Is Direct Indexing Worth the Hype?

As passive investing has grown in popularity, so too has the migration from mutual funds to ETFs.

The thesis is compelling: gain exposure to hundreds of companies by purchasing a single security, reduce costs, and improve tax efficiency.

Yet, as is often the case in investing, another innovation has emerged before ETFs have fully displaced mutual funds as the dominant investment vehicle.

Within the wealth management industry, direct indexing has become one of the most discussed developments in recent years. Despite the attention it receives among advisors, I've been surprised by how little it has entered the broader investing zeitgeist. 

Simply put, direct indexing involves owning the individual stocks that make up an index rather than purchasing an ETF that tracks it.

The investment objective remains largely the same: track the index.

The difference is how you own it.

Owning an ETF means one purchase, one tax lot, and one unrealized gain or loss.

Owning the individual stocks within an index—let's use the S&P 500 as an example—means hundreds of tax lots, hundreds of independent investment decisions, and hundreds of opportunities.

That's where direct indexing begins to differentiate itself.

The Real Benefit Isn't Performance

Most people assume any new investment strategy is designed to outperform the market.

That's generally not the objective of direct indexing.

Instead, its goal is to closely track the underlying index while creating additional flexibility for the investor.

Here are a few examples.

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Tax-Loss Harvesting

The S&P 500 finished 2025 with a return of nearly 18%.

If you owned an S&P 500 ETF, you were likely thrilled with the outcome—even though there were essentially no losses to harvest at the fund level.

Looking beneath the surface tells a different story.

Of the 503 companies in the index, 184 finished the year with negative returns. More remarkably, over 400 stocks declined by at least 5% at some point during the year.

While the index itself never produced a tax-loss harvesting opportunity, a direct indexing portfolio could have harvested losses throughout the year while maintaining similar market exposure.

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Capital Gain Management

Suppose you need liquidity or want to diversify into other investments.

A direct indexing portfolio allows you to choose exactly which tax lots to sell. Rather than selling shares of an ETF with a large embedded gain, you may be able to selectively sell positions with higher cost bases, potentially reducing the associated tax liability.

Conversely, if you're making charitable gifts, you can identify your lowest-basis, most appreciated positions and donate those shares instead.

Owning the underlying securities provides a level of flexibility that simply isn't available through a single ETF.

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Customization

Imagine you're an Amazon employee with substantial stock options.

You may prefer to exclude Amazon from your direct indexing portfolio altogether. You could even exclude the entire consumer discretionary sector if that better aligns with your overall exposure.

Similarly, consultants, investment bankers, and corporate executives are often restricted from owning or trading certain securities. Direct indexing allows those positions to be excluded while maintaining broad market exposure.

You can also customize a portfolio based on personal preferences by excluding companies or industries such as firearms, tobacco, fossil fuels, or other values-based considerations.

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There Are No Free Lunches

The most obvious drawback is cost.

Direct indexing requires sophisticated technology and ongoing management. Unless you plan to build and maintain the portfolio yourself, you'll pay a platform or advisor to implement and monitor the strategy.

Ultimately, the value created should exceed the additional cost. Paying 2% to generate 1% of annual tax benefit rarely makes economic sense.

Complexity is another consideration.

As time passes, harvested losses may become less abundant, while successful holdings accumulate increasingly large embedded gains and potentially grow into larger portfolio positions than originally intended.

Finally, investors should understand tracking error.

Customization, tax-loss harvesting decisions, and portfolio rebalancing all introduce the possibility that returns will deviate from those of the underlying index.

Tracking error isn't inherently good or bad—it simply reflects the reality that a customized portfolio won't perfectly mirror its benchmark. The key is understanding, monitoring, and intentionally managing those differences.

Who Benefits Most?

Not every strategy is appropriate for every investor.

While this is certainly not a recommendation, I generally find direct indexing to be most compelling for investors who share some of the following characteristics:

Potentially good candidates

• Large taxable investment accounts

• High taxable income

• Business owners anticipating a future liquidity event

• Investors consistently contributing to taxable accounts over time

Potentially less compelling candidates

• Investors whose assets are primarily held in retirement accounts

• Investors already drawing down their portfolios in retirement

• Investors with relatively small taxable account balances

My Personal Thoughts

Well, I suppose they're my candid professional thoughts—but from a compliance standpoint, I'm still not making recommendations.

Direct indexing isn't a magic investment strategy.

It won't suddenly produce market-beating returns. In fact, the underlying investment philosophy often looks remarkably similar to traditional index investing.

The difference is flexibility.

Rather than treating every investor the same, direct indexing allows a portfolio to adapt to an individual's tax situation, concentrated holdings, charitable goals, and long-term financial plan.

For the right investor, that flexibility may prove far more valuable than attempting to outperform the market.

It's also worth asking why direct indexing hasn't become the default approach if its potential benefits are so compelling.

I think several factors explain why.

First, the technology simply wasn't available until relatively recently. Commission-free trading, fractional shares, portfolio optimization software, and automated tax management have all been essential to making direct indexing practical at scale.

Second, access remains limited. If a bank, brokerage firm, or advisory platform doesn't have cost-effective access to direct indexing solutions, it's unlikely to offer them to clients.

Finally, there's the transition problem.

Suppose an investor already owns a taxable portfolio of highly appreciated ETFs and mutual funds.

Even if direct indexing is attractive going forward, does it make sense to liquidate existing holdings simply to move into a new strategy?

Maybe.

But that's a planning question—not an investment question—and it deserves a thoughtful transition analysis.

What I appreciate most about direct indexing is that it brings together many of the topics I've written about in recent weeks: tax-loss harvesting, capital gain management, and comprehensive financial planning.

More importantly—and this is the point I'd emphasize above all else—direct indexing doesn't replace thoughtful planning.

It amplifies it.

This material is provided for informational and educational purposes only and should not be construed as investment, legal, tax, or accounting advice or as a recommendation to buy or sell any security or adopt any investment strategy. Direct indexing and other tax management strategies may not be appropriate for every investor and involve risks and limitations, including the potential application of the IRS wash sale rules and the possibility that future tax rates or circumstances may reduce or eliminate the expected benefit. Investors should consult with their tax advisor and other professional advisors regarding their individual circumstances before implementing any strategy. Past performance is not indicative of future results, and no investment strategy can guarantee a profit or protect against loss. Advisory services are offered through Chagrin Valley Legacy Advisors, an investment adviser registered. Registration does not imply a certain level of skill or training. Please speak with a qualified tax professional and/or your financial adviser before implementing any strategies discussed.