Wealthfront’s Tax-Optimized Direct Indexing
The next evolution in index investing
This white paper summarizes the motivation, design and execution of Wealthfront’s Direct Indexing service. Our historical backtests and actual results demonstrate that Direct Indexing can significantly improve the tax efficiency and ultimately the after-tax return of your taxable portfolio. We believe Direct Indexing should be a fundamental component of most every individual’s investment management strategy.
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) can enable an investor to mirror the investment performance of a portfolio of more than 3,500 US company stocks, all for a management fee of only 5 basis points (0.05%) of the invested assets.
Index funds work because they’re generally able to achieve two objectives:
- They track their benchmark index as closely as possible. This is imperative to accurately represent a particular asset class.
- They track their benchmark index as tax-efficiently as possible – passing on as few taxable gains as possible to their investors.
Index funds can achieve the latter goal because they are inherently tax-efficient. They have low turnover because securities that comprise an index seldom change (5-20% annual turnover depending on the index). Index fund issuers like iShares and Vanguard are also able to 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. Although the fee may be small, it still acts as barrier to fully replicating the performance of a passive index investment. This management fee 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 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 in her own account on a commission-free basis, Direct Indexing effectively eliminates any Index fund or ETF management fees on the associated position, which reduces overall portfolio cost. Furthermore, by directly owning the stocks that comprise an index, investors can harvest losses at the individual stock level. We call this stock-level tax-loss harvesting. 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 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 $100 billion under management.
Wealthfront is able to offer our 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 that is inclusive of all commissions.
We believe our Direct Indexing service meaningfully addresses the two remaining shortcomings with modern index investing – the cost of the Index Fund and ETF management fees and the missed tax-savings from the inability to pass on tax losses. For this reason, we view Direct Indexing as the next evolution of index investing.
Direct Indexing Overview
Wealthfront’s Direct Indexing service replaces the ETF normally used to represent US stocks in a Wealthfront portfolio with a combination of individual securities and one or two additional ETFs. The resulting position uses the individually held stocks to capture the market performance of large-capitalization and mid-capitalization US stocks, while leveraging the ETF to represent the performance of smaller-capitalization companies. As a result, the position is able to track the movement of the overall broad US market, while maintaining a significant holding of individual stocks.
We offer three levels of Direct Indexing:
- For accounts between $100,000 and $500,000, we will replace the ETF normally used to represent a broad market of US Stocks (Vanguard’s Total Stock Market ETF) with up to 100 of the largest 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.
- For accounts between $500,000 and $1 million, we will replace the ETF normally used to represent a broad market of US stocks (Vanguard’s Total Stock Market ETF) with up to 500 of the largest capitalization US stocks and the Vanguard Extended Market ETF (VXF) used to represent the remaining smaller capitalization companies.
- For accounts above $1 million, we will replace our Vanguard Total Stock Market ETF with up to 1,000 of the largest capitalization US stocks (typically representing US large cap and mid cap companies) and the Vanguard Small-Cap ETF (VB) used to represent the remaining small-capitalization US companies.
For all levels of Direct Indexing, we will occasionally employ additional ETFs — especially in cases where the above ETFs are sold for tax-loss harvesting purposes. Thus, 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 Direct Indexing individual stock position. 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 common to Wealthfront investments (such as Foreign Stocks, Emerging Markets, Dividend Stocks, etc.). All Direct Indexing accounts also benefit from our Daily Tax-Loss Harvesting service – which harvests tax-savings at the ETF-level.
|Wealthfront Diversified Portfolio||DiversifiedPortfolio withTax-Loss Harvesting||Diversified Portfolio with Tax-Loss Harvesting and Direct Indexing|
|US Stocks||Vanguard (VTI)||Vanguard (VTI)||Direct Indexing|
|Foreign Stocks||Vanguard (VEA)||Vanguard (VEA)||Vanguard (VEA)|
|Emerging Markets||Vanguard (VWO)||Vanguard (VWO)||Vanguard (VWO)|
|Dividend Stocks||Vanguard (VIG)||Vanguard (VIG)||Vanguard (VIG)|
|Natural Resources||State Street (XLE)||State Street (XLE)||State Street (XLE)|
|TIPS||Schwab (SCHP)||Schwab (SCHP)||Schwab (SCHP)|
|Municipal Bonds||iShares (MUB)||iShares (MUB)||iShares (MUB)|
Wealthfront is the first and only company to combine daily asset-level Tax-Loss Harvesting and Direct Indexing. We offer this capability to accounts of only $100,000, one-fiftieth the size of what the competition requires.
