You may have noticed more investors begin to check out a new investment strategy–direct indexing. In the past, only large institutional clients or high-net-worth investors benefited from the power and scale of the best direct indexing providers.
With the global advent of zero-cost and fractional-share trading, retail investors like us are now able to capitalize upon the benefits of direct index investing. Strategies like tax-loss harvesting, ESG investing, and personalized indexing open themselves up to us, enabling us to consider tax and moral implications of investing.
This article explains what exactly direct index investing is, the best direct indexing providers, and why you should or should not use it for your portfolio during 2023.
What Is Direct Indexing?
Direct indexing refers to the method of replicating an index, such as the S&P 500 or FTSE 100, by directly trading the underlying securities in your portfolio – thereby directly replicating the index without having to use an index fund or ETF.
Instead of relying on a fee-charging professional provider to simply track a market index without any adjustments, say, for tobacco companies, direct index investing enables you to:
- Selectively deviate from the underlying index.
- Choose when to buy or sell.
- Adjust the amount purchased or sold.
Opt for automatic dividend reinvestment or exclude dividend-paying securities.
Direct Index Investing Versus Passive Investing
Passive investing, on the other hand, is by definition passive and removes your ability to choose. Professional index funds and ETFs fall into that category, with many professional managers opting to use a collection of various funds to make a single portfolio. However, passive fund investing offers several potential headaches and should be used when active trading is not desired or if tax considerations are not significant.
For example, the index fund VFIAX, or Vanguard’s S&P 500-based index fund, takes care of replicating this index while offering an expense ratio of 0.04%, a dividend yield of ~1.50%, and a minimum investment of $3,000.
- Pays a dividend quarterly
- Tracks the S&P 500 automatically
- Require a minimum of $3,000
- Dividends are taxable
- No ability to personalize holdings
If you’re concerned about your overall tax bill or do not wish to support alcohol, tobacco, or firearms, then passive investing may not be your best choice.
Best Direct Indexing Providers for 2023
Founded in 1946 with over 40 million client accounts, Fidelity is a leading online broker in the USA providing an incredible offering that blends the best of a zero-commission discount broker and a proven bank. They are our top pitch among direct indexing providers.
Founded in 1971 with more than 34 million accounts, Schwab is another legacy leading the online investing arena as a no-nonsense broker capable of providing top-notch advisory.
Morgan Stanley’s E*Trade runs the full gamut: from self-directed accounts backed by strong research and award-winning trading apps to personalized investment advisory, including direct indexing.
A world-famous provider of passive investing strategies to other brokers, it also provides a direct brokerage account. It is the de facto king of low-cost, buy-and-hold passive investing.
Fidelity at a glance
Fidelity is a leading online broker for the USA and abroad with an incredible offering that blends the best of a zero-commission discount broker with a proven bank known to attract top talent in investment management.
Fidelity charges nothing for US stock and ETF trading, offers a free self-directed account, and maintains a list of more than 3,000 no-transaction-fee mutual funds for passive investing. Further, it touts an extensive amount of available research alongside a robust trading platform, Active Trader Pro, offering many advanced features.
The platform’s direct index investing service comes in three levels, catering to your goals.
- Fidelity Solo FidFoliosSM enables you to manage your own custom basket of stocks and ETFs, or opt for a pre-built theme. However, tax management is done by yourself. The service has a minimum of $1 per security, and $4.99 flat fee after the 90-day-trial.
- Fidelity Managed FidFoliosSM represents the Fidelity-managed option that closely keeps to major indexes, although there is the option to consider sustainability (ESG) preferences. There is a $5,000 minimum, with an additional advisory fee dependent on your account balance.
- Fidelity Wealth Management represents the premier option for guided investing with tax management, long-term planning, and a customized portfolio of securities. There is a $100,000 minimum, with an additional advisory fee dependent on your account balance.
Fidelity’s ability to cater to every level of investor sophistication and wallet size makes it our pick for the best direct indexing provider.
#2 Charles Schwab
Charles Schwab at a glance
Schwab is another leader in online investing with the same blend of a no-nonsense discount broker and a top-notch advisor, also able to handle tax-sensitive trading.
Schwab charges nothing for US stock and ETF trading, offers a free self-directed account, and maintains a list of more than 7,000 no-transaction-fee mutual funds for passive investing. It provides two different trading platforms of note: StreetSmart Edge and StreetSmart Central. Edge caters to advanced daily traders while Central offers an intuitive experience for long-term investors.
Schwab provides a personalized index investing service only alongside a financial consultant. The platform starts with four possible strategies, which are then customizable by you, with tax-loss harvesting handled by them. To recap, tax-loss harvesting is the practice of using tax (investment) losses to offset other gains or income.
However, there is a minimum of $100,000 to get started, and the fee is 0.40%. Schwab’s service makes sense for high-tax bracket investors with complex portfolios who need a helping hand.
Wealthfront at a glance
Wealthfront is an established leader among robo-advisors, or online advisors foregoing the expenses of human advisors in favor of automated and algorithmic investing backed by sound risk management principles.
Wealthfront is unlike a traditional discount broker that provides the tools necessary for you to get started on your own. While it offers investment accounts for as little as $500, with zero account fees, free rebalancing, and a 0.25% management fee, the focus remains on handing investment control to a customized portfolio picked between you and Wealthfront.
