Are Robo Advisors Worth It Even With Tax Loss Harvesting and Direct Indexing?
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 529. It's titled, Are Robo-Advisors Worth It? Recently, I received an email from a member of our membership community, Money for the Rest of Us Plus. She was curious about my thoughts on robo-advisor platforms.

She has invested with Betterment in her HSA account and has a brokerage account with Wealthfront. She's read some reports that these robo-advisors that offer tax loss harvesting, which I'll explain in a minute, that that's more of a marketing gimmick and doesn't really add a lot of value. And then there was a concern that, well, their fees are so low and they're not profitable and potentially

And potentially, they'll have to raise fees in the future. So in this episode, we're going to take a look at robo-advisors. We'll look at tax loss harvesting, the potential benefits of that, and an element of tax loss harvesting called direct indexing.

First, a robo-advisor, it's an account. They started just over a decade ago. Maybe it's been 15 years now, but they have low account minimums, often zero. You go through a process of answering questions to determine your risk profile, and it's all automated. So there's no individual that you're working with. It's all done online.

Once the RoboAdvisor platform determines your risk profile, your portfolio objectives, it selects an asset allocation and chooses the underlying investments, which are primarily exchange-traded funds. The RoboAdvisor will rebalance your portfolio and it may offer tax loss harvesting.

Tax-loss harvesting is a strategy where investments that have dropped in value are sold to realize a capital loss, which can then oscillate

offset capital gains, reducing one's taxable income. Once that asset is sold, it is typically invested in a similar type asset. It could be an ETF, or if it's a strategy that is selling individual stocks, it could invest in a stock that has same industry or same characteristics.

In the U.S., there's something called the wash sale rule, and it says that you can't claim a loss when selling a security if you buy the same or a substantially identical security within 30 days before or after the sale.

This gets a little fuzzy when it comes to robo-advisors because they're using exchange-traded funds. And if they're practicing tax loss harvesting, they might be selling one ETF. Let's say it's a small cap ETF and then buying a small cap ETF from another sponsor or provider, even though the overall underlying holdings are

substantially the same. But it appears the IRS has allowed that because these robo-advisors have been practicing that form of tax loss harvesting from one ETF to another, and apparently the IRS has determined that they are not substantially identical.

We looked at robo-advisors way back in episode 92 of the podcast, January 2016. At the time, the top four robo-advisors were Betterment, Future Advisor, Schwab Intelligent Portfolios, which had just recently launched, and Wealthfront. Collectively, those four managed over $10 billion for 120,000 clients.

Now, Future Advisor was bought by BlackRock in 2015 and eventually closed.

If we look at the top four today, the biggest is Vanguard Digital Advisor. That launched in 2020. It has over $300 billion in assets. Empower Personal Wealth, which was formerly Personal Capital. Empower bought Personal Capital in July 2020. That has $200 billion. We're not going to spend much time on that because in some ways it's not a traditional robo-advisor because they...

want you to work with a financial advisor as part of their service and their fees at 0.89% reflect that higher level of service. There's nothing wrong with that. It's just that it's not our focus in this episode.

Schwab Intelligent Portfolios has $81 billion in assets, Wealthfront, $75 billion. And so if we look at the top four, they have over $700 billion in assets, up from $10 billion a decade ago. An incredibly successful approach.

Now, Betterment is in the top five at $46 billion. And there's Robe Advisors, another country. A large one is Wealthsimple, based in Canada. But clearly, Robe Advisors and the service they offer have struck a chord with individual investors to invest with them. And we're going to look at what they offer. And really, is it worth it? Let's take a look.

Let's take a look at Vanguard Digital Advisors. Vanguard is structured as a mutual company, which means the underlying funds own the company, and the funds themselves are owned by shareholders. And so this is a mutual company, and so it's not focused on generating profit. Schwab Intelligent Portfolios, that's publicly traded, owned by Schwab. And Wealthfront and Betterment are still private.

At some point, I suspect Wealthfront and Betterment will go public. They both appear to be profitable. But if we go then and look at Vanguard Digital Advisors, their stated fees are 0.2% to 0.25%, but they actually rebate the underlying ETF. So your all-in fees tend to be 0.15% to 0.2%, depending on which service you select.

