Save on Taxes with Direct Indexing - Frec Webinar

Welcome to this white Coat investor webinar on Direct Indexing. I am here with Mo Al Adham, the founder of frec, which is one of our new partners here in the Facebook group. And I'll give you a chance to introduce himself a little bit as well as telling us about not only direct indexing, but about his company frec, that can potentially implement this rather unique index investing approach for you on your behalf and hopefully get you some significant tax benefits in addition to providing solid returns. So let me, with that introduction, let me turn the time over to you for the presentation, then we'll move into some Q and A afterwards.

Awesome, thank you. I'm really excited to be here. So just as a quick background on myself, I'm a founder and a CEO. I founded FREC about three years ago and before that I had a separate company that we exited to Twitter and I was also the first founding advisor at Instacart, the grocery delivery app. So I've been over here in Silicon Valley for quite a while, since 2007. Before that went to school in Canada at the University of Waterloo where I studied engineering. And I'm really excited for this product and for this presentation because when we, when I built this company, it's my second company, I really wanted to build something that I had a deep need for. And Direct Indexing is a concept that was pitched to me previously by my advisor, but I completely misunderstood it and didn't really understand sort of the purpose behind it, the intricacies, the gotchas. And I sort of went into this rabbit hole of trying to understand it from the ground up and finally discovered how awesome this is if done right with the right fee structure and so on. And we built a company around it. So Frack is a venture funded company. We raised more than $26 million from some of the top investors here in Silicon Valley, like Greylock and a lot of executives and angel investors from Google and Meta. And yeah, we're a team of about 20 heavily focused on engineering and design. And the idea is to give you access to sophisticated strategies that otherwise you would have needed some expensive wealth advisor to get access to without the need for any middleman. So I'm excited for this presentation because I'm going to walk you through kind of the evolution of passive investing and how direct indexing is really sort of like a step up from what we know already and kind of walk you through how it works and kind of visualize the tax advantage of this strategy. And yeah, please Jim, ask me any questions that come up that I can help sort of answer and flip through the slides back and forth to find the relevant pieces. So maybe I'll start with the evolution of passive investing. So today we take this for granted, but back in the 90s, ETFs were a big invention, right? It was like, oh my God, this thing can get me the index returns like the S&P 500 or the Dow Jones or whatever your favorite index is without having to sort of like pay my taxes every year. It used to be with mutual funds in a taxable account that every year when you had gains, you'd have to pay your taxes on these gains. And it's going to stay current on your taxes. But with ETFs, the innovation that it did is a kind of allowed you to hold the ETF and then only pay taxes when you sold it.

Right.

And we kind of take that for granted today because we've been used to it. But back then it was a big deal. So it was a massive advantage against the mutual fund.

Right?

Now think of a direct index as an even greater advantage against the etf.

Right.

Not only does it allow you to defer taxes, it's also while you're holding onto the direct index and it's generating what they call capital losses. And these capital losses, they accrue year after year and they don't expire until you die. And so you can use these capital losses to offset outside cap gains. And then there's a second advantage to it, which is personalization. You're able to, with a direct index say, well, I want the S&P 500, but you know what, I bought a lot of Nvidia on the side over here or XYZ or I work at Uber or Meta or whatever. And I want the S and P minus these three things or plus these five things.

Right?

And so it really is a very powerful product. Although personalization is nice. But the main advantage that we see customers signing up for frac for is the tax advantage, right? That's kind of the number one and primary advantage of it.

Yeah. So one thing people may not have noticed, if they're Vanguard investors, they may not have noticed the tax improvement of the ETF revolution because the Vanguard index funds came out with this ETF share class. And so the traditional funds kind of shared in the benefits of that share class. And in that respect, the traditional fund investors didn't notice how much better tax wise it was to invest in ETFs in a taxable account. But I don't know where this came from historically, maybe it's in the Investment company Act of 1940. But the problem direct indexing is solving is created by regulation of mutual funds, right? They not only can pass gains to you, they have to pass gains to you, but they can't pass through losses to you. And that's the problem we're solving with direct indexing. So the history I think is actually pretty important on this point. And I appreciate you starting with that.

Yeah, exactly. And there's a, I think I talk about that slide here. You can think of when the ETFs first came out, actually it was marketed as an interest free loan from the irs, right? Like oh my God, I'm not going to pay my taxes until I sell this thing. And while I'm holding onto this thing, I'm deferring my taxes until the date of selling.

Right.

And so people started sort of like quantify the value of that interest free loan, right? So on the right there's a Goldman Sachs chart from 2019 that shows you the benefit, the cumulative benefit of holding the ETF over a mutual fund because you're not paying taxes until you sell.

Right.

And so yeah, this was actually, I think it was a 1970 Nixon era tax law that basically allowed for this to happen through in kind redemptions. But anyway, so there's another perk that ETFs also introduced which is the idea that this loan is forgiven at death because there's an asset step up in cost basis. So what happens is if you hold onto the ETF and you pass it down to your beneficiaries, then those taxes are just not paid because there's a step up in cost basis. Whereas if you paid your taxes every year with a mutual fund, you actually aren't taking advantage of that extra perk at death.

Right?

