Talk Your Book: After-Tax Alpha

0:00Ben Carlson:Today's Animal Spirits talk, your book, is brought to you by Brooklyn Investment Group, powered by Nuveen. Go to nuveen.com to learn more about how Brooklyn Investment Group can help with a long, short, tax-advantaged SMA. That's nuveen.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:36Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:45Ben Carlson:Welcome to Animal Spirits with Michael and Ben. Michael, when direct indexing really came on board, I guess early 2020s, a lot of the ETF crowd. And, you know, there's ETF analysts and people that follow this stuff kind of said, I don't get it. Why would you ever do direct indexing when ETFs exist? They're already pretty tax advantaged, tax efficient, low cost, simple, liquid. Owning all the individual names doesn't make any sense. And you and I have seen how this works in concert with wealth management for a number of years now. And sometimes when you see what this stuff can do, you almost kind of go, this doesn't seem like it should be legal or fair, that you can harvest so many losses.

1:29Ben Carlson:And now the thing that is happening is turning the dial all the way up and adding an overlay of a long short portfolio, right? A 13030, a 17570, whatever the number is, right? You can crank up the dial and you're adding margin leverage because using that leverage allows you to just lock in the more opportunity for losses. And if you have a huge gain in a client portfolio because they sold a business or they sold a piece of real estate or they just have a concentrated stock position they want to get out of. It's kind of crazy how magical these things are in terms of offsetting gains.

2:00Michael Batnick:This is another example of people with money have access to all sorts of solutions that advantage them. And that is just, that's the system. That's the way it is. And, um, but, but it's, it's not a free lunch. It's not too good to be true. There's no alchemy. We get into why on the show, but it's a great solution, but it's not like a rip the bandit off short-term solution where it's like, all right, I'm going to jump in and I'm just going to hop out and do something else. It doesn't work like that. And if you think that's how it works, you're in for root awakening because your advisor is not informing you.

2:33Ben Carlson:Even with like a 351 exchange fund or whatever, all you're doing is pushing the taxes off until later when you actually sell. Right. That's the beauty of it is that you're deferring taxes and allowing your money to continue to grow. And I think that's the, yeah, that's the, you're right. It's not, there's no magic here. You're not eliminating taxes. You're pushing them off into the future, but it's still, instead of paying the gains now, most people would rather wait to pay them until later. Correct? Correct. Today's show, we have Erko Atula. He is a CEO and chief investment officer of Brooklyn Investment Group.

3:02Ben Carlson:They were purchased by Nuveen a couple of years ago. And we talked to Erko about how they implement a 130-30 fund, how they use leverage, how they use long short funds to harvest more losses for their advisors and for their advisors' clients. I think this is an important topic because this stuff is just becoming more and more prevalent in the wealth management space. Prevalent. Yes. So here's our talk with Erko.

3:28Michael Batnick:Erko, welcome to the show. Thanks for having me. All right. Today, we're going to be talking about tax advantage, long, short SMEs. So hot right now in the wealth management industry. Before we get into that, But if you wouldn't mind a brief introduction on Brooklyn Investment Group. Who are you guys? Very good. Well, I founded the company 2021. We are a tech-powered asset manager. We serve both as a technology company as well as a sub-advisor to investment advisors. So we largely serve the independent space. Fast forward from 2021 to 2023, we started working with Nuveen and a number of other asset managers.

4:15And then in 25, Nuveen acquired us. So we're today a wholly on subsidiary of Nuveen. Congrats. Thank you.

4:25Ben Carlson:That was pretty quick. What changed about your organization after the merger? Anything? It's the same organization, bigger, more resources? What happened? So as you know, in any asset management business, there is the investing and the product side of the things, specifically for a technology company like Brooklyn. We have an advisor portal, we have portfolio managers portals. So these are the services that we provide to our clients. And then there's obviously the distribution side of things and client service specifically, right? So it is very hard for a small company to build distribution and really bring quality client service, which is so critical in this industry, to the market.

5:08And Nuveen has both of those. So we've been able to really leverage the Nuveen capabilities on those sites for a couple of years now. And so today, going forward, we continue as a wholly owned subsidiary of Nuveen. And that just means that we can focus what we're really good at, which is the systematic investing, tax management, and continuing to scale the platform.