Vanguard's minimum is $100, and they do offer tax-loss harvesting. Schwab says their fees are 0%. With a $5,000 minimum, they offer tax-loss harvesting for balances over $50,000. Their minimum is $5,000. And what they do, though, and we mentioned this back in 2016, they keep doing that. Their stated fee is 0%, but in their suggested allocation, they mandate a certain amount of

of allocation to cash. I went through questionnaire on Schwab and they recommended 8% in cash. What Schwab doesn't do is it doesn't pay prevailing cash yields on your cash portfolio. Pretty close. Right now, Schwab's paying 3.91% yield on cash balances within the Schwab Intelligent portfolios, but a money market account or some type of short-term treasury ETF, that's

those yields are 4.23%. And so if we do the math, about a 33 basis point difference, if it's 8% of your portfolio, their fees end up being about 0.03% plus whatever they charge on the ETFs. And so it is inexpensive. They just get to their fee a different way.

Wealthfront charges a fee of 0.25%, $500 minimum. They offer tax loss harvesting. And then Betterment also charges 0.25%. For there, you need $10 to start investing. They offer tax loss harvesting. Now, I thought I would look at how do these four robo-advisors, what do they recommend in terms of their options investments?

in investing. And one of the things that's changed with robo-advisors in the past decade is they do offer different options. Vanguard has an all-index investment option. That's their lowest one where your all-in fee is 15 basis points. And it owns four ETFs. It owns VTI, the total stock market ETF. It owns BND, the total bond market ETF. It owns BNDX, the total international bond ETF. And it owns VXUS, total international stock ETF. And so it

It owns a diversified portfolio, just four ETFs. You're paying your 15 basis points. It'll do the tax loss harvesting, the rebalancing, and you're set to go. They also offer an active index investment option where they'll include additional funds and ETFs in order to try to generate a higher return than their all-index option. They

That one, they charge 25 basis points before the fund rebate, and it includes just additional options such as a dividend growth fund, a value fund, an international growth fund. So you get a little more diversification, style tilts, and they'll make adjustments. Vanguard also offers an ESG option, which includes ETFs that do some type of environmental, social, or governance screens.

Schwab, from what I can see, offers the greatest variety and most diversified portfolio. I did go through the analysis just because I couldn't find their ETFs right away that they were using, but it will use some of their fundamental ETFs in their portfolio. And fundamental is a type of indexing strategy where your typical index fund or

ETF will rank the holdings by market capitalization or size. So the biggest company in the world in terms of its share price times the number of shares outstanding, that would get the biggest rank in the index. Well, fundamental indexing will rank by other criteria. It could be sales, it could be book value, but other criteria so that it essentially has

an embedded value tilt because it's ranking based on other criteria other than pure size. And so their product will include that, but it also includes additional diversification. It includes small cap and emerging markets. And there's in the page I found, there's probably a dozen or more ETFs that they can include. And they also include the list of the ETFs that they're using

what they call secondary ETFs for tax loss harvesting. And so it is a much more diversified portfolio. And again, 0% fee, you pay the fees on the ETFs, but you do have that 8% allocation to cash. And in an environment right now where cash is yielding 4%, that's fine. When cash was yielding 0%, not as attractive.

Wealthfront appears to be the one that has changed the least in terms of its core portfolio. 45% in stocks as represented by the Vanguard Total Stock Market ETF, VTI. 18% in foreign developed stocks, which would be the Vanguard FTSE Developed Market ETF. 16% in emerging market stocks via the Vanguard FTSE Emerging Markets ETF. Has some corporate bonds, iShares, iBox, investment grade corporate bond ETF, LQD, tips allocation, and then

an allocation to dividend growth stocks via Vanguard Dividend Appreciation ETF. So that portfolio has been there a long time. They do offer what they call a socially responsible option, but it's probably the simplest option

of the portfolios that I saw of the four robo-advisors that we looked at. Finally, Betterment offers a variety of strategies. Their core, which is sort of their benchmark strategy, has been around the longest. They also offer one with value tilt, an innovative technology one, a broad impact one, which would be their ESG. They have a climate impact one, a social impact

