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Today's Animal Spirits Talk youk 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 Batnik and Ben Carlson as they talk about what they're reading, writing, and watching.
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All opinions expressed by Michael and Ben.
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Are solely their own opinion and do not reflect the opinion of Rithwell Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spirits with Michael and Ben. Michael, today. This one was an easy one for us on top of 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.
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C
Winter of 2019. Yep.
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A
Okay. About six years or so. We've been using the Canvas Custom Indexing. We've seen a lot of different iterations. We were one of the, I guess, the very first users on the ground floor. We've seen them go through 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?
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C
Absolutely.
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A
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, 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, the potential for it. Credit to you and I. 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. Even though from an investing perspective is not completely different. It's. It's new for a lot of people.
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C
Yes. I was going to say something totally else, but I want to address what you just said. You know, there was, there was definitely a learning curve. There was definitely. We had, you know, it was a lot. It is a lot. It's a, it's a big transition and the, the, the Certainly it's been a raging success, not just for our business, for our clients, but. But in general, it's. 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. Is there a branding problem there or can they do better?
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A
You don't. You really don't like that name, do you?
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C
Yeah, well, it's not. That's not. No direct indexing. I mean, yeah, there are direct indexes where you can just do that, but with a lot of these platforms, you could do so much more than just replicate the index.
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A
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 that there's so much. It goes so far beyond that now. You're right. But I really do think it takes sinking your teeth into this and like going through a demo or trying it out to understand really what it can do for you and your clients. I think for wealth management firms, it really is a game changer. 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, that 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.
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C
I'm just asking. I think we can do better as an industry.
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A
So we talked to Aaron about just the evolution of this, how it worked, kind of 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, this talk will probably help you. So here is our conversation with Aaron. Aaron, welcome to the show.
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B
Thanks for having me, guys.
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So, a lot of times on these Talk youk Book segments, Michael and I are coming in blind or blind ish, where it's a. It's a new strategy or something 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. I 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.
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B
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, you 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, 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 and then all of the sudden that was really the watershed moment for direct indexing where prior to that the big players were Parametric and Appirio and 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 inde portfolios. And once that happened then it was really off to the races. And 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. So the market has had, 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 of 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.
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C
The success of the direct indexing strategies and you guys were late, but early parametric and Perio and others were doing this for years with the index primarily at the index level. So we're now at the point where there are products being launched, the 351Exchange 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 and P500 direct replication.
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B
Yeah. So tax loss harvesting. A lot of people think of it in the direct indexing concept because it's a really. If you put yourself in the shoes of an advisor, it's a really great pitch. Right. You've got everybody has been bludgeoned over the head about how terrible active management is. And 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. Like 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 351exchanges 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 it's really in it. I think the industry is trying to attempt to solve that problem across the board. 351 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 351exchanges 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 loss harvesting. Because if you go into 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, 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, 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? So 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.
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A
So to his credit, Michael immediately saw the benefits of 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. And 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.
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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. They 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. And there's lots of give and take to these platforms where you can take on 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, in an informed way.
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C
What do you think about the name custom indexing? Because what you all are doing is really, it's not really that, you know.
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We'Ve, we've struggled with this a lot because I was, 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, their income strategies. We just launched manage options. We 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.
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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. And 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 the. 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. So I'm just curious how that part of it has evolved.
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B
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 that. 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. But you have the ability to do it at scale across hundreds of accounts. And, 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, on total return. So I think that the key is really helping them understand what each of the levers do, the implement implications for what those toggles are and then allowing them to implement it sort of at scale, really across their, their books. You know, 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. I think that a lot of advisors that aren't using things like direct indexing or custom indexing to manage their books, maybe it's a, 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, 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.
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C
We 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 tax loss harvesting to glide path them into a more diversified portfolio.
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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 to. 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. But working down concentrated positions is very, very common. And there is a. 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 351exchanges. 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. So there's lots of different options. They kind of all have their risks and benefits in one form of another. But, but this is, this is probably like the megatrend 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.
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So we seem to get these bursts of corrections in bear markets and they happen seem to be happening quicker and quicker. And obviously advisors can, you can harvest losses then. But what does this type of strategy look like and what does it offer advisors and clients if you had a more extended bear market?
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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 the case with anything investing, you can't time when these things are going to happen. So 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 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 and it is kind of like an uncorrelated source of alpha because generally your tax alpha is going to be higher when absolute returns are the worst.
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C
So 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 canvas platform?
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B
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. We'll take a look at it. It's usually it's ETFs or funds and we'll then look through that, look at it on a bunch of different dimensions. So we'll look at risk model, exposures, sectors, industries, countries, regions, factor exposures, sectors, just the full, the full gam. 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. We think now what we're effectively doing is opening up to this portfolio the ability to add tax benefits over time.
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A
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, emerging, all these different strategies, right? Conservative, 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.
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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, different regions, different areas of the market and you know, on a go forward base. So 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 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, you know, 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, would use. We're using them for specific purposes, like I mentioned, with manage options and concentrated position work downs and long short to the, 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.
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C
Obviously a lot of what you're doing is powered by very, very significant technological resources. It sounds like you're a. But as you mentioned your background, I mean, this is an asset. You started as an asset manager. Maybe talk about the history and the transition and where did this even come from?
