Half-Baked: Index Investing and Divesting

A while back, I started thinking about putting some savings in a broad-based index fund, and I compared various brokerage providers. I was surprised to learn about one of Wealthfront’s features, which other players did not offer: direct indexing.

Direct indexing replaces a traditional passive fund with the equivalent combination of individual securities that would make up said fund. Instead of holding one share of an asset that tracks the S&P 500, you hold the fractional equivalent of the 500 stocks that that one share would represent1. This allows for more flexible tax loss harvesting strategies, and (at least in theory) leads to better performance. The wrinkle with direct indexing is that many people can’t buy and sell stocks of certain companies freely, either because of insider trading regulation, or because of the tax implications of wash sales. To remedy this, Wealthfront allows you to build up an exclusion list, a blacklist of companies that you’re not willing to hold, and which they automatically replace in your portfolio with highly correlated, but different assets to still have you hold a fund equivalent.

A few months later, in a conversation with Hannah regarding index funds, she mentioned that she wouldn’t like to use a total market fund, as she would like to make sure her money didn’t go to private prison operators, and other companies whose values she didn’t agree with. Her argument, simply put, was that if you believe that companies should be socially responsible, or environmentally friendly, then why invest in a company that does not follow what you value? When you invest in a company, you are voting with your dollars; you are saying “I am willing to let company A take my cash today so that it can put it to work and give me some return tomorrow,” literally enabling their business. This is where it gets interesting. Direct indexing lets you invest in broad passive funds while divesting2 from companies whose principles you don’t agree with!

Ultimately, I decided not to invest with Wealthfront (in part because to be able to use direct indexing, you need to invest at least 100K, but mostly because of fees), and decided to go with Vanguard instead. Today I got an email from them, asking me to vote by proxy on a proposal being considered by Vanguard’s board:

A shareholder proposal to “institute transparent procedures to avoid holding investments in companies that, in management’s judgment, substantially contribute to genocide or crimes against humanity, the most egregious violations of human rights. Such procedures may include time-limited engagement with problem companies if management believes that their behavior can be changed.”

I voted yes, and I guess that’s as good as it gets. I don’t expect Vanguard to implement direct indexing and blacklisting any time soon. There might be a market opportunity here, though.

The “Half-Baked” series is my effort to write more, and put my thoughts out there on the internet, a brain dump, unedited. Just a few minutes of writing. If you find typos, or grammatical errors, let me know. They will be corrected as I notice them, but otherwise the content will remain as published.

  1. This is not totally accurate, as the stocks that you can directly hold depend on how large your position is with Wealthfront, and the capitalization of the companies themselves, but that is not important for the point I am trying to make. 

  2. In theory you could have bought the index and shorted the equivalent amount in those stocks, but that’s not feasible even with a ton of effeort, due to limitations in the stock market. 

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