5:31Michael Batnick:These long-short extensions that we're going to talk about today, I imagine that's not where you started the company with. And if so, when did you start offering that to clients? Yeah, good question. Well, so just taking a step back, I think the tax advantaged long short strategies are probably one of the greatest innovations in the wealth management space since the invention of the ETF. And so they're combining a couple of sort of old ingredients together. So long short investing in one hand with the tax managed single stock trading, basically, or direct indexing on the other hand. Some of the first products or strategies in this space started to come into the retail SMA space really just a few years ago.

6:20So I was a Goldman Sachs for over 10 years, still sitting there in the 2018-2019 era when some folks started writing about the idea of combining what we knew as the sort of the traditional direct indexing where you're managing individual stocks rather than buying, say, an ETF. stuff and but rather rather than holding everything long you would then basically relax the long only constraint and go to say 130 30 and I always found that it was a very interesting idea and so I've had it in my mind for a long time that was not the first product we we went to market with after I founded a company in in 21 in fact the first product that we launched was a balanced solution of equities and fixed income all in a single account.

7:06And that was really to address the demand from RIAs that were really looking for operational scale. So how do you tax manage and personalize at scale across the whole portfolio? Really, the original reason for founding Brooklyn was really to provide that what we call operational alpha or for advisors, combining the stocks, bonds, personalized tax managed in a single account. And that's how Naveen came into the picture as well. But long short was always in the back of our minds as the sort of the next step. And so when we built the platform, we built the platform for scale to really allow for the daily risk management and other aspects of investing that are so important in the long short space.

7:49It was always in the back of our mind, but it was not the first thing we launched.

7:53Ben Carlson:I want to get into the details of the strategy and how you actually pull it off. But I'm curious how receptive advisors and clients are to this because it is an added layer of complexity, right? The whole long, short thing for some people, some advisors, they're just not used to it because it involves, you know, margin and borrowing money and going short. And that sounds like a hedge fund. And so I'm curious how that hurdle is with advisors. Obviously, once you explain it, I think it probably makes more sense to people. But is there a barrier there where some advisors go, no, no, no, wait, we want to keep things very simple.

8:24Ben Carlson:This is too much for us. How does that work with you? Yeah, so I think just like in any investing, whenever you're introducing any additional complexity in the portfolio, you've got to do it for a good reason, right? And so there are a number of sort of pressing use cases that are driving advisors into this space. And whenever we work with advisors, we make sure that they're doing it for the right reasons. So the main use cases are, say, liquidated events. So someone that has, say, sells a company or sells real estate or has private equity distributions in a given year, how do you rapidly generate realized tax losses to help offset some of those gains and defer them for the future?

9:11A second use case is concentrated stock diversification. So many advisors have clients with NVIDIA or other tech stocks that they would like to diversify out of into, say, like an S &P 500 or other types of portfolios. So how do they do that in a tax-neutral, a gain-neutral way? So that's another important use case. And then, frankly, as advisors are acquiring new clients, perhaps those clients' portfolios were managed in a way that was different from what the advisor was looking to advise them. And so migrating the older portfolios into the management of the advisor, long short strategies can be helpful in that portfolio migration process as well.

9:59So I think those are the main use cases. And again, And we work with advisors very closely to sort of understand the additional risks that stem from the long short strategies, because that is the most important thing in any investment management activity. And then the potential tax benefits, and then also the potential for sort of some pre-tax outperformance as the sort of the third component.

10:23Michael Batnick:So we've been, we agree with you. We've been using custom indexing since 2019. It's a big part of our business. and the long, short extensions make a lot of sense to us, and we'll get into why. The tension between scale and customizability has been flattened by companies like yours and others that are enabling advisors to accomplish both things. What was hard? I'm curious. Was it coming up with the investment solutions? I mean, obviously, the indexing part is pretty straightforward, but maybe there's some active overlay, I don't know, versus the tech part of it allowing advisors and their operational teams to integrate, connect it with the custodians and all the vendors and streamlining everything and restrictions and glide paths to the tax.

