Everyday investors now have access to tools that once belonged almost exclusively to large institutions and very wealthy families.

Zero-commission trading, fractional shares and slick platforms mean it’s possible to build portfolios that look like professional products.

Direct indexing is the latest strategy crossing that bridge, promising more control than traditional index funds with potential tax advantages to match.

What It Is

Traditional index investing is simple: buy a mutual fund or ETF that tracks an index such as the S&P 500 and own a slice of every company inside it. Direct indexing keeps the same big idea—track an index—but changes how it’s done. Instead of owning a fund, you directly own many or all of the individual stocks that make up that index.

Direct indexing allows investors to customize their portfolios and pursue tax‑efficient strategies that aren’t possible with traditional index funds or ETFs — Morgan Stanley on the benefits of direct indexing.

That structural difference matters. Holding the underlying stocks lets you tweak the recipe while still aiming to stay close to the index’s performance. The goal is to capture the diversification and low-cost benefits of indexing, while opening the door to customization and smarter tax management than a packaged fund can offer.

How It Works

With direct indexing, a provider or advisor starts from a reference index, then buys a basket of the underlying stocks in your account. You might own all the names, or a carefully chosen subset designed to closely mimic the index’s risk and return profile.

From there, the portfolio can be adjusted around your constraints and preferences. Want to exclude a particular industry? Limit position sizes? Tilt slightly toward certain themes? The engine behind a direct indexing program handles these changes while still trying to keep the portfolio tracking error—the gap versus the benchmark—within a targeted range.

Customization Power

The most obvious attraction is control. A fund forces you to accept every stock the index committee includes, whether it fits your values or not. Direct indexing lets you remove individual companies or sectors that conflict with your priorities without abandoning diversified equity exposure altogether.

This is especially useful for value-driven investors. Someone focused on environmental or social considerations, for example, can systematically screen out specific business lines while still owning hundreds of other names. Direct indexing turns broad-market exposure from an all-or-nothing decision into a more nuanced menu.

Tax Edge

The second big draw is tax-loss harvesting. In a fund, gains and losses across all holdings are blended together, and investors have very limited control over realized gains. With direct indexing, losses can be harvested at the single-stock level even when the overall portfolio is roughly flat.

When a particular stock drops below its purchase price, the manager can sell it, realize the loss and immediately replace it with a similar company or a sector ETF. That keeps your market exposure intact while creating a loss that can offset capital gains elsewhere or, in some cases, a portion of ordinary income. Over years, this “tax alpha” can be meaningful for investors in high brackets.

Why It’s Growing

For a long time, direct indexing required high balances and bespoke service from wealth managers. Technology has changed that. Automated trading systems, portfolio-optimization software and fractional-share trading now allow providers to build custom index-like portfolios at smaller account sizes and lower operational cost.

At the same time, trading commissions have effectively dropped to zero at many brokers, removing a major friction point. Buying and periodically adjusting dozens of holdings is now financially practical even for mid-sized accounts. Combined with rising interest in personalized investing and thematic tilts, those shifts have pushed direct indexing firmly into the mainstream conversation.

Who It Fits

Direct indexing is most compelling for investors with sizable taxable accounts and significant realized or expected capital gains. High-income households often stand to benefit most from systematic tax-loss harvesting and fine-tuned control over what they own.

It also tends to work best when investors are adding fresh cash, rather than trying to retrofit a complex existing mix of funds and stocks. Large, single-stock positions from equity compensation can be another use case; a direct indexing solution can be built around those holdings while diversifying the rest of the portfolio.

Main Risks

With flexibility comes complexity. Instead of a single fund position, you may end up with a statement listing tens or even hundreds of individual stocks. Understanding performance, risk and tax consequences becomes more involved, which can overwhelm investors who prefer simple, “set it and forget it” approaches.

There is also behavioral risk. Seeing many individual positions in red or green can tempt investors to trade based on short-term moves—selling laggards and doubling up on recent winners—undermining the disciplined, index-like philosophy that makes the strategy work. Frequent trading can generate unwanted short-term capital gains and higher taxes, cancelling out much of the intended benefit.

Cost Check

Even as prices fall, direct indexing usually carries higher explicit fees than buying a broad index ETF. You’ll often pay a program fee or advisory fee on top of any underlying transaction costs inside the portfolio. Those fees can still be reasonable, but they must be weighed against the expected tax benefits and customization value.

For smaller balances, the math may not work. If annual program costs eat up most of the incremental tax advantage versus a low-cost index fund, the elegant engineering provides little real-world improvement. Careful comparison of all-in costs versus a simple ETF strategy is essential before jumping in.

Practical Questions

Before embracing direct indexing, it helps to ask some pointed questions. Is there a clear reason to hold many individual stocks instead of a couple of diversified funds? Are there specific tax or value screens that truly matter to you, or does broad-market exposure already feel sufficient?

It is also worth considering how involved you want to be. Many direct indexing platforms are run in partnership with advisors who can keep behavior in check and handle the technical details. More hands-on investors using standalone tools need the discipline to avoid turning a tax-efficient, rules-based strategy into a trading hobby.

Conclusion

Direct indexing sits between simple index funds and fully customized stock-picking, offering personalization and tax tools that can be powerful in the right circumstances. For investors with larger taxable accounts, clear value preferences and a tolerance for complexity, it can be a smart upgrade.

For others, a pair of low-cost index funds may remain the better match. If you had to choose today, would you benefit more from extra customization and tax work—or from keeping your investing life as simple as possible?