And again it's exaggerated. This benefit is also exaggerated with a direct index because now you're accruing the capital losses, right? And then also not, you know, and then stepping up a bigger step up, right. In your cost basis at that. So how does direct indexing work? So we like to visualize it this way. Imagine an ETF SPY for instance, or Voo if you like, the Vanguard ETFs which tracks a certain index like the S&P 500. Right. And by the way, this index, the S&P 500 or the Russell 1000 or whatever, those are indices that you can license yourself. So we as frac, we license them, right? We pay the licensing fees and then we can know the target rate. So we Know this, if you decompose S&P 500, Microsoft makes that much of it, Meta makes that much of it, Exxon makes that much of it, et cetera. So you cost code and so on. So you decompose it into its individual holdings. And then we buy those individual holdings at the right target rates and then we monitor those holdings every day and sort of like whenever a stock goes down in value below its cost basis, we sell it and we book the loss and then we place the money temporarily into a similar stock, but not substantially identical that for 30 days to avoid the wash sale, sort of like IRS rule. And then after 30 days we come back into that same stock. So we're tracking the original stock very closely, we book the loss and at the end you end up accumulating these tax losses because you do this over and over and over again while tracking the index closely. And so that's basically the basic the mechanics of how a direct indexing works. It's doing this on a daily basis across hundreds of stocks. And it's constantly looking for stocks that have gone out in value while avoiding wash sales. And then the end result of it is you take these tax losses and you're able to offset your tax bill, assuming you have cap gains. And then there's other advantages too, which I'll get to in a minute. Even if you don't have cap gains, you can defer the taxes from withdrawing from your taxable account during retirement as well.

Plus the $3,000 a year against ordinary income.

Right?

I mean it's not all cap gains, but that is one benefit of tax losses. I mean it's relatively small change for sure, but it's a nice bonus.

And it's an and relationship by the way, you offset all your gains. And in addition to that, there's $3,000 assuming you have additional cap losses. Okay, so this is what an account looks like as a direct index. It is at least on track. We are a very sort of product design first company. So we show you all the real time information as well on our index is tracking. But to look at direct indexing to see what it looks like, you can actually go to our demo page. There's a demo page on phreg that's public freck.com app demo. And then you see all your constituents, you see the target weights and the current weight, the two arrows here you can see how much cash there is in the account. We keep a little bit of cash because the optimizer likes it. And then you also see how Your index is doing relative to the comparison etf.

Right.

In this case, when I captured this screenshot, we were approximately $100 below the comparison ETF.

Right.

You're always either plus or minus some tiny value around the ETF because you're doing that tax loss harvesting. But your tracking error is quite actually small. And we'll talk about the numbers in a minute. But you can kind of assume that this is a solved problem for now. You're going to track very, very closely to the etf and then you have at the bottom the tax losses. If you go to this demo page now, you'll see the real time tax losses as of this moment. Right now, the idea is that you're tracking the index closely, but you're getting these capital losses that you can then use to offset your gains. Then the question becomes, well, how much can I harvest in losses? Is this worth the effort? And the answer is simply that you can harvest, harvest approximately 40% of your investment over 10 years.

Right.

And this is a Vanguard study over here. You go to the tax alpha calculator from Vanguard and you can see, you know, over various decades how much you, you can harvest in losses. Obviously during the more volatile decades, like maybe the 2000s, the early 2000s or 2008, you harvested a lot more than 40%. But even from 2017 to, you know, know, 2022, you harvested approximately 40%.

Right.

But on average, our simulations kind of also confirm the same thing, that you're harvesting approximately 40% of your investment losses. You invest a million, you get $400,000 back over 10 years.

Right.

And then by the way, it depends on the index.

Right.

And this is based on a large cap index, but small cap indices harvest a lot more. And these numbers that I have on the right are over a five year period due to some data limitations, we couldn't go back 10 years to do an apple to apple. But you know, the small cap index harvests 40% five years and the mid cap 28% and the large cap about 19% over five years, which is sort of.

Yeah.

Now are you saying this is what can be captured using an ETF approach or a direct indexing approach? And if it's direct indexing, what's the difference between what you get just at the ETF level?

Yeah. So if you. So this is, these numbers are all direct indexing numbers. So this is how much you harvest using a direct index. Now if you, you can, if you want, do direct index. Oh, sorry, do tax loss harvesting with ETFs, it's more difficult and it gets you less yield. So you can buy one ETF like voo, right? And then you can monitor it, and whenever it goes down, you can sell it and buy something else like VTI or the Russell 1000 or something like that. And then when that goes down, you sell it, and then you buy something else and so on and so forth. Now, you can't, you know, by the IRS rules, you know, you can't really buy sell a VOO and buy SPY because they're substantially identical. So when you do ETF to ETF harvesting, there's two things that you're giving up. A, you may not end up in the same index that you wanted to. You may sell Voo and then end up in the Russell 1000 or VTI or something like that, which is not ideal for someone who has an idea of what they want to be invested in. The second is you get half the losses. So with ETF to ETF harvesting, you're not getting as many sort of like, individual positions that can fluctuate. You have the etf, right? So there's days where the ETF is down even. There's actually days where the ETF is up 1%, right? But underneath the surface, there's positions that are down 10%, right? So the Direct index allows you to harvest at that stock level, right? And so you're able to buy and sell stocks, and you can harvest double as much in losses. So the ETF would get you 20% over 10 years.

Okay, so it's about double, because I figure it's got to be more, right? There's no benefit. It's not more. And by the way, this is about double. So you could get $200,000 out of a million with ETFs, if you pay attention to it. And you could get 400,000 via direct index.

And we did this study, it's published on our website under a white paper called ETF versus Direct Indexing. And we were very generous with the ETFs. We assumed you can go from VSPY to VOO, right? We just made that assumption, which you can't. You got to go into something else and so on, and then you're watching it daily and you're on top of it and so on. So best case, you're doing, you know, 2x. Realistically, it's probably more than that.

