🍋 How To Level Up Your Index Investing

The Direct Indexing Era

In this weekend’s edition of Short Squeez, we’ll be doing a deep-dive on one of the hottest fintech companies at the forefront of offering investors an innovative approach called direct indexing that can improve your portfolio performance.

Frec enables you to track S&P indices with the added advantage of significant tax savings and customizations like excluding certain stocks or sectors.

The Move from Active to Passive Investing

Over the last decade, we've seen a big shift in how people invest. More and more, investors are choosing passive strategies over active ones. 

To put it in perspective, back in 2012, active funds held 20% of Wall Street stocks and passive ones just 8%. But by 2021, passive funds had taken the lead with 16% compared to active funds 14% share. This change isn't surprising, considering transaction fees have dropped to zero and the stock market has become more accessible. 

Plus, with the S&P 500's strong history of 10.56% returns per year, it's clear why many prefer parking their money in index funds.

With the rise of passive strategies is there still potential for enhanced performance without significantly increasing risk?

The short answer is yes. 

But not through levering up or hand-picking stocks like Nvidia. 

The answer lies in refining how one invests in index funds, specifically through two closely related concepts: 1) Tax-loss harvesting through 2) Direct indexing.

1) Tax-Loss Harvesting

Tax-loss harvesting is a strategy that involves selling stocks at a loss to offset a capital gains tax liability. 

For example if you face a $50,000 capital gain in a given year but have a $10,000 loss in part of your portfolio, selling the loss-bearing asset reduces your taxable capital gain to $40,000, thus lowering your tax bill. 

This principle isn't confined to stocks alone—it's applicable to any capital gains scenario, such as selling real estate. Moreover, if your losses exceed your gains in a year, you can carry over this loss to offset future gains or even reduce up to $3,000 of your regular income annually.

2) Direct Indexing

Direct indexing elevates the concept of tax-loss harvesting by allowing investors to hold individual stocks from an index, such as the S&P 500, directly in their portfolios.

In the past, the administrative and financial hurdles of direct indexing were daunting, not to mention obscenely expensive.

Today, technological advancements have democratized access to this strategy. 

The main benefit to direct indexing is that compared to ETF-level tax loss harvesting, it can double (and in some instances, triple) your tax loss harvesting yield, because an index’s underlying stocks offer more opportunities for tax loss harvesting than the index itself. 

Even as the S&P 500 might see an overall increase throughout the year, the fluctuating performance of its individual stocks provides continuous chances for tax-loss harvesting, independent of the overall index's growth.

Frec's direct indexing service, which comes with low fees, offers a substantial edge for achieving better performance.

In comparison, the ETF-to-ETF harvesting methods used by robo-advisors and other investment platforms fall short in effectiveness and cost-efficiency relative to Frec's direct indexing, capturing only a fraction of the potential tax-loss opportunities at much higher fees.

Frec allows anyone to start with direct indexing at an entry point of $20,000, a significant reduction from the typical $100,000+ minimum required by many wealth advisors, with an advisory fee of just 0.1% annually (on par with most ETF fees).

How Does It All Come Together?

With direct indexing, Frec strategically sells off individual stocks from the index and invests in other stocks with similar profiles for 30 days to ensure your portfolio closely mirrors the index. 

For example, if Amazon's stock experienced a 10% drop following disappointing earnings, Frec's strategy would involve selling Amazon's stock and reallocating that capital back into other holdings to track the index until the period for a wash sale is over.

You can see effects of direct indexing in your portfolio dashboard:

The final outcome? Based on backtesting with hypothetical data over a decade, investors could see 40% of their initial investment harvested in losses over a ten-year time frame with a minimal tracking error of only 0.5% to 1% annually when compared to the S&P 500 benchmark.

Performance data from Frec backtests

The above graph shows simulations conducted with Frec's direct index model tracking the S&P 500 index, including Frec's 0.10% annual fee. The simulations are shown as the RI (reinvestment) and No RI (no reinvestment) lines. The RI line assumes a 42.3% tax rate. They are hypothetical, do not reflect actual investment results, and are not a guarantee of future results. Actual results will vary. The SPY line reflects historical performance of the SPY ETF. The time frame considered is between 12/17/2003 and 12/14/2013, utilizing ninety-day increments over ten-year time periods and tax loss harvesting weekly with a one-time $50,000 initial deposit.

Additionally, you have the option to add or exclude particular stocks, or exclude sectors from your portfolio; for example, if you anticipate the real estate sector underperforming due to rate cuts, you can remove it from your customized version of the S&P 500.

If you’d like to learn more Frec’s Investing platform, check out their website here.

Frec is based in San Francisco and is backed by Greylock and Social Leverage.

This deep-dive is brought to you in partnership with Frec.