A Q&A with Craig Izkowitz of the Ezra Group and Smartleaf President, Jerry Michael, from the WealthTech Today podcast.
Jerry Michael recently talked with Craig Iskowitz on his WealthTech Today podcast. Here’s an excerpt:
Craig: ...[An] interesting part of your system is that tax management number that you track. I remember you used to send out newsletters, and you say, here’s the amount of percentage tax saved across our entire client base. And you constantly push that out there. How does that help drive sales? Do prospective firms respond to that number?
Jerry: They do. We can measure the taxes saved for each individual client through active tax management. And the numbers are not small. We recently had a firm do a case study where they asked the question, "in what percentage of our accounts did we save more in taxes for the client than the client paid in fees?"
And the answer was 68% of the accounts, 90% on a dollar-weighted basis. Yes, it’s very nice to be able to tell clients “hey, by the way, I saved you more in taxes than I charged fees”, but that’s not the interesting bit. I mean, it’s nice, but I don’t think that’s the greatest value. The greatest value is that the firm is able to say “look, tax management is not my primary or even my secondary value proposition, but it is important, and it is one of the things I do, and here is documentation of the quality of our tax management.”
It is, I think, a useful and true signal that this firm has its act together. That not only do they do tax management, not only do they talk about tax management, which every firm does, but here is the documented evidence.
And these firms will, I think, slightly slyly, encourage clients who work with another firm to ask the other firms “how good is their tax management?”, with the expectation that the other firm probably will not be able to respond. And when our clients – the ones that are able to measure their wallet share through some sort of aggregation service – when they measure their wallet share, consistently, they’re winning.
And they attribute this to the taxes saved report as much as anything else, even though it’s not representative of the core service that they’re providing. But it's an easy point of comparison between them and another firm. It’s hard to compare, say financial planning – "am I going to be able to retire in 30 years?" Well ask me in 30 years – it's a harder thing to measure. But the quality of the tax management is measurable.
Craig: ...Looking at tax management, you mentioned something that I want to get you to define. I was talking about tax management, tax budgeting, and you mentioned real-time risk-adjusted gains deferral. Can you explain how you tackle that?
Jerry: Gains deferral means "not selling something motivated by your desire to avoid capital gains taxes". In some sense, that’s trivial, just don’t sell anything with an unrealized gain and, presto, you have gains deferral. But you’ll end up with a wreck of a portfolio, and that’s not OK. You can’t have super-concentrated positions or super-concentrated sectors or industries. So gains deferral is a constant balancing act. On the one hand, I don’t want to sell something that’s overweighted that has gains, because I don’t want to realize the gains. On the other hand, the darn thing is overweighted, and therefore, by definition of “overweighted”, I have more of it than I wanted, and therefore I am creating risk, possibly unnecessary risk, for the client. And that is a constant balancing act.
So when we say risk-aware gains deferral, it’s not something you do once and forget about it. In some sense, tax loss harvesting is much simpler – I have some algorithm that instructs me to sell something at what percentage of basis and then I do something for 31 days and then probably I go back, and then I’m kind of done.
Gains deferral can go on for months, years, decades, constantly making sure that you do not have an unbalanced portfolio. And that’s probably why I think you hear less about gains deferral. I think it’s because it’s fundamentally harder.
Craig: ...So how do you get advisors to trust the process and just let it go?
Jerry: First, you have to enable them to serve their clients. If they’re not getting a solution, a customized solution that really does fit their client’s needs, well, they shouldn’t trust the system. So it can’t be cookie cutter. The advisor still has to be involved with – I’ll use the slightly clunky phrase – designing a customized solution. That means, for example, we’re not going to have real estate because the client has outside holdings in real estate, they want a tobacco screen, they are withdrawing $5,000 a month and we have to prepare for that, we want tax sensitive transition, we want to transition over three years. All of those options still need to be there for the advisor. They’re not the ones implementing it, but they are the one making those choices.
