Introduction
Smart Beta is Wealthfront’s next evolution of US Direct Indexing, and is available to all clients with taxable account balances over $500,000. Like US Direct Indexing, it replaces the ETF normally used to represent US stocks in a Wealthfront portfolio with a combination of large and mid-capitalization US stocks and an additional ETF. However, rather than hold the individual securities in proportion to their market capitalization (as is the case with US Direct Indexing), the weights on a portion of the portfolio are shifted to increase the expected after-tax return of the portfolio.
Smart Beta takes advantage of decades of time-tested academic research on the drivers of asset returns. The underlying research — recognized with two Nobel Prizes (1990, 2013) — demonstrated that a security’s return is determined by the set of risk factors that it is exposed to, rather than its standalone risk (e.g. as measured by its volatility). Thus, by optimizing the composition of the factors to which a portfolio of stocks is exposed, its expected return can be increased while leaving volatility unchanged. Using a multi-factor methodology, Smart Beta identifies securities which are likely to have the highest risk-adjusted returns, and overweights them relative to their allocation in the cap-weighted benchmark.
By combining this portfolio construction methodology with our US Direct Indexing stock-level tax loss harvesting service, we expect the incremental gains to be delivered in a tax-efficient manner. Specifically, employing a non-cap-weighted allocation to individual securities requires periodic trading, such that some of the incremental gains could be subject to short-term tax rates. However, the availability of tax losses harvested by our stock-level tax-loss harvesting service enables the taxation of these gains to be offset, thus deferring their taxation to a future date (i.e. when the portfolio is liquidated) when a potentially lower, long-term capital gains rate will apply.
We deliver these features to eligible clients at no incremental cost to our basic service.
Relation to US Direct Indexing
In 2013 Wealthfront launched US Direct Indexing, a stock-level tax-loss harvesting service. US Direct Indexing offers two significant advantages over our ETF-level tax-loss harvesting service, which is available to all clients. First, by replacing the ETF used to gain exposure to US equity markets with individual securities, it lowers the portfolio’s expense ratio. Second, trading in individual securities enables US Direct Indexing to harvest more losses than the ETF-level harvesting service which only relies on a pair of ETFs (Vanguard’s Total Stock Market Index, VTI, and the iShares Core S&P Total US Stock Market ETF, ITOT). [1]
Like US Direct Indexing, Smart Beta trades large-cap US stocks directly rather than only trading ETFs, which enables greater potential for tax-loss harvesting due to the dispersion in stock returns. Even when the market is up, there are nearly always some stocks (or even entire industries) in the Smart Beta portfolio that are down. Because it invests directly in the individual stocks, Smart Beta can harvest losses in the ones that have lost value, even when the market as a whole has gained.
Unlike Smart Beta, the individual stock component of the US Direct Indexing portfolio tracks a market capitalization-weighted benchmark. In other words, it seeks to deliver a return matching that of a broad US equity index, while maximizing the quantity of harvested losses. Smart Beta balances two objectives: (a) delivering additional return above the cap-weighted benchmark by relying on a multi-factor portfolio construction methodology; and, (b) maximizing the quantity of harvested tax losses. For the non-US Stocks portion of the portfolio (such as Foreign Stocks, Emerging Markets, etc. listed in the chart below), there is no change to the ETFs held. For those ETFs, all Smart Beta accounts also benefit from our Tax-Loss Harvesting service, which harvests tax savings at the ETF level outside the US stock component of the portfolio.
Costs and Minimums
For taxable accounts larger than $500,000, we offer to replace the ETF normally used to represent a broad market of US stocks (Vanguard’s Total Stock Market ETF, VTI) with stocks from the CRSP US Large-Cap Index (which contains around 600 of the largest capitalization US stocks) and the Vanguard Small-Cap ETF (VB) to represent the remaining smaller capitalization companies. By replacing VTI with a combination of individual securities and a completion ETF, you will pay a lower overall expense ratio than you would for VTI.
Around 85% of the Smart Beta position is composed of individual stocks and thus has no expense ratio. The remaining 15% or so is composed of the Vanguard Small-Cap ETF (VB). The combined portfolio remains subject to Wealthfront’s advisory fee.
Our minimums for Smart Beta are based on dollar amounts required to hold a reasonable collection of individual US stocks while continuing to track the performance of the broad US market. We found that holding hundreds of stocks requires a US equity allocation of roughly $150,000 – thus necessitating an account minimum of about $500,000 (because on average approximately 30% of our recommended portfolios are allocated to US Equities).
