Wealthfront’s US Direct Indexing

This white paper summarizes the motivation, design, and execution of Wealthfront’s US Direct Indexing service. All Wealthfront clients with Automated Investing Account balances between $100,000 and $475,000 can choose to use Wealthfront’s US Direct Indexing service, which seeks to enhance clients’ after-tax returns (clients with taxable accounts above $475k can choose our Smart Beta service, which aims to improve both pre-tax and after-tax returns). Our US Direct Indexing service launched in 2015, and results since then demonstrate that the service can significantly improve the tax efficiency and ultimately the after-tax return of your taxable portfolio. We believe US Direct Indexing should be a fundamental component of most every individual’s investment management strategy.

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. Just one share of Vanguard’s Total Stock Market ETF (ticker: VTI) lets an investor mirror the investment performance of a portfolio of more than 3,500 US company stocks, all for an expense ratio of only 3 basis points (0.03% as of 04/29/2022) of the invested assets.

Index funds work because they’re generally able to achieve two objectives:

1. They track their benchmark index closely. This allows them to accurately represent a particular asset class.
2. They track their benchmark index tax-efficiently, and pass on few taxable gains to their investors.

Index funds can achieve the latter 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 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 two disadvantages relative to optimum performance in achieving the above goals and for their investors.

• Owning an index fund or ETF comes with a fee, often called an “expense ratio.” Although the fee may be small, it still acts as a barrier to fully replicating the performance of a passive index investment. This expense ratio can add to an investor’s overall costs because it is typically in addition to any advisory fees or commissions the investor already pays.
• Index funds and ETFs are legally prohibited by The Investment Company Act of 1940 from passing on tax losses to investors. While iShares and Vanguard 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 US Direct Indexing service was developed to address both of these shortcomings.

By allowing a Wealthfront investor to hold the individual securities that comprise an index directly, US Direct Indexing reduces the overall portfolio cost from ETF expense ratios. Furthermore, by directly owning the stocks that comprise an index, investors can harvest losses at the individual stock level. To understand the benefit of this capability, consider a common situation where an overall index trades up, 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 thus ultimately creating significant value.

The opportunity to deliver a US Direct Indexing service prompted firms like Aperio Group and Parametric Portfolio Associates to pioneer managed portfolios of stocks that harvest tax losses for their clients while emulating a specific index. Unlike index funds, Aperio and Parametric prioritize both harvesting tax losses as well as closely tracking the index. These firms have demonstrated you can generate significant outperformance in the form of tax savings if you are willing to incur modest tracking differences from the designated index. Together, these firms have attracted more than $400 billion under management.

Wealthfront is able to offer our US Direct Indexing service to a much broader set of investors through the extensive automation provided by our technology platform. Our service is also offered at no additional fee beyond our annual 0.25% advisory fee.

We believe our US Direct Indexing service meaningfully addresses the two remaining shortcomings with modern index investing – the cost of the index fund and ETF expense ratios and the missed tax savings from the inability to pass on tax losses. For this reason, we view US Direct Indexing as the next evolution of index investing.

US Direct Indexing Overview

For accounts between $100,000 and $475,000, US Direct Indexing replaces the ETF normally used to represent a broad market of US Stocks (Vanguard’s Total Stock Market ETF) with up to 100 large-capitalization and mid-capitalization US stocks and a combination of the Vanguard Extended Market ETF (VXF) and the Vanguard S&P 500® ETF (VOO) to represent the remaining smaller-capitalization companies. As a result, the portfolio is able to track the movement of the overall broad US market, while maintaining a significant holding of individual stocks.

We will occasionally use additional ETFs — especially in cases where the above ETFs are sold for tax-loss harvesting purposes. Thus, US Direct Indexing clients may see a combination of the Vanguard Large-Cap ETF (VV), the Vanguard Small-Cap ETF (VB), the Vanguard S&P 500® ETF (VOO), and the Vanguard Extended Market ETF (VXF) in their portfolios in addition to their individual stock positions. As shown below, the resulting Wealthfront account replaces Vanguard’s VTI with a combination of individual stocks and completion ETFs, but continues to hold the other ETFs representing the other asset classes common to Wealthfront investments (such as Foreign Stocks, Emerging Markets, Dividend Stocks, etc.). All US Direct Indexing accounts also benefit from our Tax-Loss Harvesting service, which harvests tax savings at the ETF level.

Wealthfront is one of the first companies to combine asset-level Tax-Loss Harvesting and US Direct Indexing. We offer this capability to accounts of only $100,000, a fraction of what the competition typically requires.

