Direct indexing: What it is and how it works

Direct indexing might be a strategy worth exploring if you’d like more control over your portfolio, the ability to align investments with personal preferences or values or the potential for more tax-efficient returns.

With advancements in technology and a lower barrier to entry, direct indexing is more accessible now than ever. Learn more about this customizable investment strategy and how it works to see if it’s a suitable option.

What is direct indexing?

Direct indexing is an investment strategy that involves investing directly in individual stocks within a given index such as the S&P 500 instead of investing in an index indirectly through an exchange-traded fund (ETF) or mutual fund.

So, instead of holding a fund where you have no control over the securities, direct indexing involves individually buying all or most of the stocks in an index and attempting to weight them similarly to the index. Then, as you keep an eye on the market and the index, you can manually adjust your holdings as needed. The strategy emerged in the 1990s as a method to leverage the tax benefits of individual stocks within an index, even if the index showed gains. Initially, it was predominantly employed by high-net-worth investors.⁽¹⁾

“Indexing is an approach where you don’t try to beat the market but instead try to efficiently and precisely achieve market results,” explains Zach Teutsch, a fiduciary and founder of Values Added Financial, a registered investment advisory (RIA) firm. “Direct indexing means that instead of using a mutual fund or ETF, you hold a representative sample of individual security positions, usually hundreds of stocks.”

How does direct indexing work?

Direct indexing works by buying individual stocks to replicate an index and then adjusting those assets as the market fluctuates. For example, if certain stocks are underperforming, investors can sell those off and purchase better-performing shares. Direct indexing can be conducted directly by investors, but it’s typically done by professional investment firms through a separately managed account (SMA).

Two main reasons investors choose direct indexing are the increased customization and the potential for greater tax efficiency. Direct indexing allows a level of control you can’t get with an index fund because, when fund investing, you only own the fund, not any of the individual securities. Owning individual stocks also lets you harvest tax losses at the individual stock level.

Dive deeper: What is tax-loss harvesting and how does it work?

Direct indexing also gives investors more flexibility to include stocks that align with their personal or financial preferences and exclude those that don’t. For example, if a company on the index makes products you’d rather not support, you can exclude it from your portfolio. On the other hand, you can also buy stock in companies included on the index that are doing work you want to support.

5 steps to implement a direct indexing strategy

Whether you take a DIY approach or work with a direct indexing platform, here’s how the strategy typically works.

1. Pick an index. Select an index you want to track, such as a broad market index like the S&P 500 or a sector-specific index.
2. Build your portfolio. Buy stocks that replicate your chosen index and then weight each one to mirror that index.
3. Customize your portfolio. You can customize your portfolio by excluding certain stocks or overweighting others to more closely align with your preferences, values or investment goals. Just be careful not to deviate too far from the index, or you risk a tracking error.
4. Rebalance your portfolio. Periodic rebalancing is critical to maintaining the desired stock allocation and ensuring that the portfolio continues to track the index’s performance accurately. Most direct indexing platforms automatically rebalance your portfolio for you.
5. Optimize your taxes. One key benefit of this strategy is tax optimization. Direct indexing platforms use a tax-loss harvesting approach that sells off losing positions in the portfolio to offset capital gains and reduce tax liabilities.

Direct indexing and tax-loss harvesting

As mentioned previously, certain tax advantages of direct indexing are not as accessible when trading index funds. With direct indexing, investors can take greater advantage of the benefits of tax-loss harvesting, which entails selling off underperforming assets to offset any capital gains.

From an investment expert: Using investment losses to your benefit

Not all investments will be a winner; even the most successful investors understand there's room for chance. In volatile markets, where stocks constantly fluctuate, you can use a tax-loss harvesting approach to your benefit. With this strategic strategy, you're using losses to lower your tax liability both now and later.

— Emily Luk, CPA, CFA and co-founder of Plenty

While tax-loss harvesting can be applied to ETFs, you can only harvest the losses if the fund itself has gone down in value from where you bought it. By contrast, direct indexing tax-loss harvesting is done at the stock level, many of which might be down at any given time, giving you more opportunities to realize losses.

Harvesting losses just isn’t as efficient with an index fund, explains Andrew Grauberg, CEO and President of ABC Quant, a provider of risk management and investment solutions for the hedge fund industry.

“In simpler terms, you can lower your taxes by deducting losses from stocks that have generated negative returns during the taxable period. You can’t do the same with an index-tracking ETF, because you cannot separate [the] performance of individual stocks from the fund itself.”

Direct indexing is more accessible now than ever

Direct indexing is not a new investment strategy, but it has recently become more accessible to a wider range of investors. Historically, direct indexing was a strategy meant only for institutional investors or the very wealthy, mainly because minimum investment requirements were so high, says Teutsch.

“Direct indexing used to be almost exclusively for ultra-high-net-worth families, but as the technology has improved, investment minimums have decreased and it is available to a much wider variety of people. It primarily makes sense for people who have ~$100K or more invested in US stocks in a taxable investment account. Some providers have pushed that number as low as $5,000, but then the benefits might not be sufficient to offset the hassle.”

