The Future of Investment Management – Innovation expands access, but outcomes depend on how investments integrate with the broader financial picture.
Marcus Schafer (00:05)
What is the future of investment management? What is the future of financial advice? You know, a lot of people, they think the rich have secret access to investments. They have kind of secret tax tips. They don’t oftentimes, a lot of times they just have different and better systems where each of their decisions is connected to each other. So they’re connecting their tax situation to their portfolio.
their income situation to their lending needs, their portfolio design, to their spending habits. And when all those decisions are connected, they compound for you. When they’re kind of broken apart, a lot of times it just doesn’t lead to the same outcome. So the future of investments isn’t just products, but it’s how are those products leveraged in conjunction with the rest of your plan? And innovation a lot of times expands what’s possible, but the question we want to ask is,
does that mean it’s in our best interest? So Pat, I was hoping in episode 27 of Greenstream, we could look at this question, the future of investment management and really understand where are things going, where are they today? And hopefully we could go from there.
Pat Collins (01:19)
I think it’s great topic. think there is a tremendous amount of innovation happening in all areas of kind of business. Financial advice is not immune to that. I think overall, it’s very positive for investors. I think you pose kind of this question about wealthy folks seem to have, you I think a lot of times we’ll hear from people and say, well, tell me what the really wealthy people are doing. How are they not paying taxes or how they’re doing this or that? How are they getting really high investment returns?
My experience having worked with really wealthy people is they have the same behavioral biases that all of us do. Our brains are wired a certain way that has been happening for hundreds of thousands of years. And so we really need to make sure that we can put those in check. The thing that I would say wealthy people have that kind of maybe just the average retail investor doesn’t have is they have more margin to make mistakes. They can make a mistake and just recover from it.
make a poor investment and it’s not gonna wreck the retirement because they have enough money to be able to do that. ⁓ I think the other thing that I’ve seen and I think we’ll probably get into this around financial advice is this also this idea that more wealthy people can afford some higher level advice and hopefully better advice. I think there’s some innovation coming in to try to figure out how to bring that advice down to more kind of lower level or kind of midsize AUM assets under management clients.
But historically, kind of the mass affluent or under kind of the people just starting out, the access that they’ve had to financial advice has mainly been kind of commissioned salesmen, people selling them an insurance product or an investment product. It’s not always independent. It’s not always objective, whereas wealthier folks tend to have access to some of those higher level kind of services. So we’re going to talk, I think, about today.
about kind of what we think the future of financial advice looks like as an investor. Probably a good thing to know if you’re working with an advisor or thinking about working with an advisor. But we’re also getting some of the innovation that’s happening in the investment world, because I think that’s really interesting. To me, for years, there has been very little. There’s been some. It feels like it’s accelerated a bit here recently, probably with the advent of technology and AI. But we’re going to talk a little bit about what’s coming out and what we think about it.
The Evolution of Advice – From product sales to integrated advisory teams and expanding access to sophisticated tools.
Marcus Schafer (03:44)
Yeah, yeah. To your point on rich people, think maybe level set, like, what do we mean by that? It kind of means like people 25, 50 million, a hundred million and up. And you reference margin. They also just have more money to spread fixed costs around, right? And fixed costs are actually a big part of our thing. So if a certain investment requires a minimum of 250 or $500,000,
the percentage of their net worth that they’re applying to that investment that might only be in a few projects is vastly different. So there are kind of some limits of how this, how well this stuff can scale to different levels. The, the other thing that’s really cool is some of these innovations we’ll talk about are kind of like direct to consumer. Like some people can access some of these things directly themselves. There was going to be different trade-offs to that as well, but I think it’s
may be helpful to level set. Well, where are we? You mentioned felt like innovation stagnated a little bit and you go back to investing. Advice 1.0, which is the product commission salesperson, you grew up in this world. And then I jumped to where I think there was a little bit of that stagnation, which is the world I grew up in. It’s like this solo isolated CFP, the beginning of do-it-yourself. You can really start to figure
some of this stuff out, but you don’t have the scalability of larger teams. And it’s really is more spin less money than you make is kind of the generalized advice. And then we’re getting to what you’re talking about now, which is, Hey, there’s a lot of really interesting specialized tools that are designed for specialized use cases that previously were mostly at the
at the wins and the ultra high net worth investors were using them, but we figured out how to scale them down and apply them. And then as we figure out how to scale them down and apply them, people like you and me and the internet has helped people figure out, how are we going to actually take this and apply it to as many people as possible in the right way as possible.
Pat Collins (06:05)
Yeah, I started in this industry 26 years ago. Actually, the progression you talked about, which was kind of product focus, then moved to more advice kind of focus, but really an individual advisor working with one client and where it’s now getting to, which is more of a team of specialists oftentimes working with the client and helping them in lots of different areas of their life.
that progression, I’ve been able to live through that. I was on the very tail end of the product focus kind of group, that 1.0 of financial advice given to consumers. So that looked like people having good ideas. I got a really good idea. We should buy this stock. We should sell this stock. I think you need an insurance policy. You should buy this. So that was kind of the product salesman mentality. And that happened for probably for 80 years on Wall Street.
