Investing in the S&P 500 index is appealing to many people just starting out. It has a track record of strong long-term returns, offers instant diversification and has a low barrier to entry: You simply set up a brokerage account, pick an index fund or ETF that tracks the index, and let compounding returns do their magic.
But what if there are companies in the S&P 500 you’d rather not invest in, whether for ethical reasons or because you’re already invested in that company elsewhere? A technique known as direct indexing gives you a workaround, and it has some additional advantages, too.
Three reasons investors choose direct indexing
Avoiding overexposure
Direct indexing is an investment strategy that allows you to buy the individual stocks that make up an index, rather than investing in an index fund or ETF. Since it gives you the freedom to customize an index, it can help you avoid overexposing yourself to any one stock.
Mark McCarron, partner and chief investment officer at Wescott Financial Advisory Group, gives the example of a senior executive who already receives company stock and doesn’t want to hold more of it through an index like the S&P 500. “They can invest in a direct index and exclude that company and replace it with something that’s consistent with it but not the same,” he says.
Avoiding companies for moral or religious reasons
Another reason you may choose direct indexing is to exclude companies you don’t align with. The S&P 500 is a fairly large set of companies, which is great for diversification — but a bigger index means there’s a higher chance it will include companies that may not match your values.
If you want to avoid certain sectors due to religious or moral beliefs, “you’re able to better customize the portfolio using direct indexing to match exactly what it is that you want,” says Kris Kellinghaus, senior vice president and chief investment officer at MCF Advisors.
Tax benefits
One of the most popular reasons people choose direct indexing is to take advantage of a strategy known as tax-loss harvesting. This is when investors strategically sell certain stocks for tax benefits, says McCarron, which is harder to pull off with a traditional index fund.
Is direct indexing the right method for you?
So yes, direct indexing is one way to invest in the S&P 500 and avoid some companies, but there’s a catch: Direct indexing isn’t a simple task. Trying to replicate an index like the S&P 500 on your own requires continuous, time-consuming research and rebalancing — an undertaking not everyone can afford or keep up with.
More online brokers are beginning to offer direct indexing portfolios, but many require steep minimums. For example, Charles Schwab’s Personalized Indexing portfolio requires a $100,000 minimum balance, as does Wealthfront’s direct indexing option. Public‘s new direct indexing feature has a slightly lower (but still high) minimum of about $80,000 for direct indexing into the S&P 500.
Some brokers offer a more cost-effective version of direct indexing, like Fidelity’s $5,000-minimum FidFolios, but experts note that bigger portfolios generally see the largest benefits of direct indexing.
One common way to direct index is to outsource the portfolio management to an investment manager. As with online brokers, minimums tend to run high — but McCarron says they aren’t as expensive as they once were.
“Many, many years ago, it was millions of dollars to get access to this capability. Now it’s maybe $250,000 to open an account, and I’ve seen that further fall to $100,000 to $50,000,” he says.
Alternatives to consider
If the price tag on direct indexing doesn’t sound so great, or perhaps it’s a more complex process than you’re ready to dive into, there are other investment strategies to look into that will give you diversification while still letting you exclude certain companies.
If you want to prevent overexposure: If you’re worried about overexposure because you work somewhere that has a large presence in the S&P 500, you may look into whether there’s a different index fund you could invest in that doesn’t include your company but offers similar diversification. This stock exposure tool from ETFDB may be a good place to start. Just input the company you want to avoid, and it will show you all the ETFs that contain that stock.
If you want to invest based on your values: Aligning your investments with your values is becoming more accessible through standard brokerage accounts. There are many index funds and ETFs out there that adhere to environmental, social and governance standards (you may know this as ESG investing). Many robo-advisors also offer pre-set ethical portfolio options to pick from. These may be a good fit if you want to put your money toward companies you believe are making a positive impact instead of dodging companies you don’t like in a broad index fund.
If you want tax optimization: While direct indexing may be a good option for tax optimization, many robo-advisors offer tax-loss harvesting services in their accounts, often at no additional cost.
