The Direct Indexing Handbook
“If you cannot look inside yourself and know that you have a special gift, indexing the majority of your assets makes the most sense.”
JOHN W. ROGERS JR.
If you’ve ever looked into investing, you’ve probably heard advice along those lines before. And it’s solid advice for most casual investors. Tracking the market is a pretty good bet. Over the past 30 years, the S&P 500 has gone up an average of 10% per year.
More involved strategies like picking individual stocks might sometimes get you higher returns, but their returns are far less predictable. And not everyone has the time, expertise, or desire to figure out which stocks to pick.
Luckily, there’s a way to make more money on your investments without having to put in any more effort: Direct indexing the market. With direct indexing, you get the same simplicity and similar performance as investing in index funds, plus thousands of extra dollars in tax savings.
Sound too good to be true? The ultra-wealthy have been doing it for years. And thanks to recent technological innovations, now you can too.
What is direct indexing?
When you invest in index funds on most platforms, you’re usually buying shares of an exchange-traded fund (ETF) which is designed to track a segment of the market — an index. When you invest in this way, you’re buying into just one thing: the ETF.
Direct indexing also tracks the index. But instead of buying into one vehicle, you’re buying into all of the individual stocks that make up that index.
Why is that good?
Three words: Tax loss harvesting.
If you buy into an ETF, and the index that ETF is tracking goes up, that’s good — in a way. All else equal, you’re probably happy if your investments go up.
But you’re missing out on a crucial element: Even if the index is going up, each of the individual stocks in the index isn’t always going up. Individual stocks are bound to see losses. And those losses can make you money, too.
Tax loss harvesting is when you sell a stock that has gone down, and claim the loss on your taxes. These losses can be used to offset capital gains tax (with no limit) and income tax (up to a limit).
You can also save up tax losses indefinitely. Maybe you don’t have a lot of capital gains right now, but it’s very likely that you will at some point in the future — whether from selling a home, selling stock or crypto, or working for a company that later IPOs. Tax loss harvesting can save you thousands of dollars in taxes on all of those capital gains, whenever they happen.
When you switch to direct indexing instead of buying into ETFs, you’ll start harvesting tax losses — on top of whatever performance you get from your portfolio. That means significant tax savings.
In the rest of this piece, we’ll get into all the details of how direct indexing works — and how it can work for you.
How Frec Direct Indexing works
Frec currently has two indices, though we plan to expand in the future. Those are:
- The S&P 500
- The S&P 500 Information Technology
Our job is to keep you tracking your chosen index as closely as possible. You can expect to be either above or below the index by a maximum of 0.77% per year — this is called the ‘drift’.
So you’re getting similar performance as you would if you had just invested in an S&P 500 ETF, plus you’re harvesting losses. You save extra money, without having to do any extra work.
Customize your portfolio
Frec offers a lot more flexibility than ETFs or traditional index investing.
Say you’re interested in making money off the S&P 500, but you have reservations about investing in companies that may not align with your ethics. With an ETF, that’s too bad — it’s all or nothing.
But with Frec, you can choose to exclude certain companies from your direct index. So you can get the benefits of investing in the S&P 500, without giving any money to tobacco companies, high-emissions companies, or any other companies you take issue with.Or, say you’re an Apple employee with equity. You’re interested in the S&P 500 because you want to diversify your portfolio, but Apple currently makes up about 6.55% of the S&P 5001, and you’re already overexposed to Apple. If you were just buying into an ETF that tracks the S&P 500, you would be increasing your exposure to Apple stock even further — the opposite of what you wanted.
Fund your index with stocks from other platforms — no sale required
When you set up a direct index with Frec, you can fund it with either cash or stock2, or a combination of both.
You can transfer stocks directly to Frec from other brokerages — Robinhood, Fidelity, Vanguard, Wealthfront, Betterment, E*Trade, you name it. You won’t have to sell out of the stocks you already own, so you don’t incur any taxes.
So if you already own stocks that are in the S&P 500, you don’t have to rebuy them on Frec. You can just move them into your direct index. If you own stocks that aren’t in the index you’re tracking, that’s fine too. You can still fund your direct index with those stocks. Frec will then sell you out of those stocks slowly, in a tax-aware way, as you accumulate losses.
