What is a Direct Index and How Is It Better than Index Fund Investing

Garrett Grigas, CFA, CFP® |

Direct indexing is an investment strategy that combines the benefits of index investing with enhanced customization and tax optimization.  We are an Issaquah based financial advising firm and one of the strategies we have seen most successfully used by our clients is direct indexing. Unlike traditional index funds or exchange-traded funds (ETFs), where investors buy shares of a fund that tracks an index, a direct index investor purchases the individual stocks that make up the index. This approach gives investors greater control over their holdings, tax strategies, and customization based on personal values or financial goals.

How It Works

Direct index investing uses advanced technology and algorithms to replicate an index by directly holding its individual stocks. Investors can modify the portfolio by:

  • Excluding certain stocks or sectors – Avoiding industries that don’t align with personal values (e.g., fossil fuels or tobacco).
  • Overweighting or underweighting stocks – Emphasizing specific companies or sectors based on personal market outlook.
  • Tax-loss harvesting – Selling underperforming stocks to offset capital gains and reduce tax liabilities.
  • Customizing factor exposure – Adjusting the portfolio based on factors like volatility, dividends, or value/growth.

Advantages & Disadvantages

Advantages:

Tax-Loss Harvesting

One of the biggest advantages of direct indexing is tax efficiency. Investors can sell underperforming stocks in their portfolio to offset capital gains elsewhere, reducing their overall tax burden. This strategy is particularly beneficial for high-net-worth investors looking to manage taxable income.

Customization and Personalization

Unlike ETFs or mutual funds, direct indexing lets investors tailor their portfolios based on their values, preferences, and risk tolerance. For instance, an investor can exclude companies that do not align with their environmental, social, or religious beliefs.

Avoiding Overlap with Existing Holdings

Many investors hold ETFs and mutual funds that result in overlapping stocks across multiple investments. For example, an investor may have a large position in a single stock and not want to own more of it. Direct indexing allows for precise control over holdings, avoiding unnecessary duplication.

Better Portfolio Diversification

By directly owning stocks, investors can diversify in a way that fits their goals, avoiding over-concentration in certain sectors or assets.

Disadvantages:

Complexity – Managing a direct index portfolio requires more knowledge and oversight than a simple index fund.
Higher Minimum Investment – Most platforms require a larger initial investment compared to ETFs.
Tracking Error – Customizing an index may lead to deviations from its performance.

FAQ

Is direct index investing better than ETFs?

It depends on your needs. ETFs are simpler and can be more cost-effective for passive investors. Direct index investing provides a tax advantage and more personalization but requires active management.

How much money do I need to start?

Minimum investment requirements vary, but some platforms start at $100,000–$250,000. Fintech platforms are lowering these barriers over time.

Can I use direct index investing for ESG investing?

Yes! Direct indexing is a great fit for ESG investing. You can exclude companies or industries that don’t align with your values while maintaining index-like performance.

Is direct indexing worth it for long-term investors?

For investors with significant taxable accounts, direct indexing can provide long-term tax benefits. However, if simplicity is a priority, ETFs or mutual funds might be a better choice.

Final Thoughts

Direct index investing is an innovative approach that blends index investing with customization and tax efficiency. While it offers several advantages, it may not be suitable for every investor. Understanding your financial goals, investment knowledge, and tax situation will help determine if direct indexing is the right fit for you.

 

 

All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.