So then beyond that, we have this automated system, this black box with blinking lights, why would the firm trust that? And the answer is you can show the data that demonstrates it does a very good job of managing those portfolios. When we implement our system, when people go from decentralized to centralized rebalancing, we see that, on average, the dispersion of accounts goes down by 60%, which perhaps you would expect. The slight surprise is the level of taxes goes down by 60%, as well. And you would think that’s impossible. Choose one or the other: do you want to have lower dispersion, or do you want to have lower taxes for the accounts? But you can actually have both. And that’s a measure of how much better this process is than having the advisors manage the portfolios themselves.
Read the full transcript below (transcript has been edited for brevity and clarity).
Craig: I’m very excited to introduce our next guest on the program. It is Jerry Michael, founder and CEO of Smartleaf. Jerry, welcome.
Jerry: It’s a pleasure to be here.
Craig: It’s always a pleasure to talk to you, my friend. It’s been a while. How’s everything going? Where are you calling in from?
Jerry: I’m calling in from Cambridge, Massachusetts.
Craig: Beautiful Cambridge. It’s still lovely this time of year, getting a little chilly though.
Jerry: Yeah, but it is actually beautiful weather. We tell ourselves in New England that it’s all worth it for the change of seasons, the beautiful fall colors. I’m not sure that’s actually true, but it’s what we tell ourselves.
Craig: And we tell ourselves the same thing here in the southern northeast in New Jersey. Not as bad but still we get the same issues, but we’re still happy here.
So thanks again for being here. Excited to talk to you about portfolio rebalancing. Trends in portfolio rebalancing is what we’re talking about today. Before we start, can you please give us a 30-second elevator pitch on Smartleaf?
Jerry: Smartleaf is an automated rebalancing system. Our purpose is to make portfolio personalization simple. If we’re doing our job, managing a direct index is literally as easy as managing an ETF, and I’m using “literally” in the way that your high school English teacher would approve. All forms of tax management: tax sensitive transition, ongoing tax loss harvesting, gains deferral – all should be easy. ESG: easy. A personalized portfolio should be no harder to manage than any other portfolio.
Craig: That’s a great pitch. I’m ready to buy. Where do I sign?
Jerry: Well, just give us a call.
Craig: I will do that. But let’s talk about trends. So, you’ve been in the business for quite some time. You started your company back in 1999, is that correct?
Jerry: That’s correct.
Craig: So you’ve seen everything around portfolio rebalancing, when it comes to the financial advisory business. What are some of the things you’re seeing now? What’s changing around portfolio rebalancing? Now that we’ve been so long in the industry, things are mature.
Jerry: Well, I think the deeper trend is a change in the value proposition of wealth advisory firms themselves, away from any value proposition that’s based on performance or product or trades, towards the idea of the advisor as a financial planner. We hear phrases like “lifetime financial coach”.
If you embrace that trend, then you realize that the investor-facing advisor is not adding value by taking on rebalancing themselves. The correct amount of time for an investor-facing advisor to spend rebalancing and trading portfolios is precisely zero.
That is the largest change, that people realize that zero is the right amount of time for advisors to spend trading and rebalancing portfolios.
Craig: That is very different than what many advisors think. They think today that they need to be involved, they need to be reviewing trades, they need to be checking that everything’s working properly. Why is that something they don’t need to do with your system?
Jerry: There’s two reasons why the advisor would be involved.
One is they’re talking to their client about whatever Cramer said on TV and whether they should buy or sell Tesla. Then obviously the advisor is involved.
But apart from that, there was a belief that if you wanted customization, if you wanted great tax management, then the advisor had to be the one rebalancing the portfolio. They’re, after all, the only ones who know what the individual client needs.People always recognized that centralized rebalancing would be efficient and scalable, but the belief was that it would be cookie cutter.
We’re here to say that that’s exactly backwards: that if you want to deliver very high levels of customization and very high levels of tax optimization, the only way to do it is to centralize the rebalancing and trading. That’s because centralization is the only way to automate it, and the only way to deliver customization and tax management, truly at a high level, even for individual accounts, is through automation. Otherwise, it’s all compromise all the way down.
Craig: Indeed, I mean, the kind of rebalancers we worked a lot with are the ones that require a lot of interaction. The trades need to be reviewed, or rather, the orders need to be reviewed before they become trades or they’re approved. There’s lots of finagling and fiddling with the trade order list. So how do you get advisors to trust the process and just let it go?
