Direct Indexing: Why Millionaires Are Ditching ETFs
Direct Indexing: Why Millionaires Are Ditching ETFs
EXECUTIVE SUMMARY
- The Mechanism: Instead of buying an ETF (like SPY), Direct Indexing software buys the individual stocks inside the index for you. This “unbundles” the index, allowing you to sell the losers while keeping the winners.
- The Benefit: In an ETF, you cannot harvest losses if the index is up. In Direct Indexing, even if the S&P 500 is up +10%, ~30% of its components might be down. You harvest those specific losses to offset capital gains elsewhere.
- Authority Baseline: This analysis follows the “Tax Alpha” framework quantified by Parametric Portfolio Associates, estimating an additional 0.60% to 1.00% annual after-tax return.
- Scope Limitation: This strategy is exclusively for Taxable Brokerage Accounts. It has zero benefit in IRAs or 401(k)s where capital gains are not taxed.
ETFs were the innovation of the 1990s. Direct Indexing is the innovation of the 2020s. An ETF is a “wrapper” that traps both winners and losers inside. You are forced to hold the losers until the whole ship sinks. Direct Indexing removes the wrapper. It allows you to surgically remove the “rotten apples” (losers) to generate a tax deduction, while the portfolio continues to track the market perfectly. According to Team BMT Analysis, this is the most reliable source of “Alpha” available, because it comes from the IRS, not the market. Source: Fidelity / Aperio Group Research
Scenario: S&P 500 is up +5% this year.
- ETF Investor (SPY):
Portfolio Value: Up +5%.
Realized Loss: $0. (Cannot sell because the ETF is up).
Tax Benefit: None. - Direct Indexing Investor:
Portfolio Value: Up +5% (Tracks index).
Action: Software scans and sees that Tesla and Meta are down -20%.
Trade: Sells Tesla/Meta to book the loss, immediately buys a substitute (e.g., Ford/Google) to stay invested.
Tax Benefit: $5,000 Loss Generated. (Offsets other gains).
After-Tax Return Comparison
| Strategy | 10-Year Annualized Return (After Tax) |
|---|---|
| Standard ETF (SPY) | 8 |
| Direct Indexing (Tax-Optimized) | 9 |
*Chart Note: The ~1% difference comes purely from tax savings. This “Tax Alpha” is risk-free in the sense that it doesn’t require taking more market risk, only more operational complexity.
CRITICAL SCENARIO: The “Wash Sale” Trap
Complexity is the enemy.
| Condition | Risk |
|---|---|
| Manual Trading | High. Trying to buy/sell 500 stocks manually guarantees tracking error and accidental Wash Sales (buying back too soon). |
| Automated Software (Wealthfront/Fidelity) | Low. Algorithms handle the 31-day wash sale rule automatically. |
Execution Protocol
Direct Indexing typically requires a minimum of $100k to $250k. Below that, it’s hard to buy 500 stocks even with fractional shares without creating a mess.
Decision Order: Confirm Taxable Account Size โ Check Capital Gains Exposure โ Select Provider.
Retail: Wealthfront (Stock-level harvesting), Fidelity Managed FidFolios, Schwab Personalized Indexing.
Advisor: Parametric, Aperio (O’Shaughnessy).
Since you own the stocks, you can customize. Hate Oil? Exclude it. Work at Apple? Exclude Apple stock (to avoid concentration risk). This “Custom Indexing” is a secondary benefit beyond taxes.
Fail Condition: Turning off the software. If you stop the service, you are left with 500 individual stocks in your account. Selling them all at once triggers a tax bomb. You are “married” to the strategy.
WEALTH STRATEGY DIRECTIVE
- Do This: Switch to Direct Indexing if you are in a high tax bracket (32%+) and have significant capital gains from other sources (Real Estate, Business Sale) that need offsetting.
- Avoid This: Using this in a Roth IRA. There are no taxes to harvest in an IRA. Stick to simple ETFs like VTI there.
Frequently Asked Questions
Is it expensive?
Fees have dropped. Wealthfront charges 0.25%. Fidelity charges ~0.40%. While higher than VTI (0.03%), the 1.00% tax benefit covers the fee multiple times over.
What happens when I leave?
You can usually transfer the shares “in-kind” to another broker. But then you are stuck managing 500 tickers. It is a sticky product.
Does it track the S&P 500 exactly?
No. It creates “Tracking Error” because it samples the index (e.g., holding 300 stocks instead of 500). Returns will vary slightly (+/- 0.2%) from the benchmark.