Costs and Minimums
The cost of our Direct Indexing service is lower than the Vanguard ETF it replaces. Vanguard currently charges an annual 0.05% management fee for VTI, while the equivalent fee for all three levels of Direct Indexing is lower. That’s because we do not charge a management fee for the majority of the Direct Indexing position that’s comprised of individual stocks. The cost of that service (including all commissions) is included in our annual 0.25% advisory fee.
For $100,000 Direct Indexing accounts, that means no management fee is charged for 50% of the Direct Indexing position that’s comprised of individual stocks. The remaining 50% — comprised of roughly a 45% allocation to the Vanguard Extended Market ETF (ticket VXF, expense ratio 0.10%) and a 5% allocation to the Vanguard S&P500 ETF (ticker VOO, expense ratio 0.05%) – results in a weighted average Direct Indexing fee of 0.0475% — just under Vanguard’s 0.05% fee for VTI.
This is even better for larger accounts. For the $500,000 and $1 million levels of Direct Indexing, roughly 80% of the Direct Indexing position is comprised of individual stocks and thus has no management fee. The remaining 20% or so is comprised of either the Vanguard Extended Market ETF (VXF) for $500,000 accounts or the Vanguard Small-Cap ETF (VB) for accounts over $1 million. The management fee of these completion ETFs is 0.10% and 0.09% respectively, resulting in a weighted average Direct Indexing fee of 0.02% for $500,000 accounts (where VXF represents 20% of the position) and a fee of 0.014% for accounts over $1 million (where VB represents 16% of the position) – both significantly below the equivalent 0.05% fee from Vanguard.
Our minimums for Direct Indexing are based on dollar amounts required to hold a reasonable collection of individual US stocks in a Direct Indexing position while continuing to track the performance of the broad US market. For a $100,000 account, the average Wealthfront client will allocate 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.
To expand this position to hundreds of stocks requires a much larger account as you are forced to include allocations to smaller Mid Cap stocks in the position. We found that moving to hundreds of stocks requires a US equity allocation of roughly $150,000 – thus necessitating an account minimum of about $500,000. This minimum increases again as you exceed 500 stocks and start holding some of the smaller Mid Cap stocks in the position – thus necessitating a $1 million minimum for the highest level of our Direct Indexing service.
Wealthfront 100 (WF100), Wealthfront 500 (WF500), and the Wealthfront 1000 (WF1000)
We call the up to 100 individual stocks owned as part of our Direct Indexing service the Wealthfront 100. When Direct Indexing employs 500 or 1,000 individual stocks, we refer to that collection of stocks as the Wealthfront 500 or the Wealthfront 1000 respectively.
The individual stocks we buy are always 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.
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 would sell Coke and use the proceeds to buy more PepsiCo to maintain the correlation with VTI in the absence of Coca-Cola.
We balance two competing objectives with our 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 losing stocks. 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.
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. The constrained optimization problem is a Quadratic Programming (QP) problem, which can be solved efficiently using a QP solver or a general purpose convex solver:
|Maximize||TaxAlpha – TrackingError2|
|Subject to||The portfolio must be long only|
|Portfolio weights <= maximum weight parameter|
||Portfolio weights – benchmark weights| <= drift parameter|
|Do not trade stocks in a wash sale window|
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 stocks where trading is more likely to cause wash sales due to significant individual stock positions held outside of Wealthfront. Once identified, the Direct Indexing optimizer will not suggest any trades in “Exclusion List” stocks and if needed will buy one or more highly correlated replacement stocks or ETFs to maintain the overall tracking of broad US stock market performance.
We measure the effectiveness of Direct Indexing on two dimensions: how closely it tracks the original ETF it replaced and how much benefit it generates from stock-level tax-loss harvesting.
We use the term tracking difference to describe the difference between the portfolio’s return and the original ETF’s return in a given time period and tracking error for the standard deviation of the tracking differences.
We track the benefit generated by Direct Indexing in two ways. Tax Alpha is used to directly measure the tax benefit generated by proactively selling stocks with capital losses within a certain short period of time (say a single tax year). A Differential IRR is used to measure the additional return generated by reinvesting tax-savings from stock-level tax-loss harvesting vs. a portfolio where no such savings are generated.
We view Tax Alpha as an easy to compute and understandable metric to compute the performance of Direct Indexing, but believe Differential IRR is the more appropriate metric because it does a better job of taking into consideration the additional cash flows, tax savings reinvestment, and multi-year compounding inherent in tax-loss harvesting.
