Direct Indexing: What Is It And Why Am I Just Hearing About It Now?
How you can use direct indexing, a strategy historically used by some of the ultra-wealthy, to help you make more.
A widely adopted mental model for building wealth is to make diversified investments in broad markets and stay invested for the long term. Often, investors do this by investing periodically in exchange-traded funds (ETFs), helping them track indices like the S&P 500, Russell 2000, and others. But a strategy that many of the wealthiest people use instead is direct indexing, helping them track indices and providing additional benefits—including tax savings and meaningful performance improvements (up to 2.11%1 on top of the S&P 500’s average 10.50%2 return).
How is direct indexing different?
As an investor in an ETF, you own shares in the index fund—not the underlying stocks. And it is the responsibility of the index fund, which owns the underlying stocks, to keep track of the stocks to buy and what proportion of capital should be used to buy each stock.
For example, an index fund offering an S&P 500 ETF may use 7% of its capital to buy $AAPL; 6% to buy $MSFT; 3% to buy $AMZN; and so on, with every stock in the S&P 500 represented in some proportion.
Direct indexing, in comparison, would allow investors to hold the underlying stocks of the S&P 500 in the same proportion. Taking the S&P 500 for example, instead of owning shares in an ETF you would own 503 individual stocks.
Now, let’s dive into why direct indexing is advantageous.
Generate significant tax savings
Imagine you invested in an S&P 500 ETF, in October of 2021 for $450 per share. By October 2022, its price had declined to $375 per share. As of August 2023, it recovered back to $450 per share. In this scenario, if you held onto your ETF holdings during this two-year period, you would have no capital losses—which could have been used to offset other capital gains or ordinary income you may have.
However, over this same period, a significant number of the individual stocks in the S&P 500 lost value. And if you had owned those stocks directly, there would have been many opportunities for tax loss harvesting, which would entail selling stocks that are at a loss, capturing those capital losses, and using those funds to buy similar (but not “substantially identical”, as to avoid wash sales) stocks. Even if you didn’t have capital gains, you would generally be able to offset up to $3,000 in ordinary income per year.
To go a step further, empirical tests show that owning the underlying stocks typically yields greater tax benefits than “ETF-to-ETF tax loss harvesting,” which allows customers to select multiple indices and tax loss harvest between them, provided by some robo-advisor platforms.
Let’s take a look at an example:
Suppose an S&P 500 ETF traded flat one day but what happened underneath the hood was one stock (“A”) moved up 10% and a group of other stocks (“B”) collectively moved down by 10%—effectively canceling each other out.
In this case, no ETF-to-ETF tax loss harvesting would happen because there is no price movement at the ETF level. In this same scenario, a direct indexing approach would have provided more tax loss harvesting opportunities because you’re holding the underlying stocks, allowing you to sell out of “B” and capture the 10% in aggregate losses. When tax season rolls around, those losses can be used to offset other capital gains or ordinary income you may have—resulting in tax savings.
Get a tailor-made portfolio
Aside from the tax—and consequently, performance—benefits of direct indexing, another core benefit is the additional customization that investors get from it compared to investing in an ETF.
With an ETF, customers are unable to factor in their own market opinions relative to the index they’re tracking—since the underlying holdings are controlled by fund management.
In comparison, direct indexing can factor in your own market opinions and help you exclude individual stocks or industries while otherwise still tracking the index. For example, maybe you’d like to track the S&P 500 but exclude tobacco companies or ones that contribute heavily to greenhouse gas emissions.
Similarly, maybe you work at a company already included in the ETF and receive stock compensation. In the direct indexing paradigm, you would be able to exclude that stock if you didn’t want additional exposure to your company.
Why am I just hearing about direct indexing now?
Currently, a large number of investors who utilize direct indexing do so through their wealth advisors. Our product, Frec Direct Indexing, automates this sophisticated financial strategy and makes it available to consumers directly—making it accessible without a wealth advisor and requiring no extra work from customers.
Our research-backed algorithm is based on Tax-Aware Markowitz Portfolio Construction; if you’d like to learn more about our methodology and performance forecasts, feel free to read an in-depth piece on our methodology.
- The projection of 2.11% for Frec’s D.I. additional return and 10.50% S&P 500 index return were generated by Frec’s Direct Indexing Model tracking the S&P 500 index and is hypothetical, does not reflect actual investment results, and is not a guarantee of future results. Simulations were run on a weekly basis in a ten-year time frame from December 17, 2003 through June 10, 2022 with a $50,000 initial deposit. The simulations averaged at the end of year ten resulted in a 45.1% accumulated tax loss savings that were reinvested with a 42.3% tax rate, and includes Frec’s 0.10% fee. The prices used for stocks were adjusted for dividends. It is not possible to invest directly in an index. Results may vary.
- $1,500 if married filing separately.