Direct indexing has gained popularity in recent years. And for many people, it makes a lot of sense. But it’s by no means a free lunch that can replace indexing or ETFs.
In this article, I’ll briefly discuss what direct indexing is, as well as its potential benefits. Most importantly, I’ll review the questions you should ask yourself — from a financial planning perspective — before committing to the strategy.
What Is Direct Indexing?
Also known as personal indexing, direct indexing is a way to invest in an index (like the S&P 500). However, instead of buying an index mutual fund or ETF, you own the individual stocks in that index. This gives you more control over your portfolio while still getting broad market exposure.
The two main reasons investors choose direct indexing are:
- Tax-Loss Harvesting. Because you have direct ownership of the individual stocks, you can sell losing stocks to offset gains and lower your tax bill — something ETFs and index funds can’t do.
- Customization. You can exclude certain stocks or industries (e.g., if you already own too much of a company through work, or want to avoid certain companies for ethical reasons).
Direct indexing has become more popular as technology has made the approach easier and cheaper to utilize. What used to be an expensive strategy for the ultra-wealthy is now accessible to more investors.
What’s the “Alpha” of Direct Indexing?
“Alpha” in direct indexing refers to the extra after-tax return you might get compared to a traditional index fund.
Vanguard’s research suggests tax-loss harvesting in direct indexing can add around 0.20% to 1% per year in returns, depending on an investor’s tax bracket and contribution strategy.
The people who benefit the most are:
- Investors in a high tax bracket, where tax-loss harvesting has the most impact.
- Those who continuously invest new money, generating ongoing tax-loss harvesting opportunities.
- Those who reinvest tax savings, allowing benefits to compound.
Yet for many investors, the actual gains may be lower. Tracking error — which describes the phenomenon of a portfolio drifting slightly from the index — can occur due to frequent stock trades or excessive customizations. Wash sales can also cancel out tax benefits if investors accidentally repurchase individual securities too soon.
Case in point: the Vanguard study also found that investors who can’t save as much on taxes might see lower overall returns if they try to personalize their investments too much.
In other words, direct indexing can improve after-tax returns, but it’s not for everyone.
7 Questions to Ask Before Starting With Direct Indexing
From a financial planning perspective, here are seven important questions you should ask yourself before moving to a direct indexing strategy.
#1. Will the added complexity help you reach your goals?
Key point: Direct indexing is a more hands-on strategy than passive index investing. There’s more to manage, both on the investment and tax side. This increases your time investment, and you might end up paying for an advisor or tax professional’s help.
Direct indexing is more complex than buying a single index mutual fund (or just letting a robo advisor handle everything). For a smaller portfolio (i.e., less than $50,000), or for someone in a low tax bracket, the benefit of this complexity is minimal.
In contrast, if you have $100,000+ to invest and are in a high tax bracket, the extra tax-loss harvesting and customization could meaningfully improve your after-tax returns.
So, make sure the potential gains justify the additional moving parts.
If you have a high net worth and sophisticated financial goals (e.g., maximizing tax efficiency or aligning a large portfolio with specific preferences), the complexity may be worth it. On the other hand, if you stand to save $2,000 in taxes annually but pay $1,500 in additional management or advisor fees, is that savings worth the time and hassle?
If not, a simpler approach might suffice.
#2: Are you investing a lump sum, or will you continue contributing and rebalancing over time?
Key point: As the previously-noted Vanguard study pointed out, “the single most important behavior driving the value of tax-loss harvesting is the reinvestment of tax savings in the portfolio.” If you’re not going to reinvest, you significantly reduce the benefits of utilizing this strategy.
How you plan to fund and reinvest the account can impact the value of direct indexing.
A one-time lump sum investment can generate tax losses mainly in the early period (e.g., during a market dip after your purchase). Keeping in mind, of course, that most direct indexing services have high minimums (Schwab and Fidelity are the lowest and start at $5,000, but their fees tend to run higher).
If the market steadily rises for years, a lump-sum investor might not see many new harvesting opportunities once their positions are all sitting at gains. And in this case, they have little to reinvest, so their tax savings compound.
On the other hand, if you add money regularly (say monthly or annually), each new contribution buys stocks at a new cost basis, creating ongoing chances to harvest losses on some positions whenever the market fluctuates.
Direct indexing tends to shine for those who contribute over time, because the TLH algorithm can continually find pockets of losses in different lots of stock.
So before you invest, consider your funding plan: direct indexing is most effective when dollar cost averaging consistently and then reinvesting those tax savings, rather than with a set-and-forget one-time investment.
What you want to avoid is getting very little benefits down the road while paying a slightly higher fee but being stuck with the direct index provider because of the hassle of moving 500 individual stocks.
#3. What’s your plan for rebalancing your overall portfolio?
Key point: Have a clear plan for how direct indexing will fit with or replace your current investments, and how you’ll keep the overall portfolio in balance.
