Frec - Low Cost (0.10%) S&P500 Direct Indexing Startup

[carlivar]

I am going to try Frec. I like the low fees and I like startups/disruptors. The fact that Apex Clearing is actually holding my positions also gives me some comfort.

Why am I doing this? I have some long-term unrealized capital gains in my company stock, for which I am significantly over-weighted. I'd like to sell those positions and diversify over the next few years. I'm also in California, so while I'll pay 20% LTCG federal tax rates on the sales, California will hit me with the highest state income tax rate in my bracket, something like 13.3%.

Before seeing the light with Boglehead mentality I also acquired a bit more investment real estate than I'd now prefer, in addition to individual stock positions that have appreciated significantly enough to make taxes a major drawback to diversifying out of them.

I guess this is a long way of saying I have a "target rich environment" in terms of offsetting harvested losses and I pay very, very high tax rates.

The 0.1% fees at Frec make me less concerned about getting "stuck" in the positions, versus the 0.4% charged elsewhere (Wealthfront 0.25% to their credit).

[livesoft]

I am going to try Frec. [...]

How are you going to create losses by Direct Indexing? You would have to buy shares "high" and sell them "low." I think you would have to be periodically buying shares since your shares that are older than a year or so will be less likely to have losses. This means that investors who are not generating income to buy shares from working or inheriting or winning the lottery are unlikely to benefit.

My personal experience is that I have had no losses to harvest since about 2016 which is around the time I stopped working. Before that I was an avid Tax Loss Harvester. Since then I have bought shares, but only in the act of rebalancing in tax-advantaged accounts.

[gch]

I haven’t put a lot of thought into this, but on the surface it would seem like it’d work great in the accumulation phase of your life because you can use your new money to rebalance the index while optimally tax harvesting losses.

However, once your balance is large or you’re not putting new money in, it’d seem the capital gains tax you’d have to pay on trading to match the index would be much higher than what would occur in a large mutual fund where in flows can be used to negate a good portion of the rebalancing.

[carlivar]

the capital gains tax you’d have to pay on trading to match the index

That is a good point. One way to get cash for re-balancing would be from dividends, but I suspect that would not be nearly enough. Frec does have a bunch of writing about keeping things in balance:

https://frec.com/resources/blog/frec-di ... -algorithm

[prioritarian]

My personal experience is that I have had no losses to harvest since about 2016 which is around the time I stopped working.

Surely a few of the many hundreds of stock positions in your equity indices have decreased below cost basis at one time or another since 2016. Just because a broad index does not have capital gains does not mean that there aren't equities that crash in value or experience enough volatility to allow for harvesting of losses.

[livesoft]

My personal experience is that I have had no losses to harvest since about 2016 which is around the time I stopped working.

Surely a few of the many hundreds of stock positions in your equity indices have decreased below cost basis at one time or another since 2016. Just because a broad index does not have capital gains does not mean that there aren't equities that crash in value or experience enough volatility to allow for harvesting of losses.

I agree with that, but after a while with no new money added to a taxable account I think the amounts of losses will slowly diminish to be insignificant.

[Yarlonkol12]

I haven’t put a lot of thought into this, but on the surface it would seem like it’d work great in the accumulation phase of your life because you can use your new money to rebalance the index while optimally tax harvesting losses.

However, once your balance is large or you’re not putting new money in, it’d seem the capital gains tax you’d have to pay on trading to match the index would be much higher than what would occur in a large mutual fund where in flows can be used to negate a good portion of the rebalancing.

I've done this for years with just manually selling ETF basis with losses and buying a not "substantially identical" ETF with the proceeds, I'll only bother to do this to capture several thousand in capital losses. Usually this is the most recent basis after a market drop

My 1099 is probably much simpler to read to with only a few transactions per year, vs however many trades these things perform, that part alone makes me skeptical of wanting to jump onboard with direct indexing

[prioritarian]

I agree with that, but after a while with no new money added to a taxable account I think the amounts of losses will slowly diminish to be insignificant.

I think one of the overlooked advantages of direct indexing is that with enough individual stock positions a downturn could make for very tax efficient capital gain harvesting. A more equal weight index or an index with more volatility (e.g. SCV) could enhance the inherent tax efficiency of direct indexing.

[Lyrrad]

I agree with that, but after a while with no new money added to a taxable account I think the amounts of losses will slowly diminish to be insignificant.

I think one of the overlooked advantages of direct indexing is that with enough individual stock positions a downturn could make for very tax efficient capital gain harvesting. A more equal weight index or an index with more volatility (e.g. SCV) could enhance the inherent tax efficiency of direct indexing.

If I decide to use direct indexing on a long term basis, I expect to have a wider dispersion of unrealized capital gains compared with an index fund portfolio.

I’d expect to be able to donate or gift my shares with the lowest cost basis and end up lower unrealized gains. Even if I didn’t do so, I’d expect to be able to liquidate the highest basis shares to get cash at a lower cost than other methods when doing a partial liquidation.

