Is direct indexing better than buying an ETF?

Direct indexing may be gaining popularity soon, thanks to a continued fee war between several large brokerages. Both Schwab and Ameritrade recently announced commission-free stock trades, in addition to their commission-free ETF trades. This may sound like an appealing alternative, but direct indexing is far from simple.

What is direct indexing?

Direct indexing creates a portfolio that tracks an index through buying individual stocks. So, in the case of the S&P 500, you would invest in common stock from the 500 companies that make up the index. By eliminating the commission for each trade, the cost barrier of buying and selling each stock goes down significantly. However, it still requires many trades. In the case of the S&P 500, there are actually 505 common stock listings for the 500 companies in the index. It turns out that a few companies, like Google, have two share classes. So, one could eliminate the expense ratio of 0.04% currently charged by the iShares Core S&P 500 ETF (ticker: IVV). For a $100,000 portfolio, that is a savings of $40 a year. For portfolios of this size, I would argue that the convenience of trading a single ETF is worth $40 a year.

Tax benefits of direct indexing

When an investor builds a portfolio of common stock with direct indexing, they get more control over its holdings. While ETFs are known to be very tax efficient, tax loss harvesting is not possible at the individual security level. This benefit doesn’t make a difference in retirement accounts that aren’t paying taxes on selling stocks, but can be significant in taxable accounts for high income earners.

Conclusions

I am happy to see commissions for stock trades hitting $0, but I’m not convinced that for most investors, direct indexing makes sense. There is a cost savings, but the additional effort could be significant. And, if your larger investments are in tax-deferred or exempt retirement accounts, there aren’t any tax benefits available anyway. Tax loss harvesting appears to be the most compelling reason to direct index. It is most beneficial to individuals paying the highest marginal tax rates.

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