You know, around 2000 or so, you started to see this move towards fee advice, meaning like no more commissions. We work for the client, we give advice. That’s our product. We don’t have products anymore. We have the advice that we’re giving. That now moves to 2.0. And that progress has been happening for a while now. I would say over the, 2000-ish, maybe a little bit past that, for the next 10, 15 years, you saw that really progressing.
If you look at the industry, the flows, where clients are going, it tends to be firms like that more than the product focused firms. And now we’re kind of really moving into the next phase where advisors are assisting clients in not just investing and retirement, but they’re getting into other areas and they’re building out specialties internally to really help in those areas. So we’ve seen it at Greenspring, other firms have seen it, but really assisting clients deeply in tax.
estate, philanthropy, risk management. And so that’s kind of been the progress, at least on the advice side. There’s been things behind the scene that’s really enabled this over the years too. Different technology that really the end client doesn’t see it as much because it’s assisting the advisors in really understanding a client’s situation, whether that be their cashflow in retirement.
or how to optimize taxes and do Roth conversions and what the right breakpoints are for that, all the way up to analyzing their estate documents. So these are all things that have kind of been happening behind the scenes. I think it’s been a great evolution for investors themselves, though, because they’ve really been the benefactor. Because one of the other things that you’ve seen over the course of this time period is the services tend to be going up as far as what
advisors are offering their clients. But if you go back to where fees were, you know, they were probably, they’ve probably gone down a hair over the past 25 years. so investors are getting more for basically the same fee or maybe even a little bit less. And that’s a good sign. That means innovation’s working.
Personalization With Discipline – Moving beyond model portfolios while avoiding unnecessary customization.
Marcus Schafer (09:10)
Yeah. One of the innovations I think is personalization. And I, I imagine 25 years ago when you were kind of getting into this business, people would talk about personalization too, but it was from that product that was that advisor 1.0. Hey, I have this good investment idea. Why is it personalized? Cause you think the other person is going to buy it. Whereas personalization from the investment component today, it means a little bit more. We understand.
better what type of portfolio you’re coming from. So as we think about what’s the best portfolio for you to transition to, we can incorporate what you have and that transition path is so much smoother. Whereas 20 years ago, you would kind of have to say, you know, I, actually don’t have enough information about what you’re holding. I’m not even going to think about incorporating the existing holdings. I’m just going to kind of plug you into a model and just ignore
what you already have and that’s going to be kind of ⁓ the most efficient way to get that done.
Pat Collins (10:14)
Yeah, it’s, ⁓ I would say maybe the last 10-ish years, 15 years, one of the things I’ve seen on the personalization front is, at least with advisors, is the kind of integration of your investments and your financial plan. In the past, a lot of times advisors would kind of talk to their clients and they’d say, okay, what are you comfortable with? 60-40 portfolio, okay, we’ll put you in that and kind of you set it and forget it to a large degree.
Now, on a daily basis, if you want, you have the data from the portfolio feeding into the financial plan, which is then real-time updating how the progress is going with regards to the achievement of your goals and whether you’re ahead or behind and what your probability of success is. So that was really tough to do in the past when a lot of investments were, quite honestly, manual.
Now with the advent of technology and integrating these systems, it does allow for a lot of personalization to understand is your portfolio set up for the best possible scenario for you in retirement. It’s just one of the benefits ⁓ for advisory firms like ours. As you get to a scale where you can invest in this type of technology, can really be beneficial for clients.
Marcus Schafer (11:28)
Yeah, you can kind of maybe a way to make that tangible is advice even 10 years ago would be, you’re kind of entering retirement. Here’s what we’re going to do. We’re going to buy more bonds. So those kickoff interest and we’re going to buy dividend paying stocks. We’re going to use that to essentially put money in your account all the time. Whereas now you could say, well, I’ve learned that dividends are not the more efficient way to generate income.
So I don’t need to build a portfolio directly around those. could build a portfolio and then every month I can go in and identify what single lot level specific investment lot level just means.
Let’s say you do dividend reinvesting, you’re picking, hey, at this exact day, seven years ago, these are the shares, the value that I want to sell. And you can then factor in, okay, what do I know about the tax situation of somebody, right? Is this going to trigger more capital gains or less? Is it short-term capital gains or not? And you can think also about, hey, here’s what their portfolio is.
here’s where it is and here’s where I want it to be. So you can kind of factor in all these different lenses and then essentially create the same income, but in a much more tax efficient way. And that I think is the benefit of personalization as opposed to, hey, I have this great idea for you.
