Direct Indexing: The “ETF Killer” That Boosts Returns by 1.5%
Direct Indexing: The “ETF Killer” That Boosts Returns by 1.5%
COACHING POINTS
- The Evolution: For decades, the ETF was king. But owning an ETF means you own a “basket.” You cannot sell the loser stocks inside the basket to offset your taxes; you are stuck with the net result.
- The Strategy: Direct Indexing uses software to buy all 500 stocks in the S&P 500 individually in your account. This allows you to harvest losses on the 150 stocks that are down, even if the index itself is up.
- The Alpha: This granular tax-loss harvesting generates “Tax Alpha”—historically adding 1.0% to 2.0% to your annual after-tax returns without taking any extra risk.
Why pay taxes on an index fund when you could make the index work for your tax bill? Direct Indexing was once reserved for ultra-wealthy investors with $10M+ portfolios. Now, thanks to fractional shares and zero-commission trading, it is available to anyone. It essentially decouples the “Investment Return” from the “Tax Return,” allowing you to customize the latter. Source: Vanguard Research / Parametric Tax Alpha Study
Scenario: S&P 500 is up +10% for the year.
- ETF Investor (VTI/SPY):
You own 1 share of SPY. It went up 10%.
Tax Opportunity: $0. You have no realized losses to offset gains because the ETF is up. - Direct Indexer:
You own 500 individual stocks. 350 are up, but 150 are down.
Action: You sell the 150 losers to realize a loss (e.g., -$3,000) and immediately replace them with similar stocks.
Result: You still have the +10% index exposure, but you generated a $3,000 tax deduction to offset other income.
Tax Alpha Visualization
| Strategy | Pre-Tax Return (%) | After-Tax Return (%) |
|---|---|---|
| Standard ETF | 10.0 | 10.0 |
| Direct Indexing | 10.0 | 11.5 |
*Both strategies track the same index (10% growth), but Direct Indexing squeezes out an extra 1.5% “Tax Alpha” by harvesting individual losers.
What-If Scenario: The Customization Bonus
Comparison: Avoiding “ESG Bad Apples” or “Overexposure.”
| Feature | Standard ETF Score | Direct Indexing Score |
|---|---|---|
| Tax Efficiency | 50 | 95 |
| Customization | 0 | 100 |
Execution Protocol
You cannot do this manually (buying 500 stocks is a nightmare). Use automated platforms like Fidelity Managed FidFolios, Schwab Personalized Indexing, or Wealthfront (Stock-Level Tax-Loss Harvesting). Minimums usually range from $5k to $100k.
Direct Indexing works best with new cash or when rolling over cash. If you transfer existing ETFs, you would have to sell them (triggering taxes) to buy the individual stocks, which defeats the purpose. Start fresh.
The benefit is highest in the first 10 years of accumulation when cost bases are fresh. As the portfolio grows over decades, fewer positions will be at a loss, and the “Tax Alpha” naturally decays. It is a tool for the accumulation phase.
COACHING DIRECTIVE
- Do This: Consider Direct Indexing if you are in a high tax bracket (32%+) and have a taxable account over $100k. The tax savings easily cover the slightly higher management fees (0.25% – 0.40%).
- Avoid This: Doing this in an IRA. IRAs have no capital gains taxes, so “Tax Loss Harvesting” is mathematically useless. Stick to cheap ETFs (0.03%) inside retirement accounts.
Frequently Asked Questions
Is it complicated at tax time?
Yes. Instead of 1 line on your tax return (1 ETF), you might have 500 lines of trades. However, the brokerage provides a consolidated 1099-B form that imports directly into TurboTax or your CPA’s software, making it manageable.
What about tracking error?
Direct Indexing portfolios usually hold a “representative sample” (e.g., 150-300 stocks) rather than all 500 to reduce costs. This creates a tiny tracking error vs. the index, usually within +/- 0.05%.
Can I leave the strategy?
Leaving is tricky. If you cancel the service, you are left with 300 individual stocks in your account. You can keep holding them, or sell them (triggering gains). It is somewhat of a “Hotel California” strategy.