High-Tech Investing

From index replication to automated tax-loss harvesting, from subscribing to portfolio management to customized SRI investing, there’s a lot of technological change in the investing space.

David Armstrong, of Monument Wealth Management in Alexandria, VA, recently attracted a new $30 million client account away from a local brokerage office.  “He had previously selected them because they sold him on their team’s ability to pick best-of-breed money managers,” Armstrong says.  “But a year ago, he came back to us and said: We’d like to talk to you again,” he adds.  How would you propose to manage our assets?  We talked about how hard it is to identify managers who are going to outperform the indexes, and then I said: why not just BE the index, and have your alpha created by tax-loss harvesting and rebalancing?”

If you think that means investing in index funds or ETFs, think again.  Armstrong’s high-level asset allocation was 50% S&P 500, 30% EAFE and 20% emerging markets—which, he says, would take you pretty close to the Morgan Stanley All-Country World Index.  “We obviously adjust that on a client-by-client basis, based on their risk tolerance,” he adds.  “But this is usually the starting point and what we used for this client.”

Then, using Astro, an add-on service to the portfolio accounting platform at Orion Advisor Services (https://www.orionadvisor.com), Armstrong will select a subset of individual securities representing each of the three indices.  “I’ll start by asking the system: What do I have to buy to replicate the performance of the EAFE or EEM or S&P index?” he says.  “Of course, with the S&P 500, the software will tell me the best replication approach is to buy all 500 securities.”

Since most clients don’t want to own every company in the S&P index, Armstrong will start putting on constraints.  What if the limit is 350 securities?  300?  150?  “What we tend to find out,” says Armstrong, “is that you generally need only 300 individual holdings to replicate the factors that drive the performance of the S&P 500.  Let’s say there are 10 banks in the index,” he adds.  “The program will say: instead of investing in all ten banks in proportion to their cap weight in the index, let’s put that cap weight into two of those banks.”

As you reduce the number of securities—down to, say, 150—you increase the tracking error.  “We talk with clients about what they’re comfortable with,” says Armstrong.  “Some will say, if the S&P 500 is up 10% for the year and my portfolio is up 9.5% or 10.5%, I can deal with that variation around the index return.  But the times I’ve optimized a portfolio, we’ve found that adding 50 more securities to 300 doesn’t impact the tracking error very much, whereas you do get some impact if you take away 50.”

In this case, the client signed off on the low tracking error, and Armstrong set about generating the tangible alpha he had promised.  Every month, at the beginning of the month, he sets Astro to look at how the changes in the markets have shifted his holdings, and which securities are out of tolerance and which are sitting on tax losses.  The software is capable of looking at this down to the lot level for each holding. 

“I might find 50 stocks that are trading at a cost-basis loss in the account,” says Armstrong.  “So I ask the system, if I sell those, what other stocks could I buy that would behave very similarly to those stocks?  It will say, if you want to keep your tracking error where it is, and you want to book those losses, then sell this one bank and replace it with this other one, and so on.  I harvest losses, but am replacing those positions with securities which, theoretically, will behave in exactly the same fashion that the other ones did.”

The bottom line here, is that Armstrong believes that advisors who are still trying to identify mutual funds that will outperform the index will increasingly face an uphill battle trying to convince clients of their value.  Providing a customized tax overlay on zero-cost replicated indices, and taking advantage of many more rebalancing opportunities in portfolios with many more individual randomly moving parts, represents a much better value story. 

In addition, Armstrong says, his approach allows for tax-efficient migration from what the client currently owns to the asset allocation he proposes—he stays within a “tax budget” and harvests losses to offset gains.  It makes it easier to accommodate a significant legacy holding that clients don’t want to sell; Astro simply optimizes around that holding.  Armstrong can identify holdings that have low basis and accrue in value as the perfect vehicle for charitable contributions should clients be so inclined.  And some of those holdings can be held, untouched, until the client passes away, generating more advisor alpha by giving the heirs a step-up in basis. 

Yes, you can do that with ETFs and mutual funds.  But with many hundreds of holdings in his typical portfolios, Armstrong can provide a more granular level of tax optimization.

