Note: Wealthfront’s Stock-level Tax-Loss Harvesting is now called US Direct Indexing.
At first blush, the suggestion that finance professionals should choose an automated investment service like Wealthfront to manage their investments seems to make little sense. Wouldn’t folks who monitor 30-day moving averages and asset class correlations for a living prefer to actively manage their investments? Don’t they have pockets full of arbitrage trade ideas just waiting to be executed?
As someone who formerly worked in fixed income derivatives, I can tell you that these idealized versions of how financial professionals handle their own portfolios rarely, if ever, occur in real life. One reason is the NYSE’s Rule 407, which applies to any employee of a firm that does business with NYSE Euronext, is a member of FINRA, or is registered with the SEC – which basically means the majority of the finance industry.
Compliance regulation makes investing challenging
Under Rule 407, upon starting their jobs, employees must disclose any personal accounts in their or their spouse’s name, along with any private investments, such as hedge fund holdings or private stock. The firm then has the right to approve these outside accounts or require them to be moved to another brokerage firm. In addition, any new accounts opened after the employee comes on-board must be pre-approved by the firm. The most tedious part of Rule 407, however, requires that almost all new trades executed in an employee’s personal account be approved in advance.
These regulations exist for a good reason: To prevent employees with potentially material insider information from benefiting personally from a trade. For example, investment bankers working on a merger deal involving Company ABC should not be able to trade its stock, given their access to private material information. Any violation of Rule 407 is taken extremely seriously and is a fireable offense. (Sometimes, it can even land you in jail.)
Wealthfront’s automated investment service is discretionary in nature, meaning account holders cannot influence specific investment decisions or trade execution. Our accounts invest solely in low-cost ETFs, the exception being taxable accounts with Stock-level Tax-Loss Harvesting, which will invest in the individual stocks that comprise the S&P 500. This eliminates the possibility of an employee trading with inside information on specific companies or securities. What’s more, our software algorithmically executes trades to match a desired risk profile. This means that an account owner has no ability to exert any direct control over investment decisions. Even if finance professionals had material information on the direction of the S&P 500, they would not be able to call up Wealthfront and reallocate their holdings to take advantage of the expected market moves. Investing in a discretionary account like Wealthfront generally absolves employees of going through their employers’ compliance trading pre-approval processes, which are required for a self-directed account.
In addition, all taxable accounts with Wealthfront come with Tax-Loss Harvesting, which lowers your taxes by recognizing investment losses to offset other gains and ordinary income. It does so by selling investments at a loss and replacing them with a highly correlated alternative investment, allowing the account to harvest losses while maintaining the portfolio’s risk and return profile. Harvested losses could be highly desirable for finance professionals, since they often have large equity holdings and, as a result, plenty of capital gains.
Replicating Wealthfront’s daily Tax-Loss Harvesting manually would be onerous in terms of time and trading fees. For finance professionals, the additional headache of getting every single pair of trades pre-approved would make the practice, for all practical purposes, undoable. But those obstacles vanish with an automated investment service like Wealthfront’s.
Automated investing makes sense for other reasons as well
Although simplifying compliance procedures is convenient, it’s not the only reason automated investment services are compelling. Finance professionals may analyze company fundamentals and pitch trade ideas for a living, but that doesn’t mean they prefer to stock-pick or play the interest rate yield curve in their long-term investment portfolio when they get home. For most working in finance, Modern Portfolio Theory and the Efficient Frontier are concepts they’ve been familiar with since their Investment Theory 101 class. Sure, some in the industry may still believe they can beat the markets in their personal accounts. But there are many more drawn to the passive strategy championed by Wealthfront CIO Dr. Burton Malkiel, author of A Random Walk Down Wall Street. Our deeply experienced investment team has developed personalized, globally-diversified portfolios of index funds that maximize net-of-fee after-tax long-term returns.
Some may argue that if you have sufficient funds and understand sophisticated investment strategies, then you should pursue alternative assets like hedge funds. However, individual investors very rarely have access to the best performing alternative assets, and as a result end up with their money stuck in mediocre, but still expensive, hedge funds.