Jerry: First, you have to enable them to serve their clients. If they’re not getting a solution, a customized solution that really does fit their client’s needs, well, they shouldn’t trust the system. So it can’t be cookie cutter. The client-facing advisor still has to be involved with – I’ll use the slightly clunky phrase –designing a customized solution. That means, for example, we’re not going to have real estate because the client has outside holdings in real estate, they want a tobacco screen, they are withdrawing $5,000 a month and we have to prepare for that, we want tax sensitive transition, we want to transition over three years. All of those options still need to be there for the advisor. They’re not the ones implementing it, but they are the one making those choices.
So then beyond that, we have this automated system, this black box with blinking lights, why would the firm trust that? And the answer is you can show the data that demonstrates it does a very good job of managing those portfolios. When we implement our system, when people go from decentralized to centralized rebalancing, we see that, on average, the dispersion of accounts goes down by 60%, which perhaps you would expect. The slight surprise is the level of taxes goes down by 60%, as well. And you would think that’s impossible. Choose one or the other: do you want to have lower dispersion, or do you want to have lower taxes for the accounts? But you can actually have both. And that’s a measure of how much better this process is than having the advisors manage the portfolios themselves.
Craig: What do you mean precisely, when you say the level of taxes goes down by 60%, as well. Does that mean clients see a 60% reduction in their taxes?
Jerry: Correct, relative to what they were seeing before.
Craig: So the taxes that come from capital gains generated by the rebalancer is reduced by 60% by moving to a centralized process?
Jerry: Correct. Before this, the advisor wasn’t doing much tax loss harvesting; they were occasionally selling things short term before they went long term, etc. Most advisors were, after all, doing this largely using a manual process, and the more customized, the more tax optimized, the more manual it was. This meant they were doing it fitfully, when they had time, and they aren’t very good at trying to do this at scale.
Craig: I’ve been in the industry for 18 years, financial services for 30, but specifically wealth management 18 years, and we’re still trying to get advisors to realize their value add isn’t pushing the button, building models, and trading. But they still seem to think that, why do you think that is?
Jerry: Well, I’m not sure I’m the best person to comment on that because our clients are the clients who have identified that their future is a value proposition based on the advisor as a lifetime financial coach. As for why some advisors think otherwise, well, ultimately, it’s probably because of the customer. I think many investors still believe that their advisor is someone who’s going to be more of an expert at picking stocks, like the doctor is going to be better at picking which medicine I should get. Well my advisor, they’re going to be better at picking which stocks are going to win. That’s what a lot of investors, clients, are looking for. And some firms feel they have to accommodate that.
I’ve spoken to advisors who don't believe it at all, but they feel they have no choice. They have to pretend that they are great stock pickers, and sneak in financial planning and lifetime coaching when the client isn’t noticing. And I think it’s this hybrid approach is disappearing as firms decide they’re not going to pretend anymore that their main value is stock picking – they’re going to declare “this is who we are, and we will work with clients who want who we are”.
Craig: So you said the hybrid. So that’s in between the “do it yourselfers”, the ones who wanted to make all the trades themselves and do all the rebalancing themselves, and then you have the “set it and forget it” crowd, and then you have the middle where they’re sort of in between. What do the sort of in-between ones do and why is that the best of both worlds?
Jerry: Well, actually, let me go backwards. I was actually using the word hybrid in a rather unusual way. It was hybrid of value propositions: are we about financial planning, about being a lifetime financial coach? Or are we about being the smart person you talk to about individual trades? What we’re seeing disappear are the firms that are trying to be all things to all people, trying to do both of those. It’s those firms that are likely to be a hybrid in the sense that you were talking about, of having two separate rebalancing workflows. And I think firms realize this is no way to run a firm, to have two separate workflows. Pick one or the other.
Craig: Yeah, the firm that’s all things to all people is funny. I remember there was someone at a conference who made a fake video ad for an advisory firm and it said, “we are specialists, we focus on retirees, young people, middle aged people, people with kids, people without kids, divorcees, newlyweds”, because basically every advisor wants to serve all clients, they don’t realize they need to be in a niche.