“You’re starting to see investors becoming more familiar with the indexing opportunities and ETFs out there,” says Armstrong.  “They’re asking: Why am I paying you X percentage to manage my money when I can simply buy the index myself?  It’s a smart question, and I think people who don’t have an answer for that are going to have a tough time winning the smartest clients.  On the asset management side of your services,” he adds, “I think it is becoming increasingly difficult to distinguish your value proposition.  You’re going to have to rely on something more than just saying: I manage money better than the other person.”

The next round of disruption

At the recent Inside ETFs conference in Hollywood, FL, there were a number of sessions where a panel of distinguished money managers was asked a reasonable question.  ETFs have disrupted the traditional mutual fund industry; indeed, one panelist noted that since 2009, mutual funds have suffered $92 billion in outflows, while ETFs gained $2.3 trillion in new investment. 

The obvious question: what, in turn, could disrupt ETFs in the not-too-distant future?  What would cost even less and potentially provide greater value to the end client?

The answer that emerged, particularly for taxable portfolios, was variously called “direct indexing” or “index replication”—defined very simply as the advisor doing what Armstrong does: buying the stocks in the underlying index or some combination of them that would represent the index’s performance. 

Not only does this do away with the (admittedly low) ETF expense ratio, but it also allows advisory firms to provide a customized tax overlay for each client.  And the greater number of individual securities in a client’s portfolio should (theoretically) offer greater opportunities for tax-loss harvesting and greater advisor alpha from rebalancing. 

For estate planning, certain low basis positions across a broader portfolio can be held onto so the step-up in basis can be conferred to heirs.  More sophisticated advisors would be able to harvest gains to fill up the tax bracket that clients are already in.  Perhaps more important than all of these factors is the opportunity for advisors to customize a growing number of client SRI preferences by excluding certain companies or sectors from their portfolios, or including companies that affirmatively embrace themes like board/management diversity, clean energy, clean water or lifting global poverty.

In the past, of course, capturing advisor alpha across hundreds or even thousands of individual holdings for each client would have been easy to say and very difficult to accomplish using pen and paper or spreadsheets.  But now, with AdvisorPeak, iRebal, Orion Advisor Services, Tamarac, Total Rebalance Expert and a host of other sophisticated tech solutions, advisors can automatically locate tax-loss harvesting opportunities for each client in seconds.  Platforms like Adhesion, Foliofn, Envestnet, SEI, E*TRADE Advisor Services and others will automate the tax/rebalancing overlay by checking daily or weekly for portfolios that are out of tolerance both by asset allocation and by individual security tax loss.  They’ll also help you build index replication portfolios around legacy holdings that the client doesn’t want to sell, and map out tax-efficient ways to reduce that position if it represents an uncomfortable departure from normal diversification.

And if you’re a proponent of active asset management, there’s a remarkable number of new “model marketplaces” which provide the actual holdings of mutual fund managers—giving advisors the benefit of a manager’s insights and research while at the same time allowing them to provide customized tax management for each client.  As you’ll see in a moment, these model marketplaces currently offer a wide variety of services, but only some of them provide individual security holdings.  If index replication catches on, you can expect the active management universe to follow into the realm that could disrupt ETFs.

Welcome to the brave new world of high-tech investing.

Legacy positions and tax budgets

One firm that is following the evolution of model marketplaces very closely is Deighan Wealth Advisors in Bangor, ME.  Jenifer Butler, the firm’s Chief Investment Officer, is in charge of managing individual equities in the U.S. large cap allocation for clients with more than $1 million in assets to manage.  “Our clients were in individual equities when we started in the business,” she says.  “We had some clients with pretty low-cost legacy positions who were reluctant to let them go, whether it was an emotional attachment or for tax reasons.  As mutual funds and ETFs became more popular and transparent, we started adding them into client portfolios,” she adds.  “But we continued to maintain the U.S. large cap equity portion of it, because that is really what clients preferred.  They liked knowing the stories of the companies and they didn’t necessarily trust or understand funds.”

Unlike Armstrong, Deighan Wealth Advisors is actively managing the composition of these portfolios, using research from Bloomberg, JPMorgan, BlackRock, Northern Trust and S&P, screening for coverage ratios, margins and long-term results, then doing a deeper dive into whatever securities pass the screens, looking at price to earnings, price to sales, price to book, price to cash flow and free cash flow.  “You could think of it as a GARP approach: growth at a reasonable price,” says Butler.  “But we also value Warren Buffett’s philosophy.”  Most clients will own 20-25 large cap positions.

