“Off the Wall” Podcast

What is Direct Indexing and How Does it Work? with Patrick McStay

Feb 08, 2023 Investing & Portfolio Strategies

Have you heard the terms “direct indexing”, “custom indexing” or “factor-based investing”? This approach to investing is gaining popularity due to its ability to build allocations that are customized to an investor’s unique preferences and constraints, and its ability to harvest tax losses. Interested in learning how it works and if it could be a good fit in your portfolio? Let us break it down for you! 

In this episode of Off the Wall, host David Armstrong and guest-host Erin Hay welcome Patrick McStay, Relationship Management Specialist and Associate Director in Client Sales/Service at O’Shaughnessy Asset Management (OSAM). OSAM is the creator of Canvas™, a portfolio management software solution that allows advisors and allocators to create customized investment portfolios at scale. 

You’ll also learn about the Monument Wealth Management TRIO℠ (Tax Rebalanced Index Optimized) Portfolio, which is powered by Canvas™. 

Connect with Patrick on LinkedIn.

“People are more and more accustomed to having customized solutions for more and more aspects of their lives… I think their investment portfolio is no different and as technology continues to grow and enable different aspects, I think that more and more clients will demand some sort of customization to be engrained into their investment portfolio.” – Pat McStay

Are you looking for clarity, conviction and unfiltered advice about your wealth?

You’ve come to the right place.

Episode Timeline/Key Highlights:

[00:50] Introducing Patrick McStay & the topic of today’s episode.
[02:13] What is Canvas? & how our TRIO Portfolio uses Canvas.
[07:56] What is direct indexing and how is it used in portfolio management?
[12:19] What are stock factors?
[14:24] How factor-based investing works.
[17:04] Benefits, opportunities, and limitations of these portfolio management strategies and using the Canvas™ platform.
[26:02] Why the future of investing is customized & the history and inspiration behind Canvas.
[31:28] TRIO strategies we use to manage wealth & our thoughts on ESG stocks.
[35:50] Advice on how to be more responsible with your investing without relying on ESG investing.

Resources Mentioned:

Learn more about OSAM: http://bit.ly/3lghnjo
Learn more about Canvas: https://canvas.osam.com
Listen to the Invest Like the Best with Patrick O’Shaughnessy Podcast: http://bit.ly/3DObdgG

About Patrick McStay:

Patrick McStay is a Relationship Management Specialist and Associate Director in Client Sales/Service at O’Shaughnessy Asset Management (OSAM). Prior to joining OSAM, Patrick worked at Morgan Stanley in their Wealth Management practice. He previously held positions at Beck Mack and Oliver, LLC and Royal Bank of Scotland. Patrick holds a Bachelor of Science in Business Administration and Management from Providence College.

Full Transcription:

David B. Armstrong (Co-Host):

Welcome to this episode of Off The Wall. Today’s going to be a little bit different because today I have with me Erin Hay from Monument Wealth Management instead of my standard co-host Jessica Gibbs, but the reason Erin’s here today is we have a special guest, and we’re going to be talking about some very specific portfolio management strategies with our guests today. But I’ll start off by saying that today’s episode is sponsored by the Nickle and Nickle 2019 Cabernet that Erin and I had last night, maybe one glass too many at a client meeting last night, a lot of fun, but the reason I bring that up is because Aaron, you and I had a really interesting conversation with one of our clients last night. And his comment was, hey, I love the podcast. And I love the guests that come on. But I would really love it if there was just a little bit more specific conversations about what you guys are doing with the portfolios and it just so happens that it was fortuitous that he said that today before we were recording this podcast we’re recording in December listeners probably won’t hear this until January.

We’re coming into the Christmas season here, but this episode is going to hit on his request that he brought up last night and today we’re going to talk about the Monument Wealth Management TRIO™ portfolio which stands for tax rebalanced index optimized, and that is powered by the O’Shaughnessy Asset Management or OSAM Canvas portfolio platform. And so today we have Pat McStay, who’s an associate director at O’Shaughnessy Asset Management; they’re out of Connecticut. And Pat you work with RIA’s like Monument and also family offices who leveraged the OSAM Canvas direct indexing technology platform. And for those listeners not familiar with what that is, or as a refresher for our clients, Canvas is the portfolio management software solution that allows monument to create customized portfolios which tracks the performance of selected indexes like so for example, the Russell 3000.

