Direct Indexing 101

The evolution from mutual funds → ETFs → Direct Indexing

10 min read

Over the past fifty years, investing has become more and more accessible to the average American. That’s thanks to a few major inventions: Mutual funds, exchange-traded funds (ETFs), and now, direct indexing.

Fifty years ago, anyone who wanted to invest in the stock market would have to choose individual stocks to buy1, and those stocks could be prohibitively expensive. Mutual funds changed all that — they were the first vehicle that let average Americans invest in the stock market, buying into a professionally managed, diversified portfolio at relatively low cost. But if you own mutual funds, you most likely have to pay taxes on them every year—regardless of whether you sell or not. For this reason (and others), ETFs were invented as a more flexible, cheaper, and more tax-efficient alternative.

While both ETFs and mutual funds have served a lot of people well, there’s still room for improvement, especially when it comes to taxes. That’s why today, a new strategy is gaining popularity: direct indexing.

Like mutual funds and ETFs, direct indexing gets you market returns, but with one unique advantage — you can also reap additional tax benefits via a method called tax loss harvesting. Institutional investors and high-net-worth individuals have been direct indexing for decades, but it’s only recently that technological advancements have made it accessible to investors like you.

Below, we’ll explain the evolution of all three of these investing vehicles: mutual funds, ETFs, and direct indexing. And, we’ll explain how they compare to each other from a tax advantage perspective.

Mutual funds

What is a mutual fund?

Mutual funds pool money from many investors to purchase a diversified portfolio of securities, and the investors own shares that represent a part of the fund’s holdings. This structure makes it easier and more affordable for everyday individuals to invest in the stock market.

Mutual funds became popular in 1976 with the creation of the Vanguard 500 Index Fund,2 and they’re still popular today. Not surprising, given their advantages — they have good liquidity, they’re affordable for retail investors, and they keep risk low by diversifying investments across a broad range of assets. But they do have their limitations.

Limitations of mutual funds

Tax inefficiency

The biggest problem with mutual funds is the way they’re taxed. By law, mutual funds have to pass down capital gains distributions to their owners — and then the owners have to pay taxes on those gains, every single year.

Active management

With most mutual funds, professional fund managers make all the investing decisions on behalf of the fund owners. That might sound like a good thing — but in reality, almost no one who picks individual stocks can consistently outperform the market.3 Not even professionals. And professional management also means you have to pay management fees, which can really eat into your returns over time.

(It’s worth noting that not all mutual funds are actively managed. S&P 500 mutual funds, for example, simply track an index).

Exchange-Traded Funds (ETFs)

The origin of ETFs

In the late 1980s, Nathan Most and Steven Bloom (and others!) had a mission:4 create a product that could combine the benefits of mutual funds — broad diversification, mostly — with the tradeability of stocks. For years, Nate, Steve, and others worked to build what is likely still the most-recognizable ETF around: SPY.

Since SPY’s introduction in 1993, ETFs have gained popularity with institutional and retail investors alike — and for good reason.

What’s an ETF?

If you’ve ever looked up basic investing advice, you’ve probably heard of ETFs. They’re a simple way to invest your money with more diversification, and sometimes more reliable returns, than picking individual stocks.

Like with a mutual fund, if you buy into an ETF, you own shares in a large portfolio of stocks that’s managed by someone else. “Exchange-traded” means that ETFs are traded on stock exchanges. So, like individual stocks, ETFs can be bought and sold at market prices throughout the trading day.

Advantages over mutual funds

ETFs were introduced in 1993 as an innovation on mutual funds, and they gained popularity rapidly. Since the early-to mid-2000s, they’ve become mainstream.

ETFs have many of the same benefits of mutual funds, like affordable exposure to a diversified portfolio. But since they were created specifically to address some of the limitations of mutual funds, there are some differences. Most importantly, ETFs are generally cheaper and more tax-efficient.

Tax advantages

Compared with mutual funds that follow the same index, ETFs rarely saddle investors with taxable gains.

Like mutual funds, ETFs are legally required to pass down capital gains distributions to their owners. But ETFs get around this with a strategy called ‘in-kind redemption’, which lets them conduct their business without incurring taxable gains.

In-kind redemption means that, if an ETF wants to get rid of stocks due to liquidation or rebalancing, they don’t have to sell the stocks. Instead, they hand the stocks over to a market maker, in exchange for stocks of the ETF itself.5

So while mutual fund owners have to pay taxes on the entire appreciation of their portfolio every year, ETF owners don’t. You can think of it as an interest-free loan from the IRS for the holding period of the ETF.

Those unpaid taxes accumulate, and they compound as you reinvest them. So not only are your taxes lower, but your gains are higher over time.

Increased liquidity

Mutual funds are pretty liquid, but ETFs are more so. Whereas mutual funds may impose fees for early withdrawal or have rules about when shares can be sold, ETFs can be bought and sold at any time during market trading hours. 

Also, because ETFs can be traded throughout the day, investors can trade strategically and react quickly to market changes — unlike with mutual funds, which are only priced and traded at the end of the trading day.

Lower costs

Because they’re usually not actively managed, ETFs generally have lower management fees and operational costs compared to mutual funds. But actively managed ETFs do exist, and they have correspondingly higher fees.

Limitations of ETFs: Low tax loss harvesting potential

In a nutshell, tax loss harvesting is a way to decrease your taxes by strategically selling assets in your portfolio. If you’re curious about the specifics, we’ve written more about it [here].

