Understanding Direct Indexing vs. ETFs

Investors interested in diversifying their portfolios can use direct indexing and ETFs to achieve that goal. While an ETF can be a simpler option, you can exercise more control over your portfolio with direct indexing solutions. Let’s compare the advantages and disadvantages of both for your portfolio. A financial advisor could help you pick the best investment options for your portfolio needs.

What Is an ETF?

ETF stands for an exchange-traded fund. These investment vehicles track market indices and can be traded like a stock.

For example, many exchange-traded funds track popular indices like the S&P 500 or the Dow Jones Industrial Average. But ETFs can also track smaller indices within a particular industry.

When you purchase a share of an ETF, the value is in the underlying stock of companies within the ETF. So, you could purchase one share of an ETF to own a small piece of all of the companies within a particular index.

What Is Direct Indexing?

Like an ETF, a direct indexing strategy is based on a popular index. But instead of purchasing a single share of an ETF, the investor individually purchases every security within a particular index.

In the past, direct indexing was cost-prohibitive based on the large number of fees associated with trading. But with many brokerage firms now offering a $0 trading commission, direct indexing costs aren’t necessarily a deal breaker.

Beyond the ability to make trades without a cost, many brokerage platforms also offer fractional share amounts. The availability of fractional shares allows investors to consider direct investing, whether or not they have the means to buy a whole stock of each company in a particular index.

ETFs: Advantages and Disadvantages

Like any investment, it’s important to weigh the pros and cons before investing in an ETF.

As with all investment options, you will need to consider the advantages and disadvantages before buying an ETF. Here are three advantages:

Flexibility. You can purchase an ETF like you would purchase a stock, so it’s possible to buy and sell shares whenever you’d like to. This is a bit easier than selling off the right portion of shares in a direct indexing portfolio.
Diversify with ease. You can purchase a single share of an ETF to quickly get your portfolio off the ground. That’s a sharp contrast to a direct indexing option that requires purchasing an extensive number of individual stocks.
Low investment minimums. You can purchase a single share of an ETF at a relatively affordable price.

And here are two disadvantages:

Fees involved. Within ETFs, there are embedded expense ratios to consider. Although usually low compared to a mutual fund, you’ll need to run the numbers against your brokerage platform if considering a direct indexing strategy.
Possible errors. It’s possible for an ETF manager to track an error at some point. Unfortunately, this could cost investors holding the fund.

Direct Indexing: Advantages And Disadvantages

Before you invest in direct indexing, here are three advantages to consider:

Tax control. When you purchase individual stocks to match an index, you are in complete control of buying and selling. With that, you can potentially take advantage of tax-loss harvesting opportunities.
Customize your risks. With direct indexing, you can treat a particular index like a roadmap. But if you spot other opportunities along the way, you have the opportunity to adjust your portfolio to match your risk tolerance.
Lower costs. If you are up for managing the buying and selling of individual stocks on your own, you can potentially save money with a direct indexing strategy.

And here are two possible disadvantages:

Fractional share issues. Most investors must use fractional shares to make a direct indexing strategy work for their budget. If you must use fractional shares, that will limit which brokerage platforms will work for you.
Active management is required. You can’t just set your direct indexing strategy on autopilot. Instead, you’ll need to regularly rebalance and replace stocks along the way.

ETFs vs. Direct Indexing: When to Pick Either

ETFs are often the easier entry point for investors. They give instant diversification through one trade, with exposure to hundreds of companies inside a single fund. Because they are traded like stocks, they are liquid and flexible, and most carry very low expense ratios. For investors who want a portfolio they can set up and monitor with minimal effort, ETFs provide a clean solution.

Direct indexing takes a different approach by holding each stock in an index separately. This lets an investor control the portfolio at a granular level. You can exclude specific companies, tilt toward certain sectors or create custom rules that reflect your goals. The structure gives more choice, but it also requires more time and attention to keep everything in line.

Taxes are where the biggest differences show up. With ETFs, you benefit from the built-in tax efficiency of the fund but have little ability to influence outcomes beyond buying and selling shares. Direct indexing, by contrast, allows you to sell individual holdings at a loss to offset other gains, a practice known as tax-loss harvesting. For taxable accounts, that ability can add meaningful value over time.

Portfolio size is another deciding factor. ETFs can be purchased with just the cost of a single share, making them accessible to investors at any level. Direct indexing, even with fractional shares available today, is generally more effective with larger portfolios where the tax savings justify the added work. For small accounts, the benefit may not outweigh the complexity.

The choice comes down to what you value most. If you want a low-maintenance portfolio that is cheap and broadly diversified, ETFs are the better fit. If you want control, customization and a chance to manage taxes more actively, direct indexing has the edge. Both are tools that can build long-term wealth, but they serve different investor needs.

Bottom Line

ETFs are an easy, low-cost way to diversify, while direct indexing lets investors buy individual stocks and manage taxes more closely.

ETFs can be a practical option for investors seeking a simple, low-cost way to build a diversified portfolio. They track market indexes and require limited ongoing management. Direct indexing, by comparison, involves buying individual stocks within an index, allowing investors to control when to recognize gains or losses and adjust holdings based on their preferences or tax considerations.

“If you want to really be able to customize your stock holdings, direct indexing may be the way to go. It also offers potentially large tax benefits, since you can harvest your losses when you trade in a taxable account. If you don’t want to handle the ongoing portfolio management, though, ETFs are a straightforward solution,” said Tanza Loudenback, a Certified Financial Planner™ (CFP®).

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Tanza Loudenback, a Certified Financial Planner™ (CFP®), provided the quotes used in this article. Please note that Tanza is not a participant in SmartAsset AMP, is not an employee of SmartAsset and has been compensated. The opinions voiced in the quote(s) are for general information only and are not intended to provide specific advice or recommendations.