What Is Direct Indexing? How It Works, Who It's For, and Where It Falls Short

If you've read anything about investing lately, you've probably run into the term direct indexing. Most of the big custodians and asset managers offer it now. It gets pitched as the next step up from index funds, especially for people with larger taxable accounts. But most of the explanations out there are either too technical or come straight from the companies selling it.

Here's the plain version.

The short answer

Direct indexing means owning the individual stocks in an index instead of owning a fund that tracks the index.

When you buy an S&P 500 index fund or ETF, you own one thing: a share of the fund. The fund owns the 500 stocks. With direct indexing, you skip the fund and own the stocks themselves, in your own separately managed account, in roughly the same proportions as the index. A professional manager (or a computer program) keeps the account lined up with the index over time.

The end result looks a lot like an index fund on the surface. Same companies, similar returns before taxes. The difference is what you can do with it once you own the pieces.

Why anyone would bother

If direct indexing just copied an index fund, nobody would pay extra for it. Two things make it different.

1. Tax-loss harvesting at the stock level

This is the main reason direct indexing exists.

In any given year, an index can be up a lot while plenty of the stocks inside it are down. One example: in 2024, a broad index of the 1,000 largest U.S. stocks returned almost 25%, yet 433 of the stocks in that index lost value during the year.¹

If you own the index fund, none of that matters to you. The fund went up, so you have a gain. There's nothing to harvest.

If you own the stocks directly, the manager can sell the ones sitting at a loss, book that loss for tax purposes, and replace them with similar stocks so your portfolio still tracks the index. Those realized losses can offset capital gains you have elsewhere. If you have more losses than gains, you can use up to $3,000 a year against ordinary income and carry the rest forward to future years.²

For someone who regularly generates capital gains, that can be worth real money. The firms that run these programs commonly cite a potential 1 to 2 percentage points per year of added after-tax return for investors whose portfolios regularly realize large gains.¹ ³ Keep in mind those are provider estimates for a specific type of investor, not guarantees, and the actual benefit depends on your tax bracket, how much gain you have to offset, and what the market does.

2. Customization

Because you own the individual holdings, you can change them. Common uses include leaving out your employer's stock if you already have a lot of it through work, excluding an industry you don't want to own, or building a portfolio around a large concentrated position you're not ready to sell. You can't do any of that inside a pooled fund.

Who this tends to make sense for

Direct indexing is a taxable account strategy. Inside an IRA, 401(k), or Roth, there are no capital gains to harvest, so the tax angle disappears and you're just paying more for a more complicated version of an index fund.

The people who tend to benefit most share a few traits:

• They're in a high tax bracket. Short-term capital gains are taxed at ordinary income rates, which top out at 37%.⁴ Add the 3.8% net investment income tax that applies above $200,000 of income for single filers and $250,000 for married couples filing jointly,⁵ and a harvested loss is worth more to them than to someone in a lower bracket.
• They have gains to offset. Business owners who sell a company, executives with stock compensation, real estate investors, or anyone who sells appreciated assets regularly. If you rarely realize gains, harvested losses just pile up as carryforwards, which is nice but not a game changer.
• They have a large taxable account. Most direct indexing programs start at $100,000 or more,¹ though a few retail versions have lower minimums.⁶
• They add new money over time. Fresh contributions buy new stocks at new prices, which creates new harvesting opportunities. This matters more than most people realize, and I'll explain why below.

If you're a business owner planning an exit, this ties directly into what we wrote about in What to Do With the Proceeds After Selling Your Business. Banking losses in the years before a sale can take some of the sting out of the gain.

The honest downsides

This is where a lot of the marketing goes quiet, so let's cover it.

It can cost more. Direct indexing fees typically run between 0.30% and 0.40% a year, compared with an average of around 0.20% for ordinary ETFs and mutual funds,¹ and many broad market index ETFs charge a fraction of that. The tax benefit has to be big enough to beat that gap, every year, or you're paying for nothing.

The harvesting benefit fades. This is the part I'd want every client to understand before signing up. Tax-loss harvesting works best early, when your holdings are near their purchase price, and any dip puts some of them at a loss. After a few years in a rising market, most of your stocks are sitting on gains. There's nothing left to harvest. Morningstar's Ben Johnson describes the portfolio eventually becoming "locked up," with all the securities in gains and no more losses to realize.⁷ A 2025 article in the Journal of Financial Planning made the same point and noted that most of the ongoing tax efficiency claims in these programs assume you keep adding new money.⁸

At that stage, you're left with a higher-fee account that behaves like an index fund. You can move it, but selling means realizing the very gains you've been avoiding.

Tracking error. When the manager sells a losing stock and swaps in a substitute to avoid the wash sale rule, your portfolio drifts a bit from the index. Usually it's small. Sometimes it's not, and it can cut either way.

It's not for retirement accounts. Worth repeating. If most of your money is in IRAs and 401(k)s, direct indexing has very little to offer you.