Jerry: Interestingly, this is getting far afield, but because of the ability to be a virtual advisor – meaning you don’t have to have clients in your office, you can all be through zoom – we are seeing some hyper-specialized firms, for example, “we work with widowers.” I’m fascinated by this because they are clearly very focused on lifetime needs, the lifetime challenges that people who are going through these life changes have not been through before, but about which the advisor can develop great expertise. We’re seeing firms specialize not only in, say doctors, but specific branches of medicine. I personally find that to be a fascinating trend. It’s not directly related to what we’re doing, but it is consistent with the focus on being a lifetime financial coach.
Craig: I know there were a couple advisors, one that works with just retired airline pilots. Another one, of course we see the ones that just do doctors or lawyers or dentists or other trade specialties, but I did see one advisor who only works, who specializes in, bass fisherman. All he does. Do you have any bass fisherman type of rebalancing in your system at all? Where is the bass fisherman button, do you have that?
Jerry: We do not. And I do not know whether bass fishermen have specific needs in their portfolio. They might, I mean, part of customization is risk customization. You’re already exposed to certain industry risks so you shouldn’t have more in your portfolio and for all I know bass fishermen fall into that category. But the important point is, though I don’t know the details, I’m confident bass fishermen have different needs than other people.
Craig: Speaking differently, your product is different in one interesting way. A lot of firms use portfolio rebalancing, part of as you mentioned, to reduce taxes. And one of the things we’ll look at at Ezra Group is we spend a lot of time doing research on advanced technology. Portfolio rebalancing is one of our areas of expertise, and we’ve been following your product as well as all your competitors products for many years. And one thing we liked about your product was its tax management capabilities. One of the things you have, not only is a tax budget, limiting what the client wants to pay in taxes, how much needs to be offset. But you also have real time tracking of realized gains and losses and carrying forward losses. What was the impetus behind building that, and how much is that used by your clients?
Jerry: Let me go backwards. The purpose of the system was to make managing personalized portfolios simple. The origin was actually to automate managing direct indexing – that was actually the original conception. So, the focus was on automation, first and foremost. Tax management was always one of the advantages of owning a direct index, and ESG was another and so those were there as part of the system from day one.
And so while we think our tax management is very good, part of the quality of our tax management is actually just the automation. Turns out, more is more. If you can do year round tax loss harvesting, you’re going to do better than if you just have a workflow that does it in December.
People talk a lot about tax loss harvesting, and it is important. But actually gains deferral, risk-adjusted gains deferral, turns out in the long run to be an even more important thing, and it’s very hard to do unless you have an automated system.
We’ve never defined ourselves as a tax management software. It was just one component of personalization. Things like tax budgets, tax sensitive transitions – it all just sort of dropped out of “let’s take the standard parts of tax management and automate them”. We haven’t invented any new theory of tax management. There’s no fancy derivatives involved in what we do. It’s pretty standard – loss harvesting, gains deferral, all that sort of thing. What’s new is the level of automation.
Craig: It can do anything.
Jerry: I actually believe that even with one portfolio we could do better than most advisors who had just one job, which was just to manage one portfolio and they had eight hours to do it – I still think we could do a better job. But that’s not our client. The real issue is most people have more than one portfolio. So the real win is that you can do stuff that people already know how to do, but you can just do it for every portfolio.
Craig: Knowing that, and knowing that you can now scale your personalization, how is that helping firms deliver more value? Do you have any examples of how fast now firms can work when they’re using a portfolio rebalancing engine?
Jerry: Alright, so I’ll tell a story that goes back to March 2020, when the markets became very volatile and they sort of crashed. We had a client where the client-facing advisors, who spent no time trading portfolios, reached out in the month of March to the average client five times. At the same time, they rebalanced their entire book at least once and multiple accounts were traded more than once in a single month. And that was all done by one person working part time. So we’re illustrating two things here. One, the client-facing advisors have the time to reach out to clients five times because they’re not rebalancing the portfolio. But also, the firm had no trouble rebalancing 100% of their book in a day if they wanted to.
And at the end of the month, with the last phone call, they went back to the clients and said, “well, this was kind of a hard month, but this is what we did. It’s what we promised we would do. When there were loss harvesting opportunities in taxable accounts, we did loss harvesting. And by the way, the value of the tax loss harvesting we did in this month alone will reduce your tax bill by 3.5% of your portfolio value on average, if you’re able to use those tax losses against future gains,” which they were.
