Direct indexing
Why calendar-based rebalancing is obsolete: The case for dynamic algorithms
4 min read
In the world of personalized wealth management, some investors want more than just to track a market index. They want to outperform it on an after-tax basis, a goal known as generating tax alpha.
Achieving that requires continuous and precise portfolio management, especially when using direct indexing, where every stock affects the portfolio’s performance as stock prices move, weights drift, and tax-loss opportunities disappear quickly. Rebalancing can help realign and capture these opportunities, but done poorly, it can hurt after-tax performance.
At Frec, we have the technology and capability to rebalance every account daily, but the true advantage doesn’t come from how frequently we rebalance. It comes from the algorithms that govern the frequency.
Why calendar-based checks miss tax alpha
Traditional calendar-based rebalancing checks positions and rebalances portfolios once a month, or even once a quarter. In a direct indexing context, this is inadequate for two reasons:
- Risk of drift: While the overall index tracking may look acceptable, waiting a month allows individual, high-risk holdings to drift significantly. This exposes the portfolio to unintended concentrations and weakens overall control of risk.
- Fleeting tax losses: Tax losses are generated by short-term market dips. These opportunities are often measured in days, not weeks. If a stock drops sharply mid-month and recovers before the monthly review date, that valuable tax loss disappears.
Why daily trading isn’t the answer
While trading securities daily may sound like the answer, it’s not the most efficient approach for maximizing after-tax returns. The reason being the IRS Wash Sale rule.
The IRS Wash Sale Rule disallows claiming a loss if the same or a “substantially identical” security is purchased within 30 days before or after the sale. Indiscriminate, high-frequency rebalancing can inadvertently create a cascade of restricted wash sale periods across various securities. This effectively locks the portfolio, making it more likely to miss subsequent, larger, and more valuable tax-loss harvesting opportunities when they appear.
The takeaway here is that daily evaluation is necessary to balance risk management and tax loss harvesting (TLH) opportunities, but daily execution must be conditional and strategic to maximize potential tax alpha.
How dynamic algorithms win
Frec has the capability to trade daily, but controls trading frequency with dynamic and rule-based heuristics that optimize routine portfolio management.
Instead of trading on a calendar, our algorithms evaluate every portfolio against three criteria daily:
- Conditional execution: Our algorithms continuously evaluate the expected value-add of a potential rebalance, balancing transaction costs against risk mitigation and tax opportunity. We only execute a conditional rebalance when the risk-return trade-off makes the most sense.
- Intelligent wash sale management: We manage around wash sales the entire time. Our system actively trades off an immediate loss harvest against the likelihood of capturing future, larger, unrestricted losses. This decision-making, powered by less unnecessary wash sales, prevents the portfolio from becoming “locked up” and ensures long-term optimization.
- Continuous agility: Unlike rigid monthly schedules, our dynamic system is fully continuous. We leverage our daily trading capability to the fullest, meaning that if market volatility creates multiple profitable opportunities across different securities, the technology will execute trades on multiple days in a row to maximize after-tax return.
Using this approach, our research shows that the after-tax information ratio (IR), a commonly used industry term that measures after-tax excess return net of fees relative to tracking error, is approximately 28% higher driven by higher after-tax excess returns with lower tracking error.
| Indiscriminate daily | Dynamic algorithm | |
| After-tax excess return | 1.36% | 1.46% |
| Tracking error | 0.86% | 0.72% |
| After-tax information ratio (IR) | 1.59 | 2.05 |
This approach is only possible with advanced, integrated technology and algorithms with human oversight working together — both of which are built into our platform.
The bottom line
To generate tax alpha, portfolio management must move beyond simple capability to optimize efficiency. Calendar-based and daily trading strategies miss out on key opportunities, but dynamic trading captures them by executing only when the return justifies it.
| Strategy | Primary action | Tax-loss harvesting efficiency |
| Static monthly/quarterly | Trade (time-based) | Low (misses fleeting price dips) |
| Indiscriminate daily | Trade (high-frequency) | Medium (wash sale constraints limit future TLH) |
| Dynamic algorithm | Evaluate daily, trade conditionally | High (continuous, balanced) |
This advanced, rule-based approach is the foundational architecture we have already implemented for our customers on Frec. It represents how our platform works today, and our commitment to continuous thought leadership and maximizing our customers’ after-tax outcomes.
