Direct indexing is a separately managed account that replicates a benchmark index by holding most of its individual constituent stocks directly, rather than through a fund or ETF, which lets an investor harvest tax losses stock by stock and customize or exclude individual holdings.
In plain terms
An index fund buys one thing — the fund — which in turn owns hundreds of stocks. Direct indexing skips the middle fund: a brokerage or asset manager buys most of an index’s constituent stocks directly in the investor’s own account, in roughly the index’s weights. The investor ends up with performance that tracks the index closely, but the account now holds hundreds of individually owned, individually taxable positions instead of shares in one fund.
How it works
That ownership structure is the entire point. Because each stock is held and can be sold separately, a manager can sell the laggards in the basket at any time during the year — capturing a tax loss on, say, a handful of underperforming constituents — while buying a similar stock to hold the portfolio’s overall index exposure roughly constant. This is tax-loss harvesting at the level of individual securities rather than at the level of a whole fund, and it’s the main reason the strategy exists. The replacement security has to be close enough to maintain exposure but cannot be “substantially identical” to the one sold, or the trade runs into the wash sale rule.
Direct indexing also allows customization an index fund can’t offer in the United States: excluding a sector, a stock the client already holds too much of through employer equity, or a name the client wants out for personal reasons, all while tracking close to the benchmark’s return.
The numbers
- US direct indexing assets, year-end 2024: $864.3 billion, per Cerulli Associates.
- Share of manager-traded separately managed account assets: 37.6%, more than double its share in 2020.
- Model-delivered direct indexing, a newer and lower-cost segment: $17.2 billion, more than triple its size at the end of 2021.
- For comparison: index-tracking ETFs held about $9.4 trillion and index mutual funds about $6.6 trillion over the same period — direct indexing remains the smallest of the three wrappers by a wide margin, even as it grows the fastest.
- Wash sale window: 30 days before or after a sale, under IRC Section 1091.
What people get wrong
That direct indexing is primarily a way to get a cheaper or better index fund. The expense ratio on a direct-indexed account typically runs higher than a comparable index ETF, and the tracking is never exact — a portfolio of a few hundred individually owned stocks won’t move in perfect lockstep with an index of thousands. The entire value proposition is the tax-loss harvesting and customization, and those only pay off for a taxable account that has gains elsewhere to offset and a long enough horizon to let the deferral compound. In a tax-advantaged account, or for an investor without capital gains to shelter, direct indexing has no advantage over a plain index fund and carries a real cost and complexity disadvantage.
Related
Read more: Money Management: From Wealth Manager to Family Office · Taxes: How Wealth Is Structured and Preserved
See also: Tax-loss harvesting · Step-up in basis · Concentrated position