The platform offers direct index investing for accounts that bring in at least $100,000, although much of the portfolio will use low-cost ETFs to create broad, global exposure. Wealthfront handles the rebalancing and the tax-loss harvesting automatically, placing it firmly within the top three of our list for the best providers of direct indexing.
E*Trade at a glance
For those who don’t know, veteran leader E*Trade is now owned by global wealth management powerhouse, Morgan Stanley–leading to a great combination for retail traders like us who want direct index investing.
E-Trade climbs to the high bar already set by Fidelity and Schwab with no stock trading fees, no account minimums, over 6,000 no-transaction-fee mutual funds, and the familiar bells and whistles we want from fantastic desktop and mobile trading apps. E*Trade’s mobile app is particularly impressive, with Bloomberg TV, third-party research, and breaking news.
Similar to Wealthfront, direct index investing is on offer for those able to bring in at least $100,000. With Morgan Stanley, all the power of personalized investing, including personal goals and tax-loss harvesting, comes so long as you take on a virtual investment advisor.
We feel Morgan Stanley is a great option and direct index provider for those who want that human touch, even if delivered virtually.
Vanguard at a glance
Vanguard is a world-famous provider of passive investing strategies, most commonly through its ETFs which you’ve likely heard of before. The company is the de facto king of low-cost, buy-and-hold passive investing.
Vanguard also offers discount brokerage with no account minimums and no stock trading fees. Further, there are no closing, inactivity, or transfer fees, and over 3,000 no-transaction-fee mutual funds on offer. Of course, Vanguard funds have no transaction fees as well.
The platform offers direct index investing, again referred to as “personalized indexing,” focusing on tax-loss harvesting and catering to ESG investment themes. However, a direct Vanguard brokerage account feels lacking compared to its peers with a basic trading platform, subpar research quality, and no live chat options.
If you’re big on ETF investing and want to supplement your overall portfolio with some direct index investing, then Vanguard may work for you. We would rather recommend Wealthfront, which uses Vanguard ETFs alongside optimized direct indexing.
#6 JP Morgan
JP Morgan at a glance
Well known to professional and retail investors alike across the globe, JP Morgan also offers a self-directed account that suits beginners looking to delve into the world of investing and risk management.
Like most discount brokers, they do have zero-commission stock and ETF trades alongside no account minimums, but the platform surprisingly suffers from a lack of advanced trading tools and in-depth research. The real reason to choose JP Morgan for the direct indexing service is their portfolio builder tool, starting with a minimum of $2,500.
This tool, like the mobile app delivered through the brand Chase, is well-designed, intuitive, and takes away much of the leg work needed for manually building a portfolio. However, assistance remains limited and it would be up to you to copy your desired index. JP Morgan is a good choice for those who want to do it on their own and are not too worried about taxes.
The Pros and Cons of Direct Indexing
Direct indexing can work for you if you’re seeking the following benefits with your long-term (at least one year) portfolio. However, there are some drawbacks to consider.
- Personalization and autonomy
- Goals-based investing
- Tax-loss harvesting
- Minimal or no tracking error
- Lost time (if done manually)
- Long, confusing tax returns
- High trading fees
- High account minimums
Should I Go for Direct Investing?
Direct indexing may not be for you. The cons may outweigh the pros. It’s a personal, long-term decision not to be taken lightly.
The best of direct indexing comes when you have a helping hand, whether from your investment advisor or from your tax consultant. It tends to benefit the tax-sensitive investor with a portfolio north of $100,000 and other income streams needing to be offset with investment losses. All the better if that investor has specific ESG goals, such as climate change or fair corporate governance.
However, if you find that you can offset the majority of your tax bill through a tax-advantaged retirement account and don’t necessarily have the time to follow your daily or weekly, we would advise going for an ETF- or fund-centric portfolio. A hybrid mix of direct stock investing in American large caps alongside globally focused ETFs is one potential avenue.
Is personalized indexing the same as direct indexing?
Direct index investing, direct indexing, and personalized indexing all refer to the same practice of tailoring your stock selection to reflect, or not reflect, a set index.
How does direct indexing work?
With a self-directed account (often starting at $1), this is done manually. You would need to review the current holdings of an index, say the S&P 500, and copy the percentage weightings into your own portfolio as desired.
With an advised account (often starting at $100,000), this is done alongside an advisor, whether remotely or in-person. The advisor will likely handle all trading and tax-optimization matters.
Is direct indexing new?
In practice, no, there is nothing new about direct indexing. In the past, it was reserved for institutional asset managers or high-net-worth clients. Now, with fractional share trading and zero commissions for US stocks, major online brokers are now offering this simple yet highly effective strategy.
What’s the difference between an index fund and direct indexing?
An index fund, or mutual fund, is a professionally devised and managed strategy focusing on a set mandate. This could be a theme, like electric vehicles, or an index, such as the Nasdaq 100.
An index fund may deviate from the index weights in an attempt to actively provide higher risk-adjusted returns than the index itself. It may also pay a dividend yield. However, these index funds do not account for your personal tax situation and do not enable autonomy, unlike direct indexing.
Will I outperform the market with direct indexing?
Outperforming the market is possible with direct indexing, as you customize your holdings, trading frequency, and goals. All else held equal, a tax-sensitive trading pattern utilizing tax-loss harvesting may generate more risk-adjusted returns. However, outperforming the market comes down to strategy, experience, and investing skills.
In which countries is direct indexing available?
Direct indexing is most commonly available in the USA. This boils down to the individual broker. For example, Schwab has an international alternative for non-US residents.