What is Direct Indexing?
Instead of buying a mutual fund or ETF that tracks an index, direct indexing allows you to own the individual stocks within that index. Sounds simple, right? This approach offers flexibility and control, but historically, it wasn’t practical for most investors. Why? Because buying every stock in an index in the right proportions required significant capital and incurred trading costs, hence the rise of mutual funds and ETFs.
Two developments changed the game: commission-free trading and fractional shares. Today, even if Amazon trades at $180 and another stock at $0.50, fractional investing lets you replicate index weights precisely without needing a huge amount of money.
How Tax-Loss Harvesting Works
Tax-loss harvesting is one of direct indexing’s most powerful benefits. Let me walk you through the strategy: You identify stocks in your portfolio trading below their purchase price, sell them, and reinvest in similar, but not identical, positions to maintain your allocation. Just don't buy the same company or something too similar within 30 days, or you'll trigger a wash sale that disqualifies the loss.
The beauty? Those realized losses can offset gains, reducing your taxable income.
Let me use Coca-Cola as an example. Suppose you invest $10,000 in Coca-Cola as part of a direct indexing strategy. Over the year, your account grows to $50,000. Normally, you’d owe taxes on $40,000 in gains. But markets fluctuate. During the year, Coca-Cola dips several times—say one week it drops enough to create a $1,000 unrealized loss. By harvesting losses during these dips across multiple stocks, you might accumulate $10,000 in losses. When tax season arrives, you’ll owe taxes on just $30,000 of gains instead of $40,000. That means your tax bill drops from $6,000 to $4,500. That’s tangible savings and real value advisors can bring to their clients.
When Direct Indexing Makes Sense (and When it Doesn't)
Let's be honest: direct indexing isn't for everyone. It works best for investors with substantial taxable assets who want customization and tax efficiency. If your money is in a 401(k) or IRA, tax-loss harvesting won’t apply because those accounts already tax-deferred. Working with an advisor is critical because timing matters. Selling that slumping stock might feel right today, but what if holding on would've been better long-term? No strategy guarantees you'll maximize value.
The Tax Impact Over Time
Take a $1 million investment in the S&P 500 held for 10 years. A 1% tax drag? That costs over $300,000. A 2% drag? You're looking at more than $600,000 lost to taxes. These aren't abstract numbers - they represent things like college educations, home renovations, or retirement security.
Tax management consistently ranks as the number one financial need for high and ultra-high net worth households. When you see how much tax drag compounds over time, you understand why advisors are increasingly exploring direct indexing solutions.
Two Goals Working Together
Direct indexing aims to do two things: deliver index-like returns and harvest losses at the individual stock level.
Consider what happens during market volatility. An index might finish the year up 15%, but remember that 19% drawdown earlier in the year? Direct indexing turns that volatility into opportunity. While index funds sit tight during turbulence, direct indexing strategies can actively harvest losses from individual stocks.
Common Use Cases
Think about the situations where tax management becomes critical. Clients with significant unrealized gains in brokerage accounts or stock collections often face friction moving to more diversified portfolios because of embedded tax bills. Direct indexing platforms can address this through transition capabilities that gradually move assets while managing the tax impact over time.
Understanding the Client Lifecycle
Direct indexing adds value across three phases: transition (moving assets in), investment (ongoing harvesting), and distribution (efficient gifting or withdrawals).
For example, raising 10% of account value from an ETF might incur a 13–14% effective tax rate. With direct indexing, it may be under 2%. Over multi-year withdrawals, effective tax rates are often cut in half.
Getting Started
When you're ready to onboard actual accounts, you'll typically work with a custodian and the platform provider to set up the necessary account structure and add the manager. They’ll guide you through the final steps to get the account trading. After the first account, the process becomes routine. Most platforms use streamlined workflows that make subsequent accounts much quicker to onboard.
Keep in mind: Direct indexing typically requires separate account structures at your custodian. Make sure to plan ahead—these setups usually take about a week and can't be rushed for last-minute client meetings.
Account minimums are high, which makes this truly for clients with meaningful tax issues or potential tax challenges - think higher net worth clients with substantial non-qualified assets.
Why Direct Indexing Matters
Direct indexing isn’t just another product. It’s a way to take the “thinking” out of tax-loss harvesting.
Direct indexing fills a critical gap in comprehensive wealth management - active tax management that works alongside asset and risk management. Consider common scenarios: clients receiving annual capital gains distributions, business owners planning future liquidity events, or investors sitting on highly appreciated portfolios needing gradual transitions.
Having a tool that keeps clients invested, maintains market exposure, and actively manages taxes addresses persistent challenges. The approach saves time for other advisory priorities while aiming to solve expensive problems.
Major platforms have grown to tens of billions in assets across thousands of accounts because of the popularity of this approach. Technology that monitors daily, trades when opportunities warrant, and maintains the dual mandate of index returns plus tax harvesting delivers measurable value. Advisors gain scalability and efficiency. Clients get tax management that compounds benefits over their entire investment lifecycle.
Whether you're handling concentrated positions, planning for future liquidity events, or simply want index returns with added tax efficiency, direct indexing offers a solution worth exploring. The combination of investment expertise and sophisticated technology creates something genuinely useful—not just another product, but a tool that addresses real needs with meaningful financial impact.
Note: The strategies and concepts discussed are for educational purposes only and do not represent specific investment or tax advice. Investing carries an inherent element of risk and there is no guarantee of financial success or specific investment results. Results may vary based on individual circumstances. It is in everyone’s best interests to consult a tax and investment professional depending on their unique situations.
