Direct Indexing Deep Dive: What Tech Employees Should Know

Updated 01/13/2025

For many Seattle tech industry employees, you may be wondering what you should know about direct indexing. There’s a reason you keep hearing about it. This tax strategy presents the opportunity to add customization, control, and cost savings to your investment planning.

At Northern Lights Advisors, there’s a reason we believe in the power of direct indexing: it pays! 

What is direct indexing?

First, let’s get the obvious question out of the way: what exactly is direct indexing? Direct indexing is an investment strategy that allows investors to directly own the individual securities that make up an index, rather than investing in a mutual fund or ETF that tracks the index.

In a nutshell, direct indexing seeks to replicate an existing stock index, such as the S&P 500 or the Russell 3000, in a taxable account. With direct indexing, investors own each stock in an index individually, as opposed to buying a fund that holds them all together.

Why is direct indexing as a tax strategy growing in popularity? 

Direct indexing is growing in popularity as a tax strategy because it offers significant tax optimization opportunities. By owning individual securities, investors can engage in tax-loss harvesting*, selling underperforming stocks to offset gains and reduce taxable income. This strategy also allows investors to control the timing of capital gains, choosing to realize them in low-tax years or defer them to avoid higher tax rates. 

Additionally, direct indexing enables investors to avoid short-term gains, which are typically taxed at higher rates, by holding securities for over a year. Furthermore, it allows for the donation of highly appreciated securities, which can be a tax-efficient way to give to charity without incurring capital gains taxes. 

In short, the combo of flexibility and tax efficiency makes direct indexing an increasingly attractive option for savvy investors, including tech employees.

Benefits of direct indexing that appeals to tech employees

Direct indexing offers several unique advantages beyond tax strategies, especially for tech employees. One key benefit is customizable profiles and the ability to remove exposure to existing holdings or sectors you may want to avoid. For example, if you work at Google, you can filter out Google shares and other tech stocks to avoid over-concentration in your portfolio. Similarly, you can exclude investments in industries you find objectionable, such as guns, weapons, or coal, aligning your investments with your values (thematic investing). 

Direct indexing also allows you to work around existing holdings with large capital gains, offering a level of flexibility that ETFs and mutual funds cannot match. Another significant advantage is cost efficiency: there is no additional management cost for this strategy. For instance, Northern Lights Advisors does not charge extra for managing direct indexing portfolios compared to ETF portfolios, whereas ETFs and mutual funds typically have management fees that individual holdings do not. 

How does direct indexing work?

To illustrate how direct indexing works, I’ll share a typical example. We purchase a basket of securities that is a statistically significant version of a defined index. For example, the S&P 500 is one where you buy a couple of hundred names in the index. Existing holdings are incorporated into the portfolio, and calculations are made to get the entire portfolio to have the same risk and return characteristics as if the portfolio had simply purchased an S&P 500 ETF fund. 

The resulting portfolio will have many components of the index as individual holdings with its own gain and loss associated with it. This portfolio, over time, is bound to have performance dispersion; some stocks will have large gains, some will have significant losses. Direct indexing will allow us to sell the losers and retain the winners. 

Clients can also provide filters and instructions on names that should not be held, as well as industries and types of companies. The manager will incorporate all limitations and come up with the most closely tracked portfolio that will closely mimic the index as well as take into account these limitations. 

What happens when you sell something?

Each time a sale is made, the portfolio manager will recalculate all exposures and compare them to the “pure” index. Within statistical ranges, the portfolio will need to be adjusted. One example: We sell Coke at a loss for tax-loss harvesting purposes. Pepsi is purchased in its place, but this is not a perfect substitute. The portfolio may need a small allocation to a different stock as well in order to get in line with the total goal of tracking the S&P 500. 

What happens when you rebalance your portfolio?

Since the portfolio consists of a range of asset styles (large, small, and international stock, bonds, etc.), in any particular period, these assets will have diverging returns. A rebalance will sell assets that went up in value and purchase assets that went down. The direct indexing framework will be more flexible in a rebalance than a traditional ETF and MF portfolio since it can delay selling components with capital gains and instead reconstitute the portfolio to get to similar rebalance end result and sell components with smaller gains or even losses. 

When should direct indexing become part of your strategy?

As always, speak with your advisor before making any moves. Direct indexing is ideal for many clients, especially with large exposure to individual stocks or industries, with large capital gains results if these positions were to be sold. The direct indexing strategy will be able to incorporate these holdings into a diversified portfolio and be part of a longer-term diversification strategy. (i.e., manage capital gains realized each year, tax loss harvest when available, and reduce exposure to these names in the rest of the portfolio). 

Using ETFs and MFs will, by default, have additional exposure to the individual stock that is already being held. Example: Microsoft is approximately 2% of the S&P 500. By buying an index ETF, you would buy a chunk of the same stock you are trying to diversify away from. 

Other scenarios are where clients have stocks and industries they want to not be invested in. We can filter our names based on activities (for example, a certain percentage of their total sales is related to guns), names (no Smith and Wesson holdings), or specific industries (i.e., oil and gas).

Further, clients with fluctuating incomes from year to year would benefit from being more in charge of realizing their capital gains. If you make 1M in a specific year and 100K in the next year, you would not want to take any capital gains now and instead delay this for next year (for example, 15% vs 23.8% tax on long-term capital gains). 

Why Northern Lights Advisors geeks out over direct indexing

For many folks — including tech employees — direct indexing is a great opportunity to add customization, control, and cost savings to your investment planning. If you’d like to explore this strategy (as with most strategies), it is well worth having a conversation with your financial advisors.

At Northern Lights Advisors, we love direct indexing. It creates tremendous flexibility for our clients to manage taxes, stock exposures, and goals with how they invest their money. Being in full control of what shares are held, donated to charity, sold, or harvested for tax losses can be very powerful. Before 2022, we were less inclined to propose these strategies due to high fees with direct indexing managers. After investing in a very robust trading system, we can now offer the strategy at no cost to clients. Being able to do this without the fee hurdle is an extremely powerful tool for folks with high income and stock compensation. 

Whether you are a tech employee or not, if you’d like to learn more about how direct indexing can support the financial future you envision, schedule a consultation today.

Northern Lights Advisors is a fiduciary, fee-only Registered Investment Advisor (RIA) firm based in Seattle, Washington. The information in this article is not intended as tax, accounting, or legal advice. Read the full disclosure here.

*Tax-loss harvesting involves tax deferral, not permanent tax avoidance (as selling at a loss lowers the asset’s cost basis, potentially creating a larger tax bill upon eventual liquidation). Additionally, there is also a risk of tracking error relative to the benchmark index.