Index funds have ruled investing for years. Now you can build your own

When you own each stock in an index individually, you can control which stocks you keep, sell, and replace.

Brian Acton

By 

Brian Acton

Brian Acton

Contributing Reporter

Brian Acton is a contributing reporter at Policygenius, where he covers personal finance and insurance news. His work has also appeared in The Wall Street Journal, TIME, USA Today, MarketWatch, Inc. Magazine, and HuffPost. 

Published January 20, 2022 | 6 min read

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Direct indexing is a do-it-yourself approach to investing that attempts to replicate the performance of an index, like the S&P 500, with the investor individually purchasing all of the stocks contained within that index. To mirror an index's performance, you’ll need to buy an entire all of the stocks within that index and take time to research and monitor how each stock does. That used to present a big barrier to entry to everyday investors, but new technology has made this strategy increasingly popular.

For investors who want greater portfolio customization and tax benefits, direct indexing is an active investment strategy that offers distinct advantages. 

How direct indexing works

Direct indexing stands in direct contrast to the passive strategy of investing, where the investor buys an index fund or exchange-traded fund (ETF) that already contains all the stocks of the index, and holds on to those funds for the long term, without the need to constantly monitor performance and rebalance portfolios. These passive funds have traditionally been popular with the average investor for their low costs, hands-off approach, and history of outperforming actively managed funds in the long run.

Because of its cost and the effort required, direct indexing has typically been most appropriate for large portfolios. But more online brokerages are now offering fractional investing, where you can buy partial shares of a company’s stock instead of an entire share, which lowers the barrier of entry for investors with fewer funds to work with. Add to that the rise of fee-free trading platforms and direct indexing becomes much more affordable to a wider range of investors, which is contributing to its recent rise in popularity. 

“Fractional [investing] allows this to be done without having to buy full shares of each stock within an index,” says Drew Feutz, certified financial planner at Market Street Wealth Management Advisors

Some robo-advisors like Wealthfront now offer direct indexing portfolios with fractional investing at affordable costs. Big financial advisors like Vanguard, Morgan Stanley, and Blackrock are also betting on the future of direct indexing by acquiring companies that specialize in it, including offering automated or advisory options for a fee. But many advisors still require large account minimums for direct indexing. For example, Wealthfront and Parametric Portfolio’s direct indexing offerings require an account balance of at least $100,000. 

The benefits of direct indexing

Direct investing lets you customize your portfolio.  You can choose not to buy stocks that don’t align with your values, like tobacco or fracking, which isn’t possible with an index fund. You can also sell off existing holdings in a company if it behaves in an unethical way. 

You can also customize your portfolio to adjust for existing investments you already hold. For example, you may hold a lot of investments in a single industry or company, such as your employer’s stocks. To balance things out, you can avoid buying as many of those types of stocks when building your direct index, says Feutz. 

Tax-loss harvesting

There are also some tax benefits to direct investing that you don’t get with passively managed funds. In any given year hundreds of stocks in an index could lose money, but the index can still go up if rising stocks outgained the losers. With an index fund or ETF, you can’t take advantage of those individual losses the same as if you owned each stock individually. 

With direct indexing, you have the ability to target the individual stocks that have lost value to reduce your tax liability, known as tax-loss harvesting. You sell those stocks at a loss and you can use the proceeds from the sale to reinvest in other companies.

Meanwhile, the loss you’ve generated from the sale of the losing stock reduces the capital gains tax you owe. For example, if you had an investment worth $1,000 at the beginning of the year and you sold it for $900 at the end of the year, you will offset the other gains you owe taxes on by $100.

There are a few scenarios where the tax-loss harvesting benefits of direct indexing simply don’t apply. First, there’s the wash-sale rule which states that you can’t buy back the same, or practically identical, security within 30 days of the sale. The IRS will disallow the loss if the security is too similar.

Tax-deferred accounts, like 401(k)s and IRAs, don’t receive any tax benefits from losses so you can’t benefit from direct indexing if your investment strategy solely focuses on tax-advantaged retirement accounts.  Also, anyone who makes less than $40,400 as a single filer or married filing separately, less than $54,100 as the head of household or less than $80,000 married filing jointly does not have to pay capital gains tax, which means the tax-loss harvesting benefit doesn’t come into play at all. 

Deciding if this is right for you

Direct indexing takes a lot of work.

“Instead of owning one S&P 500 mutual fund or ETF, now you have to manage 500 different securities,” Feutz says.

Many portfolio managers hold more than a single index, which could mean they’re managing thousands or tens of thousands of securities. While more robo-advisors and financial advisors are offering direct indexing, they may require a sizable minimum account balance to make it worth their time. 

Managing this many securities yourself is more effort than you may want to take on. Tracking the data for hundreds or thousands of securities is challenging enough, and you’ve also got to pay attention to what securities are added to or removed from the index you’re tracking. And with tax-loss harvesting, you have to be strategic about which securities to sell off at a loss to offset your gains.

Owning partial shares of an entire index’s worth of stocks is less risky than putting your investments into a handful of individual stocks, Feutz says. “The risk comes into play if you’re not managing the portfolio correctly. You must be diligent about rebalancing and not getting into the game of betting on individual stocks that you have seen do well within the portfolio as a whole … it’s probably not a very good strategy for most people who do not have a deep understanding of portfolio construction and ongoing management.”

Direct indexing is mostly suitable for people who have a sizable amount of money to invest in a taxable account. It’s an active management strategy that allows for greater portfolio customization and potential tax benefits, but with much more effort involved. If you prefer the “set it and forget it” style of passive management, direct indexing might not be for you. 

But if you have the knowledge, wherewithal, or the right advisors to help you build your own portfolio, you can use direct indexing to gain greater control over the investments you choose and gain tax benefits by selling individual stocks at a loss. 

Image: Maskot / Getty