Investment Returns and Factors
The expected return on an asset can be decomposed into compensation for the passage of time, and compensation for exposure to common, non-diversifiable sources of risk (i.e. “factors”). The compensation for passage of time is captured by the risk-free rate, which measures the opportunity cost of parting with your money, and can be proxied by rates of return on US Treasuries. The compensation for bearing risk is captured by the product of a security’s exposure to a factor (measured by its beta) and the premium for bearing that risk. “Active” managers seek to identify deviations from this relationship, but decades of research show that they fail to outperform their properly risk-matched benchmarks. This is illustrated by SPIVA’s report that compares active managed funds compared to their index benchmarks.
The earliest model of security returns was the Capital Asset Pricing Model (CAPM), proposed independently by Treynor (1961), Sharpe (1964), Mossin (1965), and Lintner (1966), and recognized with the Nobel Prize in 1990. The CAPM is known as a single-factor model, where the only source of compensated risk (the “factor”) is a security’s exposure to the broad equity market. In other words, the single predictor of a security’s future expected return is how much or little it moves relative to the aggregate equity market.
Over time, researchers identified several deficiencies with the CAPM. For example, Banz (1980) showed that small firm common stocks (as measured by their market capitalization) have a tendency to outperform large firm common stocks, and this return differential cannot be explained by differences in their market betas. A decade later, a sequence of influential papers by Professors Eugene Fama and Kenneth French documented an even more significant shortcoming of the CAPM: the “value effect.” Specifically, cheap stocks (firms with a high ratio of book equity to market equity) on average outperformed expensive stocks (firms with a low ratio of book equity to market equity), even though their market betas were lower. These findings led them to extend the single-factor CAPM model to include a value factor (measured by book equity to market equity ratio) and a size factor (measured by market capitalization). The Fama-French three-factor model (1992, 1993) was an early multi-factor model, and has become an important benchmark in academic work. Around the same time, Jegadeesh and Titman (1993) identified a “momentum effect,” or the tendency for securities that have been the best (or worst) performers over the last six to 12 months to continue to be best (or worst) performers. This effect could not be rationalized by Fama and French’s three-factor model, leading researchers to include momentum as an additional, fourth factor. In 2015, Fama and French expanded the original three-factor model to a five-factor model, as they discovered that companies with strong operating profitability outperform the ones with weak profitability and companies with conservative level of investments (stable total assets) outperform the ones with aggressive level of investments. The five-factor model includes a profitability factor (measured by revenue minus costs of goods sold, interest expense, selling, general, and administrative expenses, divided by book equity) and what they call an investment factor (measured by change of total assets on the company’s balance sheet). Professor Kenneth French tabulates the historical performance of these factors on his website.
Over the past few decades, academia and industry alike embarked on a search for additional characteristics (factors) that can be used to sort stocks in a manner that produces a return spread that cannot be accounted for by exposure to the market, size, value, and momentum factors. Out of the hundreds of characteristics that have been considered, some findings disappeared following publication and others were shown to be concentrated in areas of capital markets where they cannot be reliably incorporated in portfolios at scale (e.g. among stocks with small capitalizations or where it is difficult to short). However, a small subset has proven to be robust across time, across geographies (i.e. work reliably outside of the United States), and — in some instances — across asset classes.
Methodology
Smart Beta blends five single-factor strategies (momentum, high profitability, high dividend yield, low market beta, and low volatility) with the cap-weighted market index to generate a modified index. This index then serves as the benchmark for our direct indexing service, which seeks to maximize the quantity of harvested losses while minimizing the tracking error from the supplied benchmark.
Single-Factor Strategies
Our portfolio construction procedure begins by constructing single-factor strategies. Each of these strategies ranks securities based on a single characteristic, and then invests in a subset of securities based on this characteristic (e.g. momentum, high profitability etc.). The resulting portfolio can be interpreted as a simple single-factor strategy and its composition is periodically refreshed. Our strategy is implemented using around 600 stocks in the CRSP (Center for Research in Security Prices) US Large Cap Index, which represents approximately 85% of the market cap associated with the US equity market. The CRSP index was launched in 2011 and our Smart Beta strategy was launched in 2017. We will present Smart Beta strategy’s actual performances from 2017 in later sections. For the backtest portion prior to the CRSP US Large Cap index launch in 2011, we approximate the index by using stocks in the top 85% market capitalization of the US equity market, consistent with the broad definition of the index. Factor portfolio and index returns are presented gross of fees.
