Direct Indexing 101: How Tech is Democratizing Investing

The world of investing never stops evolving, and while stockholders today have an overwhelming number of ways to grow their wealth, there have always been staples. Mutual funds have long been a cornerstone for diversification, and exchange-traded funds (ETFs) are popular for their lower costs and tax efficiency. However, with market volatility and investor demand for more control, a new strategy, direct indexing, is quickly gaining traction, offering even more portfolio control and tax benefits for those willing to put in the work—or use the right technology.

We consulted Bhavdeep Sethi, whose experience in building large-scale machine learning and AI systems, including his time leading Twitter's Ad Marketplace, positions him as an expert on algorithm-driven market strategies. As the founding engineer behind Frec’s first-to-market multi-index direct indexing algorithm, Sethi is uniquely suited to explain why this method is on the rise for retail investors.

Why ETFs Are So Popular

To fully appreciate direct indexing, Sethi explains, it’s important to understand why ETFs have gained widespread adoption: tax efficiency.
ETFs are widely favored, accounting for nearly $1.4 trillion in individual investors' assets, largely thanks to their tax advantages. Unlike mutual funds, which distribute gains annually, ETFs allow investors to defer capital gains taxes until they sell. This can create a difference of up to 4.3% of a portfolio's net asset value, depending on how long investors hold their funds. In other words, ETFs enable investors to keep more of their money in the market, allowing it to compound over time.

"ETFs have been a huge advantage for investors, especially in terms of tax efficiency," says Sethi. "But as the market evolves, we've found there’s room for even greater optimization."

Direct Indexing: More Control, Better Taxes

Direct indexing offers something different: instead of buying an ETF that tracks an index like the S&P 500, direct indexing involves purchasing the individual stocks in that index. This gives investors the ability to customize portfolios on a per-stock basis and enables more granular tax optimization.

"The biggest advantage with direct indexing," Sethi continues, "is targeted tax-loss harvesting." This strategy involves selling securities that have dropped below their cost basis to realize a loss, which can then be reinvested in a similar stock, locking in those losses for future tax benefits, like deductions on capital gains taxes. While ETFs use a broad-based strategy, adjusting their weighting at fixed intervals, it happens at the discretion of the institution providing the index. Direct indexing, on the other hand, allows investors to make these decisions at the stock level, potentially increasing tax savings across their portfolio.

Tax-loss harvesting in direct indexing can add up quickly. For instance, a study by Frec simulated a portfolio based on the S&P 500, which led to a 2% boost in post-tax returns compared to a standard ETF tracking the same index. The effect compounds over time, with early adopters benefiting the most. It's not surprising that 48% of financial advisors plan to start using this strategy more frequently in the next five years. But why wait?

A Modern Strategy

Historically, direct indexing was reserved for larger investors and institutions due to its high costs and complexity, but a few key changes in how the market works have made it available to a much broader audience. Fractional shares allow investors to buy pieces of individual stocks, lowering the initial cost, while zero-commission trading makes frequent transactions more affordable, allowing investors to take full advantage of tax-loss harvesting.
Sethi emphasizes that technology, however, is the key to democratizing this strategy. "At Frec, for example, we’re automating the hardest, most labor-intensive part. Portfolios are adjusted daily to avoid wash sales while maximizing tax alpha, based on our algorithm. We're really opening the door for retail investors to benefit."

What It Means for Your Investments

Direct indexing is part of a broader shift toward personalized, tax-efficient strategies, and they're gaining momentum. Assets in direct indexing are expected to grow at an annualized rate of 12.3%, reaching $825 billion in the next two years.

“Computing power and the push for AI have made it possible to run these strategies at scale,” says Sethi. "These are institutional-grade techniques." Whether you’re aiming to reduce taxes, align your investments with personal values, or simply have more control, direct indexing offers flexibility that traditional ETFs can't match.

For those considering direct indexing, Sethi’s advice is straightforward: “Start by understanding your financial goals and the tax implications. Explore how technology can give you better returns from your investments.”

The next time you review your portfolio, consider whether direct indexing could be a fit for you. The future of investing is here—and it’s putting more power in the hands of individual investors.