Hot Takes! All The Ways You’re Doing Portfolio Management Wrong.

Smartleaf's 2024 T3 conference presentation, together with a review by Bob Veres of Inside Information.

Earlier this year, I gave a presentation at the T3 conference in Las Vegas titled, “Hot takes! All the ways you’re doing portfolio management wrong.” The title was meant to be humorous, but the content was entirely serious. 

{Bob Veres describes the presentation in the June, 2024, issue of Inside Information. Bob writes: “…One session stood out in all this introducing and demo-ing. Jerry Michael, founder of Smartleaf’s portfolio management and direct indexing platform (https://www.smartleaf.com/), offered a deep dive into how the profession can start offering personalized, tax-optimized portfolios at scale. The presentation compared how most advisory firms are creating and tax-managing portfolios with how they could be doing it – basically turning the demo idea on its head by offering a CE session on advanced portfolio management without ever once showing the Smartleaf product…”

Read Bob’s complete writeup of Jerry's presentation here. You can see the full June edition of Bob's Inside Information here.}

It’s not a shocking observation that most advisory firms aren’t especially good at rebalancing portfolios. What’s shocking is just how bad most firms are. According to a Smartleaf analysis, when firms implement a more systematic approach to tax management, they see reductions of over 60% in their clients’ capital gains tax bills. More surprising is that they also see a 60% reduction in the return dispersion of accounts with similar risk objectives. 

This shouldn’t be possible. It makes sense that portfolios would have a trade off between taxes and dispersion. The fact that advisors can simultaneously improve tax outcomes and dispersion has a sobering implication: most return dispersion is not caused by customization or tax management. It’s just noise. An indicator of just how bad the industry is at the basics of portfolio management. 

How do you know if your portfolio management practices are up to standard? Here’s one test. You should be able to document that for most clients, you save or defer more in taxes than you charge in advisory fees. Most advisors fall far short of this standard – they can’t even measure the value of their tax management, much less show that it is greater than their fees. 

What does it take to do better? The key is automation. Almost all elements of personalization and tax management can be automated. And if you automate something, you can do more of it. You can provide every client, of every size, with tax optimization and high levels of personalization. At the same time, you can lower costs and strengthen compliance. Most importantly, you can have more time with clients and prospects.

But back to the “Hot Takes” presentation. If you’re interested, here were some of those hot takes (together with their one to three pepper hotness score):

Hot takes hotness score:

🌶: spicy

🌶🌶: spicier

🌶🌶🌶: spiciest

• 🌶️🌶️ Most advisory firms are really bad at rebalancing. Relative to existing workflows, firms can probably cut both taxes and return dispersion by 60%. 
  
• 🌶️🌶️🌶️ One implication of this is that roughly 60% of return dispersion is not due to personalization or tax management. It’s just noise.  

• 🌶️ Client-facing advisors shouldn’t be rebalancing or trading portfolios. It’s not their core strength, and they have much better things to do with their time. 

• 🌶️ You should centralize or outsource rebalancing. It’s necessary if you’re going to free up client-facing advisors to do more important things.

• 🌶️🌶 Given a choice of centralizing of outsourcing rebalancing, you should probably outsource. Rebalancing is not a core competitive differentiator. 

• 🌶️ Year-end-only tax loss harvesting is not good enough. You’re underserving your clients if you only loss harvest at year end. Year-round loss harvesting is 75% more effective than year-end-only loss harvesting.

• 🌶️ Personalized, tax-optimized rebalancing can be automated. This includes direct indexing, household-level rebalancing, tax optimization, custom cash management, ESG & religious value constraints, and more.

• 🌶️🌶️ No, really. Personalized, tax-optimized rebalancing can be automated. This means one person can manage the rebalancing of all accounts, and it means all accounts, of all sizes can have whatever level of tax management and personalization you desire. 

• 🌶️🌶️🌶️ Direct indexing should be viewed as a competence not a product. If you have the ability to implement personalization and tax optimization in a portfolio, then you have the ability to implement direct indexes, without the cost, operational complexity, tax inefficiency and risk inefficiency of a separate direct index SMA.

• 🌶️ Holistic (sleeveless) portfolio management is better than sleeve/subaccount/partition based approaches.  A holistic approach is simpler and less expensive.  

• 🌶️🌶️🌶️ Much better. It’s not just simpler and less expensive. Taxes and risk are properties of portfolios as a whole, not individual components. Because of this, a holistic approach supports both higher after-tax returns AND lower portfolio-level drift. 

• 🌶️🌶️🌶️ Working with direct indexes can be as easy as working with ETFs. Replacing an ETF with a direct index in a portfolio should be a simple selection from a pull-down menu. 

• 🌶️ Models-based investment means more, not less, personalization and tax. With models-based approaches, the implementation of personalization and tax management can be automated. And when you automate something, you can do more of it.   

• 🌶️🌶️🌶️ You should be able to document that, for most clients, you save or defer more in taxes than you charge in advisory fees. Most advisors fail even to be able to document the value of their tax management, much less show that it is greater than their advisor fees. 

• 🌶️🌶️🌶️ The main benefit of documenting that taxes saved or deferred exceed your advisory fees is not proof of value – it’s proof of competence. Tax management is not the main value proposition of most (or any advisor). But if you can document competence in tax management, your clients will infer that your entire service is buttoned up.  

• 🌶️🌶️ When it comes to household-level tax management, simply putting the "bonds in the IRA” is not good enough. It’s not the only way to use qualified accounts to reduce taxes. You can also use qualified accounts as a “tax free rebalancing center” to implement household-level asset-class rebalancing, thereby minimizing capital gains taxes.

• 🌶️🌶️ The reason using qualified vehicles as a tax-free rebalancing center is not more emphasized is that few firms can do it well. Unlike, say, putting the bonds in the IRA, it’s not a one-time operation. It needs to be incorporated into all rebalancing workflows. 

• 🌶️🌶️ Tax loss harvesting isn’t the most important component of tax management. Tax management and tax loss harvesting are often treated as synonymous. They’re not. The most important component of tax management that people miss is risk-sensitive gains deferral (holding onto overweighted positions with unrealized gains, while carefully monitoring and counterbalancing the excess risk this creates).

• 🌶️🌶️🌶️ In the long run, risk-sensitive gains deferral is more important than tax loss harvesting. Over the life of a portfolio, risk-sensitive gains deferral adds more value than tax loss harvesting.  There’s a misconception that gains deferral is a lesser form of tax management compared to tax loss harvesting because it’s only “deferral”.  But this is triply wrong: 1) deferring taxes is useful – it basically means you’re getting an interest-free loan, 2), if you hold the overweighted position until death or if you donate them to charity, the “deferral” becomes true savings, and 3) most of the time tax loss harvesting is itself a form of tax deferral (when you loss harvest, you lower the tax basis of your portfolio; if you later sell, you’ll pay more in gains taxes than you would have had you not loss harvested).  
• 🌶️🌶️ The reason risk-sensitive gains deferral is not more emphasized is that few firms do it well. Loss harvesting is a one-time operation (or, rather, two-time operation: investors may need to buy back the original security in 31 days). In contrast, risk-sensitive gains deferral requires the permanent, ongoing ability to balance low taxes and low drift.

And there it is: "Hot takes! All the ways you're doing portfolio management wrong." Delivering the presentation was great fun and the audience was very generous (no one threw tomatoes). If you have your own hot takes, let us know. We welcome feedback. 

You can look at the original presentation here.