Direct Indexing Explained: How It Works And Why Do It?

The Rise of Index Investing

Since the launch of the first index mutual fund by Vanguard in 1976, index investing has grown into an industry with more than $16T of assets under management. Overall, passive index investing now accounts for over 50% of U.S. equity fund assets.

The key reason is that it provides an easy way to diversify a portfolio and a good method for most long-term investors. Today, another method is on the rise, called “Direct Indexing”, refining index investing methods and giving back some control to investors from the fund managers.

Here are ten of the most common questions about direct indexing—and why it matters.

1. What Is Direct Indexing?

Direct Indexing refers to the practice of directly buying the stocks that form an index to mimic its performance. This replaces the purchase of index funds or ETFs.

For a long time, this method was the reserve of ultra-wealthy individuals or institutions that used it to avoid the management fees of funds and ETFs.

This is increasingly accessible to individual retail investors thanks to the emergence of zero-commission trading, fractional shares, and more flexible fintech investment platforms.

2. How Does Direct Indexing Work?

In order to replicate an index, investors will need to separately buy each of the stocks composing this index, and in the ratio the index uses. The shares are not owned in a common fund, but in a separately managed account (SMA).

Direct indexing is available from many investment firms and online trading platforms: Wealthfront, Wealthsimple, Interactive Brokers, Fidelity, Schwab, Vanguard, Public, Frec.

While this can in theory be done manually, mirroring the weight of individual stocks from the target index is usually done with optimization software. Often, such a tool is provided by the trading platform.

Contrary to ETFs and other index funds, direct ownership also allows for more flexibility, with the possibility to customize the portfolio and therefore not perfectly replicate the index intentionally.

3. Direct Indexing Benefits: Taxes, Control, and Customization

The first main benefit of direct indexing is a higher level of control, helping to improve the tax efficiency of the investment account.

The key method here is tax-loss harvesting. As each stock is owned individually, and not as a block in an index fund, the holdings that are at a loss can be sold to “harvest” the tax reduction effect and offset capital gains in other parts of the portfolio (see below point #7 for a more detailed explanation).

Depending on the service provider/optimization software and preference, direct indexing can provide a much greater level of customization:

• Value-based investing excluding specific companies or sub-sectors, notably ESG-driven exclusions.
• Sector tilts: Exposure to some sectors forming an index can be boosted by a given percentage, while others are reduced by the same amount. Too strong a tilt can drift the portfolio away from index investing, as it would stop replicating the index altogether.
• Rebalancing can be done at a chosen interval, instead of following the schedule set by an ETF or fund manager.

Note: management fees for direct indexing are often slightly higher than ETF fees. Expect to pay a management fee of anywhere from 0.30% to 0.40% for a direct indexing solution, versus 0.20%, on average, for a traditional index fund.

Still, the higher tax efficiency can be worth it, even when taking into account the management fees. It also provides an increased level of control and transparency. For example, each company, the weight of each stock, and every trade made is directly visible in the account, so each security’s contribution to the overall return is clearly visible.

“For years, robo-advisors have promoted the idea of constant rebalancing as the gold standard, but this one-size-fits-all approach often doesn’t align with real-world investor needs.

With our Portfolio Allocation feature, we’re breaking away from this flawed model.

Investors can now rebalance at their own pace, ensuring their portfolios reflect their personal strategies and with more tax-efficient alternatives.”

Mo Al Adham, CEO and Founder of Frec

Swipe to scroll →

Note: After-tax outcomes vary by tax bracket, turnover, and implementation.

4. Risks & Drawbacks of Direct Indexing

In general, no-fee transactions should make transaction costs not a concern, even for smaller accounts. In practice, this might still be important, as many platforms offering no visible fees ultimately collect money from other methods in each transaction, like a higher spread.

While automated solutions help simplify the process, this is inherently a more complex option than owning an ETF, especially if an investor tries to maximize tax-loss harvesting potential.

The tax reporting typically grows in complexity: instead of one 1099 form, investors will receive pages of transaction details, making tax assessment and preparation more cumbersome.

