Talk Your Book: How Custom Indexing Works

0:00Today's Animal Spirits Talk Your Book is brought to you by Canvas Custom Indexing. Go to canvas.osam.com to learn more about how you can use Canvas custom indexing for your financial advisory firm and your clients. That's canvas.osam.com. 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.

0:38Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:46Welcome to Animal Spirits with Michael and Ben. Michael, today this one was an easy one for us and talk your book because this is something that we're, I guess we're literally talking our book in some ways. this is a platform that we use and have used for years now i guess six years running uh 2019 yep okay about six years or so we've been using the canvas custom indexing we've seen a lot of different iterations we're one of the i guess the very first users on the ground floor we've seen them go through uh an acquisition by franklin templeton and you mentioned it on the show a little bit today but we've seen that piece go bad before where boutique, can we call O'Shaughnessy a boutique firm?

1:28Absolutely. The boutique firm who has sort of really good service, great culture, the big behemoth takes them over, and then, oh no, this is not what we used to use. And they've done a really good job, I think, of keeping that small town flavor when the big town takes them over. And you saw the first example of this from Patrick O'Shaughnessy. like he gave you the first inkling of what this was going to be. And you immediately saw the potential for it. Credit to you. And I think we probably did have a few advisors at first who were a little concerned, like, wait a minute, this is totally different than what we do.

2:07Even though from an investing perspective, it's not completely different. It's new for a lot of people. Yes. I was going to say something totally else, but I want to address what you just said. You know, there was definitely a learning curve. There was definitely, you know, it was a lot. It is a lot. It's a big transition. And certainly, it's been a rage of success, not just for our business, for our clients, but in general. It's gained massive adoption. I don't think it's an ETF killer. I think that's hyperbolic. But the use cases are undeniable. Custom indexing, is there a branding problem there?

2:44Or can they do better? You really don't like that name, do you? Yeah, well, that's not direct indexing. I mean, yeah, there are direct indexes where you can just do that. But with a lot of these platforms, you can do so much more than just replicate the index. It's kind of like one of those technology companies like Facebook that had the name. And do you really want to change the name afterwards and then get stuck with Meta as a name? I think that kind of goes to show you how much evolution there's been in the space. It goes so far beyond that now. You're right. But I really do think it takes sinking your teeth into this and going through a demo or trying it out to understand really what it can do for you and your clients.

3:28I think for wealth management firms, it really is a game changer. And there's obviously, you said it's not an ETF killer. Of course it's not. For many people, an ETF or a mutual fund is going to be fine. But for a lot of wealth management clients, this thing really can, even if it's only making a difference on the edges of your portfolio, right? People really hate taxes so, so much. And I think if you can help them on their tax bill, clients love that kind of stuff. So we talked today to Aaron Stanhope. Aaron is the Chief Investment Strategist at Canvas Custom Indexing, a term you don't like, but we're going to work on.

4:03I'm just asking. I think we can do better as an industry. So we talked to Aaron about just the evolution of this, some of our thoughts on using it. If you're a financial advisor, I think you have to at least understand what this is and know whether this is right for you and your clients or it's not. I think you have to really. And so I think this talk will probably help you. So here is our conversation with Aaron.

4:26Aaron, welcome to the show. Thanks for having me, guys. So a lot of times on these Talk Your Book segments, Michael and I are coming in blind or blind-ish, where it's a new strategy or a new product or a new service, and it's something that we may know a little bit about, but a lot of times we don't have a lot of familiarity. This is obviously a little different. We've been using the Canvas platform for a number of years now. Our firm, we were one of the very first users. But I feel like there are still a lot of advisors who are still relatively new to the idea of direct indexing and everything it can do.

4:57I did a panel in a conference last year in Miami, and they kind of did a show of hands. Like how many people use it or have heard of it? And it was a shocking number of advisors who still were sort of on the fence and didn't really get and understand it. I've always liked how you all talk about the sort of evolution of getting to this place. So maybe you could just start there just to give people an idea of like where we've been and where we're at now and where it's going. Yeah. I mean, it's actually, I'm sure one day it'll be a really interesting case study at one of the schools. I mean, the inflection point was really 2019.

5:34You know, prior to, we sort of think of things as like before Canvas and after Canvas at O'Shaughnessy. And before Canvas, I mean, we were just, we were quant active factor equity managers. And that was our decades of legacy, was in building alpha-oriented portfolios. And we sort of had this idea of, you know, let's turn the research platform inside out so that others can access it. So it sort of started out on this vein of people seem to be in smart beta. They're not interested in active and large cap. How can we continue to participate in that market? And then in October of 2019, transaction costs went away.

