Direct Indexing has been popular for a select group of investors for decades. But thanks to recent advances, its potential benefits are more widely available.

Direct indexing (DI) is not a new concept, and many select investors have benefited from the investment approach for years. Historically, DI strategies were primarily available for high-net-worth investors whose large portfolios justified the costs and human resources required to manage portfolios in a customized manner. DI’s recent rise in popularity is largely due to investment managers’ ability to streamline and efficiently manage the process through technology at scale. This has resulted in lower operating costs, which has opened the door to more investors to explore direct indexing’s potential benefits.

What Exactly Is Direct Indexing?

Direct indexing involves buying a sample of the stocks that make up a specific index (e.g., the S&P 500®). Unlike traditional vehicles like exchange-traded funds (ETFs) or mutual funds, this approach gives clients direct ownership of the individual stocks and allows for customization specific to their initially stated preferences and goals. For most DI clients, these goals are centered on realizing tax benefits and customizing their portfolio based on any number of investment views. 

How Does Direct Indexing Work?

The portfolio largely aims to track the performance of the selected index. To set up a direct indexing portfolio, the investment manager:

1. Chooses an index. This choice is based on the overall investment plan as selected by the advisor or client. 


2. Filters the stocks in the index, deciding which stocks to leave out and include. These decisions are based on the investment strategy goals.


3. Buys the chosen stocks. The investment manager uses portfolio optimization software to select a basket of securities with similar risk and return characteristics as the target index. The portfolio optimizer is a tool used to find the best allocation of assets given the investor’s objectives within specific risk and return constraints.   


4. Systematically monitors the portfolio. The investment manager makes changes as needed, including buying and selling individual stocks as markets fluctuate with an objective to add after-tax benefit within the portfolio while maintaining market exposure.

What’s in It for the Client?

Potential tax benefits: With direct indexing, each client owns stocks at a different cost basis and during times of volatility in the market, the investment manager can sell stocks that have lost value and replace with stocks that provide similar exposure. This can help lower the taxes a client owes or offset gains in other investments. This is called tax-loss harvesting, and we’ll explore the process in greater detail later in the series.