Complete Guide to Direct Indexing

Are you ready to take control of your investment portfolio?

If you answered yes, then something known as direct indexing may be for you. 

Direct indexing involves purchasing all the stocks listed in an index fund, but independently, so you can make adjustments on various holdings as you wish. This keeps you in complete control of your money, and can even provide some serious benefits come tax season (who doesn’t love that?). 💸

When employed properly, direct indexing can be even more profitable than simply investing in an index fund. Just look at Blake Grossman, an ETF pioneer who is now “urging asset managers” to switch to direct indexing.

Before you go crazy, however, and sell all your index funds to start direct indexing, you should know there are many pros and cons to this type of investing (after all, every fairy tale has to have a villain). And there’s a reason many investors continue to pad their portfolios with index funds even though direct indexing has been around for a few years. 

Ready to learn all about direct indexing, and whether or not it’s the investment strategy for you? Well, then, let’s jump into it! 👇

What you’ll learn

• What is Direct Indexing?
• How Does Direct Indexing Work?
• What is Passive Index Investing?
• When Should You Consider Direct Indexing?
• Advantages of Direct Indexing
• Disadvantages of Direct Indexing
• Conclusion
• Get Started with a Stock Broker

What is Direct Indexing? 📘

Perhaps you’re familiar with the term index investing, which is where you invest your money in a collection of companies as a single purchase on the stock market. These investment products come in a few different varieties, such as ETFs or mutual funds. 

Direct indexing is an extension of this. You will be investing in the same companies present in an index fund, and at the same weight, but as individual investments rather than one single purchase. And you, rather than the fund, will own the stocks you are purchasing. 

Direct indexing allows you more freedom than purchasing a traditional index fund, as you can exclude stocks you don’t want to purchase and buy more of those which you do. Many investors who are environmentally conscious use direct indexing to purchase a large variety of companies in a certain sector but exclude those whose practices they don’t agree with.

How Does Direct Indexing Work? 🏗

Although it may sound difficult, direct indexing is quite easy. All you have to do is find an ETF or other index fund you are interested in, and instead of purchasing one share of the fund, you purchase all of the stocks that make up the fund, and in the same amounts. 

For example, if you were interested in the S&P 500 ETF, you would look at the 500 companies involved in this index and purchase each one at the weight it pulls in the fund. So if the index was made up of 25% Amazon (AMZ) stock, you would put 25% of your money into AMZN stock and the other 75% in the other 499 companies in the S&P 500. 

Now we know what you’re thinking, it sounds like direct indexing is going to cost a lot of money you may not have. And this indeed used to be the reason many investors were drawn to index funds in the first place. 

But in the present day, you can purchase fractional shares of many stocks, which is what has made direct indexing an accessible form of investing over the past couple of years. Meaning you can own all the shares of an index, even one as large as the S&P 500, without needing a fortune. 

Why is Tax-Loss Harvesting an Important Part of Direct Investing? 🤔

Still, it sounds like buying all these stocks individually could be quite the hassle. So why would you do it?

This is where one of the main benefits of direct investing comes into play, which is that it allows you, as an investor, to tax-loss harvest. Tax-loss harvesting is where you sell the underperforming companies of your direct index, without having to pay the capital gains taxes on the sale of the companies which are profiting.

Let’s put it this way—when you buy an index fund like an ETF, it’s one unit. Therefore if you want to cut the companies which are losing money, you have to cut the companies which are making money as well, and if you sell for a profit, the IRS will come knocking. 🏎

With direct indexing, you are able to sell the companies which aren’t performing well without having to owe capital gains taxes on the companies which are netting a profit. Furthermore, this amount can even be claimed on your taxes to help offset any capital gains taxes you do owe to the government. And who doesn’t want to save money on their taxes?

What is Passive Index Investing? 📚

There are many investors out there who believe they can beat the market by picking stocks. But over the course of history, studies have shown that passive index investing is one of the few ways to generate reliable returns.

Passive index investing is where you purchase stock in an index fund and hold on to it for a long period of time, typically years. This cuts out all of the buying and selling fees associated with regularly trading index stocks as there will only be a single buy-in fee and a single sales fee. 

Many companies have used this tactic to amass billions of dollars over the years, all without having to lift a finger, or worry about frequently buying and selling their shares of specific index funds. 

When Should You Consider Direct Indexing?

Are you tired of not being in control of your portfolio and want access to some possible tax benefits? Then direct indexing could be what you’re looking for. To get a better idea if it’s right for you, examine how the following conditions apply to your needs. 

You Are Ready to Be More Active in Investing ⌚

Remember, direct indexing is not passive investing. Thus you will need to be ready to check in on the investments in your portfolio on a regular basis. 

While you may not have to do all the research required for day trading, you will still need to be prepared to look into underperforming companies and remove them from your portfolio. This is the only way you will be able to receive the tax benefits associated with direct indexing.

You Have a Lot of Capital 💰

Additionally, direct indexing works well with large portfolios as you will generally need to purchase several shares in order to hold all of those found in an index. And while you can purchase fractional shares, there is a limit to this, as many of the best stock brokerages require a minimum of a tenth of a share to be purchased. 

You Want to Be in Control 🎛

Index funds are great, except when you want to change one of the holdings of the index fund, you can’t exactly call up the fund manager and ask him to do so. With direct indexing, you are in control of your portfolio and if you want to remove a company, you can do so without any hassle, or having to close your other positions. 

Is Direct Indexing Good Fit for Any Investor? 🤔

Just like the perfect shoe, it’s important to make sure direct index investing is a good fit for you before you begin. Direct indexing is not for everyone.