I plan to look for a service that allows me to do these things before committing large amounts of my taxable investments to it.

[livesoft]

I think one of the overlooked advantages of direct indexing is that with enough individual stock positions a downturn could make for very tax efficient capital gain harvesting. A more equal weight index or an index with more volatility (e.g. SCV) could enhance the inherent tax efficiency of direct indexing.

The same principles apply to using index funds/ETFs. We had plenty of harvested losses periodically from 1987 to 2016 that carried over and were applied to very tax efficient capital gain harvesting. That is, there was no need for Direct Indexing for us to take advantage of Tax-Loss Harvesting and thus enhance the inherent tax efficiency of using broad market, passively-managed, low-expense ratio index funds.

And we have earmarked our SCV index ETF shares purchased in 2009 with decent unrealized capital gains for periodic donation to our DAF, so we will not pay any taxes on the unrealized capital gains. The charitable deductions offset Roth conversions, too.

[aristotelian]

Seems like the rebalancing would cost more in tax than you would save in tax loss harvesting. Another solution in need of a problem, IMO.

[prioritarian]

Seems like the rebalancing would cost more in tax than you would save in tax loss harvesting. Another solution in need of a problem, IMO.

Or one could just let the index drift a little and "rebalance" it slowly with dividends and cheaper basis during crashes.

(A direct index that has drifted away from the target index by 5-10% may only have a modest impact on returns.)

[prioritarian]

The same principles apply to using index funds/ETFs. We had plenty of harvested losses periodically from 1987 to 2016 that carried over and were applied to very tax efficient capital gain harvesting.

But there is far more volatility at the level of individual stocks.

[aristotelian]

Seems like the rebalancing would cost more in tax than you would save in tax loss harvesting. Another solution in need of a problem, IMO.

Or one could just let the index drift a little and "rebalance" it slowly with dividends and cheaper basis during crashes.

(A direct index that has drifted away from the target index by 5-10% may only have a modest impact on returns.)

NVDA is up 168% this year. How are you going to buy 168% of the rest of the index with dividends?

[Lyrrad]

NVDA is up 168% this year. How are you going to buy 168% of the rest of the index with dividends?

I don't understand this argument.

I'd expect market cap weighted indexes to increase stock allocation by a similar to percentage to their gains in value.

There are corporate actions that can affect this like stock buybacks, so I think some drift is inevitable if you don't sell stocks at a gain.

[the_wiki]

Seems like the rebalancing would cost more in tax than you would save in tax loss harvesting. Another solution in need of a problem, IMO.

Or one could just let the index drift a little and "rebalance" it slowly with dividends and cheaper basis during crashes.

(A direct index that has drifted away from the target index by 5-10% may only have a modest impact on returns.)

NVDA is up 168% this year. How are you going to buy 168% of the rest of the index with dividends?

We aren’t making an equal weight index. So you don’t do anything. We are supposed to have more in NVDA when the value increases in a cap weighted index.

[ze3kr]

I actually think this is more of a drawback than a benefit because you end up paying that 0.25% on BND and other basic ETF holdings

What I mean is they are two different things. Rebalancing bonds/stocks as I invest my money into them is also worth something because it saves my time. So I pay 0.25% for Wealthfront to do both Direct Indexing, ETF level TLH, and rebalancing, while Frec focuses on one thing only. One can argue that rebalancing isn't worth a 0.25% fee. I agree. I'd rather pay Wealthfront a fixed amount of money a year rather than a percentage, but that's a different topic.

[ze3kr]

Frec recently made some updates. Now they announced that they reached 100M AUM, and also announced new indices. The two new indices I am interested in are:

1. Russell 3000 (similar to VTI; fee: 0.27%!!! with ~3000 positions!!!)
2. S&P Developed Markets ADR (similar to VEA, fee: 0.17%, with ~150 positions)

I don't think I have ever seen a direct indexing offering similar to these, at least not offered to the public. The fee is higher than 0.10% but still quite competitive. However, I am not sure how having 3000 positions can dramatically increase the TLH performance because the smallest 2000-2500 positions in Russell 3000 are really small (like less than 15% of the overall portfolio). Wealthfront has a blog post explaining why they don't offer direct index with 1000 stocks anymore because of the little extra tax benefit: https://www.wealthfront.com/blog/updates-to-smart-beta/

So I would imagine in the near future their 0.10% fee S&P 500 will still be the one that is most popular

[prioritarian]

Frec recently made some updates. Now they announced that they reached 100M AUM, and also announced new indices. The two new indices I am interested in are:

1. Russell 3000 (similar to VTI; fee: 0.27%!!! with ~3000 positions!!!)
2. S&P Developed Markets ADR (similar to VEA, fee: 0.17%, with ~150 positions)

