How Does Direct Indexing Work?

Quick Answer

Direct indexing involves buying stocks from an index rather than investing in an index fund. This investing strategy gives you many of the benefits associated with index funds, including diversification, but it also gives you more flexibility.

A man wearing a watch is looking at a stock chart on his laptop.

Direct indexing is an investment strategy in which you buy stocks included in index funds on your own rather than investing in the funds themselves. The process offers more flexibility in how you manage your portfolio, as well as the benefits of direct ownership.

There are also some potential disadvantages to consider, and it's important to pick index funds that align with your investment objectives. Here's what you need to know about direct investing, how to get started and the pros and cons to keep in mind.

What Is Direct Indexing?

Index funds can offer many benefits to investors. They make it easier to diversify your portfolio, and they often have low fees because they're not actively managed—they merely track stock indexes, such as the S&P 500 or Dow Jones Industrial Average (DJIA).

But investing in index funds means you won't have full control over what's in your portfolio. And while you'll benefit from price appreciation and dividends, you don't get other benefits of stock ownership.

Direct indexing, on the other hand, puts you in the driver's seat. As an example, let's say you want to invest in the 30 stocks that make up the DJIA. Instead of investing in an index fund that tracks the DJIA, you'd obtain a list of the stocks, which includes companies like Apple, McDonald's, Microsoft and Nike, and buy them on your own.

You can use the same approach as the index fund and buy the stocks proportionally based on their stock price, or you can weigh your portfolio as you see fit.

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How to Get Started With Direct Indexing

If you don't already have a brokerage account, open one to get started. Because many indexes are made up of dozens, hundreds or even thousands of stocks, consider a broker that offers fractional shares. Some brokers allow you to invest as little as $1 in a single stock, so you'll have a better chance of being able to buy all the stocks you're looking for without needing a massive investment balance.

If you're not sure which index to use, think about your investing goals and risk tolerance. For example, the DJIA is made up of 30 stocks from well-established companies. If preserving your capital and earning income are your top priorities, DJIA may be a good choice since you're more likely to earn dividends from these companies and the annual return will be less volatile. But if you're investing for the long run and want to maximize your annual return, you may be better off with the S&P 500 index or another index that includes smaller companies.

Once you've established which index you want to follow, find a list of the stocks and start making trades. In most cases, brokers no longer charge commissions on stock trades. But as with any investment, you'll also need to keep taxes in mind. If you sell your position within a year, any gains you earned will be subject to ordinary income tax, but if you hold your position for longer than a year, you'll pay a lower long-term capital gains tax rate.

Pros of Direct Indexing

There are many reasons to consider direct indexing instead of buying into an index fund:

  • More control: Once you choose an index fund, you have no control over which stocks you're invested in. With direct indexing, however, you can simply avoid a company if it doesn't align with your values or you don't view them as a wise investment. Or, if you want to weigh your holdings differently, you can choose how you want to do it. Index funds typically weight their holdings based on stock prices or the total value of all the companies shares (market capitalization), but some give equal weight to each stock.
  • Ownership: When you invest in an index fund, you'll still earn dividends. But you won't get voting rights. If you want all of the benefits of stock ownership, direct indexing is the better option.
  • Less expensive: Even though index funds tend to charge lower fees than actively managed funds, you'll still pay a small amount every year. If you invest in stocks directly, you typically won't have to pay a trading fee, and there's no annual fee because you're the one managing your portfolio.

Cons of Direct Indexing

While direct indexing has its perks, there are also some downsides and potential risks you'll want to consider:

  • More complicated: With an index fund, you don't have to do any of the legwork associated with trading. If you go the direct indexing route, you'll need to keep an eye on stock prices and rebalance your portfolio, add and remove stocks as the underlying index changes and more. If you're not a seasoned investor, it can get overwhelming.
  • Tax implications: If you're constantly buying and selling stocks to keep up with the index, you're more likely to end up with short-term capital gains, which are taxed at a higher rate. If you're doing direct indexing in a tax-advantaged retirement account, you don't have to worry as much about this drawback.
  • You could miss out on other stocks: If you're focused only on stocks that are included in a specific index, you may miss out on gains by smaller stocks that aren't big enough to be included in popular indexes.

Consult With an Investment Professional on Your Strategy

Before you decide to try direct indexing, consider speaking with a financial advisor who can help you determine whether it's right for you. They may also be able to help you define your overall investment strategy, whether or not direct indexing fits your goals, and assist you in picking the index or indexes you should follow. Some advisors may charge for this service, but it can be worth ensuring that you get started on the right foot.

Before making any major investment decisions, make sure it aligns with your budget. Your financial obligations should already be taken care of, including your emergency fund and retirement contributions. Doing so will help protect your finances, as well as your credit score, if an unexpected major expense were to pop up.