Alright, great. What does that mean? Well, here’s what that means. Investors have a couple different choices, let’s just say that you really want to track the performance of the Russell 3000. Well, you can go out and buy an ETF that tracks the Russell 3000, right, you can try to buy and manage 3000 stocks, and weight them accordingly. It’s essentially impossible, which is why you always hear the disclaimer like, this is an index and can’t be replicated.

You’ve all seen those kinds of disclosures, if you know what I’m talking about. Or third option is something like the Monument TRIO strategy that uses the Canvas platform to actually construct a basket of individual securities. That’s way less than 3000 stocks, but then is weighted and invested in a way that will mimic the performance of the Russell 3000 index with a little bit of a tracking error in there. But that’s the goal. Okay, big deal. Great. Congratulations Monument, that you can mimic the Russell 3000 index with less than 3000 stocks. So what Okay, well, here’s the so what: The benefit to that TRIO portfolio, through the use of Canvas is that some securities in that basket when it’s purchased will invariably trade at a loss after they’re purchased. And then the Canvas software platform will go find another security that acts exactly the same way and will replace that stock that has an unrealized loss by realizing that loss and then replace it with a new security.

So, an example would be you have Home Depot in that basket, you buy it trades at a loss, sell it and you by Lowe’s kind of a good example. It automates the loss harvesting and it does it in a way that avoids the wash sale rule violations, while also closely tracking that Russell 3000 index. And then another benefit is that the TRIO through the use of Canvas can either unwind existing securities from another portfolio strategy that get brought into this. And those existing securities may have really large embedded unrealized gains. And so, this strategy can be used to unwind those securities by offsetting the gains with losses taken into other securities in the basket or strategy can be funded and started from scratch with cash and then just used to track the Russell 3000 index, all while accumulating losses over time that can be carried forward indefinitely and used in the future. So quick background on what we’re about to talk about today. But Erin with that intro I know you had some questions for Pat to kind of kick things off and be a little bit of an icebreaker and let Pat introduce himself.

Erin Hay (Co-Host):

Yeah, for sure. Thanks, Dave, for having me on. And thank you to Pat for coming down from Connecticut to join us. I know that train ride’s always an adventure. So, thank you. But before we dive into some questions and unpack a lot of what Dave just introduced for us, we’ve got some hard-hitting stuff for you.

David B. Armstrong (Co-Host):

Yeah, here comes put your analyst hat on.

Pat McStay (Guest):

All right, awesome. Okay.

Erin Hay (Co-Host):

What’s your favorite Christmas movie?

Pat McStay (Guest):

Oh, wow, that’s a tough one. So, it’s typically going to be between Home Alone 1 and Home Alone 2, with a potential third category of Christmas Vacation. All three are excellent choices in their own right. but I think I have to go with Home Alone 2.

Erin Hay (Co-Host):

Okay. Strong choice. All right, like that. This is question number two: what was your favorite present receiving as a child?

Pat McStay (Guest):

Present? Oh, wow. So, I’ll never forget opening up – I’m dating myself a little bit here but – the original Nintendo platform. It was something that my sisters and I really wanted badly growing up. And unwrapping that present on Christmas morning was just an incredible feeling of magic. And yeah, even 30 years later, I can still remember the sense of excitement and magic and seeing that.

Erin Hay (Co-Host):

Great answer. I’m actually in that category too – my personal was my Nintendo 64 with Goldeneye 64.

David B. Armstrong (Co-Host):

Here’s where I sound really old – mine was the Atari 2600 with the red button on it. And it had pong and biplane, and anybody my age is going to know what I’m talking about.

Erin Hay (Co-Host):

All right, Pat, well, you talked about unwrapping gifts. Here’s your final question: on a scale of one to 10, how good are you at wrapping presents?

Pat McStay (Guest):

So gosh, so a scale of one to 10. I’m going to conservatively put myself at about it two. Fortunately, I have my lovely wife. There’s a 10 out of 10 on that. And so, I essentially outsource all wrapping to my wife to handle that.

Erin Hay (Co-Host):

That’s fair. I’m I’d have to say I come in, definitely shy of two. I’m probably more on the one scale, so.

David B. Armstrong (Co-Host):

I would ask for some negative, I would ask on a scale from negative five to 10, where do you fall? Because I would give myself a negative five. I just get one of those recyclable Amazon bags with a drawstring at the top and I just go for that. That’s fine. That’s my time. Yeah, that’s what I’m doing now.

