Building Custom Baskets with Direct Indexing

Direct indexing replaces a single ETF with hundreds of individual stock positions that replicate the index. This sounds like unnecessary complexity—until you understand the tax math. A well-executed direct indexing strategy generates 1-2% of annual tax alpha through systematic loss harvesting that ETFs cannot provide. Over a 20-year horizon, that tax drag reduction can add 15-25% to your terminal wealth versus holding an equivalent ETF. The practical point: for taxable accounts above $100,000, direct indexing may be the single highest-ROI strategy available—if you understand its mechanics and limitations.

Direct Indexing vs. ETF Ownership (The Core Difference)

When you buy an S&P 500 ETF (SPY, VOO, IVV), you own one security that holds 500 stocks. Your cost basis is the ETF purchase price.

When you direct index the S&P 500, you own 500 separate stock positions in the same weights as the index. Each position has its own cost basis.

Why individual positions matter:

On any given day, even in a rising market, some stocks decline. With an ETF, those losses are trapped inside the wrapper—you can only realize a loss if the entire ETF is down from your purchase price.

With direct indexing, you harvest losses at the individual stock level:

• Market up 10% overall
• 150 of your 500 positions are down from purchase
• You sell those 150 losers, realize the losses, immediately buy similar (but not "substantially identical") stocks
• Your portfolio still tracks the index, but you've generated tax losses

The tax alpha calculation:

Example: $500,000 direct indexing portfolio, year 1

• Index return: +12%
• Portfolio return (gross): +12%
• Harvested losses: $35,000 (7% of portfolio—typical first-year harvest)
• Tax value of losses (at 37% federal + 10% state): $35,000 × 47% = $16,450
• After-tax alpha: $16,450 / $500,000 = 3.3%

First-year harvesting is typically highest because all positions are "fresh" (recently purchased). Subsequent years generate 0.5-1.5% annually as opportunities compound.

Tax-Loss Harvesting Benefits (The Compounding Advantage)

Tax-loss harvesting doesn't eliminate taxes—it defers them and converts character.

Immediate benefits:

1. Offset gains elsewhere: Harvested losses offset capital gains in the same year (from selling winners, real estate, or other assets)
2. Offset income: Up to $3,000 of net losses can offset ordinary income annually
3. Carry forward indefinitely: Unused losses carry forward until exhausted

Long-term benefits:

Deferred taxes compound in your favor. If you harvest $50,000 of losses in year 1 and invest the tax savings:

You eventually pay taxes when you sell (or at death with stepped-up basis), but you've earned $86,000 in additional returns on money that would have gone to taxes.

The wash sale trap:

The IRS disallows losses if you buy "substantially identical" securities within 30 days before or after the sale. Direct indexing platforms navigate this by:

• Selling Exxon (XOM), buying Chevron (CVX)
• Selling Microsoft (MSFT), buying Google (GOOG) or a tech sector ETF
• Maintaining index exposure while avoiding wash sales

Why ETFs can't do this: When you sell SPY at a loss, you cannot buy any S&P 500 ETF (VOO, IVV, etc.) for 30 days without triggering a wash sale. With direct indexing, you sell individual losers and immediately buy similar-but-not-identical stocks.

Minimum Account Sizes (When Direct Indexing Makes Sense)

Direct indexing requires holding hundreds of positions, which creates practical minimums.

Position size constraints:

To own 500 stocks in reasonable proportion:

• $50 minimum position → $25,000 minimum portfolio
• $200 minimum position (for practical trading) → $100,000 minimum
• $500 minimum position (for proper weighting) → $250,000 minimum

Why size matters:

At $50,000, your smallest positions might be $10-20. Transaction costs and bid-ask spreads erode returns on small positions. Fractional shares help but don't fully solve the problem.

Provider minimums:

The break-even analysis:

Direct indexing costs more than index ETFs (fees + complexity). When does the tax benefit exceed the cost?

Assumptions:

• ETF cost: 0.03% (VOO)
• Direct indexing cost: 0.25%
• Cost difference: 0.22%
• Required tax alpha to break even: 0.22% / marginal tax rate

At 37% marginal rate: Need 0.22% / 0.37 = 0.59% annual harvesting rate At 24% marginal rate: Need 0.22% / 0.24 = 0.92% annual harvesting rate

Most direct indexing platforms harvest 0.5-2% annually in early years, declining to 0.3-0.5% as the portfolio matures. The strategy is most valuable for:

• High tax brackets (37%+ federal)
• Taxable accounts (no benefit in IRAs)
• Long time horizons (compounding of deferred taxes)
• Investors with other capital gains to offset

Customization Options (Beyond Tax Efficiency)

Direct indexing enables portfolio customization impossible with ETFs.

