Direct indexing is an investment strategy that consists of directly buying the components of an index. The approach has typically been reserved for investors with large portfolios, such as institutions or high net worth individuals, but the introduction of commission-free trading and fractional shares makes direct indexing accessible to more people these days. .

One of the main advantages of direct indexing is that it allows investors to more effectively reap investment losses to reduce or avoid taxes. A 2020 study published in the Financial Analysts Journal found that from 1926 to 2018, an investor using an approach similar to direct indexing to a portfolio of the 500 largest US stocks would have improved after-tax returns by 1.08 percentage points. percentage per year compared to a portfolio that did not use tax loss harvesting. Although it may not seem like much, the benefits can be significant over an investment lifetime.

Here’s what else you need to know about direct indexing, along with the top pros and cons of using this popular investment approach.

How direct indexing works

Investors who buy traditional index funds invest indirectly in the companies that make up the index. While the fund will rise and fall with the shares held in the index, you will not be considered a shareholder of the individual companies and will not be able to buy or sell shares within the fund.

With direct indexing, you essentially build the index fund from scratch, allowing you to customize the portfolio and make buy or sell decisions on individual stocks in the index. For example, if you have environmental, social or governance (ESG) issues that are important to you, you can invest in this direction.

You will also be able to sell stocks that have gone down and use the loss to offset the gains to lower your tax bill or avoid taxes altogether. This strategy is known as tax loss harvesting and can help boost your returns, but it only applies to taxable accounts, not retirement accounts such as 401(k)s or IRAs.

How much money does it take to start direct indexing?

Although lower trading costs and the introduction of fractional shares have made direct indexing more accessible than before, you will still need a good amount of money to invest before you get started.

Charles Schwab requires investors to have at least $100,000 to participate in their custom indexing program. Wealthfront, a leading robo-advisor, also requires at least $100,000 to participate in direct indexing. Of course, you can take a direct indexing approach yourself with less money, but you will need to be able to handle the complexities of building a portfolio and managing positions in terms of size and size. tax.

Benefits of Direct Indexing

• Tax savings: The ability to use the harvest of tax losses to enhance your portfolio returns by keeping more of the return in your pocket is one of the main advantages of a direct indexing approach. By having dozens or hundreds of individual positions, you can sell stocks with losses to offset your gains, potentially limiting your tax bill. This is not possible with traditional index mutual funds or ETFs because you are not able to manage individual positions within the fund.
• Personalization: The other major appeal of direct indexing is the ability to customize portfolios based on your investment beliefs or opinions. If you have opinions on ESG issues, you can easily integrate them into your portfolio with a direct indexing approach avoiding sectors or industries that cause concern. You may also work in a certain industry and want to diversify outside of that area with your investments. All of this can be done with direct indexing, but remember that the further away you go from the index (tracking error), the less likely you are to match its returns.

Disadvantages of Direct Indexing

• Requires a fairly large portfolio: Although you won’t need as much money as you used to to pursue direct indexing, you’ll still need a good amount to get started. You’ll need $100,000 to start direct indexing at most brokers or robo-advisors, but you could potentially go it alone with less.
• Complex to manage: Because you will be managing a portfolio of tens or even hundreds of securities, direct indexing can be complex to manage. You will need to keep up to date with changes to the index you are tracking and adjust your portfolio accordingly, while paying attention to the tax implications. Harvesting tax losses can also be difficult to manage on your own, as you will need to know your cost basis for each security and decide when to realize the gains and losses.
• May miss gains from small actions: Some direct indexing strategies seek to match the performance of the index by holding only the major stocks in the index. Although it is not necessary to own all the stocks in the index to match the performance of the index, you may miss outsized gains from smaller stocks as they become larger in the index. ‘hint.
• Costs: Although direct indexing can generate tax savings that benefit your portfolio’s after-tax returns, you’ll pay higher fees than a traditional index fund if you use a broker’s direct indexing service. Schwab charges 0.40% per year for assets up to $2 million, where the fee then drops to 0.35%. Wealthfront offers direct indexing for clients with at least $100,000 and charges an annual fee of 0.25% (there is no additional charge for direct indexing).
• May run out of losses to harvest: A challenge associated with direct indexing is that the longer you use the strategy, the harder it can become to find losses to harvest. As you sell the stocks that have fallen each year to realize losses, you end up with a portfolio full of gains, which can make it costly to deviate from the direct indexing strategy as you will generate a large tax bill if and when you sell.

Should you consider direct indexing?

While direct indexing can generate tax savings and make it easier to customize portfolios, the approach isn’t right for everyone. You need a considerable amount of money to get started, and wallets are complex to manage on your own. Going through a broker can make it easier for you, but you will pay significantly higher fees than those charged by a traditional index fund.

The more you customize your portfolio or move away from the index you are trying to track, the more active you become, which may or may not pay off in the long run.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. Further, investors are cautioned that past performance of investment products does not guarantee future price appreciation.