The Compound and Friends - Custom Indexing is a Tidal Wave (with Patrick O'Shaughnessy)

Episode Date: December 25, 2020

On the final episode of The Compound Show in 2020, Josh talks to Patrick O'Shaughnessy, CEO of O'Shaughnessy Asset Management about the wildly successful launch of his firm's proprietary custom indexing platform, Canvas. Please see the disclaimer below. If you're enjoying the show, the best way to support it is to leave a rating or review: https://podcasts.apple.com/us/podcast/the-compound-show-with-downtown-josh-brown/id1456467014 The opinions, viewpoints and analyses expressed herein are solely those of Patrick O’Shaughnessy of O’Shaughnessy Asset Management, LLC and should not be regarded as opinions or advisory services provided by Ritholtz Wealth Management or performance returns of any Ritholtz Wealth Management Investments client. The opinions expressed in this program are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. O’Shaughnessy Asset Management LLC is a sub advisor and independent money manager for Ritholtz Wealth Management. CANVAS® is a registered trademark of O’Shaughnessy Asset Management LLC. Ritholtz Wealth Management manages its clients’ accounts using a variety of investment techniques and strategies, in addition to CANVAS®, which are not necessarily discussed in the commentary. The views reflected in this commentary are subject to change at any time without notice. Nothing in this podcast constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. As always please remember investing involves risk and possible loss of principal capital; please seek advice from a licensed professional. Ritholtz Wealth Management is a Registered Investment Advisor. Advisory services are only offered to clients or prospective clients where Ritholtz Wealth Management and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Ritholtz Wealth Management unless a client service agreement is in place. Ritholtz Wealth Management clients may also be charged fees for their investments that are allocated to O’Shaughnessy Asset Management LLC. The terms and conditions under which the client shall engage the third party investment advisory firm shall be set forth in a separate agreement between the client and O’Shaughnessy Asset Management LLC. Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

This week, sometime in the middle of the night, while I was sleeping, the Compound Show podcast broke a million lifetime downloads. A million downloads. Downloads are the most widely cited stat in the podcasting world. They're like, let's say, page views for websites. Libsyn is one of the biggest podcast media hosting platforms in the industry. According to Libsyn, there are now over 850,000 podcasts in existence. Over 10% of them, though, have only ever published a single episode.

So that's what they call the pod fade. So pull those out and you still have quite a lot of different podcasts, unlimited choice, all different sorts of things that anyone can be listening to at any given time. Most podcasts though, never really find their audience. And you know, even if they keep going, you, there are podcasts that have done hundreds of episodes that almost nobody listens to. And it takes, I guess, a lot of fortitude to keep going when you're posting something every week and nobody hears it. But those do exist as well. I want to break down a little bit about what you would call podcasts that, that matter. about what you would call podcasts that matter. And the numbers are, I mean, this kind of blew me away. It was way different than what I, I understand there are power laws in anything to

do with media, but I was very, very surprised by this. Okay. Libsyn says that if the newest episode of your podcast gets within its first 30 days of release, so one episode, right? within its first 30 days of release, so one episode, right? If it gets more than 136 downloads, you are in the top 50% of podcasts. So all you need is 136 people to listen to your podcast and you're in the top half. If you get more than 1,100 downloads, you're in the top 20% of all podcasts. So all you need, 1,100 downloads, it's nothing. You probably know 1,100 people in your life. If each of them download your newest episode in the first 30 days, you are a top quintile podcaster. Congratulations. That number is tiny. I was blown away by that. If you get more than

3,200 downloads of your most recent episode in its first 30 days, you're in the top decile, the top 10% of all podcasts. This is worldwide. If you get 7,700 downloads, you're in the top 5%. worldwide. If you get 7,700 downloads, you're in the top 5%. If you get 20,000 downloads in the first 30 days, you're in the top 2% of podcasts. You're podcast royalty if you can get 20,000 people to download you on a weekly basis or however frequently you podcast. And if you get more than 36,000 downloads, you are in the top 1% of all podcasts. That's it, 36,000. Our last two episodes did over 40,000 downloads each in their first week of release,

which puts us in the top 1% of podcasts globally. So you guys, the audience, were ahead of the curve. You guys got what I was doing. You were early adopters when I first revamped this thing over the summer, this past summer, and I told you in June, I'm really going to go for it. I'm going to do a really good show. I'm going to focus a lot of energy and time on this thing. You guys came along with me along for the ride. I hope you were entertained. I was.

I've had so much fun doing this. I hope you learned a lot. I definitely did. You have to do a lot of research if you're going to be talking with some of the people that I've brought on to talk with. You can't just be like, hey, what's up, right? This isn't a pop culture podcast. We're talking about research, big insights, the writing that people are doing. So I definitely got a lot smarter. And I think I'm a better financial advisor and CEO of an investment firm

as a result of having worked on this. So I got smart. I also had a lot of fun and I hope that you guys had a lot of fun and got smarter just as I did. What began six months ago as an experiment has now become a new passion of mine. So we're going to take this into 2021 and we're going to turn this into one of the biggest podcasts in the investing category. And you'll be able to tell people that you were listening when I had a couple of hundred people tuning in. My goal is to make this show so good for the audience, for you, that it averages a top 20 ranking on Chartable for the entirety of

2021. Chartable is like where you could see like the US investing category, and you could see all the podcasts in there. And I've been consistently top 40s, top 30s, but that's not good enough. So this year, my goal is to deliver for you guys like so big, and I promise I will. The content will be major. The interviews will be major. I will. The content will be major. The interviews will be major. And then you can help. Ratings, reviews, sharing the podcast, telling your friends. That's going to put us where we deserve to be. So we've come a long way already. And for that, I want to say thank you to you guys. I know when I began in June, I was a little unsure of myself, a little bit like a baby on ice skates, right?