Some roboadvisors offer ETF-to-ETF tax loss harvesting. That means asset managers sell index funds that have depreciated, and temporarily purchase similar funds in their place, so that investors can claim the tax loss while maintaining their market position.

But in a bull market, there are limited opportunities for ETF-to-ETF tax loss harvesting, because correlated ETFs all appreciate simultaneously. And if you do manage to tax loss harvest, there’s a risk of not being able to buy back into your original ETF. Plus, roboadvisors charge fees up to 0.25%6 for tax loss harvesting, on top of your normal ETF expenses.

Direct indexing

The latest development in retail investing is direct indexing. Like investing in ETFs or mutual funds, it’s a way to track the market — but direct indexing is more tax-efficient and more flexible.

What is direct indexing?

Direct indexing is a tax deferral strategy that the ultra wealthy have been using for decades to save on taxes — and now it’s available to investors like you. 

Here’s how it works.

Say you have an index like the S&P 500 that you’re trying to track. If you were using ETFs or mutual funds, you’d buy shares of one thing: an index fund tracking the S&P 500.

But if you’re direct indexing, you buy all of the individual stocks that make up the S&P 500, at their target weights.

Why? So you can leverage tax loss harvesting. 

Any time the value of one of the individual stocks dips below the price you bought it for, you have the opportunity to sell it, to harvest the loss. Since there are hundreds of stocks in the S&P 500, some of them will go down every day.

With daily tax loss harvesting like we do at Frec, direct indexing can generate about 40% of a deposit in realized capital losses over 10 years.7

Why is it available now?

While tax loss harvesting has been around for decades, it’s only recently become accessible to the average investor. That’s thanks to a happy confluence of market innovations and technological developments.

Fractional share investing

For most of the history of the stock market, anyone who wanted to buy a stock had to buy a whole share — no matter how expensive it was. This was a major barrier for direct indexing, because unlike investing in mutual funds or ETFs, direct indexing requires buying individual stocks. So if you wanted to direct index, you’d need enough capital to buy all of the hundreds of individual stocks in the index.

But thanks to fractional share investing, the minimum amount needed for direct indexing has drastically decreased.

Fractional share investing is just what it sounds like: investors can purchase a fraction of a share, instead of the whole thing. It only became available to the average investor in 2017, when M1 Finance rolled it out on their platform.

Zero commission fee trading

Until recently, every single trade on the stock market would cost you several dollars in transaction fees. Since tax loss harvesting involves making lots of trades, that made it an extremely expensive strategy.

But over the last decade, trading fees have dropped to $0.8 So now investors can leverage much more frequent tax loss harvesting — Frec’s harvesting is daily — without breaking the bank.

Lower compute costs

Historically, if you wanted to index the S&P 500, it would have to be done by a team of elite wealth managers. Those people would have to make hundreds of trades to keep all of the stocks at their target weights and harvest losses. So back then, direct indexing was only worth it if your investments were in the hundreds of thousands of dollars.

Today, computers can do all that, and they’re faster and better at it than humans ever could be. And as compute has gotten cheaper, it’s enabled more advanced optimizations. With Frec’s algorithm, we can harvest your tax losses daily, while keeping your portfolio tracking the index very closely.

Advantages over ETFs & mutual funds

Tax efficiency

The main value-add of direct indexing is that it saves you money on taxes by harvesting tax losses to offset your taxable gains. That means it’s particularly useful if you expect capital gains from other sources outside of the index.

Lower costs

Fees are low because there’s never a human managing your portfolio — it’s all automated. That’s why Frec only charges 0.10%.

Personalization & transparency

With mutual funds and ETFs, you own shares of a fund. That fund is relatively opaque to you, and you definitely can’t control what it does.

With direct indexing, you own the securities yourself. So you have full visibility into what you own, and you can customize your portfolio to better suit your personal needs and values.

Direct indexing is the future

Direct indexing is growing faster than ETFs, mutual funds, and SMAs. It’s projected to exceed $800 billion in AUM by 2026.9

We think that growth is because more and more people are hearing about direct indexing for the first time — and realizing its potential.

From where we’re standing, it’s no wonder that people are attracted to direct indexing. After all, it gives you very similar performance to ETFs and mutual funds, while saving you money on taxes. 

We believe direct indexing is the future of investing. And with Frec, you can get started with just $20,000. Sign up here.

References to 40% tax loss harvesting of your portfolio result from simulations conducted with Frec’s Direct Index Model tracking the S&P 500 index. The results are hypothetical, do not reflect actual investment results, and are not a guarantee of future results. They were generated with a one-time $50,000 investment with a ten-year time frame of ninety day increments. The date range for the 40% tax loss harvesting was between 12/17/2003-06/10/2022.

This handbook is for information purposes only and not intended as tax advice. Frec does not provide tax advice and you are encouraged to consult with your personal tax adviser. 

Commission-free trading refers to $0 commissions for Frec Securities’ self-directed margin brokerage accounts that trade US listed stocks and ETFs electronically. Keep in mind, other fees such as trading regulatory fees or wire transfer fees may apply to your brokerage account. Please see Frec’s fee schedule to learn more. 

Fractional shares are illiquid outside of Frec and not transferable. See paragraph 28 of Frec’s Customer Agreement for more details.