If you already have an investment portfolio, whether that’s a 401(k) or a taxable account, think about how you’ll integrate direct indexing into your overall strategy.
Will you be replacing an index fund or ETF you currently hold with a direct index? If so, be mindful of tax consequences: selling a large ETF position to move into hundreds of equities could trigger capital gains.
Direct-indexing services like Frec (read my Frec review) allow for in-kind transfers of individual stocks that are part of an index you’re replicating. However, this only applies to individual stocks — not index funds or ETFs.
You might choose to transition gradually — for example, direct-index only new contributions or a portion of your assets — to avoid a hefty tax bill. Alternatively, if you keep your existing holdings, you’ll need to rebalance to maintain your desired allocation.
#4. Will you actually benefit from direct indexing’s tax advantages?
Key point: Evaluate whether your financial situation (now and in the future) makes those tax-loss harvests meaningful. If you’re not in a position to use the losses, direct indexing may not be worth the effort.
Tax-loss harvesting is the primary “alpha” from direct indexing, so it’s important to ask if those tax benefits truly apply to you.
Consider your tax bracket and capital gains situation. High-net-worth investors in high tax brackets or with substantial capital gains each year have the most to gain from harvesting losses. If you regularly sell investments or have big stock compensations or real estate sales, those losses can be very valuable.
By contrast, if you’re in a low tax bracket or don’t expect to realize many gains, the benefit might be less impactful. You could end up with a pile of losses that you’re only able to deduct at $3,000 per year against income.
Additionally, remember that direct indexing isn’t a way to avoid taxes permanently; it’s a way to defer and reduce them. Eventually, if you liquidate the portfolio, you’ll realize gains that could offset the accumulated losses.
The ideal scenario is to use those losses over the years to offset other taxable gains (or even ordinary income, up to $3K per year), effectively boosting your after-tax return.
#5. Do you need personalized portfolio customization that an index fund can’t provide?
Key point: When you start to tinker with your portfolio, you’re leaning towards more active investment rather than passive. In this scenario, you might underperform the index.
One often-touted benefit of direct indexing is the ability to customize, or tilt, your holdings. But this can add risk.
Indexing works because you’re not constantly tinkering with and adjusting your portfolio. Excessive customization can lead to your portfolio diverging from the underlying benchmark.
So, only opt for customizations if you have a reason; otherwise, you might complicate your portfolio without a clear benefit.
#6. Do you have wash sale risk?
Key point: Direct indexing can significantly increase your tax complexity, which may result in paying a tax or financial advisor on top of the additional management fees for direct indexing.
A wash sale happens when you sell an investment at a loss and then buy the same or a very similar investment within 30 days before or after the sale. If this happens, the IRS won’t allow you to claim the loss on your taxes — thereby reducing one of the main benefits of direct indexing.
Unlike index funds, direct indexing involves direct ownership of individual stocks, and tax-loss harvesting happens automatically. But if another account you control — like a 401(k), IRA, or a spouse’s account — repurchases the same stock within 30 days, you can accidentally trigger a wash sale, disqualifying the tax loss.
For example, say your direct-indexed S&P 500 portfolio sells Apple at a loss for tax harvest benefits. But your spouse owns Apple in a separate brokerage account, and four days later — after the algorithm automatically rebalances in your direct index account — a dividend is reinvested automatically in your spouse’s taxable account. Since you technically “re-bought” Apple within 30 days, the IRS disallows the loss from your direct indexing trade.
There are ways to work around wash sales — like turning off automatic dividend reinvestment, manually tracking trades across accounts, or swapping stocks for similar ones. But each of these adds complexity, and more complexity increases the risk of mistakes or unintended tax consequences.
Before using direct indexing, consider whether you’re comfortable with the added layer of management needed to avoid these pitfalls.
#7. Are there simpler tax savings strategies available?
Key point: Direct indexing is often the most tax-efficient way to invest but also the most complex. There are simpler alternatives available, which might not get the maximum tax benefits, but which are still suitable for many investors.
Direct indexing is a tax strategy, but it’s not the only way to manage taxes efficiently. Investors looking to reduce capital gains taxes without the complexity of owning hundreds of stocks may find tax-managed ETFs and mutual funds to be a better fit.
For example, Vanguard’s tax-managed mutual funds and broad index ETFs use strategies like tax-loss harvesting, low turnover and in-kind redemptions to minimize taxable distributions — without requiring investors to handle individual stock trades.
While you’re not going to get personalized daily tax-loss harvesting with these funds (as the losses are not going to be as high), they can still help minimize taxes and are much easier to place in a portfolio than adding and managing individual stocks.
Final Thoughts
Overall, I don’t think direct indexing should replace index investing, despite what some people have claimed.
Is it a strategy worth considering? Absolutely! Vanguard’s studies prove this point.
However, there are still risks associated with this strategy, and carefully understanding these risks can help you decide if it’s truly right for you — or if it’s something you might regret down the road.