Erin Hay (Co-Host):

It’s good. Well, that’s great. So, let’s dive into some stuff here. So Pat, you’re with O’Shaughnessy, which for listeners and for clients, you might hear us reference OSAM. That’s what we’re talking about there. And Dave, in the intro, you use these terms direct indexing, you might also hear something called custom indexing or God forbid we get into some more, I’m going to call them wonky terms – factor based investing.

Pat McStay (Guest):

Yeah. Factor based investing – good term.

Erin Hay (Co-Host):

So here at Monument, we’re all about plain English, but we’re also about bringing in experts to help us unpack these things. So Pat, let’s just talk in plain English, and we can go back and forth on this. What is direct indexing? How do you guys at O’Shaughnessy and at Canvas, talk about direct indexing with clients?

David B. Armstrong (Co-Host):

Right. Explain to me like I’m a golden retriever.

Pat McStay (Guest):

Will do, will do. So, I think to understand what direct indexing is. Let’s use a very simplistic example. If you were to take a look at the largest ETF in the world – the SPY ETF – it basically is one security that underneath that wrapper owns 500 individual securities. It provides incredible diversification at a really cheap price. But what if we could, through software, allow clients to own essentially the 500 stocks that underlie the SPY ETF and allow them to customize for preferences? Like, I don’t want to own Wells Fargo. Well, I can eliminate that stock from the 500 that I’m owning. And also, Dave, to your point about how stocks at some point during the year often are down from a return perspective to quantify that, on average, based on our research, about 31% of stocks at some point during the year are down. And owning the underlying stocks allows us to actually sell those stocks, book that loss, create that tax asset, replace that stock with another similar name, and continue to manage the portfolio within a range of difference.

David B. Armstrong (Co-Host):

Right, that’s my Home Depot, Lowe’s kind of example. Coke or Pepsi or something like that.

Erin Hay (Co-Host):

That kind of leads into our next question on how it works. We talked about Home Depot, Lowe’s, Coke and Pepsi, Dave, I know that’s one of your favorites.

David B. Armstrong (Co-Host):

Yeah, but I’m going to shift it to Home Depot and Lowe’s now, I just I don’t know why. I’m getting tired of the Coke and Pepsi.

Erin Hay (Co-Host):

All right, I’m going to have to upgrade my vernacular.

David B. Armstrong (Co-Host):

I’m just saying like it’s we’re heading into a new year. You know, let’s change things up a little bit.

Erin Hay (Co-Host):

I like that. It doesn’t have to be as simple, and I guess linear as replacing Home Depot with Lowe’s. And that’s sort of where the magic of Canvas comes into play and how this works, and the concept that we’re discussing here is actually quite simple, but the underlying software, the technology that underpins all of this can be quite complex. And this is actually why we rely on our partners at O’Shaughnessy, and Canvas to help us unpack this, so how does this work, Pat? As we just said, it doesn’t necessarily have to be we’re going to sell Home Depot and buy Lowe’s. It could be we’re going to sell Home Depot and go buy a basket of stocks that seemingly have no relationship to one another.

Pat McStay (Guest):

Exactly, exactly. So, it’s a very in depth process that we’ve spent the last several decades building and perfecting. And to give you a sense of on how sophisticated the approach is, we call it an optimization process, which basically looks at Coke to stick with that example, Dave, that you used.

David B. Armstrong (Co-Host):

It’s still 2022.

Pat McStay (Guest):

We’ve got a couple of weeks. Yeah. So, we’re going to take a look at Coke through a number of different lenses. So, we’ll look at its characteristics, its factor scores, we’ll get what sector it’s in, we’ll look at its geographic distribution, its sensitivity to interest rate changes, commodities, inputs, etc. It’s actually 51 different individual metrics to assess and determine what names are closest to Coke. And so, we like to use the example of Coke versus Pepsi to give a sense of what’s happening. But when you look under the hood, it’s a much more involved sophisticated approach that we’ve spent a long time perfecting, right?

David B. Armstrong (Co-Host):

So, it doesn’t necessarily need to be, okay, Coke and Pepsi, we’ll still use Coke and Pepsi, Coke and Pepsi. They both make soda, right? Or pop or wherever you’re from, it needs to be, Coke acts like this, by looking at would you say 52 different characteristics or?

Pat McStay (Guest):

51

David B. Armstrong (Co-Host):

51 different things and trying to find another security that closely mimics those 51 things. It could end up being Wells Fargo. I mean, not likely because they’re not but you’re not trying to match something that’s exactly similar from you walk in the store, and it looks the same. It’s those 51 things that really matter. So, it doesn’t necessarily mean that it could be Coke and Pepsi, it could be Coke, and then Exxon Mobil. If those 51 things were very similar to each other, and the stocks act the same way.