This approach, Butler explains, has helped the firm trim down legacy positions from new clients; the client’s CPA will provide a tax budget, and that, plus harvesting losses to offset gains, will gradually allow the portfolio to become more diversified.  The firm uses Tamarac (https://www.tamaracinc.com/) for tax loss evaluations and rebalancing. 

“It is,” Butler admits, “pretty time-consuming.”

The chore has been lessened somewhat by outsourcing some of the work on proxy voting on behalf of clients—it is now organized by Chicago Clearing Corp (https://www.chicagoclearing.com/), which the firm uses to handle receipts from class-action lawsuits.  “They do securities litigation work, and you give them each client’s transactional history, what the holdings are, through a direct link from Schwab,” says Butler.  “For 10% of the proceeds of any litigation, they will do all the legwork.”

Penny Marchand, of Cambridge Financial Group in Tucson, AZ, takes a somewhat less labor-intensive approach.  “If somebody has three or four million dollars in a brokerage account, then it’s a perfect opportunity to put a million or two in a blue chip stock index with individual securities,” she says.  But the portfolio is actually managed by Asset Dedication (https://www.assetdedication.com), which proposes the securities that will go into the blue chip index, and the advisor makes the selection.  “Whenever we have a down market,” adds Marchand, “they list all the accounts where there are more losses than we specified as a tolerance.  We just go yes, yes, yes, no yes, and they take care of the trading.”

The emphasis is on tax management.  “When we get ready to implement the portfolio, we look at the capital gains,” says Marchand.  “How much can we take without changing tax brackets?  If they’re Medicare-eligible, you have to really watch how much capital gains you generate for someone, because you don’t want to kick them into a different premium level.” 

The firm looks for appreciated securities to move over to donor-advised funds (thus avoiding capital gains taxes) and for direct gifting.

Marchand says that her firm’s primary value is financial planning, but she also believes that the asset management should be adding value to the client.  “Investing isn’t that hard the way most people are doing it,” she says; “it’s just indexes, keep diversified, keep your costs low.  If I were just doing investments,” she adds, “I’d be really worried about that.”

Model marketplaces

If the increasingly sophisticated tax management/rebalancing software capabilities are luring the more adventurous advisors into individual security management and index replication, a sudden explosion of model marketplaces seems likely to turn the idea into a trend.  The sheer number of new entrants is confusing, but you can organize them in your mind in different categories.  When you subscribe to the most basic marketplaces—including the new TD Ameritrade Model Market Center (https://www.tdainstitutional.com/offerings/investing-wealth-management/model-market-center.html), Morningstar’s Model Marketplace (https://medium.com/morningstar-office/morningstars-model-marketplace-32123cb1c524) and the Riskalyze Partner Store (https://www.riskalyze.com/partner-store)—the marketplaces are recommending asset allocations of funds or ETFs, and you’re doing the trading yourself.  The models tend to be fund of fund models like BlackRock and Morningstar (two frequent platform members), where a mutual fund or outside provider is recommending a mix of funds or in-house ETFs.  Typically, there is no subscription fee, but you pay the underlying fund or ETF expense ratios. 

There are some interesting tweaks at this level; for instance, Riskalyze allows advisors to post their own fund models, and get paid a subscription fee from any advisory firm that wants to outsource its fund research to them.  The Partner Store also includes some out-of-the-box management options, such as Swan Defined Risk, which uses options strategies inside of their mutual funds, and in the models it runs—for an annual fee north of 100 basis points. 

Advisors with a more hands-on approach can subscribe to LikeFolio, which will comb through the Twitter data streams and put together sentiment analyses of publicly-traded companies, with buy and sell recommendations that change with the market sentiment.  Advisors can approve proposed changes to the portfolio, or not.

The most advanced of the basic marketplaces are closely integrated with rebalancing engines: Morningstar with Total Rebalance Expert, TD Ameritrade with iRebal.  But do people really want somebody to give them an allocation of ETFs or funds when they’ve been doing that for years?  “From our perspective, you get a fair amount of value being delivered to the advisor from these strategic asset allocation models,” says Dermot O’Mahony, Morningstar’s head of software products. “If they need to get into the more complex type of strategies, we have our own at Morningstar where we run our own actively managed strategies on top of that.” 

