Can Direct Indexing Offer a Better Alternative to ETFs?

Direct indexing involves purchasing individual stocks to replicate the performance of a specific index, such as the S&P 500.

Rather than holding every stock in an ETF, direct indexing enables you to customize your exposure to a stock index. For example, you might exclude specific components of an index for ethical or tax reasons. These adjustments can help you increase the tax efficiency of your portfolio or better align your portfolios with their values.

The strategy is popular among high-net-worth investors. But fractional shares and other advancements have recently opened the door to ‘mass-affluent’ investors. Those with portfolios worth between $100,000 and $1 million can now access these advanced strategies. But before making the switch, it’s worth considering how it compares to simple ETFs.

The most popular direct indexing providers include:

 

When choosing between these options, you should research the minimum required investment and fees, among other criteria. For example, Fidelity has the lowest minimums and fees among major direct indexing providers, but they don’t handle tax management at those levels. So, you’re responsible for harvesting your own tax losses to realize the benefits.

Direct indexing’s primary advantage relates to taxes. In particular, owning individual stocks makes it possible to harvest tax losses yearly since some stocks will inevitably decline. In contrast, you can only harvest an ETF’s tax losses if the fund’s entire portfolio is in the red. Generally, these strategies can add 0.2% to 1% to a portfolio’s annual returns.

However, the benefits of tax-loss harvesting may dissipate over time. Since the stock market tends to rise over time, you will be less likely to experience losses with longer-term stock positions and have fewer losses to harvest. That said, you’ll likely see some benefit on an ongoing basis from any new contributions (e.g., in a Roth or traditional IRA).

Customization is another–albeit less quantifiable–benefit to direct indexing strategies. Investors that care deeply about ESG principles can customize an index to cut out specific companies that don’t match their values. Or, you can assign more weight to companies actively working to improve climate change, gender equality, or other outcomes.

The biggest drawbacks of direct indexing are the fees and tax prep. Direct indexing often involves higher management fees than low-cost ETFs. And at the end of the year, you will receive far more tax paperwork, which could increase tax preparation costs. As a result, you should carefully consider the pros and cons before making a decision.

Direct indexing provides several tax and customization benefits over ETFs. But there are fee and tax-related drawbacks to keep in mind. The right choice depends on your personal financial goals and the impact of a more tax-efficient portfolio on your bottom line.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.