Wealthfront’s S&P 500 Direct Methodology White Paper

Editor’s note: This white paper describes the methodology used for Wealthfront’s standalone S&P 500 Direct product, which directly holds individual stocks that comprise the S&P 500® Index. S&P 500 Direct has a minimum investment of $20,000 to get started and has an annual advisory fee of 0.09%.

Introduction

Wealthfront’s S&P 500 Direct allows you to invest in individual stocks that comprise the S&P 500® index, the most popular and oft-cited index of large-cap US stocks that covers about 80% of the total market capitalization of the US stock market. S&P 500 Direct seeks to match the performance of the index closely, while also improving the tax efficiency and after-tax return of your portfolio through tax-loss harvesting (TLH), all for the same price charged by the most popular S&P 500® ETF. It also allows you to exclude certain stocks of your choice, such as the stock of your employer, from being bought or sold.

Background

Over the last 40 years, index funds and index-based ETFs have unlocked the power of passive investing for the individual investor by offering a cheap, easy, and highly accessible way to invest in a wide range of asset classes.

Index funds are popular because they’re generally able to achieve three objectives:

They track their benchmark index closely. This allows them to accurately represent a particular asset class.
They are very inexpensive to own. Most index ETFs typically have expense ratios that range from 0.03% to 0.15%.
They track their benchmark index tax-efficiently and pass on minimal taxable gains to their investors.

Index funds can achieve the last goal because they are inherently tax-efficient. They generally have low turnover because securities that comprise an index seldom change (annual turnover is typically 5-20% depending on the index). Index fund issuers like iShares and Vanguard can also intelligently realize and carry forward losses on the underlying securities in their funds to minimize the gains they have to distribute to their investors each year.

However, index funds and ETFs have a disadvantage relative to owning individual stocks in a separately managed account. The Internal Revenue Code and the Investment Company Act of 1940 prevent ETFs from passing on tax losses to investors. While index fund issuers can use any realized losses in their funds to minimize any gains they distribute to investors, any leftover losses cannot be used to reduce investors’ taxes even further.

Wealthfront’s S&P 500 Direct product was developed to address this shortcoming. By allowing you to directly hold individual securities that comprise the S&P 500® , we can carry out tax-loss harvesting at the individual stock level to capture tax losses and use them to potentially reduce your tax bill.

What is Tax-Loss Harvesting?

Tax-loss harvesting is a strategy to make an investment portfolio work even harder – not just in generating investment returns, but by also generating tax savings.

Tax-loss harvesting works by taking advantage of investments that have declined in value, which is a common occurrence in broadly diversified investment portfolios. By selling investments that have declined below their purchase price, a tax loss is generated which can be used to offset other taxable gains or income, thus lowering your taxes.

What’s more, any investment sold in this manner can be replaced with other highly-correlated investments, such that the risk and return profile of your portfolio remains unchanged, even as tax savings are created. These tax savings can even be reinvested to further grow the value of the portfolio.

To understand the benefit of this capability, consider a common situation where an overall index trades up for the day, but a number of its component stocks trade down because they missed their earnings estimates. The losses on these individual companies can be harvested and the resulting tax savings can be reinvested and compounded over time, ultimately creating significant value.

For example, if Coca-Cola misses its earnings estimate and drops precipitously in value, we may sell Coca-Cola and use the proceeds to buy an equal amount of PepsiCo to maintain the correlation with the index in the absence of Coca-Cola. The loss taken on Coca-Cola may be used to lower the tax you would otherwise pay on gains you might have incurred or even ordinary income. After 31 days we may sell the Pepsi stock and repurchase an equal amount of Coca-Cola stock to maximize correlation with the index. We have to wait at least 31 days to repurchase Coca-Cola otherwise we incur what is known as a “wash sale” in which case the loss taken on the previous trade is disallowed as a deduction in that year, but may generate a benefit in a future tax year.

Many people mistakenly believe tax-loss harvesting provides no benefit because you must ultimately pay a tax on the gain that results from the lowered cost basis achieved through tax-loss harvesting. What they fail to realize is the tax rate you pay on the ultimate gain is almost always lower than the rate at which you can benefit from your harvested loss.