Tax-Aware Implementation – How direct indexing and technology enable more precise after-tax portfolio management.
Pat Collins (13:00)
Yeah, just maybe taking it even a step further. And I know we’re to talk a little bit more in depth about some of the new innovations happening. But I just see this accelerating. So if you think about the progression of how we tend to invest, which is kind of global diversification, owning lots of stocks, it started from in most cases with mutual funds. So you can go back. I can’t remember the first mutual fund was like in the 1920s or 30s, I think, if I remember correctly.
So that was the advent, they were really not mainstream until many, many years later. But as the first index came, fund came about in the 1970s, you saw mutual funds be the preferred vehicle of choice for most advisors because, you know, obviously, and for clients, because it was an efficient way to get access to lots of stocks, globally diversified and whatnot. So that was the case for a long, time. We had innovation.
25-ish years ago, maybe a little longer now, with the first ETFs, exchange traded funds. So mutual funds kind of adapted. They still are out there, but a lot of them decided or lot of managers decided to put themselves into an ETF structure. And without getting into too much detail, that created a lot more tax efficiency for investors, in some cases, maybe lowered fees a bit.
allowed them to trade daily or like intraday versus just once a day in a mutual fund. So there’s some benefits that came about it. But when you think about personalization, neither of them really had much other than I could select whether I wanted to invest in large US companies or international companies, I buy this index or that index. But I could never really say, hey, Mr. Manager, why did you buy that stock over that stock inside of my mutual fund? They just didn’t, you you gave them discretion to do that.
where we’re at now. they’ve been around for a while. It’s funny, when I got in the business, a lot of people are calling direct indexing, separately managed accounts. But what we’re doing basically is we’re now saying, hey, instead of buying a mutual fund or an exchange traded fund, we’re just gonna allow you to buy all the underlying stocks inside of that mutual fund.
So instead of owning one position, now you own 500 positions or 2000 positions, whatever it is. And it was hard to do that in the past because it was expensive. The trading costs were high. When I first started in the business, they had these, they really touted them at the firm I was at. They started at two and a half percent. That was the cost. Now we’re at a point, at least at Greenspring, where there’s no difference basically between the cost of the mutual fund, the exchange traded fund,
or owning all of the funds separately or the underlying stocks separately. And this is where personalization comes in. Now you could say, you know what, I don’t really love, you name it, oil companies, let’s say. I would like to exclude them or at least limit them in the portfolio. And all of sudden you can do that inside of your portfolio and really personalize it. So you see this a lot with socially responsible investing.
ESG, which is environmental social governance screens. People kind of really want to make sure that they are following some sort of screen on that. So or you could have the situation of I work at Johnson and Johnson. I have a ton of stock in Johnson and Johnson. I just I don’t really want to own it inside of my diversified portfolio. So can we just exclude that stock and maybe some of the other industry peers because they all act very similarly. So I think there’s some really interesting things going on. We’ll talk about the tax benefits of it as well.
but this is all kind of coming from innovation, the ability to take what was really only available to very high net worth folks, bringing it down market so that kind of everyday investors can invest in these things and get some of the benefits.
Marcus Schafer (16:51)
It is weird, right? If you think about the transition, you were owning individual stocks, then mutual funds and improvement over that. Then an ETF kind of tends to be an improvement over that structure. And then you almost go back full circle and you say individual stocks, but I’m going to take what I learned about mutual funds and ETFs and use that to my advantage. I’m going to buy as much as possible. I’m going to build diversification into the portfolio. And then with any
With any gift, you got to be careful that you don’t stretch it too far, right? You don’t want to unlearn the lessons that you learned from ETFs and mutual funds, which is if you have a personal belief about a holding because you think it’s a good stock or a bad stock, the market really doesn’t care about your opinion. That’s probably not the reason why you want to personalize. You want to personalize more for what you were talking about. Hey, there’s a different component in my financial life.
that I might be overweight in and I don’t want to double or triple dip. There’s values that I have that I am willing to sacrifice some degree of control over and then understanding what are the limits of those. think those are good reasons to diversify, to deviate. To your point, we’ve got to essentially, you can replicate exactly what you can get in a mutual fund or an ETF.
And now you’re just understanding, well, in my particular situation, is that going to benefit me or am I adding complexity for no discernible benefit?
Pat Collins (18:28)
Absolutely. And I think there’s a few other benefits that we’ve seen with clients other than just the personalization, which there’s a clear benefit there, obviously, if you have a need for that. And I want to be clear, this is not for everybody. Sometimes this isn’t the right decision to make because maybe you don’t really care that much about personalizing it. You want to have as much diversification as possible. That’s totally fine. I think where this has gotten for me, it was always a hard
kind of leap to say the benefit of doing this is worth an extra 1%, 2 % in the very beginning. That to me seems really crazy when I could buy something at 0.2%, but I was paying 2 % instead 10 times the cost. That was kind of a crazy, but now we’re at this point where technology has brought it down to a very, basically the fees should not be the main driver at this point.