Assuming one believes in a passive investment approach, the next question is how the strategy can by executed most efficiently. Finance jobs are known for their long hours and heavy workloads. It’s unlikely people in the industry will want to spend time at home reinvesting dividends, rebalancing portfolios or manually harvesting tax-losses. With Wealthfront, they don’t need to, because we automatically do it with software. Time is money, and being able to take a “set-it-and-forget-it” approach can be incredibly valuable. In addition, having access to an investment service that’s available 24/7 on desktop and mobile devices, and doesn’t require scheduling a call with your advisor, ought to be extremely appealing to finance professionals who spend a lot of their lives traveling for roadshows and client meetings.
A compliant and convenient choice
Given the finance industry’s unique regulatory environment, employees are limited in their ability to execute trades in their personal accounts. Automated investment services can provide a complementary service that not only helps finance professionals comply with Rule 407, but also manages their long-term investments while giving fees, taxes, and diversification all of the attention they are due.
Nothing in this blog should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront Inc. clients pursuant to a written agreement, which investors are urged to read carefully, that is available at www.wealthfront.com. All securities involve risk and may result in some loss. For more information please visit www.wealthfront.com or see our Full Disclosure. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront does not guarantee the accuracy of the information.
This blog is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.
When Wealthfront replaces investments with “similar” investments as part of the tax-loss harvesting strategy, it is a reference to investments that are expected, but are not guaranteed, to perform similarly and that might lower an investor’s tax bill while maintaining a similar expected risk and return on the investor’s portfolio. Wealthfront assumes no responsibility to any investor for the tax consequences of any transaction.
Tax loss harvesting may generate a higher number of trades due to attempts to capture losses. There is a chance that Wealthfront trading attributed to tax loss harvesting may create capital gains and wash sales and could be subject to higher transaction costs and market impacts. In addition, tax loss harvesting strategies may produce losses, which may not be offset by sufficient gains in the account and may be limited to a $3,000 deduction against income. The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any.
Wealthfront’s investment strategies, including portfolio rebalancing and tax loss harvesting, can lead to high levels of trading. High levels of trading could result in (a) bid-ask spread expense; (b) trade executions that may occur at prices beyond the bid ask spread (if quantity demanded exceeds quantity available at the bid or ask); (c) trading that may adversely move prices, such that subsequent transactions occur at worse prices; (d) trading that may disqualify some dividends from qualified dividend treatment; (e) unfulfilled orders or portfolio drift, in the event that markets are disorderly or trading halts altogether; and (f) unforeseen trading errors. The performance of the new securities purchased through the tax-loss harvesting service may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes.
Wealthfront only monitors for tax-loss harvesting for accounts within Wealthfront. The client is responsible for monitoring their and their spouse’s accounts outside of Wealthfront to ensure that transactions in the same security or a substantially similar security do not create a “wash sale.” A wash sale is the sale at a loss and purchase of the same security or substantially similar security within 30 days of each other. If a wash sale transaction occurs, the IRS may disallow or defer the loss for current tax reporting purposes. More specifically, the wash sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale, and the 30 days after the sale. The wash sale rule postpones losses on a sale, if replacement shares are bought around the same time.
The effectiveness of the tax-loss harvesting strategy to reduce the tax liability of the client will depend on the client’s entire tax and investment profile, including purchases and dispositions in a client’s (or client’s spouse’s) accounts outside of Wealthfront and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term). Except as set forth below, Wealthfront will monitor only a client’s (or client’s spouse’s) Wealthfront accounts to determine if there are unrealized losses for purposes of determining whether to harvest such losses. Transactions outside of Wealthfront accounts may affect whether a loss is successfully harvested and, if so, whether that loss is usable by the client in the most efficient manner.
A client may also request that Wealthfront monitor the client’s spouse’s accounts or their IRA accounts at Wealthfront to avoid the wash sale disallowance rule. A client may request spousal monitoring online or by calling Wealthfront at 844-995-8437. If Wealthfront is monitoring multiple accounts to avoid the wash sale disallowance rule, the first taxable account to trade a security will block the other account(s) from trading in that same security for 30 days.
About the author(s)
The Wealthfront Team believes everyone deserves access to sophisticated financial advice. The team includes Certified Financial Planners (CFPs), Chartered Financial Analysts (CFAs), a Certified Public Accountant (CPA), and individuals with Series 7 and Series 66 registrations from FINRA. Collectively, the Wealthfront Team has decades of experience helping people build secure and rewarding financial lives. View all posts by The Wealthfront Team