Direct Indexing Explained: Should Investors Build a Custom Index?

Affluent investors have recently taken an interest in a strategy called direct indexing. Often described as “building your own index,” direct indexing is a hybrid approach to index investing: instead of buying a pooled fund, an investor holds the individual stocks that make up an index, generally in proportions that mirror the index itself.

Morgan Stanley offers a concise description: direct indexing seeks to replicate a stock index—such as the S&P 500 or the Russell 3000—inside a taxable account. Using optimization software, a manager may include a representative sample of index constituents so the portfolio closely mirrors the index’s performance while enabling customization.

An article from Morningstar Canada frames direct indexing as a modern iteration of separately managed accounts (SMAs). Decades ago, SMAs were popular because they were customized alternatives to mutual funds, but they sometimes disappointed because of high annual fees. Direct indexing today can be less expensive than the early SMA model—especially when investors implement it themselves—though working through advisors will typically add a fee layer.

Why would an investor want to do direct indexing?

Direct indexing does not guarantee lower costs, but it provides customization that a traditional index fund or ETF cannot. In taxable portfolios, this flexibility often makes direct indexing attractive because it enables active tax-loss harvesting and targeted portfolio adjustments.

Historically, replicating a broad index by buying every component required hundreds of trades and substantial transaction costs. The rise of zero-commission trading and fractional shares has changed that dynamic, making it far easier for retail investors to construct and maintain customized portfolios. As a result, many financial firms now offer automated direct-indexing services that handle the precise weighting and periodic rebalancing required to mirror an index.

Is direct indexing worth it? How does it work?

At first glance, direct indexing resembles a common do-it-yourself practice in which investors “skim” an index—buying the largest holdings of an index or ETF—to avoid management fees. It is similar, but not identical. Direct indexing can be offered as a managed service by advisors or firms, allowing them to add value for clients while charging a fee for that service.

Industry observers note that technological advances and structural changes in wealth management have reduced barriers to adoption. As automation and optimization software improve, direct indexing becomes cheaper and more accessible, which helps explain recent growth in interest.

Can you build your own index in Canada?

Many of the same forces driving direct indexing adoption in the U.S. apply in Canada. Research firms expect significant growth in direct-indexed assets as investors seek customizable portfolios. Yet practical adoption depends on client demand, fee sensitivity, and the availability of Canadian products.

Several major investment firms have rolled out direct-indexing offerings in recent years. Fee levels for these products typically range higher than the lowest-cost broad-based ETFs, which can make the economics less attractive for small accounts. As a result, some wealth firms in Canada have been slow to introduce fully managed direct-indexing products, citing limited client demand and the practicality of offering such services at scale.

Advisors who favor direct indexing point to benefits like tailoring portfolios to tax situations, values-based exclusions, or concentrated stock positions. Opponents note practical concerns: tracking and managing hundreds of individual holdings is time-consuming, and rebalancing or exiting a portfolio built from many fractional share positions can require numerous trades. For many investors, a low-cost ETF may remain the simplest and most efficient choice.

DI vs DIY

Professional, advisor-led direct indexing is one route; a DIY hybrid approach is another. Many retail investors have been doing a version of direct indexing for years by combining core low-cost index funds with selected individual stocks. Zero-commission trading and fractional shares have made this strategy increasingly practical for ordinary investors.

Why choose a DIY hybrid? For taxable investors, the ability to harvest losses and manage realized gains is often the primary draw. Custom ownership also allows investors to exclude industries they object to or overweight sectors and companies where they have high conviction. For example, someone might choose to mirror broad sector allocations while omitting or increasing exposure to certain names that reflect personal preferences or tax-planning goals.

Some critics argue that the customization offered by managed direct indexing is largely marketing spin: a cheaper and cleaner route is to buy a core index fund and trade individual equities on the side. Many Canadian ETF advocates follow exactly that approach—using index ETFs for the portfolio core and owning select individual stocks alongside them.

Experienced DIY investors and bloggers often advocate a “core and explore” model. The core—typically broad, low-cost index ETFs—provides diversification and stability, while the explore portion (a smaller percentage) focuses on concentrated, high-conviction picks such as dividend payers or sector-specific opportunities. This method captures many of the benefits of direct indexing while avoiding the operational complexity of managing a full custom index position.

For example, one investor described building a small concentrated portfolio from large-cap dividend “achievers.” He selected 15 names after researching the concept and bought those stocks directly rather than replicating an entire dividend index. That selective approach illustrates how a hybrid strategy can be implemented without adopting a full direct-indexing platform.

The bottom line: Is it an “ETF killer?”

For many investors, direct indexing will not replace ETFs. Instead, it complements them. Hybrid strategies allow investors to maintain a low-cost indexed core while pursuing targeted customization through individual stock holdings. This approach can capture tax and personalization benefits without the operational burden of fully replicating an index.

Some investors find value in converting small ETF positions into direct holdings when those ETFs have relatively high expense ratios for a narrowly focused sector. That gradual transition can lower fees over time while preserving the desired exposure. But for most retail investors, especially those who value simplicity and minimal trading, broad low-cost ETFs remain an efficient, practical choice.

Direct indexing is another tool available to investors and advisors. It can be powerful in the right hands—especially for taxable accounts where tax-loss harvesting or values-based exclusions matter—but it is not a one-size-fits-all solution. For many savers, a blended approach that leverages both ETFs and selected individual stocks offers a compelling balance between cost, customization, and simplicity.

Jonathan Chevreau is the Investing Editor at Large for MoneySense. He is also founder of the Financial Independence Hub, author of Findependence Day and co-author of Victory Lap Retirement.

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