Costs and Minimums

The cost of our US Direct Indexing service is lower than the Vanguard ETF it replaces. Vanguard currently charges an annual 0.03% expense ratio for VTI, while the equivalent fee for US Direct Indexing is lower, because clients do not pay an expense ratio for the portion of the US Direct Indexing position that’s composed of individual stocks. The cost of that service is included in our annual 0.25% advisory fee.

US Direct Indexing clients pay no expense ratio for the 50% of their US Stocks position that holds individual stocks. The remaining 50% — comprised of roughly a 43% allocation to the Vanguard Extended Market ETF (ticker VXF, expense ratio 0.06%) and a 7% allocation to the Vanguard S&P 500 ETF (ticker VOO, expense ratio 0.03%) — results in a weighted average US Direct Indexing fee of 0.0279%, which is just under Vanguard’s 0.03% fee for VTI.

Our minimum for US Direct Indexing is based on the dollar amount required to hold a reasonable collection of individual US stocks while continuing to track the performance of the broad US market. For a $100,000 account, the average Wealthfront portfolio allocates about $30,000 to US equities. We found this $30,000 to be the minimum amount that allows for ownership of up to 100 large-cap US stocks while maintaining a good ability to track broad US market performance.

The individual stocks we buy as part of the US Direct Indexing service are selected to minimize tracking error with Vanguard’s Total Stock Market ETF, VTI, not based on their fundamentals or any perspective on whether they are fairly valued by the market. We harvest losses on individual stocks based on a threshold and use the proceeds to purchase other highly correlated stocks within the appropriate US stock index.

Methodology

We balance two competing objectives with our US Direct Indexing service: maximize the after-tax benefit of harvesting losses (Tax Alpha) and minimize tracking error. We do this by maximizing a function of Tax Alpha minus tracking error squared. 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 keep the overall portfolio close to the index. In some cases, we may purchase more of an existing holding. For example, if Coca-Cola misses an earnings estimate and drops precipitously in value, we may sell Coca-Cola and use the proceeds to buy more PepsiCo to maintain the correlation with VTI in the absence of Coca-Cola.

We manage the portfolio and 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 avoid wash sales. 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 give a good trade-off between tax benefit and tracking error vs. the benchmark.

In addition to avoiding wash sales through a constraint on our optimization, we also do not trade in stocks identified by the client via an “Exclusion List.” By adding stocks to an “Exclusion List” you’re able to identify stocks that you are restricted from trading (e.g., the stock of your employer) as well as stocks where trading is more likely to cause wash sales due to significant individual stock positions held outside of Wealthfront. Once identified, the US Direct Indexing optimizer will trade any “Exclusion List” stocks and, if needed, will buy one or more highly correlated replacement stocks or ETFs to maintain low tracking error to the broad US stock market performance.

Results

This section summarizes the results realized by clients using our US Direct Indexing service since it launched in February 2015. We measure the effectiveness of US Direct Indexing on two dimensions: how closely it tracks the original ETF it replaced, VTI, and how much benefit it generates. The daily return of the US Direct Indexing portfolio is calculated as a value-weighted average of the return of the US Direct Indexing position of all clients enrolled in the service on that date, and compounded to measure the performance over longer periods of time. These returns do not represent the experience of any particular investor.

We use the term Tracking Difference to describe the difference between the US Direct Indexing portfolio’s return and the return of the VTI ETF (the primary ETF used to represent the US stock market in our ETF-only portfolios)  in a given time period. We use the term Tracking Error for the standard deviation of the tracking differences.

Tracking Difference = (US Direct Indexing Pre-Tax Return) – (VTI Return)

Tracking Error = Standard Deviation(Tracking Difference)

We track the benefit generated by US Direct Indexing using Harvesting Yield, which measures the magnitude of losses harvested as a fraction of the portfolio value:

Harvesting Yield = Total Losses Harvested / Total Balance

As with the portfolio return, Harvesting Yield is calculated daily and aggregated over longer time periods. It represents an aggregation of client results, and not the results of any individual account. For comparison purposes, we’ll compute Harvesting Yield for both US Direct Indexing clients and for clients using our ETF-only Tax-Loss Harvesting service. Because US Stocks is the only asset class in which US Direct Indexing is implemented, we only compare the Harvesting Yield within the US Stocks portion of clients’ portfolios. The Harvesting Yield for US Direct Indexing includes losses harvested in both the individual stocks and the ETFs used to implement the strategy, while the Harvesting Yield for the ETF-only portfolios includes the losses harvested in the primary and alternate ETFs used to represent the US Stocks asset class.

