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The Unexpected Impact of Commissions


The recent enhancement to our tax loss harvesting service prompted a few readers to privately ask if it’s possible for us to use Dimensional Fund Advisors’ (DFA) mutual funds rather than ETFs to implement our service. Prior to our launch in December 2011, we considered both Vanguard and DFA products as they offer what we believe are the best net of fee returns in the industry.

Before we launched our service we met with DFA sales reps and learned that on average DFA funds generate the same return as Vanguard on a net of management fees basis. In other words DFA funds earn a higher gross return, but their much higher management fees end up negating that advantage. We went with Vanguard for a combination of two of the five reasons we listed in Five Ways ETFs Surpass Index Funds:

  • ETFs have very low commissions
  • ETFs enable tax-loss harvesting

We believe DFA funds are outstanding products, especially in the small cap universe where they essentially are market makers. However, the software-based investment strategies that Wealthfront offers are only possible when commissions are free.

Commissions Can Influence the Services You Offer

DFA funds are typically charged a much higher commission than other securities. Those of you with a financial advisor that employs DFA funds might not realize it, but you are likely to incur a significant commission on every trade you make. For instance, the typical DFA commission negotiated by a financial advisor who uses Charles Schwab as a custodian is $25 per trade — almost three times the $8.95 commission Schwab charges on stocks and most ETFs. Schwab’s not the only custodian to do so either; Fidelity just announced they are raising their commission on DFA products to $50 per trade. According to a Fidelity spokesperson, Fidelity must raise its commissions on DFA because DFA does not compensate Fidelity for administrative and shareholder services that Fidelity performs on their behalf.

Prior to our launch in December 2011, we considered both Vanguard and DFA products as they offer what we believe are the best net of fee returns in the industry.

These unusually large commissions on DFA funds can either change the behavior of the advisor or significantly impact your total cost of investment management. This is especially problematic when it comes to tax-loss harvesting.

Let me explain. According to our back-tested models we make an average of 25 trades each year to implement the swaps associated with our asset class level tax-loss harvesting service (for more details on how this service works, please read our white paper). At $25 per trade this represents a total cost of $625 per year. That translates to an additional 0.625% per year on a $100,000 portfolio (the minimum account size required to enable our daily tax-loss harvesting service). At that rate commissions would eat up a sizeable percentage of the 0.93% potential annual benefit from our daily tax loss harvesting service. Our service is only possible because we were able to negotiate such low commissions on ETFs from our custodian partner that we are able to absorb the cost of the commissions as part of our annual 0.25% advisory fee. We, like other advisors, were not able to negotiate low commissions for DFA funds.

Obviously commissions as a percentage of account value decreases as your portfolio size increases, but it still represents a sizeable number and one that is seldom fully realized or understood by many investors.

A Tough Rebalancing Act

Commissions also affect the way DFA-based advisors rebalance their portfolios. Reinvesting dividends in your under-weighted asset classes helps reduce the frequency with which you need to sell over-weighted asset classes, thereby avoiding likely capital gains and their associated taxes.

With commissions charged on trading of DFA funds being so high it would be cost prohibitive to use dividends to rebalance your portfolio. Assuming a portfolio of six asset classes, each of which generates a dividend at least quarterly, and dividends are aggregated to buy half the asset classes each time they are paid (assume half the asset classes are under weighted) then you would have to make an additional 12 trades per year(three asset classes four times each year). At $25 per trade that adds up to $300 or 0.30% of a $100,000 portfolio per year. Clearly the commission cost swamps the potential annual tax benefit.

Obviously commissions as a percentage of account value decreases as your portfolio size increases, but it still represents a sizeable number and one that is seldom fully realized or understood by many investors.

Most brokerage firms do not charge commissions on dividend reinvestment plans. This probably explains why most advisors who use DFA reinvest the dividends generated by their funds back into the funds from which they were generated. The downside of reinvesting dividends this way is it likely increases the amount by which your asset classes stray from their optimal allocation, leading to a worse risk-adjusted return.

Wealthfront’s commission free service allows us to rebalance each time dividends are paid on our ETFs (usually 12 times per year) which likely results in more optimal and tax-sensitive rebalancing. This should lead to a higher pre-tax and after-tax portfolio return and lower volatility (risk).

In Short, Commissions Matter

We believe DFA funds are outstanding products. However the crazy commissions brokerage firms charge for the right to use them make tax minimization features of the type enabled by a software-based financial advisor impractical.

 

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Disclosure

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.

This blog 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 844-995-8437. 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.

About the author(s)

Andy Rachleff is Wealthfront's co-founder and Chief Executive Officer. He serves as a member of the board of trustees and chairman of the endowment investment committee for University of Pennsylvania and as a member of the faculty at Stanford Graduate School of Business, where he teaches courses on technology entrepreneurship. Prior to Wealthfront, Andy co-founded and was general partner of Benchmark Capital, where he was responsible for investing in a number of successful companies including Equinix, Juniper Networks, and Opsware. He also spent ten years as a general partner with Merrill, Pickard, Anderson & Eyre (MPAE). Andy earned his BS from University of Pennsylvania and his MBA from Stanford Graduate School of Business. View all posts by Andy Rachleff