Listener Question:
“A friend suggested direct indexing could give me an edge on tax loss harvesting, especially since I already donate appreciated stock to our donor advised fund. Is it worth the complexity?“
Direct indexing has exploded in popularity over the past few years. Five years ago, few investors had heard of it. Today, it’s pitched almost everywhere as a tax-advantaged upgrade to traditional index funds.
At a high level, the pitch sounds great: instead of buying an S&P 500 ETF, you directly own all 500 underlying stocks. When one stock drops, you can sell it, capture the tax loss, and replace it with a correlated name so your overall exposure stays intact. Over time, you generate tax savings without giving up market returns.
That’s the theory. The reality is more complicated.
Where Direct Indexing Works
- Upfront tax savings: In the early years, there may be plenty of opportunities to harvest losses as different names in the index move around.
- Ongoing contributions: If you’re adding significant new money regularly, that new capital creates fresh opportunities for loss harvesting.
- DAF synergy: Since you already donate appreciated securities to a donor advised fund, direct indexing can dovetail by giving you additional “fuel” for gifting.
Where It Breaks Down
- Diminishing returns: Markets tend to trend upward. After a few years, you’re left with hundreds of positions purchased at very low cost bases. The opportunities to harvest losses shrink dramatically.
- Embedded gains trap: You could end up with 500 individual stocks, all sitting on large unrealized gains. Unwinding that portfolio can become painful.
- Fee drag: Direct indexing platforms typically charge advisory fees on top of the underlying trades. Paying 30–70 basis points for a strategy that loses its edge after a few years can be hard to justify.
- Complexity: Instead of one simple ETF, you’re stuck with hundreds of positions that require monitoring and create messy tax reporting.
A Smarter Middle Ground
You don’t need 500 individual stocks to harvest losses. Splitting an index into a few ETFs—say value vs. growth, or sector-based funds—can provide similar tax opportunities without the cost and complexity of direct indexing.
Key Takeaway
Direct indexing isn’t a scam—it can generate real tax benefits upfront. But those benefits fade over time, and what you’re left with is complexity, fees, and a portfolio that may be harder to manage or unwind than when you started.
For many high-net-worth investors, the smarter play is combining simple index funds with selective tax strategies like donor advised fund gifting. That way, you capture tax efficiency without boxing yourself into a corner.
This post was adapted from an episode of the Scholar Wealth Podcast. For more insight, listen to the full episode here.