And then some cash reserves, as well as a taxable bond account. And then they offer, which uses some Goldman Sachs tax smart bonds. Finally, they have the BlackRock Target Interest.

income. And so there's a lot of variety in terms of, well, which service of Betterment do we choose? We look at just their core portfolio. It owns the SPDR S&P 500 ETF, the Vanguard FTSE Developed Markets ETF, the Vanguard FTSE Emerging Markets ETF, iShares Core U.S. Aggregate Bond ETF, and it has an allocation to U.S. mid-cap stocks via the S&P 400 mid-cap ETF, small-cap stocks through the SPDR S&P 600 small-cap ETF,

And then it has some alternatives, presumably for tax loss harvesting, such as the Vanguard small cap stock ETF. And finally, the Vanguard total international bond ETF. And finally, they own the iShares emerging markets U.S. dollar bond ETF. With all these robo advisors, you're going to get a diversified portfolio of ETFs. The ETFs have lower expense ratios and it's a solid service, which is why they have so

$700 billion in assets. Now, in all disclosure, Betterment and Wealthfront, they have sponsored the podcast for a few episodes, not much. Betterment ran for a few episodes last year. I think Wealthfront bought an episode or two sponsorship in 2022. For many years, I turned down. Every year, they were asking to sponsor the podcast. And finally, I said, well, I've seen how the product evolves. It is a useful service. Sure, you can sponsor the podcast.

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All of them talk about this tax loss harvesting and in many cases are offering something called direct indexing. And to understand why,

what direct indexing is. Instead of buying an ETF, it buys a portion of the holdings that make up an ETF or an index. So it might buy all or most of the stocks that make up the S&P 500. And then for the tax loss harvesting, it would sell stocks that are at a loss and to offset stocks that are at a gain, and then you'd swap out and get different holdings.

one of the questions is, well, how much additional after-tax return is there with tax loss harvesting compared to not doing it? And that's not easy to quantify because it depends on one's individual tax rate, depends on the approach, but there are some underlying principles that can help us at least intuitively think about, is tax loss harvesting helpful? First off, the higher the volatility is

especially within the holdings, the more opportunities there are for tax loss harvesting because there's more losses. And that's where direct indexing, where indexing

individual stocks are owned because there's more movement within the portfolio, within individual holdings, there's more opportunity for tax loss harvesting. As opposed to just owning ETFs, the tax loss harvesting is really at the asset class level. Did emerging markets sell off? Then you could do some tax loss harvesting there. But because there's less volatility, there's just less opportunity to add wealth.

what's known as tax alpha, incremental return because of tax loss harvesting when you own ETFs, which most of the...

Robo-advisors, that's their primary holding. ETFs are naturally tax efficient given their structure, given they're working with market makers and authorized participants in creating and redeeming shares as part of that process. They can pass on stocks with a low cost basis that have appreciated and passes on to their authorized participants as part of redeeming shares and that reduces the tax burden.

Some other principles when it comes to tax loss harvesting is the benefit of it is lower as time passes because there are fewer losses. As the stock market appreciates over time, if you're a longtime client of

of Wealthfront or Betterment, and this is a taxable account, at some point there isn't anything to sell because nothing is at a loss. So over time, the benefit of tax loss harvesting is reduced. Now, tax loss harvesting can be beneficial if you have other investments outside of a robo-advisor. For example, if someone's investing in a hedge fund that might be using futures and options and is generating a lot of

short-term gains, which are at a higher tax rate, then tax-loss harvesting tends to be more beneficial. But for a typical robo-advisor, where there aren't a lot of short-term gains, then the benefit of tax-loss harvesting is less.

I found two academic papers that I'll link to in the show notes that try to quantify the benefits of tax loss harvesting. Now, in their case, they did the simulations using individual stocks, so more of a direct indexing approach. And so direct indexing, because there's more volatility for the individual holdings, will have a greater tax alpha, excess return due to tax loss harvesting. Using this as our analysis, this is the most we'll get

And using ETFs, it'll be much less than that.

