Direct Indexing: A Better Way to Index
Passive investing into index funds has become the dominant method of investing into the U.S. stock market, surpassing actively managed funds1 in popularity over last year. This migration has come as very few active managers consistently beat the market, and the market has performed well historically. The S&P 500 is up 18.2%* in 2024 so far and has averaged a 9.9% annual return over the past twenty years.2 The Nasdaq 100 is up 19.5%* in 2024 and has averaged a 14.5% annual return over the past twenty years.3 Due to the consistent performance and low fees that ETFs usually charge, index investing has grown in popularity among investors, even those who like private markets but prefer a core liquid allocation to balance them out.
What is Direct Indexing?
Rather than buy shares in a mutual fund or ETF, direct indexing enables the investor to own the individual stocks that make up an index like the S&P 500. While this may seem like a small distinction, it is an extremely important one, because by actually owning the underlying stocks, rather than shares in a fund that owns the stocks, investors can unlock additional benefits not available otherwise. Most importantly, it unlocks the possibility of tax loss harvesting.
What is Tax-Loss Harvesting?
Tax-loss harvesting (TLH) is the process of selling assets, in this case, stocks, with a capital loss, in order to offset capital gains in the present or future. These tax benefits are accessible in perpetuity, as capital losses can carryover indefinitely until they are used. As a result, tax-loss harvesting is a way for investors to potentially save significant money on their taxes over a number of years.
The TLH strategy is particularly useful to people expecting large capital gains from events like selling property, exiting a profitable investment, or selling an equity stake in a company. In some cases, ordinary income can also be offset by up to $3,000 of capital losses in a given year.
In a diversified portfolio, some stocks will naturally go up in value, and some will go down. When stocks underperform and decline in value below the original cost of the stock, they are sold, to “harvest” the loss. They are then temporarily replaced with similar stocks within the same index. After 30 days, the original stock is repurchased to avoid the SEC’s wash-sale rules.
For example, if you own a share of Tesla that you bought at $100 and it declines to $90, you would sell that share and “harvest” $10 worth of tax losses. You would buy a correlated stock or basket of stocks that is designed to continue tracking the index during the next 30 days while waiting out the wash trading period. After 30 days, you sell those stocks and rebuy Tesla.
The difference in performance between the stock that has been sold and the basket of stocks purchased to replace it is called the “tracking error,” and can be positive or negative. For example, if Tesla outperforms the basket of stocks in that 30 day period, the tracking error would be negative, but if Tesla underperformed the basket of stocks, the tracking error would be positive. Ultimately, if the original stock has been replicated correctly, the tracking error should be minimal. Moreover, because the volume of trades performed with direct indexing is high, on average the cumulative tracking error will be minimal, so investors can see fundamentally similar returns to the market while also generating tax benefits.
Direct Indexing and Tax-Loss Harvesting
As direct indexing gives investors direct ownership of stock, it allows for tax-loss harvesting at a much greater scale than with ETFs or robo-advisors. While there are some ETF-to-ETF tax loss harvesting strategies, direct indexing allows for tax-loss harvesting at the individual stock level, which is not possible in an ETF. As a result, direct indexing can potentially double the amount of tax losses harvested versus an ETF-to-ETF strategy.
Estimated tax-losses with direct indexing can be up to 15% of a total portfolio in year one and 40% of the portfolio1 by the end of year ten. So, a $100,000 portfolio could generate $15,000 in capital gains losses in one year and $40,000 over ten years. Because of these potential tax benefits, direct indexing has been gaining in popularity, and is projected to grow faster than ETFs and mutual funds over the next two years, reaching $800 billion in assets by 2026.
Additionally, direct indexing allows for greater customization of a portfolio. If an investor already owns a substantial amount of stock in certain companies, investing in an ETF could overweight their portfolio with those positions, but when investing directly, they can simply choose not to buy those stocks. This is a situation that many startup employees and founders could find themselves in. Or if an investor is interested in including or excluding certain sectors, they can accomplish that with direct indexing.
Of course, there are reasons not to use direct indexing, as well. If an investor does not have, and does not expect to have any significant capital gains, the tax benefits of direct indexing would not be as advantageous. Though not a major reason to not direct index, it is worth considering that the tax benefits decline over time, because as time goes on, and the value of the underlying stocks rise, the opportunity for tax-loss harvesting becomes less frequent as the likelihood of the stocks value dropping below their cost basis will decrease. Thus, if investors are using a third-party service to direct index, a low fee structure is important so they don’t get stuck paying high fees as the benefits diminish.
