This article explains the concept of direct indexing in India which allows you to build a personalized portfolio by directly purchasing stocks that mirror popular indices like the Nifty 50 or SENSEX.

📚 Table of Contents

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• Introduction to Direct Indexing
  • What is Direct Indexing?
  • Benefits and Drawbacks
• Who Should Consider Direct Indexing?
  • NRIs due to taxation rules
  • DIY Investors Seeking Customization
• Strategy 1: Equal-Weighted Top 10 Stocks
• Strategy 2: High Dividend Yield stocks
• Strategy 3: Factor-Based Portfolios
• Strategy 4: Market-Cap-Weighted Indices
• What are the Implementation Steps for Direct Indexing?

Introduction to Direct Indexing

What is Direct Indexing?

Direct indexing is creating a passive index fund of your own by directly buying and selling the stocks underlying a particular index. For indices like the SENSEX (30 stocks), direct indexing is easier to implement since the number of stocks is manageable vs. indices like the Nifty 500 with 500 stocks in it.

Benefits and Drawbacks

What works well	What you should be aware of
Customization: Personalize portfolios based on specific sectors, values, or factors	Complexity: Managing a portfolio of individual stocks requires more time, effort, and expertise
Tax Efficiency: Enables tax-loss harvesting, reducing overall tax liability	Higher Minimum Investment: Often requires a substantial initial investment
Cost Savings: Avoids fund fees associated with mutual funds and ETFs	Potential for Higher Costs: Transaction costs for buying and selling individual stocks can add up
Control: Allows more strategic decisions and adjustments	Tracking Error: Will not perfectly mirror the performance of the index

This article will implement direct indexing for a particular set of indices focusing on simplicity of implementation and maintenance while minimising tax due to excessive trading. In each case below, the stocks in the indices can be found by searching the index name.

Who Should Consider Direct Indexing?

NRIs due to taxation rules

Investors who cannot invest in Indian mutual funds or ETFs are the best candidates for direct indexing. A good example is US-based NRIs, who are taxed on unrealized gains on their Indian mutual funds or ETFs (PFIC rule) but not on direct stock holdings. Due to PFIC taxation, their compliance requirements are high, and returns are significantly lower. Direct indexing by purchasing stocks is how US-based NRIs can get exposure to the Indian equity markets without paying PFIC-tax.

DIY Investors Seeking Customization

Another audience that can benefit from direct indexing are those seeking exposure to quantifiable custom styles, themes, sectors and strategies not currently available as investible funds or ETFs.

Anyone else should directly invest in mutual funds and ETFs since that is simpler to implement.

Strategy 1: Equal-Weighted Top 10 Stocks

As per the NSE, “the Nifty Top 10 Equal Weight Index which aims to track the performance of the top 10 stocks selected based on 6-month average free-float market capitalization from the Nifty 50.” In simpler terms, this strategy invests equal amounts in the largest companies in India. Here largest is defined using free-float market capitalization.

Choosing this index allows you to effortlessly invest in the largest stocks in the country without worrying about the allocation since each position is equal weighted i.e., having 10% allocation.

Points to be noted if you follow this strategy:

• this strategy is simple to implement and makes tracking error (vs. the benchmark index) least
• equal weighted indices tend to have higher turnover since the weights are rigidly defined and even slight price movements will trigger rebalancing
• price volatility of these stocks, due to their mega-cap nature, is expected to be low

Strategy 2: High Dividend Yield stocks

Here we will track either the NIFTY Dividend Opportunities 50 index from NSE or the MSCI India High Dividend Yield Index and create a portfolio with the top 10 stocks from either index.

Note: The returns shown are for the entire index. A portfolio of 10 stocks will have different (higher or lower at various times) returns vs. the actual index. This caveat applies to the remaining strategies in this article as well. Since these indices are focused on high-dividend payout stocks, this strategy can work for those investors looking to create a passive income stream from dividends. Dividends are taxable at slab rates with 10% TDS if you receive dividends of ₹10,000 or more in a year from any single company. However, as per Budget 2025, since up to ₹12 lakhs is tax free in the new tax regime, an investor can get up to ₹12 lakhs/year income tax-free if their only source of income is stock dividends.

