Direct indexing, also called custom indexing, is an investment strategy where you directly own the individual stocks that make up an index, rather than buying an ETF or mutual fund that tracks it. Owning the individual shares in your own account gives you two forms of control a pooled fund generally can’t offer: what you hold, and when you realize gains and losses for tax purposes.
Many people simply invest their savings in low-cost, passive exchange-traded funds (ETFs) or mutual funds, parking them there as broad diversification to the equity markets. For some investors, that may be good enough. However, there are now more customizable and tax-efficient ways to invest, and direct indexing is one of the most flexible of them.
To oversimplify, direct indexing offers three levers that traditional funds don’t: ownership, customization, and tax control. The rest of this article walks through each one.
How Does Direct Indexing Work?
Direct indexing uses individual stocks to mimic the risk and return of a passive index, an active factor-based strategy, or a combination of both. The counterintuitive part is that you don’t need to own every company in an index to build a portfolio that behaves like it. Using the S&P 500 as an example, you may only need to own 100 to 250 of the 500 companies, because a well-chosen subset can deliver the vast majority of the index’s risk and return characteristics over time.
Since you aren’t required to hold every single name, you can set unique portfolio parameters inside the account, including ESG considerations, specific security restrictions, and annual tax or capital gains budgets. That sounds like a lot of moving pieces, but modern portfolio technology handles the heavy lifting — a great example of how man and machine can work in perfect harmony.
Direct Indexing vs. ETFs: The Customization Difference
Traditionally, the “cheap and easy way” to manage a diversified stock portfolio is to buy a passive ETF or mutual fund that mirrors a chosen index. In that case, you are buying into the fund’s strategy, and the fund isn’t going to factor in each individual investor’s wants and needs.
For example, let’s say you work for a major company in the S&P 500 index, and you already hold a large position in company stock through your equity compensation and employer retirement plan. If you want broad equity market exposure through any of the ETFs tracking the S&P 500, can you have them exclude that particular ticker? The answer is no. If you buy the fund, you are getting exposure to the stock, because ETFs and mutual funds generally aren’t flexible to each investor’s unique circumstances.
A direct indexing account can be built around that reality, for example: excluding your employer’s stock, underweighting a sector you’re already exposed to, or working within a capital gains budget that makes your overall tax picture more efficient.
Here is how the two approaches compare:
 |
Direct Indexing | Index ETFs & Mutual Funds |
|---|---|---|
| What you own | The individual stocks that make up the index | Shares of a fund that invests in the stocks |
| Input on holdings | You can exclude specific companies or sectors, apply ESG screens, or tilt toward different factors | No control over/input on the fund’s underlying securities |
| Tax-loss harvesting | At the individual-stock level, even in years when the index finishes higher | Only at the fund level, when the fund itself trades below your cost basis |
| Concentrated positions | Built around existing low-basis holdings or employer stock grants | The fund adds exposure to what you already hold |
| Cost | Generally low, though typically above the cheapest index funds; advisory and platform fees vary | Among the lowest expense ratios available |
| Ongoing management | Requires active trading, monitoring, and wash-sale coordination | Minimal once purchased |
| Typically suited for | Investors with larger taxable accounts who want customization or specific tax needs | Investors seeking simple, broad market exposure |
To be fair to the humble ETF, low-cost index funds remain a sensible core holding for many investors, and direct indexing carries real operational complexity. Whether the customization and tax control justify that complexity is, in my experience, a question that usually depends on the next section.
The Tax Benefits of Direct Indexing: Tax-Loss Harvesting
There are many benefits to a direct indexing strategy, but one of the most powerful can be the tax efficiency created by active tax-loss harvesting. Direct indexing gives a portfolio the ability to harvest losses by selling any of the underlying individual stocks trading at a material loss, and then immediately reinvesting the proceeds in other stocks that fit within the current strategy’s allocation.
For instance, if Target ($TGT) stock decreases in value, you could consider selling that position at a loss and booking a tax loss for your account. You can take that action because you own the individual $TGT shares. But if you own shares of a passively managed fund that is only mirroring an index, like $SPY, there is no way for you as an individual to take advantage of the downward move in Target, because you don’t own $TGT directly, just shares of $SPY.
Once the sale is complete and the tax loss is booked, the proceeds need to be reinvested quickly. Sometimes it’s as simple as buying Walmart ($WMT) to preserve the portfolio’s allocation, and sometimes it’s better to buy smaller amounts of five other individual stocks across various sectors that fit the overall strategy. Either way, each repurchase has to be planned carefully to avoid wash sales, which we’ll address below.
Here’s what many investors find counterintuitive: some of the better harvesting years are ones when the index finishes higher. An index is an average, and even in a positive year, some of its individual constituents finish lower. A fund investor experiences only the average, while a direct indexing investor can act on the losers and stay invested in the winners.