I don't think I have ever seen a direct indexing offering similar to these, at least not offered to the public. The fee is higher than 0.10% but still quite competitive. However, I am not sure how having 3000 positions can dramatically increase the TLH performance because the smallest 2000-2500 positions in Russell 3000 are really small (like less than 15% of the overall portfolio). Wealthfront has a blog post explaining why they don't offer direct index with 1000 stocks anymore because of the little extra tax benefit: https://www.wealthfront.com/blog/updates-to-smart-beta/

So I would imagine in the near future their 0.10% fee S&P 500 will still be the one that is most popular

Their new CRSP USA small cap index (0.15 ER, 50K min) should have more opportunity for tax loss harvesting than a large cap index. I hope they open a microcap index because that would be something I would be very interested in.

https://frec.com/pricing

Parametric is one of the largest players in institutional direct indexing, which is way ahead of retail, and they say this about small cap and emerging market direct indexing:

Volatility can present opportunities for tax-loss harvesting throughout the year. Small-cap and emerging-market stocks tend to have higher volatility than large-cap and developed-market stocks.

https://www.parametricportfolio.com/blo ... pectations

If someone really wants to game the US tax code it should be possible to create high volatility indices that would be expected to perform approximately as well as market weight (based on back testing) but would maximize tax harvesting.

It's also amusing that they opened a CRSP large cap index -- evidently I'm not the only S&P 500 hater.

[ze3kr]

Their new CRSP USA small cap index (0.15 ER, 50K min) should have more opportunity for tax loss harvesting than a large cap index. I hope they open a microcap index because that would be something I would be very interested in.

I won't change my holding just for TLH purposes, it's stupid to do that. I have a small cap, but only for a small amount. VTI = 85% VV + 15% VB so even if small-cap has a good TLH opportunity it will only be weighted to 15%.

But you give me an idea. I can hold VOO in my tax-advantage account, and hold small-cap in a taxable account and still have the same risk profile.

[nvrmnd]

One can argue that rebalancing isn't worth a 0.25% fee. I agree.

Yeah, that was what I was arguing (pointing out).

But also, I don't see the value in rebalancing in general and certainly not when it involves a fee. Rob Berger has an interesting video on rebalancing (https://www.youtube.com/watch?v=sO8SLwDOvCk) -- starting with the "Jack Bogle founder of Vanguard says you should never rebalance your portfolio" -- anyway you can show that you can expect to deposit far more money into your fixed-income portion as you are constantly trying to maintain that percentage of your allocation. Rebalancing periodically, not on deposits, is tax-inefficient and also has a similar effect of migrating your stocks -> fixed income to maintain the percentage.

Instead, many investing blogs etc. suggest a fixed percentage on deposit approach, e.g. each deposit is 10% fixed income, 40% VTI, 50% VT (let's say). Then let your allocations grow as they will.

You certainly don't need to pay a fee for that and AFAIK Wealthfront does not even allow you to do this, it would automatically rebalance for you in the ways mentioned above.

[nvrmnd]

If someone really wants to game the US tax code it should be possible to create high volatility indices that would be expected to perform approximately as well as market weight (based on back testing) but would maximize tax harvesting.

Long-Short direct indexing is basically this: https://www.aqr.com/Insights/Research/J ... -Investing

[whodidntante]

It's also amusing that they opened a CRSP large cap index -- evidently I'm not the only S&P 500 hater.

Go on...

[whodidntante]

Frec recently made some updates. Now they announced that they reached 100M AUM, and also announced new indices. The two new indices I am interested in are:

1. Russell 3000 (similar to VTI; fee: 0.27%!!! with ~3000 positions!!!)
2. S&P Developed Markets ADR (similar to VEA, fee: 0.17%, with ~150 positions)

I don't think I have ever seen a direct indexing offering similar to these, at least not offered to the public. The fee is higher than 0.10% but still quite competitive. However, I am not sure how having 3000 positions can dramatically increase the TLH performance because the smallest 2000-2500 positions in Russell 3000 are really small (like less than 15% of the overall portfolio). Wealthfront has a blog post explaining why they don't offer direct index with 1000 stocks anymore because of the little extra tax benefit: https://www.wealthfront.com/blog/updates-to-smart-beta/

So I would imagine in the near future their 0.10% fee S&P 500 will still be the one that is most popular

Fidelity offers something similar to #2, but with a higher fee. They argue the after-tax returns are superior, but I got bored with trying to figure out why that might be. Maybe it's something special about the ADR wrapper or less withholding tax somehow.

[prioritarian]

If someone really wants to game the US tax code it should be possible to create high volatility indices that would be expected to perform approximately as well as market weight (based on back testing) but would maximize tax harvesting.

Long-Short direct indexing is basically this: https://www.aqr.com/Insights/Research/J ... -Investing

That approach is not direct indexing. I think it should be possible to do something like this at the individual level (given that models with lower number of stocks can approximately mirror index returns).