Points to be noted if you follow this strategy:

• TDS and taxation at slab will reduce returns unless actual income is needed
• Use “yield on cost” (today’s dividend/price originally paid) as a metric over time to measure how passive income is growing
• Choose MSCI over NSE as the index data provider if you want to get the benefit of global best practices of filtering stocks based on dividend payout

Strategy 3: Factor-Based Portfolios

NSE, via niftyindices.com, has launched many factor-based indices tracking factors like low-volatility (stocks that do not fluctuate a lot), momentum (stocks that rise and fall fast), alpha (stocks that are currently beating the market index) among others.

Here we will sample the top 10 stocks in the Nifty Alpha Quality Value Low-Volatility 30 Index which is defined by NSE as:

Nifty Alpha Quality Value Low-Volatility 30 Index is designed to reflect the performance of a portfolio of stocks selected based on top combination of Alpha, Quality, Value and Low-Volatility.

There are many factor indices that you can choose but this one has exposure to multiple factors in one.

Points to be noted if you follow this strategy:

• This strategy can be complicated to implement if you frequently change your mind about which factors to implement
• Factor-based changes can be frequent meaning that you might need to rebalance more often which introduces tracking error due to capital gains tax

Strategy 4: Market-Cap-Weighted Indices

Here we will use our more familiar Nifty 50 or SENSEX indices and choose the largest 10 stocks in the index to create the portfolio.

In this case, we will invest in the top 10 stocks from the index.

Points to be noted if you follow this strategy:

• This strategy is the closest to traditional indexing with sufficient research backing it and creates a portfolio with low churn and tracking error
• The market capitalization-weighted portfolio is more diversified than the Top 10 strategy and is amongst the best options for investors looking to get true market exposure at the least effort and cost by direct indexing

In summary, you can choose a strategy based on what kind of portfolio you wish to create based on the table below:

Focus	Index	Purpose	Rebalancing
Mega-cap	Nifty Top 10 EW	Stability	Quarterly
Dividend	Nifty Dividend 50 / MSCI India High Dividend	Income	Quarterly
Factors	Nifty Multi-factor	Growth	Monthly
Market-cap	Nifty 50/SENSEX	Passive Indexing	Half-yearly

What are the Implementation Steps for Direct Indexing?

We show the steps for implementing the entire plan in the simplest way possible:

• Step 1️⃣: Choose the index that you wish to track: The choice here is important from both the future return and portfolio management point of view but not worth spending days/weeks agonising over the choices. At the end of the day, these are passive portfolios with exposure to the equity market. Some indices will outperform others at different points of time but over the long-term, these differences will average out.
• Step 2️⃣: Choose the number of stocks you wish to invest. There is no point investing in a lot of stocks since the effort that goes in maintaining such a portfolio becomes extremely high in terms of buying/selling and tax calculations. In our examples, we have chosen 10 stocks in the portfolio.
• Step 3️⃣: Choose the weights of each stock from the fact sheet of the index you are tracking. The Top 10 equal weight index has 10% weight for each stock, but the rest have different weights. Since top 10 stock weights do not add up to 100% in all cases outside the Top 10 index, then you can divide each weight by the sum of the total weight to reach 100%.
• Step 4️⃣: First allocate your portfolio to cash which is the initial lump sum and purchase the stocks from that cash allocation based on chosen weights until the cash is used up
• Step 5️⃣: Repeat the above step every month (or quarter or any other chosen frequency) when you wish to add cash into the portfolio
• Step 6️⃣: Rebalance by selling stocks whose value has gone up and purchase those whose value has gone down to systematically buy low and sell high. The weights (from Step 3) will change over time since the index will periodically review and readjust the weights of each stock. It will also happen that stocks will enter or exit the top 10 list you have chosen and then you can choose to exit one or more stocks to adjust for the new incoming stock.

Remember: selling means you must pay capital gains tax and tax-harvesting from loss-making position becomes an important activity that needs to be done to reduce your tax from selling stocks in the portfolio