Index funds and exchange-traded funds (ETFs) revolutionized investing by providing a simple way to get instant diversification. Now, brokerage firms like Fidelity, Vanguard and Wealthfront are taking the next step—direct indexing, which allows you to replicate a major index identically or customize one to reflect your personal preferences by eliminating particular stocks or industries. Examples: You could invest in the stocks of the S&P 500 Index but remove tobacco stocks.
How it works: Instead of buying shares in a fund that tracks a major index, your broker purchases the underlying individual stocks in that index, minus the companies you don’t want. In taxable accounts, direct indexing also can produce better after-tax returns because your broker monitors your portfolio for losing positions. Those stocks are sold, and shares of similar companies are purchased as replacements. That allows your portfolio to replicate the returns of the benchmark index plus capture capital losses without running afoul of the IRS wash-sale rule, which states that you cannot buy the same or substantially identical security within 30 days before or after selling one at a loss. Using capital losses to offset capital gains this way can earn direct indexers 1% to 1.5% more in after-tax returns annually. If capital losses exceed gains in a given year, you can apply them in future years, or use them to offset up to $3,000 of ordinary income per year.
Drawbacks: Higher fees—Fidelity Managed FidFolios carry a 0.4% annual expense ratio versus just 0.03% for a conventional fund such as the iShares Core S&P 500 ETF.
Keep in mind—direct indexing is most effective when using indexes that track highly liquid US and international large-cap stocks.