But he adds that Morningstar plans to offer active manager subscriptions in the future, when the underlying platform has been further developed.  “We wanted to get our model marketplace into the market, and we didn’t want to wait until our own internal processes had been developed all the way to that level,” says O’Mahony.  “From a purely technical perspective,” he adds, “it’s a lot easier when you’re not moving money around and we are not charging fees to the individual investors’ accounts and then moving those monies back to asset managers.”

The most sophisticated version of this model marketplace concept are the platforms that take the service right down to individual securities and handle the buying and selling for you.  This list includes Adhesion eXchange ((https://exchange.adhesionwealth.com/), Folio Institutional’s Model Manager Exchange (https://info.folioinstitutional.com/model-management), E*TRADE Advisor Services Money Manager X-Change (https://www.trustamerica.com/ria-services/money-manager-x-change), Advent’s adjunct providers SMArtX (http://www.smartx.us/) and SMArtXChange (https://smartxadvisory.com/) and the Orion Communities Model Marketplace (https://www.orionadvisor.com/communities).  When you work with these platforms, the platform is making the trades and, of course, tracking the assets.  That’s important, because it allows fund managers to charge a basis point fee and keep track of which advisory firm is managing how many assets.  The subscription costs range from 25 basis points on the low end to 50 on the high end, but seem to be lower than the expense ratios of similar funds managed by the same firm.

At their best, the platforms will let you specify rebalancing and tax-loss harvesting tolerances on all securities, which can be different for each type of security or asset class (for instance, a wider rebalancing band on small cap stocks than large caps), alert you to all client portfolios that breached these tolerances during the previous trading day, and automatically execute any transactions that you approve. 

The best way to think about the model is as a do-it-yourself TAMP, where the advisor has more control over everything that affects the individual client.  Indeed, when Orion decided to enter the model marketplace arena, it purchased a prominent TAMP: FTJ FundChoice, with $13 billion on the platform, most of it from dually-registered advisors.  The Orion Communities Model Marketplace doesn’t offer individual securities or fund manager subscriptions yet (it fits more in the non-platform category at the moment), but when FTJ FundChoice is integrated with Orion’s Eclipse trading platform sometime this summer, advisors will be able to select index replication strategies and have them implemented automatically, subscribe to active management mutual fund models vetted by Rocaton Investment Advisors (formerly the Rogers Casey Group), and subscribe to portfolio models created by other financial planning firms.

The Eclipse software will automatically identify tax-loss opportunities and recommend rebalancing whenever a client portfolio exceeds tolerances that advisors set themselves.  “When a manager proposes a trade, the software will look at these factors before the execution occurs,” says Dean Cook, former president of FTJ FundChoice who is spearheading the Model Marketplace buildout.  “It will exclude trading any positions that the advisor has put a fence around.  And advisors will be able to approve the trades.”

Cook says that the model marketplace concept sits nicely between the TAMP and the do-it-yourself portfolio management option.  “The TAMP does everything for people: the trading, the portfolio accounting, all of that,” he says.  “And on the other end of the spectrum, you have advisors that do everything themselves.  Eric [Clarke] and I want to create an environment where advisors can live in the middle, where an advisor can outsource a lot of labor-intensive things without losing control,” and, of course, be in a better position to provide customized service that a fund or ETF can’t, due to its structure, deliver to clients.

Right now, you can’t get security-level services from the model marketplaces from a custodian—with one exception.  E*TRADE Advisor Services’ Money Manager X-Change platform now has 13 managers using individual securities, including Earth Equity, Clearbridge Investments, Horizon Investments and Manning & Napier, who charge “strategist fees” ranging from free to 1% of AUM.  The custodian provides tax harvesting and rebalancing software at the account level, which also alerts you if a wash sale is being contemplated.  You can transfer in a client’s existing portfolio and do tax-aware migration to your proposed portfolio or subscription models,

Marketplace meets platform

How do these more comprehensive model marketplaces work in real life?  Scott Heichel, Chief Investment Officer of Pinnacle Wealth Planning Services in Columbus, OH, says that his firm doesn’t start introducing individual securities into taxable accounts until the client is in the $3-5 million AUM range.  He uses the Adhesion platform, and subscribes to a variety of mutual fund models: Lazard, Zach’s, ClearRidge for large cap, Great Lakes for small cap, WCM International when the allocation ventures overseas. 

