Direct Indexing: Prudent Investment Strategy with Tax Benefits

Direct Indexing: Prudent Investment Strategy with Tax Benefits

By Anthony Criscuolo, CFP®

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For decades now, many investors and professional advisors have been using low-cost index funds as an efficient way to gain broad market exposure and build a diversified portfolio. This is a great investment strategy! Indexing solutions have evolved over time and have helped address real problems – high fees, unnecessary trading, and the persistent illusion that active managers could consistently predict the future and outguess the market.

A strategy called “direct indexing” is the next step in this evolution. It takes the core idea of indexing – broad diversification, low-cost, disciplined exposure – and enhances the tax benefits for individual investors. Let’s dive deeper into direct indexing and how it can be integrated as part of your broader investment, tax, and financial planning strategies.

What Is Direct Indexing

At its core, direct indexing means you own the individual stocks within an index rather than buying the index through a mutual fund or an exchange-traded fund (ETF). Instead of purchasing a single S&P 500 ETF, for example, you directly own many (or all) of the underlying companies in the index at a similar proportional weighting – Apple, Microsoft, Johnson & Johnson, and so on.

On the surface, this may not sound revolutionary. After all, you end up with the same overall market exposure – that is the point. The main difference is control and tax planning opportunities. When you own the individual stocks, you gain the ability to manage them individually. This opens the door to a set of tax and customization strategies that simply are not available inside a pooled vehicle like a mutual fund or ETF.

How We Got Here: From Institutional Strategy to Everyday Tool

Direct indexing is not new. Large institutions and ultra-high-net-worth families have been using variations of this approach for decades, often referred to as “separately managed accounts” (SMAs). However, this strategy has become much more widely available, mainly for two reasons:

1. Better Technology – Managing hundreds of individual securities across thousands of separate client accounts used to be operationally complex and expensive. Today, advances in trading systems, automation, and portfolio management software have made it scalable and efficient.
2. Fractional Shares & Lower Costs – The ability to trade fractional shares at most major custodians means portfolios can closely track an index without requiring millions of dollars. What once required $5 to $10 million as a minimum SMA account size can now be implemented at a fraction of that level.

In short, what used to be reserved for institutional investors is now accessible to a much broader audience. Fees have also come down and are more competitive with ETFs and other low-cost pooled investment vehicles. Direct index SMAs are still usually a little more expensive than a comparable ETF, but the tax planning benefits are often worth it.

The Real Advantage: Tax Planning Benefits

If direct indexing stopped at “replicating the index,” it wouldn’t be particularly compelling. The real value lies in how it allows you to manage taxes more proactively. For high-income investors, taxes matter more than most people realize. As we’ve written before, long-term wealth is not just about returns, it’s about what you keep after taxes.

With a traditional ETF, you own a single security. If it’s up, you have a gain. If it’s down, you have a loss. With direct indexing, you own hundreds of individual stock positions, which in the aggregate can mimic the same exposure you would achieve using a single ETF. However, even in a rising market, there are almost always some stocks that are temporarily down – this creates opportunity.

One of the more underappreciated aspects of equity markets is just how much dispersion exists beneath the surface. Even in years when the S&P 500 Index delivers strong positive returns, it’s common for roughly a quarter to a third of the stocks in the index to be negative in a given year, reflecting the natural dispersion of returns across companies.

This is not a flaw of the market – it’s a feature. Returns are often driven by a subset of companies, while others lag or temporarily decline. For traditional index fund investors, those individual losses are unusable from a tax perspective. Within a direct indexing framework, however, those same declines become opportunities to improve after-tax outcomes, without changing the overall market exposure. You can sell those individual positions at a loss, realize that loss for tax purposes, and reinvest into similar securities to maintain market exposure. This process is called “tax-loss harvesting” and it can be done continuously throughout the year.

Over time, the harvested tax losses can:

• Offset other realized capital gains (even from a home sale, business sale, or other capital gains passed through from a Schedule K-1)
• Reduce other ordinary taxable income (but only up to $3,000 per year)
• Improve after-tax returns without changing the overall investment strategy
• Unused losses in any calendar year carryforward on your tax return indefinitely (we call this a “deferred tax asset” in nerdy financial advisor-lingo)

This is not about predicting markets or taking active bets on individual stocks. It is about systematically taking advantage of volatility – something markets naturally provide. In lieu of direct indexing, a good strategy is to build a diversified portfolio of different asset classes using various ETFs – this allows you to tax loss harvest, but only at the asset class level (you have to have a loss in the overall ETF position).

