For decades, the default approach for most investors seeking broad market exposure has been simple: buy a low-cost index fund or ETF and hold it for the long term. That strategy remains powerful and simple to implement. But over the past decade, a newer approach has started to challenge the dominance of index funds: direct indexing.
At its core, direct indexing gives investors ownership of the individual securities that make up an index rather than owning a fund that owns them. Advances in technology and declining trading costs have made direct indexing more affordable and accessible than ever, unlocking benefits in tax management, customization and values-based investing that wasn’t possible in the past for the average investor.
Direct indexing didn’t begin as a retail product. Institutional investors and high-net-worth clients with specific mandates were its early adopters. They had the scale, sophistication and size to justify customized portfolios built one security at a time.
Over the last decade, these strategies have become much more accessible because of several factors: lower trading costs have dramatically reduced execution expenses, managers have streamlined the process to where automated portfolio platforms can now assemble and maintain hundreds of individual stocks efficiently with enhanced technology, and fractional share trading lets smaller investors own smaller slices of expensive stocks. Strategies once reserved for institutions or ultra-wealthy families are now available to investors with lower minimums than ever before.
How direct indexing works
Instead of buying a single ETF or mutual fund, direct indexing means you own the actual constituents of an index — for example, the 500 stocks in the S&P 500 — in proportion to their weights in that index. This direct ownership allows for tax-aware adjustments in which you can sell losing stocks to realize losses without selling a whole fund. On the other hand, it also allows you to make custom exclusions or tilts, meaning you can remove or underweight stocks that don’t align with personal values. This captures the most important aspects of direct indexing, which are tax minimization and personalization.
Tax minimization and harvesting losses
Perhaps the most celebrated benefit of direct indexing is its ability to generate tax losses intentionally. In a traditional index fund, you can’t choose which holdings to sell. A fund’s structure drives all decisions. With direct indexing, an investor can identify individual stocks that have declined below cost basis and sell them to lock in losses. These losses can offset gains elsewhere, lowering taxable income or deferring taxes.
This process — called tax-loss harvesting — is possible with ETFs too, but it’s limited. When you sell an ETF share, you realize gain/loss on the entire fund position, and your replacement must be a different fund to avoid wash-sale rules. Direct indexing unlocks far more granular tax decisions, potentially every stock in your portfolio. Over years or decades, especially in volatile markets, these accumulated losses can meaningfully reduce overall taxes and improve after-tax returns.
Value personalization
Another fast-growing appeal of direct indexing is customization. Investors can exclude companies or sectors they find objectionable, such as fossil fuels, tobacco or weapons manufacturing. Portfolios can be tilted toward other factors like low volatility, dividends or carbon emissions intensity. Goals beyond returns — such as values, mission alignment or social impact — can be embedded at the security level. With direct indexing, you define the screens and tilts that matter to you.
Who direct indexing is for
Direct indexing tends to work well for investors facing meaningful capital gains tax burdens on an ongoing basis, investors seeking customized ESG or values-based exposure and investors with longer time horizons and sophisticated planning needs who can benefit from systematic tax-loss harvesting and enhanced strategy.
It’s less compelling for those with very small portfolios where trading and management costs dominate, investors who prefer simplicity and minimal oversight, and those with primarily tax-advantaged (retirement) accounts where tax management is irrelevant.
Direct indexing represents a powerful evolution of traditional indexing — one that blends passive exposure with personalization and tax efficiency. Once the exclusive domain of institutions, it’s now accessible to a broad range of investors thanks to modern technology and lower costs. For investors seeking more control over what they own, how they pay tax and how their investments align with their values, direct indexing offers an intriguing option worth exploring — and one that could certainly become a mainstay of future portfolio design.
Zach Harney is a Wealth Manager at Creative Planning. He welcomes questions you may have concerning investments, taxes, retirement or estate planning. Send your questions to: Zach Harney, 2340 Garden Road, Suite 202, Monterey, CA, 93940. Or you can email zach.harney@creativeplanning.com. This commentary is provided for general information purposes only, should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.
