an ideal opportunity for us to use our software skills to bring an advanced investment management service to a much broader audience.

Our decision to proceed became easy when, David Swensen, Chief Investment Officer of the Yale Endowment, surprised us by suggesting we harvest losses within the S&P 500 index. Burt and Dave pointed out a simple fact: While there are significant tax loss opportunities across ETFs, there are even more opportunities if you harvest losses within the index itself.

Stock Level Tax-Loss Harvesting: How Does It Work?

Wealthfront has leveraged its software expertise to offer a unique service that combines asset class level tax-loss harvesting with stock level tax-loss harvesting.  We continue to hold five ETFs that represent major asset classes in your portfolio, but replace the sixth ETF that is normally used to represent a broad cross section of US stocks with up to 501 individual securities – the 500 stocks in the S&P 500 index and an ETF used to represent non-S&P 500 smaller capitalization companies.

The 500 individual stocks are used to closely track the performance of the S&P 500 index while providing opportunities for stock level tax-loss harvesting. We call this new portfolio the Wealthfront 500. The smaller cap ETF is included so the portfolio better tracks the broader US stock market ETF that is being replaced (Vanguard’s VTI).

When an individual stock in the Wealthfront 500 declines by a certain amount we sell it and replace it with a highly correlated stock. We carefully manage the interaction and timing of trades to avoid wash sales and also continue to look for losses to harvest at the asset class (ETF) level.

Wealthfront is the first and only company to combine asset class level and stock level tax-loss harvesting. We are pleased to be able to offer this service to accounts over $500,000, which, while sizable, is also one-tenth what firms like Aperio Group and Parametric require.

To learn more about our new service, please read our newly updated whitepaper on tax-loss harvesting.

Lower Costs and Better After-Tax Returns  

By owning individual stocks, Wealthfront has orders of magnitude more opportunity to take advantage of tax losses in your account without changing the risk and return characteristics of your portfolio. The best news is we offer this value added service for no additional fee.  You just pay an annual 0.25% advisory fee on your entire portfolio value. As is the case with our other services you incur no commissions.

From January 2000 to November 2013, the most popular S&P 500 ETF, the SPDR S&P 500 (Ticker: SPY), returned 3.8% annualized after-tax. Our research shows the Wealthfront 500 component of your portfolio would have returned 7.1% after-tax over the same time period.  More importantly, in a bad year like 2008, the Wealthfront 500 could have boosted your after-tax return by 9% over that achieved by the SPDR S&P 500 ETF.

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Combining the stock level tax-loss harvesting of the Wealthfront 500 with our asset class level tax-loss harvesting service enables us to harvest losses in both good and bad markets.  According to our research our new combined tax-loss harvesting service could add 1.63% to your diversified portfolio’s annual after-tax return.  This compares favorably to the 0.93% projected annual benefit of our asset class level tax-loss harvesting alone.

Looking for losses to harvest on a daily basis leads to significantly more opportunities than if we just left it to the end of the year (as most advisors do — if they perform loss harvesting at all). Stocks and ETFs can temporarily trade down and recover before year-end. Wealthfront’s daily tax-loss harvesting service can capture these losses when the year-end approach cannot. Our research shows the annual benefit of the year-end asset class level tax-loss harvesting approach offered by some other financial advisors would add only 0.65% annually.

Taxes Matter

Our introduction of stock level tax-loss harvesting expands the ways Wealthfront can minimize your taxes. We now minimize your taxes in five distinct ways:

  1. We use index funds rather than mutual funds to populate your portfolio
  2. We use dividends to intelligently rebalance your portfolio
  3. We use different asset allocations for taxable & retirement accounts
  4. We use daily automated asset class level tax-loss harvesting
  5. We use daily stock level tax-loss harvesting

In our recent blog post, Minimize Your Investment Taxes, we found the first four techniques could lower your taxes by an amount equal to 2.94% to 3.34% of your portfolio value each year.  The addition of stock level tax-loss harvesting could bring this total annual benefit to 3.64% to 4.04%. That’s more than 10x the 0.25% annual all-inclusive advisory fee we charge.