Yeah.

Okay. And so the question becomes after that is, okay, I can get 40%. But so, like, one interesting property is, like, at what schedule?

Right?

And the nice thing about Direct indexing is that the losses are front loaded. So in the first year you harvest about 15% and then the second year about 10, and then 8, and then it kind of plateaus down to a point where you get 1 to 2% a year. And this is an area that is going to get sort of like, I want to say, resolved in the next few months at frac, because we're introducing other types of indices that what I call long short indices that kind of solve this problem and get you losses that perpetually up and to the right in terms of percentage of portfolio.

Right.

So you're not going to be any more sort of like losing efficacy over time. But you can also solve it with a long only index if you kind of are reticent to the long shorts by doing repeat deposits. Right. So every deposit is sort of like recreating this curve for that deposit. Right. So imagine this being the first deposit, 15, 8, 10, 8, et cetera. And then you do another deposit in year two. That deposit is also harvesting at the same curve.

You'd see that just harvesting ETFs, right. I mean, because the market generally goes up over time, your losses have to be relatively front loaded. That's just the way they're going to come. And lots of people that have been investing for a long time realize that in a nasty bear market where they go to do some tax loss harvesting, they're only harvesting losses from stuff they bought in the last couple of years, for the most part.

Exactly. Yeah, exactly. Okay. And so you may be wondering, well, why now? What has changed? Why am I hearing more about this? Well, there's been one major, I would say advancement in the way trading happens, which is fractional shares. Before fractional shares were introduced, you had to buy whole shares of everything. So if I wanted to buy the S&P 500 stocks, all 500 stocks of the S&P 500, then you needed at least a million dollars to get good coverage and good tracking. But now, because we can buy fractions to the fifth decimal point of a stock, we can track the index very, very closely without a big investment upfront.

Right.

You can put in $20,000 is the minimum on frac, and then you can get, you know, basically very, very, very good tracking on the index without having to put up a lot.

Right.

And then there's obviously zero commission trading. We're trading a lot on track. We also, the optimizations that we run every day to figure out what to buy and what to sell, they're quite expensive and so compute Cost is low enough that we can run these optimizations on a daily basis. Okay, so, so let's look at some visuals on the tax advantage of direct indexing. We call it di. And the cool thing about it is there's really two big use cases for it. The first one is you can use it to offset outside cap gains. So say you have your money that you're putting into the market every month or in lump sums and you decide to put it into direct index as opposed to an ETF. Now this money is generating again, for every deposit, 40% of it back in cap losses over 10 years, you're accumulating these cap losses. And remember, the cap losses never expire, right? So they carry forward year after year. And then you have some outside cap gain event. You're selling a house, you're downsizing, you had an angel investment that's gone public. You have any other kind of cap gain event in your life that has taken place, you can offset them dollar to dollar, right? So if you have a million dollars in losses and a million dollars in gains, you don't pay taxes on the million dollars in gains. And on top of that, you also kind of COVID the $3,000 of ordinary income. So that is the classic use case for direct indexing, right? There's no limit to how much you can offset in gains and they carry forward year after year. And if you wanted to do some math on, well, what does that mean in terms of alpha, right? How much can I generate or beat the market? Assuming you have gains every year, you can expect to outperform the market by 1.36 to 3.1% every year over 10, 20 years. It adds up to quite a bit. But this is assuming you have those cap gains every year. Just keep that in mind when you look at this number, because the cap losses are meaningless unless you monetize them by saving taxes.

That's where I'm sitting in my life, mo. I got all these capital losses and nothing to use them against because I don't realize capital gains. Well, barring selling my company or my house. That's why I continue to accumulate them, is because they would be useful in that sort of a situation. But for the most part, I'm definitely not one of those people that are realizing capital gains every year in any significant portion compared to what I have in losses already.

So let me address your use case because it's a very common use case and you at some point will want to draw down probably from your investable, from your taxable Portfolio, Right.

Maybe at some point it's a big maybe and maybe just fine just spending dividends the rest of my life. It just depends on where people are at. You know, I mean, some people, absolutely they will be selling shares and, and you know, they're maybe just deferring those, those, you know, gains for years. But it's very individual on how useful the capital losses will be to somebody. Some people, they're very, very useful and other people, you know, not as useful. I tend to flush lots of my capital gains out of my account with charitable giving. And so it's not as useful for me as it is for some other people who have capital gains every year and potentially could boost their after tax returns by 2 or 3% a year.

So let's take this example of someone who actually plans to. At some point they're investing in all these ETFs or investing in all these index funds, right? At some point they want to retire and want to start spending, they want to start to withdraw. Call it just to make the math easy, $10,000 a month and they're in a relatively low tax state. Maybe they're paying 28% when they withdraw the money and it's a 15 year horizon, right? And so let's compare. If you want to put in a lump sum investment of a million dollars into an ETF versus a direct index, what happens is you put in the million dollars in year one, you're still working, so you didn't actually sort of withdraw from that million dollars. And then you start drawing down $10,000 a month. So you pay taxes when you start drawing down on the etf, Right? So in this case, this is the ETF case, it's kind of, we all know how this works. You only pay taxes when you start drawing down the money. And by sort of like after year 15, you sell it all. So you pay everything else. And the top quadrant is the cumulative cap gains, right? The realized cap gains.

Right.

