Direct Indexing – Beat the Mutual Funds at Their Own Game

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Warren Buffett is well known for being the “Oracle of Omaha.” He is an investor with a legendary track record of making good decisions. And he’s just one of many investors who believe that index investing is the best path for achieving long-term market success. Buffett touts the overall strength of the United States economy and low fees associated with index funds. We all want to be like Buffett, but investing in funds can be a pricey proposition.

However, there’s another method to model your portfolio after an index like the S&P 500 without pouring money into mutual funds or exchange-traded funds (ETFs): direct indexing.

What Is Direct Indexing?

The S&P 500 is made up of 500 of the biggest American stocks on the market. All listed stocks in the index must have a market capitalization of over $5.3 billion and four straight quarters of positive earnings, along with meeting several other requirements regarding liquidity and trading volumes.

Index funds allow you to buy all stocks in the index at once. You can use direct indexing with any index. But since the S&P 500 index is so popular, we’ll use that for our examples in this article.

With direct investing, an investor would buy all 500 stocks individually rather than in an index fund. Doing so gives an investor exposure to the entire index, with all the benefits of diversification that come with an index fund. But instead of an investment fund manager keeping the entire fund in balance with the S&P 500, you (or a computer or financial advisor) handle it directly.

Why Direct Indexing Can Beat Index Funds

With index funds, investors can buy a bucket of investments that is made up of all 500 stocks in Standard and Poor’s famous index. This is great because you get access to 500 stocks with having to pay only one trade commission.

But with direct indexing, you are able to take advantage of tax-loss harvesting at a scale not possible with traditional funds. After all, with a fund, when you buy or sell, you are buying or selling the entire list of stocks. Many robo advisors, such as Betterment and Wealthfront, offer opportunities for tax-loss harvesting. Betterment takes care of tax-loss harvesting only at a fund level. But direct indexing (and Wealthfront) allows tax-loss harvesting at the individual stock level.

HighlightsBettermentWealthfront
Rating9/109/10
Minimum to Open Account$0$500
401(k) Assistance
Two-Factor Auth.
Advice OptionsAutomated, Human AssistedAutomated
Socially Responsible Investing

While you may end up paying more fees for a managed direct indexing portfolio than you would with a low-fee index fund, tax-loss harvesting benefits can make up for those costs and then some.

To see how the numbers fall into place for your portfolio, let’s look at an example. Let’s say you bought a handful of S&P 500 stocks at the start of the year. From January to October, one stock you hold falls by $4,000. If you want to keep building your portfolio and avoid selling, you get no tax benefit from this scenario in an index fund. But with direct indexing, you can sell the stock with a $4,000 loss and buy a comparable S&P 500 stock with the proceeds. This locks a $4,000 capital loss into your portfolio, offsetting a future capital gain. At the 25% tax bracket, that is worth $1,000 in tax savings.

Is Direct Indexing the Next Evolution of Index Funds?

Index funds and lower trading fees have democratized the investment markets. But wealthy investors still have access to many options regular investors do not. However, technology is changing those norms.

Technologies at leading robo advisors give more investors access to tax-loss harvesting. And now, advances in trading technologies are opening up the markets to direct indexing from regular investors.

Not that long ago, investors had to call a stockbroker and pay a $50 fee to trade a single stock. Now you can trade stocks for $5 from many brokerages, and one app offers free trades. In recent years, a massive number of dollars have flowed into index funds, with industry leader Vanguard passing $4 trillion in assets under management. As of 2016, 42% of U.S. stock mutual fund assets are held in passive funds.

How to Get Started With Direct Indexing

Wealthfront offers the most accessible route to direct indexing, with a $500,000 minimum for the advanced indexing plan. This gives the firm an edge over Betterment but only for investors with a six-figure portfolio.

Building a direct indexing portfolio on your own requires a ton of time and significant assets. For most investors, it would not be practical to attempt such a portfolio manually or without professional assistance.

However, that does not mean you should ignore tax-loss harvesting. A solid portfolio built with tax-loss harvesting can help you save up enough assets to eventually begin direct indexing. And you can learn a lot about tax-loss harvesting along the way.

Any form of tax-loss harvesting requires a fairly large portfolio to make a significant impact. But you can start with tax-loss harvesting in smaller portfolios as well. Tax-loss harvesting has some skeptics but many more fans. If you are looking for an option to take your portfolio and tax strategy to the next level, direct indexing may be perfect for you.

Further Reading: What is Robo Advisors

Eric Rosenberg

Eric Rosenberg is a finance, travel and technology writer in Ventura, California. He is a former bank manager and corporate finance and accounting professional who left his day job in 2016 to take his online side hustle full time. He has in-depth experience writing about banking, credit cards, investing and other financial topics and is an avid travel hacker. When away from the keyboard, Eric enjoys exploring the world, flying small airplanes, discovering new craft beers and spending time with his wife and little girls.

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2 Comments

  1. Hi Eric, are robo-advisors the only firms that offer Direct Indexing? Or are there other retail financial companies that offer direct indexing?

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