Direct indexing is mainly about enhancing tax efficiency while keeping true to the prudent investment principles of a low-cost, long-term, diversified, asset allocation strategy. The graphic below provides a good overview of how a traditional ETF compares to a direct indexing strategy.

A Practical Use Case: Managing Out of a Concentrated Stock Position

One of the most powerful applications of direct indexing is helping investors manage out of a concentrated stock position over time. Let’s consider a simple example:

• You have $5 million in investable assets, but $2 million is in a single stock – perhaps from your equity compensation package (RSUs, stock options, etc.).
• The stock has a low cost basis (thus you have a large, unrealized gain).
• Selling it outright would trigger a significant capital gain (potentially hundreds of thousands in taxes).
• So, you hold it, and it becomes a growing source of risk, often becoming more concentrated into retirement, and the tax gain only grows, making it harder to exit.

This is a common dilemma – you know you’re too concentrated, you prefer a diversified portfolio, but the tax cost of fixing it feels prohibitive. Direct indexing introduces a more gradual and tax-aware solution, as outlined below:

1. Build a Direct Index Portfolio Around the Concentrated Position – Instead of buying traditional ETFs, you build a diversified portfolio of individual stocks, but within the context of a broader asset allocation strategy.
2. Systematically Harvest Losses – Over time, the direct indexing portfolio generates realized losses through ongoing tax-loss harvesting, while still achieving returns similar to the overall index (or group of indices) you are tracking as part of your broader asset allocation strategy.
3. Use The Losses to Offset Gains – You begin to trim the concentrated stock position gradually. The realized gains from those sales are partially (or in some cases fully) offset by the harvested losses.
4. Reduce Risk Without a Large Tax Shock – Instead of a single large taxable event, you unwind the position over multiple years in a controlled, tax-efficient manner. (Some direct indexing strategies can even add in option-overlays and other risk hedging factors to help with managing out of a concentrated position – that is beyond the scope of this article, but it’s good to know that these capabilities can be layered into the planning if desired).

This is planning, not prediction. We are not trying to guess when the stock will peak, instead we are managing risk while being thoughtful about the tax consequences. Importantly, we are aligning your portfolio with the core investment principles we emphasize often: avoiding concentration and maintaining diversification, while minimizing taxes.

The visual below provides a good summary of how a direct indexing strategy can help diversify out of a highly concentrated stock position in a tax efficient manner over time.

What Direct Indexing Is Not: Limitations & Drawbacks

It is worth being clear about what direct indexing does not do. It does not:

• Guarantee higher returns
• Eliminate market risk
• Replace the need for proper asset allocation

You still own equities. You still experience market volatility. You are still subject to the same long-term drivers of returns. Direct indexing is also not about implementing a concentrated, “active” stock picking strategy. The goal is to own the market more intelligently by improving after-tax outcomes and increasing flexibility.

There is another subtle limitation in the direct indexing strategy whereby the tax loss harvesting opportunities diminish overtime – this is often referred to as the direct index becoming “tax locked.”

Early on, the benefits of tax-loss harvesting are meaningful and relatively easy to capture. Markets are volatile, individual stocks move differently, and there are usually plenty of opportunities to realize losses, even in an overall rising market. But over time, as markets generally trend upward (as they historically have), most positions eventually show gains. At that point, there are simply fewer losses available to harvest.

“Tax locked” doesn’t mean the strategy stops working. It just means the incremental tax benefit from harvesting losses declines. Think of it this way:

• In year 1, you invest $1 million across hundreds of stocks: Some are up, some are down – you harvest the losses.
• By year 3 or 4, many of the positions have now appreciated and have large, unrealized gains; fewer are trading below their cost basis.
• By year 5+, in a strong market, most positions may be sitting on big gains. You simply have no losses to harvest. It’s a good problem to have, of course, but often cited as a longer-term limitation to direct indexing.