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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 rumbling 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. So 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, we got frustrated with them because we couldn't implement as efficiently as we wanted to. So we built our own. So we have our internal oms that we use to trade our entire book of business. So we kind of just gradually layered things on. And so we moved offices recently post acquisition, but prior to when we moved, if you walked into our trading floor, it was kind of like this large dining room table where the tech team sat on one side and the PM team sat on the other. So technology was always critically important to what we did. And we always had a bit of an outsized technology technology staff. If we didn't have that in our culture, we wouldn't be able to deliver on Canvas the way that we are. Technology is incredibly important to what we do.
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C
We've worked with several service providers over the years who have gotten acquired. You mentioned the acquisition. You guys were bought by Franklin Templeton. And in many cases, not all, but in many cases, things change and not for the better. And in your case, it's been business as usual. Plus obviously you guys have more resources. And that is a credit to the culture that Jim built once upon a time. Obviously you and the team and Ari and Roger and everybody else, keeping that in check. But what's it been like for you working for Franklin Templeton, a much larger organization?
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B
I think that like most people, to your point, when these mergers and acquisitions, when they occur, you never know really what's going to happen. And I do feel like the acquisition went from our, from an employee perspective about as well as a corporate acquisition could occur. You know, we. We sit within an entity within Franklin that's dedicated towards innovative solutions and technology and sort of growing those. So we get the benefit of kind of being able to. To act like a startup within, you know, within a larger corporate entity and the resources that exist. So from that perspective, I'm very Very thankful because you know, the other thing that we were really concerned about is, you know, we got acquired and then all of a sudden our investment philosophy is going to have to change and we're going to have to neuter all the products and everything like that. That never happened. And I think that, you know, those are some of the things that have enabled the platform to continue to grow. They said they were going to invest in us and Franklin has platform went from I think around $2 billion when we got acquired to now about $15 billion. So we've been able to invest in scale in the platform and the people and everything.
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A
So what can advisors look forward to in this platform going forward?
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B
I think our operating ethos is really, it's a couple things. I think that we have a little bit of an advantage given that we sort of have this alpha oriented background which I think is an underappreciated trait for sort of direct and custom index providers. Because when you have to do things like generate alpha in a previous life and that's solely what you're judged on, you've got to be really creative in doing that because you're against the most competitive set in the world. What Canvas has allowed us to do is sort of redirect that creativity to solving client problems. And so if we can then do that on a platform that has scale, it's sort of like the nick sleep idea of like economies of scale shared. If we can solve a problem for one client that then gets put on the platform that adds value to everyone. And so that's really what our team is, is oriented towards doing is, is solving these problems. And with that is going to naturally come as the different regimes come and go with good returns and bad returns as new and different capabilities. We have some specific ones, you know, coming online over the next, over the next few quarters. But this sort of culture of trying to solve client problems and then add them to the platform at scale so that we can help our clients. That, that's really what it, what it's all about.
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C
How long does it take for a firm to get up and running? I mean it is not a light lift. There are all sorts of moving parts. There's the investments, there's the operations, there's the, the advisor training, the client training. I mean there's, there's a lot that goes into it. What does the process look like?
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B
So it depends on, on how a client is, is coming into the platform. So there's certainly a lot of training that's involved. There's training from the perspective of the investments themselves, from the operational perspective, there's usually different, a few different tiers of, of users that are going to be coming onto the platform and using it on different ways. So there's specific trainings around each of those and then there's an onboarding process that of mapping over accounts. It depends on if there are custodial changes that are involved, integrations with performance software and existing software and things of that nature. So it is definitely a multi month process.
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A
Are there certain types of advisors that you're looking to work with outside of handsome podcasters like us?
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B
Always. I think that one of the things that we learned early on in the process, I know you all know very well, is when we initially started up, we started with nine Canvas partners and what we really wanted to do with them is learn alongside them for what features of the platform we needed to develop that they would benefit the most from. And one of the things that we learned in that whole process was about the type of clients that we want to work for. We're not interested in people that are looking for the hot dot. Those that are willing to use Canvas as basically like their, their investment management operating system, they tend to get the biggest bang for the buck out of it as well. It's not sort of a one off account type platform because of all the reasons that we talked about. There are a lot of features to the platform that need to be used in the proper way. And so that's really important. And that's one of the things that we're very open about at the outset is we want Canvas to be used as sort of the investment management oper system at the firm. And we think that the statistics bear that out because Canvas partners that have been with us are generally growing at about 2x the industry average. And so that that sort of deep knowledge of the platform itself is incredibly helpful. I think what it ultimately does is it allows advisors to focus on either servicing the clients as opposed to kind of like all the administrative minutiae that can exist with having to trade individual accounts on your own and things of that nature.
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C
Well, the platform has been great for our clients and for our business. And don't just take my word for it. Reach out to Aaron and his team. Canvas. Canvas. Aaron, for advisors that want to learn more about the platform. Where do they find you guys?
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B
Just canvas.osamosam.com it's the best place.
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C
All right, appreciate the time today.
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B
Thanks guys.
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A
Okay, thank you, Aaron. Remember, check out canvas.osam.com to learn more. Email us animalspiritscompoundnews.com.