The interface is simple. Link your brokerage account with Plaid, and choose which stocks you want to transfer. Then those stocks will appear on Frec within five business days.
Your whole shares of stock are never sold, they just move to our platform. You can think of it like a wire transfer system for stocks — the way money moves between banks, whole shares of stock also can move between brokerages without any tax implication.
How Frec does tax loss harvesting
If one of the stocks in your portfolio goes down, we sell that stock to harvest the tax losses. We can’t just immediately rebuy that same stock, due to a regulation called the wash sale rule. But we don’t want you to be sitting on cash either.
Instead, we use the proceeds of the sale to rebalance the rest of your portfolio, to better track your chosen index. Then, if there’s leftover money, we buy stocks that are handpicked by our algorithm to closely track the performance of the one we sold. After the 30-day wash sale period is up, we’re able to continue buying into the original stock.
Wash sale rule
In the United States, if you sell something that would normally incur a capital gain or a capital loss, you have to wait 30 days after the sale for that gain or loss to crystallize. If you rebuy before the 30 day period is up, you can’t claim the loss on your taxes.
The wash sale rule was instituted because some investors were exploiting a loophole: they would buy a losing security, sell it to claim the tax loss, and then buy back into it almost immediately. So they would have a capital loss from a tax perspective, but their financial situation wouldn’t actually have changed at all. They’d still have the same exposure to that security.
Rebalancing your portfolio
When we’ve sold one of your stocks to claim a tax loss, the first thing we do with the cash is rebalance your portfolio.
Because we’re trying to track your chosen index as closely as possible, we have a target rate for each of the stocks in your portfolio. So, if you’re direct indexing on the S&P 500, Microsoft is supposed to make up about 7.2% of your portfolio, Apple 6.5%, etc.3
Some of the stocks in your portfolio are likely to be below their target at any given time. So we take the proceeds from selling your stocks at a loss, and use them to buy the below-target stocks, bringing them back up to their target while avoiding wash sales.
Similar stocks
If there’s still cash left over after we’ve rebalanced your portfolio, our next move is to invest it into a combination of stocks that perform as similarly as possible to the one you sold.
For example, if Tesla was down, we would sell some of your shares in Tesla for a loss. Because we can’t rebuy Tesla for 30 days after that, we would put the money into stocks that continue to track the index while avoiding wash sales. After the 30 day wash sale period expired, we would sell those other stocks and rebalance your portfolio.
Benefits of direct indexing
Don’t leave money on the table
Direct indexing gets you savings on top of your investments, like earning credit card points on money you were going to have to spend anyway.
The amount of losses you can harvest is staggering: nearly 40% of your portfolio.
So, say you have $100,000 invested in the S&P 500. With Frec direct indexing, you can get $40,000 back in losses on that portfolio over ten years, with the majority of the losses front-loaded in the first few years. The number of real dollars you can save on your taxes is [your losses] x [your tax rate], so if your tax rate is 33%, you could save up to $13,333 on your taxes.
At our current investment minimum, you should be able to deduct at least $1,000 in tax savings your first year5. If you have capital gains, your capital losses can be used to offset those first — with no cap on the amount. So if you have $200,000 in gains and $200,000 in losses, you can completely cancel out the gains and pay no taxes on them.
If you don’t have capital gains — or if you have more losses than gains — you can use the excess losses to offset up to $3,000 of other income per year6.
And if you don’t use up all of your tax losses in a year, they carry over to the next year — and the next, and the next.
Win in bull and bear markets
Frec’s tax loss harvesting strategy means that you come out on top whether we’re in a bull or a bear market.
With many other investment products, like ETFs, you’re likely to do well when there’s a bull market. But then when there’s a bear market, your investments are just down. And you don’t get any consolation for that.
With direct indexing, your money goes to work for you either way. In a bull market, you get all the normal benefits of the market being up — and then some. And then in a bear market, you also do well, because there are more losses for you to harvest.
Advantages over ETFs
You might think: Wait, but aren’t I already harvesting tax losses?