First and foremost, direct indexing, although much easier to accomplish than it used to be, still takes a fair amount of capital to do well. You will also need to educate yourself on how to properly balance a portfolio and know how to buy and sell certain stocks. 

You also need to have time as an investor if you would like to engage in direct indexing. Direct indexing will require you to purchase multiple shares where other investors simply purchase one. And if you choose to buy all the stocks in the S&P 500, well, you will definitely have your work cut out for you. 

Plus, depending on the index you are purchasing the stock of, you may find yourself purchasing some illiquid assets. This could put a damper on the control you are trying to gain from direct indexing as it could make it difficult to close out a position you wish to exit. This also could make it difficult to tax loss harvest as you may have planned. 

Advantages of Direct Indexing 🌟

Even though direct indexing isn’t for everyone, don’t let the information above scare you off, as there are several advantages to direct investing. Let’s dive into the most important benefits that direct indexing can offer.

Fund Fees Are Zero ✔

Remember that money you pay to the manager of the ETF you invest in? With direct indexing, you are the manager, meaning those fees are null. 

Can Be Tailored to Suit Your Needs ✔

Don’t feel like investing in a certain company? Not a problem. Put in purchase orders for all of the stocks in your desired index except that one. It’s that easy to tailor a direct indexing portfolio. 

You Aren’t Locked In ✔

Maybe you purchased some stock in Tesla last month, and now, based on recent news, you just don’t believe that Elon Musk will be able to deliver on all his promises. This is no problem as well, as you are free to sell any single stock (or all of it) from your portfolio at any time without penalty. 

You Can Tax Loss Harvest ✔

Not only can you sell whatever holding you want whenever you want, but you can also claim this amount as a loss on your taxes–which will help offset any capital gains taxes you do owe. 

You Can Tilt Your Portfolio ✔

Many indexes and ETFs are filled with stocks from certain sectors. You can put what is called a ‘tilt’ on your portfolio by switching out a few stocks within the same sector. Many investors engage in this practice in order to better prepare their portfolios for a possible bear market. 

Disadvantages of Direct Indexing 🚧

Every rose has its thorns, including direct indexing. You’ll want to take a look at both the advantages and the disadvantages before you decide to directly invest in index funds.

It’s Not Passive ✔

If you are looking for an investment that you select and leave to grow for years to come, direct investing is not for you. Direct indexing requires frequent check-ins, and changes to your portfolio, in order to reap the benefits.

There are companies however, that you can hire to do this for you if you really want to directly invest but not check your portfolio. These companies charge fees, however, which means you will lose the no-fee benefit of direct investing. 

It Requires Capital ✔

For those with only a few hundred dollars to invest, direct indexing will be difficult to achieve. There are simply so many companies included in most indexes(even if you select one that isn’t the S&P500) that your money won’t be enough to purchase them all.

Tax-Loss Harvesting Becomes More Difficult Over Time ✔

When you first start direct investing and tax-loss harvesting, it is very easy to select the companies which are declining and close your positions on them. But once you have closed the worst companies, you’ll have to go back through and select the worst of what’s left. 

Eventually, all that will remain are highly performing companies that you cannot sell to tax-loss harvest. Therefore this benefit should not be your only reason for direct investing. 

Some Assets Are Illiquid ✔

As previously mentioned, there are many indexes that contain illiquid assets. Therefore you should be prepared to hold these positions for a long time. This can be difficult, especially if you are interested in tax-loss harvesting and one of the losing stocks is illiquid. 

It’s Hard to Switch to Another Strategy ✔

There are many investment tactics out there, and it’s okay to shop around a little to find the one which is right for you. The problem is, once you are in direct indexing, it can be very difficult to get out without paying a large amount of capital gains taxes. 

And if you do decide to go for it, keep in mind that the amount you made from tax-loss harvesting will be much less than the amount you will need to pay in capital gains to switch. Therefore direct investing is a long-term investment strategy. 

In Summary: Pros and Cons of Direct Indexing 👇

Conclusion 🏁

Overall, direct index investing may be just the solution you need to return the control of your portfolio where it belongs. With direct investing, you can take advantage of not having any fees and many of the tax benefits that come with being the manager of your own portfolio. 

Keep in mind that it isn’t for everyone however and that it is very difficult to get involved in direct indexing without a large amount of upfront capital. And once you are there, it can be difficult to leave and take up a lot of your time.

No matter what you decide in the end, just be sure any investment strategy you pursue aligns with your goals and risks when it comes to investing. 

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Rating

8.0/10 Visit Robinhood on Robinhood's website

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Fees

Account minimum

$5 required to start investing

$0

Starts at $3*

Minimum initial deposit

$0 to open account

$0

$0

Commissions

$3 or $5/month

$0

$0

General

Best for

People who struggle to save

DIY stock trading

New investors

Highlight

“Invest spare change” feature

Pioneer of commission-free stock trading

Value-based investing

Promotion

Free stock

$5 bonus¹

Rating

7.0/10 Visit Acorns on Acorns' website

8.0/10 Visit Robinhood on Robinhood's website

8.0/10 Visit Stash on Stash's website

About the author

Tim Fries

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Tim Fries is the cofounder of The Tokenist. He has a B. Sc. in Mechanical Engineering from the University of Michigan, and an MBA from the University of Chicago Booth School of Business. Tim served as a Senior Associate on the investment team at RW Baird's US Private Equity division, and is also the co-founder of Protective Technologies Capital, an investment firm specializing in sensing, protection and control solutions.