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.
Direct Indexing
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.
The Deal
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.
Too Optimistic
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.
Sign up for Wealthfront today!
Sign up for Betterment today!
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!
I agree that tax loss harvesting and direct indexing are oversold by the Roboadvisors. This is especially true if you are an investor who does not trade in their taxable account and just buys an ETF and holds it for decades. You have one correction like 2000 or 2008 and you have enough losses to harvest and get the maximum deduction for the next 20-30 years.
I have another more fundamental problem with their tax-lost harvesting approach. Once a stock appreciates over its purchase price it can no longer be tax-lost harvested. As the market appreciates over time you lose the initial benefit and lack the diversification of a broader index fund. If you started this strategy in 2009 how much harvesting could you really do going forward? There may be some initial savings but to claim it as yearly is misleading.
The temptation for these companies to raise fees is strong. It is amazing how long Vanguard has lasted (and thrived) without giving into that.
I think the difference with Vanguard is what they are trying to sell you IS the low fees. Sure, you can now use one of their advisors at a very low cost (0.3% AUM or something), however that’s an added service, not a core service.
The moment they raise their fees, Vanguard becomes just like everyone else.
It’s a structural difference. There is no one who benefits from fees going up (well, except perhaps the employees.)
Guess they know they’ll lose business not gain income by raising fees more than necessary.
Isn’t this the same thing that Personal Capital has already been doing as their investment strategy?
When I signed up to use their free portfolio tracking, one of their advisors tried to sell me on something that sounded very similar to this.
I am invested w/Personal Capital. They don’t try to claim they’re indexing. Their strategy is to spread your $ out over a lot of different individual stocks by cap, domestic/int’l, some ETF’s/index funds and whatever mix of bonds (via ETF’s mostly) that you and they agree is reasonable. They don’t put enough of the client’s $ in any one stock to have a material impact on the portfolio if it blows up. Their view is that indexes get too over-weighted and/or under-weighted to 1 sector or another at times which can whack you harder in some markets (i.e. S&P was heavily weighted to financials pre-’08). I’ve been invested w/them for about exactly a year. I am not 100% sold on their approach as their fees are higher (0.79% over $1m AUM I think and 0.69% over $3m). That said they are relatively proactive about having you chat w/your investment rep whenever they or you feel like the portfolio needs a tweak. I struggle at times w/the higher fee since I don’t currently need to use them for estate planning, banking etc. However, I also feel that this new Wealthfront product sounds kinda gimmicky. You’re either active or you’re passive. I’m not clear how they pick 100 stocks if you have $100k invested w/them so I can’t judge but if I’m going to index, I’m going to invest in said indexes and Vanguard, Schwab etc are extremely low cost as it is.
I view wealthfront as the better value now w the TLH feature. Perhaps if betterment came out with a bunch of automated financial planning features that allowed bots to come up w a plan to implement. A lot of financial planning is automatable and I think the roboadvisors will move in the direction of vangaurd personal advisor services down the line
Maybe twenty, twenty-five years ago, I tried to build my own index fund and tax loss harvester thingamajig applying the same logic and rationale Wealthfront appears to be using now. (I even got a bit of help from one of the finance professors I knew from MBA school.)
It was really hard to get the mechanics to actually work in practice.
One thing I remember, for example, was unless you ended up with (in those days) a Microsoft or Dell Computer in your portfolio, you fell short of the index results you could have enjoyed with a simpler Vanguard-based approach.
Also, this comment from a practicing CPA: These computer-managed portfolios can make your Form 8949 a bear to complete.
We see a couple of things that blindside tax return clients with astronomical bumps in return preparation fees: Investing in a bunch of multi-state partnerships (like a oil or gas pipeline that runs through a dozen states)… and then using something that creates hundreds or thousands of transactions in a taxable account due to lots of rebalancing.
Heaven help you if you do this in more than one taxable account and have to deal with wash sale adjustments.
On a basic level (not well versed in finance) I’ve toyed with personally holding the stocks that make up the index funds I’m in, maybe even changing holdings when the index funds do. But just the hassle of getting dividend checks and statements for a few hundred companies aside from whether I can buy proper proportions of each stock without onerous brokerage costs is worth up to the 0.5% I pay Vanguard to avoid that. I DO hate the forced capital gains whenever (I presume) a bunch of fellow holders of my MF want to take their own capital gains but have adjusted for that over time.
8949s indeed. My brother had us into selling options starting when it was more lucrative (not everyone else had gotten into it yet) but since he didn’t do the taxes for me I soon decided the extra work might not be justified by the hoped for extra returns.
