There’s an investment strategy to suit pretty much every type of investor. Looking to amplify your gains? If you’re okay with amplifying your risk, too, a strategy like margin trading might be your style. Curious about possibilities beyond stocks? Options trading could open new doors.
Want the performance of the S&P 500 but with more customization opportunities and tax benefits than a typical index fund offers? Enter direct indexing.
Traditional indexing means buying an exchange-traded fund (ETF) or mutual fund that mirrors the index you want to invest in. Those funds are pooled vehicles; when you buy into them, you own a slice of that pool. With direct indexing, you buy the individual securities (stocks) yourself, rather than the fund that holds them all.
How direct indexing differs from traditional indexing
Personalized portfolios. Direct indexing gives you flexibility to choose which of the underlying stocks within an index you want to purchase.
Direct ownership. With direct indexing, you own the stocks directly; the shares sit in your account.
Tax benefits. Because direct indexing gives you ownership over the individual stocks, you can take advantage of certain opportunities to reduce your taxes that traditional indexing doesn’t allow for.
Benefits of direct indexing
Customization
Direct indexing is a more personalized investment strategy than traditional indexing because you don’t have to purchase shares of each underlying stock that makes up an index. You can customize your portfolio, excluding companies that don’t match your investment style or personal values.
Transparency and control
Unlike traditional indexing, direct indexing gives you complete visibility into your holdings, letting you make adjustments in real time based on the performance of individual stocks.
Tax efficiency
Tax-loss harvesting is a portfolio tax management strategy that lets you use investment losses to offset your taxable investment gains. In its simplest form, tax-loss harvesting means that if the value of a stock drops below the price you bought it for, you can sell that stock and realize the loss for tax purposes. In other words, that loss can offset your gains from other investments.
Here’s an example of tax-loss harvesting in action:
You buy 100 shares of a company stock at $50/share, for a total of $5,000.
A few months later, the price drops to $30/share.
You sell your shares, and realize a $2,000 loss.
When it comes time to file your taxes the following year, you subtract that $2,000 from your taxable gains in your other investments, effectively reducing the taxes you owe.
The performance and value of an index fund will always be down, flat, or up. When you own shares in an ETF or mutual fund, tax-loss harvesting opportunities are limited because you can only realize a loss when the fund as a whole is trading below what you paid.
With direct indexing, your tax-loss harvesting opportunities are much more frequent; you can sell and realize a loss whenever a stock is down, even if the overall index is up.
Drawbacks and risks of direct indexing
Complexity
Buying into an ETF or mutual fund is simple: one purchase, and you get instant exposure to all the companies in the index. The fund manages those holdings for you, so you can be pretty hands-off.
Direct indexing means buying and managing those individual shares independently. There are tools that can assist with the process, but even so, it’s more hands-on. That complexity isn’t necessarily a bad thing, but it means direct indexing isn’t the right strategy for every investor.
Potential for higher transaction costs
Buying and selling individual stocks can create transaction costs that exceed the costs of holding a single ETF or mutual fund, reducing returns.
Tracking errors
An ETF or mutual fund mirrors the performance of an index. Direct indexing strives to mirror that performance, but once you start customizing your portfolio, it no longer fully matches the index. That can lead to a gap — called a tracking error — between the performance of your portfolio and that of the index, for better or for worse.
Active maintenance
The customization offered by direct indexing can help you minimize your losses and maximize your gains. But realizing those benefits requires you to actively monitor and rebalance your portfolio in real time, which can be a lot of work.
How direct indexing works
Here’s how to incorporate direct indexing into your investment strategy:
Choose which index you want to mirror.
Buy the individual stocks that make up that index. Do this proportionally to match the index exactly, or customize the stocks based on your investment values and goals (just remember, the more you customize, the greater the gap can become between your portfolio’s performance and that of the index).
Monitor your stocks consistently so you can rebalance your holdings as needed. Some platforms offer automated rebalancing.
Watch for opportunities to sell losing stocks and offset your gains elsewhere. (This can be automated too.)
Replace sold stocks with similar — but not identical — alternatives to keep your portfolio invested in the same sectors while still preserving the tax loss.
The key is to avoid the wash sale rule: if you buy the same or a very similar investment within 30 days before or after selling an investment at a loss, you can’t claim that loss on your taxes. The rule exists to prevent investors from creating artificial tax losses while maintaining essentially the same investment position.
Who should consider direct indexing?
Direct indexing isn’t for everyone. Generally speaking, the investors best-suited to direct indexing are:
Tax-sensitive investors. Investors who face big capital gain tax bills stand to gain from direct indexing. By maximizing tax-loss harvesting opportunities, they can offset their gains.
Active investors. Sophisticated investors who enjoy actively maintaining their portfolios are more inclined to the kind of real-time monitoring and rebalancing that successful direct indexing requires.
High-net-worth individuals. Direct indexing usually requires higher account minimums, meaning it makes more sense for investors who can commit a larger portfolio.
Who might not benefit from direct indexing? Investors with smaller portfolios and investors who prefer a “set-it-and-forget-it” approach to investing.
Direct indexing vs. ETFs vs. mutual funds
Beyond the general differences between direct and traditional indexing, there are also differences between direct indexing, ETFs, and mutual funds.
Direct indexing | ETFs | Mutual funds | |
|---|---|---|---|
| Ownership | You directly own the individual stocks | You own shares of a pooled fund that holds the stocks | You own shares of a pooled fund that holds the stocks |
| Customization | High; you can exclude or emphasize certain companies/sectors | Very limited; all investors in the ETF have the same basket of holdings | Very limited; the fund’s holdings are set by the manager |
| Tax benefit | Strong; year-round opportunities for tax-loss harvesting on individual stocks | Moderate; tax-loss harvesting is only available if the entire ETF is down | Lower; frequent trades by the fund manager can create taxable events for shareholders |
| Best suited for | High-net-worth, tax-sensitive, or value-driven investors | Cost-conscious, hands-off investors | Investors who prefer professional management |
In summary
Direct indexing lets you directly own the individual stocks of an index, rather than a single pooled fund. That ownership gives you more flexibility to customize your portfolio according to your goals and values, offers more visibility into your holdings, and lets you harvest tax losses more often to offset other taxable gains.
While direct indexing can be more complex (and time-consuming) than simply buying an ETF or mutual fund, it can be a solid investment strategy for the right investor. Before diving into direct indexing, consider whether its benefits (and drawbacks) make sense for your individual investing approach.
