By Justin May, Portfolio Manager

If you buy a total market index fund like Vanguard’s Total Stock Market Index (VTI), you own shares of about 3500 U.S. companies in one convenient package. Immediately, your investment is well-diversified and well positioned for long-term growth. It’s a great investment, and the right choice in most cases.

But some investors are better served holding not one single index fund, but rather the many underlying stocks that make up the index, in the weights the index assigns. This strategy is commonly called “direct indexing”. It has become much more viable over the last few years as technology allows this to be done at a fraction of the cost of years past, making it almost as inexpensive as low-cost index funds. Because an investor using a direct indexing strategy has access to each individual stock within an index, they have some advantages:

1. Tax Loss Harvesting: For a broad stock market index to create a negative return, the weighted average performance of all stocks in the index must be negative. Generally, something bad has to happen to trigger this (think COVID). But it’s normal for stocks within an index to drop, even though performance of the overall index is positive. For example, in 2025 the S&P 500 returned over 16%, but more than 20 companies within the index lost more than 1/3 of their value. In a direct index, you can sell the companies with negative returns at a tax loss and reinvest in similar companies (or the same company after 31 days). If you hold onto the winning stocks and sell only the losing stocks, you can generate a net tax loss, while the performance of your direct index is similar to an index fund.
2. Gifting: Donating appreciated securities to a charity (or donor-advised fund) allows the charity to receive the full market value of the investment, while the donor can deduct the full market value of the investment from their tax bill. Any embedded gain in the investment is never taxed, making the donation of appreciated investments much more attractive than that of cash. When an investor donates an index fund to charity, they’re donating many stocks; some of these stocks have done very well, some have done poorly. Investors using a direct indexing strategy can donate the stocks with the highest gain, maximizing the portion of their donation that avoids taxation. NVIDIA’s stock price has risen 1,200% over the last five years, while the S&P has risen 70% - this can really make a difference over time.
3. Flexibility: If you hold an index, you’ll only ever hold the stocks in that index, in their assigned weights. Many years in the future you may decide you want to sell your fund and invest in a different index. Making that change in a taxable investment account (not an IRA) will likely result in a large tax bill, even if there’s substantial overlap between the underlying stocks bought and sold. A direct index may allow you to make such changes with much less tax impact.
4. Customization: Many investors are interested in aligning their investments with their personal values. A direct indexing strategy allows investors to choose specific companies, issues, or industries to exclude from their portfolio, whereas similar funds are much less personalized.

Of course, there are drawbacks. The main one is the added complexity in owning thousands of stocks rather than one single index fund. Minimum investment sizes must be met. Transaction fees and management costs are also higher than a similar index fund.

The direct indexing approach isn’t for everyone. Generally, I don’t find it valuable in IRA accounts unless customization is especially attractive; most of the benefits are in taxable accounts. We find it’s a good fit for clients with substantial income, substantial cash to invest into stocks, a long time horizon, and strong investment aptitude.