Platforms like Wealthfront and Betterment support ETF to ETF harvesting: They buy ETFs, and if one of the ETFs goes down, they sell it and buy another one. But with an ETF-based approach, you only harvest about 20% of your portfolio in losses.
With direct indexing, you harvest nearly double that.
The reason direct indexing outperforms ETF to ETF harvesting is that there’s a lot more movement beneath the surface of an ETF. For example, let’s say today Tesla is down 10%, but the ETFs are up 0.4%. If you do your tax loss harvesting at the ETF level, you miss out on capturing losses from Tesla being down.
Addressing common concerns
Your assets stay safe, no matter what
Your money always stays in your name, and you’ll always have access to it, even if Frec closes its doors. Here’s how it works:
- Your assets are held with Apex Clearing, which has been in business since 1979 and holds assets for many other brokerage firms, like SoFi, Ally, Betterment, and WeBull. Using Apex, you can transfer your assets out of Frec to another brokerage firm at any time.
- Frec is a member of SIPC, which protects securities customers of its members up to $500,000 (including $250,000 for claims for cash). Explanatory brochure available upon request or at www.sipc.org. Apex has additional insurance on top of that.
- We are legally required to keep customer funds separate from firm funds, so that your funds are safeguarded.
Filing your taxes is easy
This whole thing might seem intimidating. Maybe you’re thinking that you’re going to have to manually comb through hundreds of pages of documents to figure out how to apply this ‘tax loss harvesting’ thing to your own taxes, and you don’t want to deal with that.
Luckily, it’s actually very simple.
You get a single 1099 document from us. It may be long, but there’s only one section you need to worry about: the summary. This is always on page 2 of the form, and it shows your total net short-term and long-term gains or losses.
You plug in the summary numbers to your tax filing software, and you’re done. If you use H&R Block or TurboTax, it’s even easier — you can just upload the document and it’ll be taken care of automatically.
If you need to liquidate, you’ll be fine
You might be worried about what happens if you need to leave Frec for some reason. After all, buying into ETFs is simple — you have a single position, and you can just do an ACATS transfer — but Frec direct indexing means you have hundreds of individual stocks. You don’t want to manage all those stocks yourself.
Not to worry. If you decide to leave Frec, you have two options.
First, you could switch to another direct indexing provider. There are others out there, so you’re not locked in with Frec. You can take all of your stocks and transfer them8 to a wealth manager, who will manage them for you on another platform.
Second, we can sell you out of your stocks intelligently. At the end of it, you’ll be left with only the top ten or twenty stocks to manage.
How does this work?
The S&P is a market cap weighted index, so all the gains accumulate at the top of it. At the time of writing, the top five stocks in the index alone make up nearly 25% of the portfolio.9 That means we can sell the vast majority of the stocks you’re holding, while still letting you retain most of the value of your portfolio.
And at the time you want to liquidate your portfolio, you may also have unused capital losses — losses that we’ve harvested for you, but that you haven’t used to offset any capital gains. So as we sell you out of the long tail of your stocks, we can use your accumulated losses to offset any capital gains you incur. After we’ve used up your capital losses, you’ll be left with a handful of just the top stocks to manage.
Fees and transaction costs are a small fraction of what you save
Frec charges a 0.10% annual fee for managing your direct index portfolio. Our regulators also charge a small fee every time you buy or sell a stock, and we pass these fees onto you. Since direct indexing means that Frec does a lot of trades on your behalf, you might wonder if those fees add up. Luckily, it turns out the total fees are only a small fraction of what you save in taxes by using Frec. Our projections suggest that you’ll save about fifty times more money on your taxes than you spend on transaction costs.
The S&P 500 gives you international exposure
Since Frec currently only offers direct indexing on the S&P 500, some people may be concerned about geographic concentration. But investing in the S&P 500 isn’t just a bet on the United States economy. You’re also getting international exposure — even though it’s made up of companies domiciled in the United States, an estimated 41% of all S&P 500 revenue is international.11
Why now? The history of direct indexing
Direct indexing has been around for a long time. It’s a tried and true strategy. But until recently, it was only available to the ultra wealthy.
So why is it available to you now? The short answer is: technology.
Direct indexing involves managing hundreds of individual stocks and paying close attention to the movement in all of them. When this had to be done manually by an elite team of sophisticated wealth managers, only the richest people could afford it.
