Did the evolution of investing culminate in the creation of the index ETF, a simple product packed with decades of finance research and technological smarts?

Or can the new generation of software-centric investment firms deliver on promises to improve the low-cost investing game beyond ETFs?

Beginning 75 years ago, mutual funds pooled investor money to improve upon haphazard stock portfolios. Index funds, dating to the 1970s, were even more efficient than mutual funds and outperformed most of them. Exchange-traded funds that track market indexes then added greater liquidity and tax benefits, growing from zero to $2 trillion in two decades.

Now a leading automated investment service for individuals is claiming to outdo even index ETFs – by, rather ironically, unbundling them into individual stock holdings.

Wealthfront, a low-cost online investment advisor, has a “direct indexing” service that promises added tax-optimized returns for clients with at least $500,000 at the firm. Instead of simply holding the usual array of index ETFs that Wealthfront employs for standard client portfolios, this service invests in the individual stocks that comprise a broad U.S. stock index, in order to better harvest losses for tax purposes.

Here's how it works: A Wealthfront tax-optimization program books losses from declining stocks and reinvests the cash in similar stocks in order to mimic the index while generating better after-tax returns. These tax losses can offset taxable gains elsewhere in an investor’s portfolio, and up to $3,000 of these losses can be used to reduce taxable income in a given year.

Burton Malkiel -- the Princeton professor, author of “A Random Walk Down Wall Street” and an intellectual father of index investing -- is enthusiastic about the product.

“It’s not that [direct indexing] is different form a regular index fund. It is a regular index fund, simply enhanced with tax-loss harvesting,” says Malkiel, who serves as Wealthfront’s chief investment officer.

In a white paper detailing the strategy, Wealthfront calculates that from 2000 to 2014 this program would have wrung roughly an extra two percentage points of return per year, based on certain assumptions.

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Strictly speaking, the tax liabilities are mostly deferred and not eliminated. And at the end of a long period, tax-loss harvesting systems will result in a portfolio full of stocks acquired at very low cost with substantial embedded taxable capital gains.

Yet Malkiel says tax deferral translates into real money when the savings can be reinvested and compounded. And gifting highly appreciated stock as part of an estate plan can mitigate the ultimate tax bill.

As Wealthfront is quick to point out, its approach is not novel and has been employed for years by a number for quantitative institutional money managers, such as Parametric Portfolio Associates, an Eaton Vance Corp. (EV) subsidiary.

The firm positions itself as a democratizer of fancy services typically accessible only to institutions and the wealthy. Wealthfront charges nothing beyond its standard 0.25% annual advisory fee plus any management fees on ETFs used. The effective annual fee for direct indexing for accounts between $500,000 and $1 million (which make some use of a U.S. ETF) is 0.02%, and is 0.014% for accounts above $1 million.

A Wealthfront spokeswoman says $500 million of the $1.7 billion the firm oversees is now in the direct indexing product, and 77% of eligible accounts have opted to use it. More than 90% of clients take advantage of some form of tax-loss harvesting.

New take on Jack Bogle's school of indexing

In a way, the Silicon Valley “robo-advisor” is casting itself in the role Vanguard founder Jack Bogle played in creating the watershed Vanguard 500 Index fund (VFINX) in 1975, bringing the newfangled indexing strategy employed for institutions at Wells Fargo & Co. (WFC) to the masses.

Yet investment pros question just how reliable the estimated return advantages are, and how much of an advance the service represents over more routine tax-loss tactics using ETFs.

A discussion string on the Bogleheads blog – devotees of index investing – features doubt cast at the back-tested return estimates, pointing out that most of the tax-related outperformance was collected in savage bear markets, when the loss-harvesting chances are rife.

Eaton Vance points out that its tax-management service has been available since the late 1990s on some financial advisory platforms to individuals with as little as $250,000 in the strategy -- and that its services go beyond a simple tax-loss harvesting engine.

Ben Carlson, who writes about investing at A Wealth of Common Sense and as a Yahoo Finance contributor, says: “I do think it's an interesting product and something the robo-advisors will continue to roll out to differentiate themselves. I'm not a tax expert, but I tend to think it's not going to be easy to beat the tax efficiency of ETFs.”

He cites the risk of “tracking error,” or straying from the index when replacing some stocks for others, among other concerns that could mute the benefits over time.

“It's a cool idea and maybe if it helps soften the blow during a bear market it's worth it for some investors, but I think over time the net bonus would slowly fade away,” he concludes.

A 'nice to have' service for investors

Many of the benefits are probably accessible in tax-loss programs offered by competitors such as Betterment, Charles Schwab Corp. (SCHW) and other low-cost online investment shops.

Asked about the direct indexing approach, a Betterment spokesman says: “We have looked at it and continually do analysis on a variety of possible features that could potentially improve customer returns.”

The fact that a sophisticated, ultra-low-cost service such as Wealthfront’s direct indexing offering is seen as a “nice to have” enhancement but not revolutionary is truly the good news here for investors.

It means that the industry – exemplified by the robo-advisors and the incumbent firms rushing to match them -- is already offering investors such a good deal with standard low-fee offerings that the competitive front has moved to less-essential premium strategies.

Of course, part of the reason that private upstart firms such as Wealthfront are eager to give away more for less is to build market share without much focus on immediate profitability.

Some have argued that robo-advisors will need enormous asset totals to make a decent buck – and of course, it’s hard to know whether a bear market will intervene and halt growth, or cause many clients to seek out human financial advisors.

But none of this should cause an immediate problem for the lucky investors today, who can enjoy the competitive arms race that works to their benefit.