What is direct indexing & is it right for your portfolio?

Direct indexing is an investment strategy that lets you directly own the individual stocks in an index rather than shares of a fund that tracks it. That gives you more freedom to customize what you own while still aiming to track the index’s performance.

Maybe you own a lot of stock in one company and want to diversify. Maybe you’d rather not invest in certain industries that don’t align with your values. Or maybe you’re looking for more ways to manage the tax impact of your investments with strategies like tax-loss harvesting. Direct indexing can give you more control over choices like these.

That control comes with some trade-offs, including greater costs, higher investment minimums and more complex tracking and management. Understanding what you gain, what you give up and how direct indexing compares with other options can help you decide whether it fits your portfolio and goals.

With direct indexing, you’ll start by purchasing individual stocks that make up a market index—a benchmark that tracks the performance of a group of investments—rather than opting for a mutual fund or ETF. While your portfolio generally will aim to track the index’s performance, you can customize it by adding, removing or changing the weight of individual stocks.

That doesn’t mean you’re making these adjustments yourself on a daily basis. A service, such as a technology platform, algorithm, financial advisor, investment manager, or a combination of these, can manage your portfolio. The system will then monitor your portfolio and the index, buy and sell individual stocks as needed so your portfolio continues to resemble the index, and apply your customization preferences.

For example, you could track an index such as the S&P 500 while choosing not to own a particular company included in that same index.

All four of these approaches can provide exposure to a broad group of investments, but how you own and manage them differs.

To compare direct indexing, index mutual funds, index ETFs and separately managed accounts (SMAs), examine the cost, investment minimums, customization levels and tax-loss harvesting opportunities (using investment losses to offset capital gains) of each.

These factors vary considerably by provider and strategy, so the figures below are representative rather than universal.

Seeing how these options compare can help you decide whether the added flexibility of direct indexing is worth the additional cost and complexity for your portfolio.

Potential tax benefits and more customization are a few reasons you might consider direct indexing.

Because you will own individual stocks with direct indexing, you can sell a stock that has declined in value and use the loss to offset capital gains, subject to tax rules.

For example, if you sell one stock for a $2,000 loss and have $2,000 in capital gains from another stock, the loss may offset those gains, assuming the losses and gains are recognized in the same tax year and subject to applicable tax rules. You then can use this tax-loss harvesting strategy to replace the sold stock with another investment that keeps your portfolio broadly aligned with the index.

If a large portion of your portfolio is invested in a single stock, you have what’s known as a “concentrated position.” Let’s say you received company stock through restricted stock units (RSUs) or inherited shares that have increased in value. If you sold all the shares at once, you could end up with a large capital-gains tax bill.

Direct indexing can help you gradually sell shares from your concentrated position and reinvest the proceeds across many stocks. Tax-loss harvesting also may help offset some of the capital gains you realize along the way.

Direct indexing gives you more control over values-aligned investing because you can customize the individual companies you own. For example, if you volunteer for a lung cancer awareness organization, investing in a tobacco company may not align with your values. You could exclude that company from your portfolio or reduce its weighting while continuing to track the broader index.

That level of individual-stock customization generally isn’t available with a traditional index fund or ETF, where you invest in the fund’s predetermined holdings. Direct indexing gives you more say in how your portfolio reflects what’s important to you.

The flexibility of direct indexing comes with some trade-offs. Before deciding whether it’s right for you, consider the higher costs, higher minimums and added complexity.

Owning dozens or hundreds of individual stocks requires more ongoing management than investing in a single packaged fund. Direct-indexing fees help cover that ongoing management, including keeping your portfolio aligned with its target index while maintaining your customizations.

The trade-off is that the same flexibility that gives you more control over your portfolio also can make it more expensive than a standard index fund or ETF.

Direct indexing generally requires a larger initial investment than buying a single share of an index fund or ETF. Minimums vary by provider, but the higher threshold can make direct indexing less accessible if you have a smaller portfolio.

Before choosing this strategy, consider whether you have enough invested to make the added flexibility and potential benefits worthwhile.

Owning individual stocks means tracking more cost basis, dividends and gains or losses during tax season. With a fund, you generally receive a consolidated tax form. Direct-indexing portfolios can generate multiple individual transactions and tax lots.

That can mean more tax-related activity to keep track of yourself or with the help of a tax professional. If you’re a whiz during tax season or already have a trusted CPA, this added paperwork may be doable. If not, it’s another trade-off to consider for greater customization.

For every security that is not held in a direct indexing portfolio, the portfolio’s performance will differ from the index it seeks to track. Investment managers can employ methods to minimize tracking error, but there always will be some difference in performance versus the index, either lower or higher. 

Before you decide to try direct indexing, weigh whether the potential benefits and trade-offs align with your portfolio, tax situation, values and tolerance for investment complexities.

Here are some questions to guide your self-evaluation. Try working through these on your own or with a financial advisor:

• Do you face a concentration risk? Do you hold a concentrated stock position that has grown large enough to create risk if the stock falls? Employer stock, inherited shares and investments that have appreciated significantly over time can all lead to this situation. If diversification is one of your priorities, direct indexing may be able to help you spread that money across more investments without making one large move all at once.
• Could tax management change your decision? Would tax-loss harvesting through direct indexing make it easier to diversify or manage your capital gains? If you don't have significant taxable investments or capital gains to manage, some of the tax advantages may matter less to you.
• Do your values affect what you own? Are there companies or industries you would prefer to avoid that are in your current ETF or mutual fund? Direct indexing can afford you more selection over which companies you own and how heavily they’re represented in your portfolio.
• How much control do you want? Would you rather have more control over your individual holdings even if that means more information to track at tax time? If not, an index fund or ETF may be a better fit. Or you could look into an SMA, which offers customization through a different management approach.
• Is the added cost worth it? Minimum investment requirements, management fees and customization may not be cost-effective for you, and that’s OK. If your portfolio is relatively small, consider whether the potential benefits justify the added cost.

Direct indexing can give you more control over your investments, but more control isn’t necessarily better for every investor. The question is whether the potential tax benefits, customization and flexibility support your goals enough to justify the added costs and complexity.

A Thrivent financial advisor can help you look at your portfolio, tax situation and priorities to determine whether direct indexing fits into your broader investment strategy. And if an index fund, ETF or SMA is a better fit, you still can build a portfolio designed around how you want your money to work for you.