Why You Should Probably Avoid Direct Indexing at All Costs

There’s a new-ish investment strategy out there (new-ish to retail investors, at least), direct indexing, that’s gaining popularity among high-income earners. It seems to be on the radar of many people, as we’ve had numerous conversations with prospects and clients on this topic lately.

Direct indexing, in a nutshell, is a pretty straightforward process: create an investment strategy that intentionally harvests tax losses to offset other capital gains you may have.

Instead of buying an index fund, such as a Vanguard or iShares ETF, in your account, direct indexing involves purchasing the individual stocks that make up the index. You would then sell losing positions to realize a tax loss, all while still being exposed to the underlying index. Sounds great, right?

For example, the S&P 500 currently weights the following companies:

• Nvidia – 8.1%
• Microsoft – 7.0%
• Apple – 5.78%
• Amazon – 4.0%
• Meta – 2.8%

…and so on, which make up the S&P 500.

With direct indexing, you’d own all, or at least many, of these stocks directly. That’s 503 individual positions (yes, 503, not 500, as some companies issued multiple classes of shares) inside a single brokerage account.

Naturally, some positions will perform well and others won’t. The underperformers would be sold to realize losses, offsetting gains elsewhere. For someone selling concentrated stock, a business, or another asset with a low basis and high tax liability, this can feel like a godsend. In these situations, it is normal for people to turn over every stone in an effort to minimize their tax burden.

But be forewarned. As with everything else in life, there is no free lunch.

Tax Deferral, Not Elimination

Over the past year, we’ve onboarded several clients who used direct indexing as a way to cut their tax bills. And it worked, initially. They harvested losses, lowered their tax liability, and felt they were ahead.

But these benefits were short-lived. The problem today is that their portfolios are filled with positions that only have gains. Hundreds of them. They realized that they didn’t simply reduce their tax bill; they only deferred it to a future date. These investors learned a very important lesson: tax-loss harvesting doesn’t eliminate your tax liability. It defers it. When these investors finally decide (or are forced) to liquidate these positions, the deferred gains will finally be realized.

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They also learned that tax-loss harvesting is most beneficial when the cost basis of their positions is closer to their market price, early on. As the portfolio appreciates over time, the opportunity to harvest losses decreases. To ‘refresh’ the harvesting potential, investors would need to continually add new capital, which may be unpalatable and/or unfeasible.

Off The Mark

Direct indexing also creates another problem: tracking error. Over time, of course, the market trends higher. However, the market hasn’t just been trending higher lately; it’s been on a tear. Even mediocre companies have been lifted by the rising tide.

Direct index investors now have a brokerage account with hundreds of tiny positions that they can’t sell without realizing a tax gain. Further complicating the matter is that they don’t really know the companies they own.

Is Ametek positioned well in its industry? How is Elevance Health doing? Is Illinois Tool Works undervalued or overvalued?

The vast majority of investors have never heard of these names, let alone understand their value proposition or market positioning.

The beauty of a market-cap weighted index, like the S&P 500 and NASDAQ 100, is that it will automatically size the position in your portfolio based on the company’s market value, giving it greater weight to the largest firms and less to the smaller ones. Every day, the market adjusts each company’s valuation based on its performance. Capitalism at its finest.

Direct indexing skews and distorts this. Because they sold off certain stocks and sectors along the way, their portfolios no longer track the S&P 500 as expected. Some companies that performed poorly are sold off, and those that performed well are kept in the portfolio. If those underperforming companies make a comeback, a direct indexing portfolio would not be able to capture that performance because the shares have already been sold. This is known as ‘tracking error,’ and such deviation will likely result in underperformance. And the longer one participates in direct indexing, the more distorted their portfolio becomes.

There are many different ‘flavors’ of direct indexing: factor-based, ESG, investing around concentrated stock, and even ‘enhanced’ direct indexing, which is a long/short strategy using extreme leverage. Each of these variations is packaged in a way to fine-tune your exposure or add value. But in reality, they introduce more complexity, higher costs, and greater tracking error. What starts as a simple idea (mimicking an index) can quickly turn into something that bears little resemblance to the index at all.

It Gets Worse

As mentioned earlier, one solution is to keep contributing new money into the account to rebuild missing positions or sectors. If the investor is paying an SMA/portfolio manager to manage their direct indexing strategy, costs are to be considered. Direct indexing strategies typically come with higher management fees compared to low-cost ETFs or mutual funds. And even though commissions are low or nonexistent, the sheer number of trades required to replicate and rebalance a portfolio leads to higher transaction costs over time (and don’t discount the hidden cost of bid/ask spreads).

All of this assumes that the investor has the cash flow to sustain the strategy.  

What happens if there is an unexpected drop in income? Or, what happens when the investor retires, and the income stream stops? At that point, the investors would need to draw from their portfolio, and having an account stuffed with unrealized gains and misaligned exposure makes that far more difficult to manage.

Furthermore, what positions would the investor sell? If they invested in an index fund, they could simply sell the number of shares needed. However, it’s not feasible to sell all direct index positions pro rata. A decision would need to be made: do I sell Nvidia/Apple/Amazon, or do I sell a no-name company I know nothing about? Is this the correct decision? What if the no-name company is the next Nvidia?

What To Do Instead

Direct indexing is not a scam. For a narrow set of circumstances, like someone facing a large, one-time tax event, it can provide short-term relief. But for most investors, the strategy runs into diminishing tax benefits, tracking error, higher costs, and a portfolio that becomes increasingly difficult to manage and exit.

Sophistication does not always translate into better results. More often than not, simplicity wins.

At Bull Oak, we take a different approach. Our investment philosophy is built around low-cost, diversified index funds, disciplined rebalancing, and tax-efficient planning that works with your full financial picture, not just one account in isolation. We have seen what happens when a clever-sounding strategy creates more problems than it solves. If you’re currently in a direct indexing portfolio and unsure how to unwind it, or if you want to avoid the trap altogether, we can help.

Ryan A. Hughes

Ryan is the founder of Bull Oak, a financial advisor in San Diego. He’s been listed in InvestmentNews 40Under40 and his firm has been named one of the fastest-growing by Wealth Management Magazine.