Table 1 displays the backtested returns for each of the five single-factor strategies from 1965 to 2016, matching the span of data available from CRSP. We report the annualized (arithmetic) mean return, volatility, and Sharpe Ratio (computed as factor return minus the one-month Treasury Bill return, divided by volatility. This measures the risk-adjusted return). We observe that on average all factors outperformed the index and have higher Sharpe Ratios – in other words, a better risk-adjusted return.
There are substantial benefits to be gained from factor diversification. To illustrate this, Table 2 displays the correlation matrix of the return differentials of each factor relative to the cap-weighted index. The factors exhibit low (and sometimes negative) correlations, such that different factors are likely to contribute incremental returns at different points in time. A second benefit of the low factor correlations is that ranking securities on different characteristics will generally point to different securities, resulting in a well-diversified portfolio once the single-factor strategies are combined. Smart Beta exploits this feature by combining the five single-factor strategies.
Constructing the Modified Index
After constructing the single-factor strategies, we combine them to produce a multi-factor “overlay” portfolio, which includes securities with strong momentum, high profitability, high dividend yield, low market beta, and low volatility. These factors are equally weighted in the portfolio. This overlay portfolio is blended at a ratio of 30% overlay and 70% cap-weighted index to produce a modified index, which serves as the benchmark relative to which the direct indexing service will seek to minimize tracking error. The goal of this construction is to overweight securities with high expected returns, while ensuring the modified index remains close to the cap-weighted benchmark, thus keeping overall portfolio risk unchanged.
Table 3 follows the format of Table 1, but compares the performance of the cap-weighted benchmark and the modified index. As before, the underlying data span the period from 1965 to 2016. Over this period the modified index outperformed the cap-weighted index by 0.86% per year before taxes. These results were accomplished while maintaining portfolio volatilities that were no greater than the volatilities of the cap-weighted indexes. As a result, the Sharpe Ratios of the modified indexes are 20% greater, indicating an improvement in the risk-adjusted return from deploying the multi-factor overlay.
To provide more detail on their relative performance, Figure 1 below displays the annualized return differential between the modified and capitalization-weighted indexes over three-year rolling windows. Positive (or negative) values indicate that the modified index has outperformed (or underperformed) the cap-weighted benchmark. Although the modified index outperformed in over three quarters of the three-year periods, it is important to note that there have been three-year periods in which the annual underperformance equaled almost 2% per year.
Combining the Modified Index with US Direct Indexing
Smart Beta combines the multi-factor overlay described in the previous section with Wealthfront’s direct indexing service to deliver portfolio gains tax-efficiently. Since the overlay requires periodic rebalancing, a portion of the gains that it generates will be from securities held less than one year, and therefore “short-term” in nature for tax purposes. These gains would typically be subject to the relatively higher tax rates applicable to short-term capital gains. However, by offsetting these gains with harvested tax losses, it is possible to defer their taxation into the distant future and pay the lower long term capital gains rate. We implement this by using the modified index as the benchmark for the direct indexing service, which seeks to balance tracking error from the modified index with the quantity of harvested losses. We refer the reader to the US Direct Indexing white paper for additional details on how this works, the underlying optimization objective, as well as assumptions used to derive estimated potential tax benefit.
Realized Results: Pre-Tax Returns
This section compares the actual performance of our Smart Beta strategy[2] to Smart Beta mutual funds and ETFs and explores the underlying factors that drive differences in performance. The analysis runs from July 1, 2017 (the launch date of our service) to December 31, 2023. Note that we replaced the value factor with the profitability factor and updated the stock universe from the largest 500 stocks to the entire CRSP US large-cap index (approximately 600 stocks) in January 2022. All returns shown in this section are annualized.
To calculate returns for our Smart Beta strategy, we calculate the return for each client enrolled in Wealthfront Smart Beta strategy for each trading day and compute a value-weighted average. We then compound the daily returns to derive an annualized total return over the comparison window. As a benchmark, we display the total return of VTI, the ETF used to represent US Stocks in Wealthfront’s ETF-only portfolios.
