Why Direct Indexing Is Better Than an ETF

We recently asked an LLM (a large language model) a question we know our clients have from time to time: Which is better, investing in an index-based ETF or a direct indexing product that tracks the same index? We think the answer is pretty straightforward, which is why we were surprised to see the LLM provide guidance that we believe was clearly incorrect. That guidance was based on some common misconceptions about direct indexing rather than data, and we wanted to clear things up. 

First, a quick refresher: Direct indexing is a strategy that involves directly holding individual stocks that make up an index in your brokerage account (thus the name direct indexing) instead of an index-based ETF. You can then conduct tax-loss harvesting with those individual stocks, which provides more opportunities to harvest losses than you’d get with an ETF because individual stocks are far more volatile than broad index funds (even on a day when the index is up, many of its component stocks will be down). As a result, direct indexing provides a similar return as an index-based ETF (return of the index) with an added benefit: the potential to generate tax savings. Skeptics sometimes say those tax savings are not worth the supposed downsides of the strategy, but the data clearly tells a different story.

In this post, we’ll explain why we believe direct indexing, as implemented by Wealthfront, is nearly always superior to holding an ETF that tracks the same index for investors who have at least $5,000 to invest in a taxable account. We’ll focus our argument primarily on our standalone direct indexing products: S&P 500 Direct and Nasdaq-100 Direct.

Myth: The tax benefit from direct indexing “decays” or dwindles to nearly nothing over time

Reality: Index turnover, dividends, and add-on deposits provide new tax lots to keep harvesting losses

We’ll tackle what is arguably the most consequential misconception first: Some investors mistakenly believe the tax benefit from our standalone direct indexing products wanes over time to the point where it no longer justifies the fees we charge for them, even though these fees are very low. While it’s true that Tax-Loss Harvesting can become more challenging over time when no additional deposits are made, reinvesting proceeds from harvested investments tends to lower the portfolio’s cost basis. In an upward-trending market, this lower cost basis means it can be harder to find losses to harvest in the future.

While you might not maintain the exact same high level of benefit year after year, we believe even without add-on deposits our standalone direct indexing products should continue to generate more than enough estimated benefit to cover their fees, which are shown in the table below. Few other direct indexing services charge such a low price with such low minimums, and even ETFs like QQQ and QQQM have a higher price than Nasdaq-100 Direct.

While neither S&P 500 Direct nor Nasdaq-100 Direct yet have a long-enough history for us to share results over longer periods of time, we can look at the performance of our US Direct Indexing product to see how the estimated tax benefit changes over time. US Direct Indexing is an upgrade available within our globally diversified Automated Investing Account to replace the ETF that represents the US equities asset class. For clients with the US Direct Indexing upgrade, when their account reaches $100,000 in value, our software will purchase up to 100 individual large- and mid-cap US stocks (and certain ETFs to cover the remainder of the CRSP US Total Market Index) and conduct tax-loss harvesting with those stocks. 

Because of this, US Direct Indexing is useful for understanding how much potential tax benefit S&P 500 Direct and Nasdaq-100 Direct can provide over time. In the table below, we show “harvesting yield” for the US stocks portion of US Direct Indexing portfolios that have not benefited from any add on deposits post account creation (harvesting yield measures the quantity of losses harvested as a percentage of portfolio value), and we apply assumed tax rates to demonstrate the potential value of those losses. This table shows only the results for clients who used US Direct Indexing for at least a year with no add-on deposits.

Source: Wealthfront¹

As you can see, in nearly every case, that estimated after-tax benefit is still enough to cover the fee for S&P 500 Direct or Nasdaq-100 Direct over a period of many years when clients have gains and ordinary income to offset. And the numbers above actually understate the estimated after-tax benefit for four reasons: 

1. Tax rate assumptions: A 25% marginal combined federal and state tax rate is a very conservative assumption that we think applies to very few of our clients using these products. The low end of the tax benefit range is likely not applicable.
2. Use of dividends to rebalance other asset classes: Wealthfront uses dividends to rebalance our Automated Investment Account portfolios, intelligently reinvesting dividends generated by US Direct Indexing and ETFs to buy more of the underweighted asset classes in the portfolio. This reduces (but does not eliminate) the need to rebalance by selling asset classes that have exceeded their target, which in turn reduces taxable gains. US stocks have outperformed in recent years, which means dividends from US Direct Indexing were likely reinvested in other asset classes in order to rebalance the portfolio and help keep clients close to their target allocations rather than reinvested in the US Direct Indexing portion of the portfolio, which would have created more tax-loss harvesting opportunities. 
3. Total number of stocks: US Direct Indexing employs up to 100 stocks whereas S&P 500 Direct employs up to 500 stocks. More stocks create more harvesting opportunities.
4. Add-on deposit behavior: While the analysis above excludes accounts with any add-on deposits for the sake of argument, this is not reflective of actual client behavior. In fact, almost all our clients follow best practices for building long-term wealth and continue to add to their portfolios over time. It is extremely rare for them to only make one deposit.

