Direct indexing is an investing strategy that involves purchasing the components of an index directly. The approach has typically been reserved for investors with sizable portfolios, such as institutions or high-net-worth individuals, but the introduction of zero-commission trading and fractional shares makes direct indexing accessible to more people these days.

A key advantage of direct indexing is that it allows investors to more efficiently harvest investing losses to lower or avoid taxes. A 2020 study published in the Financial Analysts Journal found that from 1926 to 2018, an investor using an approach similar to direct indexing on a portfolio of the 500 largest U.S. stocks would have improved their after-tax returns by 1.08 percentage points per year compared to a portfolio that didn’t use tax-loss harvesting. While that may not sound like a lot, the benefits can be significant over an investing life.

Here’s what else you should know about direct indexing, as well as the key advantages and disadvantages of using this hot approach to investing.

How direct indexing works

Investors who purchase traditional index funds are indirectly investing in the companies that make up the index. While the fund will rise and fall with the stocks that are held in the index, you won’t be considered a shareholder in the individual companies and won’t be able to buy or sell stocks within the fund.

With direct indexing, you’re essentially building the index fund from scratch, allowing you to customize the portfolio and make buy or sell decisions on the individual stocks in the index. For example, if you have environmental, social or governance (ESG) issues that matter to you, you can invest along those lines.

You’ll also be able to sell stocks that have declined and use the loss to offset gains as a way of lowering your tax bill, or avoiding taxes altogether. This strategy is known as tax-loss harvesting and can help boost your returns, but it’s only relevant for taxable accounts, not retirement accounts such as 401(k)s or IRAs.

How much money does it take to start direct indexing?

While declining trading costs and the introduction of fractional shares has made direct indexing more accessible than before, you’ll still need a healthy chunk of money to invest before you get started.

Charles Schwab requires investors to have at least $100,000 to participate in their personalized indexing program. Wealthfront, a leading robo-advisor, also requires at least $100,000 to participate in direct indexing. Of course, you can take a direct indexing approach on your own with less money, but you’ll need to be able to manage the complexity of building a portfolio and managing the positions for size and tax purposes.

Advantages of direct indexing

  • Tax savings: The opportunity to use tax-loss harvesting to improve your portfolio’s returns by keeping more of the return in your pocket is one of the major benefits of a direct indexing approach. By having dozens or hundreds of individual positions, you’re able to sell stocks with losses to offset your gains, allowing you to potentially limit your tax bill. This isn’t possible through traditional index mutual funds or ETFs because you aren’t able to manage the individual positions in the fund.
  • Customization: The other major draw of direct indexing is the ability to customize portfolios based on your unique beliefs or investment views. If you have views around ESG issues, you can easily incorporate them into your portfolio with a direct indexing approach by avoiding sectors or industries that cause concern. You may also work in a certain industry and want to diversify away from that area with your investments. All these can be done with direct indexing, but remember that the more you stray from the index (tracking error), the less likely you are to match its returns.

Disadvantages of direct indexing

  • Requires a fairly large portfolio: Although you don’t need as much money as you once did to pursue direct indexing, you’ll still need a fair amount to get started. You’ll need $100,000 to begin direct indexing at most brokers or robo-advisors, but could potentially get going on your own with less.
  • Complex to manage: Because you’ll be managing a portfolio with dozens or even hundreds of securities, direct indexing can be complex to manage. You’ll need to stay up to date on changes to the index you’re tracking and adjust your portfolio accordingly, while also paying attention to the tax implications. Tax-loss harvesting can also be difficult to manage on your own because you’ll need to know your cost basis in each security and decide when to realize gains and losses.
  • May miss gains of small stocks: Some direct indexing strategies seek to match the performance of the index by holding just the main securities in the index. While holding every stock in the index may not be necessary to match the index’s performance, you may miss out on outsized gains from smaller stocks as they grow into larger weights in the index.
  • Fees: While direct indexing can generate tax savings that benefit your after-tax portfolio return, you will pay higher fees than a traditional index fund if you use a broker’s direct indexing service. Schwab charges 0.40 percent annually for assets up to $2 million, where the fee then drops to 0.35 percent. Wealthfront offers direct indexing for clients with at least $100,000 and charges an annual fee of 0.25 percent (there is no additional fee for direct indexing).
  • May run out of losses to harvest: One challenge associated with direct indexing is that the longer you use the strategy, the more difficult it can become to find losses to harvest. As you’re selling the stocks that have declined each year to realize losses, you end up with a portfolio full of gains, which can make it costly to move away from the direct indexing strategy because you’ll generate a large tax bill if and when you sell.

Should you consider direct indexing?

While direct indexing can generate tax savings and makes it easier to customize portfolios, the approach is not right for everyone. You need a sizable amount of money to get started, and the portfolios are complex to manage on your own. Going through a broker can make it easier, but you’ll pay a fee that is significantly above what a traditional index fund charges.

The more you customize your portfolio or stray from the index you’re trying to replicate, the more you’re becoming an active investor, which may or may not pay off in the long run.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.