Table 4 shows returns of VTI and the Smart Beta strategy. Both reflect Wealthfront’s 0.25% advisory fee. In 2023, the total return of Smart Beta lagged VTI by 5.6%, which brought Smart Beta’s 5-year and Since Inception returns below VTI’s as well, with Smart Beta underperforming by 0.75% annually over the 5-year period and 0.63% annually since inception. Over the past three years, however, Smart Beta outperformed VTI by 0.18% annually.
Next, we compare the returns of Wealthfront’s Smart Beta strategy to several smart beta mutual funds and ETFs since the launch of Smart Beta in July 2017. All the funds included in the comparison invest in diversified portfolios across all sectors of US stocks and, like Wealthfront’s Smart Beta strategy, employ a “multi-factor” approach. The funds differ in the selection of factors used, as well as the exact universe of stocks included in the portfolios. Some salient characteristics of the funds used in the comparison are displayed in Table 5. Besides the visible differences, there are a number of decisions in portfolio construction which can drive differences in returns – these include (potentially time-varying) factor weightings, choices of underlying descriptors to construct factor scores, trading frequency, and portfolio constraints [3]. Note that we include two funds managed by Dimensional Fund Advisors – both funds invest in the same universe and use the same set of factors, but the US Core Equity 2 fund takes more tracking error than US Core Equity 1, with the intent of achieving higher returns above the benchmark.
Figure 2 shows the total return of each fund, in addition to the total returns of Wealthfront Smart Beta and two index ETFs: VTI, which tracks the CRSP US Total Market Index, and VOO, which tracks the S&P 500. We include both VTI and VOO as comparisons because the funds we selected to compare trade over different universes, and we don’t want to misrepresent a choice of universe as underperformance – for example, the S&P 500 outperformed the Russell 1000 over this time period, but we would not say that a fund designed to track the Russell 1000 underperformed because it returned less than the S&P 500. Since its launch, Wealthfront Smart Beta returned 11.71%. This does not reflect Wealthfront’s 0.25% advisory fee, which includes the management of assets in other asset classes, or the benefit of our tax-loss harvesting service. If this fee was deducted, the performance of Wealthfront Smart Beta would be 11.46%. The returns of the other funds are net of the funds’ respective management fees, but also do not deduct any additional advisory fee. According to AdvisoryHQ [5], the average AUM-based advisory fee in 2023 was 1.02% for a $1 million account.
Of the six smart-beta funds in our study, only GSLC outperformed the VTI index fund. The others underperformed to varying degrees, with QCELX and LRGF lagging VTI by more than 2% annually. All funds underperformed VOO, including GSLC, which underperformed by 0.3%.
Our intent is to show that the performance of Wealthfront’s Smart Beta portfolios relative to index funds during this period was not abnormal. We do, however, point out that Wealthfront’s Smart Beta strategy is available at no extra cost beyond the Wealthfront advisory fee, unlike funds in the study, which all have higher expense ratios than both VOO and VTI and don’t offer tax-loss harvesting, which can add significant after-tax value.
All of the returns in Figure 2 are pre-tax. In our research, we find that Wealthfront’s stock-level tax-loss harvesting service, which is automatically included at no extra fee in Smart Beta portfolios, in some instances may harvest enough losses to create an average annual tax benefit of over 2% of the account value. On an after-tax basis, Wealthfront Smart Beta may have relatively better performance due to tax benefits than an index (for example, the S&P 500) or a fund that does not include tax-loss harvesting. Detailed tax-loss harvesting results are in the next section “Realized Results: Tax-Loss Harvesting”.
Analyzing Smart Beta’s Performance
Finally, we examine the performance of the individual factors used in Wealthfront Smart Beta, to indicate which factors contributed to or detracted from the performance of Smart Beta. Consistent with other analysis in this section, we calculate daily returns from July 1, 2017, to December 31, 2023.
As described in previous sections, each factor portfolio is an equally weighted basket of stocks. The baskets are defined by ranking around 500 of the largest US stocks by a certain characteristic, and choosing subsets of the highest-ranked stocks. The baskets are refreshed approximately monthly as we obtain new market data.
Figure 3 shows detail on the returns of each factor portfolio for each year (partial years where applicable) since the launch of Smart Beta. Specifically, each bar shows the total return of a factor portfolio in excess of the VOO ETF. A positive value indicates that the factor outperformed VOO, while a negative value indicates underperformance.