So let's see what happens with the direct index. So if you instead put in the million dollar investment into a direct index, what's happening in years one to five is you're accumulating losses, you're kind of collecting and accumulating these cap losses. And then when you enter into this phase in your life and you're drawing down and selling your investments, you're not paying taxes anymore. Instead you're chipping away at the losses that you've accumulated already. So you see that yellow bar kind of got chipped away a bit. So by the end of it. The first time you pay taxes on a direct index is by year 13, whereas the first time you pay taxes on an ETF is year six. And that is basically the magic of direct indexing. It's just helped you from the same portfolio, the million dollars defer taxes even further. So even if you are drawing down and selling your investments in the future to, you know, basically live off of them or to make some big purchase or to go on a fancy holiday or something like that, you have deferred your taxes even further by using the accumulated cap losses.

Right?

Yeah. Let me emphasize this point even more because I'm not sure everybody is getting it. The magic of direct indexing is more losses, you're getting more losses than if you're just doing this with your ETFs. And for example, I have a lot of lots of ETFs that I have bought that have never had a loss. They've only gone up from the time I bought them. Whereas if you did that with direct indexing, some of the stocks in that lot did have losses and could have been harvested. And so you're just getting more losses. And of course, if you have more losses and you're, you're generating capital gains later to spend your money from your portfolio, then having more of those losses allows you to go further into that portfolio before you have to start paying capital gains taxes on those.

Exactly. Yep, that's exactly how it works. And when you're a direct index portfolio, and another kind of like hidden property of it is when you are withdrawing from a direct index portfolio, the optimizer is automatically choosing the most favorable tax lots of to sell first. Right. So it may choose the tax lots that are most that have the highest cost basis first and then choose the lowest cost basis tax lots later, further deferring taxes.

Right.

Whereas with an ETF, you have an average cost basis for everything that you've bought.

Right.

Well, I mean, you could specifically ID them. Presumably somebody who knows what they're doing is managing the portfolio and you do the same, same thing. But because you have such fewer number of investments and tax slots to choose from, there's not going to be nearly as many good options. I mean, you're still trying to do the same thing with your ETFs. You just don't have as many options as you do when you own, you know, hundreds of stocks.

Yeah, exactly. Exactly. Okay. So then naturally the question becomes, well, these are kind of nice advantages, Right. I'm deferring my taxes, I'm you know, until later. And, and by the way, over here, if, you know, not to sound morbid, but if you die over here, right. You, you wouldn't have paid any of these taxes. Right. Kind of your, your whoever inherits the completely avoided.

Yeah.

The loan is forgiven by the irs.

Right.

And so at what cost does it make sense to buy this? And you know, back to the founding story of the company, when I was on the receiving end of this pitch, it was pitched to me as like, hey, this product will just invest by Vanguard. It's going to cost you 40bps. And my mind was blown. I was like, you're asking me to pay 13x more than the ETF. Can you do the math for me? That's what I told the advisor. I'm like, why does it make sense for me to pay 13 times as much as the ETF? The ETF is three bips, right? Vanguard's Voo. And you asked me to pay 40 bps, like 37 bips more and more. What happens in seven years?

Right.

In 10 years, in 15 years, I don't want to have to deal with 500 stocks. So probably everything that most customers think about when they evaluate the strategy, it turns out okay. And we'll do like a simple sort of like a case study here. If you believe the 40% investment is turned into cap losses, which I think given the Vanguard study and so on, is a believable number. And if you have some gains outside, of course, if you have gains at a different schedule, it will matter differently. And if you take a million dollar portfolio that's maybe growing 10% a year, let's see how the strategy makes sense of different fees. And this may look like a complicated graph, but bear with me for a second. So this is the difference between the ETF and the direct index with reinvesting the tax savings back into that portfolio at different rates. And so what the purple line is telling you is if you're paying 0.75% to an advisor to run direct indexing for you, and the ETF is three basis points, then the strategy kind of stops making Sense by year 11. In the first five years, you're harvesting a lot in losses and you're saving a lot of money in taxes, and you're bringing these tax savings back into your portfolio hypothetically. And then that portfolio is compounding, but because you're paying this big fee over time and forever, potentially, then the fee taxes away your portfolio way more than the benefit of the tax savings reinvested. And so that's why the curve goes up and starts after year five when you're stopped harvesting losses, it kind of starts to decay and starts hitting the X axis. And you might as well have stuck with an etf.

Right.

And kind of that math happens at different price points as well. In fact, the 10 basis points difference price point, which is what FRAC charges. Actually frac charges less charges seven because three bips versus ten is only seven. But let's for simplicity use ten.

Right.

Then you're going to win. All the tax savings are going to compound and then you're basically way above the ETF's value. There's no magic here because over time the blue line will also hit the X axis. But it's like at year 150 after you've died.

Right.

So it doesn't matter. All of these lines will hit the X axis at some point because you're paying more than the etf. But the point is. Yeah, which, you know, can you make it such that you kind of. That it outlives you basically.

Right, Exactly. You got to get it to the end of your life. And this is a really important point to make here. So let's spend just a minute on the fees. FREC is not the first company that has come to advertise the white coat investor that offers direct investing. It is the first company from who we've taken money and had you advertising. The reason why is the fees. You know, I had advisors whoever come to me and offering direct indexing and I could not justify the FEES. It was 75 bips or 100 bps or whatever. And I'm like, I'm not sure the benefit is there. But at 10bps it becomes much easier. Even if you don't have capital gains all the time, you know, you have lower capital gains like I do because you're flushing them out or charitable giving or whatever. You just happen to invest very tax efficiently. At 10bps it's a lot more palatable. I mean you used to pay 15 or 20bps for a Vanguard index fund. You know, these are very low cost fees to get some benefit out of. And I don't think it's that hard. I mean just not screwing up your own ETF. Tax loss harvesting is probably worth 10 bips. I mean people do that all the time. And so now you don't have to deal with tax loss harvesting. You've got them to do it for you. At these price points, I think it makes sense to at least consider it. And so I'm Excited to do this webinar with Freck and to have them here at the White Coat Investor talking about this stuff.

