Direct Indexing 101

Why you should leave tax loss harvesting to the algorithms

3 min read

According to Vanguard research, much of the value of financial advisors comes from “behavioral coaching.” In fact, their paper claims that advisors can add up to a 2% alpha to your portfolio.1 In other words, creating a buffer between you and the “buy” or “sell” button. Selling in a state of panic or buying in a state of greed is a common psychological trap when it comes to investing.

To take a deeper look into how human emotions can lead to costly investment mistakes, let’s take manual portfolio tax management as an example.

Consider a situation where you’ve purchased an index ETF like SPY (tracking the S&P 500) at a market high, like in November 2021. A few months later, you’d be staring at a position that’s trading at only 80% of the value you purchased it for. 

Even though no one wishes for a bear market, you embrace the silver lining by trying to capture the losses to offset against your tax bill.

For DIY investors, there are two primary sub-par options.

Option 1 is to swap SPY for another “similar but not substantially identical position”, like an ETF that tracks another index besides the S&P 500. Option 2 is to sell SPY, set a calendar reminder for yourself in 30 days for the wash sale window to expire, then repurchase SPY. Let’s walk through both of these options. 

Sell and swap

First, you could sell SPY and capture the losses. You would then immediately buy a “similar but not substantially identical position”. You might sell SPY and buy an ETF that tracks a different index, like the Russell 2000. So you sell SPY and buy IWM temporarily, with the hope of eventually coming back to SPY. 

But what if IWM goes up? You would then have to sell it at a gain to get back to SPY, resulting in capital gain taxes. Or you may decide to stick to IWM for the long term – not ideal, since it wasn’t your intended investment (looking at IWM, it has significantly underperformed SPY over the last 5 years)

Sell and wait

Alternatively, you could sell SPY, wait 30 days, and then buy it again.The problem with that is the price of SPY might shoot up in that time. You might harvest some losses, but you end up buying SPY at a much higher price tag. We call that a lose-lose. 

These are precisely the types of situations where you might want an automated, emotion-free algorithm to make decisions for you.

Making these decisions yourself may be very costly, as you may impulsively exit or enter the market at the wrong time. Some of us at Frec learned this the hard way and came together to solve this pain point. 

At Frec, you won’t even need to monitor your portfolio for capital loss capture, since we already do that for you, which translates to an alpha of up to 2.11%2 but without the 1%3 fee you see from wealth advisors for “behavioral coaching.” 

Warren Buffet famously remarked, “The stock market is manic depressive.” We don’t think you should be making buy and sell decisions on your core, long term portfolio.  Instead, Frec Direct Indexing can help you to distance your inherent irrational impulses from your investments, stay in the market, and generate tangible value in the good times and the bad.

  2. This projection was generated by Frec's Direct Indexing Model tracking the S&P 500 index and is hypothetical, does not reflect actual investment results, and is not a guarantee of future results. Simulations were run on a weekly basis in a ten-year rolling time frame of ninety day increments from December 17, 2003 through June 10, 2022 with a $50,000 initial deposit. The simulations averaged at the end of year ten resulted in a 45.1% accumulated tax loss savings that were reinvested with a 42.3% tax rate, and included Frec's 0.10% fee, resulting in a 2.11% additional return. The prices used for stocks were adjusted for dividends and corporate actions. It is not possible to invest directly in an index. Results may vary.
  3. A 2021 AdvisoryHQ Survey showed 1% AUM fee is common for a wealth adviser. See: Frec does have an advisory fee of 0.10% for both of its direct indexing products.