What Is Direct Indexing?

In 1924, mutual funds made it possible for everyday investors to buy a basket of stocks in one shot. In 1976, index mutual funds took it a step further by letting you buy “the market” at low cost. In 1993, ETFs added intraday trading and even better tax efficiency. The latest step in that evolution is direct indexing, holding the individual stocks of an index in your own account so you get broad market exposure and the ability to customize and manage taxes in ways a traditional fund can’t.

Not long ago, if you wanted to manually mirror the big indexes, you basically needed the wealth of a Rockefeller. For example, to mimic the S&P 500, you’d have to buy hundreds of stocks one by one, in the same proportions as the actual S&P 500, and actively buy and sell those stocks to keep pace with it. Only the ultra-rich could afford the time and trading costs for that. In fact, when direct indexing first came around a few decades ago, it was basically an exclusive club for ultra-high-net-worth investors¹. The rest of us had to settle for ordinary index funds. But not any longer!

What Exactly Is Direct Indexing?

Okay, now that I’ve built it up, let’s clearly define it. Direct indexing means investing in all (or a representative sample) of the individual components of an index directly, rather than buying a fund that tracks that index. Instead of buying an S&P 500 index mutual fund or ETF, you set up a portfolio where you own the stocks yourself (usually via a separately managed account set up by your advisor or platform). You end up with similar exposure to the index – you’re still broadly diversified across the market – but you hold the actual shares of each company in your account.

Why would someone do that? After all, index funds and ETFs are cheap, easy, and wildly popular. To answer that, it helps to remember one of those boring disclosures we always hear: “You can’t invest directly in an index.” You can, however, invest in all the parts of an index, and doing so gives you a degree of control that a prepackaged fund doesn’t. With direct indexing, you essentially create your own personalized index fund. 

Mechanically, setting up a direct indexed portfolio is usually handled by an investment manager or a nifty piece of software. They’ll start with the target index (e.g., the Russell 3000 or S&P 500), and buy most or all of the stocks in that index for your account at the proper weights. In practice, very small accounts might buy just a sampled subset to approximate the index – but larger ones can hold every single constituent. 

This approach blurs the line between passive and active investing. It’s passive in that you’re tracking an index, but active in that you can customize holdings and trades specifically for you. In a way, direct indexing is bringing a bit of the institutional portfolio management experience to individual investors.

The key is that you own the stocks directly, and that direct ownership is what unlocks the tax efficiency we cover below.

The Rise of Direct Indexing

Direct indexing has indeed surged in popularity. Assets under management in this space nearly doubled between 2020 and 2024—climbing from roughly $350 billion to $864 billion.

That’s a powerful bull run of growth. So why the change? 

In a word: technology. Over the past decade or so, several trends converged to lower the drawbridge and “democratize” this strategy. First, trading costs plummeted. Today, we have zero-commission trading on stocks at most brokers. Remember when it cost $10 or more per trade? Those days are gone. Second, the rise of fractional shares means you no longer need huge sums to buy slices of expensive stocks. Want to replicate the S&P 500 but only have a few thousand bucks? Fractional trading lets you buy, say, 0.1 shares of a $3,000 stock to get the right weighting. Third, computing power and portfolio management software have gotten really good. The heavy number-crunching and rebalancing that used to require a team of analysts can now be automated by algorithms in the cloud.

All of this led to a steep drop in the required account size for direct indexing. What used to demand $10 million+ now might require far, far less. In fact, some investment firms have introduced direct indexing for retail investors with account minimums as low as $5,000.  

The Potential Benefits of Direct Indexing

So why go through the trouble of holding hundreds of stocks individually? Two big reasons: tax management and personalization.

1. Better Tax Efficiency (Especially Tax-Loss Harvesting).

This is often touted as the number one advantage of direct indexing, and it’s a compelling one. If you’ve ever owned a mutual fund in a taxable account, you may have been unpleasantly surprised by capital gains distributions (often at year-end) that you had no control over. With an index ETF, you avoid most capital gains distributions, but you still can’t utilize individual stock losses within the fund – they’re trapped inside. When you directly own the stocks, however, it opens up the strategy of tax-loss harvesting on a whole new level. 

This means intentionally selling stocks that have dropped below your purchase price to “harvest” the capital loss, which you can use to offset gains and reduce your tax bill. You then replace that sold stock with another similar stock or ETF (to maintain your market exposure) and potentially avoid wash-sale issues.