Yeah. And you know, we use our own products too. And so we couldn't justify, you know, everyone at this company is a customer.

Right.

And so we wouldn't be using it if it was, if the price was unreasonable. And a lot of these other platforms and wealth advisors, they treat it as a business. They're like, great, we're going to get this customer. The lifetime value of the customer is seven years. And then after that they'll churn out and then we would have made our money from them. And it's all good, but it doesn't make sense. It's kind of like the product just wouldn't get adopted this way. Because people are smart, they'll do the math and they'll figure out that this doesn't make sense for them. I mean, some people will unfortunately fall for it. But for us, we're trying to get customers in that want to invest for a lifetime with us.

Right.

And it only makes sense at a low price point. So let's talk about some other features because there are other things that make FRAC unique. We have a lot of indices. We have a collection of 14, actually. We're going to add more to this collection very soon. But you have The Russells, the 1000, 2000, 3000, there's international indices, there's US large cap, all cap, the VTI index. And so I know you can construct, for example, 6040 portfolio, the three fund portfolio, or you can do a tech heavy portfolio. And all of them are individual indices.

Right.

So that's a nice feature on track. So you're not limited to just the one index. And then you can set it, set them up as an allocation.

Right.

And you can have an allocation and you can rebalance it whenever you want to rebalance it. Or on deposit. Every time you deposit, it kind of rebalances in a way that, that tries to hit your North Star target allocations.

Right.

Okay.

I'm looking at the indices there. Are there international ones as well? Are there small value indices? Any plans to add those or.

We have international. Yeah, we have international ADR indices. So we have emerging and developed market indices as well. We have small caps. We're just about to introduce value and growth large caps, but we will also introduce value and growth small caps as well. So those are all kind of coming very, very shortly.

Okay.

Yeah, there's also an ESG index in there and there's a semiconductor, some specialized Indices like the SMH index, for example, some of the other features. So it's a, it's a full brokerage account, right? You can buy and sell stocks as well. And then when you sell and buy stocks here, it knows that, oh well, Apple is in your index. So, you know, here's a warning. Don't buy it or don't sell it because of the wash sale. So, you know, it's nice to have that integration. There's a Treasury account that pays you 4.12% on your cash and then there's a line of credit so you can borrow against your stocks or your indices at a rate of Fed plus 1%.

Right.

And you can take the money out. If you need some temporary sum of money to renovate your bathroom and pay it back, you can do that at a rate that's arguably even lower than like a heloc, for example. And then for the margin loan product specifically, we put in a lot of effort into explaining to our customers the risk associated with that. So it tells you how much the stock market would need to, or your portfolio would need to drop before you get into a margin call and how much that margin call would be. Of course, like using margin has some risks associated with it. So, you know, I would use this feature carefully. But we wanted to give our customers the opportunity to get some liquidity without selling because selling is, you know. Yeah, exactly. It's exactly the opposite reason why you, you want to have a direct index. Also, you can move your assets from other brokerages very easily from frac. So you go to frac, you go to click on your brokerage account and then a few clicks and the assets arrive with their cost basis on frac. Okay, so a few common questions that we get all the time. WASH sales tracking error. What if I get stuck with hundreds of stocks at the end if I want to exit the strategy? What about tax filings? So I'll walk through them very quickly. And so the first one is WASH sales. So our platform, it avoids wash sales for you across your account. Self managed and direct indices.

Right.

You can even have two indices with overlapping positions like smh. The semiconductor index has Nvidia and then your large cap also has Nvidia. It knows, sort of like it can consolidate the trades between them and so nothing to worry about. Now it's a. We have a lot of finance geeks that use frec, and a lot of us here are finance geeks. So we do introduce every now and then a feature that is a bit more advanced. So this is our Strategic wash sale feature. So if you read up on this and you want to get 16% more losses harvested, you can turn on strategic wash sales, and it will essentially get you more losses harvested without clawing back any already harvested losses. And so there's white papers and research on these topics as well. So if you find yourself wanting to geek out on these topics, our resource section's got a lot of cool, nerdy topics in there for you. And then tracking error. So this is a very common question. People are like, okay, well, what's my tracking error? Well, the algorithms have gotten very good. The risk models tell you, okay, well, if you sell Tesla, buy these seven other stocks, and you'll pretty much track it really closely. You can think of tracking error as basically when a tax loss harvest event happens and you're sitting on this replacement basket of stocks for 30 days, how well do these replacement stocks end up tracking the performance of the stock you just sold, right? And for the most part, you can expect to have a tracking error of actually 0% on average. But there's obviously different confidence intervals, right? But you can expect a plus or minus, a maximum of 1% with a 95% confidence, right? So a lot of our customers, actually half of our customers approximately, have a positive tracking error, and the other half has got a negative tracking error. And it's mostly luck, but the tracking is very small. And again, if you have the losses and if you have the gains, then they're more than justified with the losses. And also, some years may be positive, other years may be negative. And so you have an equal chance really of being positive or negative against the index. And then, by the way, you can change your preferences too. You can say, well, I really want to track closely. Try your best not to not create any tracking error. Or you can say, well, I have a ton in gains, so I don't care as much about tracking, obviously, still track it closely, but prioritize harvesting losses than tracking. And this option does exist as well on track, okay? And then there's the question of will I be stuck with 100 stocks or hundreds of stocks to manage at the end? And you know, it's funny, you don't need to if you're paying a low fee, you don't need to ever exit. But let's say you decide to exit maybe for some other reasons. So you can always transfer your stocks in kind to another brokerage, right? You can say, well, I want to migrate out of Frac Fidelity, for example, and that's easy. It's A few clicks on Fidelity, the stocks arrive to Fidelity with their cost basis, right? But you may also say, well, I don't want to be left with a bag of 500 stocks to manage because I kind of, you know, I don't want a direct index anymore. Maybe I want to save every single penny. I don't want to pay the expense ratio and instead I want to minimize the number of stock positions that are there. And that's also very doable because what you can do is you can take the harvested losses that you've already accrued in your account and you can use them to sell the long tail of your portfolio. And because these indices are market cap weighted, meaning the gains tend to accrue to the short tail of the index, then your losses will be more effective if they went towards selling the long tail. And then you'll have about 20 stocks to manage. And so again, this is kind of worst case scenario. You really want to exit the pricing, you're not happy with it and then you don't want to manage 500 stocks. There's ways to do that, right?