Through the end of 2020, most factors underperformed VOO. Until 2020, the magnitudes were generally small. In 2020, the Low Beta, Dividend Yield, Value, and Low Volatility factors all lagged VOO significantly. During the onset of the COVID-19 pandemic, the Value and Dividend Yield factors dropped faster than the market, as interest rates fell and investors began to favor growth over value. Through the end of March 2020, Value was the largest driver of underperformance of Wealthfront’s Smart Beta. As the market recovered after March, Value and Dividend Yield actually outpaced VOO, but not enough to overcome their earlier underperformance. For Low Beta and Low Volatility, underperformance mostly came as the market rallied. This isn’t surprising; low beta stocks by definition have a lower sensitivity to the overall market than the average stock.
Value and Dividend Yield continued their turnarounds in 2021 and 2022—as inflation grew and interest rate hikes appeared imminent, investors began to favor value over growth and momentum. In 2022, the Low Beta and Low Volatility factors began to outperform as the market entered a correction. In 2022, the Wealthfront Smart Beta strategy outperformed its benchmark by 4.71%. From inception through the end of 2022, the Smart Beta strategy outperformed its benchmark by 0.18% annually.
In 2023, the market recovered from the 2022 correction. However, factor returns uniformly lagged VOO. This is because VOO’s 2023 recovery was mostly driven by the tech sector, and in particular a group of seven stocks (Microsoft, Google, Apple, Meta, Amazon, Nvidia, and Tesla) named the “Magnificent Seven” by a Bank of America analyst. Due to the characteristics of technology stocks, they are often not included in the Smart Beta factor portfolios over time. Technology stocks are believed to be high beta, high volatility, and low-yielding, and are thus less likely to be included in our Low Beta, Low Volatility, and High Dividend factors. Tech companies also generally focus on growth over strong profitability, and so often aren’t included in the profitability factor portfolio. Finally, tech stocks were among the worst performers in 2022, and were therefore less likely to be included in the high momentum factor (which is constructed using performance over the trailing year) in 2023. In fact, none of the “Magnificent Seven” appeared in any of the Smart Beta factor portfolios in 2023. However, we believe this was a unique characteristic of the 2023 market rather than a long-term phenomenon and we continue to believe in the long-term performance of these factors.
Figure 4 shows the total return of each factor portfolio over the full comparison period, along with the total return of the S&P 500. We observe that all factors underperformed the S&P 500, with the Low Beta factor having the most significant underperformance, most of which occurred in 2020 and 2023 as explained above. The Wealthfront Smart Beta strategy underperformed less than the average of the single-factor portfolios because the modified index only has 30% of its weight given to the overlay portfolio (which is an equal-weighted average of the five single-factor portfolios). We note that the factor performance numbers don’t correspond to returns of any traded portfolios, and do not reflect any costs of trading. Their purpose is only to help explain the performance of Wealthfront Smart Beta at a more granular level.
We initially launched the Smart Beta strategy with a value factor (book-to-price ratio) based on the Fama French three-factor model, hence it is shown in the list of factor portfolios above. We removed the value factor in December 2021 (see blog post for details) and replaced it with the profitability factor from the new Fama French five-factor model.
We see results consistent with our factor performance in the returns of “single-factor” funds from other managers. iShares, Fidelity, and Invesco each offer a suite of ETFs containing funds designed to capture one single factor. With the exception of Invesco and the Dividend Yield factor, every manager offers funds providing exposure to each of the five factors listed. Table 6 shows the annualized returns of each manager’s offerings, along with the returns of Wealthfront’s factor portfolios over the same time period. The returns of other managers’ funds are net of expense ratios, while the Wealthfront returns do not include a fee – as noted above, they don’t correspond to the returns of any portfolios managed by Wealthfront.
All factors across managers lagged the S&P 500 return. Notice that even for the same factor, there can be significant dispersion in the returns across the providers of the funds. For example the returns of “value” funds range from 7.9% to 11.6%, and the returns of “low volatility” funds range from 7.6% to 12.2%. Every manager has its own definition of each factor, another contributor to the dispersion in fund returns shown in Figure 2.