I would say the biggest use case we’re seeing with clients with these types of investments going into direct indexing is for tax purposes. And I think we’re going to talk a bunch about some tax innovations that’s happening on the investment side. But when you think about, let’s just say the S &P 500, on average, it goes up every year. Sometimes it goes down, but about two out of every three years or so, it goes up. And…
When you think about it going up, if you own a mutual fund of the S &P 500, if the S &P is up 10%, then your mutual funds up 10%. What you don’t see is if you were to deconstruct that and say of all the 500 stocks in the S &P, some of them went up, some of them went down. It’s probably something like 30 % maybe went down that year. Now the aggregate went up, like if we average it all together. But when I deconstruct it, I can say those ones that went down,
I actually want to sell those and harvest the loss that I can use now against future capital gains that I may have. So where do we see this valuable? Sometimes concentrated positions, people that have a lot of money in one stock, they can start to invest in this type of strategy, harvest some gains, some losses to be able to offset the gains that they have. We’ve had clients that have sold businesses or planning to sell a business. We use a strategy to harvest losses so we can offset their gains on their business. So
There’s some really interesting use cases for tax purposes that you don’t get in a mutual fund or an ETF that you can get in a direct indexing strategy. So something to think about if you are an investor and you know, and sometimes for a lot of people, they say, I don’t know what exactly, you know, what capital gains I have upcoming, but I know I’m going to have them because I’m going to retire in 10 years or five years. And I know I’m to have to start selling portions of my portfolio to fund my retirement.
it would be great if I had some losses that I could use to basically generate tax-free income essentially off the portfolio or at least be able to offset the gains. And so the nice thing about harvesting losses under the current tax code, they will basically allow you to keep them kind of indefinitely. So if you have a loss, you just hold onto it. You don’t have to use it in a given year. It will just roll forward until you use it. So for a lot of clients,
If I were looking at it and said, I can use these losses to offset gains in the future, it’s a nice little thing to build up. It’s kind of like an asset that you have because this is things that will be used to offset taxes in the future. So I look at it as almost like a deferred asset that I have.
Marcus Schafer (22:01)
Yeah, I think that’s really well said. Another kind of hidden use case. If you have tax inefficient investments in taxable accounts, it’s a really helpful tool to help you think about getting out of it. just had a client, they were in a fund they bought a long time ago. It’s happened to do really well. The fees are like a percent, but there’s a 2 % tax drag every single year, a solution like this.
would help you think about, this portfolio, what’s a way to gradually unwind and get that into a more tax efficient solution? It would be to pair it with something that helps you out a little bit and maybe just the counterpoint, right? Which is who might it not make sense for? So one of the things you’re doing is you’re taking one portfolio that you get the benefits of economies of scale, meaning
As other investors come in and out, it might help you rebalance the portfolio. But if you don’t have cash coming in or cash coming out, you kind of have to do it yourself. You don’t have these other investors to help you think about rebalancing, which means your potential range of outcomes over a long time period are going to expand. ⁓ So if you’re somebody who is starting in your career a little bit and you’re kind of like,
Well, I took some great advice and I just have a very simplistic ETF portfolio and I went with less funds as opposed to more funds. You might not need this level of complexity. You might just say, Hey, actually. I, it’s just the benefits don’t apply to me because I don’t have the same challenges.
Pat Collins (23:48)
Yeah, it’s a great point. think it’s really important for all these things to always understand the downsides, the pros and the cons. I agree with you there. think the the con that if you think about our example of stock market goes up, but inside the market, there’s certain funds that are stocks that have gone down. We harvest those losses. We obviously would probably keep the stocks that have gone up for the most part. What happens after a few years is you have lots of stocks that have
lots and lots of gains associated with them. So they have really appreciated and you have potentially other parts of the market where you’ve maybe been selling. And so you may be slightly different than the market weights. So you may deviate from what you would get in an index fund or in an ETF that may work for or against you. So I think it’s really important to understand the strategy. How do they handle that? How much…
In the industry, they call it tracking error. But basically, how much deviation are we going to have from the index after three or four or five years? And are we OK with that? In most cases, we’ve seen it’s reasonable. But I think you have to really understand the strategy. We are using much more broad based type strategies. ⁓ The one other thing, too, where this can be helpful is if if you were a an individual that likes to or has given money to charity every year is it’s you you talked about
not being able to rebalance or making it more challenging because you’re the only person putting money in or out of it. If you are ⁓ charitably inclined, this is an interesting strategy because you will have appreciated securities. You can gift away your appreciated securities and avoid the capital gain if it’s given to charity. So there are certain ⁓ use cases. I would also just say if you are an investor that has most of their money in tax-deferred accounts like IRAs, 401ks, these are probably not the right products for you.
