When Direct Indexing Makes Sense

Building wealth and keeping wealth often require different strategies. Once a portfolio reaches a certain size, taxes begin to matter almost as much as investment returns. That is one reason direct indexing has become one of the fastest-growing investment strategies among affluent investors.

Few investment innovations have had a bigger impact on long-term investors than the index fund. Instead of trying to pick tomorrow's winning stocks, investors can own hundreds or even thousands of companies through a low-cost index fund and participate in the market's long-term growth. It is simple, inexpensive, and remarkably effective.

A newer approach called direct indexing is built on the same philosophy of broad diversification, but it takes a different path to get there. Rather than buying shares of an index fund, you own the individual stocks that make up the index. Advances in technology, fractional share trading, and automated portfolio management have made this strategy practical for a much larger group of investors than was possible just a few years ago.

As portfolios grow, the focus shifts toward managing taxes, concentrated positions, charitable giving, estate planning, and the countless other decisions that affect long-term wealth. Direct indexing addresses many of those issues while keeping the core investment philosophy intact.

Looking Under the Hood

An S&P 500 index fund and a direct indexing portfolio are built with the same destination in mind. Both seek to give investors access to America's largest publicly traded companies and are designed to participate in the market's long-term growth. Over time, their returns should be similar because they are tracking the same benchmark.

When you purchase an index fund or ETF, you own shares of the fund, which in turn owns the underlying companies. The fund manager handles rebalancing, adjusts for changes in the index, and takes care of the administrative work required to keep the portfolio aligned with its benchmark seamlessly in the background.

With direct indexing, there is no fund sitting between you and the companies. Instead, your account owns the individual stocks directly. Sophisticated software manages the process, buys fractional shares when necessary, and keeps everything remarkably close to the index. What used to require institutional-sized assets can now be done efficiently for individual investors because software has automated much of the process.

That difference in ownership may seem subtle, but it creates planning opportunities that generally do not exist inside a traditional index fund.

Where Direct Indexing Starts to Shine

Tax-loss harvesting is where direct indexing begins to separate itself from a traditional index fund. An index may have hundreds or thousands of holdings, and its returns represent the combined performance of the stocks it tracks. While the overall index may post a positive return, some of its individual holdings can still be temporarily below their purchase price. Because you own those stocks directly, they can be sold to realize tax losses while similar replacement securities are purchased to keep the portfolio aligned with the target benchmark. Those realized losses may offset current or future capital gains and, subject to IRS rules, up to $3,000 of ordinary income each year, with unused losses carrying forward indefinitely.

Direct indexing also provides an opportunity for customization. Investors can exclude certain companies, reduce concentrated positions created by employer stock, or incorporate personal preferences while still maintaining diversification. For example, assume you spent your career at Microsoft and accumulated a sizeable amount of company stock, creating a concentrated stock position. If you buy an S&P 500 ETF, you would be purchasing even more Microsoft stock because it is one of the index’s largest holdings. Alternatively, using a direct indexing approach allows you to reduce or eliminate Microsoft while increasing other holdings so your overall market exposure remains similar to the index. That allows the investor to reduce single-company risk without abandoning a diversified investment strategy.

The Enduring Strength of Index Funds

Traditional index funds remain one of the most efficient investment vehicles available. They provide inexpensive, diversified market exposure with almost no maintenance required from the investor. They are also incredibly tax efficient on their own, particularly ETFs, which generally distribute very few capital gains because of their creation and redemption process. Because they are pooled investments, they also tend to track their benchmark very closely while keeping trading costs low.

For retirement accounts such as traditional IRAs, Roth IRAs, and employer-sponsored retirement plans, those characteristics often make index funds the preferred choice. They are also ideal for investors who simply want a straightforward way to invest in the benchmark without additional complexity.

Understanding the Tradeoffs

Owning hundreds of individual securities in a direct indexing strategy requires more sophisticated management and often involves higher costs than purchasing a low-cost ETF. In addition, portfolios can experience modest tracking differences as stocks are bought and sold for tax management. Tax-loss harvesting itself is also subject to the IRS wash sale rules, which require careful coordination across taxable and retirement accounts. In smaller accounts, the potential tax savings may not justify the additional complexity or cost. Tax benefits also tend to diminish over time as appreciated positions accumulate and fewer harvesting opportunities remain.

Index funds, by comparison, sacrifice customization in exchange for simplicity and efficiency. Investors cannot harvest losses on individual companies because they own shares of the fund rather than the underlying stocks.

The Type of Account Matters

One of the biggest factors in deciding between direct indexing and an index fund is the account's tax structure.

In a taxable brokerage account, investment gains and losses have immediate tax consequences. Every harvested loss can potentially reduce taxes today or create tax assets that can be used in future years. That is where direct indexing can provide meaningful value.

Inside a traditional IRA, 401(k), or other tax-deferred account, those tax benefits largely disappear because buying and selling investments does not create current taxable gains or deductible losses. Since tax-loss harvesting is unavailable, much of direct indexing's primary advantage is lost. In those accounts, a traditional index fund often accomplishes the same investment objective with less complexity and lower cost.

A Practical Example

Sarah and David are two investors who each want to invest $1 million in large U.S. companies in a taxable brokerage account.

Sarah purchases a low-cost S&P 500 ETF in her taxable brokerage account. By year-end, the fund has gained 10 percent. Although several companies within the index declined during the year, Sarah owns only the ETF, so there are no individual stock losses available to harvest. She continues holding the fund and benefits from broad market exposure.

David invests the same $1 million through a direct indexing strategy designed to track the S&P 500. His portfolio also gains 10 percent, but dozens of individual stocks finish the year below his purchase price. His investment manager harvests those losses and purchases replacement securities that maintain similar market exposure while avoiding wash sale violations. David still participates in the market's overall growth and earns a similar return to Sarah, but he also accumulates realized tax losses that may offset gains elsewhere or be carried forward for future use.

Both investors achieved diversified access to the same segment of the market. The difference is that David's ownership of the underlying securities created opportunities to improve after-tax returns. Had both investors instead held their investments inside a traditional IRA, those harvested losses would provide no current tax benefit. In that situation, the additional complexity of direct indexing would likely offer much less value.

Matching the Tool to the Job

Direct indexing has gained popularity because it lets investors combine a diversified investment mix with ongoing tax management and portfolio customization. Index funds remain one of the most efficient and cost-effective ways to build long-term wealth, particularly inside tax-advantaged retirement accounts where tax-loss harvesting provides little benefit.

The most appropriate vehicle often depends less on the investment itself than on where it is being held. Taxable accounts may benefit from the flexibility of direct indexing, while tax-deferred and tax-free retirement accounts frequently favor the simplicity of traditional index funds. When both tools are used where they are most effective, investors can build portfolios that pursue broad market returns while making thoughtful use of the tax rules that apply to each account.