Advanced Investing: What Is Direct Indexing?

Choosing the right tool for the job. It’s a maxim that has withstood the test of time, because it applies to nearly every situation. Whether you’re building a chair, figuring out the best software program, or preparing a meal, understanding your options and picking the best one for your situation can save time, reduce frustration, and improve the overall experience.  

It also applies to investing. 

There are so many ways to invest in your future, so many ways to reach your financial goals. For many investors, the core building blocks are things like contributing to a 401(k) or choosing one or more mutual funds or ETFs. There’s nothing wrong with that — in fact, it can be a sound approach for many investors.  

But there are other investment options available that may be more effective for certain people with specific goals. Let's start with Direct Indexing... 

DIRECT INDEXING 

Maybe you’ve heard about Direct Indexing in the news, or from a colleague, or while scrolling on social media. Or maybe you’ve never heard about it and have no idea what we are talking about. Either way, direct indexing is a strategy worth understanding. 

What is Direct Indexing, exactly? Who is it for? What are the pros and cons?  

Let’s start with the word “indexing.” As you probably know, an index tracks the performance of a group of securities, like stocks. The S&P 500 is an example of an index.  

Traditionally, index investing means to buy a fund that passively tracks the performance of an index by owning the same shares, in the same proportions. The idea isn’t to outperform the index; it’s simply to match what it does. Index funds are generally low cost, and because they aim to closely track the index rather than beat it, though after fees, their results will typically trail the index slightly.  

Now the “direct” part. With direct indexing, you don’t buy a fund. Instead, you buy each of the individual stocks that make up an index. From there, you can decide to hold some stocks in greater or lesser proportion than others or even skip some stocks entirely if they don’t match your needs for whatever reason. 

Owning every stock in an index has traditionally required a larger investment. Fractional-share trading has lowered that barrier. But why do it this way at all?  

Well, direct indexing may offer some potential advantages compared with a traditional index fund. 

Potential tax advantages. With direct indexing, you have direct ownership of the individual stocks in an index. That means you have more flexibility over when individual positions are bought or sold, which may help you manage the timing of capital gains or sell “losing” positions to potentially offset gains. (This is known as “tax-loss harvesting.”) Wash-sale rules apply, and any tax benefit depends on your individual situation. 

Control over concentration. Many indexes are “weighted” so that certain stocks make up a greater portion of the index’s total value. (For example, the S&P 500 is a capitalization-weighted index, which means companies with a higher market capitalization make up a larger share of the S&P’s overall value.) That means, when you own an index fund, a larger share of your money is concentrated in the biggest companies. With direct indexing, you can control how much or little of each stock you want to own, which may help reduce concentration in the largest companies, if that’s a goal (though excluding stocks can also reduce diversification). 

More customization. Some investors may want to own more or less of a particular sector than others. This could be for financial reasons or even philosophical ones. Either way, direct indexing can allow you greater customization of what you own than an index fund. 

Every investment strategy brings potential downsides, and direct indexing is no exception. For example, that same customization can bring more risk, because you are now deviating from the index you are trying to track. That means your results may differ from the index’s, for better or worse, including the risk that you underperform it. Direct indexing can also cost more than owning an index fund in the form of additional fees. And while fractional ownership makes direct indexing more accessible, it still usually requires much more to directly own all the securities in an index than to simply buy a low-cost fund.  

Finally, the tax benefits of direct indexing may diminish over time if the index consistently appreciates in value, limiting your ability to harvest losses. 

For these reasons, investors — particularly those in higher tax brackets — who are looking for ways to optimize their taxes may want to consider direct indexing. Experienced investors who are comfortable with hewing close to an index but require more customization, or who want to better align their investments with their values, may also want to consider it. On the other hand, this strategy probably isn’t a good fit for those looking to keep costs down or who are investing primarily through their retirement accounts, as tax-loss harvesting only works in taxable accounts.  

Ultimately, direct indexing is not a requirement to reach your financial goals, and it’s definitely not right for everyone. In many cases, simpler is better! But it can be a useful strategy for those who want a more personalized portfolio with potential tax advantages. 

If you’re curious whether direct indexing, or any of the strategies in this series, fits into your overall plan, Hilltop is happy to talk it through. 

Disclosure: Hilltop Wealth Advisors is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.