But it's coming along. And I'm glad you guys stuck with me through the early days and the development process. And now we're ready to roar next year. So thank you and happy holidays and happy new year from me to you. And speaking of podcasts, oh man, are you gonna love this show? I have a guest on today who needs no introduction. I'm gonna give him a big one, but he doesn't need it. He is podcasting royalty.

So Duncan, hit the music. Let's get on with the show. Welcome to the Compound Show with Downtown Josh Brown. Josh is the CEO of Ritholtz Wealth Management. All opinions expressed by Josh or any podcast guest are solely their own opinions and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for investment decisions.

Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast. Merry Christmas and Happy New Year and welcome to the final episode of the Compound Show of 2020. This week, we're going to be talking about the biggest technology breakthrough for investors and the advisors they work with since the first ETF began trading in 1993. Years from now, you're going to look back on this moment and perhaps even this podcast episode as being a seminal moment for the entire investment management industry. Because as this technology takes root and begins attracting new adherents, we're never going back to the other

way of doing things. ETFs have become a $4 trillion business since the advent of the SPY and some of the early index tracking products that came to market in the 1990s. This next evolution, custom and direct indexing, is going to happen even faster given the sophistication of modern software and the mass distributive power of cloud computing. My guest today, Patrick O'Shaughnessy, the Chief Executive Officer at O'Shaughnessy Asset Management, otherwise known as OSAM. You will not hear me say O'Shaughnessy Asset Management again for the remainder of this podcast. Patrick's podcast is Invest Like the Best, which I know if you listen to me, you definitely listen to him.

He interviews the top investors, technologists, entrepreneurs, venture capitalists in the world. Recently passed 7 million listeners, I think. Patrick's podcast is a top five for me personally. new technology and asset management platform Canvas, which I think is in position to lead this new evolution into direct indexing and completely customizable portfolio management. And because I'm a registered investment advisor and we both use Canvas and O'Shaughnessy Asset Management's traditional separate accounts in client portfolios, I am obligated at gunpoint to read this very brief disclaimer before I can even say hello to Patrick and welcome to the show. I'm going to rip the duct tape from his mouth once I've indemnified both of us. So listen to this and then I'll be

right back on the other side with Patrick. The opinions, viewpoints, and analyses expressed herein are solely those of Patrick O'Shaughnessy of O'Shaughnessy Asset Management LLC and should not be regarded as opinions or advisory services provided by Ritholtz Wealth Management or performance returns of any Ritholtz Wealth Management investment client. The opinions expressed in this program are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or any specific security. O'Shaughnessy Asset Management LLC is a sub-advisor and independent money manager for Ritholtz Wealth Management. Canvas

is a registered trademark of O'Shaughnessy Asset Management LLC. Ritholtz Wealth Management. Canvas is a registered trademark of O'Shaughnessy Asset Management LLC. Ritholtz Wealth Management manages its clients' accounts using a variety of investment techniques and strategies in addition to Canvas, which are not necessarily discussed in the commentary. All right. Now, the second half of that is coming up. No, I'm kidding. All right. Look, this is important stuff. I don't mean to minimize it. I have more of that disclaimer printed in the show notes, but my chief compliance officer asked me to at least make sure we did that. And if you're really into disclaimers, you can go to my blog and read the show notes and get the whole thing, which is thousands of words long. Patrick, how are things in Connecticut this winter? They're great. And I was going to open by saying, you may not know just how much of a part of this whole story you are, because I know we'll talk a lot about Canvas today, but I would say this

all began if there was a seed or an acorn or something at the beginning of it. It was this newfound discovery of doing our learning search very much in the open. And my earliest days of doing that, because Canvas in many ways was designed by a lot of these software experts that you talked about that I've gotten to know, just me stealing lessons from them. And I would never have gotten to them had I not met a batch of people doing this, kind of the first people to do it in finance, yourself included. So this is a fun, a bookend, if you will, to what's been an incredibly fun journey that you certainly have been a part of, if you knew it or not. So thanks for having me.

Right. So we first met you, you were not doing content. You had done 11 years in the research department at O'Shaughnessy Asset Management, and you were like starting to do a book, Millennial Money. And your dad was like, hey, you should meet my son. He's working on a book. And Barry and I are like, sure, we'll meet your son like as a favor. And now it's a decade later and we're doing business together to the tune of hundreds of millions of dollars. So it's pretty cool that things – yeah, I love that things turn out that way. You dropped the white paper this month.

Am I phrasing that right? Is it PDF? But is it a white paper? Paper, PDF, however you want to consume it. You got it. Okay. You dropped a killer new album this month. But you called it Custom Indexing, the Next Evolution of Index Investing.

And it starts out with a pretty bold claim. And if you read my blog, I like to punch people in the face the first thing I say to get their attention. So I love your opening sentence. And for people who aren't ready, it's like a pail of cold water in the face. It's like in a nice way, like, yo, wake up. So I'm going to quote you to define what we're talking about here. Quote, I can't do your voice, so I'm going to quote you in my voice. By 2025, most financial advisors will use web-based software to create and manage custom indexes for their clients. Standard indexes have a single methodology,

one rule set dictating what they own and how they rebalance. Standard indexes are one size fits all. Like standard indexes, custom indexes also invest in rebalance according to a defined methodology. But with custom indexes, the methodology is personalized based on an investor's circumstances and preferences and can be easily adjusted as an investor's circumstances change. This flexibility is possible because custom indexes are implemented through separate accounts where investors can directly own a custom mix of individual stocks and bonds rather than indirectly owning positions through a collection of funds and ETFs. So you are removing the wrappers, the ETF wrapper, the mutual fund wrapper.

