The benefits of direct indexing

Discover the benefits of direct indexing, a cutting-edge investment strategy offering tax optimization, portfolio customization, and enhanced control over capital gains for high-net-worth investors.

Introduction

Direct indexing is an investment strategy that offers high-net-worth investors unique advantages, including tax efficiency which leads to greater control over capital gains and portfolio customization.

In this guide, we’ll explain what direct indexing is, highlight its key benefits, and help you determine if it suits your financial goals.

What is direct indexing?

Direct indexing involves purchasing individual stocks that make up an index—such as the S&P 500—instead of investing through pooled funds like mutual funds or ETFs. This ownership of the underlying stocks provides greater flexibility for tax strategies and portfolio customization.

Example: Instead of holding a tech-heavy ETF, you could directly own fractional shares of the companies within the index, with the option to exclude specific sectors.

This combination of personalization and tax efficiency makes direct indexing a favorable option for investors with taxable portfolios. You can learn more about Frec’s direct indexing algorithm here.

5 key benefits of direct indexing for high-net-worth investors

1. Tax optimization through loss harvesting

One of the most significant advantages of direct indexing is tax-loss harvesting (TLH). This is achieved by selling stocks at a loss to offset capital gains and reduce taxable income, potentially saving investors thousands annually.

• Example: If Stock A decreases in value, you can sell it to realize a loss and reinvest in a similar stock to maintain market exposure.

Studies suggest TLH with direct indexing can add 1% or more to after-tax returns. For a detailed comparison, see our white paper, Tax-Loss Harvesting: ETF vs. Direct Indexing.

2. Customized portfolio construction

Direct indexing allows investors to personalize their portfolios in two ways:

• Excluding sectors or companies (e.g., fossil fuels).
• Add individual stocks. For instance, if you’re tracking the S&P 500 Information Technology sector but want to include GOOG or META (classified under Communication Services), direct indexing makes this possible. 

This ensures your portfolio reflects your goals and values while maintaining diversification.

3. Control over capital gains

Unlike mutual funds that may distribute taxable capital gains annually, regardless of whether you sell your shares or not, direct indexing gives you more control over reducing your capital gains.

ETFs vs Direct indexing: While ETFs defer capital gains until shares are sold, direct indexing allows for more flexibility. You can harvest individual stock losses and use those losses to strategically realize gains outside of your direct index at any time

This flexibility is particularly beneficial for managing tax exposure in high-income years or aligning gains with other tax strategies.

4. Diversification and concentrated stock management

Investors with large, concentrated stock positions can diversify over time without triggering or reducing immediate tax liabilities.

By gradually reducing concentrated positions and offsetting gains with harvested losses, you can maintain market exposure without incurring significant or any immediate tax penalties.

5. Estate and philanthropic planning

Direct indexing supports long-term goals like wealth transfer or charitable giving.

• Donate appreciated stocks directly to avoid capital gains taxes.
• Transfer holdings to heirs to take advantage of the step-up in cost basis, resetting the taxable value to market value at transfer and minimizing taxes. 

For advanced strategies like Buy, Borrow, Die, direct indexing seamlessly integrates tax-efficient gifting and inheritance options. 

Is direct indexing more expensive?

Direct indexing typically costs more than ETFs due to the need for individualized accounts and fractional share management. Fees range from 0.10% to 0.45% with Frec, and often higher with outside providers. 

Example: A $1M portfolio would incur fees between $1,000 and $4,500, compared to under $1,000 for many ETFs.

Why it’s worth it: The tax savings from strategies like loss harvesting often outweigh these incremental costs. For high-net-worth investors, the added customization and tax benefits make direct indexing a cost-effective solution.

Additionally, the tax savings generated through TLH can be reinvested back into the market, growing your portfolio while creating ongoing tax-loss harvesting opportunities. Explore the details in our white paper here.

Is direct indexing right for you?

While direct indexing offers significant advantages, it may only be ideal for some investors. Key considerations include:

• Portfolio size: Many providers require a minimum investment of $250,000, but Frec has lowered this to as little as $20,000.
• Investment goals: It’s particularly useful for managing taxable portfolios, optimizing concentrated positions, and personalizing investments.
• Time horizon: Its benefits, especially tax savings, compound over time, making it ideal for long-term investors.

How does direct indexing save on taxes?

Direct indexing enhances tax efficiency by enabling TLH, strategic capital gains management, and optimized tax exposure. These benefits compound over time, making it ideal for long-term investors. Frec’s platform simplifies this with our automated algorithm, harvesting daily losses to maximize tax savings.

What is the future of direct indexing?

While direct indexing has been historically limited to institutional investors and high-net-worth individuals, the future of this strategy is changing rapidly. Solutions like Frec Direct Indexing are breaking down this barrier by offering low fees, automated solutions, and lower minimums.

As this strategy gains more popularity, more investors—especially those with taxable portfolios—will benefit from sophisticated tax strategies previously reserved for the wealthy. 

Conclusion

Direct indexing is transforming how investors approach portfolio management. By combining tax efficiency, customization, and enhanced control, it offers advantages that traditional funds can’t match.

If you’re looking for a tailored investment strategy with long-term benefits, direct indexing may be the right choice. Frec simplifies the process, offering low fees, automation, and professional support every step of the way.

Curious about learning more? Click here to book a demo.