But with recent technological advances, it’s become possible to automate all of that complex market tracking. So direct indexing is accessible to people like you, at a much lower cost.
You may be curious about the specific innovations that have allowed broader access to direct indexing. In brief, these are:
Fractional share investing
Traditionally, investors had to purchase whole shares of a stock. So if a stock was expensive, the average person couldn’t invest in it. Today, investors can purchase a fraction of a share — so people with smaller amounts of capital have access to a much wider range of investment opportunities.
While fractional share investing was first introduced in 1999, it wasn’t available to the average person until M1 Finance rolled it out in 2017. Then Robinhood, SoFi, and Cash App started offering fractional trading in 2019, and Fidelity in 2020.12
New algorithms
Every day, Frec solves a complicated, almost unsolvable linear algebra problem for you. The goal of the algorithm is to do two things at the same time:
- Minimize drift (how far you are from the index you’re tracking)
- Maximize tax losses
The algorithm we use is based on research that was first published in 2021 — before that, such sophisticated direct indexing wouldn’t have been possible. You can read more about the technical details in our white paper.
Commission-free stock trading
Traditional brokerage firms charged commissions for every single trade. This made direct indexing extremely expensive, since it involves such frequent buying and selling of individual stocks.
Today, you can use complex investment strategies like direct indexing without racking up fees, because most online brokerage platforms (like Frec) don’t charge any commissions. But the first commission-free trading app only publicly launched in 2015, and it was only in late 2019 that commission-free became the default.
Automation and processing power
Direct indexing involves analyzing vast amounts of data. If you buy into the S&P 500 with Frec, you have 501 stocks. If each of those stocks has ten tax lots, that’s 5010 stock lots in total. Every day, our algorithm figures out which ~20 of those 5010 tax lots to trade to get you the maximum losses with the minimum drift.
Without modern processing power, this just wouldn’t be possible. The only way to get the same level of customization and precision would be to pay a team of elite financial advisors — and most people can’t afford that.
Conclusion
Frec was born out of the confluence of these four innovations. Direct indexing is a better form of investing, and we believe it should be available to everyone — especially you.
You don’t have to settle for ETFs anymore. With Frec direct indexing, you get double the tax savings with the similar performance, and a customizable portfolio.
It’s easy to get started. Set up an account within minutes and transfer your stocks from other platforms with a few clicks. Ready to start saving money on top of your returns? Sign up here.
References to Frec’s .77% tracking error, 40% tax loss harvesting of your portfolio, 20% tax loss harvesting of an ETF-to-ETF strategy and saving 50x more on tax loss than transactions costs are all results from simulations conducted with Frec’s Direct Index Model tracking the S&P 500 index. The results are hypothetical, do not reflect actual investment results, and are not a guarantee of future results. They were generated with a one-time $50,000 investment with a ten-year time frame of ninety day increments. The date range for the .77% tracking error and 40% tax loss harvesting was between 12/17/2003-06/10/2022; while the date range for 20% tax loss harvesting of ETF-to-ETF strategy and saving 50x more on tax losses than transaction costs was between 12/17/2003-07/25/2023. The ETF-to-ETF strategy used was trading between SPY and IVV, and includes Frec’s 0.10% annual fee and 0.25% fee for ETF-to-ETF strategy.
This handbook is for information purposes only and not intended as tax advice. Frec does not provide tax advice and you are encouraged to consult with your personal tax adviser.
Commission-free trading refers to $0 commissions for Frec Securities’ self-directed margin brokerage accounts that trade US listed stocks and ETFs electronically. Keep in mind, other fees such as trading regulatory fees or wire transfer fees may apply to your brokerage account. Please see Frec’s fee schedule to learn more.
Fractional shares are illiquid outside of Frec and not transferable. See paragraph 28 of Frec’s Customer Agreement for more details.
Stocks shown above are for demonstration purposes only and should not be considered a trade recommendation. The scenario to sell most of your stocks in an S&P 500 direct index using your tax losses harvested to reduce the amount of constituents to 20 positions may not be suitable for all investors and is intended as an example for educational purposes and not a recommendation.
