As I work with more high-income professionals and business owners, we have conversations about investment strategies that go beyond traditional index funds. One approach that keeps coming up—and for good reason—is direct indexing.
If you’re familiar with index investing, you’ve likely built your portfolio around funds that track major indices like the S&P 500. It’s a time-tested approach that offers diversification, low costs, and the ability to match market returns without the stress of picking individual stocks.
But what if I told you there’s a way to maintain that same passive investment philosophy while potentially unlocking significant tax advantages and customization opportunities? Enter direct indexing—a strategy that’s gaining traction among high-income investors looking to optimize their portfolios. Direct indexing allows you to own the individual stocks that make up an index (like the S&P 500) in a separately managed account, rather than buying a mutual fund or ETF.
What Is Traditional Index Investing?
Before diving into direct indexing, let’s establish the foundation. Traditional index investing typically involves purchasing a fund—whether it’s an ETF or mutual fund—that tracks a specific index. These indices come in many forms:
• Broad Market Indices: Like the S&P 500, which tracks the 500 largest U.S. companies
• Market Cap Indices: Such as small-cap, mid-cap, or large-cap focused funds
• Sector-Specific Indices: Technology, healthcare, energy, and other industry-focused options
• International Indices: Emerging markets, developed international markets, specific countries, etc.
The appeal of index investing generally lies in passive management. Rather than trying to beat the market through active stock selection, you’re essentially saying, “I’ll take whatever the market gives me.” This approach has proven successful for millions of investors who prefer steady, long-term growth over the complexity and risk of trying to outperform.
How Direct Indexing Works
Direct indexing takes the same philosophical approach as traditional index investing but with a crucial difference: instead of owning a single fund, you own each individual security within the index.
For example, a direct indexing strategy that mimics the S&P 500 would involve purchasing individual shares of companies like Apple, Microsoft, Amazon, and so on. However, you don’t necessarily need to own all 500 stocks to achieve your goal. Many direct indexing strategies own a representative sample—perhaps 250-300 stocks—that effectively tracks the index while maintaining a small tracking error (the amount of deviation from the index performance).
Think of it like creating your own custom index fund, but with individual stock ownership rather than fund shares.
The Tax Efficiency Advantage
Here’s where direct indexing gets interesting from a tax perspective. When you own individual securities, you have the flexibility to tax loss harvest throughout the year—something that’s not as easy to accomplish with traditional index funds.
Here’s how it works:
Scenario: Let’s say the S&P 500 is up 8% for the year, but within your direct indexing portfolio, some individual stocks are down. With traditional index investing, you’d pay taxes on the overall 8% gain. With direct indexing, you can choose to:
- Harvest the losses by selling the underperforming stocks
- Immediately reinvest in similar (but not identical) securities to avoid wash sale rules
- Accumulate a “bucket” of tax losses that can offset future gains
This strategy allows you to stay invested in the market while potentially reducing your tax burden—which can be a win-win scenario for high-income earners.
Customization Opportunities
Beyond tax efficiency, direct indexing can open the door to portfolio customization that traditional index funds simply can’t offer.
Managing Concentrated Stock Positions
This strategy can be particularly powerful for individuals with large gains in a single stock—often from equity compensation or inherited positions. Instead of facing a massive tax bill by selling everything at once, you can consider:
• Creating a custom direct indexing strategy around your concentrated position
• Gradually selling portions of your concentrated stock over time
• Offsetting the gains with harvested losses from your direct indexing portfolio
• Diversifying your holdings while helping to minimize tax consequences
Sector Customization
Direct indexing also allows you to tilt your portfolio toward specific sectors or themes while maintaining broad market exposure. For example, you might:
• Overweight technology if you believe in long-term innovation trends
• Underweight energy if you prefer a more ESG-focused approach
• Exclude specific companies that don’t align with your values
Who Should Consider Direct Indexing?
Direct indexing isn’t for everyone. It typically makes the most sense for investors who check these boxes:
High Tax Bracket
The tax savings generated through loss harvesting need to outweigh the additional costs and complexity of the strategy. If you’re in a lower tax bracket, the benefits may not justify the effort.
Substantial Portfolio Size
Most direct indexing strategies require a minimum investment of $250,000 to $500,000 to achieve proper diversification while keeping transaction costs reasonable.
Concentrated Stock Positions
If you have significant gains in individual stocks (often from equity compensation), direct indexing can be an excellent diversification tool.
Tax-Sensitive Situations
High earners who are already maximizing tax-advantaged accounts and looking for additional tax optimization strategies.
Potential Drawbacks to Consider
While direct indexing offers compelling benefits, it’s not without considerations:
• Higher Complexity: Managing hundreds of individual securities requires more sophisticated technology and oversight
• Increased Costs: Transaction fees and management costs are typically higher than traditional index funds
• Tax Reporting: Owning individual securities creates more complex tax reporting requirements
Is Direct Indexing Right for You?
Direct indexing represents an evolution in passive investing—maintaining the core philosophy of index investing while adding layers of tax efficiency and customization. For high-income investors with substantial portfolios, it can be a powerful tool for optimizing after-tax returns.
However, like any investment strategy, it requires careful consideration of your specific financial situation, tax circumstances, and long-term goals.
The Bottom Line
Direct indexing isn’t about abandoning the principles that make index investing successful. Instead, it’s about enhancing those principles with modern technology and tax optimization strategies. For the right investor, it can provide the best of both worlds: the diversification and simplicity of index investing with the tax efficiency and customization of individual stock ownership.
If you’re in a high tax bracket, have a substantial portfolio, or are dealing with concentrated stock positions, direct indexing might be worth exploring. As always, work with your financial advisor and tax professional to determine if this strategy aligns with your overall financial plan.
The key is understanding that direct indexing isn’t necessarily better than traditional index investing—it’s simply a different tool that may be more appropriate for certain situations and investor profiles.
Implementing a direct indexing strategy will result in commissions or fees outside of the financial planning fee. Please consult with your financial advisor for more information prior to investing.
This blog post is for general information only and should not be construed as personalized financial or tax advice. Please consult with a financial advisor and/or qualified tax professional regarding your individual situation.
CRN202807-8994670
