By Dr. James M. Dahle, WCI Founder
I wrote this post back in January the day that Betterment announced it was raising prices from 0.15% to 0.25% of assets under management per year for accounts over $100,000. That was lame to see, as up until that point they had been the low cost leader in the roboadvisor space as I wrote about a couple of years ago when I did an extensive overview of roboadvisors. I announced it on Twitter, then had a reply from Wealthfront, perhaps their most important competitor (which has been charging 0.25%) that alerted me to a concept called “Direct Indexing.” I became curious and really like the concept. Whether or not it would be worth the additional cost and hassle of using a roboadvisor (and risk that Wealthfront could raise prices just like Betterment) is hard to determine, but I love seeing the innovation.
So what is direct indexing? Well, instead of taking your money and investing it in a reasonable mix of index mutual funds or ETFs, Wealthfront is creating an index fund just for you. In some ways, it is like Phil Demuth's idea about buying individual zero dividend stocks. The downsides of the investment strategy may be made up for with the tax advantages. Basically, in your taxable account, Wealthfront is buying up individual stocks, and just like Vanguard, trying to match the index return. But where a mutual fund might send you a big taxable capital gains distribution but never sends you a capital loss to use on your taxes, Wealthfront is trying to actively harvest losses to pass on to you. Pretty cool idea, huh? It makes you wonder if there will ever be a future mutual fund structure change to allow for passing losses through to you.
So here's the deal. When your account hits $100K, instead of using the Vanguard Total Stock Market ETF for your US domestic stock exposure, they start buying individual stocks . If you have $100K in the account, they buy 100 stocks, $500K is 500 stocks, and at $1M they buy you 1,000 stocks. They figure the more stocks they hold, the more opportunities to harvest a loss!
They claim (but don't guarantee) that direct indexing can increase your portfolio's return by 0.20% at $100K, 0.35% at $500K, and 0.5% at $1 Million. This is in addition to the usual bump from tax-loss harvesting they claim (they do a more Betterment-like daily tax loss harvesting process for the other asset classes in the portfolio.) All in, they think they can add something like 2% to your returns.
Personally, I think their estimates are way too optimistic. I mean, tax loss harvesting is cool and all, but it can be dramatically oversold if you don't understand how it works. With tax loss harvesting, when you have a loss in a taxable account, you exchange the investment for one that is substantially different but has a very high correlation with the original investment. Those losses are first used to offset any capital gains you may have, then you can use up to $3K per year of them against your regular earned income, and the rest can be carried over to next year. Cool trick huh? It gets even better if you give money to charity frequently. Instead of giving cash, you donate the appreciated shares, thus flushing the capital gains out of your account. You get the tax losses on Schedule D (which are really just paper losses), you get the full gains the investment made, you get to deduct the charitable contribution on Schedule A, the charity doesn't have to pay the capital gains taxes either, and everybody but Uncle Sam is happy.
However, if you don't give those shares to charity (or leave them for your heirs for a step-up in basis) eventually you will have to sell the investment, at which point you will have to pay capital gains taxes on what you previously deducted as a loss. So, let's say you buy the investment at $100, you tax-loss harvest it at $80, then you eventually sell it 10 years later at $200. If you had never tax loss harvested, you would pay long-term capital gains taxes on $100. Now, however, you owe LTCG taxes on $120. So a large chunk of the “tax savings” you obtained with TLHing is given back when you sell. Not all of it, of course, especially if you were able to use the entire loss against your regular income. Then there is a bit of an arbitrage- you took the deduction at perhaps 40% and paid the taxes later at perhaps 20%. (Insert your own marginal rates into the previous sentence rather than emailing me about how mine are wrong.) Plus you get the time value of that money you got to use for 10 years, which is worth something. But it is important to recognize that the entire tax loss you claim on your taxes that year should not be added to your investment return, since much of it will probably be paid back later.
In addition, there is no way to donate these appreciated securities to charity through Wealthfront (or Betterment for that matter), which is a major part of my taxable account strategy. Plus, there is a certain amount of risk there that Wealthfront isn't as good at indexing as Vanguard. But hey, if Schwab and Fidelity can do it, why not Wealthfront?
Hiring an Advisor
But wait, there's more. How much of your investment account is in taxable anyway? In my case, it's less than 10%. This additional return (whether it is 2% or 0.2%) only applies to the taxable portion of it. If you're paying 0.25% on your entire portfolio, but only 10% of the portfolio is in taxable, you're not going to make back your fees even at Wealthfront's optimistic projected return. So in this respect it's a bit like DFA funds. If you're going to hire an advisor anyway because you value something else that the advisor is doing for you, then it is great to get a value-add like this. But it is probably not worth hiring the advisor JUST to get this feature.
Want a Roboadvisor?
Roboadvisors like Betterment and Wealthfront provide other benefits, of course. You get a good portfolio and automated portfolio management for a much lower fee than a traditional advisor. You do have to pay a low fee, and they won't manage your 401(k) (so you'll have to be either a partial DIYer or hire an advisor for that part of your portfolio), but it is still way better than what a lot of you out there are doing (or more likely, not doing at all.) So if you want to hire a roboadvisor, I would appreciate it if you would sign up through the links on this page. I get a small affiliate marketing fee if you do so. Where my roboadvisor recommendation used to be Betterment for their slightly lower fees, I now lean a little more toward Wealthfront with their Direct Indexing feature, but both are very good for what they do. If you prefer a real, live advisor to manage your entire portfolio, be sure to check out the list of WCI recommended financial advisors.
What do you think? How much benefit do you think “direct indexing” can add to a portfolio? Did Betterment's price jump make you leave (or less likely to sign up?) Who do you think a roboadvisor is right for? Comment below!