Some call it direct indexing, and others call it stock-level tax-loss harvesting. No matter what you call it, this strategy’s potential to enhance your after-tax investment returns is significant. Wealthfront was the first robo-advisor to offer this service, and we remain the only one. However unlike the offerings from Parametric and Aperio Group on which our service is modeled, we charge no incremental fee for our service.
Direct indexing has become more popular since Wealthfront first began offering it. A recent article in Forbes observed that “direct indexing is rapidly emerging as the new, new thing for individual investors.” And last month, BlackRock announced that it would acquire Aperio Group (which is renowned for its direct indexing offering) for $1.05 billion.
Here we’ll take a look at what direct indexing is and why it matters for your investment portfolio.
What is direct indexing?
Direct indexing is the name we coined years ago for tax-loss harvesting within an index. We called it direct indexing because you directly own all the stocks that comprise an index in your brokerage account (instead of owning an index fund) and then perform tax-loss harvesting on those individual stocks. For example, you might own all 500 stocks that comprise the S&P 500 instead of owning an S&P 500 index fund.
When you hold individual stocks, you get more opportunities to harvest losses because individual stocks are typically more volatile than index-based ETFs, and market volatility is what makes it possible to conduct tax-loss harvesting. At the same time, the risk profile and pre-tax return of your portfolio generally remain the same with direct indexing because the tracking error relative to the index is relatively low. Your post-tax return should be better with direct indexing because you should be able to harvest more losses that you can then use to lower your taxes.
Let’s look at an example that illustrates how this works. Let’s say you use a direct indexing service to hold the 500 individual securities that make up the S&P 500. On a day when the S&P 500 is up 1%, Coca-Cola might have announced poor earnings and declined 10%. With ETF-level tax-loss harvesting, there would be no loss to harvest. But if the 10% decline in Coca-Cola brings the stock’s price below its purchase price, you can sell it at a loss and temporarily replace it with a highly correlated alternative stock like Pepsi. When you sell Coca-Cola at a loss, you “harvest” that loss and use it to offset other gains and up to $3,000 of ordinary income each year. After 30 days you can sell Pepsi and repurchase an equivalent amount of Coke.
Wealthfront’s direct indexing
Wealthfront’s Stock-level Tax-Loss Harvesting is available to clients with taxable Investment Accounts of at least $100,000. For our Stock-level Tax-Loss Harvesting 500 service, we replace the ETF that would normally represent the U.S. stock portion of your portfolio, VTI, with 500 of the largest U.S. market cap stocks, along with a completion index ETF that gives you exposure to all 8,000 stocks that comprise the total stock market ETF that we replace. This way, you can benefit from more opportunities to harvest losses (and thus reduce your taxes) in the U.S. stock portion of your portfolio while you continue to benefit from ETF-level tax-loss harvesting for other asset classes.
Direct indexing has the potential to significantly reduce your tax bill. Wealthfront clients who use our Stock-level Tax-Loss Harvesting 500 service earned an extra pre-tax benefit worth approximately 0.5% of their portfolio value over and above what they get from our ETF level tax-loss harvesting over the past seven years. This translates to an estimated after-tax benefit of between 0.12% and 0.25% of their portfolio value from Stock-level Tax-Loss Harvesting. For more details on our Stock Level Tax-Loss Harvesting service, we encourage you to read our white paper on the topic.
Direct indexing is an excellent complement to Wealthfront’s ETF-level Tax-Loss Harvesting service which, as we’ve written before, generates tax savings that are at least three times our clients’ annual advisory fees, rendering our investment offering basically fee-free.
Build a socially responsible portfolio
Another great thing about Wealthfront’s direct indexing service is it enables you to build a custom socially responsible portfolio by excluding specific stocks. We introduced this functionality to help clients who, for compliance reasons, could not hold specific stocks in their portfolio because of their employer. However, it has the added benefit of making your U.S. stock allocation highly customizable. If there are specific companies (or types of companies) that you don’t want in your portfolio, you can delete them.
Software is better than people
We’re proud to offer unique valuable services like Stock-level Tax-Loss Harvesting to our clients at no additional cost. It’s our commitment to software that allows us to make sophisticated services like Tax-Loss Harvesting, Stock-level Tax-Loss Harvesting, and Smart Beta so widely available. A traditional advisor is highly unlikely to execute these strategies on your behalf manually, let alone do so for free. Only through software can you lower the cost of delivering a service enough so that you can make money with your clients, not from them. And at Wealthfront, that’s at the heart of what we do.
We’re building a financial system that favors people, not institutions. That means we’re always working to deliver you more value, whether that’s through sophisticated investing offerings like direct indexing or valuable banking services like high-interest checking. Our products and services are always getting better, and we’re excited to show you what’s next.
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 Advisers and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term). Wealthfront Advisers’ 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.
Tax loss harvesting may generate a higher number of trades due to attempts to capture losses. There is a chance that 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.
The information contained in this communication is provided for general informational purposes only, and should not be construed as investment or tax advice. Nothing in this communication should be construed as a solicitation, offer, or recommendation, to buy or sell any security. Any links provided to other server sites are offered as a matter of convenience and are not intended to imply that Wealthfront Advisers or its affiliates endorses, sponsors, promotes and/or is affiliated with the owners of or participants in those sites, or endorses any information contained on those sites, unless expressly stated otherwise.
Investment advisory services are provided by Wealthfront Advisers, an SEC-registered investment adviser, and brokerage products and services are provided by Wealthfront Brokerage LLC, member FINRA / SIPC. Wealthfront Software LLC (“Wealthfront”) offers a free software-based financial advice engine that delivers automated financial planning tools to help users achieve better outcomes.
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The Wealthfront Team believes everyone deserves access to sophisticated financial advice. View all posts by The Wealthfront Team