I like it. Mo. This is my other big beef with direct indexing. Over the years I'm like, well, this is fine until you're done with it and then you're stuck with all these stocks. But it's true you ought to be able to use some losses to sell off a whole bunch of them without gains because most of the gains from an index fund over time are from relatively few companies. And 20, 20, whatever it is, you would be stuck with those unless you want to realize the capital gains. But that's much more manageable than 500.

And there's a bunch of new developments as well in general in the ETF space. So there are ETFs now that you can see in kind. They tend to be expensive, but you can go to an ETF provider and say, well, here are my stocks and then I want the ETF. It's called a 351 exchange, I believe. And so there's some emerging solutions in the space, right?

It may continue to get better. That'd be pretty cool actually to be able to go to an authorized participant and really flush some of these shares out.

Now what we got more asked about is how can I in kind out of an etf? Because I want a direct index, so can I give you my VOO and you can sort of in kind out to the stocks and I want to direct index that. And unfortunately there isn't a good solution for that. Yet today?

Not yet. Hopefully it's coming. Yeah, I hope so, because it really isn't fair. Right. It's not fair that I can build this fund myself via FREC and get the losses, but a mutual fund can't do it. I mean, that's really the fact of the matter. Why direct indexing exists. Do you worry at all about that legislative risk that all of a sudden mutual funds would be able to pass through losses and all of a sudden there won't be a role for direct indexing?

You know, like so, so I think the law is that mutual funds have to pass through gains and losses. They just happen to pass through more gains than losses every year.

Right.

I know that even at the end of a nasty, you know, 2020 or 2022 or 2008, they're not sending me losses. And you know, even an index fund that's not realizing a lot of gains as it goes along, I'm pretty sure they cannot send you a net loss. They do, you know, obviously, you know, total them out and put them against each other. But I think if the total for the year is a net loss, I don't think they can send it to you.

Yeah, I'm not an expert in this area, but my understanding was that it depends on how much there has been in terms of in kind redemptions during the year from their customers. But to answer your question at a high level, legislative, yeah, definitely. Although it's something that we think about sometimes. But direct indexing has been happening for decades now. Before starting this company, I interviewed a bunch of family offices, very wealthy billion dollar plus offices that have been using the strategy since the 80s. And obviously they split their money. They invest a bit differently than probably the white coat investor or even folks in tech invest. They have a bunch of money that goes into public equities and a bunch of money that goes into private and the private goes into different VC funds, et cetera. And they use the public, the direct indexing in the public side to accumulate what they call a shield against cap gains that will emerge from the private side. And so since this has been happening for decades, it wasn't a risk that I called out, at least to our VCs, to our investors invested in frac. Okay, so the last point is about tax forms. And Freck does a ton of trading. Right. If you, you know, my tax form last year had 5, 500 pages of trading, but luckily, you know, there's a summary page. The summary page tells you the short and long term tax losses and tax gains Net gains and net losses basically. And that's all your accountant needs.

Right?

And you can take that page and even use online software like TurboTax and that's all it needs to parse. And obviously the record of the rest of the trades exists for you, but that's not necessary. All right, so that's on taxes. I should say a couple of things. So you know about our platform. So we use a custodian called Apex Clearing. So we're a startup and we're very self aware of the fact that we're new, relatively new. We've been around for three years now, but customers are always like, well what if the startup runs out of money? And we're like, well, you don't have to worry about it because your account is with Apex Clearing. Apex Clearing is this large custodian. They've been around for decades. $165 billion in assets. They custody, betterment, SoFi, ally, you know, Robinhood used to be with Apex and Wealthfront as well. And those people went and graduated beyond them. But Apex is a very tech forward custodian. They have APIs. We execute our trades on top of their APIs. You can actually open an account with Apex to see your assets. It's not going to look pretty at all, but they have an interface for you as a customer to go in and see your assets there. And there's CIPIC insurance.

Right?

