Direct Indexing vs. Broad-Based ETFs: What’s the Better Move for Your Portfolio?

In the world of investing, the debate between direct indexing and broad-based exchange-traded funds (ETFs) is kind of like arguing whether vinyl sounds better than streaming music. Both have their strengths, and neither is inherently wrong. It just depends on your taste, your goals, and, if we’re being honest, your tax bracket.

So, what’s the real difference? And more importantly, which one might be better for you?

Let’s break it down.

First, a Quick Refresher: What Are We Talking About Here?

Broad-Based ETFs
These are your efficient, low-cost options. A broad-based ETF, like the SPDR S&P 500 ETF (SPY) or Vanguard Total Market (VTI), gives you exposure to hundreds or even thousands of stocks in one tidy holding. You get instant diversification, low expense ratios, and a disciplined approach that captures broad market performance without a bunch of complexity.

Direct Indexing
Direct indexing, on the other hand, is the grown-up version of index investing with a custom wardrobe. Instead of buying a fund that holds all the stocks in an index, you own the individual stocks yourself, usually through a separately managed account (SMA).

The Benefits of Direct Indexing (a.k.a. The “Why Bother?” Section)

1. Tax-Loss Harvesting on Steroids

ETFs offer limited opportunities to sell holdings at a loss because you're selling the entire fund, not the individual stocks within it. Direct indexing? You get to pick off individual losers to offset the gains of the winners.

2. Customization (Because You’re Not a Cookie-Cutter Investor)

Hate Big Oil? Love Big Tech? Have too much Apple stock because your RSUs showed up all at once? Direct indexing allows you to build around those preferences.

3. Better for High-Income or High-Net-Worth Investors

Direct indexing starts to shine in this space. While the strategy has historically been available only to the ultra-wealthy, modern platforms are making it more accessible.

4. Transition Management

Have legacy stock positions with huge embedded gains? A direct indexing strategy can help you migrate to a more diversified portfolio over time, harvesting losses where possible and minimizing the tax hit.

Why ETFs Still Deserve a Seat at the Table

We’re not here to throw ETFs under the bus. They’re a go-to for investors who want smart, streamlined exposure to the market without the extra layers.

They’re also tax-efficient in their own right. Thanks to a little-known mechanism called the “in-kind redemption process,” ETFs can minimize capital gains distributions. That’s a fancy way of saying they keep your tax bill low by avoiding taxable events inside the fund (unlike mutual funds, but that’s a different article).

If your financial life is straightforward, your tax bill is manageable, and you’re not trying to optimize every corner of your portfolio, then ETFs are more than fine. They’re great.

But if you’re in a higher tax bracket, want to personalize your exposure, or have legacy positions you’re trying to work around, direct indexing might be the upgrade you didn’t know you needed.

It’s like moving from off-the-rack to bespoke tailoring. Same basic function, but with a lot more precision and panache.

Next Steps

If direct indexing sounds intriguing or if you’re just wondering whether it’s right for your situation, it’s worth having a deeper conversation with your Allworth advisor. This is not a one-size-fits-all strategy, and like all great things in life (tailored suits, custom kitchens, children), it requires a bit of attention and care.

But for those who qualify, the payoff can be significant.

And hey, if you can pay Uncle Sam a little less while you keep a little more? That’s what we call a win.

This information is meant for educational purposes and not as direct tax or legal advice. Rules and regulations can shift anytime, so it’s always best to consult a qualified tax advisor, CPA, or attorney for guidance tailored to your specific situation.