Mostly because of all the tax benefits that you would normally get in an after-tax account, you don’t get in an IRA. The only time it could be maybe worthwhile to consider for an IRA is that you are very, very out of the personalization of what you own. That could maybe make some sense. But otherwise, the fact that you don’t get tax efficiency, in most cases, we’re recommending people stick with ETFs and mutual funds instead of like their IRA accounts.
Marcus Schafer (26:11)
Some of these tax benefits kind of unlocked by technology, just enabling. If you kind of think about this from the manager’s perspective, this is way harder to do because instead of just managing one portfolio for a hundred thousand investors, you’re managing a hundred thousand portfolios and you need to be buying and selling oftentimes daily.
And so the complications we’ve seen a lot of innovation in that where even before it used to be, well, because we have so many portfolios, we can only look at your account once every so often. And markets just tend to move faster than that every so often. So the admin of technology that allows people to look at accounts and understand these trade-offs and synthesize a lot of conflicting data, that’s been an evolution. ⁓
Generally, one of the big areas of innovation you and me are seeing is all around understanding the implications between tax and expected return to kind of get to this, what does the after-tax return mean for you as an investor? And this is where people are very different. You can understand, pre-tax return, there’s less friction, I’m shooting for this number.
But if people are at different tax rates and those tax rates are changing over time, how you think about incorporating that information into the portfolios you’re building and then also the portfolios you’re using for anybody, that’s super, super important too.
Pat Collins (27:52)
This is where I think we’re maybe going to move into the ultra wealthy strategies. It’s been brought down market a bit, but some of these have been reserved for ultra wealthy. But I think now it’s starting to become available for kind of what I would call more middle market type investors that have a million dollars, two million dollars, five million dollars. of like it’s not just reserved for the 50 million and above kind of thing.
Before we get to that, kind of curious from your perspective, because you came from an asset manager, and this maybe gets to the point of technology really innovating and allowing us to move down market. But at your company, they’re one that recently, maybe not recently, over the past five-ish years or so, have really gone into direct indexing the firm you came from, Dimensional Fund Advisors.
But prior to that, do you recall, like if I had gone to Dimensional and said, I’d like to set up a direct index with you, I wanna open my own account, you trade it for me, and I wanna kind of direct you on what I wanna exclude and some tax optimization, how much would that have been then? And what is it now? Just to give our listeners an idea of kind of what the progression’s like.
Marcus Schafer (29:01)
It’s dropped from call it 50 million to 500,000. So it’s probably a 100 times drop just in terms of minimum account size. So yeah, so 25 to 50 million, depending on the asset class down to 250 to 500,000 as a starting point.
Pat Collins (29:22)
It’s amazing, yeah. So this is the kind of innovation we’re seeing. And I think they’re bringing that to some of the tax things we’ll talk about now. So we’ve talked about direct indexing as a strategy to minimize or hopefully optimize your after-tax return by harvesting losses where you can. There’s been, I’d say, again, over the past, this one’s probably been more recent. I would say I’ve seen it mostly maybe over the past three-ish years, maybe three to five, is kind of…
the direct indexing, I would call it on steroids. So what some managers are doing is trying to figure out ways to harvest a tremendous amount of losses to offset all sorts of capital gains that could happen in the future. So what that looks like, and this is one of the more complex products, but we’ll try to explain it in a simple way. Let’s just say you have a portfolio and a taxable account of 60 % stocks, 40 % bonds, maybe it’s an ETFs.
a very simple portfolio, you would give it to that manager. They would not sell it. They would basically hold that, almost as collateral, and they will go out and they’ll go long, a group of stocks, maybe 1,000 stocks, and they will go short as well, which means they’re betting against those stocks, the ones that are going short, they think they’re gonna go down, and they think another group of stocks is going to go up. They’re going long on those. So you have these two groups.
They’re basically diversified. In both cases are diversified portfolios. They know that one of them is going to be a loser and one’s going to be a winner. But that’s the whole point. That’s why they’re doing it. They think, yes. Well, yes, maybe they don’t know for sure, but they definitely believe that, let’s just say. And so what do you get with that? Well, let’s just say the stock market goes up in that example. So the things that you went long on, you’re happy. Those have gone up in value.
Marcus Schafer (30:57)
they think.