At the same time they were able to report that they were able to actually reduce overall dispersion. And the reason was, when you do tax loss harvesting you’re selling something and you have cash, and in our system, you’re not constrained to put that in cash or put that in SPY. It’s cash, and you can just use that cash to fill in the valleys of underweighted securities, sectors, and industries. So they used the tax loss harvesting not only to lower taxes, but, in the month of March – I think it was the most volatile period in something like 20 years – to actually reduce dispersion. That’s an example of the system doing what it’s supposed to do, both freeing up the advisors and making no problem for the firm to trade 100% of their accounts in a day.
Craig: Well, another interesting part of your system is that tax management number that you track. I remember you used to send out newsletters, and you say, here’s the amount of percentage tax saved across our entire client base. And you constantly push that out there. How does that help drive sales? Do prospective firms respond to that number?
Jerry: They do. We can measure the taxes saved for each individual client through active tax management. And the numbers are not small. We recently had a firm do a case study where they asked the question, “in what percentage of our accounts did we save more in taxes for the client than the client paid in fees?”
And the answer was 68% of the accounts, 90% on a dollar-weighted basis. Yes, it’s very nice to be able to tell clients “hey, by the way, I saved you more in taxes than I charged fees”, but that’s not the interesting bit. I mean, it’s nice, but I don’t think that’s the greatest value. The greatest value is that the firm is able to say “look, tax management is not my primary or even my secondary value proposition, but it is important, and it is one of the things I do, and here is documentation of the quality of our tax management.”
It is, I think, a useful and true signal that this firm has its act together. That not only do they do tax management, not only do they talk about tax management, which every firm does, but here is the documented evidence.
And these firms will, I think, slightly slyly, encourage clients who work with another firm to ask the other firms “how good is their tax management?”, with the expectation that the other firm probably will not be able to respond. And when our clients – the ones that are able to measure their wallet share through some sort of aggregation service – when they measure their wallet share, consistently, they’re winning.
And they attribute this to the taxes saved report as much as anything else, even though it’s not representative of the core service that they’re providing. But it's an easy point of comparison between them and another firm. It’s hard to compare, say financial planning – am I going to be able to retire in 30 years? Well ask me in 30 years – it's a harder thing to measure. But the quality of the tax management is measurable.
Craig: That is good. So just to reiterate, you said in one case study, one client, 68% of their clients saw tax results, basically reducing their capital gains taxes by more than the fees they are paying the advisor.
Jerry: Correct, and that’s actually inclusive of fees paid to third party models.
Craig: Even more impressive. Because it's harder to do.
Jerry: That’s harder to do. The answer to your earlier question is yes, our taxes saved report is valued. I think interestingly, the most important aspect of that value is simply that demonstration that this is an organization that is buttoned up.
Craig: We talked about, around the financial crisis, how advisors were trading their entire book, in one day or less. And so, how many advisors are currently trading on your platform, and how many accounts do you currently process?
Jerry: We have about $50 billion managed through the platform, about 350,000 accounts. I do not know offhand how many advisors that is. I should probably find that out.1
Craig: Could be useful, we love stats. Do you have any kind of statistics that would be useful for getting firms that may not be familiar with you an understanding of where you fit in the market?
Jerry: I can go through a list of some of our clients: the investment management unit of SEI; Apex Clearing has rebalancing functionality that is powered by us; there is a new firm on the market, Altruist, their rebalancing is powered by us; Altium is an RIA that recently joined Hightower, and I think they’ve been anointed by Hightower to be the direct index provider to the Hightower family of firms; AdvisorEngine, another firm where the rebalancing component is powered by us. There’s then a slew of banks and other RIAs that are direct clients.
Craig: That’s great. I was just writing that down. You had a lot of clients in the banking space for many years as sort of one of your primary client bases, but you’ve since expanded into the RIA space.
Jerry: That is correct.
Craig: And how did that transition go?