That’s because your loss creates value at the short-term capital loss rate and the ultimate gain is taxed at the much lower long-term capital gains rate. In addition, the savings you create from tax-loss harvesting can be reinvested and compounded until you withdraw all your money from your investment account.

Wealthfront developed our TLH software to make this powerful strategy available to a far broader set of clients than would typically have access to TLH services. Implementing TLH with software makes it possible to look for harvesting opportunities on a daily basis, which could result in significantly greater benefit than what can be achieved from the manual end-of-year approach typically taken by traditional financial advisors.

Tax-loss harvesting applied to a portfolio of stocks that comprise an index is commonly known as Direct Indexing, a term Wealthfront coined in 2013.

Who should use Tax-Loss Harvesting?

Tax-Loss Harvesting is valuable for all investors who earn an income. Harvested losses can be applied to offset both capital gains and up to $3,000 in ordinary income annually: First, harvested short-term losses can be used to offset short-term gains and harvested long-term losses can be used to offset long-term gains. If there are net short-term and long-term gains and losses, they can offset each other. For example, as shown in Table 1, assume a person has harvested $5,000 in short-term capital losses and $500 in long-term capital losses. Let’s further assume this person also has $1,000 in short-term capital gains and $1,000 in long-term capital gains. First, we use the $1,000 short-term loss to offset all short-term gains. Then we use the $500 long-term loss to offset $500 of long-term gains. Once that is done, we still have $4,000 in net short-term losses and $500 in net long-term gains. They can offset each other. We use $500 of the remaining short-term losses to offset the remaining long-term gain, leaving us with a $3,500 net short-term loss. Finally, any unused losses after this step can offset up to $3,000 of ordinary income annually. Any losses that cannot be used in a given tax year can be carried over indefinitely to offset future income and capital gains. In our example, since we have $3,500 in net capital losses left, we can offset $3,000 of ordinary income for the current year and carry over $500 for future years.

Table 1: Example harvested losses and capital gains

	Harvested Losses	Capital Gains	Net
Short-term	$5,000	$1,000	$4,000 loss
Long-term	$500	$1,000	$500 gain
Final Net			$3,500 loss

Of course, TLH is especially valuable for investors who regularly recognize short-term capital gains. These gains often arise from the sale of company stock, real estate, or just about any investment. Tax-Loss Harvesting can even be used to minimize the gains associated with liquidating a portfolio to move to a new financial advisor.

S&P 500 Direct Portfolio Construction

S&P 500 Direct directly buys stocks that comprise the S&P 500® index in a separately managed account. The minimum investment to open an S&P 500 Direct account is $20,000. This minimum is based on the dollar amount required to hold enough individual US stocks to reasonably track the performance of the S&P 500® Index. Generally, the higher the total value of the portfolio, the more stocks we will be able to hold in the account and the closer we can track the index. Portfolios of $20,000 may hold roughly 100-250 stocks. Portfolios of $100,000 may hold around 300 stocks. For portfolios of more than $1,000,000, we attempt to hold all 500 stocks, but due to Tax-Loss Harvesting, which sells stocks that have decreased in value and purchases similar stocks which we may already hold to replace them, the actual number of stocks in the portfolio is likely to be no more than 400.

In constructing your S&P 500 Direct portfolio, we attempt to balance tax-loss harvesting benefits and minimize the deviation from tracking the performance of the S&P 500® index through mathematical optimization (see “Methodology” section for details). We seek to invest in stocks using similar weights to those in the S&P 500® index. However, there can be deviations from the weights in the index, as the exact weight may not result in an integer number of shares. Deviations can also occur because of tax-loss harvesting that sells certain stocks and purchases more of other stocks. These deviations may result in performance differences relative to the S&P 500® index. These performance differences could be positive or negative, but should generally be small. We expect the differences should average out to zero in the long run. If there are any changes made to the S&P 500® index, such as adding new stocks, removing existing stocks and changing index weight of the stocks, we will update your portfolio to track the updated index’s performance.

