Direct Indexing

A collection of strategies to help business owners keep more of their wealth.

Key numbers

What It Is

A standard index fund wraps all its holdings into a single vehicle. You own shares of the fund, not the underlying stocks. That's efficient and cheap, but it means you can't harvest individual stock losses. If the index is up 15% for the year, your fund is up roughly 15%, and there's nothing to harvest. Dozens of individual companies inside the index may have fallen 20%, 30%, or more, and none of those losses are available to you.

Direct indexing solves this. Instead of buying the fund, a separately managed account (SMA) purchases the individual stocks that make up the index. You get effectively the same market exposure, but because you own each position separately, you can sell the losers, realize the loss, and immediately replace them with a similar (but not substantially identical) stock to stay invested. The IRS gets a loss. Your portfolio stays fully exposed to the market.

The Math

In any given year, the S&P 500 might return +15%. But within that index, 150–200 individual stocks might be down, some meaningfully. A fund can't touch those losses. A direct index account can realize every one of them.

Example: You have a $1M direct index account. In a year the index gains 12%, your account also gains roughly 12%. But along the way, the manager harvested $60,000 in individual stock losses. Those losses offset $60,000 of capital gains elsewhere in your portfolio. At a 37% combined rate, that's $22,200 in tax savings — a 2.2% benefit on your $1M account. Your direct index program charges 0.30%, or $3,000. Net benefit: roughly $19,200, or 1.9%.

Realistic long-run estimate: 0.5–1.5% annual tax alpha, depending on market conditions and portfolio size.

When It Makes Sense

1. Large taxable accounts with ongoing capital gains. The benefit scales with portfolio size. Below $250K, there aren't enough positions to diversify effectively while harvesting, and the fee isn't worth it. Above $500K, the math starts working clearly. Above $1M, it's a serious conversation.

2. You're in a high combined tax rate. At a 23.8% federal rate without state tax, the math works but is tighter. Add California's 13.3%, and you're at a combined 37%+ rate. Every dollar harvested saves 37 cents. At those rates, direct indexing earns its keep.

3. Accumulation phase, not distribution phase. Direct indexing is most powerful when you're still building the portfolio and making new contributions.

4. You want ESG or custom exclusions. Direct indexing lets you exclude individual stocks from your portfolio — tobacco, firearms, a company you work for, a competitor. You maintain broad index exposure with a customized filter.

5. Transition from a concentrated position. If you have a large concentrated stock position, a direct index account can be seeded with those shares and use harvested losses elsewhere to offset gains as you sell down.

When It Doesn't Make Sense

Below $250K. The diversification math breaks down. A broad market ETF at 0.03% is better.

Tax-deferred or Roth accounts. Direct indexing only works in taxable accounts. There's no benefit to harvesting losses inside a 401(k) or IRA.

When you plan to pass assets to heirs. Harvesting now saves taxes today but drives down your cost basis. If those assets will pass to heirs at death, they receive a step-up in basis and the embedded gain disappears entirely. Aggressive harvesting during your lifetime might not be optimal.

When you don't have gains to offset. If you have no gains, you're limited to $3,000 per year of ordinary income offset. The losses carry forward, but the payoff is slow.

The Cost Basis Depletion Problem

Every time you harvest a loss, you reduce your cost basis in the replacement position. Over time, with consistent harvesting, your entire portfolio is marked at a lower basis. You've built up a large deferred gain. The tax isn't eliminated; it's deferred.

The optimal strategy treats direct indexing as a deferral tool, not an elimination tool, unless the assets are held to death. Plan accordingly.

Fees and Providers

• Parametric / Morgan Stanley: the institutional standard; minimum $250K+; 0.30–0.40%
• Aperio / BlackRock: similar profile; strong for ESG customization
• Fidelity, Schwab, Vanguard: have entered the space at lower minimums ($100K–$250K) with lower fees
• Wealthfront, Direct Indexing SMAs: fintech entrants; lower minimums but more automated, less customized

Rule #1 Check

At $1M+ with meaningful capital gains to offset and a 37% combined rate: yes, clearly. The expected 0.5–1.5% tax alpha comfortably exceeds the 0.20–0.40% fee.

At $250K–$500K with moderate gains and no state income tax: maybe. Run the numbers.

Below $250K, no significant capital gains, or assets destined for heirs in a step-up scenario: probably not. A broad market index ETF does the same job for almost nothing.