We are a member of CIPIC as well. Same policy that Fidelity's got, right. There's no difference there. And then we are a very sort of like security conscious company. A lot of our engineers come out of Google and Meta and Twitter before it turned into X. But a lot of great engineers and everything we do is with security in mind and we hire third party auditors all the time that inspect our code to make sure there's no flaws or anything like that. And then we have trading oversight. So even though we're automated trading and we've been now running the strategy for more than a year and a half, there's a human in the loop. There's flags that happen and if errors do happen, we have the ability to cancel and correct. So everything's sort of running as a tight operation. Okay, so I just want to give a quick nudge on frack, what else are we building? And so there's two areas that are interesting to us. The first one is, I kind of alluded to this earlier, called a long short direct index. So this essentially is an index that you can kind of come in and bring an opinion to it. You can say, well, I want you to go long growth, short value or long value, as small cap short this or, and you know, it's not a product for everyone. But if you're looking to multiply your capital losses by 3x or more, you go long short, right? You go 150 long, 50 short. And then you're basically, you have this like tilt, right? And you know, it's a product that's good for someone who sold a business and they're staring in the face of a $4 million tax bill, right. And they're trying to get the as many losses as possible. That's where the longshore product is very relevant.

Right.

The second area is a lot of our customers buy the Bitcoin index. And so instead of buying the etf, they can, we're partnered with a custodian to essentially buy the individual coins themselves, maybe Bitcoin plus Ethereum or something like that. And then we can tax loss, harvest the individual coin without having to worry about the wash sale window because it's a commodity, not a security. So those are kind of the two areas that we're exploring to build next. And then finally, how do you get started with frac? If that's interesting, if you're depositing, if you kind of like the idea and you want to give it a shot and you're making new investments in an etf, then consider making those same cash deposits into a direct index.

Right?

Because then you can accumulate the losses.

Right.

If you have an ETF that's trading at a loss, maybe something that you've bought in the past 12 months, those ETFs are good candidates for tax loss harvesting. You could sell them, book that lost, and use the money into an equivalent index on frac.

Right.

And so you kind of future proof that investment for tax loss harvesting. And then if you have existing stocks as well, you can use them to seed your index.

Right.

It doesn't have to be all cash. And then I'll just close with this. We have a special promotion for White Coat investor members. We are giving away $75,000 managed for free on FRAC per year. And you use this referral code, frac.com referral whitecoat. And if you sign up through that link, you can then get your first 75k in an index. It's not going to charge you any.

Fees and that's forever. That's not just for a limited time. If you're with Freck for 40 years, the first 75 still fee free.

If you're still. Yeah. A member of voico.

Yeah, by that.

Very cool. All right, well, awesome job on the presentation and thank you for putting this together and getting the fees down to the point where at least it makes sense for many investors. I got a few questions I wanted to talk about though. One is I run into people every now and then who are very much into ESG investing or they are Muslim and they want, you know, a Halal investment, a Shariah compliant investment. Now I understand you can do some customizing around the indices that FREC offers. Can you do enough that you could come up with an ESG type portfolio, that you could come up with a Sharia compliant portfolio? Is that a possibility? Do you think so?

Yeah, we have actually, because we have gotten so many of these asks, we launched specific indices that have those customizations built into them already. So we have a customized. We have a Sharia index, the S&P 500 Sharia index, and we also have a crisp index, ESG index as well. Okay. On the platform.

Yeah.

So that's kind of the way you would deal with that rather than trying to customize the S P500 or something like that.

Exactly.

Now tell me the, the minimum investments are different depending on the index. For example, if I wanted a 500 index versus if I wanted a total stock market index, the minimum investment is different.

Correct.

What are those minimums?

So for Most indices they're 20,000, but some indices that are, that have a lot more constituents, like the total US Market index, like the VTI index, basically that has a 50,000 minimum because we have to go in and purchase a lot more securities. To track the index closely.

What are you finding among your clients? Are most of them wanting a smaller index, a 500 index, or most of them looking for a total stock market index?

Our most popular index is S&P 500 right now.

Okay, well, certainly if you get to the point where you're trying to drop stocks, it'd be easier to deal with 500 of them than 4,000 or whatever you end up with. Okay, another question for you is, does FREC do anything to deal with the 60 day rule? You know, this can be an issue if you get into, you know, frenetic tax loss harvesting where you're selling things multiple times in a month or within a couple of months. If you don't own it for 60 days around the ex dividend date, you're turning your dividends from qualified dividends into unqualified dividends. Dividends. Does FREC do anything about that to Try to minimize that or how much of an effect has it seemed to have if not.

Yeah, that's a great question. It's something that's on our roadmap to basically ask the optimizer to take that into account. If the optimizer comes up with a solution that says sell these eight stocks and buy these other seven stocks, but one of the eight stocks is, is borderline about switch dividend status or something like that, then maybe it should pick something else that has similar properties. Yeah, that's certainly something that's going to be resolved soon for us. It's on our roadmap.

Okay, another question for you. Is there an option for no dividend stock for the ultimate in tax efficiency? An index where, uh, it's just the stocks in the S&P 500 that don't pay dividends and now you're getting all these losses from them as well. You offer anything like that.

So we're, we're about to launch a growth index. So that's probably the closest. An index that doesn't pay a lot in dividends, by the way. For the dividend ones you have, there's some really nice properties. You know, you also have a value one, the large cap value index that pays more in dividends. You can go on track and say, well, I want to redirect my dividends to automatically pay off my line of credit, or I want to actually do not reinvest my dividends, like take them out because I'm living off of my dividends. So there's some power features there that, you know, if you're advanced enough, you can go in and kind of muck around with where you want your dividends to go.

Yeah, very cool. What do you expect to happen to the fees over time? Do you expect the fees to stay about where they are? Do you expect them to go up? Are these viewed as kind of introductory level fees? Or do you expect they'll kind of gradually trend down like you've seen at Fidelity and Vanguard and iShares over the years?

So I think so. Our pricing philosophy is essentially like, look at the price of the ETF, the closest ETF. So in the case of the S&P 500, maybe the closest ETF is V or Spy.