ETF wrapper, the mutual fund wrapper, you are giving the client of the financial advisor utilizing Canvas an ability to create an index that makes perfect sense for the specific and unique situations of that advisor's client. Am I explaining this right? Yeah, that's right. And I would say there's two pieces to this. There's the technology side that enables it, which is really important. We can dive into that and why it's so important. And there's the investing strategy. And maybe the investing strategy is going to be the less controversial part of this. It's why I said by 2025, this will happen.

My friend Josh Wolf has this great phrase, directional arrows of progress in technology, where something just keeps getting better and better, kind of in a predictable way. My favorite example in our world is Robinhood and zero cost trading. If you charted the cost of trading over the last three or four decades, if you extrapolated that line, the endpoint was zero and Robinhood just jumped the line. It was just natural that that's where it was going to go. And they built a big business by just going three, four years ahead of its competitors. I think the same is true here with custom indexing, that it's gone ever more towards the investor getting exactly what they want at very, very low cost. And the low cost is enabled

by technology and or scale. So Vanguard's more of a scale story, right? They can share the scale economies with their customers. The technology is our way of making this more accessible and more cheap. But I don't think anyone would argue with the fact that if there was a Vanguard fund that costs five basis points, that was perfectly tailored to the specific situation of a given investor, and they were the only ones allowed to invest, that they would invest in that rather than the S&P 500. And there's all sorts of reasons why they might differ a little bit. Most of their portfolio will look kind of like the S&P 500, I would argue, in most cases. But with technology, the cost can come down. And that's why I think this is so inevitable. Okay. I don't think you could have launched this 10 years ago because the computing power and the commissions on trades, even if they were $3 commissions,

it would make this kind of thing cost prohibitive and more trouble than it's worth, and advisors would not be as quick to adopt it. But commission-free trading and the cloud and the degree to which you can use software to, in real time, make changes to a proposed allocation, all of that is very, very recent technology technology and you hopped on it really fast. Did you see that the technology was – and the industry structure, market structure frankly were getting us to this place and you were ready for it? Or did you just react really quickly once these tools and market structure changes became available? Well, there's another friend named Dennis Hong who has this great way of thinking about perfect solutions where he says, we shouldn't think about things. How could we improve what we have incrementally? We should think about what is the perfect thing? It's not Uber Plus,

it's teleportation, right? Work backward from teleportation and see how close you can get. And our view is always just the perfect thing would be an exactly perfectly tailored portfolio for each individual at very low cost. What's in the way of that? Well, you mentioned one of them, commissions in trading, really any cost makes it harder to do this. Fractional shares is something that we're seeing more and more of that will make this ever more possible. Just the operations and the technology behind the operations makes it possible. So you need all these other things to happen. Timing really matters. 10 years ago, it would have been impossible. I think the unique part about our story is we were lucky in that we were building all this technology anyway, without knowing that

Canvas was coming or custom indexes were coming because we needed it for our own purposes. We managed separate account. Our business was a separate account business. We managed thousands of accounts. We did quant research. We had all the stuff you need to be able to offer this already. And we had been building it for 10 years. So if we had any insight, it was just, wait a minute, we can pull the same thing Amazon pulled with web services and say, they built all this cost center infrastructure. What if we offer the infrastructure itself to our clients? We're basically doing the same thing.

We built our own infrastructure. Canvas is just us offering that infrastructure to clients to manage unique strategies. So we had a head start. Right. So this is like an – it's an operating system. The way you've explained it, and I think it's apt, it's an operating system that an advisor, which would be my firm in this example, my firm can use your operating system to build portfolios that are accustomed to each of our clients. You don't know our clients. We are accustomed to each of our clients. You don't know our clients. We are telling the software about our clients.

And then there are more layers to it later. But just like from a very high level, just some very simple scenarios where we've found this helpful, have a client who 80% of their liquid net worth is tied up in the stock of the company they work for, right? Let's say it's a large technology company. It's Facebook or it's Apple or Google. And then we're going to give them the Qs. We're going to layer on more of that stock into their portfolio because the ETF is cheap and easy.

Or we build them a custom index that's meant to approximate the real indices that we're trying to get exposure to, but we zero out that security, right? Another scenario, a client comes in, they've got a $6 million account, and they have, let's say, $300,000 or $400,000 in embedded liability, tax liability in the form of one really big holding that's done very well. We can lock that security and begin to tax manage. And we can on canvas make like direct requests of when we want to pay that tax bill.

Do we want to eat 50% of it on the transition of that client bringing their account over to us and then work on the rest? Do we want to eat all of it this year? And that client bringing their account over to us and then work on the rest. We want to eat all of it this year. And where are we going to find those losses? And Canvas has given us the ability to do those two things in a way that would be really hard to do in an ETF model portfolio world.

