Why You Should Consider Direct Indexing Over ETFs

 

English Alt Text: A four-panel comic showing an advisor explaining direct indexing, covering benefits like tax efficiency and customization, and noting the higher management effort compared to ETFs.

Why You Should Consider Direct Indexing Over ETFs

Direct indexing is quickly gaining popularity as an alternative to exchange-traded funds (ETFs), particularly among sophisticated investors.

While ETFs have long been celebrated for their low costs and broad diversification, direct indexing offers unique advantages that are hard to ignore.

In this post, we’ll explore why you might want to consider direct indexing over ETFs and how it can fit into your investment strategy.

Table of Contents

What Is Direct Indexing?

Direct indexing allows investors to own the individual stocks that make up an index, rather than purchasing a bundled product like an ETF.

Instead of buying a share of an S&P 500 ETF, for example, you would directly hold all 500 stocks—or a representative sample—in your brokerage account.

This approach has become increasingly accessible thanks to zero-commission trading and fractional shares.

Advantages of Direct Indexing

The biggest benefit is tax-loss harvesting.

Because you own individual securities, you can selectively sell losing positions to offset gains elsewhere in your portfolio, potentially reducing your tax bill.

Direct indexing also allows for greater customization.

You can tailor the index to exclude companies that conflict with your personal values or overweight companies you believe in.

Another advantage is the ability to avoid embedded capital gains often found in ETFs, particularly in actively managed funds.

How It Compares to ETFs

ETFs offer simplicity, liquidity, and low costs, making them an excellent choice for many investors.

However, they lack the customization and tax efficiency that direct indexing can provide.

With ETFs, you are limited to the fund manager’s decisions, and you can’t offset taxes at the individual stock level.

Direct indexing, on the other hand, offers hands-on control and can lead to higher after-tax returns if managed properly.

Who Should Consider Direct Indexing?

Direct indexing is best suited for high-net-worth investors and those in high tax brackets who can benefit the most from tax-loss harvesting.

It’s also attractive to investors who want to align their portfolios with specific environmental, social, or governance (ESG) criteria.

However, it requires more oversight and often comes with higher minimum investment amounts, so it’s not ideal for every investor.

Final Thoughts

Direct indexing offers a powerful alternative to ETFs, providing tax advantages, customization, and the potential for better after-tax returns.

As trading technology improves and minimum investment levels drop, direct indexing is becoming an option for a wider range of investors.

If you’re looking for more control over your portfolio and a way to boost tax efficiency, direct indexing is definitely worth exploring.

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Important keywords: direct indexing, ETFs, tax-loss harvesting, portfolio customization, investment strategy