Another potential issue is tracking error. By having a different rebalancing strategy or replacing some stocks of the index with “similar ones,” direct indexing performance can drift from the benchmark index, either positively or negatively.

Overall, this strategy can make sense not just for high-net-worth individuals but for many other types of investors. They, however, need to understand the details of this strategy and be ready to put up with the effort it requires.

5. Who Offers Direct Indexing Today?

As mentioned, many different investing platforms offer direct indexing today. But they can differ in the requirements, like minimum investment, fees, etc.
Swipe to scroll →

6. Direct Indexing vs ETFs: Key Differences Explained

The main difference between direct indexing and ETFs & mutual funds is the direct ownership of stock, instead of passing through the custody and management of fund managers.

Thanks to tax-loss harvesting, the performance can be 1–2% higher, compensating for the higher management fees.

Diversification should be managed by replicating as closely as possible the reference index. Too much change or exclusion could reduce the point of index investing—broad exposure to dozens, hundreds, or even thousands of stocks.

Liquidity can potentially be an issue, but as long as the reference indexes themselves are liquid, this should not be a concern for major indexes.

Because the main advantage of direct indexing is tax-loss harvesting, it makes much less sense to use this strategy for non-taxable accounts like IRAs or 401(k)s.

7. Tax-Loss Harvesting Explained

Tax-loss harvesting is when a stock that has declined in price is sold to claim the tax benefit from the loss, compensating for capital gains in other segments of the investment accounts.

In direct indexing, the stock sold at a loss can then be replaced by a similar stock that had a similar performance and/or activity — for example, selling Coca-Cola and buying Pepsi to maintain industry exposure while capturing the loss.

This helps maintain the risk profile but collects the tax loss.

The wash-sale rule keeps investors from selling at a loss, buying the same (or “substantially identical”) investment back within a 61-day window, and claiming the tax benefit.
Also, the IRS has stated it believes a stock sold by one spouse at a loss and purchased within the restricted time period by the other spouse is a wash sale.

Losses can also be used to offset up to $3,000 of ordinary income each taxable year on top of offsetting capital gains. If losses exceed both, they can be carried forward into future years.

Over time, as most investments rise above their purchase value, the potential for tax-loss harvesting will decrease — unless new money is continuously added to the account.

8. Customization & Values-Based Investing (ESG, Sector Tilts)

The possibility to individually handle the stock making up the account and index is useful to shape it to someone’s values or ESG targets, making it more flexible than usual index investing.

A specific company with problematic practices can be excluded, or exposure to preferred sectors can be increased. However, this customization must be balanced carefully to avoid harming performance.

Interestingly, so-called “sin stocks” — companies in weapons, gambling, oil & gas, or tobacco — are historically known to outperform the market on average.

9. Who Should (and Shouldn’t) Use Direct Indexing?

Historically, direct investing was reserved for high-net-worth individuals and institutions due to its complexity. Today, newer platforms and fractional shares make it accessible to smaller accounts, though most still require at least $100,000.

It is best suited for investors with some experience. It helps smaller investors offset early taxes and larger investors manage irregular gains — for example, selling real estate or business assets without moving into a higher tax bracket.

It also benefits investors with concentrated stock exposure, allowing them to exclude their employer’s stock from their index replication.

Overall, direct indexing and tax-loss harvesting should be part of a broader investment and tax strategy. Its benefits tend to compound over several years rather than in the short term.

10. Future of Direct Indexing

Further progress in low-cost transactions, automation, and fractional shares should boost the adoption of direct indexing.

According to Cerulli and Associates, only 14% of financial advisors are actively using direct indexing to help their clients with their specific needs.
Cerulli also believes that direct indexing assets under management (AUM) will grow by 12.4% a year, faster than mutual funds, ETFs, or retail separate accounts.

Still, for now, ETFs remain dominant due to their simplicity. Direct indexing’s profitability and popularity will take time to fully prove, but as robo-advisors and AI evolve, the method could grow in use among investors seeking tailored portfolios with tax optimization.

Final Takeaways

Direct indexing mostly makes sense when tax optimization can significantly improve an investor’s performance, provided they understand the method and IRS rules. Investors should carefully evaluate their experience and the value of customization before proceeding.