Compare direct indexing and ETFs: learn the differences, tax advantages, and when each strategy is best.
Direct indexing is transforming how high net worth investors approach portfolio construction. Unlike traditional ETFs or mutual funds, which bundle investors’ money into a single pool that tracks a market index, direct indexing lets you buy the individual securities that make up that index—offering control, customization, and tax efficiencies that were once the exclusive domain of large institutions. But how do you know if this approach is right for you, and how does it compare to sticking with well-known ETFs?
With direct indexing, investors open a separately managed account, selecting the underlying stocks of a chosen index—such as the S&P 500 or Russell 2000—and directly owning each position. This contrasts sharply with an index ETF, which simply represents fractional ownership in a fund tracking the market basket with limited input or personalization.
The direct indexing approach offers advantages: you can exclude certain stocks (useful for those with concentrated positions), overweight or underweight sectors, or impose ESG screens that match your values. Importantly, you (or your advisor) can harvest tax losses opportunistically throughout the year—something an ETF cannot offer.
What sets direct indexing apart is its ability to boost after-tax returns—a concept known as “tax alpha.” Because you hold the stocks individually, you can systematically sell losing positions to offset gains elsewhere, a powerful advantage for high-income investors managing taxable portfolios. Over time, this strategy can meaningfully reduce your annual tax bill, potentially adding several tenths of a percent to long-term returns. Customization is another draw. Investors focused on sustainable investing can exclude fossil fuels, tobacco, or any category not aligned with their ethical standards—while ETFs can only offer what’s designed by the fund provider. Similarly, if you already own legacy shares in your employer’s company, you can carve it out from your index replication to avoid over-concentration risk. Rebalancing is also far more flexible with direct indexing; you and your advisor set the rules, timing, and triggers for buying or selling, rather than automatic ETF rebalancing dictated by broad market changes. Platforms offered by Schwab, Fidelity, and others make this process streamlined for qualified accounts.
While direct indexing has compelling advantages, there are situations where ETFs remain a strong choice—particularly for smaller portfolios or for those seeking ultra-low management costs and simplicity. ETFs offer diversification, liquidity, and tax efficiency (through the in-kind redemption process), making them appropriate for many investors. For those without large taxable accounts, or who don’t require customization, an ETF may be the right solution. Consider direct indexing if you have specialized tax needs, assets above $250,000 in taxable accounts, significant charitable giving goals, or a desire for deep ESG customization. But if you want a purely "set it and forget it" option, low-cost index ETFs are still best-in-class. Work with a fiduciary advisor to align the right investing tools for your unique circumstances.