Complexity. Instead of one fund on your statement, you might have several hundred positions. Your 1099 gets longer. If you own the same stocks in another account, you can accidentally trigger wash sales that cancel out the harvested losses. The wash sale rule disallows a loss if you buy a substantially identical security within 30 days before or after the sale.⁹ Good programs manage this within the account, but they can't see what you're doing in an account they don't manage.

It can be a distraction. Direct indexing is a tax tool. It doesn't replace having the right mix of stocks and bonds, a plan for withdrawals, or an estate plan. It's an optimization on top of those things, not a substitute for them.

How it compares

Here's a simple way to think about the three options for owning "the market" in a taxable account.

Index mutual fund. Simplest. Lowest cost. Least flexible. Can pass along capital gains distributions from the fund's own trading, which you owe tax on even if you didn't sell.

Index ETF. Also simple and cheap, and generally more tax efficient than a mutual fund because of how ETFs are structured. Still no ability to harvest losses on individual holdings. We compared these two in ETF vs. Mutual Fund: What's the Difference and Which Is Right for You?

Direct indexing. Highest cost and complexity. Most flexible. Adds stock-level tax-loss harvesting and customization. Most useful for high bracket investors with large taxable accounts, ongoing gains to offset, and new money going in.

Is this a fad?

No. The numbers say it's here to stay. Cerulli Associates reports direct indexing assets ended 2024 at $864.3 billion. That's still small next to the $9.4 trillion in index ETFs, but it's growing, and about 18% of financial advisors now use it with clients.¹⁰

That said, popularity isn't the same as fit. Cerulli's own research found that 26% of advisors have access to direct indexing and choose not to use it.¹⁰ Some of that is education, and some of it is that for a lot of clients, a low cost ETF portfolio does the job just fine.

The bottom line

Direct indexing is a legitimate strategy for a specific kind of investor: someone with a sizable taxable account, a high tax bracket, capital gains that need offsetting, and ideally new money going in each year. For that person, the tax savings can outweigh the higher fees, at least for a number of years.

For everyone else, a well built portfolio of low cost index funds and ETFs is usually simpler, cheaper, and nearly as effective.

We offer direct indexing at Dreyer Wealth Management, and we also tell plenty of people it isn't the right fit for them. The answer depends on your bracket, your gains, and where your money sits, not on what's popular this year. If you're not sure which camp you fall in, that's a reasonable question to bring to us, along with your last tax return. We covered the broader picture in Tax-Efficient Investing in 2026: How to Keep More of What You Earn if you want to dig further.

Dreyer Wealth Management does not provide tax or legal advice. Tax-loss harvesting involves risk, including the possibility of unintended tax consequences and portfolio tracking error, and there is no guarantee that any tax strategy will reduce your overall tax liability. Direct indexing is not suitable for all investors. Investing involves risk, including possible loss of principal. Past performance does not guarantee future results.

Sources

1. D.J. Tierney, "Tax Advantages and Risks of Direct Indexing," Charles Schwab, March 7, 2025. Index return and count of 433 declining stocks refer to the Schwab 1000 Index for calendar year 2024; underlying data from Bloomberg. Also the source for the typical fee range, typical minimums, and the 1 to 2 percentage point estimate. https://www.schwab.com/learn/story/tax-advantages-and-risks-direct-indexing
2. IRS, Topic No. 409, Capital Gains and Losses ($3,000 net capital loss limit and carryforward). https://www.irs.gov/taxtopics/tc409
3. Vanguard, "How to Use Direct Indexing with Tax Loss Harvesting" (1% to 2% or more after-tax alpha estimate). https://advisors.vanguard.com/investments/personalized-indexing/direct-indexing-and-tax-loss-harvesting
4. IRS, "IRS releases tax inflation adjustments for tax year 2026, including amendments from the One Big Beautiful Bill" (37% top rate). https://www.irs.gov/newsroom/irs-releases-tax-inflation-adjustments-for-tax-year-2026-including-amendments-from-the-one-big-beautiful-bill
5. IRS, Topic No. 559, Net Investment Income Tax (3.8% rate and thresholds). https://www.irs.gov/taxtopics/tc559
6. Fidelity, "Direct Indexing Overview" (retail program minimums). https://www.fidelity.com/direct-indexing/overview
7. Ben Johnson, "Should You Follow Vanguard Into Direct Indexing?" Morningstar. https://www.morningstar.com/portfolios/should-you-follow-vanguard-into-direct-indexing
8. Tiboris, Bremer, and Ulbrick, "Direct Indexing and the Diet of Distraction: A Financial Planner's Case for Simplicity," Journal of Financial Planning, June 2025. https://www.financialplanningassociation.org/learning/publications/journal/JUN25-direct-indexing-and-diet-distraction-financial-planners-case-simplicity-OPEN
9. U.S. Securities and Exchange Commission, Investor.gov, "Wash Sales." https://www.investor.gov/introduction-investing/investing-basics/glossary/wash-sales
10. Cerulli Associates, "Direct Indexing Assets Close Year-End 2024 at $864.3 Billion," April 10, 2025. https://www.cerulli.com/press-releases/direct-indexing-assets-close-year-end-2024-at-864.3-billion