Are those the two primary use cases that you're seeing right off the bat as advisors start coming to you and plugging in your tool? I would say that's two of the three. So the first is risks. It's a big bucket, right? But every person has exposure to risks. Their human capital, their personal capital, let's say they work at Apple and they have a bunch of Apple stock. Well, they're very exposed to Apple's future already, right? And so I would call that a risk. We're able to route around risks. So that's bucket one. Bucket two, and there's all different kinds of examples of that that are really interesting. Industry risks. Industry. The energy industry. Yeah, tons of stuff. Exposures through private equity holdings. I mean, there's all sorts of cool ways that's

getting better every year, right? We're going to improve the system every year. You can route around risks. Taxes is probably the most interesting because it's the one that we probably underestimated how important it would be when we launched V1 of Canvas. Some large part of our development sense has been deep customizable tax tools. And there are really cool ways that people do this. Like some years they'll say,

I don't care what my tracking year is to the S&P 500 this year, I need losses. Like I'm selling some business or I'm selling some big set of shares. All that matters to me is reducing my tax bill. So drag that tolerance up this year. And it's as simple as doing so quickly in software. There's no paperwork or anything involved. So that's one example. We see so many custom tax settings. I'm not willing to pay more than $100,000 of gains this year. So don't let the system generate that any more than that. Or I want to maximize losses or I want to transition away from my Facebook or my Google or my Apple stock over one year,

over five years. I mean, there's just all these different things that you can program into the system. So taxes, I would say, honestly, is probably the thing we see used the most. So taxes, I would say, honestly, is probably the thing we see used the most. You're talking to CFPs and CFPs like as fiduciaries, it's like certified financial planners, like the ones who interact with clients at my firm. Taxes are a massive part of the conversation, right? From even before client. And one of the questions we get, especially in a year like this, that people want to come over, become clients of the firm.

They're worried we're going to wipe out their whole portfolio and put them into our strategy. And that's going to create this big tax liability. And when we walk them through Canvas, in which this probably takes place in the fourth out of four conversations before they become a client. But when we walk them through Canvas, they say, oh, wait a minute. So I don't have to wipe out all these stocks and funds that I'm sitting in huge gains. There's actually an intelligent way to gradually move into this new portfolio and have control over the tax hit. And I mean, they're thrilled to see it. So I agree with you. What's the third bucket after risks and taxes? The third bucket is what I'll call factor exposures of all different types. So people are familiar with like value or momentum or these concepts. That's our firm's legacy and history. And so we offer those exposures in very customizable

ways. But what's interesting is new versions of factors. It's just basically reasons to own a stock other than its market cap, right? Which would be our default beta assumption. There's two examples of that that stand out, maybe a third waiting in the wings. The first is income related. So lots of people want dividend stream from their equity portfolio. And there are some very cool ways that that can be engineered. And again, it's not typically income strategies has been like, you know, one size fits all. The VIG is a famous ETF in this space. What we found is that levers matter. Like some people want more risk for more income. Some people are accepting of lower income, maybe above market, but lower with lower risk. And so you can engineer these outcomes through Canvas as well. The second would be quality,

which is just exactly what it sounds like, overexposure to more high quality businesses, strong balance sheets, et cetera. And the final would be growth. Youitionally, quants aren't growth managers other than the momentum factor. And what we've seen is people that want certain kinds of exposure. We haven't done this yet live, but it's an area of research that would target innovative technology companies, let's say, systematically. So factors, kinds of exposure to certain kinds of stocks beyond just market cap weighted would be the third bucket. Everybody wants you to create a custom index that looks like Cathie Wood, but they want it starting from 2017. All right. And then I think in that third bucket would be ESG.

So factors that are not necessarily just about performance and risk, but also have this other attribute about how it makes the holder of the portfolio feel about what their money is invested in, which I understand that there's an older generation that maybe looks down their nose on this or not everyone in the older generation. But you can say whatever you want. This is where the money is flowing. So you could have a problem with it if you want to, but here's a stat for you. You know, I'll admit, I didn't have a hypothesis around what the popularity of our ESG component would be.

And we allow it to be very granular. So part of the hypothesis was, you don't just need a, again, one size fits all like impact portfolio. You can literally just care about one tiny thing and we'll just adjust for that one tiny thing. Maybe that's. You can take out guns. I want you to take out gun manufacturers and you'll do it. Right. Or more positively, I want you to overweight companies, not just eliminate, but overweight companies that have great diverse boards. That could be your one issue you cared

about and we would do it. So when we started, I think we may have even had bets, like how many portfolios will actually use this? We weren't sure. And in the early days, I would say not many did. To set the stage a little bit, we now manage about a billion dollars on the platform, just about to cross that number that we started a year ago, and 500 individual accounts. So 70% of those accounts of the strategies that are managed are totally unique, meaning their settings are totally custom. There's no other portfolio like that. Custom, custom. Custom, custom. So with that as the sort of baseline, we just crossed $100 million, so about 10% of the portfolios that have a specific ESG setting tuned on them. So 10%

of the assets, it's a little bit more of the number of accounts, but 10% of the assets have this. And frankly, I would be shocked if that doesn't grow as a percentage of the total, just based on Josh, what you and I've seen with ESG as the uptick in interest in it from the investors who are not, to be clear, I don't think almost any of that money is doing it because they think they're going to earn a better return. They're doing it for some other reason, which we call a preference. And we're here to accommodate those things, not really opine on them. Now, it just so happened that you did not suffer in performance for having been an ESG investor. This year, you actually did way better because if you were an ESG investor, you probably had a higher percentage of your assets weighted