11:14Michael Batnick:It's a lot. There's a lot of moving parts. Yeah. So if you kind of think about the different components of these tax-bounded long-sort strategies, there is the tax management piece, which has sort of existed in different shapes and forms since the 1990s, where you're just doing tax-offs harvesting at an individual stock level. Then there's the other component, which is the long-short investing. So as we know, the first hedge fund, called the Hedged Fund at the time, was 1949 by A.W. Jones. So long-short investing has also been around for some time. So we're kind of now putting the two things together.

11:50But what that sort of creates is the idea that every portfolio is going to be different. And particularly when you have short positions in the portfolio, you've got to be risk managing everything on a daily basis, right? And so imagine running tens of thousands of accounts. Now, all of a sudden, the investment process is actually meeting software engineering, right? How do you build scalable systems across tens of thousands, hundreds of thousands, even millions of accounts where each portfolio gets the attention that it deserves? So that's where I would argue the answer to your question is that there are some custodial changes that sort of happened that allowed retail SMAs to short stocks.

12:36And then those were combined with basically the technology that enables this sort of daily monitoring and tax management whenever an account needs to be traded. And that's what we spend a lot of time on. So I would argue that the toughest part was to build the technology itself and to make sure that it really scales. And every portfolio is not only risk managed, but also tax managed. And then the pre-tax alcohol, the stock selection component, which is an important part of those strategies, we've taken the approach of sort of letting the advisor choose whether they want to go sort of a more factor based route, or whether they want to use our proprietary alpha signals for stock selection, which again, come from our investment team that has experience managing these long short portfolios.

13:29So those are the two components, how they came together. But I would argue that having a robust technology platform, that was certainly the tougher ask in many respects.

13:40Ben Carlson:You got a little bit to my next question, but so it sounds like you have your own models, but if an advisor comes to you and has a model that they use or a portfolio they use, they can also implement that as well? Or is it just your models that you can use on the platform? The benchmark or the target allocation. So if you kind of think about a long, short strategy, there's two things there. There's what is the benchmark, right? You know, traditionally it was something like the S &P 500 or Russell 3000 or blend of the above. And then there's the other part, which is like, how do you do the stock selection for the long, short extension?

14:12So advisors can bring their own models for the sort of the beta part or the core part of the portfolio. Many advisory firms run their, say, own active models, right? So the core of the portfolio could be a tracking, say, a dividend growth model or any other sort of advisor-led model. So we're kind of nicely combined the idea of a rep as a PM in terms of the stock selection work with the management of the portfolio that we do. So the advisor can then bring their own model to serve as part of the asset allocation of the core of the portfolio. Now, in terms of the stock selection, it is possible for the advisor to bring their own long short stock selection signals as well.

14:55But that just means that they really have to have views on about, you know, 3 ,000 stocks in the US stock universe. Because what is really important about those long short extensions is that you have plenty of replacement securities as you're trading in and out of these portfolios. those replacement securities are very, very liquid. So you've got to have to look at the sort of the 2700 or so most liquid stocks in the US stock universe. And then you get to have signals that actually work and are not sort of correlated to what everybody else is doing. So there's sort of a balance there. Now, some advisors had said like, look, we just want to have an overlay that goes long, high quality stocks and short junk stocks.

15:35So those types of like simple factor-based extensions, those can be implemented per the advisor demand. But where our advisors tend to be gravitating is sort of more uncorrelated stocks reduction signals that traditionally come more from the hedge fund space.

15:51Michael Batnick:Ben, are you still short Berkshire Hathaway?

15:54Ben Carlson:Well, I mean, the shorting piece is the one that obviously people probably have the hardest time with. But I guess maybe you could kind of talk about how that overlay works. And maybe, I don't know how much you can quantify it, But the difference between, you know, a lot of people listening are probably familiar with direct indexing and the tax loss harvesting that you can get there. But how much more of a premium in terms of the taxes are you getting by adding the long short piece? So that one 30, 30, you know, you're going long an extra 30 % to short. So your net is still 100. But like, what's the difference between just a long only tax loss harvesting system?