Pat Collins (31:16)
the things that you’ve gone short on, meaning that you were betting against, those that go against you, you are gonna have losses there. So they’re okay with that, because they’re basically saying the losses and the longs and the shorts are gonna offset each other for the most part. I still have the 60-40 that’s going up at my average whatever return is getting, but this other part of the portfolio is, I’m going to sell the losers and I’m gonna keep the winners. On paper, I basically kind of have a wash, but
with from a tax perspective, I am harvesting tremendous amounts of losses. And in many cases, that is, those losses are available for offsetting things like getting out of a big concentrated stock position. Somebody selling a business for $50 million and being able to offset a big chunk of that gains, they don’t have to pay tax when they sell their business. So it is really an interesting thing that’s coming out. There are…
several cons to this that everybody needs to understand. So this is not a strategy. I think if you talk to them, to the managers that do this, a lot of times they’ll say, this is a great strategy for everybody. I am not in that camp. I definitely think you have to be very discerning as to who this really makes sense for and whether even if it does, you you can make a use case for it, whether you want to deal with the complexity and not necessarily permanence, but you can’t just unwind this, you know, a year later.
This takes years sometimes to get out of. So you kind of have to know what you’re getting into. But it is an interesting development in the world of finance. And ⁓ we’re seeing a lot of wealthy people do it. I don’t know if we have gone through a full market cycle to really be able to understand it and understand how much deviation is it truly going to create from having just own an index fund? And is that is the value enough to offset the fees, ⁓ taxes, all that kind of thing?
Marcus Schafer (33:12)
Yeah. And the fees, it’s not just the manager fee, which you would expect somebody if they come with something super, something very interesting, something that…
Anytime there’s a claim of value, right? The question you’re asking is, okay, well, who’s going to get the value? it the manager that has to develop all these tools and techniques in order to get that value? Or is it me, the consumer? there’s the fees component. And then there’s also cost component, right? Because you’re, what you’re saying is long something short something else. That means there’s going to be some sort of borrowing cost. Those costs are going to fluctuate. Just something to, to consider. You you think about.
diversification, you got to really unpack that because if you’re going long, some stuff and short, stuff, it could happen that the opposite thing you expect happens. so you kind of your, is tough already for people to understand what is a
Pat Collins (34:17)
NORMAL.
Marcus Schafer (34:19)
distribution from expected returns. That’s tough. Finance is fatter tails, which means unexpected outcomes happen more often that already exists. And so you’re piling on more uncertainty. But to your point, it’s kind of like first to check, hey, does direct indexing make sense based upon tax situation? And then second check, okay, well, how big do you think that tax situation is?
And also getting back to what your total portfolio look like, right? This kind of gets to your opening comments about margin, about fixed costs. Okay. Does it then make sense from that level?
Concentrated Wealth Strategies – Exchange funds and 351 structures, and when their structural tradeoffs may matter.
Pat Collins (35:00)
Yeah, this is not for the faint of heart. I would encourage if anybody’s interested in this, go to an advisor that understands this stuff. Make sure they do a full analysis on it because and you fully understand what you’re getting into because we’ve seen several circumstances where prospective clients have come to us with these strategies, not really understanding them and not fully understanding how long it’s going to take to get out of without causing a tax bomb, basically. So just something
to keep in mind, but know it’s out there. Know that if you’re kind of in those circumstances where you may make the ⁓ decision that having all of my money in one stock and just liquidating it and paying it may be worse than using a product like this and diversifying, but ⁓ also having some costs and complexity associated with it. So it is just trade-offs that you have to think through. There’s kind of a…
A next step, would say, that’s, again, been around for a long time, and we’re seeing technology really bring this back down to the masses. And this is something called exchange funds. ⁓ And so this is really to help investors that have concentrated risk in one or two or just a few positions. So I’ll use the example. I work at Apple, for example, and I’ve been getting stock.
as compensation for years and years and years. after, at the time of my retirement, I realized, wow, 90 % of my wealth is in Apple stock and it’s done really well. I could either sell it and pay a bunch of taxes to diversify. I, if my goal is, you know, I’ve made a lot of money in this, I just don’t want to lose it. If something happens to Apple, I believe I need to diversify. So my, you know, one option is I could just go sell it.
Two is what we’ve been talking about, which is kind of some sort of direct indexing kind of strategy where you might be able to harvest losses. And three, in this exchange fund, it’s kind of an interesting structure where basically you have hundreds of investors typically that all come together that have the same problem just with different stocks. So I have a problem because I own all my money is in Apple. You have a problem maybe because all of your money is in ExxonMobil.
And then we kind of go around and what this manager does is it collects essentially all these people and says, contribute your stock to an exchange fund. So we’re not selling it. We’re all just putting our money together and we now will all own a share of that exchange fund. So instead of now owning Apple, I own basically a slice of the exchange fund, which maybe owns 300 stocks. So now I have diversification. And then there is rules where as long as I hold that exchange fund for a period of time,
I can get a distribution back out of it that has a diversified portfolio. And that’s really kind of an interesting way to diversify the portfolio. Now, I haven’t got rid of the potential tax. It’s still there. It’s not like the tax goes away. I still have a very low basis in these basket of stocks that I get, but I might be more apt to hold it for a long period of time because it’s diversified. And what am I going to do? Sell it and then put it into a mutual fund that’s going to invest in the same things.