toward NASDAQ 100 companies rather than old industrial companies and specifically energy. And now that could reverse, but I happen to think that the flows to ESG and the outflows from almost every other category of active investing actually has played a role in the depressing of the multiples of oil companies. I don't think they shrank to being less than 1% of the S&P 500 completely in a vacuum. And it's not as though oil prices fell to $10 a barrel. Something else has been going on. That something else is a combination of Tesla and the battery future having become more apparent and investor preference for non-polluting corporations to invest in. Now, that could reverse and maybe energy companies have a great year next year. But I think the point is you always see performance chasing. And ESG now is just one more example of performance chasing because an ESG strategy

crushed the S&P this year because of the types of stocks, not only it owns, but what it won't own. So now you're going to see this phenomenon, I think, go into overdrive in 21. You guys will play a role in that, in giving people those tools to really fine tune how E, how S, and how G they really want to be. Right. And the last thing I would say is governance has been a thing forever. I mean, I would say E and S are a little bit more recent, but even for quants like us, governance just means well-run companies. They tend to earn higher returns on capital. They tend to produce better shareholder returns. So this is not a new thing. I think that the

tech companies are, for the most part, exceptionally well-run companies. Like when you just dig into them fundamentally, you know, their speed of innovation sometimes increases. It's supposed to decrease when you get really big. So if anything, it seems to have increased and they're governed really well. So none of these ideas are that new, but I do think the adoption and the preference for them is rising. Okay. I also think that because of when they were built, these are companies that were founded in the last five or 10 years. They don't have a lot of the legacy governance issues to undo. They don't have a board of 12, 70-year-old white men that all of a sudden they have to start replacing. They're starting from scratch, and this is the most diverse generation in history, the people founding companies now in their 20s and 30s. So I think that that governance thing comes a little bit more naturally to them anyway. So if you were an ESG

investor, you had a tech-centric portfolio even more so than if you just had the S&P 500 in its market cap weights for each sector. So you mentioned that you're over a billion dollars on the platform. So I want to talk a little bit about how my firm is using Canvas. So I had Patrick Haley run these numbers for me this morning. And he is our primary liaison between us and you. And we'll talk about that in a minute. But Patrick tells me we now have 168 households with Canvas portfolios, about $232 million in assets under management. And interestingly, 35 of those are qualified accounts, meaning they're not even getting those tax harvesting benefits. So we're in there as investors. investors. I won't go through the strategies, but it looks like about 50% of those accounts are in our most aggressive asset allocation mix. It's an 80-20 stocks bonds, and that accounts for half the portfolios we're setting up in Canvas. Is that about what you see across most of the

people who are building these accounts? Are you seeing more 80-20s than, let's say, 50-50s from the advisors who are setting up? Again, maybe this is a good, it's good from my perspective. The answer is there is no really common setup. So we only have nine partners. We did that by design. So all the growth has been with the original partners that we signed up literally in the first month we launched. We had a lot of demand to be in that first group. And we had to do that because we had so much left to build. If we had tried to take more partners, we wouldn't have been able to expand the product. So it would have just, our hair would have been on fire. So the answer is the nine firms, no two firms have the same setup or strategies. They all tend to have the same like couple templates that they use, but the Ritholtz

templates are quite distinct from firm XYZ. And they range from very aggressive, meaning like all active, very high octane asset allocations, all the way down to very, very passive and everything in between. So there is no normal, but once the partner sets their templates, they tend to stick with them as has been the case with you and your firm. Okay. So I was told that I have to give a shout out to three members of your team who have been extraordinarily important in the setup of our accounts with you. And the setup is the most critical thing that happens because if it's not done right, you have a million errors that could stem from that original flaw. So these are very front-end loaded procedures to get accounts set up on Canvas.

But it's worth doing that front-end loaded work to save yourself a lot of aggravation later. But in particular, Claudine, Ari, and Lenny the Trader. And I've not met Lenny. And I know you have many technologists at your firm who have been building this product with you. But these are the three people that I've been told are your most indispensable people. So I wanted to give them a shout out. So we, I think we're setting up three or four of these a week or two or three of these a week or depending on the week. And these are the people that we rely on to help us get that front end loaded work done correctly.

When I mean work, I mean determining how much money is going to be leaving this account each month. When are we sending these distributions out, right? Because these are wealthy people drawing down. That's a huge process that has to take place in my back end and yours and a host of other things. What types of accounts are we opening? Which account are we using for which? This is not computerized stuff. These are your excellent people and my people liaising literally hourly at this point.

Two observations there. First, I sometimes joke that Canvas is actually just our marketing for our actual product, which is getting to interface with Claudine and Lenny and Ari. They're the best at what they do. I mean, they're incredible. The other thing that's worthy of note, you made the point, like there is a service offering that is required, at least in the early days, probably for the next many years, hopefully forever, that is real. Like this is not just a pure web interface. You never talk to a person like this. It's pretty critical that you have, especially at big scale with hundreds of millions of dollars, that you have incredibly talented people watching over this stuff on both sides for the client.

And I mean, you sniped some of our secret weapons at OSAM. And, and you know, I couldn't agree more. So I appreciate you pointing them out. Yeah. And I think like, there's this, I think there's this prejudice toward new technologies, especially in financial services. And this applied to the, the robo advisors when they came along and this replied to rebalancing software before that. And anytime something comes along and people say, oh, they think they can get away with replacing people with software. It never works. It's going to fail. But that's almost never the case.

It's always taking software and enabling people to do more for more people. And I think you guys are a great example of that. I listened to you talk to Sam Hinckley from the 76ers, and I guess he's like a hiring guru. And you had mentioned you're hiring like crazy right now and leaning on Sam. is not at all technology replacing people. It's technology empowering people. You're going to need a lot more people given the demand that you expect to come. So talk a little bit about that. Well, I would just say the beautiful thing about technology, there's a long conversation about whether or not it replaces jobs. I think it creates new and more interesting jobs, at least in our experience. What we're doing with this software is removing the crappy part of even some of those same people's jobs as much as we can. Like no one wants to do boring, repetitive work, especially when it's detail oriented and hard and mentally stressful.