While direct indexing has been around for a long time, it has traditionally only been accessible through wealth advisors, often at high fees, and with very high minimum investment requirements. Of course, investors can also mimic an index manually by purchasing and selling stocks, but it would be extremely difficult and time consuming to reap the tax benefits and rebalance their portfolio daily.
Recent developments have made direct indexing much more accessible to the everyday investor, with commission-free trading, the advent of fractional shares lowering the minimum amount needed to construct the portfolio, and most importantly, advanced computer algorithms that automate the process. Now, there are platforms available that make it easy for anyone to add direct indexing to their portfolio.
Who is Frec?
Frec is an investment platform based in San Francisco that was founded in 2021 by CEO Mo Al Adham, the first advisor to Instacart and previously founded Twitvid. Its mission is to allow everyone access to sophisticated investment strategies that had previously been the purview of family offices and high net-worth individuals. The company raised $26.4 million in funding and launched to the public in October 2023. Since then, its customer assets have reached $100 million. In addition to offering direct indexing, they also offer a Portfolio Line of Credit at lower rates than competitors, and a high-yield treasury account for excess cash.
Why Invest with Frec?
If you are looking to invest in an index fund, direct indexing could be right for you. And if you are interested in direct indexing, Frec offers a low-cost and easy product. Their starting 0.10% annual fee for the S&P 500 is essentially the same as the 0.09% expense ratio of the popular SPDR S&P 500 ETF ($SPY), and significantly less than other tax-loss harvesting services.5
Besides the S&P 500 index, Frec offers nine other direct indices, providing investors with the greatest number of options of any consumer platform. The offerings include Russell 1000, 2000 and 3000, the S&P Information Technology index, S&P Developed Markets ADR and the CRSP large and small cap indices, MVIS US Listed Semiconductor, and CRSP ISS US Large Cap ESG. They also offer the ability to customize indices by excluding stocks you already own and you can also choose to include or exclude specific sectors.
Their proprietary algorithm not only maximizes your tax-loss harvesting, but it has historically replicated the underlying indices with minimal tracking errors. They have been running a live demo portfolio since December 2023, which started with a $50,000 deposit and has generated over $1,800 in tax losses with an average 0.13% tracking error and only $18 in fees.
Frec Securities is an SEC-registered broker dealer and member of FINRA, while Frec Advisers is an SEC-registered investment adviser and fiduciary. Your stocks are held in your name at Apex Clearing, which custodies over $110 billion for some of the largest investment platforms—meaning you always have access to it. Frec is also a member of SIPC, so securities in an account are insured for up to $500,000.
With a minimum investment of $20,000, Frec makes it easy for people to access direct indexing and reap the resulting tax benefits while still achieving market returns.
*as of 8/19/24
1 https://www.cnbc.com/2024/01/18/passive-investing-rules-wall-street-now-topping-actively-managed-assets-in-stock-bond-and-other-funds.html
2 https://tradethatswing.com/average-historical-stock-market-returns-for-sp-500-5-year-up-to-150-year-averages/
3 https://tradethatswing.com/historical-average-returns-for-nasdaq-100-index-qqq/
4 40% tax losses harvested from a portfolio is based on a ten-year time frame and simulations results from 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. The simulations were run to tax loss harvest on a weekly basis in a ten-year time frame of ninety-day increments from 12/17/2003 - 06/10/2022 with a $50,000 initial deposit. The simulations averaged at the end of year ten resulted in a 40% accumulated tax loss savings and does not include Frec's 0.10% fee.
5 Frec's direct indexing annual aum fee depends on the index strategy you select and ranges from 0.10% - 0.35%. Frec also has other fees, such as regulatory, outgoing wires, and outgoing ACATS fees. See all of them at https://docs.frec.com/pricing-fee-schedule.pdf. Competitor fees: Fidelity is 0.40% and Wealthfront is 0.25%. SPY is the largest ETF tracking the S&P 500 but there are other S&P 500 ETFs with lower expense ratios.
Investing involves risks, including the risk of loss. Advisory services provided by Frec Advisers LLC, an SEC registered investment advisers, and brokerage services provided by Frec Securities LLC, member FINRA/SIPC. Both are wholly owned subsidiaries of Frec Markets, Inc.