Right.

Let's call it Voo. Right. For a second. So that's three basis points. So our price cannot be more than 10 basis points on top of the closest ETF price.

Right.

Because, you know, we're trying to get you the same performance as the etf, but with A tax benefit.

Right.

And we think, as we saw in the price chart, the tax benefits are worth the extra 7 to 10 basis points. And so to the extent that ETFs themselves start to become cheaper, which we saw with the Vanguard announcement, they continue to make their ETFs more affordable, then also our indices are going to be under that same kind of pressure, the downwards pressure, and they will become cheaper over time. You know, maybe if VO1day is, you know, 2 basis points, we may offer it at 9 basis points. For us right now, where we're going to make money as a company is through these other more powerful products like long, short direct indexing is where we make our money.

Right.

Because if you want three times the losses, right, then you can pay 50 basis points now because the tax alpha is great, is much more meaningful to you.

Right.

And there are spread fees that are there when we go long and short, you know, we're taking margin to go long and there's revenue there for us.

Right.

So these more specialized products, like going 250, 150, 130, 30 is where frack will make money. And these products still are very profitable from a unit economics perspective. They're still money makers for us, but, you know, they're not going to get us to the $100 million revenue mark quickly enough.

Yeah, one question I had, I mean, there's a lot of trading going on that you might not necessarily see in a comparable etf. And there's a certain cost to trading. There's a certain amount of, you know, bid ask, spread. That's, that's every time you make a trade, some tiny fraction of money is being lost. Do you think that that is significant enough that it could cause the average performance of a direct indexing to lag behind a similar etf?

So we actually quantified the price impact to the transaction costs of using of direct indexing and all the trading that happens. And the Dragon is approximately 2 basis points in summary.

Right.

Which is not a lot.

Right.

You have very, very minimal. And the reason you have that drag is you have a, like, like you said, the bid ask spread.

Right.

So that's kind of the hidden fees in trading.

Right?

We don't make any money from that. But, you know, probably the market makers do. There's a bid ask spread there and then there's the SEC and the TAF fees, which are the regulatory fees that you have to pay per trade, which are very minimal. Yeah, those kind of add up to about 2bps per year.

Right.

In Additional fees that you're paying.

Okay, another thing I wanted to talk briefly with you about. You know, I mean, obviously you and I were personal finance nerds and we talk about this stuff. And one thing people always get into when they're talking about tax loss harvesting is what substantially identical means. And, you know, you mentioned earlier you thought VO and SPY might be considered substantially identical. So I've asked people this over the years if they've ever been audited on this point, so long as they weren't selling one fund that was a different share class of the same fund. Have you actually seen anybody, have losses clawed back that swapped one S&P 500 index fund for another S&P 500 index fund?

We've never seen it, but we've got it. We spent a lot of money getting legal opinions on this stuff because obviously this is our business and we want to make sure, like, we're totally not, not even operating in any kind of gray areas. And so, you know, the lawyers we talked to have told us that if two ETFs are tracking the same underlying index, and even though they may have different dividend policies or dates or different rebalancing schedules, that in the eyes of the irs, you know, it could be deemed that they are.

There was some. There was some risk there anyway.

There's some risk, exactly. I mean, you know, will the IRS audit? You know, I have my doubts on that, but, you know, they have bigger fish to fry. But certainly they're not going to have.

A problem with the direct indexing issue in that respect, by any means.

Yeah, I mean, yeah, totally, because we use, actually we license a very sophisticated risk model that a lot of the hedge funds license, the MSI bar risk model. Now, many of the asset managers in the world license the same model that we license as well. And so when we ask this model, give me two stock, give me that basket of stocks that is correlated with Tesla.

Right.

It's not going to spit out something that is correlated substantially identical to Tesla. There are no other stocks.

There is no other stock.

Yeah, exactly. It doesn't exist.

Very cool. So, I mean, the value proposition is you're paying a low fee and you don't have to worry about doing your own tax loss harvesting anymore, number one. Number two, you'll probably get more losses. You know, best guess, it sounds like it's twice as many losses if you're really paying attention to tax loss harvesting your ETFs. And if you ended up exiting at some point down the road, you could use some of those losses to at least trim the number of shares that you're owning in individual stocks moving forward. And of course you can dispose of those as you do with any sort of appreciated shares. You want to give them to charity or gift them to somebody in your family in a much lower tax bracket. There are other ways to get rid of those shares as well. So you make a pretty compelling case for direct indexing now that you've gotten the price down to where it is. I'm impressed with what you guys have done.

Awesome. No, thank you. We're very, very excited to be here and talking to this community. We actually have a lot of doctors that use frack and folks who own dental practices as well, and so it's a big constituent of ours.

No surprise there. Obviously there's not a lot of benefit to this if you have an IRA or you're in a 401k or something like that. This is taxable accounts only because we're talking most of the benefit here from the tax loss harvesting. But those of you who have tax loss harvested with all the drops in the market in 2025, imagine if you could have twice as many of those. How useful would that be to you? Would it be worth paying 10 basis points to get that? Or 7 basis points?

Really?

The additional cost? I think it's something for White Coat investors to think about. If you can't remember the URLs, go to whitecoatinvestor.com FREC F R E C and that'll get you where you want to be. MO thank you so much for your time helping us do this webinar and explaining Direct indexing and all the innovations that FREC has done around it. And thank you so much.

Awesome. Thank you so much for having me.

The hosts of the White Coat Investor are not licensed accountants, attorneys, or financial advisors. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.