So I think the beautiful thing about tech is ripping and replacing the time spent on that so that those same talented people can do more interesting, more challenging, higher impact work. And that's what we see over and over again, but you still need a lot of people. All these things are blends of technology and people and services. And so that's what I love, especially in other technology companies, is when it lets people be more creative, more hands-on, solve more problems versus just turn a crank. So we're trying to turn all those cranks into just automated software and let people like the ones you mentioned really shine, which is working with other people and supporting them. And I think that will just continue. I think we'll have to hire, as we

have been, like MAD, to support the growth of Canvas and the platform. Okay. Three years ago, there was a growing consensus that what the financial advisor space was going to look like was essentially cookie cutter firms working down the street from each other, comparing one portfolio of ETFs to someone else's portfolio of ETFs and probably competing on price to the point where they were charging hourly for something that was just like pull it off the shelf and it's yours. This is my Vanguard mix versus my competing, the competing advisor across town. That's his BlackRock mix. And then pay me, I don't know, $3,000 a year. No, pay me $29.99 a year, right?

Like that's what some of the more skeptical people that follow our industry thought that we were about to devolve into. I think what 2020 has done is accelerated an ease and a comfortability with technology on the part of our clients and potential clients. I think it's made advisors more comfortable with technology. And I think it's proven that in the end, people really don't just want a plain vanilla portfolio. We had like 30 or 40 million new people come along and open up brokerage accounts this year.

There's been an absolute explosion in interest in the markets, in active management, in trading, in growth stocks, in SPACs and venture and Bitcoin. That flame never was fully extinguished, even though it looked that way and everyone was just going to be plain vanilla Vanguard, leave me alone. I don't want to hear about it. That's now over. Nobody's talking that way. And I think what you're offering is going to be the Vanguard of a much bigger movement to build these customized portfolios on the part of advisors working with high net worth investors. Do you foresee a time three years from now, five, 10 years from now, where these tools become very widespread and do-it-yourself investors

begin working directly on creating custom indexes? I think there's just always a frontier. Nothing in capital markets is static. So technologies become utilities. We see it over and over and over again. Railroads seem boring today. They were yesterday's technologies. And the same is true here. So we're going to have five years, 10 years from now, very simple commodity versions. What we have today is going to be ridiculously simple and cheap, and anyone will be able to access it just because that's how technology works. But in 10 years, whatever we call Canvas will have evolved to accommodate maybe lots of the things you mentioned. Maybe we're going to be able to do other asset classes and even more bespoke fractional things, exposure to securitization of more interesting assets. Like who knows where it goes? Nothing is static. So I

think the key is just try to always work with a provider that's going to stay on that cutting edge because it will keep changing. But I think the direct answer to your question is yes. Like Wealthfront already has their concept of self-driving money. Wealthfront can offer you tax loss harvesting in probably a pretty efficient way as can other platforms like them. So a lot of this stuff exists already today. And I just think that's doing a different job than someone hires an advisor to do. And we've seen that theory of robo taking over advisors has been completely wrong. And I think it will remain wrong. And you just have to stay at the vanguard. I think that's my mandate to my team and my firm is just always make sure we're offering the most cutting edge thing because that thing will change over time.

One of the things that you guys are working on right now is a more robust performance attribution engine. So right now you can show us the performance of our client accounts, but being able to get very granular and to be able to say to someone, for example, last year, your portfolio benefited by, I'm making these numbers up. Your portfolio benefited by 600 basis points because you had an aversion to oil companies and we left those out. And then in a year where energy outperformance, be able to say, look, you trailed the S&P 500. Not that that matters, but you trailed by X percent or X dollars.

Not that that matters, but you trailed by X percent or X dollars. And that's as a function of your decision to not be invested in for-profit prison companies or whatever the things that you told us to leave out or to overweight companies with female CEOs. Like whatever your decisions were as a person, as a client, we're not saying it's good or bad, but this is where the attribution differed. Like, oh, this is where the performance differed. Talk more about why that's so important. It's funny. So when we launched Canvas, we realized in about a week that we had only built one third of what we needed to. That one third was the ability to design the strategies and then we would implement them. The second piece that we built was this tax transition you talked about earlier. There's a starting point and there's a destination. You got to build a roadmap. So we had to build this technology that let you choose what that map

looked like, especially around taxes. And then the third has been this performance reporting piece that you talked about, which has actually been the largest software build of anything that we've done by a lot. It's many screens of software. And what we've realized is that like anything in life, it's not necessarily what happens, but how you communicate it and how some end investor understands that thing that ultimately matters. Because we want to frame things in terms of their choices, not in terms of some random set of variables. But if they chose with their advisor to do things a certain way, we want to report back what happened through that same lens because that will make sense to them. That's hard to do. Like if any

investor out there, whether you're an advisor client or really anyone sees like a PDF of like a quarterly report, there's a lot of human hours that typically go into the presentation of performance, you know, slicing and dicing it 10 different ways. Really what we're trying to do with this technology is create an even better version of that output with none of the human input. So just the ability to click John Doe's account, generate performance report, and then basically as the advisor choose which of these lenses do I want to present in a really, really fast, snappy way. But most importantly, again, just to say it twice, framed through the lens of the choices that the advisor and investor agreed to and understand already, not through some mass market template. Here's like sector attribution.

