A Beginners' Guide to Direct Indexing

If you’ve heard of ETFs (exchange traded funds) and index funds, you need to understand the Direct Indexing strategy. Direct Indexing is used by portfolio managers and financial advisors to maximize after-tax investment gains.

Direct indexing is manually replicating an existing stock index, such as the S&P 500. The investment manager is responsible for adjusting the allocations periodically in the portfolio to match the weight of each stock in a particular index.

How to use the Direct Indexing Strategy

1. Choose an ETF that tracks the S&P 500

   We’ll use State Street’s S&P index fund ,SPDR S&P 500 ETF Trust, Ticker symbol $SPY.

2. Decide your allocation strategy

   You can choose to invest in each stock equally or mirror the allocation percentages of the stocks in the index. For this example, we’ll invest in the top 10 stocks in the S&P 500 based on their weight within the index. ⬇️

3. Sell the Losers

   Before 12/31 each year, sell the stocks that are in a loss position, securing the loss amount to net against capital gains or ordinary income. More on that below.

4. Reinvest

   Selling those stocks means you have capital that’s available to put back in the market. Reinvest the money that’s available back into the stocks of the index.

   • Using this example, we invested $198 into Apple.

   • If Apple is down 5% since we invested, we you would sell at a loss.

   • Wait 31 days.

   • Then reinvest the remaining $188 back into Apple to stay in-line with the allocation.

   Tip: If you sell a stock at a loss, you have to wait at least 31 days to buy that same stock or the losses will be cancelled. This is called the wash sale rule.

Pros

Tax-Loss Harvesting: Selling stocks that are at a loss before the end of the calendar/tax year so you can net the entire loss against your capital gains (stocks you sold for profit) and up to $3,000 to offset ordinary income (W-2, real estate, or business income). A powerful wealth protection tool!

No Guess Work: Since you’re following an index, you don’t have to figure which stocks to buy. Index fund managers choose the stocks based on their size compared to others in the index. For example, if the value of Apple ($AAPL) is 5% of the top 500 companies, managers of an index fund tracking the S&P 500 will adjust the fund so Apple is 5% of the fund. As Apple’s market cap rises and falls, manages will adjust accordingly. You never have to figure out what to buy.

Cons

Semi-Passive Approach: You have to be active in your portfolio. This might not be an issue for some investors. At least annually, you’ll need to log into your portfolio and sell the stocks that are losers. If you want to “set it and forget it”, it may best to simply buy shares of an index fund.

Diversification: The top stocks in the S&P 500 are tech heavy. A direct 7 of the top 10 stocks of the S&P are either in the technology or communications sector. Google and Meta are considered tech companies by may due to being internet based companies. The direct indexing strategy could mean your portfolio may experience more volatility than you’re comfortable with since most of your portfolio is in a few sectors.

Direct indexing is great for beginners and those looking for a semi-passive investing strategy that utilizes a tax-loss harvesting strategy.

Sources: https://www.ssga.com/us/en/intermediary/etfs/funds/spdr-sp-500-etf-trust-spy