We think the data above should give investors confidence about the ongoing potential tax benefits of our direct indexing products, especially given that we believe they significantly understate the actual benefit, though final benefit may vary.

So how can direct indexing products generate tax savings without add-on deposits, even as tax-loss harvesting lowers your cost basis? The answer is primarily twofold: index turnover and dividend reinvestment in the underlying indices, both of which are significant in the S&P 500® index and the Nasdaq-100 Index®.

• Index turnover: Index turnover refers to changes in the makeup of an index over time—component stocks periodically decline in value and get removed (and others added) which creates opportunities to sell stocks and purchase new ones, creating new tax lots. The S&P 500® Index has nearly 4% turnover each year, and the Nasdaq-100 Index® has annual turnover of almost 11%.
• Dividend reinvestment: Over 80% of the stocks that comprise the S&P 500® index pay dividends to shareholders, which means you get cash to invest in new tax lots even without making add-on deposits. Annual dividend yield for the S&P 500® Index is over 1.5%, and a little less than half that for the Nasdaq-100 Index®.

In short, data analysis from another Wealthfront product strongly suggests investors need not feel concerned about the estimated tax benefit from direct indexing not exceeding the fee we charge over time.

Myth: Using direct indexing means you are “locked in” to a specific investing platform

Reality: Being “locked in” is only a concern if you believe the fees aren’t justified over time

We suspect the main reason people might worry about being “locked in” is they think direct indexing products will stop generating enough benefit to justify their fee. They don’t want to stick around and pay a fee that isn’t justified, but they also don’t want to close the account and incur a tax liability from the gain or transfer out hundreds of shares and then manage those shares themselves (more on this below). Hopefully, we’ve addressed the fee justification concern well enough above. 

We believe the other reason people might worry about potentially being “locked in” is that they think Wealthfront might take advantage by raising our fees over time. However, as any Wealthfront client can tell you, we’ve actually done the opposite. In our 14 years of history, we have only ever lowered our fees. We do this because we put clients first in everything we do—this is core to our mission (building a financial system that favors people, not institutions), and it’s part of why we have an annual client retention of 95%. 

Still, we understand that clients do leave sometimes, and we strive to make that process convenient and tax-efficient. In that case, you should know that liquidating some or all of your direct indexing positions with us is free, and can have a similar tax efficiency when compared to selling an ETF, with just one caveat. When you sell your direct indexing positions, you’ll owe taxes on the realized gains. Because we expect the performance of the direct indexing product to be very similar to that of the ETF (more on this below), we also expect that realized gains (and tax liability) are the same, all else equal. But here’s the caveat: Because you’ve been using Tax-Loss Harvesting, your cost basis is lower and the taxes you owe at liquidation could be higher—and if you’ve already benefited from deferring those taxes, then you have had the opportunity to reinvest your savings in the meantime. Ultimately, we still expect you to come out ahead as long as you’ve had capital gains and/or ordinary income to offset along the way. 

If you end up deciding to liquidate your direct indexing account with us, transferring 500 individual stocks (in the case of S&P 500 Direct) out of Wealthfront is just as easy as transferring a single ETF. In fact, it’s the exact same process. However, once that process is complete, it’s true that managing 500 individual stocks is more work than managing a single ETF. But given the fact that our direct indexing products are automated and provide a potential tax benefit that should, at a minimum, cover our fee over long periods of time, it is arguably less advantageous to do so.

Myth: Direct indexing is far worse at tracking an index than an ETF is

Reality: Direct indexing and ETFs give you very similar exposure to the underlying index

Another common objection to direct indexing is potential tracking error, or the volatility of performance differences between the direct indexing product and the index itself. These performance differences can be positive (you beat the index) or negative (you lag the index). 

Tracking error is something to pay attention to, but you should know that ETFs and direct indexing will both have performance differences from the index (which is not investable anyway). In both cases, we expect these performance differences to average out to nearly zero over the long run. Here’s a closer look at the details:

• In ETFs, tracking error comes from the fee and some other slight differences. Performance differences on any given day should be very small, and they should average out to be close to zero over time. 

• In direct indexing products like ours, tracking error comes from tax-loss harvesting, very small accounts that cannot hold as many stocks compared to larger ones, and, when applicable, individual stock exclusions. Excluding very large-cap stocks is especially likely to introduce tracking error, because they can comprise such a large portion of the total index weight. While the magnitude of the performance differences on any given day might be higher than that of an ETF, we still expect the long-term average of those differences to be close to zero.