Like, who cares? Right. No one made a choice to be overweight a certain sector. Typically, it's just a residual. So why would we explain performance back to somebody through that lens? It makes no sense. explain performance back to somebody through that lens, it makes no sense. So re-imagining how someone's performance is explained to them and offering the opportunity to change things or tweak things if they don't like something they hear. That's the other thing is that these

strategies are living and breathing. It's not fixed. So sometimes we've seen people go in and say, actually, I don't want to be so averse to owning more tech stocks because I work at Apple. I'm willing to own some. That sort of thing changes. And so reporting is like the feedback loop that allows these things to stay alive and relevant. So here's what I want to ask you. You make that statement early in your paper that you're saying most financial advisors by 2025. So it's 2021 right now, let's say, for all intents and purposes. And we're, you know, my firm is an early adopter. And by the way, let me share with you that the first 11 accounts that we put on Canvas, which we did in December, 2019, like right at the rollout of the first 11, the original 11,

five of those were family members of people in my firm. So like someone's dad, someone's personal account, like we started, we were our own guinea pigs for this. So yeah. All right. So, but, and now we're, we're hundreds of households and, and, and we're both bringing on new client households and converting existing and not always, but it depends on if there's a good reason to, right? There's got to be a compelling reason. But we're an early adopting firm to begin with. Like we're very tech centric. We've been on the cutting edge since we founded the firm. And you know, one thing about our industry is that most financial advisors are not, they don't consider themselves to be cutting edge people. They think more about the risks than the rewards of any new thing they're about to adopt,

et cetera. So that statement that most was a little bit surprising to me. You really think the adoption curve within four years will get us to more than 50% of RIAs doing custom indexing? I do. And I think you've already seen, and I think in this bucket, direct indexing, which I would describe as very simple versions of just owning the stocks directly, but without the customization potential or benefits, and typically not the software or

technology orientation that you'll see from custom index providers. But what you've seen lately in Morgan Stanley and BlackRock and JP Morgan's acquisition of companies like Parametric and Appirio and 55IP, they are laying the groundwork to roll these things out inside of the big brokerage platforms. The RIA community, I would say, is somewhere in between the, what I'll call innovator and early. I would put you guys in the innovator bucket very early. The second classical bucket is the early adopter. And that's really where the S curve starts to take off. I think you'll see all the firms that want to be competitive, good RIAs have to offer something like this because it's going to be table stakes, just like access to a mutual fund or something. It'd be ridiculous if you went into an advisor and said, I want to buy an ETF or a

mutual fund. And they said, we don't have access to that. I think it'll be ridiculous if an investor comes in and says, look, I want this tax treatment. I want this outcome that custom indexing enables. Wait, wait, wait. You think investors are going to be driving these decisions? Because I don't see it that way. I think many investors will come in, and especially if they're being referred, have friends that are working with advisors, that there's a snowball effect that they'll say, well, I want the ability to generate, you know, tax losses too. Like, what do you have for me? And so I don't think that every RIA or half of them will use it as their primary way of investing. I think funds and ETFs

will probably dominate for a long time, but I'll wager that most of the fast-growing RIAs will have some option that they're able to solve at least some use cases for certain clients using something like a custom index, and that that will definitely happen over the next four years. And I think the fact that it's happening at the big banks and platform brokerage firms and asset management firms already is a great sign that this separate account-based direct or custom index is a serious wave that will happen fast. I have a hard time imagining solo RIAs, smaller RIAs, being able to keep up with the mid-sized firms like ours, let's say, and the larger kind of roll-up conglomerate firms. I can't imagine them being able to pick this up as

quickly as we were able to. We have dedicated staff to set up new accounts, allocate accounts, figure out the tax consequences of various strategies that we want to run. Most solo RIAs, people with $100 million or less under management who are basically themselves or themselves and a partner. I know how much work goes into all of our front end loaded work that I referenced earlier. I'm not sure that this next level step up. I think we're going to lose a lot of smaller firms and they just won't be able to make this leap. Maybe I'm wrong because the technology becomes so plug and play that anyone can do it. But right now, as discussed, it's not plug and play. We're on the phone with your people and vice versa to get this stuff right. So what are your thoughts about whether or not this could

become a dividing line between mid-sized and small firms? I think that's kind of always true in a number of different ways. I think, look, what people care about is convenience. That's the investor. It's the advisor too. It's quite easy to build somebody a portfolio of ETFs. And I think that's a big reason why a lot of people do it, right? It's convenient and simple. Right. There are accountants doing that. Like it doesn't even require an investment person to do that. So obviously, look, my belief in how big this is going to be means we will be far from the only firm doing this. We have a specific strategy. We want to operate at the high end with more complex situations that requires more Claudines and Lenny's to be a high touch service

model. That's our choice. It's where we like to play. There will be other players that create an extraordinarily simple, convenient, probably less functional with less features, but it will be accessible to a solo advisor with a $50 million book of business. And it's all about convenience. And that's what software is built for, is to make things convenient for the end user. So somebody will serve that audience because the benefits are too good to not want to at least learn about it and offer it. So someone will fill that gap. It probably won't be us, but someone else will. Okay. I want to get your take on this. What you're saying, although we can agree this technology is