6:11And then all of a sudden, that was really the watershed moment for direct indexing, where prior to that, you know, the big players were parametric and imperial. Their businesses were designed around this sort of white glove service for ultra high net worth investors that could really handle all the transaction costs associated with these direct index portfolios. Once that happened then, it was really off to the races. Very quickly, the interest in our platform and other platforms became around bringing this idea of direct indexing into more of the mass market. And so I think that today now, we've also been in this period where since that time, the equity markets have really just been on a tear.

6:56So the market has had to, the industry has had to mature really, really quickly because, you know, that sort of sowed the seeds of what is now the biggest problem that everyone in the industry has, which is I've been in a direct index portfolio for a couple years. and now all of a sudden, I don't know that I have any more tax loss harvesting that's remaining in these portfolios and kind of what do I do now? And I think that's kind of like where a lot of things sit at the moment. The success of the direct indexing strategies, and you guys were late but early. Parametric and Imperio and others were doing this for years with the index, primarily at the index level.

7:36So we're now at the point where there are products being launched, the 351 exchange products being launched to take advantage of the ossification of these strategies. Maybe talk about how what you're doing is a little bit different and why there is less of that existing on Canvas as opposed to if you were to just run a straight S &P 500 direct replication. Yeah, so tax loss harvesting, a lot of people think of it in the direct indexing concept because if you put yourself in the shoes of an advisor, it's a really great pitch, right? Everybody has been bludgeoned over the head about how terrible active management is.

8:19And so all of a sudden then, you can make this trade where you get index exposure, but you get to do it in a way that you can defer the tax losses. That's a really great, easy pitch for a lot of clients. And that's fantastic for a lot of clients. Tremendous value has been created. But what has also happened to your point about 351 exchanges is it's not just appreciated ETFs. It's also appreciated concentrated stocks. It's really everything because we've had these historically high equity returns over the past several years post-COVID. So I think the industry is trying to attempt to solve that problem across the board.

8:57351 exchanges is a really interesting idea. I don't think that it solves everything, just as exchange funds don't solve everything. There's kind of like hair on everything, right? And so we think 351 exchanges are really, really interesting and are going to be a great use case for lots and lots of clients. But for us, what we really think about is most clients, first of all, are going to be dipping in and out of their accounts. When we look across our client base, in a given calendar year, 70-ish percent of accounts have either a withdrawal or an inflow into their accounts. So then all of a sudden, I think one thing that's really underappreciated is that changes the whole calculus of tax management and tax house harvesting.

9:44because if you go in a 351 exchange, as long as you're willing to leave that money in there and forget about it kind of forever until you can gift it away, if you need to dip into it, you're going to kind of end up being at the same spot because when you do a 351 exchange, your basis doesn't change. The perspective that we've always taken is we see clients transacting in their accounts. And so we want to be able to provide flexibility there for them to be able to do the analytics to basically say, okay, if I do want to make this withdrawal, here's the impact. And do we have a way that we can minimize that tax impact?

10:22So there's lots of different ways. But I think that one of the key things is you really have to take it from a practical perspective, where a lot of what you read about is making some assumptions that the money is just going to sit there kind of like forever. So to his credit, Michael immediately saw the benefits of the Canvas platform. But I think one of the things that we were a little nervous on at the beginning is like, how do we explain this to our advisors? And then how do we help the advisors explain it to the clients as well? Because this is a relatively new thing that not a lot of people have experience with.

10:54And now they kind of more people understand it. But it is still, if you compare this to the mutual fund industry or the ETFs or whatever, direct indexing is probably still pretty small relatively. So I'm curious how you guys think of first educating advisors who are new to this and how you explain it to them and how you help them explain it to their clients as well. We have a pretty robust system. A training program is honestly how it works. And it's multiple hours because there's a lot of different layers to custom indexing platforms. There's the investment capabilities, which just table stakes need to be world class.

11:31They need to be really great investment offerings. the perspective that we've always taken is we don't want to tell you what you have to use. You get to design it. But in order to do that, we need to offer a full range of different capabilities so that advisors and investment teams can solve whatever the particular client problem is. So there's definitely a process of education. It's not just a log on and it works. So there's sort of an investment layer. And then at sophisticated firms, there's an operational layer that exists as well. Custom indexing, as much as anything, is about the workflow as it is just about the investments in and of themselves.

12:10And there's lots of give and take to these platforms where you can take on a certain amount of tax budgets or tracking error budgets relative to your models. And you have to be aware of what those trade-offs are because you can end up in situations where there might be violent market events where things may not act the way that you intended. And so I think in a lot of ways, it's really just educating our partners and advisors of the choices effectively that they're making so that they can make those on their own in an informed way. What do you think about the name custom indexing? Because what you all are doing is really, it's not really that.