We’ll start by comparing returns. The chart below shows the pre-tax growth of $10,000 invested in both US Direct Indexing and VTI, gross of advisory fees, starting in February 2015 and extending through the end of 2021. The two series track each other extremely closely. In fact, the correlation between the daily returns series of US Direct Indexing and VTI is over 99.6% during this period.

Table 1 compares the returns by calendar year (the returns for 2015 start on February 4 and the 2022 results end on April 30) plus selected trailing periods, net of a 0.25% annual advisory fee. There are small differences in any given year, but on average the two sets of returns are very close. Over this period, US Direct Indexing trails VTI by about 0.65% per year, but over the long run, we expect the difference to get closer to zero.

Next we’ll look at Tax-Loss Harvesting results over the same time periods. Table 2 shows the Harvesting Yield for each year from 2015 through 2022. In each year, US Direct Indexing produced a higher Harvesting Yield than the ETF-only Tax-Loss Harvesting strategy. Over the full period, the annualized difference in Harvesting Yield is about 1.6%. This is despite the fact that clients in the ETF-only strategy actually made more deposits (as a fraction of portfolio value) than US Direct Indexing clients did over this period. This is important, as fresh deposits raise the cost basis of the portfolio, increasing the ability to harvest losses.

As an additional check, we can control for client tenure by measuring the Harvesting Yield of client cohorts, grouped by the year they first enrolled in either version of our Tax-Loss Harvesting service. Client tenure affects Harvesting Yield as well. Over time, asset prices tend to rise and without new deposits, it becomes harder to find harvesting opportunities. Table 3 shows the annualized Harvesting Yields for client cohorts starting in 2015 and extending through the end of April 2022.

From this we see that the Harvesting Yield from US Direct Indexing is higher than the yield from ETF-only Tax-Loss Harvesting for every client cohort except 2020.

What was different about 2020? We believe the answer is broad market performance. Before we go into detail, consider the following simple example: suppose a market index contains two stocks, at equal weight. A US Direct Indexing portfolio holds both stocks at equal weight as well. If both stocks drop by 10% from the initial purchase prices, the portfolio manager can sell one stock and buy the other, yielding 5% in realized losses. However, a portfolio holding an ETF tracking the index could sell that ETF and buy a similar one as a replacement, yielding 10% in realized losses. In this situation, ETF-level Tax-Loss Harvesting is at an advantage.

This was in fact what happened in 2020. In March, at the onset of the COVID-19 crisis, the US equity market (measured using the SPY ETF which tracks the S&P 500 index) declined rapidly, bottoming out at more than 30% lower than its value at the beginning of the year.

The chart below shows the cumulative return of SPY in 2020 along with the cumulative Harvesting Yield of the 2020 cohorts in the US Direct Indexing and ETF-level Tax-Loss Harvesting strategies. As you can see, the difference in Harvesting Yields widened in March and April of 2020, when SPY was far below its level from the beginning of 2020. During this time, recent purchases of index ETFs could be sold to harvest sizable losses. You’ll also notice that the lines representing the cumulative harvesting yields start to grow closer together as SPY recovers through the second half of 2020 and 2021. It is periods like this when US Direct Indexing has the advantage —even when the market is broadly moving up, some stocks will inevitably go down in price and provide tax-loss harvesting opportunities.

Economic Advantage of Direct Indexing

Over time, we expect that the pre-tax return of US Direct Indexing will be very similar to that of VTI, the ETF it replaces. Most of the economic advantage should come from the additional tax-loss harvesting that we expect US Direct Indexing to achieve. We observed that both of these expectations held true in the results realized by clients so far—returns of US Direct Indexing tracked VTI very closely, and US Direct Indexing achieved an annualized Harvesting Yield of about 1.5% higher than that of ETF-level Tax-Loss Harvesting over the seven years since the launch of the service.

Conclusion

We believe the results presented in this white paper clearly demonstrate that Wealthfront’s US Direct Indexing could significantly improve your after-tax investment results while closely tracking the returns of the US equity market.

Investing directly in stocks provides an immediate cost savings by avoiding the expense ratios charged by index funds and ETFs. ETF-level Tax-Loss Harvesting could be at an advantage in years with steep market declines, as we have seen recently. While times like this can (and will) occur, US Direct Indexing usually provides better opportunities to harvest tax losses. We believe US Direct Indexing reflects the next evolution in index investing and thus should be a key element of every investor’s portfolio.