So it allows me to defer the tax for a much longer period. it’s interesting models. There’s obviously, again, trade-offs with it. There’s some lockups that you have to think about. You can’t just put your money in and get it back out next year. further, again, the right type of client that has a very concentrated position, these exchange funds are interesting things to look at.
Marcus Schafer (38:35)
Yeah. And it’s an episode that’d be helpful to kind of go back and refresh is just when we talk about how much investment diversification you really need and why. Like a single stock is so risky, even any stock that’s more than 10 % of your investable net worth.
It just, it’s going to drive the volatility for your whole portfolio. And luckily we’re in an environment where specifically US, specifically tech companies have done so phenomenally well over the past 10, 15 years that there’s a lot of people that have these challenges. One of the big changes of the evolution that we’re seeing is if you kind of think about your example, what stocks does everybody has?
Apple stocks that needs, that has this problem. What problem do you have? You have an Apple stock problem. So if 300 people all go to somebody with one problem and it’s the same problem, it’s difficult to help them. So a lot of these exchange funds wouldn’t be open to new investors. A second consideration would be the fees of them. They’d be so high when you would run the math. It was, I think what you were talking about earlier.
You run the math and you say, you know what, instead of setting myself up for a seven year lockup, because anytime you don’t allow me to touch my money without significant penalties for seven years, get nervous. Let me just run the math if I like incrementally sold this down over seven years. And the math would come out pretty close. Also, hey, like we believe markets are efficient. That kind of makes sense. So you’re starting to see some of those.
innovations happen where people are addressing these challenges. There’s another tool that’s come out recently and has started to gain traction, which is a 351 exchange, which essentially means if you have a single position and this position could be kind of anything, you can contribute that to the launch of a new ETF. And so the thought process behind that is you have these, it’s the same ideas.
an exchange fund. just allows you to contribute different types of investments beyond kind of individual stocks. And now you have shares of this ETF and the ETF can rebalance over time.
Evaluating Private Markets – Expanding access, fee structures, liquidity constraints, and incentive alignment.
Pat Collins (41:13)
Yeah, really fascinating stuff. So again, if you if you’re an investor that has a concentrated position or has a large capital gain upcoming sale of a business, sale of real estate, ⁓ it’s worth digging into this stuff a little bit more just to understand your options, understand the pros, the cons, what the tradeoffs are. But I do think there’s there’s other elements we’ll probably get into in a future episode around some of the innovations and tax. But I do want to move on to the last section is
around some of the things happening in the private markets when we think about innovation. So again, this is an area historically where it’s been mostly reserved for wealthy family offices, endowments of large universities. You can argue whether or not it’s been actually beneficial or not to them. Some you would probably say, they went through a lot of work and got very little excess returns or maybe none. So, but.
It is definitely something to be aware of, of what’s going on in the market right now, which is taking illiquid investments. So I would I would categorize that as things like private equity. So ownership of private companies, private debt, ownership of private loans that are not done through like bonds. And, you know, and then you could also see things like private real estate as well. So ownership of real estate properties and.
There are different vehicles that are coming out that are allowing investors to invest in these things at small dollar amounts in different types of structures that maybe don’t lock them up as much as some of the ones have in the past. ⁓ But again, this is one where it feels like a lot of investment companies are running towards these private markets. This is where they’re going. You can see why the fees are extremely high compared to public. And so I think a lot of managers are looking at it as kind of a
a land grab to a degree to generate more fees, you have to be very, very thoughtful if you’re going into private markets to understand what you’re getting into, what the lockups are. Am I really getting any excess return with this? ⁓ Am I really getting any extra diversification with this? And so these are some of the things to consider, but just know that there is quite a bit happening in this space. If you’re working with an advisor, I wouldn’t be surprised if you’re not already or looking at.
know, types of investments like this. But ⁓ but it’s definitely an innovation that’s happening, trying to figure out ways to get private investments into retail hands. The last thing I would just say is ⁓ basically we have a new kind of regulation that is now even allowing these investments in 401k plans. ⁓ We have a whole 401k practice here. I’ve talked to them. They’ve said that they don’t know many or if or very few firms that are even considering this at this point. But
it is now a possibility to own things like private equity inside your 401k plan. I would not, I think this trend is gonna continue. You’re gonna hear more about it.
Marcus Schafer (44:13)
Yeah, it face value. Here is what the proposal is. You can own more of different types of companies. And people said, yes, at face value, that sounds like a very compelling proposition. The challenge is understanding are those benefits going to accrue to you as the investor? And also at what level net worth
Are you in that’s going to you access to the right type of investments in the right structure for the right asset class? Right? Like if we just take private equity as an example, the historical structure would be they’re going to go to a few very large institutional investors and say, when we buy a company, we’re going to come to you and ask for some money to help us buy that company. And then when we sell that company,
We’ll send you some profits. Well, if you think about how to scale that over a lot of people, that seems very, very challenging. it’s okay. So what if we built a vehicle where you give us money and then we just pull the money from that vehicle when we need investments.