Realized Results: Tax-Loss Harvesting
In this section, we compare the tax-loss harvesting results achieved in client accounts using Smart Beta to those in accounts using ETFs for exposure to US Stocks. Remember that investing in hundreds of individual stocks rather than index-tracking ETFs gives Smart Beta more opportunities to harvest losses, and the potential to save clients more money on taxes, when compared to harvesting losses using ETFs. Because US Stocks is the only asset class in which Smart Beta strategy is implemented, we will only compare the tax-loss harvesting results within the US Stocks portion of clients’ portfolios. We measure the rate of tax-loss harvesting using Harvesting Yield, the magnitude of losses harvested as a fraction of the portfolio value:
Harvesting Yield = Total Losses Harvested / Total Balance
As with the portfolio return, Harvesting Yield is calculated daily and aggregated over longer time periods. It represents an aggregation of client results, and not the results of any individual account.
For comparison purposes, we’ll compute Harvesting Yield for both Smart Beta Strategy clients and for clients using our ETF-only Tax-Loss Harvesting service from the launch of Smart Beta in July 2017 through the end of 2023. The Harvesting Yield for the Smart Beta strategy includes losses harvested in both the individual stocks and the ETFs used to implement the strategy, while the Harvesting Yield for the ETF-only portfolios includes the losses harvested in the primary and alternate ETFs used to represent the US Stocks asset class.
Table 7 shows the annual Harvesting Yields achieved by both Smart Beta and our ETF-level TLH service since July 2017. In all years except 2022, Smart Beta produced a higher Harvesting Yield than the ETF-level Tax-Loss Harvesting service. The annualized difference between the Harvesting Yields of the two strategies over the full period was 1.30% in favor of Smart Beta.
As an additional check, we can control for client tenure by measuring the Harvesting Yield of client cohorts, grouped by the year they first enrolled in either version of our Tax-Loss Harvesting service. Client tenure affects Harvesting Yield as well. Over time, asset prices tend to rise and without new deposits, it becomes harder to find harvesting opportunities. Table 8 shows the Harvesting Yield by client cohort enrolled from 2017 to 2023. The Smart Beta Strategy provided a higher Harvesting Yield than the ETF-only Tax-Loss harvesting service for every cohort.
Table 10 shows annualized Harvesting Yields by client cohort for the trailing one and five year periods to complement the since-inception yields in Table 9. This data shows a similar pattern, with the Harvesting Yield of Smart Beta accounts higher than those of ETF-level accounts, with the exception of the very recent cohorts over the last year.
To understand more about why Smart Beta produced a lower Harvesting Yield compared to the ETF-only version in 2022, let’s first consider two examples. Suppose the market index consists of two equally-weighted stocks, A and B. The Smart Beta Strategy holds the stocks at 50/50, consistent with the index. If both stocks drop 10%, the Smart Beta strategy can at most sell one stock completely and buy the other stock. The Harvesting Yield will be 5% (50% weight multiplied by a 10% loss). However, a portfolio holding an ETF tracking the index could sell that ETF and buy a similar one as a replacement, providing a 10% Harvesting Yield. Thus, when most of the stocks in the market are declining, ETF-only Tax-Loss Harvesting is at an advantage. For other market conditions, Smart Beta Strategy’s Stock-Level Tax-Loss Harvesting can have more harvesting opportunities. For example, if stock A is up 10% and stock B is down 10%, the index value does not change and there is no ETF-level tax-loss harvesting opportunity. However, the Smart Beta Strategy can potentially harvest up to 5% by selling B and buying A.
Periods where Smart Beta Strategy’s Harvesting Yield lagged were similar to the first example described above. Let’s look at the Harvesting Yield from January 2022 through December 2023. Figure 4 shows the cumulative price return of SPY along with the cumulative Harvesting Yield difference, which we calculated by subtracting the cumulative ETF-level Harvesting Yield from the cumulative Smart Beta Harvesting Yield.
We can see the annual Smart Beta Harvesting Yield was greater than the US Stocks ETF-level Harvesting Yield until June 2022, when the market had a sharp decline. In the first half of June 2022, the market declined more than 11%, reaching its low point on June 16. The difference in Harvesting Yield also dropped sharply and the ETF-level Harvesting Yield overtook Smart Beta’s. In September 2022, the market experienced another large correction, losing more than 9% for the month and around 25% since the beginning of the year. In September, the ETF-level Harvesting Yield was again higher than Smart Beta’s. Then, as the market started to recover from October 2022, Smart Beta’s Harvesting Yield closed the gap and eventually surpassed the ETF-level Harvesting Yield at the end of May 2023.
