The Pros and Cons of Direct Indexing

Traditional index investing means buying a passive fund that seeks to track, rather than outperform, its benchmark index. Direct indexing, in contrast, involves buying most (if not all) of the individual stocks that make up an index, and then adding to, subtracting from, or reweighting its components, depending on your investment strategy and tax goals. This gives individual investors more control over their investment.

As you can imagine, the cost of replicating a benchmark index with individual customizations—to say nothing of the associated investment management and trading fees—would be cost prohibitive for most investors, which is why direct indexing was previously available only to ultra-high-net-worth investors. However, the rise of zero-commission trading, as well as advances in technology, have made it possible for investment firms—including Schwab—to offer direct indexing products at a much lower cost. Here are some considerations to help you determine if a direct indexing strategy can help you create a more personalized portfolio.

There are several key advantages to customizing an existing index:

1. Potentially boost after-tax returns: When you invest in an index mutual fund, you're subject to regular taxable distributions—even if you don't sell any shares—because mutual funds are required to distribute to shareholders any capital gains that were realized as a result of selling their underlying holdings. One of the benefits of direct indexing is the direct ownership of the individual securities of an index, so there's much more flexibility around when shares are bought and sold, allowing tax liabilities to be optimized for your benefit. You can then defer capital gains and strategically sell some of your losers to offset any capital gains taxes a strategy known as tax-loss harvesting.
2. Help reduce concentration risk: If you own substantial shares in a company that also represents a significant portion of an index, adding that index to your portfolio could create a concentration risk. For example, let's say you own $10,000 of stock ZYX and want to invest an additional $90,000 in an index fund. If stock ZYX makes up 5.9% of the index the fund tracks, your concentrated stock exposure to ZYX would rise to 15.3%. Direct indexing would allow you to exclude stock ZYX and keep your allocation to that stock at 10% of your overall portfolio.
3. Gift highly appreciated stock: When you own a diverse set of stocks, a small subset of the stocks may grow dramatically over time, leading to concentration risk. Selling those positions as a means of rebalancing your portfolio could leave you owing capital gains tax. But a tax advantage of direct indexing is you may transfer out those highly appreciated shares for gifting, which isn't possible through traditional indexed investing with mutual funds or ETFs. Gifting the stock to family or a trust can help reduce your taxable estate—though the cost basis will carry over and the recipient will owe. And if philanthropy is integral to your wealth management strategy, gifting the stock directly to charity allows you to not only avoid taxes on capital gains, so long as you've held the assets for longer than a year, but also potentially deduct the fair market value—up to 30% of your adjusted gross income (AGI)—if you itemize. (If the amount exceeds 30%, you can carry over and deduct the excess for up to five additional years.)
4. Better align your portfolio with your values: With a traditional index fund, there's no way to avoid industries that may be at odds with your goals or personal beliefs, such as gambling or tobacco. You can opt for a socially conscious fund, of which there are many, but you still have no control over the individual companies in which it invests. With direct indexing, you can make exclusions within certain parameters. At Schwab, for example, you can exclude individual stocks as well as entire industries and sub-industries.

There are some trade-offs with investing this way, namely:

1. Higher costs: Expect to pay a management fee of anywhere from 0.30% to 0.40% for a direct indexing solution, versus 0.20%, on average, for a traditional index fund. However, fees may come down as more direct indexing providers enter the market.
2. Higher minimums: Unlike index funds, many of which can be purchased for less than $50 a share, you'll likely need thousands if not hundreds of thousands of dollars to invest in a direct indexing strategy.
3. Diminishing tax benefits: Over time, the opportunity to harvest capital losses can decline as stock values rise. This is especially true in a portfolio you've held for several years that has appreciated significantly.
4. Administrative burden: The downside to owning hundreds of individual stocks is that each will have its own cost basis, dividends, and profit and loss, which could become burdensome at tax time. You may have to report each transaction individually on your tax return if your brokerage firm doesn't provide consolidated 1099 tax statements, or if your tax-preparation software doesn't accurately read the statements.

Ultimately, direct indexing makes the most sense for investors in high tax brackets who want to take advantage of tax-optimization opportunities, as well as individuals with more investing experience who want more customization than they can get from a traditional index fund. Your investment advisor can help you create an indexing portfolio that provides both diversification and tax-efficiency.