Direct indexing is an investment strategy that involves purchasing individual stocks that make up an index rather than investing in a fund designed to track that index. This level of control can offer investors tax and customization benefits.
What is direct indexing?
When a portfolio is built through direct indexing, the investor or portfolio manager mimics a stock market index by directly buying the stock in the companies within the index.
Until recently, direct indexing was mostly only accessible to high-net-worth individuals or very savvy investors. This is because buying and managing hundreds or thousands of stocks individually (as would be required to mirror the Nasdaq, with its 3,000+ components, or even the S&P 500, with its 500) would be meticulous and expensive work.
Swift advancements in the investment industry are changing all of that. For one thing, stock trading commissions at online brokers have essentially dropped to zero, which means investors who direct index don’t have to pay a fee for each individual stock they buy or sell. The work involved in creating a direct indexing portfolio has also fallen substantially — several robo-advisors and online brokers now offer this service, taking on most of the effort.
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Why is direct indexing advantageous for investors?
Direct indexing is beneficial for investors because it allows them to customize their portfolios by investing in individual stocks rather than traditional index funds or ETFs. This customization can lead to increased tax efficiency and the ability to align investments with personal values or beliefs.
One of the key advantages of direct indexing is the potential for tax-loss harvesting, which involves selling investments at a loss to offset capital gains and reduce taxes owed. Additionally, direct indexing can provide greater control over investment decisions and the ability to optimize for factors like risk tolerance and diversification.
Another advantage of direct indexing is the ability to avoid double taxation on dividends, as individual stocks held in a direct index are not subject to the same tax treatment as mutual funds or ETFs. This can result in higher after-tax returns for investors.
Overall, direct indexing can offer investors a more personalized and tax-efficient investment strategy compared to traditional index funds or ETFs.
What are the disadvantages of direct indexing?
If all of the above sounds like a decent amount of work, that’s because it can be — and that’s one of the main disadvantages of direct indexing.
But there are a variety of services that will do all of this for you. Online trading platforms and investment management firms like Wealthfront and Charles Schwab offer direct indexing products, as do some online financial advisors like Facet. Many traditional financial advisors will offer this service as well, often as part of their ongoing tax and investment guidance.
Of course, you’ll pay for this convenience, and there may be overall investment minimums that are required to access direct indexing services — this is because you still need enough money to spread around to build a diversified portfolio out of individual stocks, especially if the service doesn’t offer access to fractional shares. Here are the investment minimums and fees of some of the services that offer direct indexing:
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