Sunday Deep Dive: The Frec Edition

Happy Sunday, and welcome back to another Sunday Deep Dive. In the past, we have used our Sunday Deep Dives to discuss the histories and business models of interesting startups, but today’s piece, sponsored by Frec, will be a bit different. Instead of a full business breakdown, we want to discuss a market opportunity that Frec is addressing: direct indexing in a market that is increasingly dominated by passive investors.

Before we begin, you can click here to check out Frec, one of the first direct-to-consumer platforms that enables customers to track S&P indices – delivering the benefits of index investing, with added tax savings and customization.

Let’s dive in.

The most important trend in public markets right now is the shift in investor preferences from active to passive management. In 2012, active funds held 20% of US stocks as measured by market cap, while passive funds were responsible for 8%. By 2022, passive funds had overtaken active funds as a percentage of the total US stock market, at 16% and 14% of total US stock market cap respectively.

It shouldn’t be a surprise that passive investing has grown so popular. Transaction fees have dropped from several dollars per trade to $0 over the last decade, making the stock market widely available to all investors. Meanwhile, the S&P 500 has averaged 10% returns per year over the last century. Considering that most professionals underperform the S&P 500 benchmark, why wouldn’t the average investor park their money in an index fund? And millions have done just that.

The rise of index funds does, however, raise an important question: is there room for any level of improved performance in a market dominated by passive investments? The answer is yes, but the source of improvement isn’t stock picking or leverage. In fact, you don’t have to change your asset allocation at all. Passive investors can improve their portfolio performance by investing in index funds more efficiently through tax-loss harvesting and direct indexing.

More on these below:

Tax-Loss Harvesting

Tax-loss harvesting refers to the act of selling a stock to lock-in a loss, which lowers your taxable income for a particular year.

Imagine, for example, that you booked $60,000 in capital gains in 2023, but one position still in your portfolio was down $15,000. If you held that position, you would be taxed on $60,000 of capital gains, but by selling that position before the end of the year, your net capital gains would be $45,000, reducing your final tax bill. These benefits aren’t exclusive to stock portfolios, either. Those tax loss benefits can offset any capital gains, such as gains from selling your house. And, most importantly, if your capital losses in one year outpace your capital gains, those losses carry forward for life.

If, for example, you booked a $15,000 loss in 2023 with no corresponding gains, and you booked a $20,000 capital gain in 2024, you could carry that loss forward and only be responsible for paying taxes on the net $5,000 gain in 2024. You can also reduce your non-capital gains income by up to $3,000 per year through capital losses.

If it’s not already obvious, tax-loss harvesting is an incredibly effective strategy for minimizing your tax liability.

A century ago, some traders gamed the system through wash sales, where they would “sell” a losing position one afternoon before immediately buying it back the next morning, to lock-in losses without materially changing their portfolios. The US government has since implemented a wash sale rule that prevents traders from using wash sale “losses” as tax deductions, and investors now have to wait 30 days to repurchase the security if they want the tax benefits.

ETF-level tax-loss harvesting, where asset managers sell index funds that have declined, purchase similar funds, and then swap them back for the original fund once the wash sale period has ended, is currently offered by robo-advisors.

They have, however, three issues:

1. Limited opportunities to tax loss harvest in bull markets due to correlated ETFs all appreciating simultaneously

2. Risk of not getting back into your original ETF

3. Fees (up to 0.25%) on top of ETF expenses

The first point illustrates the need for direct indexing.

Direct Indexing

As the name suggests, direct indexing involves replicating an index with one’s own portfolio. To direct index the S&P 500, for example, you would buy the index’s underlying components. Historically this was a tedious and expensive effort, as it could take hundreds of trades and hundreds of transaction fees to maintain the appropriate weighting, with accompanying minimums in the hundreds of thousands. Thanks to recent technological developments, asset managers can now more readily offer direct indexing to clients.

The primary 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. While the S&P 500 may continue to appreciate all year, underlying stocks will periodically fall, introducing opportunities to harvest an index’s components regardless of the index’s performance.

Low-fee direct indexing creates a massive opportunity for outperformance, and that’s exactly what Frec aims to provide.

ETF-to-ETF harvesting offered by robo-advisors and other investing platforms is less effective and more expensive than the direct indexing solution offered by Frec, as you’re harvesting between ½ and ⅓ of the tax-loss opportunities for 2-4x the fees. On Frec, anyone gets started direct indexing with $20,000 (down from $100,000+ at most wealth advisors), and the advisory fee is only 0.1% per year.

A bit about how their platform works:

Through direct indexing, Frec sells individual stocks within the index and reinvests in similar, highly-correlated stocks for 30 days to maximize your portfolio’s tracking accuracy. Imagine, for example, that Delta’s stock fell 10% on a poor earnings report. Frec’s Direct Indexing would sell Delta and reallocate that capital in a bucket of stocks highly correlated to Delta until the wash sale window had passed.

The final result? Over a 10-year period, backtesting hypothetical data showed that investors harvested 45% of their initial deposit when reinvesting their losses over time, and the tracking error when compared to the S&P 500 benchmark was only 0.5% to 1% per year.

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.

So why are we telling you about this? Because direct indexing isn’t a blip. If anything, it’s accelerating. In financial markets, the adoption curve works something like this:

A new breakthrough emerges, but it’s expensive. High networth individuals can tap into it, but everyone’s left out. Then a low-cost provider enters the market, forcing the other players to adapt their models. We saw it when Vanguard first introduced low-fee index funds, and we saw it when early online brokerages like E-Trade (and later, Robinhood) reduced trading fees to zero. The total AUM of direct indexing strategies is expected to grow at a 12.3% CAGR from $462M in 2022 to $825B in 2026, so I think it’s safe to say direct indexing will only grow more relevant.

If you want to learn more about Frec Direct Indexing, you can check out their site below. Thanks for reading!

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