ESG and values-based screens:

Exclude specific stocks or sectors while maintaining diversification:

• Remove fossil fuel companies (Energy sector exclusion)
• Exclude weapons manufacturers (specific defense names)
• Screen out tobacco, alcohol, gambling
• Apply custom ESG scoring thresholds

Example: S&P 500 minus Energy sector

• Original S&P 500: 100% market cap weighted
• Energy exclusion: ~4% of index removed
• Remaining sectors: Reweighted proportionally
• Tracking error vs. S&P 500: ~0.5-1.5% annually (varies with energy performance)

Concentration limits:

If your employer stock (or a previous holding) has become concentrated:

• Exclude that stock from direct indexing
• Gradually sell the concentrated position while harvesting losses elsewhere
• Maintain overall market exposure without doubling up

Factor tilts:

Overweight desired characteristics within the direct indexing framework:

• Quality tilt: Overweight high ROE, low debt companies
• Value tilt: Overweight low P/E, high dividend yield
• Momentum tilt: Overweight recent outperformers
• Low volatility: Overweight low-beta stocks

These tilts layer on top of the tax harvesting benefit.

Industry restrictions:

Professional restrictions (insider trading rules, compliance requirements):

• Lawyers: Exclude client companies
• Investment bankers: Exclude coverage names
• Consultants: Exclude current engagement targets

Practical Implementation Considerations

Tracking error expectations:

Direct indexing introduces small deviations from the benchmark:

A well-managed portfolio with minimal customization should track within 0.5% of the benchmark annually. Heavy customization (multiple sector exclusions) can push tracking error to 2-3%.

Tax lot management complexity:

With 500+ positions, each potentially purchased multiple times, you accumulate thousands of tax lots. Direct indexing platforms handle this automatically, but:

• Switching providers requires transferring all lot information
• Manual tracking is essentially impossible
• Year-end tax reporting includes hundreds of transactions

The cost basis step-up opportunity:

If you hold a direct indexing portfolio until death, heirs receive stepped-up basis on all positions—including those with embedded losses. This eliminates the "tax debt" of deferred gains while you captured the benefit of harvested losses during your lifetime.

Direct Indexing Decision Checklist

Essential criteria (all should be "yes"):

• Taxable account (no benefit in IRAs/401ks)
• Account size >$100,000 (ideally >$250,000)
• Marginal tax rate >24% (higher = more benefit)
• Time horizon >10 years (allows compounding)
• Comfortable with hundreds of positions on statements

High-impact enhancements:

• Other capital gains to offset (real estate, stock sales, business income)
• Desire for ESG/values-based customization
• Concentrated stock position to manage around
• Willingness to leave assets with one provider long-term

Situations where ETFs are better:

• Tax-advantaged accounts (no harvesting benefit)
• Account size under $50,000 (position sizes too small)
• Low tax bracket (harvesting benefit minimal)
• Frequent provider switching (lot transfer complexity)
• Need for simplicity (one line item vs. hundreds)

Next Step (Put This Into Practice)

Calculate your potential tax-loss harvesting benefit.

How to do it:

1. Determine your taxable investment account size
2. Find your marginal federal + state tax rate
3. Estimate annual harvesting rate: Use 1.5% for year 1, 0.75% for subsequent years
4. Calculate annual tax alpha: Account size × harvesting rate × tax rate

Example calculation:

• Account size: $300,000
• Tax rate: 37% federal + 5% state = 42%
• Year 1 harvesting: $300,000 × 1.5% = $4,500 in losses
• Tax value: $4,500 × 42% = $1,890
• As % of portfolio: 1,890 / 300,000 = 0.63% tax alpha

Interpretation:

• Tax alpha >0.5%: Direct indexing likely beneficial
• Tax alpha 0.25-0.5%: Marginal; depends on other benefits (customization)
• Tax alpha <0.25%: ETFs probably more cost-effective

Action: If your calculation shows >0.5% annual tax alpha and you value customization, request proposals from 2-3 direct indexing providers. Compare fees, minimums, and customization options before committing.