Our Direct Indexing list is comprised of the best passive ideas from across our coverage. Direct indexing is a strategy where you directly own the stocks that comprise an index rather than an ETF or index fund. The list is pulled from all of the stocks in our coverage.

Direct indexing allows you to avoid asset management fees. All index funds charge an asset management fee, usually a few basis points annually. The fee is small, but it compounds over time. When commissions were high on individual stock trades, it made sense to buy an ETF or index fund because it resulted in lower transaction costs. Instead of paying a commission 500 times to buy each individual stock in the S&P 500, you only paid it once to buy an ETF or index fund that held a basket of stocks. Now that commissions on most stock trades are zero, there’s no benefit to buying a single share of an ETF or index fund rather than the underlying stocks. ETFs and index funds don’t really provide any value add these days, so there is no reason to pay an asset management fee for passive exposure if you don’t have to.

Direct indexing is more tax efficient. It’s well known that ETFs are more tax efficient than mutual funds. Mutual fund redemptions are met by selling shares, which are taxable events. ETF redemptions are met by exchanging “in-kind” baskets of securities, which are not taxable events. This minimizes tax consequences for all ETF holders. However, ETFs are not conducive to tax-lass harvesting. Tax-loss harvesting is a process where you sell losers at the end of the year to realize losses that you can use to offset gains on an equal amount of winners. This essentially increases your tax basis in your winners, resulting in lower taxable gains when you sell the stocks. After the wash sale period expires (61 days), you can repurchase the stocks you sold. In the interim, you can purchase proxy stocks that you think will have similar performance (e.g. Coca-Cola instead of Pepsi). Since you own the individual stocks comprising an index with a direct indexing strategy, you can use tax-loss harvesting to minimize your tax obligations.

Direct indexing is achievable without buying every stock in the index. You don’t have to buy 500 stocks to recreate the performance of the S&P 500. The S&P 500 is weighted by a company’s market capitalization, which means that the biggest companies drive most of the index’s performance. In fact, the weighting is so lopsided that you only need to buy the top 10 stocks in the index to recreate 90% of the index’s performance. The opportunity cost of missing out on a high performing stock with a much smaller market capitalization is very low. If a stock goes up 100%, but only has a 1% weighting in the index, it would only contribute 1% to the index’s performance. This makes direct indexing easy to implement from a more practical point of view. Most index’s are weighted by market capitalization (e.g. Nasdaq-100), so you can use this approach for any index.

Direct indexing lets you deviate from the index based on your risk tolerance. Since most index’s are weighted by market capitalization, they are not diversified. If you have 100% of your portfolio invested in an index fund or ETF, you are really tied to the performance of a handful of megacap tech stocks. If you want to be more diversified, it’s easy to do by decreasing your allocation to stocks with high market capitalization. At the other extreme, you could own a portfolio that is equally weighted. This strategy may have less downside risk, but it will likely underperform the market when tech stocks do well.

We have 2 direct indexing strategies, depending on what kind of risk you want to take. The first strategy attempts to recreate index returns for the S&P 500 while minimizing the number of stocks held. This strategy will closely match the performance of the S&P 500, but its overweighted to technology stocks and less diversified. Our second strategy places lower weights on technology stocks, and is more diversified. We rely on insights from the rest of our coverage when determining the weights.