Direct Indexing: What Is It and Who Should Invest?

Learn how direct indexing works and how it compares to ETF investing.

kent
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Research Lead
Reviewed by: etf.com Staff
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Edited by: James Rubin

Direct indexing (DI) has gained popularity in recent years, driven by advancements in technology that have made it more accessible and cost effective.

Various financial institutions and investment platforms, including Vanguard and Wealthfront, offer direct indexing services, allowing individual investors to create customized portfolios aligned with their investment goals and values.

But how does direct indexing work, and how does DI strategy compare to investing in ETFs?

What Is Direct Indexing?

Direct indexing refers to investing where an investor purchases securities, such as stocks, in proportion to a specific index, such as the S&P 500, or a custom index created by the investor. By mimicking the composition of an index, investors attempt to achieve a similar performance to the index itself.

Therefore, direct indexing typically involves purchasing individual securities, rather than investing in a mutual fund or an exchange-traded fund (ETF) that holds a portfolio of securities. This approach allows investors to own the underlying assets directly, rather than holding shares of a fund that represents ownership in a pool of assets.

Pros & Cons of Direct Indexing

Direct indexing offers several potential advantages, including portfolio customization and tax optimization. But there are also potential disadvantages, such as higher capital requirement, increased complexity and higher costs compared to traditional index investing.

Here are the pros and cons of direct indexing:

Pros

  • Customization: By selecting specific stocks or excluding certain stocks/sectors, investors can customize their portfolio, which allows investors to align their investments with their personal preferences, values, or investment objectives.
  • Tax optimization: Investors can selectively sell individual stocks to realize tax losses, offsetting gains in other parts of their portfolio. This “tax loss harvesting” can result in potential tax savings and improved after-tax returns.
  • Enhanced control: Investors have direct ownership of individual stocks, providing more control over the composition and management of their portfolio. They can make real-time adjustments, rebalance, or implement tactical decisions based on market conditions or personal beliefs.
  • ESG and social impact considerations: Direct indexing allows investors to align their investments with environmental, social, and governance (ESG) factors. They can exclude companies that don't meet their sustainability criteria, or target investments in specific industries to promote social impact.

Cons

  • Higher capital requirement: Direct indexing typically requires a larger amount of capital compared to investing in mutual funds or ETFs. To achieve adequate diversification and minimize risk, investors may need a high level of assets, such as $1 million or higher, to purchase a broad range of individual stocks.
  • Increased complexity: Direct indexing involves selecting, monitoring and managing individual stocks, which requires more time, knowledge and expertise. Investors must stay informed about market trends, perform fundamental analysis and make informed decisions regarding their portfolio.
  • Transaction costs: Buying and selling individual stocks can result in higher transaction costs compared to investing in a mutual fund or ETF. Frequent trading or rebalancing activities may lead to increased brokerage fees and potentially impact overall portfolio returns.
  • Active management challenges: Direct indexing blurs the line between passive and active investing. While investors have more control over their portfolios, they need to actively manage their holdings, monitor market trends and make timely investment decisions. This active management can be challenging and may lead to suboptimal outcomes if not executed effectively. It may also lead to reliance on advisors, which can lead to higher costs.

Direct Indexing vs ETFs

Direct indexing and ETFs share similar investment approaches but have some key differences. Direct indexing may be suitable for high-net-worth individuals seeking customization, tax optimization and greater control over their portfolios. By comparison, ETFs provide instant diversification, lower capital requirements and ease of use for investors seeking a simpler, more hands-off approach.

Here are the key differences between direct indexing and ETFs:

  • Customization and control: With direct indexing, investors can select individual securities and hold them directly in a portfolio that aligns with their preferences, investment objectives, or values. While ETF investors don’t control the portfolio holdings, and don’t directly hold the securities, they can buy low-cost funds with niche strategies.
  • Tax efficiency: Investors can selectively sell individual stocks to realize tax losses, potentially offsetting gains in other parts of the portfolio. This can lead to tax savings and improved after-tax returns. While ETF investors can’t control this aspect, they generally offer tax efficiency, and investors can choose ETFs with specific tax strategies.
  • Managing costs: Direct indexing can be cost effective compared to ETFs, especially for larger portfolios. By avoiding fund management fees, investors may achieve cost savings. However, direct indexing may require professional management and can potentially have higher transaction costs than ETFs due to higher trading frequency.
  • Complexity versus simplicity: Direct indexing involves the selection, monitoring, and management of individual stocks. By comparison, investing in ETFs is generally simpler and requires less active involvement from investors, who can gain broad market exposure without needing to select and manage individual stocks.
  • Investment minimum requirements: Direct indexing provides access to a wide range of assets that may be cost prohibitive to hold individually. ETFs allow investors to gain exposure to a diversified portfolio with relatively smaller amounts of capital compared to direct indexing.
  • Passive management: Direct indexing blurs the lines between active and passive management. While most ETFs passively track an index and aim to replicate its performance, actively managed ETFs are growing in availability and diversity in the marketplace.

What Is Tax Loss Harvesting?

Tax-loss harvesting involves strategically selling investments that have decreased in value, locking in a capital loss. This loss can then be used to offset capital gains from other investments you've sold, thereby reducing your taxable income and potentially lowering your tax bill.

For example, imagine you own 10 shares of Company A that you bought for $10 per share ($100 total). The price has dropped to $8 per share. You could sell those 10 shares for a capital loss of $20 (10 shares * ($10 original price - $8 current price)). If you also sold other investments this year for a capital gain of $20, you could use your capital loss from Company A to offset that gain. This would reduce your taxable income by $20, potentially lowering your tax bill.

Bottom Line on Direct Indexing: Is DI Right for You?

Direct indexing allows investors to replicate an index by directly owning stocks within the respective index. However, a DI strategy has a higher capital requirement than ETFs, and it is typically designed for tax optimization; therefore, direct indexing may be best suited for high-net-worth individuals with taxable brokerage accounts.

Ultimately, the choice between direct indexing and ETFs depends on an investor's financial circumstances, individual preferences, and goals.

Kent Thune is Research Lead for etf.com, focusing on educational content, thought leadership, content management and search engine optimization. Before joining etf.com, he wrote for numerous investment websites, including Seeking Alpha and Kiplinger. 

 

Kent holds a Master of Business Administration (MBA) degree and is a practicing Certified Financial Planner (CFP®) with 25 years of experience managing investments, guiding clients through some of the worst economic and market environments in U.S. history. He has also served as an adjunct professor, teaching classes for The College of Charleston and Trident Technical College on the topics of retirement planning, business finance, and entrepreneurship. 

 

Kent founded a registered investment advisory firm in 2006 and is based in Hilton Head Island, SC, where he lives with his wife and two sons. Outside of work, Kent enjoys spending time with his family, playing guitar, and working on his philosophy book, which he plans to publish in the coming year.