Academic Finance Research and Insights

Many investors face the complex decision of whether to transition from a diversified ETF to direct indexing. When is this switch a poor investment choice? My findings suggest that many investors are better off avoiding it. Direct indexing remains attractive even with a decent amount of embedded capital gains, up to approximately 40% of initial investment, for investors in the highest marginal income tax bracket.   However, for lower-tax investors with a marginal income tax rate of 22%, ETFs often prove more advantageous: when embedded capital gains exceed 10%, a consumption-focused investor is better off staying in an ETF.  While the other benefits and costs of direct indexing are difficult to quantify, my results indicate that it is far from a universal solution. Investors with high embedded gains and lower tax rates should approach direct indexing cautiously.