At this stage, the portfolio begins to resemble a traditional ETF index from a tax perspective – still diversified, still efficient – but with fewer opportunities to generate new tax losses. You essentially just have a private ETF with embedded gains, but you still have greater control over when and how those gains are realized. If you have charitable intent, you can also donate the most highly appreciated stocks to charity – you get a tax deduction for the current higher value and avoid paying any tax on the gain.

Industry research and practitioner experience generally suggest that, without adding new capital, a direct indexing portfolio can begin to feel “tax constrained” somewhere in the 3- to 6-year range, depending on market conditions and volatility. This is not a precise timeline, but it aligns with how markets tend to compound overtime.

This is where planning becomes critical. The “tax lock” dynamic is significantly reduced – or in many cases, largely avoided – when new capital is added over time. Each new dollar invested creates a new cost basis. That fresh capital effectively “resets the clock” on tax-loss harvesting opportunities. New purchases introduce positions that will inevitably have short-term volatility and some of those positions will be temporarily down, and thus those losses can be harvested and used to offset gains elsewhere.

In other words, the strategy remains alive and active as long as periodic deposits are occurring into the taxable account. This is one of the reasons direct indexing tends to be particularly effective for: high-income professionals still in their wealth accumulation years; families regularly adding to taxable accounts; and investors with ongoing liquidity events (bonuses, equity compensation, business income).

Also, it’s somewhat obvious the main benefit of direct indexing is the tax loss harvesting opportunities, so this strategy makes little sense for retirement accounts like IRAs or 401(k)s. A direct indexing strategy is mainly for larger taxable brokerage accounts held by individuals or trusts. It also does not need to be your only strategy; you may want to use direct indexing for part of the portfolio and complement that with low-cost ETFs or other investment vehicles.

Direct Indexing: Part of a Broader Plan

Direct indexing is not a standalone solution. It is one tool within a broader framework of tax-aware portfolio construction. It tends to be most valuable when:

• You have significant taxable assets
• You expect to be adding to your taxable savings over time
• You are in a higher federal and state tax bracket
• You have, or expect to have, realized gains to offset
• You are managing around a concentrated stock position
• You value customization (ESG preferences, exclusions, factor tilts, etc.)

It also integrates naturally with other planning strategies like asset location and multi-year tax planning – both of which can materially impact long-term outcomes. The main idea here is that direct indexing should not be viewed as a standalone investment “product.” Rather, it is one strategy that may be appropriate to integrate into your broader financial and tax planning.

Direct indexing is a good example of how investment strategy continues to evolve, not by chasing trends, but by refining what already works. Indexing brought discipline, diversification, and cost efficiency to investing. Direct indexing builds on that foundation by adding control – particularly around tax planning. Overall, wealth is not defined by a benchmark or a headline return. It is defined by how effectively you manage risk, structure your assets, and navigate taxes across decades.

Markets will always be uncertain, that part of investing doesn’t change. But the way you manage your portfolio within that uncertainty – that’s where thoughtful planning can make a meaningful difference. Direct indexing is yet another thoughtful tool to help implement diversified, tax-efficient investment strategies.

Anthony Criscuolo, Senior Wealth Manager

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Bluerock Wealth Management is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Registration as an investment advisor does not imply a certain level of skill or training. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC. All information referenced herein is from sources believed to be reliable. Bluerock Wealth Management and Hightower Advisors, LLC have not independently verified the accuracy or completeness of the information contained in this document. Bluerock Wealth Management and Hightower Advisors, LLC or any of its affiliates make no representations or warranties, express or implied, as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Bluerock Wealth Management and Hightower Advisors, LLC or any of its affiliates assume no liability for any action made or taken in reliance on or relating in any way to the information. This document and the materials contained herein were created for informational purposes only; the opinions expressed are solely those of the author(s), and do not represent those of Hightower Advisors, LLC or any of its affiliates. Bluerock Wealth Management and Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material was not intended or written to be used or presented to any entity as tax or legal advice. Clients are urged to consult their tax and/or legal advisor for related questions.

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Bluerock Wealth Management is registered with HighTower Advisors, LLC, an SEC registered investment adviser and/or Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through HighTower Advisors, LLC. Securities are offered through HighTower Securities, LLC.

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