Index investing has become one of the most popular investing strategies in recent decades. Rather than picking individual stocks, you can simply invest in a mutual fund or exchange-traded fund (ETF) that tracks an index like the S&P 500. 

But thanks to direct indexing, you can mimic the returns of major stock indexes and funds by owning each stock individually. You could still get largely the same (or at least similar) returns while taking advantage of increased customization and the opportunity to realize your investment tax losses and lower your tax bill.

If you’re considering a direct indexing strategy, it’s important to understand how it works, the benefits, and some risks to look out for.

Key Takeaways

• Direct indexing allows investors to own individual stocks in an index for more control over taxes.
• Applying tax-loss harvesting to your direct indexing strategy can offset capital gains and improve after-tax returns.
• Benefits of direct indexing include customization, risk management, and potential charitable giving advantages.
• Risks of direct indexing include tracking errors, complexity, and increased costs or investment minimums.
• This strategy works well before or after large transactions or when transitioning portfolios.

What Is Direct Indexing?

Direct indexing is an alternative approach to index investing where, instead of investing directly in an index mutual fund or ETF, you buy individual stocks to replicate a market index. For example, rather than investing in an S&P 500 index fund, you would buy each of the individual underlying stocks in the index. 

This approach offers more control over portfolio construction and tax management compared to traditional index funds or ETFs.

This strategy is more attainable today for a couple reasons. First, before commission-free trading and fractional shares, direct indexing was only available to high-net-worth investors. After all, you would have to buy and sell a large volume of shares, which requires a large amount of cash. It can also be a time-consuming strategy, requiring both the administrative work of buying and selling the shares, as well as staying informed about the index you’re tracking.

Now, investors have the option to DIY their direct indexing with commission-free trading and fractional shares, work with an advisor who can execute the strategy for them, or invest in direct indexing products, which are available through some major brokerages.

How Tax-Loss Harvesting Works

One of the key benefits of direct indexing is that it allows you to engage in tax-loss harvesting in a way that index fund investing doesn’t. Tax-loss harvesting involves selling securities at a loss to offset capital gains from other investments. Losses can also be carried forward to future tax years to offset gains later. In direct indexing, this strategy can be applied more efficiently because you own individual securities rather than a single fund.

Offsetting Capital Gains

First, tax-loss harvesting allows you to offset your capital gains with capital losses. For example, let’s say you sell a major investment for a $100,000 gain. Assuming a 30% tax rate, you would pay $30,000 in capital gains taxes on that sale. But for each dollar of that gain you’re able to offset with losses, you lower your tax bill. And if you claim $100,000 in losses, you can eliminate your capital gains taxes altogether.

Carrying Losses Forward

The IRS allows you to deduct an additional $3,000 in capital losses above and beyond your capital gains. And anything above that amount can be rolled forward to future years, reducing taxes when your portfolio generates capital gains.

If you have $10,000 in capital losses this year but no gains to offset, consider rolling the full amount forward to next year when you’re planning to sell off a large number of assets. 

Be Aware of the Wash Sale Rule

The IRS wash sale rule prohibits investors from buying substantially identical securities within 30 days before or after selling an asset at a loss. To avoid running afoul of this rule, either wait at least 30 days to repurchase a security or buy a security that’s similar, but not substantially identical.

Benefits of Direct Indexing

There are good reasons why some investors turn to this alternative approach to index investing. Here are some benefits to consider if you’re wondering if direct indexing is right for you:

• Tax Efficiency: Thanks to tax-loss harvesting, direct indexing offers more tax efficiency, allowing you to keep more of your investment earnings.
• Customization: Investors can control exposure based on their preferences by choosing which stocks, industries, or sectors to include or exclude. This could be based on an investor’s investment views or values.
• Risk Management: Diversifying exposure by owning stocks tailored to an investor’s risk and investment objectives can more closely align with a long-term financial plan and allocation goal.
• Transition Planning: With concentrated positions or a portfolio with unrealized gains, investors can potentially move a portfolio closer to the benchmark while minimizing tax consequences.
• Charitable Giving: Gifting appreciated stock can be a tax-efficient way to support causes you care about.

Risks and Considerations

While direct indexing offers flexibility and tax advantages, it also carries certain risks and downsides:

• Tracking Errors: A simple tracking error could result in your returns being different from the index you’re tracking, especially if you’re doing all your own trading. The more customized your portfolio is, the more room there is for variation in returns.
• Execution Risk: Direct indexing on your own requires certain tools, technology, and expertise. Without those, you could end up improperly tracking the index.
• Market Volatility: As is the case with all stock investing, you’re vulnerable to market volatility. Despite the tax advantages of direct indexing, losses can still occur.
• Increased Costs and Minimums: Direct indexing products often have higher fees and higher minimum investments than typical index mutual funds or ETFs.
• Increased Administrative Burden: If you choose to DIY it rather than working with a professional or investing in a direct indexing product, you’ll take on a considerable time investment.

Real-World Example

Suppose you have a $1 million portfolio, 50% of which is in U.S. equities. Let’s assume for the purpose of this example that you could earn $50,000 per year, which is a return of 10%, the long-term stock market average. Assuming a 30% tax rate, you would pay $15,000 per year in income taxes on those gains. 

But what if you applied a direct indexing strategy instead? Let’s assume you earn the same $50,000 in short-term gains per year, but you’re also able to claim $25,000 in losses. Your new taxable gain is just $25,000, meaning you cut your tax burden in half from $15,000 to $7,500. And if you do that each year, your tax savings will rack up to tens of thousands of dollars (or more). 

If we take this one step further and say you reinvest that $7,500 in the first year, your portfolio (and your returns) could grow larger and larger each year with the help of continued tax-loss harvesting.

Is Direct Indexing Right for You?

Direct indexing can be an effective approach to mimicking the returns of a popular stock index while reducing your tax burden. But because of the complexity and the administrative burden, it’s not right for everyone. Direct indexing may be right for you if you’re in one of the following situations:

• You’re a high-net-worth investor: The higher your income and net worth, the more you have the potential to save using a direct indexing approach.
• You want greater control over your portfolio: Direct indexing gives you more control than traditional index investing, allowing you to deviate from the exact allocation of an index fund.
• You have significant capital gains: Someone with significant capital gains each year has the potential to save a lot by offsetting those gains with losses.
• You’re comfortable with the added complexity and risks: Direct indexing is a complex strategy that introduces some additional risk. If you’re comfortable with that and are in one of the situations above, direct indexing might be right for you.

Frequently Asked Questions

Q: Is direct indexing better than ETFs?

A: It can be more tax-efficient and customizable, but ETFs are simpler and often cheaper to manage.

Q: How does tax-loss harvesting work in direct indexing?

A: By selling individual stocks at a loss, you can offset gains elsewhere in your portfolio or carry losses forward.

Q: What are the main risks of direct indexing?

A: Tracking error, higher operational complexity, and market volatility.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

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