Morgan Stanley
Investment Management

Investing Smarter with Direct Indexing

May 13, 2025

Amid volatile markets, investors might consider direct indexing, which offers portfolio customization and the ability to pursue tax-efficient strategies within passive investing.

Key Takeaways

  • Investor demand for direct indexing is growing because it lets investors customize their portfolios while pursuing tax-efficient strategies in passive investing.
  • If you’re focused on long-term investing, are interested in having your investments reflect your values and are in a higher tax bracket, direct indexing may be right for you.
  • Technology advancements are helping lower minimum investments and fees, making direct indexing more accessible.

Amid volatile and fast-evolving markets, investors are increasingly interested in controlling their passive investment portfolios with flexibility and targeting tax efficiencies.

 

One option to consider is direct indexing. Unlike traditional index funds or exchange-traded funds (ETFs), direct indexing allows investors to customize investments, letting them reflect their personal values, financial goals and tax strategies in their passive investing.

 

Technology advancements that are reducing costs and the minimum investment required are helping fuel the rise of direct indexing by making it more accessible. Direct indexing assets under management have grown at a 12.7% compound annual growth rate in five years.1

 

Ranjit Kapila and Thomas Lee, co-presidents of Parametric Portfolio Associates, which pioneered direct indexing more than 30 years ago, further explain this investment strategy and why investor demand is growing.

Q
What is direct indexing?
A

Direct indexing is an investment strategy in which an investor directly owns the individual stocks composing an index, rather than investing in mutual funds or ETFs.

Purchasing shares in a passive index-tracking mutual fund or ETF offers investors broad market exposure to a particular benchmark, but it doesn’t allow for customization. With direct indexing, however, the investor directly owns the individual securities in a separately managed account (SMA). The SMA allows the investor to have a custom passive portfolio designed to track a particular benchmark.

Q
Who is direct indexing for?
A

Direct Indexing may benefit many types of investors based on their investment objectives. Investors can ask themselves the following questions to determine whether direct indexing is right for them:

  • Am I focused on long-term investments? Direct indexing would allow you to potentially benefit from tax deferral as more of your money stays invested . Harvested capital losses, which can offset capital gains and reduce your tax bill now, means that you can keep more money invested, compared to mutual funds or ETFs, which can compound over time. 
  • Am I interested in having my investments reflect my values? If so, you may appreciate the ability to customize to implement responsible investing, faith-based investing or any other personal values.
  • Am I in a higher tax bracket? Direct indexing with continuous tax-loss harvesting could improve your after-tax returns.
  • Do I want to fund a portfolio with existing securities? You may experience real pre- and post-tax savings from direct investing, compared to selling all of your current positions and reinvesting in a commingled fund.
Q
What are the potential benefits of customization through direct indexing?
A

Customization lets investors have greater control. Their investments can reflect what they value and their long-term needs. Direct indexing lets investors customize portfolios to actively harvest capital losses  from individual securities while deferring capital gains. They can also tailor the portfolio to their social or environmental principles, avoid redundant risk-compounding holdings or combine multiple benchmarks to achieve the precise exposure they want.

Direct indexing providers also manage risks by:

  • Keeping exposures aligned with an investor’s chosen benchmarks
  • Trading only when value-add justifies the cost of transacting
  • Staying mindful of IRS wash-sale rules, which are designed to prevent an investor from claiming capital losses as tax deductions if re-entering a similar position too quickly
  • Seeking to harvest capital losses and defer capital gains to reduce the investor’s overall tax bill
Q
What types of customizations do investors want and why?
A
These are some of the common types of customizations that investors want:
 
  • Diversifying from concentrated positions: Typically, 10% to 20% of an investor’s portfolio is held in concentrated stock positions. Direct indexing can help reduce concentration by increasing diversification through access to broader index exposure. It also helps lower investors’ tax burden from selling the concentrated positions by offsetting realized gains through tax-loss harvesting.
  • Values-based investing: Direct indexing allows for robust screening, which lets investors align their passive portfolio with their values. They can invest in companies that align with their beliefs, spanning equities or fixed income.
  • Charitable giving: Investors can gift individual securities to charities instead of cash, unlocking potential after-tax benefits for themselves and still meeting the needs of the charity.
Q
Why is demand for direct indexing growing?
A

Investor demand for personalized investment strategies continues to increase, and direct indexing has become one of the fastest-growing segments in the separately managed account space. According to a report by Cerulli Associates, 69% of sponsor firms want to add direct index separate accounts to their platforms.2 Trends in technology and lower transaction costs have made personalization more accessible, further fueling demand. Customization also makes sense for people who want their values, tax goals and long-term plans reflected in their portfolios.

Q
How is technology accelerating direct indexing to create outcomes that investors want?
A

Scalable technology solutions are making direct indexing accessible to a growing number of investors by enabling lower minimum required investments.

In addition, financial advisors can more easily build and evaluate portfolios for each investor’s unique needs. Transition-analysis tools help assess the tax implications and potential benefits of moving investments into a direct index SMA by simulating scenarios. Meanwhile, reports with portfolio characteristics, tracking error, realized and unrealized gains and losses, and credit quality help to streamline advisor-client communication. This helps investors better understand their current portfolios and make informed decisions toward achieving their long-term financial goals.

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Sources & Disclosures

Sources:

1 https://www.cerulli.com/press-releases/cerulli-associates-projects-direct-indexing-assets-to-top-800-billion-by-2026-while-outpacing-growth-of-etfs-mutual-funds-and-smas

2 https://www.cerulli.com/press-releases/cerulli-associates-projects-direct-indexing-assets-to-top-800-billion-by-2026-while-outpacing-growth-of-etfs-mutual-funds-and-smas

Disclosures:

Past performance is no guarantee of future results. The returns referred to in the commentary are those of representative indices and are not meant to depict the performance of a specific investment.

RISK CONSIDERATIONS
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and may therefore be less that what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks. In general, equities securities’ values also fluctuate in response to activities specific to a company. Stocks of small- and medium-capitalization companies entail special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. Investments in foreign markets entail special risks such as currency, political, economic, market and liquidity risks. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risks). Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility.

DEFINITIONS
The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto. The S&P 500® Index measures performance of the large cap segment of the U.S. equities market, covering approximately 75% of the U.S. market, including 500 leading companies in the U.S. economy. 

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