But it’s not as clear as here’s when the capital call comes in, when you need the money, here’s the distribution, here’s when you’re going to get it. So is the vehicle the right match for the asset class? And that’s why you’re kind of talk about liquidity, which is if they don’t sell the investments, it’s really tough to get liquidity back to investors if they need it. So trying to keep an eye on, hey, we understand the benefits.
costs are coming down, but they are pretty high and there’s different degrees of high. And then are the benefits going to accrue to me in terms of after tax expected return?
Pat Collins (46:15)
Yeah, I think that’s that’s the key. ⁓ There’s always a narrative around these. always a story on why it’s a great investment, why you should invest in it. We’ve probably our investment committees looked at dozens of these ⁓ products that have come to us. you know, we with full disclosure, we do have some private investments in our portfolios for clients. But that kind of you know, that’s probably three or four things out of dozens and dozens that we’ve looked at. So it just tells you that
most of the time when we look at these things, they’re just not worth investing in. The juice isn’t worth the squeeze, if you will. You’re not getting enough extra diversification, extra return for the risk that you’re taking from an illiquidity standpoint, from a fee standpoint. So I think you just have to be very, very mindful when you’re going into these things. But it is an area that I would expect because I just think more more firms are getting into this space, I think, because of technology.
I do expect fees to continue to come down. That’s been a trend in investment management for a long time is is fee reductions for asset management. And I think this will be the next one probably at some point. Right now it’s still high, but as you get more entrance and more competition, you should expect to see fees come down at some point. So just something to keep in mind as an investor. So ⁓ anything else on the investment front that you want to want to touch on?
Marcus Schafer (47:39)
just one thing on the investment front and it’s kind of a simple example, which is, ⁓ does it sometimes make sense to just get diversification and not chase all these, all these really cool things? And I would look at it in terms of like your taxable account, which means there’s going to be taxes on it. Should you buy municipal bonds or
reverse taxable corporate bonds. If you look at the research, there’s just diversification benefits where you might say, hey, I’m willing to sacrifice a little bit of tax efficiency because my after tax expect return over time as these variables change seems to be a little bit better or I get some diversification. So it’s just really tough to also think you have to tax is one factor of investments.
but you also have to think about the return and you got to combine those two and it’s really hard to do, but sometimes you might see less tax efficient investments, but it still might be the right choice for you. And I think that’s one of the really challenging things to unpack.
The Penny Framework – Determine whether potential advantages justify added complexity, cost, and tradeoffs.
Pat Collins (48:53)
a story yesterday about the ⁓ discontinuation, I guess, of the penny. So U.S. mints are no longer creating, I think they created the last penny in November. were no pennies will eventually go out of circulation. We will no longer have pennies. So the reason I bring that up is, you know, why did they do this? a lot, one, it was, it costs more to make a penny than one cent. So it was costing the government more than a penny, more than a cent to make a penny.
So I think that’s a good lesson for all of us is to think about, we going through the motions, but we’re not really getting any benefit out of it. The other thing though, is it just creates simplicity in our lives. If I’m trying to pay with something with exact change, I don’t wanna have to carry pennies around. It’s just extra things in my pocket. If I’m paying with cash, I don’t wanna get pennies in return, because what am gonna do with them? So even though it might be optimal for me to hold pennies, because I can get down to the last cent basically,
instead of rounding up to a nickel, it just may be not worth the aggregation of it. And I think about that exact same example with investing is some of this stuff is such at the margins and we’re trying to pick up pennies and we just have to make sure that the cost of doing all this, either from a just a time standpoint, complexity standpoint, know, just tax filing, all these different things, is it worth the complexity?
of doing it or should I just maybe get a little bit less optimal, but keep it simple. So those are the things that you should be talking to your advisor about and really understanding if I make this change, what’s the real benefit to me? And is it worth it to jump all through all these hoops, change things to get this small benefit? Maybe it’s a big benefit and maybe it really is worth it. But I think it’s important you know that before you make these changes.
Beyond Investment Management – Innovation across planning, lending, and the broader advisory relationship.
Marcus Schafer (50:43)
That is a great story, Pat. I think we’ll probably come back with another episode just thinking about outside of investments, what are all the other innovations, your financial picture is not just stocks, it’s your tax situation. It’s how do you use, how do you think about getting loans? What’s the fee that you pay for those loans? How do you think about insurance? So there’s also just a ton of innovation that’s happened recently, just
continuing to create new ways to solve particular problems. So we’ll come back with that, but you are now in the camp of people that do not like the penny. Apparently that’s a divisive topic and I know where you stand now.
Pat Collins (51:29)
Absolutely, yes. I’m happy not to have them in my house anymore, but great episode. Look forward to the next conversation.
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