12:48You know, we've struggled with this a lot because I was just speaking to one of my colleagues about this a few minutes ago because we're actually getting ready to launch a few new capabilities over the next few quarters where, again, along this idea that if you – we have to provide sort of world-class investment solutions. And so that means long only. And within that, that means total return type strategies. For us, it's quant factor because that tends to cater really, really well to tax loss harvesting. There are defensive equity strategies. There are income strategies. We just launched managed options.

13:23We have individual municipal bonds. We're getting ready for long short and ETFs and things like that as well. So it's kind of more around model management of the entire book than it is just about custom indexing in and of itself. I think that is probably one of the things that most people don't understand. And I think a lot of people in the ETF industry kind of look at direct indexing or custom indexing, whatever you want to call it, and say, why would we need this? ETFs are already a really great wrapper. They're tax efficient. They're easy. And then we've had clients and prospects before tell us once they get it.

14:02And I think it is the education piece, like you said, is so key because for some people, it is a learning curve. But once the light bulb goes off, they go, oh, geez. And we've had clients say, why doesn't everyone just do this? Once you kind of get it. But obviously, it's not for everyone. But I guess I'm curious about the importance of the financial advisor in this equation because it is not a set it and forget it type of strategy. Like you said, there's dials you can turn up and turn down, and you have to kind of set budgets and understand when it makes sense to use certain tools and when to sort of back off of them.

14:33So I'm just curious how that part of it has evolved. Yeah. Again, tremendous education around it because those different levers that exist. So first of all, there's so many different levers that are available on the platform. So number one is awareness. Second is understanding what each of them do. And then when I think about the platform and what it does, for Canvas partners, it really enables scale for the firm, where you can customize on each account, whether that be a tax budget or a tracking error budget or ESG or whatever those parameters are or individual stock restrictions or things of that nature.

15:14but you have the ability to do it at scale across hundreds of accounts. And for many firms also, they have different, we call them templates, whether that may be for an investor that's looking to be a little bit more conservative or one focused on income or one focused on total return. So I think that the key is really helping them understand what each of the levers do, the implications for what those toggles are, and then allowing them to implement it sort of at scale really across their books. Also things that ordinarily should be super, super easy like reallocations. It's actually a really complicated exercise, particularly when you start thinking about things like taxes.

15:57I think that a lot of advisors that aren't using things like direct indexing or custom indexing to manage their books, maybe it's an ETF model, they may not even be aware of the tax implications of what those moves are. So that firm may be focused on specifically the investment offering, but when you start doing the analytics to try and understand how those model updates and reallocations are impacting their clients from a tax perspective, then all of a sudden that deteriorates the actual after-tax wealth that you're providing for clients. So I do think in a lot of ways what we're offering is scale in the business of managing wealth as well in a more informed way.

16:37We are more than a decade into a bull market, and we're in a bull market in which a lot of people have made a lot of money and a handful of names. How frequent is it where you get people with concentrated portfolios and you are using taxables harvesting to glide path them into a more diversified portfolio? It's very common. I'd say the most common application is an incumbent portfolio that's coming over. that is low basis in nature, where we are trying to, in a tax-efficient way, move it to a new target portfolio. That's probably the most common. But practically, it's the same implementation. One, there's just a lot more risk concentrated in the single position.

17:25But working down concentrated positions is very, very common. And in the next few quarters, there will be a pretty broad suite of options available in order to do that. You can do it with, you know, we talked about 351 exchanges. Other ways to do it are just a straight long only work down. Clients can contribute cash alongside the position or the existing portfolio that helps work things down. You can pair it with a managed option strategy as well to hedge some of the risk. You can do concentrated work downs or transition ossified portfolios with long short type strategies as an overlay as well.

18:03So there's lots of different options. They kind of all have their risks and benefits in one form of another. But this is probably like the mega trend that exists in our industry right now is this idea that there's been tremendous appreciation and then all of a sudden, what do I do with this if I get stuck in whatever the names are that have appreciated so much over the last five to 10 years. So we seem to get these bursts of corrections in bear markets, and they seem to be happening quicker and quicker. And obviously, advisors can harvest losses then. But what does this type of strategy look like?

18:42And what does it offer advisors and clients if you had a more extended bear market? Well, it certainly makes it a lot easier to change allocations and move out of those portfolios. So I'll give you an example. earlier this year. I mean, in April of this year, we had really historic volatility, 10 % swings in a given day. And I think something like 99 plus percent of our taxable accounts traded multiple times in that period. So you have to dip in when there's opportunity. I think that one of the challenges is you can't time, just as is the case with anything investing, You can't time when these things are going to happen.

