Exchange-traded funds (ETFs) have become an increasingly popular way for investors to get broad market exposure at a low cost. However, a lesser known strategy called direct indexing is gaining traction, especially among high net worth investors and families.

So what exactly is direct indexing and why is it better suited for wealthy investors compared to plain vanilla ETFs?

What is Direct Indexing?

Direct indexing involves building a custom portfolio by investing directly in the individual stocks that make up an index, like the S&P 500 or Russell 2000. The goal is to closely track the performance of the index while allowing for greater flexibility and customization¹.

With direct indexing, you own the actual shares rather than owning a fund that owns the shares on your behalf. This gives you more control compared to owning an ETF or index mutual fund.

For example, if you wanted to track the S&P 500, you would work with a financial advisor to build a portfolio owning individual shares of each company in the index, weighted appropriately to match the index. As the index changes over time, your portfolio is rebalanced to continue tracking the benchmark.

So in essence, direct indexing provides similar broad market exposure to plain vanilla ETFs but with additional benefits specifically useful for high net worth investors².

Key Benefits of Direct Indexing

Here are some of the main advantages of using a direct indexing strategy, especially for wealthy families and individuals:

1. Tax Management and Loss Harvesting

One of the biggest benefits of direct indexing is it allows for tax-loss harvesting at the individual stock level³.
For example, if Apple stock drops below your cost basis, you can sell it to realize the capital loss. That loss can then be used to offset realized capital gains from other parts of your portfolio to reduce your tax bill.

This type of tactical tax management is not possible in an ETF or index mutual fund structure⁴.

Studies show this tax alpha can potentially boost after-tax returns 1% annually, especially for investors in higher tax brackets who have sizable capital gains⁵. Over long periods, this additional return may help compound wealth.

2. Customization and Personalization

Unlike an ETF or index fund which must rigidly adhere to its stated benchmark, direct indexing provides flexibility to customize your market exposure⁶.
For example, high net worth investors often have concentrated stock positions in a single company, sometimes making up 50% or more of their total portfolio. This creates risk.

With direct indexing, you can neutralize that concentrated position by underweighting or even excluding the single stock from your customized index⁷. This reduces your risk while still maintaining broad market exposure.

Other customizations are possible too, like restricting entire sectors or industries, over/under weighting factors, or filtering companies based on ESG criteria⁸.

3. Lower Investment Minimums

In the past, building an indexed portfolio required purchasing potentially hundreds of individual stocks in proportion to the index. This was only practical for large institutional investors.

But thanks to fractional share trading and turnkey direct indexing services offered by leading wealth management platforms, minimums have dropped dramatically to between $5,000 to $100,000 — well within reach for most high net worth families⁹.

4. Charitable Planning

Many wealthy investors have embedded capital gains on appreciated stock positions they intend to give to charities over time.

Direct indexing allows for a tax-savvy transition plan to systematically realize those gains each year while also harvesting losses from other holdings to minimize taxes owed¹⁰.

By coordinating the tax plan with their charitable goals, investors can reduce their tax bite and maximize the total funds making it to the charities.

Who is Direct Indexing Best Suited For?

While direct indexing has gone mainstream with some brokerages now offering it to clients with as little as $5,000 to invest, it remains best suited for high net worth investors who can benefit the most from the advanced tax management capabilities¹¹.

Generally, the ideal direct indexing client has:

• $250,000 to $500,000+ in investable assets
• A long-term time horizon
• Significant embedded capital gains that create tax drag
• A concentrated stock position or other complex tax planning needs
• An interest in customizing market exposures based on personal preferences
• An existing relationship with a financial advisor

Additionally, direct indexing aligns well for investors focused on tax-efficient charitable gifting programs.
For smaller investors new to investing, an index fund or ETF is likely the better choice given the simplicity and rock-bottom fees.

Providers of Direct Indexing Services

In the past, building and managing a direct indexed portfolio required major commitment from the investor and advisor. But thanks to technology improvements, turnkey solutions now exist making it much easier to implement and manage.

Most major wealth management platforms like Morgan Stanley, Merrill Lynch, Fidelity, and Charles Schwab now offer direct indexing services with a range of customizations available¹².

Typically the minimum investment required ranges from $100,000 to $250,000. Management fees also apply on top of the investment minimum but are relatively low, often between 0.30% to 0.75% annually¹³.

For investors who want professional management but have assets below $100,000, robo-advisors like Wealthfront and Betterment provide direct indexing options with no minimums in some cases. However, the degree of customization is more limited compared to traditional wealth managers¹⁴.

Conclusion

Direct indexing has emerged as a viable alternative to traditional index funds and ETFs, providing high net worth investors a more flexible, tax-efficient way to track the broad stock market.

With the ability to harvest losses at the individual stock level to offset gains, direct indexing can boost after-tax returns by up to 1% annually compared to an ETF tracking the same index¹⁵.

Additionally, wealthy investors often have unique needs, like concentrated stock positions to unwind or assets they intend to give to charities. Direct indexing allows for custom transitions and gifting strategies that plain vanilla index funds cannot accommodat^e16.

While ETFs still retain cost and simplicity advantages that make them appropriate for smaller investors new to the markets, direct indexing solves complex problems for the wealthy while providing better tax outcomes.

This powerful combination of tax management and personalization is why direct indexing is becoming the strategy of choice for high net worth families and individuals looking to boost returns.