“We have ten managers that we’ve selected that would take the place of a mutual fund if the situation and client size warrants that,” Heichel explains, adding that Adhesion does the trades and the clients are all owning individual securities recommended by the managers through the subscription fee arrangement.

Heichel says that many clients will come in with legacy assets, which triggers a normalization process.  “Initially, we leave it as part of the allocation,” he says.  “We’ll look at the asset and make sure that it meets at least some of our criteria.”  Using the free version of TD Ameritrade Institutional’s iRebal program, Heichel and his team will get a proposed trade that is within the client’s specified tax budget.  “Then we go on Adhesion’s platform and tell them to make the trade,” he says, adding that sometimes that legacy position, if there are significant embedded capital gains, becomes an excellent vehicle for charitable giving.

On an ongoing basis, Adhesion’s algorithms will look for tax-loss harvesting opportunities, and every month they will look at whether any of the allocations are out of tolerances that Heichel sets for each individual asset class. 

The tolerance can also specify that no short-term gains will be taken when rebalancing, but Heichel will normally double-check every recommendation and approve the sales and purchases.  One thing he looks for is one manager selling the same stock that another is buying, but he’s found that Adhesion’s software is also checking for this.  “Whenever that happens, Adhesion will automatically take the stock that is being sold and send it over to the part of the portfolio where it was being purchased,” says Heichel.

What does the portfolio buy whenever Adhesion is harvesting a loss—to reduce tracking error?  “If it is in a stock with a large cap value mandate, they will sell the stock and buy a large cap value ETF that tracks the same index,” says Heichel.  “The software does a good job of telling us to buy back 31 days later and sell the ETF.” 

The result is very low tracking error whenever the portfolio deviates from the fund manager’s model.

Harvesting gains, of course, is easier because there is no wash-sale rule.  “If a client happens to be in a low tax bracket in any individual year, you can set the system to harvest $50,000 in gains, and Adhesion will tell you what securities it would be most optimal to sell,” Heichel explains.  “We do that a lot, filling up tax brackets.”

How does he pay the fund manager’s subscription fee, the platform’s cost and take out his own quarterly fee?  “Adhesion is considered the manager, rather than Zack’s or ClearRidge,” Heichel explains, “because Adhesion is the one that is actually responsible for placing all the trades.  So they pull one fee, which is what the manager fee is, and they split that manager fee with the manager.”  Heichel notes that Adhesion also offers an index replication option for 12 basis points, where there obviously is no manager subscription fee.  Heichel signed up for Adhesion’s asset-based pricing, which pays for all the ticket charges.

What’s the big picture advantage to owning individual securities under the subscription model?  One value-add is the best thinking of the managers you’re subscribing to, assuming you believe they can add value.  But Heichel says the individualized tax overlay is where the real value lies.  “It gives you a lot more opportunity to cherry-pick stocks with low basis or high basis, which you cannot do with an ETF,” he says.  “Even in a great year, there are still some sectors and some individual stocks that go down, and there is nothing you can do about that if you own SPY.  You’re going to be up, which is a good thing.  But the way we do it, even though the index is up 30%, there are still some socks that we can sell for a loss in that year.”

But isn’t the arrangement somewhat complex for clients?  “Adhesion allows you to put all six or seven of your money managers into a single account, one single 1099,” says Heichel.  “TDA does a pretty good job of making sure the various disclosures and stuff the companies send out is in electronic format if you ask them to,” he adds, “and you can allow the manager to make the proxy voting decisions for you if they prefer it that way.  I tell clients this is the ultimate form of transparency,” Heichel says.  “You’re going to look at the statement, and you’ll see our fee, the manager’s fee, TDAI’s fee.  You’ll see all the stocks in your account, and all the trades that were made in that time period.  It helps them understand what’s going on a little better.”

Folio investing

When I asked Inside Information readers whether any of them were creating individual stock portfolios, and inferred that this was kind of a new idea, I received several messages from advisors who have been using the Foliofn platform and have been doing many of the newfangled things I was talking about for at least 20 years.  Foliofn’s retail side allows advisors and individuals to create “folios” of up to 120 listed securities of any sort—stocks, mutual funds, ETFs—and then create portfolio allocations using these folios like building blocks or legos.  All it costs is a modest subscription fee, and since Foliofn executes omnibus block trades twice a day, there are no additional fees for executing the trades.