19:24So if you're not already set up, ready to go, it's really hard to make a tactical decision in a moment to say, oh, I'm going to direct index or I'm going to start doing tax loss harvesting. So it tends to be the periods that are best for tax loss harvesting are kind of flat markets, volatile markets, down markets. So if we went into a multi-year extended bear market, that'd be great for tax loss harvesting, probably not so great for absolute returns. That is one of the sort of nuances of tax loss harvesting. It is kind of like an uncorrelated source of alpha because generally your tax health is going to be higher when absolute returns are the worst.

20:00So how does it work when you're talking with an advisor and they're having an initial conversation with you? They want to learn more. They go through the process and they get to the five-yard line, maybe the 20. Let's just say inside the red zone. And they say, all right, here's how we manage money. what does it look like if we were to transition our portfolio over to the campus platform? So we have a process that we call a map over. That's basically, so our client portfolio management team basically gets paired up with the prospect or the client to basically say, hey, give us your investment allocation.

20:39We'll take a look at it. Usually it's ETFs or funds. And we'll then look through that, look at it on a bunch of different dimensions. So So we'll look at risk model exposures, sectors, industries, countries, regions, factor exposures, sectors, just the full gamut. And what we'll try to do is translate that to the Canvas platform so that advisors can see what an apples to apples comparison is. And again, we're not trying to say that our investment offerings are better than what you currently have. but it's to basically translate to say by unwrapping the wrapper of what's in your existing portfolio and providing the individual securities and similar exposures.

21:23We think now what we're effectively doing is opening up to this portfolio the ability to add tax benefits over time. The investing piece was important for us because we wanted to take our current portfolios and exposures and have you map them out, which was a cool process to go through. But since the start of the platform, you've obviously added a ton of investment strategies. Now, I don't know what the numbers would be if you went through all the different iterations, and because of all the different choices you can make between index and active and large, small, mid, international, all these different strategies, right?

21:54Conservative, aggressive, all these different things that you've added. I'm curious just what you've learned over time, adding these different investment strategies and taking kind of the best of what's out there in the current fund landscape and making your own tweaks and changes to those types of strategies for this platform? Yeah, there's something like 150 or so different strategies and combinations. It's growing. What we were able to do from the outset is leverage all of those strategies, leverage a suite of foundational factor building blocks. So that's how we're able to add the scale and the number of strategies that are available and really just apply those to different regions, different areas of the market.

22:36And on a go-forward basis, I think we have a lot of the ground covered. So we have proprietary passive, we have branded passive from some of the popular index providers, we have factor strategies that we've traveled in for 30 plus years. And so really now, I think the biggest area of growth for us is really, I mentioned we added individual bonds. Having those in a single account is something that clients have said is really, really important to them. So we've added that as well. And then also things that I think are more alternative-like. We're not creating hedge funds on the platform, but there are some capabilities that are coming to bear on the platform that are kind of like ones that normally hedge fund type strategies would use.

23:21We're using them for specific purposes, like I mentioned with managed options and concentrated position work downs and longshore to the same effect. So those are kind of the places that we've been adding more and more recently, because they're really meant to solve specific client problems that we've been talking about of the appreciation that we've seen over the last five to 10 years. Obviously, a lot of what you're doing is powered by very, very significant technological resources. It sounds like you're a technology company, but as you mentioned, your background, I mean, this is an asset, you started as an asset manager.

23:54Maybe talk about the history and the transition and where did this even come from? So Jim O'Shaughnessy was always a bit of a technophile. Even in the 80s and 90s, some of my colleagues can tell the stories about him packing his old computer into the trunk of his car and taking it with him on family vacation. So technology has really always sort of been in our DNA, certainly since I joined the firm in 2010. Jim was the largest systematic equity manager at Bear Stearns. They left in 2007, fortunately, before a lot of the rumblings started to occur. the purpose was to build out a research platform where there just wasn't the investment while they were at that firm in the platform that he wanted to see.

24:37So they split out to build the research platform. And then basically since then, we generally found... So because of that, we were a really weird equity, boutique equity factor shop in that we managed lots of separately managed accounts. Most firms of our side would be like a single commingled fund, hedge fund type structure. It really wasn't us. So we had to build this operational backbone to handle thousands of separately managed accounts where we were managing the tax lots for those really from the get-go. And so then connect the research platform, the operational platform. We had a third-party provider that we use for our trading and our OMS.