The Most Tax Sensitive Investment Manager

We believe Wealthfront delivers more ways to minimize your taxes than any other financial advisor in the investment management industry. The beauty of a software-based approach to investment management is it’s only going to get better over time.

Wealthfront is just getting started. Join us on the journey.


Disclosure


This blog was prepared to support the marketing of Wealthfront’s investment products, as well as to explain its tax-loss harvesting strategies. This blog 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 blog 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 charts showing the performance comparison between the up-to-500 individual stock position in the Tax-Optimized US Index Portfolio (“Wealthfront 500”) vs. the SPY ETF 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.

We simulated the potential after-tax benefits of our tax-loss harvesting services and found that asset-class tax-loss harvesting added an average of at least 0.93% annually and stock-level tax-loss harvesting combined with asset-class tax-loss harvesting added an average of at least 1.63%. We used several assumptions to create these possible approximations, but did not rely on actual client trading history. These results are based on a study Wealthfront conducted for the years between January 2000 and November 2013, assuming a Wealthfront account with a risk score of 7 an initial deposit of $100,000, additional quarterly deposits of $10,000, and periodic rebalancing for asset-class tax-loss harvesting and an initial deposit of $500,000, additional quarterly deposits of $50,000, and periodic rebalancing for stock-level tax-loss harvesting combined with asset-class tax-loss harvesting. Dividends and interest were not considered.

To compare the possible benefit of continuous vs. annual year-end tax-loss harvesting, we use the same assumptions for the historical simulation for the years between January 2000 and December 2012 but with tax-loss harvesting opportunities examined daily vs. annually at year-end.

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.

While the data used for its simulations are from sources that Wealthfront believes are reliable, the results represent Wealthfront’s opinion only. The return information uses or includes information compiled from third-party sources, including independent market quotations and index information. Wealthfront believes the third-party information comes from reliable sources, but Wealthfront does not guarantee the accuracy of the information and may receive incorrect information from third-party providers. Unless otherwise indicated, the information has been prepared by Wealthfront and has not been reviewed, compiled or audited by any independent third-party or public accountant. Wealthfront does not control the composition of the market indices or fund information used for its calculations, and a change in this information could affect the results shown.

 

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5 Responses to “Introducing a New Level of Tax-Loss Harvesting”

  1. Jonathan Boutelle December 11, 2013 at 10:42 pm #

    This is a pretty impressive offering.
    1) It’s impossible to mimic with a mutual fund or set of mutual funds.
    2) It’s exactly what you would do if you had unlimited resources to run a portfolio and believed in the efficient market hypothesis.
    3) There’s no way a human could do this. It’s too tedious and involved, it needs to be done by a computer.

  2. Josh December 16, 2013 at 12:40 pm #

    How do you choose the “highly correlated stock” with which to replace the one you are selling? Can you please describe the process for how this replacement stock is chosen? Thanks.

    • Andy Rachleff December 16, 2013 at 2:50 pm #

      We first estimate a covariance matrix for all the index constituents. We then feed that information into an optimizer that attempts to maximize tax alpha subject to minimizing tracking error. The optimizer will choose replacement stocks to keep the portfolio similar to the index, and those stocks are the ones highly correlated with the stocks just sold as determined by the covariance matrix.

      For more information, please read our white paper

  3. Ben December 28, 2013 at 1:46 pm #

    This seems like a great idea, and the next logical step in tax-loss harvesting.

    Are there any plans to expand “stock-level” tax harvesting to international / emerging stocks? Similarly, couldn’t the same be done with other asset classes (e.g., corporate debt, emerging market debt)?

    Thanks,
    Ben

    • Andy Rachleff December 30, 2013 at 11:20 am #

      Unfortunately not at this moment.

      It’s not currently practical for us to apply stock level TLH to International because we would either have to trade in local shares (which our current custodian doesn’t support via API) or settle for working with ADRs which do not represent all the stocks in the indexes we want to replicate.

      We also can’t trade bonds in an automated way to harvest within a bond index. Real estate is irrelevant because we don’t use it in taxable accounts due to its tax inefficiency.

      I hope that helps.

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