Wall Street has long grappled with a persistent challenge for affluent investors: maintaining equity exposure while generating losses to offset hefty tax bills from accumulated gains. This issue has intensified as portfolios swelled with appreciated positions from the Magnificent Seven stocks, broad index funds, and equity compensation from soaring tech firms.
Direct indexing has emerged as a potent solution. Instead of buying an ETF or mutual fund tracking an index like the S&P 500, investors own the underlying stocks individually. This structure enables precise tax management, as specific positions can be sold or retained based on their tax profile while the portfolio mirrors the benchmark. According to The Cerulli Edge, direct indexing assets ended 2025 at $1.2 trillion, and the firm projects it will grow faster than ETFs, mutual funds, and traditional separate accounts over the next five years.
Ken Lassner, Lead Product Strategist at Northern Trust—the third-largest direct indexer—joined the firm 18 months ago to extend its 35-year capability to the broader intermediary channel. He offers a pragmatic view of how the strategy functions in real client portfolios and what advisors often overlook when comparing it to ETFs.
A Structural Solution to a Structural Tax Problem
Lassner identifies two primary reasons to use direct indexing over an ETF: tax management and customization. The core mechanism is tax-loss harvesting. In any broad index, some stocks rise while others fall. An ETF investor experiences this dispersion only in aggregate. In a direct indexing portfolio, the manager can selectively sell positions trading below their purchase price, realize losses, and replace them with similar stocks to maintain benchmark tracking. "If you invest in the S&P 500 or any broad stock market index, some stocks are going to go up, some stocks are going to go down," Lassner says. "If you're in an ETF, you really have no capability to take advantage of that volatility. But if you're in a separately managed account, you do." Over three to five years, and out to ten or twenty, Lassner estimates the process can add approximately 1 to 2% per year of excess return after taxes versus an ETF, which compounds substantially over time.
The same structure enables customization that pooled vehicles cannot offer. Lassner points to a corporate executive holding a large stake in their employer's stock. A broad-market ETF likely holds that same name, increasing concentration risk. "In a separately managed account direct indexing portfolio, we have the capability to exclude that stock or even exclude the whole industry if they're really worried about the risk of being very exposed to that industry," he says. The same tools can implement values-based screens or factor tilts, though Northern Trust treats the process as consultative. Historically, minimum investment levels were high, but technology and automation have made customization accessible to more clients while managing wash sales and other tax considerations.
Ossification, Education, and the Long-Term View
One persistent misconception concerns ossification—the phase after five to seven years when gains accumulate and cost bases reset, reducing harvestable positions. Lassner acknowledges the pattern but challenges the notion that direct indexing's value ends there. "There's a perception that ossification is a bad thing, meaning that there's no more value. And that's absolutely not true," he says. "The benefit is not only offsetting gains today, but deferring taxes over long periods so capital can continue compounding." Practical steps like adding cash or donating positions to charity can refresh a portfolio's tax profile.
Education remains critical. Northern Trust surveyed "super users"—advisors who have fully integrated direct indexing across RIAs, banks, and wirehouses. They found the strategy transformative, but many "wish they started earlier and they wish they had engaged in more education about direct indexing," Lassner says. "Education is very critical, not just for advisors, but also for end clients." At Northern Trust, direct indexing now sits at the core of almost every wealth and family office client portfolio that meets minimums and fits the right tax profile. For clients with capital gains from other investments, direct indexing can make a lot of sense.
For advisors exploring this approach, understanding the nuances of tax-loss harvesting and customization is key. As the industry evolves, tools like Potomac Fund Management's enhanced SDBA program offer additional ways to access assets, while Millennials face delayed financial independence due to housing and student debt, highlighting the need for tailored strategies.
