Direct indexing: The ends justify the means
Direct indexing has taken the tax-aware investment community by storm. Yet, misconceptions about its complexity and benefits continue to circulate. We’re here to cut through the noise and address the most common criticisms to reveal why direct indexing could be a compelling approach for many modern portfolios.
Administrative complexity: Critics claim that managing dozens or hundreds of individual positions is overwhelming, especially when navigating wash-sale rules.
Frec fully automates this process. Our technology monitors every position across your portfolio to avoid wash sale violations and maximize tax-loss harvesting opportunities. You get all the benefits without the hassle.
Excessive trading costs & fees: Many investors worry that frequent trading to harvest losses or maintaining index alignment generates high trading costs or that advisory fees associated with direct indexing are far higher than ETFs.
Our platform uses fractional shares and optimized trade executions to keep trading costs low. All trades on Frec incur zero commissions1, and our average trading cost is less than 2 basis points (0.02%). This allows us to charge advisory fees as low as 0.1%2, which is comparable to standard ETF index costs, so you can keep more of your returns without paying a premium for better tax efficiency.
Temporary tax benefits: Some argue that tax-loss harvesting only defers taxation rather than eliminating it, questioning its long-term value.
While tax-loss harvesting does not eliminate taxes forever, dismissing it as “temporary” misses the bigger picture.
We believe that deferring taxes is one of the only guaranteed wins in investing. Harvested losses can offset immediate capital gains or up to $3,000 of ordinary income per year, but the real advantage comes from keeping more of your capital invested.
Year-round tax loss harvesting builds a reserve of losses that can be used to offset future gains tax, such as when you start withdrawing for retirement. Research shows that investors who tax-loss harvest through direct indexing can achieve up to 7 additional years of tax-free withdrawals compared to ETF-based strategies. So instead of paying taxes as you withdraw, you can keep your money invested and compounding for longer.
Tracking error: Critics argue that replicating an index with individual stocks, rather than using an ETF, can introduce tracking error that may drag on long-term performance.
Any tax loss harvesting strategy can experience some degree of tracking error, including those using ETFs. One way Frec minimizes tracking error is by trading fractional shares when available. For example, of the 503 positions in the S&P 500, two positions do not allow fractional shares. Frec will invest in the remaining 501 positions, capturing 99.6% of the index. This allows for near-complete exposure to the index, rather than relying on a smaller subset of whole shares.
Furthermore, while short-term deviations in performance can occur, these are typically a reflection of market conditions. Over time, you may see periods of slight overperformance or underperformance relative to the index, but in the long run, these periods of deviation typically average out over time. We believe a small tracking error is a reasonable tradeoff for the opportunity to harvest losses along the way.3
Direct Indexing’s advantages over ETF-based approaches
We have previously described the many advantages of direct indexing over tax loss harvesting approaches that utilize ETFs. However, here are the key takeaways:
1. More frequent tax-loss harvesting opportunities: Individual stocks generate a steadier stream of harvestable losses due to their natural price movements, unlike ETFs, where losses are lumpier and less frequent.
2. Quantifiably superior tax efficiency: Research demonstrates that direct indexing harvests 1.9x more losses over a 10-year period compared to ETF-to-ETF approaches. This ratio increases to 2.1x when you account for the tax implications of selling assets to pay fees—a substantial difference in long-term performance.
3. Smarter withdrawals: Need to access cash? Direct index portfolios can sell specific securities to help minimize tax impact, which could be a crucial advantage over platforms charging management fees for ETF-based tax-loss harvesting (particularly when the average ETF position would be a much larger percentage of the overall portfolio).
Critiques of direct indexing largely stem from outdated perceptions that don’t reflect today’s automated, streamlined implementations. Technology has reduced costs, eliminated administrative burden, and minimized tracking error or portfolio drift.
The question for forward-thinking investors and advisors is not whether they can manage the complexity of direct indexing—it’s whether they can afford to miss out on the compelling benefits in an increasingly tax-conscious investment landscape.
Frec does not provide legal or tax advice and does 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 Frec 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. Frec assumes no responsibility for tax consequences to any investor of any transaction.
The effectiveness of Frec’s 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 Frec, the type of investments (e.g., taxable or nontaxable), or holding period (e.g., short-term or long-term. 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.