Read in an article recently that most common stocks do not even outperform Treasury bills over their full lifetimes on CRSP. It is a very small percentage of big gaining stocks (4%) that accounts for the entire gain in the US stock market since the 1920s.
I am certainly not smart enough to pick those winners, nor is Wealthfront I suspect. So I still don’t feel great with a basket of 500, 750, or even 1000 stocks. I want the whole market and guarantee myself inclusion of the winning 4%.
I also agree with prior posters that all it takes in one 2008 sized correction to negate the advantage of any software algortithm designed to maximize frequent TLH.
I also do not want to complicate my taxes any further.
I also don’t have confidence that fees will remain low with these companies.
Finally, those I know that have tried Betterment and Wealthfront have been underwelmed by the TLH results vs just doing it oneself.
TOO EASY TO DIY No reason to piss away tens of thousand with any advisor for stock/bond investing
A 5th grader can grasp this
I am not a huge fan of the concept. It might be marginally better than buying index ETFs and TLHing on your own. I am also concerned about the increased complexity (and cost) for our tax return.
I’ve had a taxable Wealthfront account for two years.
1) As of 2016, Wealthfornt summarizes the TLH, cap gains, etc. at years end. Your accountant will have LESS / not more, work to do.
2) Yes, you can do your own TLH during the bear markets. I had huge tax losses carry forward from 2000-2003 and 2008-2009, These lasted me until 2014. Then I wish I would have had more. As an example, during this year, 2017, Wealthfront has captured $450 in TLH on a $425,000 account, during a bull market. Every little bit is appreciated.
Addendum, I follow the purchases made in the Wealthfront account to inform/confirm/compare with one of my DIY accounts. Currently the Wealthfront account is buying energy ETFs.
Thanks for sharing your experience.
You are welcome. It bought more XLE today. (of course the purchase is AA, risk, and timing specific).
I appreciate your point about using taxable appreciated assets later for charitable giving. Wealthfront is adding features rapidly, so giving at the granular level might be a future possibility.
Hi all,
I love the blog and of course like all of you am disappointed to see anyone as an advisor feeling justified in RAISING their rates. But what caught my attention was WCI’s statement:
“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.”
WCI, as always, I love the blog and the discussions. I think you are referring to the general idea that DFA may produce ~1-2% higher returns compared to Vanguard funds but it ends up being a wash once you pay for the advisor’s fees. I think you’ve made that point before.
But, I like to point out that there is at least one advisor (Evanson Asset Management) that provides access to DFA at a very low cost. I use them and can vouch for the effective fixed fee rate of what would be 0.15% of AUM. Here is what their website says:
“Evanson Asset Management® (EAM) is a fee-only advisor and receives no compensation other than from our clients. We charge a fixed quarterly retainer fee based approximately upon the total number of hours required to service a family’s accounts. A typical family will have three or four accounts, both taxable and tax-deferred. Typical fees run from $625 per quarter or $2,500 per year to $2,000 per quarter or $8,000 per year and that covers all accounts for a family. We manage some smaller accounts for less and a few very large family accounts with multiple trusts and objectives for more. If calculated on a percentage basis our typical client is paying between 0.05% and 0.15% annually on assets though we use a fixed fee that doesn’t change as the value of assets change, not a percentage fee. “
By the way, tax loss harvesting may not be all that it’s cracked up to be for the long term if the plan is to immediately reinvest in the same asset class:
https://www.evansonasset.com/tax-loss-harvesting-56.htm
While it’s best if the security is never sold, even deferring those taxes is valuable due to the time value of money.
Could you clarify this? The taxes are paid only after the securities are sold. So imagine a (probably typical) scenario that most securities are sold only with long-term capital gains. Then TLH gives you nothing above $3k/year of income offset (which includes time value of money, of course, but it’s limited to $3k).
In other words, TLH at best can give you the following (assuming you maximize it):
1. $3k less taxable ordinary income per year.
You will still pay taxes on these $3k, but they will be on long-term rate, not the income rate. Plus you will pay them later, thus having the time value of money. But it’s still capped on $3k / year, and the real money gain from it depends on your tax bracket (for 28% bracket it’s $840).
2. All your short term capital gains are offset.
But the thing is that, being a rational investor, you shouldn’t have much of those. Even if you need your money quickly (say, buying a house or emergency), most of your sells will probably produce long-term capital gains, and only the ones bought during the last year will produce short-term gains.
3. None of your long term gains are offset. Let’s say you carry over lots of losses over years. Then at some point you decide to sell the securities. So you’re offsetting your long-term gains with the losses you carried. But it effectively gives you *nothing*: the lowered cost basis for the securities with harvested losses is exactly equal to your offsets.
