Individual Stocks vs. Index Funds: The Next Frontier

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One appeal of broad stock index funds is their tax efficiency: They don’t distribute a lot of taxable capital gains, in large part because the index components don’t change frequently.

But some firms say there is an even more tax-efficient approach—call it Indexing 2.0—at least for people with a lot of money to invest. It involves holding all or most of the stocks that comprise an index, rather than an index fund, to not only minimize taxable gains but also generate extra taxable losses that investors could use to offset gains in other assets or their regular income.

Index funds, by contrast, are prohibited from distributing net capital losses to their investors.

But while Indexing 2.0 might have some merit for some investors, experts say it isn’t for everyone, and the tax benefits could be smaller than advertised.

A big proponent of this approach is Wealthfront, one of a new breed of automated investment advisers known as roboadvisers. Beginning in April, clients with taxable accounts of at least $100,000 will be able to sign up for what the company calls tax-optimized direct indexing. That option is currently available only to clients with at least $500,000 in assets at Wealthfront.

A handful of boutique investment firms, including Parametric, a subsidiary of Eaton Vance, and Active Investment Advisors, a unit of Natixis Global Asset Management, have offered similar services to high-net-worth investors for years. Wealthfront aims to reach a broader swath of investors.

Wealthfront’s direct-indexing approach involves replacing the Vanguard Total Stock Market ETF in client portfolios with a combination of individual stocks from the S&P 500 and S&P 1500 indexes and exchange-traded funds that provide exposure to smaller stocks, such as the Vanguard Extended Market ETF and the Vanguard Small-Cap ETF.

The larger the account, the greater the number of stocks the client directly owns. The more stocks the client owns, the more opportunities there are for tax-loss harvesting, or selling shares that have fallen since they were bought.

The stocks sold are replaced with a similar stock or group of stocks to maintain the portfolio’s desired risk and return characteristics. The client can use the capital losses to offset capital gains realized in other assets, plus up to $3,000 of ordinary income each year. Losses above that amount can be carried forward indefinitely for use in future years.

Wealthfront’s software scans each account daily to identify potential trades, says Adam Nash, the firm’s chief executive. Even when the S&P 500 index is up, some stocks in the index likely are down—witness the latest swoon in the stocks of energy-related firms.

In Mr. Nash’s personal account, for example, shares of energy stocks Baker Hughes, Cimarex Energy, Spectra Energy and ConocoPhillips were automatically sold at a loss and replaced mostly with an increased position in Chevron. The goal is to hew as closely as possible to the performance of the index while maximizing the amount of tax losses generated.

Fees for such a service typically range from around 0.15% to 0.45% of assets, on top of any investment adviser’s fee. At Wealthfront, which itself is an investment adviser, the direct-indexing program is included in the 0.25% annual fee charged on assets above $10,000.

Turnover is higher in a directly-indexed account than in an index fund, but the practitioners typically qualify for institutional rates, keeping trading costs minimal. Wealthfront doesn’t charge trading commissions.

Mr. Nash says the service could add as much as 2.03 percentage points to investors’ annual after-tax returns over a similarly invested portfolio with no direct indexing or daily tax-loss harvesting. But the estimate—which is derived from backtests conducted by Wealthfront—is based on some favorable assumptions: namely, that investors are in the highest tax brackets, the tax losses can be used immediately (rather than carried forward), and the tax savings are reinvested and compound over time.

It also assumes that after an initial $1 million deposit, the investor continues adding $100,000 every quarter to the account.

The continued investing is a key assumption. The biggest tax benefits from direct indexing typically come in the first three to five years, after which it gets harder and harder to find losses to realize, as the portfolio continually sheds its losers and lets its winners ride, says Paul Bouchey, co-chief investment officer at Seattle-based Parametric, which has provided tax-managed indexing to high-net-worth investors for more than 20 years.

If you keep adding money, it can ameliorate the problem, he says.

Candidates for direct indexing include investors in the highest tax brackets who realize a lot of capital gains on a continuing basis, such as those who invest in hedge funds and those in the process of diversifying concentrated stock positions, says Allan Roth, an independent financial adviser in Colorado Springs, Colo.

It also helps if they can avoid ever realizing the gains that tend to pile up inside the directly-indexed portfolio, say, by giving the assets to charity or leaving them to heirs, who benefit from a reset of the assets’ cost basis to their current market value, Mr. Roth says.

Even if the portfolio is eventually liquidated, the gains realized and the taxes paid, you still might come out ahead, provided your holding period is sufficiently long.

Of course, if tax rates increase it can backfire, says Mr. Roth. In January, President Barack Obama proposed raising the top capital-gains rate and curtailing the step-up—remote possibilities, to be sure, but a reminder of the legislative risk inherent in any tax-driven investment strategy.

Most investors would be better off simply holding tax-efficient investments, such as broad-market index funds and municipal-bond funds, in taxable accounts, and holding tax-inefficient investments, such as taxable bonds, in 401(k)s and individual retirement accounts, says Vanguard Group investment strategist Fran Kinniry.

Such moves can add as much as 0.75 percentage point to annual returns, depending on the mix of investments, according to Vanguard research.

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