Lastly, Harvesting Yield is only a measure of the amount of losses harvested, not of their value. To assess the true economic benefit, we need to multiply the Harvesting Yield by an appropriate tax rate. Since nearly all of the losses harvested by either service are short-term, we should apply the ordinary income tax rate to the Harvesting Yield to measure the economic value. Marginal income tax rates vary by state and income. For clients enrolled in the Smart Beta strategy, estimated marginal income tax rates (federal and state combined) mostly fall between 24% and 46% [6] as of December 2023. If we apply these rates to the 1.30% improvement in Harvesting Yield between Smart Beta Strategy and ETF-level Tax-Loss Harvesting, we get an after-tax return improvement between 0.31% and 0.60% on the US Stocks portion of your portfolio. Amazingly, the Smart Beta service is available at no extra cost above our standard advisory fee of 0.25%.
Conclusion
Wealthfront Smart Beta provides clients with taxable accounts in excess of $500,000 access to a tax-efficient multi-factor investing strategy at no incremental cost. Unlike single-factor smart beta ETFs available from other managers, the Wealthfront Smart Beta strategy relies on multiple factors when selecting which securities to overweight. This ensures the portfolio remains highly diversified, and minimizes the chances of underperforming the cap-weighted index. Moreover, by harvesting losses at the stock level, clients can defer the taxation of the incremental gains relative to the cap-weighted index until portfolio liquidation. All this, at no incremental cost to our standard advisory fee.
Over the period where we have actual results, Smart Beta accounts have, on average, underperformed a relevant index fund on a pre-tax basis. This is not unique to Wealthfront—five of the six multi-factor funds we evaluated also underperformed index funds over the same period. Despite the recent performance, we continue to believe that a diversified multi-factor approach, delivered at a reasonable price, can add returns tax-efficiently over an index over the long term. Additionally, Smart Beta may provide higher Harvesting Yield and tax benefits than ETF-level Tax-Loss Harvesting, at no extra cost.
Disclosure
Nothing in this whitepaper 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 available at www.wealthfront.com, which investors are urged to read carefully. All securities involve risk and may result in losses. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront does not guarantee the accuracy of the information. For more information please visit www.wealthfront.com or see our Full Disclosure.
[1] Intuitively, even though an asset class as a whole may be appreciating, thus offering few opportunities for harvesting at the asset class level, there will almost always be some securities within the asset classes that have declined in value, and can be used to harvest losses. As a result, US Direct Indexing is able to magnify the quantity of harvested losses, delivering more potential Harvesting Yield to clients, while lowering the expense ratio of the portfolio.
[2] Wealthfront Smart Beta is a strategy available to Wealthfront clients whose account balances meet a qualifying minimum value. Wealthfront Smart Beta is not available as a mutual fund or ETF.
[3] As an example, the annualized returns of the S&P 500, Russell 1000, and Russell 3000 – three cap-weighted indices of US Stocks – over our analysis period were 12.92%, 12.60% and 12.20% respectively.
[4] The following mutual funds and ETFs were used as sources in our study: Dimensional US Core Equity 1; Dimensional US Core Equity 2; AQR Large Cap Multi-Style Fund; iShares MSCI USA Multifactor ETF; Goldman Sachs ActiveBeta US Large Cap Equity ETF; JP Morgan Diversified Return US Equity ETF
[5] Advisory HQ | Average Financial Advisor Fee in 2023
[6] We estimate each client’s federal and state marginal income tax rate based on their self-reported annual income, state of residence and marital status as of December 2023. By “mostly”, we mean the range between the 10th and 90th percentile of the combined federal and state tax rates among Smart Beta clients.
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.
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 circ*mstances. 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). 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.
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 impact. 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 ordinary income and distributions.
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 for “wash sales.” 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. 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.
Investment management and advisory services–which are not FDIC insured–are provided by Wealthfront Advisers LLC (“Wealthfront Advisers”), an SEC-registered investment adviser, and financial planning tools are provided by Wealthfront Software LLC (“Wealthfront”). Brokerage products and services are offered by Wealthfront Brokerage LLC (formerly known as Wealthfront Brokerage Corporation), member FINRA / SIPC. All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. Please see our Full Disclosure for important details.
Wealthfront Advisers, Wealthfront Brokerage and Wealthfront are wholly owned subsidiaries of Wealthfront Corporation.
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