You can avoid trading specific stocks by adding them to your “stock restrictions list.” These might be stocks you are personally restricted from trading (for example, the stock of your employer) or stocks traded in the S&P 500 Direct portfolio that could cause wash sales due to trades in those positions outside of Wealthfront. Once you add a stock to the stock restrictions list, Wealthfront will no longer buy or sell it. This means if the stock was in your portfolio before being added to the list, it will remain in your portfolio—but we won’t buy more of it, even if you make additional deposits. When you have stocks on your stock restrictions list and make a deposit into your portfolio, we will purchase highly correlated stocks to help you continue to track the performance of the index. Adding more stocks to the list, or adding stocks with large index weights, makes it more difficult to track the index’s performance closely. This could lead to potentially larger performance differences between your portfolio and the S&P 500® index.

Methodology

We balance two competing objectives with our S&P 500 Direct product: Maximize the after-tax benefit of harvesting losses (tax alpha) and minimize tracking error, which measures the difference in performance between our S&P 500 Direct and the S&P 500® index and is calculated as the standard deviation of performance difference. Note that we do not select individual stocks based on their fundamentals or any perspective on whether they are fairly valued by the market.

We balance the two objectives by maximizing a combined objective of tax alpha (with a positive weight) and squared tracking error (with a negative weight). The tax alpha component encourages selling stocks that have declined in price. The tracking error component penalizes sales that cause significant tracking differences from the relevant index and encourages buying correlated replacement stocks that help keep the overall portfolio close to the index. In some cases, we may purchase more of an existing holding. As in the example in the “What is Tax-Loss Harvesting?” section, we may buy PepsiCo to replace Coca-Cola.

We manage the portfolio and aim to avoid wash sales by applying constraints to our optimization. For example, we enforce a maximum constraint on each stock’s relative portfolio weight to ensure portfolio diversification. We also enforce a maximum drift constraint on each stock’s weight to ensure it stays relatively close to its benchmark weight, and trade direction constraints to help avoid wash sales in Wealthfront managed portfolios. Portfolio weights are determined by solving the following optimization problem:

maximize: 𝛼⋅(Tax Alpha) – (Tracking Error)²

subject to: Portfolio is long-only

Portfolio weights ≤ maximum weight parameter

|Portfolio weights – benchmark weights| ≤ drift parameter

Do not trade stocks in wash-sale window

In this formulation, the parameter 𝛼 represents the weighting given to tax alpha in the objective. We chose the value of 𝛼 to balance tax benefit and tracking error relative to the benchmark.

Potential TLH Benefit

Wealthfront’s S&P 500 Direct launched in November 2024. As a result, we don’t yet have a long enough history with the product to publish realized results. To understand the potential of S&P 500 Direct’s tax-loss harvesting benefit, we examine below the realized tax-loss harvesting results of a similar product managed by Wealthfront since 2015. This product, called US Direct Indexing (USDI), is managed using the same methodology and software as S&P 500 Direct, and should therefore provide a useful reference point for the ability of S&P 500 Direct to harvest tax losses, although actual S&P 500 Direct results will vary. USDI differs from S&P 500 Direct in two important ways:

USDI seeks to track the pre-tax performance of the CRSP US Total Market index, a broad market index that covers more than 3,500 large, mid, and small capitalization US stocks, rather than the S&P 500®, which covers only 500 large capitalization US stocks.
USDI invests directly in up to 100 individual stocks, and adds exposure to other stocks through the use of ETFs to obtain exposure to the remaining more than 3,400 stocks that comprise the CRSP Total US market index rather than the S&P 500 Direct, invests directly in up to 500 stocks to obtain exposure to the S&P 500® index.

We measure the rate of tax-loss harvesting using harvesting yield, the magnitude of losses harvested as a fraction of the portfolio value:

Harvesting Yield = Total Losses Harvested / Total Balance

Harvesting Yield is calculated daily and aggregated over time. It represents an aggregation of client results, and not the results of any individual account. Harvesting Yield is only a measure of how many losses were realized, not of their value. To assess the true economic benefit, we need to multiply the Harvesting Yield by an appropriate tax rate. Since nearly all of the losses harvested by either service are short-term, you should multiply your marginal ordinary income tax rate—both federal and state combined—to the harvesting yield to measure your full economic benefit.