the next evolution of asset management or investment management, that's not the same as saying it's the death of the ETF. And the best evidence of that is that mutual funds still have more money under management than ETFs have. So ETFs are an incredible product. We use them every day. They will always have a place in this industry and their use case does not disappear just because there's a more granular, sophisticated way to do custom work. There will always be people for whom the ETF is a superior solution because of its ease of use and that end client's lack of complexity in their own personal needs. Do you see things that way? I think so. I think there's a couple issues. There's

low basis tax consequences to leaving those places, which is, I think, always going to be true. There's a ton of money in ETFs and funds. And so sometimes it's just not going to make any sense for almost any benefit to leave that low basis position. So that's one piece of it. You could also look at this just from a new flow standpoint. So say, forget the legacy positions, new cash that's getting put to work, new wealth being deployed in investment strategies, how much share of that will go to custom indexing versus ETFs. I even still think a lot will go to ETFs and still probably even some mutual funds. And there are ways in which custom indexing stops to make sense. If a strategy has crazy high turnover, you want that inside of an ETF because of the tax impact

for taxable investors of that kind of strategy. That's typically not what we're doing. for taxable investors of that kind of strategy. That's typically not what we're doing. So there's always going to be reasons that that wrapper will be a great technology itself. My point is more that for so many investors, especially taxable ones, this format unlocks a lot of potential benefits that ETFs simply cannot accommodate, specifically taxes and customization. And there will be a huge appetite for that. So there's not one thing to rule them all here. There's going to be several solutions. I think ETFs and custom indexing will be sort of the twin winners of general investment management. So the complexity, some of it's perceived complexity, but some of it is actual complexity.

The complexity of a custom indexing strategy is reduced greatly by an advisor who is creating custom indexes all the time for all of their clients and do not do a great job because either they're not thoughtful practitioners or they are taught wrong or they're working with janky software that's not as good as what I think Canvas is. Where do you see this going very wrong? Could this lead to something that becomes a big problem in the industry with many victims and accounts blowing up if the wrong people are using it the wrong way? Or am I overstating the potential risks in this kind of transition to a new technology? I guess the question is how many guardrails are on the system? Something like Robinhood has no guardrails. So you're going to see pretty much the worst things that could happen are going to happen on Robinhood to certain investors. Cause you can buy call options on whatever penny stock or, you know, crazy behavior that you see. Our philosophy is like, we're going to manage what you can and can't do. Like there's a lot

of things we will not let you do. Cause we fundamentally just think it's bad for you and bad for the investor. And that's, and that's all the obvious stuff, you know, crazy option strategies or over-trading or tons of share turnover, chasing stocks, this sort of thing. So we don't want to be just like a general purpose platform that lets you program anything you want into it. We're going to always have this writing sort of fiduciary and research oversight into what's possible so that, of course, bad things could still happen based on your choices. You could choose international stocks and they could do really badly. Like that's something you could do on the platform today. But you can't choose, you know, Tesla and Nikola and five other stocks and that's your whole portfolio. Like we won't,

we won't let that happen today and won't in the future. So. Are you also looking carefully at who you're allowing as advisory firms to be on your platform? Yeah, because life's short. We don't want to work with the wrong kinds of people. And it's very quickly apparent. I mean, in the first meeting, in the first five minutes, typically, who gets it and understands how this can be used as a great way to build portfolios versus start to asking those questions like, could I program it to do X, Y, or Z? To be clear, as a venture investor, I've looked at companies that are just providing or trying to build general purpose, like investing algorithm as a service that would let you program anything. And I think something like that will get built. I don't want to invest in it because for the same reason that

I probably wouldn't have been a Robinhood investor early on, even though it's obviously an incredible story and an incredible company. I just think that there's a lot of danger when you give investors too much freedom. So sort of managed freedom is the name of the game for us. I love that. Managed freedom. I think that's right. I think that's a good note to end on.

I want to thank you for coming on the podcast and thank you for bringing Canvas to us in the early stages. We've learned a ton about what our clients really want just by showing them these capabilities and they open up even more than they ever have about some of the risks that they're most worried about and some of the ways in which they think about their investments with us. So it's been a great tool for us from that standpoint. And I hope that some of our feedback to you guys has helped you build a better product because we're telling you about how we're actually using it in the field. Well, you know, everyone sees your guys as public facing

stuff. Obviously they don't get to see you guys behind the scenes. Like we have you, I mean, by design, you were literally the first person that saw our first demo. I remember it quite well. I think it was April of 2019, something there right around there. And that was for a good reason. So Batnick lost his mind. Yeah, I remember. And so we were excited to show it to you guys in large part, one, because we knew you and trusted you, but also because we knew you'd give us persistent, honest, helpful feedback, which has continued to be the case. And that's been, honestly, we've been lucky to have picked really well and we'll be working with great firms that do something similar, but you were the first ones to see it.

You were the first ones to take a bet on us. And so we're just, as you know, deeply appreciative of the partnership and I appreciate the time today and the forum today. Absolutely. Patrick, I want to wish you the best of luck as canvas really rolls out in in 2021. Merry Christmas and happy new year. And we'll talk to you and your team, most importantly. That's me. I'm boring. I'm useless.

All right. Hey, your podcast is called Invest Like the Best. Everyone should be listening to that. And I'm going to include your, it's not a manifesto, but we'll call it that. I'm going to include your Canvas manifesto in the show notes. All disclaimers and disclosures apply. None of what we've just said is investment advice. Remember, do your own research, et cetera, et cetera. And we'll talk to you guys all soon. Thanks for having me, Josh. Thanks for listening. Check us out at thecompoundnews.com for daily investing and market insights. You can watch all of our videos at youtube.com slash the compound RWM.

Talk to you next week.