Those tax-harvested dollars can be meaningful. Consider a hypothetical scenario: during 2026, a direct indexing strategy harvests $30,000 of losses while keeping the portfolio’s allocation intact, and that same year the investor sells a stake in her business and realizes long-term capital gains. Under 2026 federal rules (all subject to change), capital losses first offset capital gains — $27,000 of them in this example — and up to $3,000 of any remaining net loss ($1,500 if married filing separately) can offset ordinary income each year, with the excess carrying forward, as outlined in IRS Topic No. 409. At the 2026 top long-term capital gains rate of 20%, plus the 3.8% Net Investment Income Tax where it applies, and a 35% ordinary income bracket, the combined federal benefit works out to roughly $7,500. Two conditions matter here: the netting rules match short-term and long-term positions first (a detail worth confirming with your advisor), and the harvested losses lower the cost basis of your replacement shares, so much of the benefit comes as deferral — meaning the tax bill moves to a future year..
Deferral can still carry real value, because at some point in your life, you’re going to have gains again. Where this strategy can add the most is when you know a taxable event is coming, whether that’s selling a business, exercising stock options, or letting go of a possible vacation home. Losses harvested and carried forward today can be waiting for that moment, which is why we treat harvesting as one piece of the broader tax strategies for high-income earners toolkit rather than a standalone tactic.
Want to hear how we think about tax-loss harvesting in real portfolios? We unpacked it on Off the Wall: The Million-Dollar Illusion: What Your Portfolio is Actually Worth. Watch the episode here.
Wash Sales: The Rule to Plan Around
A wash sale happens when you repurchase the same security, or one the IRS considers substantially identical, within 30 days before or after selling it at a loss, and it disallows the immediate tax benefit of that loss. Wash sales can be avoided, but they need to be handled carefully, because every purchase in a direct indexing account needs to be planned around the account’s unique trading history and realized losses. We cover the full rule, including how it applies across accounts and to equity compensation, in our guide to what a wash sale is and how to plan around it.
While we want to be tax-aware with these strategies, taxes should never be the sole driver behind investment decisions. Your allocation, goals, and investment time horizon need to remain the top priority. Ideally, we book tax losses without materially changing the portfolio’s allocation and limit the time any funds sit uninvested.
How to Use a Direct Indexing Strategy
Thanks to improvements in direct indexing technology, you don’t have to settle for investing in an ETF or mutual fund that might be “close enough” to your goals and values, and many investors are considering some form of direct indexing in their portfolios.
Monument implements direct indexing strategies through our Tax Rebalanced Index Optimization (TRIO™) accounts, which utilize the Canvas™ technology suite operated by O’Shaughnessy Asset Management (OSAM), a wholly owned subsidiary of Franklin Templeton. We run TRIO™ across various investment styles and mandates as part of our investment management work that builds custom strategies tailored to each client’s expressed wants and needs.
Want to hear how the technology behind direct indexing works? We unpacked it with Pat McStay of OSAM on Off the Wall. Watch the episode here.
Common Direct Indexing Questions
Is direct indexing the same as custom indexing? Yes. Direct indexing and custom indexing describe the same strategy: owning the individual stocks that make up an index directly, in your own account. Some providers prefer the “custom indexing” label, but the mechanics are nearly identical.
Is direct indexing tax efficient? It can be, in the right account. The tax benefit comes from harvesting losses at the individual-stock level, which you can’t directly control by investing a pooled fund. The tax benefits only apply to taxable accounts, since realized losses inside an IRA or 401(k) generally carry no annual tax deductions, so the case for direct indexing in an IRA rests on customization instead.
How many stocks does a direct indexing portfolio hold? Usually fewer than the index itself. A portfolio tracking the S&P 500 may hold roughly 100 to 250 stocks, because a carefully chosen subset can capture most of the index’s risk-and-return profile while leaving room for customization.
Is Direct Indexing Right for Me?
Direct indexing may be an ideal way to create a truly bespoke asset allocation with ongoing, tax-aware management, but it is not easy to run on your own. Working with a wealth advisor who leverages the right technology can make it much more manageable, with potential added value in how your portfolio is traded and managed inside your overall asset allocation.
Currently, direct indexing is best suited for larger, taxable accounts, though it can also be appropriate for retirement or other qualified accounts in the right situation — the tax-loss harvesting benefit, however, belongs to taxable accounts. The decision to implement direct indexing, like the strategy itself, should be customized to you and your specific needs and goals.
What to Do Next
The lesson is a simple one: direct indexing is not a way to avoid taxes, but a way to be more efficient with them while keeping your portfolio pointed at your goals. The aim is to know what you own, know why you own it, and know what each holding is doing for your after-tax return.
If you’re weighing whether direct indexing fits your situation because you have a concentrated position, an upcoming liquidity event, or a portfolio that has outgrown one-size-fits-all funds, our integrated approach to financial planning strategies like tax planning along with customized investment management can help. We offer a complimentary Wealth Check to assess whether direct indexing is right for you. Ready to start the conversation? Let’s talk.
Note: Monument is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. Please consult your CPA for tax advice.
Want to suggest a correction to this article? Email us at info@monumentwm.com. Please note that Monument Wealth Management and its advisors are not tax advisors, and this article is not a replacement for professional legal, accounting or tax advice.
