This Investing Strategy Used by the Top 1% Is Becoming Mainstream -- and Helping People Pay Less in Taxes

Suppose you wanted to invest in a stock index, like the S&P 500. You have two choices:

• You could buy an S&P 500 index fund, which is a mutual fund or exchange-traded fund (ETF) that tracks the performance of the index.
• You could buy all 500 stocks represented in the index.

The latter option is known as direct indexing. It sounds like a big headache, right?

Wealthy investors have practiced direct indexing for a long time, though, primarily because it can provide tax savings and help you customize your portfolio. For a long time, this strategy was out of reach for ordinary investors, but it's becoming more mainstream. Learn how direct indexing works and find out whether the benefits outweigh the hassle.

How direct indexing works

Direct indexing is an investment strategy where a money manager attempts to match the performance of a stock index by directly buying the individual stocks in the index on a client's behalf with the help of algorithms.

The reason some investors use this approach boils down to tax-loss harvesting, which is a way of lowering capital gains taxes by using losses to offset the gains. If you have net losses for the year, you can use your losses to reduce your income by up to $3,000 for the tax year. You can carry forward any remaining losses and use them to offset income for future tax years.

Tax-loss harvesting doesn't work with index funds because, technically, you only own interests in the fund itself, rather than individual shares.

Another reason wealthy people use direct indexing: It affords them greater control over how their money gets invested.

You might not want to own all the stocks represented in an index, particularly if ESG investing is important to you. For example, you may want to own all the stocks in the S&P 500 index or Russell 2000 index, with the exception of tobacco and oil companies. Through direct indexing, you could invest in the bulk of companies represented, while excluding those that conflict with your conscience.

Why is direct indexing becoming more accessible to regular investors?

There are two primary reasons direct indexing is becoming more accessible to retail investors. First, most brokerages have introduced commission-free trading. Second, many brokerages offer fractional shares, which makes it possible for investors to buy broad swaths of stocks because they don't need to purchase an entire share.

Still, most investors don't have the resources to track and replicate the performance of a stock index -- an extraordinarily complex undertaking. If you want to try the strategy, you'll probably need to go through a financial institution that offers a direct indexing product.

While the investment minimums for direct indexing at many institutions have dropped, they're still substantial. You'll typically need at least $100,000 to get started. One exception is Fidelity, which offers Fidelity Managed FidFolio customized portfolios with a $5,000 minimum investment.

Is direct indexing right for you?

While direct indexing may sound appealing, it isn't a great choice for most investors for a few reasons.

For starters, you probably don't have the giant gains and losses that an institutional investor has, so your tax savings will likely be minimal. You'll also pay substantially higher fees than you would if you invested in a regular mutual fund or ETF.

Direct indexing also won't work as a tax-loss harvesting strategy if you're investing in a tax-advantaged account, like a 401(k) or individual retirement account (IRA), since you don't pay capital gains taxes on these accounts, even if you buy and sell securities at a gain or a loss. Instead, you're taxed when you contribute the money or take a distribution, and you're taxed at ordinary income rates.

If you're interested in direct indexing because you want investments that align with your values, a better option would be to invest in an ESG fund. You can find funds that invest in an index of companies that have high levels of commitment to ESG practices, as well as those that invest in a major index but exclude certain types of companies, like those that make firearms or tobacco.

If you're considering a direct indexing strategy, check with a tax advisor first. They can help you decide if the potential tax savings and other benefits are enough to justify the extra effort and fees involved.