Table 2 shows the annual Harvesting Yields achieved by USDI (total daily losses harvested in the USDI product / total daily USDI balances, in aggregate) since February 2015. The exact value varies from year to year and is generally correlated with market volatility (i.e. the higher the volatility, the higher the harvesting yield). For example, the US equity market experienced large drawdowns in early 2020 as the COVID-19 virus began to spread, and through much of 2022 as inflation spiked and expectations of increasing interest rates began to develop. These two years have the highest Harvesting Yields in the sample. In contrast, the US equity market performed extremely well in 2021, and as a result had a relatively low Harvesting Yield value, but it still generated Harvesting Yield.

These results can be influenced by client tenure. Over time, asset prices tend to rise and without new deposits, it becomes harder to find harvesting opportunities. We can control for this effect by measuring the Harvesting Yield of client cohorts, grouped by the year they first enrolled in USDI. Table 3 shows the annualized harvesting yield for each client cohort since 2015.

Marginal income tax rates vary by state and income. Based on the current self-reported income, state of residence, and tax-filing status (e.g., single, married filing jointly) of clients invested in USDI, marginal income tax rates (federal and state combined) typically[1] fall between 18% and 44% as of December 2023. If we assume these clients had short term losses or ordinary income against which they could use these losses, and multiply their tax rates by the harvesting yields in Table 3, we calculate a range of estimated annual after-tax benefit between 0.73% and 7.69% of account value invested in USDI. Given that S&P 500 Direct is managed by the same methodology and software as USDI, we believe S&P 500 Direct could offer significant value in excess of what an investor could get from just owning an S&P 500® ETF or index fund.

Table 4 shows annualized harvesting yields by client cohort for the trailing one- and five-year periods to complement the since-inception yields in Table 3.

The effect of client tenure is apparent here, particularly in the “one year” column—more recent cohorts had higher Harvesting Yields in 2023.

Note the results above are an aggregation of client investments in our USDI product and reflect their deposit behavior. Many of our clients make follow-on deposits into their USDI investments after their opening deposits. Since over the long-term, indexes trend up in general, follow-on deposits tend to have higher starting cost basis and makes it easier to carry out tax-loss harvesting.

Potential Tracking Error

We use the term Tracking Difference to describe the difference between our S&P 500 Direct’s return and the return of the S&P 500® Index in a given time period. We use the term Tracking Error for the standard deviation of the tracking differences, which measures how far your portfolio is from the index in terms of risk.

Tracking Difference = (our S&P 500 Direct Pre-Tax Return) – (S&P 500® Index Return)

Tracking Error = Standard Deviation(Tracking Difference)

There are three primary potential factors that can cause an S&P 500 Direct account to have tracking error relative to an S&P 500® index fund:

Carrying out tax-loss harvesting will cause some small, temporary weight deviations for certain stocks. As we sell stocks that have decreased in value and purchase similar stocks to replace them, these stocks’ weights in the portfolio will temporarily deviate from their weights in the S&P 500® Index.
As mentioned before, small portfolio sizes may limit how many stocks we can hold in the portfolio, as index weights for certain stocks may be far below one share due to the small portfolio value.
Stocks identified in the stock restrictions list may limit our ability to track the index closely. As more stocks are excluded, it becomes harder to find highly correlated replacement stocks to maintain our tracking of the index performance.

Thus, there is usually a small amount of tracking error present in the portfolio, and your portfolio is likely to have tracking differences to the index over any given time period. Tracking differences in a given year can be positive or negative, meaning we may outperform or underperform the index. Over the long term, we expect the tracking difference caused by tax-loss harvesting to be insignificant. However, tracking differences caused by small portfolio sizes and stock exclusions may persist over time.

Just as in the last section, we lack a long history of realized results to show the tracking error of S&P 500 Direct, so we will use results from USDI as a reference. Of course there will be differences in the observed results of S&P 500 Direct and USDI.

The chart below shows the pre-tax growth of $10,000 invested in both USDI (net of a 0.09% annual advisory fee) and the CRSP US Total Market Index, starting in February 2015 and extending through the end of 2023. The two series track each other extremely closely. In fact, the correlation between the daily returns series of USDI and the CRSP index is over 99.6% during this period. The tracking error between USDI and index, calculated using daily returns, was about 1.65%.