Like Riskalyze, Foliofn allows advisors to post their own models, but most consumers and advisors will select from a very wide spectrum of pre-built folios that are designed to capture the returns of everything from any single Central American country to the global oil industry.  Unlike everybody else on this list, the Folio platform allows for fractional shares, which means that if you have a client with a $50,000 portfolio, you can allocate 3% of it to Berkshire-Hathaway.

Folio Institutional was one of the first into the model marketplace arena with Model Manager Exchange.  MMX, as it is referred to, will do just about anything that Adhesion and Money Manager X-Change will do in terms of tax management: let you subscribe to active fund manager models with security-level detail, approve or veto proposed trades, automatically receive alerts when a client is out of allocation tolerance or there are tax losses to harvest, and generally get the benefit of fund management with an individualized client tax management overlay.  The ability to use fractional shares brings the service down to the level of smaller clients.

Folio Institutional has also been instrumental in bringing another advantage of model marketplaces and individual security management to advisors: the ability to customize portfolios according to client SRI or ESG preferences.  Now that surveys say 40% of all clients and up to 80% of all millennials want some form of socially-responsible screening in their portfolios, the ability to custom-remove single stocks or groups of stocks and still replicate indices would seem to be one of the key trends of the model marketplace concept.

Gary Matthews, of SRI Investing, LLC in New York City, uses a patented feature of Folio Institutional called the “tax football” to optimize the tax results of the trades that he or the managers might be making.  “Typically, there are a lot of trades in these accounts, especially when they’re triggered by either a periodic rebalance or significant inflows or outflows of cash,” he says.  “The tax football allows us to review the trades and optimize the tax situation.”

But he actually views the biggest advantage as the ability to customize what before was somewhat rigid: the ESG overlay of individual client portfolios.  “We sit down with clients and design their portfolios with the social and environmental characteristics that they prefer,” he says.  Sometimes a client meeting will add another bit of customization.  “I’ll be reviewing the portfolio with a client,” Matthews explains, “and suddenly he’ll look up and say: Why is Merck in there?  I can’t believe Merck is in there.  So we’ll sell that holding and reoptimize around it.”

Matthews is currently “subscribed” to folios managed ty Advisor Partners, Trillium, Boston Common and Green Alpha—all respected names in the SRI world.  As with the other model marketplace systems, the managers are paid an asset-based fee, which is shared with Folio and First Affirmative Financial Network (https://www.firstaffirmative.com/) in Colorado Springs, CO, which maintains what might be described as a fee-only SRI broker-dealer that serves as consultant, platform and aggregator of socially responsible investing options. 

Matthews’ clients are able to see their performance through Folio’s platform at the account level, at the folio level and with each individual security—and see the performance compared to an index.  “SRI investors are not always as concerned about performance as other investors,” says Matthews.  “But when I DO talk about performance with clients, the Folio site is a really nice way to do that.  And First Affirmative produces the quarterly reports that most advisors give to clients, which provide performance net of fees.”

First Affirmative is now a subsidiary of Folio Institutional.  First Affirmative president and founder George Gay says that currently 350 advisors use FAFN mutual funds or models on the Folio platform, all of them using some form or another of an ESG due diligence process. 

“The way we see it, SRI is the value-set or the principles that clients want to organize their portfolios around, and ESG is the research into the principles,” Gay says.  The newest trends, he says, are fossil-fuel-free and animal cruelty, and the firm now has positive screen models on the Folio platform that invest in firms whose social impact is clean water, healthy food, improvement of the climate, elimination of waste, alleviation of poverty, social justice, peace and security, and human health.

The Folio Institutional platform, Gay says, allows additional customized screens, which was not easy to accomplish before.  “In addition to the screening that the model manager has already done,” he says, “you’ll have clients who say: could we also take this particular company out? We had one just recently,” he adds, “who said: I don’t want any insurance companies.” 