- TrackingDifference = PortfolioPreTaxReturn – BenchmarkReturn
- TrackingError = StandardDeviation(TrackingDifference)
- TaxAlpha = (STCL * STTR + LTCL * LTTR) / PortfolioBeginningBalance
- Differential IRR = IRR(Direct Indexing Portfolio with tax savings reinvested) – IRR(Portfolio with same asset-allocation and cash flows but no Direct Indexing or Daily Tax-Loss Harvesting)
- STCL is the short-term net capital loss realized
- STTR is the combined federal and state short-term capital gains tax rate
- LTCL is the long-term net capital loss realized
- LTTR is the combined federal and state long-term capital gains tax rate
- PortfolioBeginningBalance is the value of the portfolio at the beginning of each year
Wherever possible we use assumptions for our analyses that are based on the actual observed behavior of Wealthfront clients.For this analysis, we were able to use two sets of client data. To accurately describe Wealthfront 100 clients, we used information on clients of our Daily Tax-Loss Harvesting service – which for several years has been offered at the same minimum ($100,000) as the Wealthfront 100 version of Direct Indexing. Similarly, to accurately describe our Wealthfront 500 and Wealthfront 1000 clients, we use data on clients that adopted an early form of Direct Indexing launched in December 2013 (with a $500,000 minimum).
Thus, our critical assumptions are:
- Client age: 37 (median age of our Direct Indexing and Daily Tax-Loss Harvesting clients)
- Marital status: Married (the majority of our clients are married)
- Annual income:
- WF100 Clients: $260,000 (the average joint income reported by our Daily Tax-Loss Harvesting clients)
- WF500/WF1000 Clients: $422,000 (the average joint income reported by our Direct Indexing clients)
- State of residence: California (the most popular state of residence for our Direct Indexing and Daily Tax-Loss Harvesting clients. Residents of high state income tax states represent the vast majority of such clients.)
- Combined federal and state short-term capital gain tax rate:
- WF100 Clients: 42.7% (the marginal tax rate for married California clients with an average annual income of $260K = 33% federal tax rate + 3.8% additional tax on Net Investment Income for those earning above $200K (ACA tax) + 9.3% CA tax rate – the anticipated deduction of California state taxes from federal taxes)
- WF500/WF1000 Clients: 44.5% (the marginal tax rate for married California clients with an average annual income of $422K = 35% federal tax rate + 3.8% additional tax on Net Investment Income for those earning above $200K (ACA tax) + 9.3% CA tax rate – the anticipated deduction of California state taxes from federal taxes)
- Combined federal and state long-term capital gain tax rate:
- WF100 Clients: 24.7% (the marginal tax rate for married California clients with an average annual income of $260K = 15% federal tax rate + 3.8% additional tax on Net Investment Income for those earning above $200K (ACA tax) + 9.3% CA tax rate – the anticipated deduction of California state taxes from federal taxes)
- WF500/WF1000 Clients: 24.5% (the marginal tax rate for married California clients with an average annual income of $422K = 15% federal tax rate + 3.8% additional tax on Net Investment Income for those earning above $200K (ACA tax) + 9.3% CA tax rate – the anticipated deduction of California state taxes from federal taxes)
- Portfolio risk level: 7 (the average risk score on a scale of 0 – 10 for our Direct Indexing clients). A risk level 7 portfolio for such clients would be allocated across six asset classes as follows:
- Investment cash flows: We assume clients make an initial deposit necessary to meet the minimum account size of the desired level of Direct Indexing and then continue to make add-on deposits amounting to 10% of their initial deposit every quarter. For an account with the Wealthfront 100, therefore, this would mean an initial deposit of $100,000 followed by add-on deposits of $10,000 every quarter. For the Wealthfront 500 this would mean an initial deposit of $500,000 followed by $50,000 deposits every quarter.Note that these assumptions underestimate actual client behavior. Clients of our early $500,000-minimum version of Direct Indexing, for example, made quarterly deposits equal to an average of 14% of their initial deposit during the year that this service has been available – as reflected in the chart below.
The graph below presents backtested return results for the three levels of Direct Indexing service compared to VTI (the ETF used to track a broad market of US stocks in a Wealthfront portfolio).
The results above assume the tax rates and cash flow patterns listed in our assumptions above and incorporate the added performance from the tax savings generated via direct indexing (i.e. Tax Alpha).