Table 5 compares the returns by calendar year (the returns for 2015 start on February 4) plus selected trailing periods, for both USDI (again net of a 0.09% advisory fee) and the CRSP US Total Market Index. There are small differences in any given year, but on average the two sets of returns are very close. Over this period, USDI trails the index by about 0.4% per year, but the product was designed to minimize the difference over the long term.

The USDI results above showed some small positive and negative performance differences to the index each year, but fairly close performance differences on average. These results strongly suggest that the tracking error for S&P 500 Direct will also be small because S&P 500 Direct is managed by the same software as USDI, which is designed to maximize a combined objective of tax alpha (with a positive weight) and squared tracking error (with a negative weight) for a highly correlated index.

Conclusion

We designed S&P 500 Direct with the objective to significantly improve your after-tax investment results while closely tracking the performance of the S&P 500® index.

Over the long term, we expect the pre-tax return of S&P 500 Direct will be very similar to that of the S&P 500® index. Most of the economic advantage relative to the index should come from the tax-loss harvesting that we expect our S&P 500 Direct product to achieve. The benefits of these losses, if achieved on the scale of our other index based TLH service, should represent a sizable multiple of the 0.09% advisory fee we charge for the product. As a result we believe S&P 500 Direct reflects the next evolution in index investing and a tremendous value to our clients.

Disclosure

[1] We estimate each client’s federal and state marginal income tax rate based on their self-reported annual income, state of residence and marital status as of December 2023. By “typically”, we mean the range between the 10th and 90th percentile of the combined federal and state tax rates among USDI clients.

The S&P 500® index is a product of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”) and has been licensed for use by Wealthfront Advisers LLC. Standard & Poor’s®, S&P®, S&P 500®, US 500 and The 500 are trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Wealthfront Advisers LLC. Wealthfront’s S&P 500 Direct Portfolio is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates and none of such parties make any representation regarding the advisability of investing in such product nor do they have any liability for any errors, omissions, or interruptions of the S&P 500® index.

This white paper is for informational purposes only and is not intended as tax advice. Wealthfront Advisers and its affiliates do not provide legal or tax advice and do not assume any liability for the tax consequences of any client transaction. Clients should consult with their personal tax advisors regarding the tax consequences of investing with Wealthfront Advisers and engaging in these tax strategies, based on their particular circumstances. Clients 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 Advisers assumes no responsibility for the tax consequences to any investor of any transaction.

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).

Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and the strategy could introduce portfolio tracking error into your account. Tracking error is a measure of financial performance that determines the difference between the return fluctuations of an investment portfolio and the return fluctuations of a chosen benchmark. There may also be unintended tax implications.

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 Tax-Loss Harvesting results presented for the USDI product are extracted from portfolios offered by Wealthfront Advisers. Upon written request, Wealthfront Advisers will promptly provide results of the total portfolios from which the performance was extracted.

Wealthfront Advisers and its affiliates do not provide legal or tax advice and do not assume any liability for the tax consequences of any client transaction. Clients should consult with their personal tax advisors regarding the tax consequences of investing with Wealthfront Advisers and engaging in these tax strategies, based on their particular circumstances. Clients 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 Advisers assumes no responsibility for the tax consequences to any investor of any transaction.

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.

Investors may experience different results from the results shown. Future performance may deviate from past results due to changes in recommended asset allocations, as well as differences in future market or economic conditions. Correlation is a measure of statistical association, or dependence, between two random variables. The values presented here are based on a particular historical sample period, data frequency, and are specific to the assets/indices used in the analysis. Correlations may change over time, such that future values of correlation may significantly depart from those observed historically.

Wealthfront Advisers is compensated for its advisory services by charging an annual account fee of 0.09% on the net market value of a Client’s account.

Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Investment management and advisory services–which are not FDIC insured–are provided by Wealthfront Advisers LLC (“Wealthfront Advisers”), an SEC-registered investment adviser, and financial planning tools are provided by Wealthfront Software LLC (“Wealthfront”). Brokerage products and services are offered by Wealthfront Brokerage LLC, member FINRA / SIPC. All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. Please see our Full Disclosure for important details.

Wealthfront Advisers, Wealthfront Brokerage and Wealthfront are wholly owned subsidiaries of Wealthfront Corporation.