Jerry: Well, there’s a couple of things. Banks put a greater emphasis on the holistic management of the account and less on trades, that’s historically been true. And so there was a natural cultural fit with banks. They also tend to be larger, and at the time we mostly served larger organizations. To serve RIAs, we have launched a sub-advisory service, where we will do the rebalancing and trading for them. The investor and the client-facing advisors’ experiences are the same. The Investment Policy Committee’s experience is the same, but we will take over the role of the one - or two - person rebalancing group. We’ve also integrated directly with some custodians – currently Fidelity and Schwab – which makes it easier for RIAs. There’s no software integration, so it makes it possible for us to serve smaller firms. And that means that it opens up more of the RIA space.
Craig: What’s the breakdown of your clients from the enterprise space to the independent RIA space?
Jerry: The TAMPs and banks are still the majority. The fastest growing segment is RIAs. Which is probably the story of the industry.
Craig: Yes, it’s been. I think that story’s been the same for 20 years, now that I think about it. Looking at tax management, you mentioned something that I want to get you to define. I was talking about tax management, tax budgeting, and you mentioned real-time risk-adjusted gains deferral. Can you explain how you tackle that?
Jerry: Gains deferral means “not selling something motivated by your desire to avoid capital gains taxes”. In some sense, that’s trivial, just don’t sell anything with an unrealized gain and, presto, you have gains deferral. But you’ll end up with a wreck of a portfolio, and that’s not OK. You can’t have super-concentrated positions or super-concentrated sectors or industries. So gains deferral is a constant balancing act. On the one hand, I don’t want to sell something that’s overweighted that has gains, because I don’t want to realize the gains. On the other hand, the darn thing is overweighted, and therefore, by definition of “overweighted”, I have more of it than I wanted, and therefore I am creating risk, possibly unnecessary risk, for the client. And that is a constant balancing act.
So when we say risk-aware gains deferral, is it’s not something you do once and forget about it. In some sense, tax loss harvesting is much simpler – I have some algorithm that instructs me to sell something at what percentage of basis and then I do something for 31 days and then probably I go back, and then I’m kind of done.
Gains deferral can go on for months, years, decades, constantly making sure that you do not have an unbalanced portfolio. And that’s probably why I think you hear less about gains deferral. I think it’s because it’s fundamentally harder.
Craig: Knowing when something’s gonna go down.
Jerry: Well, loss harvesting is fundamentally easier because I’m going to do something and most likely I’m done in 31 days. Loss harvesting done well is not done by mechanical rules. But you can do a decent job of loss harvesting by just following some mechanical rules. But you can’t do a decent job of gains deferral using mechanical rules.
Craig: So why can’t you do that? What is so complicated about tax loss harvesting that you can’t just do it by mechanical rules?
Jerry: Actually, loss harvesting you can. I mean, I don’t think you can do a great job of tax loss harvesting by using a mechanical rule – by mechanical rule I mean something like “I will sell any tax lot at 80% of basis, I will then buy SPY for 31 days and then I will go backwards.” That’s a simple rule. – It'll do an okay job. It won’t do a great job.
However, gains deferral is harder. If this mutual fund is overweighted, well, is that good or bad? You can’t have a simple rule of “no a mutual fund can be overweighted by 10%.” It’s not good enough. Can your large cap mutual fund that’s overweighted by 10% be a decent substitute for the mid cap, so maybe you can underweight the mid cap? Well, plausibly. But you won’t get that through any sort of mechanical rule.
Craig: You’re talking about wash sale rules, mechanical wash sale, where if I sell something, automatically buy this other thing until 31 days and sell it and buy the other one back.
Jerry: With loss harvesting, you could do something not great, but you’ll get something from it. I don’t know of any way to do long-term, a possibly decades-long approach to gains deferral, holding onto overweighted positions with large capital gains, and do that well by any sort of simple rules and call it a day.
The interesting thing is, the individual components of tax management, they’re well known. They’re not new. But doing it well, automating it, doing it at scale, that is new’.
Craig: Jerry we’ve run out of time, you’ve said it all. Could you please tell everyone listening where they can find more information about Smartleaf?
Jerry: You can find more information on our website at Smartleaf.com.
Craig: Jerry, thanks so much for being on the program. I really appreciate it.
Jerry: Craig, thank you so very much.
1 There are currently 1200 advisors on our system, not including advisors of our TAMP clients.
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