But they went and looked at just largest U.S. securities. From 1926 to 2018, they used securities from the Center for Research and Security Prices, CRISP, so it wasn't the S&P, used a long and short-term capital gain tax rate of 15% and 35%. And they came up with potential tax loss harvesting benefit of 1.1% per year. And if they've constrained by the wash sale rule, it was around 0.5%.

85% per year. Again, this was with individual securities. There's one caveat, though, and this would have increased the return. Whenever there was a tax benefit, they assumed that that tax benefit was reinvested in the fund. And so you were compounding based on those tax benefits. But it was 85 basis points to 1.1%.

There was another academic study where they did a similar type analysis and they found in the first year, the benefit was around a half a percent. But after that, it dropped rather quickly. So assuming no capital flows into the portfolio, they came up with about 15 basis points of benefit from tax loss harvesting, which is relatively small. And again, their analysis was based on a

a direct indexing approach. And so my conclusion based on that is if one is using a robo-advisor, using the ETFs, they're not doing direct indexing. It's based on just selling specific ETFs as part of tax loss harvesting that the benefit is minimal, especially for long-term holders as markets appreciate because at some point it just doesn't make sense. There'll be more benefit in the early years, much less

in the later years. If one is really concerned about reducing taxes, then direct indexing makes the most sense. But for that, we don't even have to use the robo-advisor service. Fidelity has a specific service. Schwab has one. There's a new entrant in the direct indexing space called FREC, F-R-E-C, where they charge 0.1%. And this is all facilitated by technology. So the technology is much better

than it used to be. But again, even if you're doing direct indexing, potential benefit in the later years of 20 to 30 basis points per year and you have to decide, well, is that really worth it to set up a new account and

And again, it's going to generate a lot of transactions over time, which have to be shared as part of your tax return. Sometime that import can be automated. The fact that transaction costs are so much lower than they used to be, that that has made direct indexing and tax loss harvesting much more feasible. The only robo-advisor that doesn't have a direct indexing option right now is Betterment. And they've

and they just purchased a firm and are starting to roll that out. So this shows that technology has advanced enough in the past decade that the cost of implementing direct indexing has fallen, and it's just a better tax loss harvesting approach than trying to do it via ETFs. Another benefit of direct indexing is you can exclude certain stocks. If you are opposed to the actions of a particular company, they'll allow you to exclude stocks

certain stocks. There's a limit to that. And there's different minimums for the different services. So I won't go into details of what each service offers with direct indexing. There is the opportunity for some customization, but it's through the direct indexing portion and will often not be your entire portfolio. It could be just be the U.S. large cap. Some of them will offer for some of the other areas of the market, such as small cap.

But we step back and think, well, a robo-advisor is worth it. I personally don't invest with a robo-advisor. And an individual could see the robo-advisor holding, such as a wealth front core portfolio, and replicate it and not pay the 25 basis points. I think we've substantiated that just the tax loss harvesting with ETFs, the benefit just isn't that great, especially for if you hold it over a long period of time. On the other hand, robo-advisors can be very...

very helpful if they help you save more because it's so automated. Does it ease your worry if you just don't want to deal at all with picking ETFs or rebalancing? Then a robo-advisor can make sense. I admire robo-advisors. I was certainly skeptical in the early years because I'm thinking, well, why would we pay 25 basis points to do something that one could just open an account of Vanguard and replicate on their own? But the fact that so many people have

have used that suggests that they like how automated it is and just how much it eases their worries. And it just allows them to save. And so that's a good thing. And looking at the four, I prefer the portfolio construction approach for Schwab, but I've used fundamental indexes for years, but I'm not saying they're better by any means. I think they're all comparable.

Vanguard's are less expensive, so that's a plus in their camp. But I don't think you invest in a robo-advisor for tax savings. You invest in them for ease and for automation and to help you to save more and be disciplined in that way. If you're more interested in tax savings, then I would look closer at direct indexing, but I'll admit...

I don't do direct indexing either. Most of my portfolio, publicly traded, they're diversified ETFs. They're already super efficient. I just don't want to go through the complication of direct indexing. That's not to say that there isn't a potential benefit there, but as a long-term holder, those benefits will ease over time as the stock market appreciates over a number of years.

That's our look at robo-advisors. This is episode 529. Thanks for listening.

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