Investing Essentials What is direct indexing and how does it work?

What is direct indexing?

Direct indexing involves buying the underlying securities that constitute an index in the weights needed to mimic the performance of that index.¹

Should you want to replicate the performance of, say, the S&P 500 Index or the Nasdaq 100 index, you may consider buying an index mutual fund or exchange-traded fund (ETF) that tracks that index. With direct indexing, you would instead purchase the individual stocks that make up that index.²

Up until somewhat recently, if you were an investor who wanted to use a direct indexing approach, you would need a relatively significant amount of money to buy all the stocks in a particular index to replicate its performance (not to mention trading costs associated with rebalancing to reflect changes in the index would add up). Direct indexing has become an option with the rise of commission-free trading and fractional-share stock investing, that allows you to purchase fractional shares in a certain dollar amount.³

Direct indexing is typically done in a separately managed account and is handled by an investment manager.⁴

Potential benefits of direct indexing

Direct indexing could provide you with some specific advantages, namely potential tax savings not typically possible when you own a traditional index fund. This strategy also offers more flexibility when it comes to the individual stocks you choose to own, letting you customize your holdings to fit your preferences.⁵

Directly holding securities within an index enables you to potentially take greater advantage of tax-loss harvesting, a maneuver that may ultimately lower your tax bill. Tax-loss harvesting involves selling an investment at a loss, replacing that investment with something similar (but not substantially identical) and using the tax loss to offset other taxable capital gains. This can help minimize your portfolio’s tax burden, but this practice is subject to meeting certain requirements. ETFs or mutual funds, for example, make it harder to harvest losses from individual positions because you own a component of the fund, not the individual stocks that comprise the fund.⁶ While you may be able to harvest losses by selling an ETF for a highly correlated one, it may not be as effective as holding the individual stocks.

Potential drawbacks of direct indexing

As with most investment strategies, direct indexing isn’t without its downsides. Direct indexing requires constant monitoring and maintenance as opposed to simply holding an index fund or index ETF. This constant rebalancing and scrutiny for tax-loss harvesting opportunities can mean higher transaction costs and management fees than a typical ETF or index fund.⁷

This hands-on approach can also lead to tracking error, where your portfolio strays from its target allocation. Should the replacement stocks or funds in a tax-loss harvesting strategy have higher costs than the original, your portfolio may deviate from its target. Looking at your portfolio holistically and ensuring it remains on track with benchmarks and your investment goals is important when considering a tax-loss harvesting strategy.

Also consider that the tax-loss harvesting strategy itself carries risk. Tax-loss harvesting doesn’t guarantee you’ll come out ahead; in fact, the potential tax benefit of this approach depends on the stock market environment and also on whether the “wash sale” rule applies to the loss transaction, which may defer or deny any tax deduction arising from the loss sale if a substantially identical position is repurchased too quickly. Extended market downturns let shareholders realize significant capital losses from their directly indexed portfolios, while bull markets often provide fewer opportunities.⁸ If you have questions about potential tax consequences, please consider speaking with a tax professional.

Direct indexing vs. ETFs and index funds

When you buy a share of an index fund or ETF that tracks a specific index, the value of your shares rise or fall based on the companies’ performance within the index over time. But you don’t have direct ownership – you don’t get a vote as a shareholder in company decisions, for example.

When you own an index fund or ETF, the manager decides the components of the fund and how closely to track the index. With direct indexing you own the securities outright and you can customize your “personal index” to your liking. If investing based on environmental, social and corporate governance (ESG) factors is important to you, and if there are companies represented in the index that don’t align with your values, you can remove them.⁹

Similarly, direct indexing also allows you to modify your portfolio relative to the index weightings to slightly overweight or underweight certain stocks or sectors. For example, you may tilt your portfolio by holding 2% more tech stocks than the index and 2% fewer oil stocks if you wanted to.¹⁰

Bottom line

Direct indexing, is an investment strategy that involves purchasing the component securities of a particular index as a way to replicate the performance of the index itself. It has the potential to offer certain investors greater tax advantages than owning a traditional index fund or ETF, as well as the ability to customize their holdings. Speak with a tax professional or your financial advisor with any questions.