16:26So if you think for simplicity, just the first year of investing. investing. So suppose you have an advisor with a client that has, say,$10 million liquidity event, right? And they deploy that in, say, like a US large cap benchmark. Your traditional, so long only, direct indexing strategy probably generates on average about 10 % in terms of realized losses over the first year, right? So about 10 % of the initial investment. Now, when you go to 13030, you're talking about numbers that are around 25%. And so what the interesting thing about that is like, obviously, you can then scale the leverage higher, if you need more realized losses based on the amount of gains that you realized, right?

17:15And then the other thing is that suppose the initial investment is not cash, but maybe it is some legacy portfolio. You can take that legacy low basis stock portfolio as collateral and we can then create the extension around that. So that's a way to kind of use existing legacy assets and basically turn them into sort of productive members of the household by introducing the long short extension on top of them. So then you're kind of removing the long only portion and then you're just generating the losses by the extension, which is about 15 % in the first year for the 130-30.

17:55Michael Batnick:So you just mentioned it, the 130-30. Is that the only levels that you have available or are there more that go, I don't know, 200-100? And I guess a follow-up, are you always running at net 100? No, we are very flexible in terms of the continuum of different levels of leverage that we can provide, as well as the beta exposure, which goes to your second question about are you always running net of 100 in exposure. So talking about the first part first, so on the low end, frankly, we have clients who are just like dipping the toe in the water and they're running a 1-10-10 type of portfolios. That's totally fine as well.

18:39Then at the other extreme, there we're really limited by the custodian requirements. So going up to 325, 225, that's sort of the range that is just sort of doable in the sort of the retail SMAs at the main custodians. Now, in terms of the beta exposure...

19:00Michael Batnick:Wait, Arka, can we... Actually, I should have broken this question up. Let's get to the beta in a second. but can you talk about the spectrum of one, 10, 10, get out of here, all the way up to 325? 225. Okay. So if some is good, surely more is better, but what are the risks? What happens when you start pushing the limits of, all right, now we're pretty levered up here, even if the net is 100? First of all, whenever you go beyond REC-T, so 200 % of gross notion, now you're living in the well the portfolio margin, right? And that's just the way for the brokers to assess the risk in the portfolio, right?

19:39Now, what are the tangible risks? Well, obviously, when you scale the leverage tracking error relative to whatever you're tracking is going up, roughly linearly, right? So if a 130-30 strategy is running with a tracking error of say one and a half to 2%, then a 250-150 would be running at a tracking error of 7 % to 8%, for example, right?

20:04Michael Batnick:What does tracking error mean? Yeah, so the tracking error, the way to think about it is like, what is the expected deviation in return relative to your benchmark in a given year? So say a 2 % tracking error means that, say, if you're tracking the S &P 500 in any given year, sort of two-thirds of the time, so the one standard deviation that we learned at school, two-thirds of the time you are within 2 % of the benchmark return. Now, obviously, you can have a two standard deviation or three standard deviation events. So I typically sort of, when talking to advisors, emphasize that the client should prepare for at least sort of two standard deviation events in either direction.

20:48So thinking about, say, the 130-30 strategy, that means that you could sort of outperform or underperform sort of plus minus 4%, right, in a given year. And then always you could have three standard deviation. And in the financial crisis, we talked about a four standard deviation event. So that's one way to think about the risk in sort of just how far you are from the benchmark, right? All right.

21:10Michael Batnick:So that's obviously like, now listen, risk cuts both ways. I mean, you could have positive experience where you outperform by two or three standard deviations and you're like, oh my God, more, more, more. That was amazing. And of course, we understand it cuts both ways. Why even do that? Like, what is the, and you're welcome for that. I know this is a softball question, but why do people even do this? What are they trying to achieve to say nothing of potentially outperforming? The main thing in these strategies is basically split into the stock selection. so the active component of the alpha, right?

21:44And then there's the tax alpha, right? So we talked about the potential tax benefit that can accrue from these strategies and we talked about some of the numbers and how you can really boost the realized loss generation for your clients. So the reason to go into the long short space is really an urgency to create tax losses to help offset gains somewhere else.