Direct indexing isn't a new strategy. But it has become more popular recently across a spectrum of investors, thanks in large part to declining trading costs—for example, many brokerage firms now offer zero-commission online stock and ETF trades—and ever-improving trading technology. You can implement a direct indexing strategy on your own or via a professionally managed account.
Is this strategy something you should consider? Here's what you need to know about direct indexing.
What is direct indexing?
Investing by attempting to replicate the performance of an index—like the S&P 500 or the S&P SmallCap 600—is a common strategy many investors use. To do this, most investors typically buy mutual funds and ETFs to track an index (because you can't invest directly in an index).
Another way to do this is direct indexing, where you buy the individual stocks of an index so that your investments have similar characteristics to that index. Essentially, direct indexing involves choosing the index whose performance you want to replicate and then buying a representative amount of all of those index's components individually.
For example, if you wanted to replicate the performance of the S&P 500, which tracks the largest companies in the US, you would buy a representative amount of all of the stocks within the S&P 500. You would then rebalance those positions as needed to continue to closely replicate the S&P 500 Index's performance.
What's changed lately?
In the past, direct indexing would require a relatively significant amount of money to buy all of the stocks in a particular index needed to replicate its performance. Additionally, the need to periodically rebalance (i.e., adjust your holdings so that the percentages of stocks you own align with that of the index) and reconstitute (i.e., sell stocks that drop out of the index and buy stocks that are added) to continue to track the index's performance was relatively costly due to commissions and other trading costs. Having to buy a relatively large number of individual stocks that make up an index, in the percentage needed to replicate its performance, has traditionally been an impediment for most investors to use this strategy. Consequently, direct indexing was effectively limited to wealthier investors.
Several factors have changed this dynamic somewhat, including the adoption of fractional shares trading. The availability of dollar-based fractional shares trading makes it a little easier to buy the holdings of an index in the percentages needed to closely replicate the performance of that benchmark with a relatively lower amount of money.
The increasing prevalence of zero-commission trades has been another important factor. Rebalancing and reconstituting a portfolio to track an index can be costly for investors that do not have access to commission-free stock trades. More brokerage companies offering zero-commission stock trades has contributed to more investors considering direct indexing.
Advantages of direct indexing
A primary difference between this strategy and buying a fund that attempts to track the index is that, with direct indexing, you can customize this position. In contrast, the manager of an ETF and mutual fund decides the components of the fund and how closely to track the index—assuming that is the fund's objectives.
Direct indexing in view
Additionally, direct indexing can enable tax management. Given that you are purchasing individual stocks, it can be possible to tax-loss harvest each position to help manage your tax bill.* By contrast, an ETF or mutual fund does not offer the ability to harvest individual positions. Typically, direct indexing is done in a taxable brokerage account for this reason, and not tax-advantaged accounts. Investors can either implement this strategy on their own or utilize a direct indexing opportunity that’s managed for them.
Is direct indexing right for you?
Of course, this strategy isn't right for everyone. It still requires a sufficient amount of capital to implement effectively, even with fractional shares trading capabilities.
Moreover, because direct indexing involves active management to track the index as desired, it is significantly more complex compared with simply buying a fund that attempts to track a benchmark. This means having to keep tabs on the index, for example, to know when it rebalances or changes individual constituents. If you are unable to track the index changes, your investment performance could deviate from the performance of the benchmark (i.e., tracking error). You can also be exposed to tracking error if you choose to customize the position or tax-loss harvest. Recall that a reason investors choose this strategy is for the purpose of replicating the performance of an index, and so tracking error may not be desirable.
As with any investing decision you make, you should ensure that it aligns with your specific goals, risk tolerance, liquidity needs, tax considerations, and any other factors that might be relevant to your situation.
With that said, if you want to mimic the performance of an index and you want the ability to customize that position, with the possibility of enhanced tax management capabilities, direct indexing might be something you want to consider.