The problem, of course, is figuring out how an insurance-less portfolio will track against whatever benchmark had been set for the original portfolio.  “We know that less diversification will raise the level of risk in most portfolios,” says Gay.  “The research shows that, on a risk-adjusted basis, those traditional screens really don’t affect long-term performance very much.”  But of course nobody has researched the millions of potential exclusions that socially-conscious investors might want to add—which now, for the first time, CAN be added quickly and easily.

Customized SRI

To accommodate that growing group of one-off SRI investors, Gay is working on the next iteration of SRI investing—which Folio and First Affirmative are co-developing—called the Digital Wealth Services platform. 

“The goal is to allow every advisor to work with a much larger number of exclusions and inclusions and still deliver a portfolio that has very tight risk expectations and portfolio construction constraints,” says Gay  The optimizer will sort through the exclusion screens on a portfolio, and the one-off screens, and then pull in historical return and volatility data for the rest of the marketplace and identify securities and weightings which will fit the target risk and return goals.

None of this would affect the ability to provide a customized tax overlay or work within a capital gains recognition budget.  But it would, for the first time, give Folio and First Affirmative users the ability to identify replacement securities when there is a tax-harvesting sale, which would avoid tracking error to the extent possible. 

Total cost: 25-40 basis points for the platform, on top of 35 basis points for the model managers.

ESG outsourcing

Digital Wealth Services sounds pretty well-automated, but if advisors want to offload the SRI asset management completely, they can turn to Horizons Sustainable Financial Services (http://horizonssfs.com/) in Santa Fe, NM, which has a new offering managed by First Affirmative’s former Vice President for Investment Services: Johann Klaassen.  Klaassen is a bit of an unusual figure in the money management world; he may be the only Ph.D. in ethics and social philosophy who also creates customized folios using 55 models on the Folio Institutional platform. 

Advisors who are not familiar with the SRI world, or who have one-off situations where a client wants SRI screens, can subcontract with Horizons to have those preferences reflected in the portfolio.  And as an added service, Klaassen will vote the proxies for all 700-900 individual securities that might be included in the mix.  “We use a variety of proxy monitoring services and participate in some of the shareholder advocacy work,” he says.  “Instead of just voting, we’re also initiating or participating in legal action.”

Klaassen says that the fractional share concept really helps with diversification, particularly when a number of stocks are being excluded from client portfolios.  “I can take even a small account and put it in eight or ten different folios,” he says.  “Some of the money will go to Trillium, and Pax World, and it might include a fractional share of Google, 0.01865 of a share—without having to worry about owning whole shares or whole lots.” 

It is not uncommon, he says, for clients to want a layer of screens and then to want customized exclusions.  “For example,” says Klaassen, “one of the managers has a couple of small positions in some of the smaller oil and natural gas companies, and my client told me he didn’t want to hold those.  So I excluded them, and that gets prorated among the other holdings.”

I suspect that this point, most readers are so far from their normal client investment experience that they can hardly see it from here—and that’s exactly the point.  My experience tells me that whenever it becomes possible to offer additional services, clients are going to want them, some advisors are going to provide them, some tech companies are going to make that easier, and eventually the entire profession has shifted to something more sophisticated and beneficial.  That seems to be happening—rapidly—in the asset management world.  New investment technology is here to stay, and will keep growing as more advisors begin pinning their portfolio management value on advisor alpha.

The deep thinkers in the ETF world already believe that the next disruptor will be index replication, and it can hardly be a coincidence that the most advanced new model marketplaces allow for individual security holdings, while the others are moving in that direction.  Meanwhile, the tax management and rebalancing software is becoming more sophisticated and easy to use.

For clients, the endgame appears to be an individualized tax management overlay across, not ETFs or funds, but the individual components that they invest in.  This provides a much richer opportunity to harvest tax losses, and potentially more advisor alpha when all those positions are opportunistically rebalanced through the normal white noise of the markets. 

The model marketplaces mean that advisors will be able to gain these new capabilities without having to totally give up on active management.

And as the client base moves into a generation that might be 80% in favor of SRI overlays on their portfolios, having more control over the individual elements of a client portfolio, being able to include and exclude on a one-off basis, becomes increasingly important.

Let me be clear: I do not expect every advisor reading this to rush out and embrace all of these changes to traditional asset management.  But I do think it’s interesting that all the platform providers are rushing out to create the capabilities for you to do so.  What do they know that the rest of the marketplace does not?