Direct Indexing with Exclusions

June 5, 2026

Direct Indexing with Exclusions

Epistemic status: I came up with an idea for excluding stocks in a direct index, googled around and found out that it's already a product with a startup offering it for a fair price. I have not used this long, and may discover new points of concern as I get more experience with it.

There have been a few news stories recently about people lobbying index providers to exclude SpaceX. Could you accomplish the same thing without negotiating with index providers? This post explains the costs and benefits of direct indexing, and compares the services available.

Direct Indexing<br>Direct Indexing is a financial product that behaves like an ETF except you hold the basket of stocks directly instead of paying the ETF provider to do it for you. That gives you more flexibility in what and when you trade.

The mechanics of rebalancing a direct index varies from provider to provider. I think they're all doing some form of the following:

1. They run a solver periodically, minimizing a loss function.<br>2. That loss function penalizes: excessive trading, tax costs, tracking error.<br>3. Solving is subject to regulatory constraints like wash sale rules.

If the direct index provider has the ability to send the balancing transactions for all their customers at once to the market makers on the other side, it is likely they'd get a very good price. The flow is predictable, uninformed, and partially offsetting, so market makers are able to compete hard for it.

I believe direct indexing is much more viable these days than it used to be. If your account is limited to buying whole shares you'd need ~$23m of S&P 500 exposure to bother buying your first share of NVR, a ~$6000 stock with a 0.0265% weight. Now that fractional shares are commonplace, this constraint is gone and it makes it much easier for individuals to track a direct index at scale.

Exclusions<br>Some direct index providers let you exclude sectors and stocks from your index by tweaking your rebalancing algorithm. The hope is that customers can use this feature to:

- exclude sectors they're already exposed to via their employment<br>- exclude Elon Musk companies<br>- exclude meme stocks<br>- express ESG or anti-ESG opinions<br>- express negative opinions about single stocks without being exposed to the complexities and convexities of short selling

As you add more and more exclusions you'll stop tracking The index and instead track Your index. I find this to be a nice balance for most people between broad diversification and wanting to express opinions about certain companies being bad for their portfolio.

Tax Loss Harvesting<br>Direct Indexing also gives you the ability to "harvest" tax losses. That's the idea that if you sell stocks that have lost money since you've bought them, then you can reap a capital loss to offset other capital gains. You will still owe that tax eventually -- tax loss harvesting provides tax deferral, not tax avoidance.

The amount of harvested gains you get to keep is the growth of your deferred tax, after tax. Quantitatively, if your holding decreased X% and your marginal tax rate is T% and you keep the holding for N years compounded at R%, this saves you X%*T%*(1-T%)*(1+R%)^N. In words, you keep X%*T% money that you otherwise would have paid in tax, that money grows by a factor of (1+R%)^N, and then you get to keep the part of that growth which isn't taxed: (1 - T%) of it. For me, T%*(1-T%) comes out to ~25%. So I get to keep about a quarter of harvested losses, compounded over my holding period.

Tax Loss Harvesting Strategies<br>It's worth pointing out that unless you have an alternative source of capital gains every year, you'll be limited by a maximum of $3000 of losses deducted against ordinary income. If you happen to be compensated in stock of a publicly traded company you can combine tax loss harvesting with selling enough of your concentrated position to generate capital gains offsetting your capital losses. It's a neat party trick, but if you find yourself in that position and your concentrated position(s) is/are > $1m, ask your wealth manager about a Section 351 or Section 721 exchange instead.

A valuable pattern for Direct Indexing is that if you regularly add money from your job and give away money to tax-deduction eligible charities, you have a source of freshly purchased securities to harvest and a source of highly appreciated individual stocks to give to charity. Donating appreciated stock means you never pay capital gains on them, and this turns your working hours into more money for the charity. If your capital gains are highly taxed, getting this right over time can be worth quite a bit to your charities.

Limitations<br>Most of the tax losses will be harvested early in the life of your position. As stocks generally go up, you'll have fewer and fewer opportunities to lose money relative to where you bought things. This means the product looks like it easily pays for...