For a broad market index, we consider tracking error of up to 1% to be very low, and it’s worth noting that it can be in either direction (above or below index return). Since inception, S&P 500 Direct’s tracking error has been 0.54%–0.63% depending on the number of exclusions—comfortably within that margin. We expect that to continue.

Myth: Direct indexing means you have to worry about wash sales

Reality: Our direct indexing products are specifically designed to help you avoid wash sales

Some people might worry about wash sales when it comes to direct indexing products like S&P 500 Direct and Nasdaq-100 Direct. A wash sale happens when you sell an investment within 30 days of purchasing a “substantially identical” one, which in the context of direct indexing usually means the same stock. Wash sales themselves are not illegal or inherently problematic, except for the fact that the IRS does not allow you to claim losses on wash sales in the year in which they were realized. Rather, a loss from a wash sale can be claimed when you finally sell the replacement securities and do not trigger another wash sale within 30 days. The disallowed loss is added to the cost basis of the new shares, deferring the loss until the new position is closed. So ideally, if you’re conducting tax-loss harvesting, you generally want to avoid wash sales. 

Wealthfront’s products are designed to avoid wash sales both within and across all of your accounts with us, except for Stock Investing Accounts (which we do not monitor for wash sales). As a result, wash sales are extremely rare at Wealthfront—we find that they affect less than 0.01% of the daily dollars traded (in the accounts we monitor, and excluding withdrawals). 

It’s worth mentioning that both S&P 500 Direct and Nasdaq-100 Direct allow you to address the kind of wash sales that might result from your Stock Investing Account by excluding specific stocks from trading in the DI account, making wash sales pretty easy to avoid. You can plan to exclude your employer’s stock if they are a publicly traded company, either to comply with trading restrictions your employer might have or just to avoid more exposure to a stock you already own a lot of.

Myth: ETFs are already the most tax-efficient way to invest

Reality: ETFs are tax-efficient, but direct indexing can be better

It’s true that ETFs pass along very few gains to investors, making them very tax efficient (this is part of why we use them in Wealthfront’s Automated Investing Accounts). But our standalone direct indexing accounts realize very few gains, too. In fact, just like an index-based ETF, the only situation other than withdrawals where we’ll realize a gain in S&P 500 Direct or Nasdaq-100 Direct is when a stock is removed from the index and we’re forced to sell it at a gain to continue tracking the index. 

Some investors—and LLMs—mistakenly assume that in a situation where, in order to conduct tax-loss harvesting, we sell Coke at a loss and buy Pepsi (and harvest the loss), we then sell Pepsi at a gain after 31 days to return you to your original position. But unlike many other direct indexing products, this isn’t what we do. There isn’t a 1:1 relationship between selling one stock and buying another in our direct indexing products (although simplified examples often illustrate it this way for ease of comprehension). Instead, when we sell a stock, we use a mathematical model to buy highly correlated substitute stocks chosen for the fact that they have historically moved in similar patterns to the one sold. Our approach looks at the overall basket of stocks we buy and sell rather than trying to match stocks 1:1. In this way, we try to minimize tracking error and your tax bill, which means we work to maintain your index exposure without realizing gains (which as we explained above, we only do in very limited cases).

Put simply, we believe our standalone direct indexing products are just as tax-efficient as an ETF given their added benefit of conducting tax-loss harvesting to generate tax savings.

Key takeaway: Direct indexing is almost always better than an ETF

We’d be hard pressed to think of someone who would be worse off for using our S&P 500 Direct or Nasdaq-100 Direct instead of an ETF. But we do think there are limited scenarios where they aren’t the right fit. This can include:

• Someone with relatively little to invest (below the $5,000 minimum) 
• Someone who only invests in tax-advantaged accounts like IRAs and 401Ks, and does not have any interest in taxable investing. That said, we think opening a taxable investing account is a good option for most people because of their flexibility and liquidity. Plus, retirement accounts have contribution limits, meaning if you want to invest more than those limits, you have to use a taxable account. 
• Someone who frequently trades a large number of the same individual stocks that make up the index (because this behavior would likely create a lot of wash sales) 
• Someone who has a very low tax burden 

But for just about everyone else, we think the answer to this is easy: Direct indexing offers many of the same benefits of ETFs with more customization and the key advantage of generating tax savings through individual stock tax-loss harvesting. That’s especially valuable if you:

• Live in a high-tax state
• Are in a high tax bracket 
• Realize (or expect to realize) a lot of capital gains—for example, if you have a lot of incentive stock options (ISOs) in a company that’s about to IPO, or you’re liquidating a lot of investments to buy a home.

Part of what sets Wealthfront apart from other investment services is our focus on maximizing your after-tax returns. Automated direct indexing, which we pioneered, is a key part of how we attempt to do that. We hope this article helps you navigate the choice between an ETF and direct indexing more confidently.