Direct Indexing: Who It Helps, Who It Does Not, and What It Costs

Key takeaways

Direct indexing owns the stocks in an index directly, which creates far more harvestable losses than a single fund, mostly in the first few years.
The advantage applies only to taxable accounts and mainly to investors with regular gains to offset and high brackets.
Costs are higher than an index ETF, tracking is looser, and the portfolio becomes hard to leave without realizing gains.
Most investors get most of the benefit from a low-cost ETF and disciplined harvesting at the fund level.

Direct indexing used to be a service for eight-figure accounts. Now most large custodians and a growing number of advisors offer it at $100,000 minimums. The pitch is tax alpha: own the index as hundreds of individual stocks instead of one fund, and you can harvest the losers while the index as a whole rises. That part's true. Whether it's worth the cost and the complexity depends on who you are, and for most investors the answer isn't what the marketing suggests.

How it works

An S&P 500 ETF holds 500 stocks inside one wrapper. When the index is up 10% for the year, the ETF is up 10% and there's nothing to harvest, even though a hundred of the underlying stocks may be down. Direct indexing buys those stocks individually in your account, in weights that track the index. When a stock falls, it gets sold, the loss is realized, and a similar stock (or the same one after 31 days) takes its place. The portfolio keeps tracking the index. The account piles up realized losses.

Those losses offset capital gains elsewhere, then $3,000 a year of ordinary income, with the rest carried forward. Same mechanics as tax-loss harvesting with an index fund, applied to many more positions.

What the benefit is worth

Academic and industry studies put the value of the added harvesting at roughly 0.5% to 1.5% of the account per year in the early years, measured as the tax value of losses realized. That figure declines as the account ages and the positions build up embedded gains. After five to ten years in a rising market, most positions sit above their basis and there's little left to harvest unless new cash keeps coming in.

Two things decide whether that number is worth anything to you. First, do you have gains to offset? Losses are only valuable against gains, plus that $3,000 a year of ordinary income. Someone who realizes large gains regularly, from a business, a concentrated position, real estate, or an actively traded taxable portfolio, can use the losses. Someone who buys and holds index funds has few gains to offset and ends up with carryforwards they may never use.

Second, your tax rate. At 23.8% on long-term gains the harvested losses are worth more than at 15%, and at 0% they're worth nothing. Retirees in the 0% capital gains bracket should be harvesting gains, not losses, and direct indexing works against them.

What it costs

Fees. Direct indexing platforms charge more than an index ETF: commonly 0.2% to 0.4% a year at the custodian level, and more through some advisors, versus 0.03% for a broad ETF. On a $1 million account, that's $2,000 to $4,000 a year the harvesting has to earn back before it does you any good.

Tracking error. A portfolio of 300 stocks chosen to approximate the index, with constant swaps for harvesting, doesn't track it exactly. Some years it trails, some it leads. The deviation is small but it isn't zero.

Complexity. Hundreds of positions, hundreds of lots, and a 1099-B that runs to many pages. Rebalancing, charitable gifting, and estate administration all get more involved.

Lock-in. After a few years, the account holds hundreds of positions with embedded gains. Moving to a different manager or a simpler structure means realizing them. Easy to enter, hard to leave. Which, for the provider, is a feature.

Lower basis. As with all harvesting, the losses defer tax rather than eliminating it, unless the positions are held until death or given to charity. The account's basis drops as losses are harvested, and the future gain grows to match.

Who it fits

Direct indexing makes sense for a taxable investor in a high bracket who has a recurring source of capital gains to offset, adds new cash regularly (which refreshes the harvesting opportunity), plans to hold for the long term or use the appreciated positions for charitable gifts, and has an account big enough that the loss harvest justifies the fee difference. Someone unwinding a concentrated stock position over several years is a good example. Direct indexing on the diversified side generates losses that shelter the gains on the concentrated side.

It also fits investors who want to exclude their employer's industry, or specific companies, from the index. A fund can't do that.

Who it doesn't fit

Most investors. Retirement accounts (no tax benefit at all). Investors in the 0% or 15% gains bracket with no other gains. Buy-and-hold investors with nothing to offset. Smaller accounts where the fee difference dominates. Anyone who values simplicity or expects to change advisors or custodians someday.

What we'd do

We use broad, low-cost index and factor funds as the core of taxable portfolios, harvest losses at the fund level with paired replacements when a loss is big enough to matter, and harvest gains at 0% when a client's income allows. For the subset of clients who fit the profile above, particularly those diversifying out of a large position, we'll use direct indexing on the appropriate slice of the portfolio, at custodian-level pricing, and we tell them what it costs and when we expect its usefulness to fade. It's a tool inside investment management, not a philosophy.

Frequently asked questions

Is direct indexing the same as separately managed accounts?

Direct indexing is a type of separately managed account (SMA) where the manager tracks an index rather than picking stocks. Traditional SMAs, with active managers and higher fees, are a different product.

Can I direct index in an IRA?

You can, but there's no reason to. Losses inside an IRA have no tax value, so the fee is pure cost.

What happens to the losses I can't use?

They carry forward indefinitely against future gains and $3,000 of ordinary income per year. A large unused carryforward is only an asset if you eventually have gains to apply it to. At death it's lost.

Does it beat the index?

Before tax, it tracks the index with some error and returns less after fees. The claim is about after-tax return for investors who can use the losses. For them it can be a modest improvement. For everyone else it's a fee.

Joseph G. Valerio, CFP®, EAFounder and Lead Advisor at Valerio Wealth Management, a fee-only, fiduciary virtual family office in Miami, Florida. One advisor, credentialed in both financial planning and federal tax. About Joseph

This article is general education, not individualized advice, and it is not tax, legal, or accounting advice. Figures reflect federal law for the year stated and can change. Valerio Wealth Management does not prepare or file tax returns. Speak with a qualified professional about your own situation before acting.