Direct Indexing outperformed VTI in a substantial majority of years, especially in bad markets. Interestingly it outperformed VTI in some very good markets as well. The average (geometric mean) after-tax annual return for VTI over the 14 year period was 3.22% vs. 5.99% for the Wealthfront 100, 6.09% for the Wealthfront 500, and 6.14% for the Wealthfront 1000.
As expected, adding more individual stocks to the Direct Indexing position (i.e. moving from the Wealthfront 100 to the Wealthfront 500 to the Wealthfront 1000) improved after-tax performance. This is in large part due to the extra tax-loss harvesting opportunities available with the larger set of individual securities.
Under the same assumptions, the graph below presents the Tax Alpha generated by Direct Indexing. Direct Indexing generated Tax Alpha nearly every year and had an average annual Tax Alpha of 2.15% for the Wealthfront 100 version, 2.50% for the Wealthfront 500 version, and 2.66% for the Wealthfront 1000 version. Interestingly, Direct Indexing generated Tax Alpha even in some years when the market traded up (2003 to 2007). It should be noted that our daily asset-level tax-loss harvesting service failed to generate much tax alpha in that same period.
The graph below displays the Direct Indexing tracking differences from its VTI benchmark by year based on the same assumptions. The tracking differences each year were modest. In some years they were positive (i.e. the portfolio outperformed the benchmark) and in some years negative (i.e. the portfolio underperformed the benchmark). In this limited time sample the average difference was very slightly positive, but over the long term you should expect an average difference of zero.
The table below summarizes the Tax Alpha, tracking difference, and tracking error for Direct Indexing vs. VTI based on annualized monthly tracking error and the same deposit assumptions as above. As expected, the Tax Alpha of the Direct Indexing increases as the number of individual stocks held increases (moving from the Wealthfront 100 to the Wealthfront 500 to the Wealthfront 1000) and the Tracking Error decreases.
|TAX ALPHA||TRACKING DIFFERENCE||TRACKING ERROR|
Thus, for an extra 1.72% of tracking error, you could have the opportunity to increase your annual after-tax returns on the US equity portion of your portfolio by as much as 2.66%. We believe that is a trade off well worth making.
Finally, the graph below displays the overall portfolio differential IRR produced by an average (i.e. risk level 7) portfolio that includes the Wealthfront 100, Wealthfront 500, and Wealthfront 1000 across multiple 10-year holding periods. We also assume both portfolios benefit from Wealthfront’s Daily Tax-Loss Harvesting service.
We believe this differential IRR metric is the best way to quantify the incremental return from the Direct Indexing strategy. As the graph shows, Direct Indexing can generate an impressive incremental IRR for a Wealthfront portfolio over a 10-year period. The minimum IRR generated was 1.21% for the Wealthfront 500 over the 2005 to 2014 time frame. The maximum IRR was around 2.42% for both the Wealthfront 500 and the Wealthfront 1000 over the 2000-2009 timeframe.
Across these six 10-year periods, the Wealthfront 100 version of Direct Indexing generated an average IRR of 1.77%, while the Wealthfront 500 version generated an average IRR of 1.88%, and the Wealthfront 1000 version generated an average IRR of 2.03%.
We believe the results presented in this white paper clearly demonstrate that Wealthfront’s Tax-Optimized Direct Indexing could significantly improve your after-tax investment results.
By addressing the two remaining shortcomings of Index Fund / ETF investing – fund management fees and the inability to harvest tax losses – we believe Direct Indexing reflects the next evolution in index investing and thus should be a key element of every investor’s portfolio.
This white paper was prepared to support the marketing of Wealthfront’s investment products, as well as to explain its tax-loss harvesting strategies. This white paper 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 white paper 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 various charts displaying simulated Tax Alpha from tax-loss harvesting 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.
The chart showing the tax alpha and cumulative return for Tax-Optimized Direct Indexing clients is based on Wealthfront’s estimates from existing client data since we launched our asset-class tax-loss harvesting in October 2012 through December 2014. The chart was based on the subset of our clients with tax-loss harvesting enabled in their accounts and the returns and tax alpha were estimated for their accounts only. The return estimates were based on IRR (Internal Rate of Return). The cumulative returns were calculated by taking the composite’s daily return based on its daily balance series, where the composite’s balance is the aggregated value of all the accounts under our Tax-Optimized Direct Indexing strategy. We then compound the daily return series to get the compounded return over the period. The monthly tax alpha was calculated using the net tax benefit/liability and dividing by the aggregate balance. The net tax benefit over the period includes the liquidation of positions transferred in and sold to invest the client account in the Wealthfront portfolio.
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.