4. There can be some difference if your tax bracket changes over time, or the taxes generally go up or down, but it doesn’t seem rational to gamble on that, so it probably shouldn’t influence the current decisions (of preferring some advisors over others based on TLH).
Do you have a question I can help you with? Your understanding of TLHing seems pretty good other than you seem to skip over the fact that the taxes saved by TLHing may never be recouped if you donate appreciated shares to charity or leave them to heirs.
Thank you, I just wanted to confirm that my understanding is correct. Yes, thank you for mentioning the charity and heirs points.
Yes, I love the model Evanson uses (i.e. a flat annual fee for investment management.)
I’m a little skeptical that the “DFA difference” is 1% though. I never seem to be able to find that when I run the numbers, but that’s all past performance anyway, which you can’t buy. I could be convinced the DFA difference is as much as 0.5% though.
Wealthfront is now (a little) cheaper than Betterment, especially for >$100,000 accounts. In addition to the first $10,000 free at WF (saves $25/year ($10k x 0.25%), the Direct Indexing portion of your account has no ETF fee (vs. a Betterment account which would use Vanguard’s VTI ETF at 0.05%). Assume a $100,000 account with a typical 35% allocation to US stocks (which is typical allocation for Wealthfront), that’s another $17.50/year ($35k x 0.05% VTI fee) for a total savings of $42.50/year.
For a $1,000,000 account the WF savings is $200/year.
For this reason (and the fact that Betterment has raised fees (NOT what you want to see for such a young company – when’s the next hike?), and what should be superior TLH at Wealthfront, I would pick Wealthfront over Betterment.
It’s probably obvious, but I should have pointed out that the 0.05% is not a direct fee that is paid to Vanguard, you (or your robo) just buy the ETF, but that fee is real, drags on fund/ETF performance, and is not charged for the Direct Indexing portion of your WF account.
http://www.mrmoneymustache.com/betterment
http://dispatchist.com/betterment-vs-wealthfront-vs-vanguard-a-comparison-of-robo-advisors-3/
Just a few imperfect data point comparisons.
I’m doing my own as well with wealth front up to their maintenance free limit.
My gut tells me on my own will be superior.
As of today, wealthfront allows you to design whatever portfolio you want, including say 100% US Market, so if you just transfer them the portion of just your taxable that you want direct indexed, they can do it.
Paying 25 basis points for them to say create and manage and tax harvest from 1000 individual positions in a $1mil allocation for example, seems to be an interesting idea.
I didn’t want to have Wealthfront manage my entire account, but what I loved about them was their direct indexing, so I’m thinking of giving them a pile and letting them do their thing to tax loss harvest. I’m not ready to do it yet, but probably will in the next few months.
The problem is when you multiply an AUM fee by larger and larger amounts of money where TLHing becomes less and less valuable. There’s a crossover point where it’s no longer a good idea I’ll bet it comes before $1 million.
Could you expand on this idea? Shouldn’t TLH scale proportionally with AUM? Thanks, nice site!
No because you can only use $3,000 in losses a year against ordinary income. So beyond that, TLHing is much less valuable. For some that expect the sale of a business or something in the future or who make large charitable donations of appreciated shares they can be still be pretty useful, but not nearly as useful as the first $3,000 per year. So if you have a million dollar account, you can probably get a few hundred thousand dollars worth of losses within a few years and for many people, there is little point in doing TLHing beyond that, but you’re still paying gobs of AUM fees for it.
Gotcha, I thought you were suggesting a tapering of the % of harvestable capital losses at higher AUM. Understood the capital losses don’t help much if there are no gains to offset. Could be an interesting strategy though for people with significant gains as you say. Or for those with a bunch of probably overvalued US tech looking to take some gains and diversify and minimize tax impact.
In a world of free stock trades one could easily create a google doc or something with the entire 1000 stock listed and design your own index, then place a bunch of tiny market orders for free to build it. Once built, it’s low cost and you could come along once a year or so and capture the biggest tax losses yourself. At no fee but your time.
With that said, paying for the algorythm to do it for you and execute all the trades and then just use them… that could be valuable. And I’m not opposed to the factor tilts they apply as well nowadays. Although mostly just marketing, at least in theory I tend to agree with them a bit.
Most of the tax loss harvesting advantages come in the first few years of an account, once you’ve washed through your first correction or two, and the market has gone up about 50% or so from where you invested, much less so. You could have wealthfront build the index for you, wait a couple years for the TLH advantages to be realized, then transfer the entire account over to another brokerage to just let it sit if you didn’t mind the “index” going stale. Could save a lot of money that way and it’s the ultimate in tax efficiency.
Anyway, I still think for people that wanted to do direct indexing, this new development is very interesting. Thanks for the reply WCI.