Plus, many brokerage firms don’t charge account fees and now offer fractional share trading and zero-commission trades. These innovations help make this type of strategy more affordable for less affluent investors who want to try this on their own or with the assistance of a professional advisor.

However, even though it may be less expensive now, it’s still a time-consuming and complicated process to replicate an index and continually rebalance as needed. But with the rise in robo-advisors, direct indexing is even more accessible. For example, Wealthfront, Fidelity, Charles Schwab and Frec are direct indexing platforms that offer automated rebalancing and tax-loss harvesting, so even the most hands-off types of investors can get in on the game.

Direct indexing platforms at a glance

Here is a sampling of investment firms that offer a direct indexing product, including investment minimums and advisory fees.

Company	Direct indexing product	Annual advisory fee	Investment minimum
Charles Schwab	Schwab Personalized Indexing	0.40%	$100,000
Fidelity Investments	Fidelity Managed FidFolios	0.40%	$5,000
Frec	Direct Indexing	0.10%	$20,000
Wealthfront	Direct Indexing	0.25%	$100,000

Benefits of direct indexing

Direct indexing is a worthwhile strategy for several reasons, and it’s now available to a broader range of investors.

• Customization. When you buy an ETF or mutual fund, you have no choice in the component stocks. Direct indexing allows you to opt out of companies that don’t align with your social or financial goals and buy ones that more closely reflect your values.
• Tax efficiency. Because you’re individually buying and selling stocks, you can take advantage of tax-loss harvesting at the stock level.
• Risk management. Not only can you customize your portfolio based on your values, you can also use direct indexing to avoid certain sectors or companies that you feel are too risky.

Downsides of direct indexing

Every investment strategy has its own set of risks or potential pitfalls to be aware of.

• Ongoing portfolio management fees. Unless you plan to do all the work yourself, you’ll have to pay someone to manage your investment account, which could be around 0.40% annually.
• High minimum investment requirements. Investment requirements for direct indexing have decreased, but many firms require at least a $100,000 minimum investment, which can still be too high for many investors. There are firms with lower minimums, but some experts agree that the strategy may not be worth the effort for smaller investments.
• Not suitable for IRA or 401(k) investors. If your primary means of investing is through a tax-advantaged retirement account, direct indexing doesn’t make sense. You typically need a separate, taxed brokerage account to enjoy the tax benefits of direct indexing. You don’t pay capital gains taxes or deduct losses on retirement accounts as long as the money remains in the account, so there’s no immediate tax benefit to offset capital gains with harvested losses. Tax-loss harvesting is a primary reason for using the direct indexing strategy.
• Potential for tracking error. If you overly customize your portfolio or fail to track index changes, your performance could stray from the index’s performance.

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Is direct indexing right for you?

Direct indexing might be a good idea if you have a fairly large sum to invest and want to try your hand at duplicating the performance of an index. It’s also a solid strategy for those who typically have a large capital gains tax bill. And, finally, it can often be a more satisfying option for investors who prefer to have a more customized and flexible portfolio.

However, you may want to consider alternative investment strategies if you don’t have a lot of money to invest, your primary investment vehicle is a tax-advantaged retirement account or you don’t want to pay to have your account professionally managed.

Direct indexing can be complex and requires diligent management to optimize tax efficiency and achieve desired outcomes. While some investors may choose to handle direct indexing themselves, others may prefer professional portfolio managers for their expertise, resources and ability to navigate the nuances of the strategy effectively.

Bottom line

As with any investment decision, it’s important to consider your level of risk tolerance and involvement style, financial goals, tax concerns and other factors before deciding if direct indexing makes sense in your situation. And it’s always a smart move to explore multiple investment options, with your specific objectives in mind, so you can find the best investment strategy for you.

Frequently asked questions

What are my options to manage my direct indexing account?

You can opt to buy, sell and manage your own portfolio, but that takes a lot of time and expertise. You could also use a robo-advisor platform or a separately managed account, which will do the work for you. However, a robo-advisor takes away some control. You could instead hire a professional advisor to help manage the account, but you’ll still have the flexibility to make your own decisions.

Do I need a separate account to manage my direct indexing portfolio?

Technically, you don’t need a new account to use a direct indexing strategy, but it could make more sense. For example, if you are trying to monitor the benchmark index yourself, it can be much easier to compare it to your portfolio’s performance if those stocks are the only assets in that account. Also, some direct indexing providers may only offer their product as a separately managed account

Is direct indexing better than an ETF?

Neither one is necessarily “better” than the other. Index ETFs are rarely a bad idea because they give you a stake in all the stocks within an index, thereby spreading out your risk. But you have no choice about which stocks are included or how they are weighted. Direct indexing might make more sense if you prefer having the ability to customize your profile to align with your social and financial goals or want to mitigate capital gains taxes.

What are the tax benefits of direct indexing?

For investors who realize significant capital gains, those wins can translate into hefty tax bills. If you use a direct indexing strategy, you can take advantage of tax-loss harvesting at the stock level — selling off underperforming stocks at a loss — to potentially offset or reduce your tax bill.