What is it?

Direct indexing is an innovative investment strategy that allows individuals to own the underlying securities of an index, rather than purchasing shares of an index fund or an exchange-traded fund (ETF). With direct indexing, investors can replicate the performance of a specific index, such as the S&P 500, but have the flexibility to customize the portfolio to better meet their financial goals, tax strategies, or personal values. This approach is made possible by advancements in technology and lower trading costs, which allow for the efficient management of individually tailored portfolios.

Benefits of Direct Indexing

This type of strategy is particularly appropriate for investors who are looking to get broad index exposure along with other investment related benefits such as tax optimization or allowing an investor to better align their portfolio with their values. For example, direct indexing can help implement tax-loss harvesting more effectively by selling specific stocks at a loss to offset gains from other investments, thus reducing realized capital gains. Let’s say one of the names held within the index is Oracle (ORCL) and it was purchased at $160.00 per share. If the share price of Oracle drops to $150.00 a share through market volatility, this creates an opportunity for the direct indexing strategy. In this case and with the opportunity presented, the strategy will sell the position in Oracle and immediately purchase shares of a name within the same sector (i.e., Palo Alto Networks Inc.). This accomplishes two things: it has enabled the investor to realize a capital loss from selling Oracle and has allowed them to maintain proper sector exposure by immediately purchasing shares of a comparable company. Over time, an investor using a direct indexing strategy with tax loss harvesting capability will attain performance that aligns with the respective benchmark but will also have garnered losses that can be carried forward to offset future gains – this can significantly increase the after-tax returns of a portfolio or, what we refer to as, “tax alpha”. This level of tax efficiency is not as easily achievable with traditional index funds or ETFs.

Similarly, investors who wish to avoid certain industries—such as fossil fuels—or who want to prioritize ESG (Environmental, Social, and Governance) investments can use direct indexing to construct a portfolio that reflects their ethical preferences without sacrificing diversification. The ability to exclude certain industries or specific companies has also proven to be quite useful for employees of certain larger companies that are publicly traded who cannot transact in shares of that company. This type of restriction can be easily solved for with direct indexing customization.

To Conclude…

One of the key benefits of direct indexing is its ability to offer personalization. Unlike traditional index funds, which are standardized to include all the companies in an index, a direct indexing portfolio can be adjusted to exclude specific stocks or sectors that may conflict with the investor’s values or interests. This allows investors to maintain exposure to the broader market while still tailoring their investments to align with their unique goals.

Direct indexing is becoming a powerful tool for investors seeking greater control over their portfolios. Whether you are looking to optimize taxes, invest in line with your personal values, or simply want more flexibility, direct indexing offers a modern, customizable approach to wealth management.