We’re back after taking a week off to move across the country. I’m now settled in my new home and excited for the things to come.
Anyway, enough about me and to the article.
In an earlier edition of Net Worth the Wait, we covered index funds. A quick recap: an index fund is a mutual fund or exchange-traded fund (ETF) that tracks market indexes, such as the S&P 500. The index fund will have weights similar to those of the index it tracks. However, the investor is left with little control over the fund’s weights and limited ability to customize. Direct indexing offers a solution.
Direct indexing follows a similar strategy, but instead of buying a fund, the investor purchases the individual stocks themselves to mirror a particular index. So rather than owning an index fund that provides exposure to all of the different stocks in the index, you would own the actual stocks at the individual level.
When you own an index fund, you own shares of the fund, not the underlying stocks themselves. The fund holds the stocks, which means you cannot manage gains and losses at the individual security level. With direct indexing, you skip the fund entirely and own the stocks directly.
Direct indexing opens up a level of flexibility that index funds cannot offer. For instance, if you want to hold a higher weighted percentage in Microsoft than the market index does, you have the flexibility to do so. You can also exclude individual companies entirely, or overweight certain sectors based on your own conviction.
The cost barrier and how it’s evolved over time
Historically, direct indexing was a strategy reserved for the wealthy. If you were trying to mirror the S&P 500, you would essentially be purchasing hundreds of individual stocks and managing them over time, which meant significant trading costs and management fees that made the strategy impractical for most investors. Minimums at traditional wealth management firms like Morgan Stanley and Schwab have historically started at $100,000 to $250,000.
This has changed significantly as time has progressed. Technology and the rise of fractional share investing have driven costs down dramatically. Today, platforms like Fidelity offer direct indexing starting at $5,000, Schwab at $100,000, and newer platforms like Public have brought the minimum as low as $1,000 with an annual fee of just 0.19%, though minimums and fees are subject to change and worth verifying directly with each platform.
The broader trend toward zero-commission trading, which has been driven by the rise of platforms like Robinhood, has played a role here as well. The bigger firms are evolving with the times and technology, and that has made a strategy like direct indexing more accessible to the average investor than it has ever been. That said, just because something is accessible does not mean it is right for everyone. Some investors probably should not be playing in the direct indexing sandbox, and for those individuals, a straightforward index fund is still a more advisable path.
The tax-loss harvesting benefit
One of the most compelling reasons to consider direct indexing, especially for high earners, is the ability to use tax-loss harvesting more effectively than you could with a traditional index fund.
Tax-loss harvesting is a tax-efficient strategy where you sell certain holdings at a loss to offset any capital gains you may have earned during the year. In essence, it lowers your tax bill by reducing your total taxable capital gains.
Here is a simple example: if your portfolio of stocks generated $100,000 in capital gains, but your portfolio also had $40,000 in positions sitting at a loss, you could harvest those losses and reduce your taxable gain to $60,000. At a 32% tax rate, that is a $12,800 reduction in your tax bill.
There is one important rule to be aware of: the wash sale rule. This rule prohibits you from selling a position at a loss and then immediately reinvesting in an identical holding within 30 days. However, you can reinvest in a similar but not identical holding. For example, selling an S&P 500 index fund and replacing it with a total market index fund allows you to stay invested while still capturing the tax benefit.
It is also worth noting that if you have no capital gains for the year, you can still claim up to $3,000 in net losses against your ordinary income. Any losses beyond $3,000 can be carried forward to future years.
A word of caution
Direct indexing is not without its limitations, and it is important to go in with realistic expectations.
The first concern people often raise is that the tax-loss harvesting benefit diminishes over time as your portfolio matures and positions appreciate. The opportunity does tend to shrink as a portfolio matures, but in 2024, a year in which the broader market returned nearly 25%, 433 stocks in the Schwab 1000 Index still lost value. The opportunity shrinks, but it does not disappear. Additionally, the Schwab Center for Financial Research has found that tax-loss harvesting can still generate an additional 1 to 2 percentage points of after-tax returns depending on your situation.
The limitation that gives more pause is the administrative complexity. Owning hundreds of individual stocks means each position has its own cost basis, dividends, and transaction history. Most platforms have automated a lot of this, but it is worth asking how many 1099 forms you would receive at tax time and whether that would complicate your filing. For some investors, that added paperwork, even if manageable, would be a consideration.
The third concern is tracking error. The fact that your direct index will never perfectly match the performance of the underlying benchmark. Index funds do not perfectly match their benchmarks either. And the whole point of direct indexing is that you have more flexibility over the portfolio. If you want to put more weight into a certain stock than the market index dictates, you can do that. The slight deviation from the benchmark is often the point. However, overconcentration in your portfolio in certain sectors and a lack of diversification may hinder your long-term outlook. Direct indexing may entice some to heavily weight the portfolio towards tech stocks or other sectors. You must understand the risks, and seeking advice from your financial advisor before engaging is a good step.
So, is it right for you?
Direct indexing tends to make the most sense for investors who are in a higher tax bracket, have significant taxable accounts, and have enough capital to make the tax savings meaningful. It is particularly well suited for founders and business owners who have large capital gains events, like selling a business, exercising stock options, or selling investment properties, and want a tool to help offset those gains over time.
Direct indexing products have become more accessible, but they typically carry an expense ratio of 0.30% to 0.40%, compared to 0.20% or less for a standard index fund, and often significantly less, as many index funds today carry fees below 0.10%. If the tax savings do not outweigh that cost difference, a standard index fund is likely the better starting point.
If you are just starting to build your investment portfolio or are primarily investing through tax-advantaged accounts like a 401(k) or IRA, direct indexing is likely not necessary at this stage. A simple, low-cost index fund remains one of the most effective investment strategies available and is a perfectly sound foundation for long-term wealth building.
But if you are a high earner with a growing taxable portfolio and a meaningful capital gains picture, direct indexing is a strategy worth exploring with a financial advisor.
*This is not meant to be investment advice or tax advice and is for general information purposes only.
Did you know?
Direct indexing closed 2024 with $864.3 billion in assets — significant growth, but still a fraction of the $9.4 trillion held in index-tracking ETFs and $6.6 trillion in mutual funds.
Something to ponder…
Does direct indexing offer enough upside to pursue, or is a straightforward index fund the right foundation for where you are right now?
Interested in exploring direct indexing? Schedule a free consultation with Texel Compass and see if it’s the right strategy.