Pat McStay (Guest):

That’s a great way to think about it.

Erin Hay (Co-Host):

So, you brought up the term factors here, and we kind of glossed over it a little bit. I do think it would be helpful just to, in plain English, you know what factors are because this is where I think the approach that we take care of Monument and one of the reasons that we rely on the Canvas platform and O’Shaughnessy is, we don’t just use the TRIO platform, which is Dave said, stands for tax, rebalance index, optimized. Taxes are definitely a big component, so we’ve already sort of laid out, you can go sell Pepsi at a loss, book that for your taxes, buy Coke. We just talked about factors. What exactly is a factor? I think we internally, here at Monument, And I hope we don’t do this with clients, where we just sort of gloss over what factors are we take for granted, that people know what is a factor with a stock? How would you unpack that for someone? You know what our stock factors?

Pat McStay (Guest):

Sure, yeah, great. So, factors are characteristics. They are things like price to earnings, EBITDA to enterprise value, dividend yield, they’re characteristics that we can use to evaluate what stocks have given investors an edge over longer periods of time. And our team has spent decades studying which factors, which characteristics, and which combination of factors have given investors those edges over longer periods of time.

Erin Hay (Co-Host):

That’s a good explanation for factors. It’s just the basic characteristics, common groupings for stocks.

David B. Armstrong (Co-Host):

Right, I like that. It’s DNA. That’s a great way to think about it.

Pat McStay (Guest):

And to continue that analogy, you know, we all have DNA that we just to be a certain height, certain health. Stocks have certain characteristics that have led them to outperform over longer periods of time, and our firm has been an ongoing research project to determine which of those factors we should use to screen stocks in, and which factors we should use to avoid large swaths of the universe. So that isn’t a very important value proposition to the Canvas offering.

Erin Hay (Co-Host):

So that does bring up a good point. We’ve talked about to the related concepts, but different ways of execution. Dave, during your introduction, you talked about something as basic as the Russell 3000. For the S&P 500. I think most people listening know what the S&P is; 500 companies and you can buy them in their appropriate ways for some clients, not all of course, it might just be appropriate to have an allocation to something as simple as the S&P 500, but to be very tax aware along the way again, pulling out those losses when stocks pull back, that I think you said in any given year, what was it 31%?

Pat McStay (Guest):

Yep, 31%

Erin Hay (Co-Host):

Stocks are going to be down during the year. So, using that to your advantage for other clients. And again, this is governed by clients, private wealth design, their individual plans, it might be more beneficial for a client instead of having just basic, we call it passive, S&P 500, Russell 3000 type exposure, to where we are more aggressively, and I’m using air quotes there, or we are more consciously tilting a portfolio to a factor, right? So, it’s not necessarily just the S&P 500. It would be stocks that are in the S&P 500, but have those common characteristics, those factors, such as price momentum, which we can talk about that a little bit, but price momentum is definitely a factor. It is an empirically tested, I believe, Pat, and you guys are the experts at OSAM on this. But momentum, I think Eugene Fama who came up with the efficient markets hypothesis has said momentum, which we’ll ask Pat here in a second. Momentum is known as the premier anomaly, the premier unexplained factor. So that’s two different ways we can use these types of portfolios, it can be for just basic S&P core stock exposure, or it can be really to tilt the portfolio to a factor that over longer periods of time, has shown the ability for a client to outperform the broader markets.

Pat McStay (Guest):

Yep. And I think that’s part of the beauty of the platform. It’s the ability to customize the amount of index replication and the factor tilts that you want your portfolio to have. And to do that, all within the user interface is a really compelling part of the offering. And I know we’ll talk about customizing the portfolio further for topics like taxes or even personal preferences. But yeah, you’re spot on, the ability to customize how much exposure to a certain factor is a very important part of the platform.

Erin Hay (Co-Host):

So, let’s riff on that a little bit more. Let’s talk about benefits, opportunities, or we’d be remiss if we didn’t talk about even some limitations, right, of these types of strategies, no strategy is perfect. We all know that. We’ll just have more of a conversation about what some of the other benefits aside from taxes are, again, we’re pulling out certain terms, you’re going to hear these along the way – direct indexing, index replication, factor-based portfolios. So, outside of taxes, what are some of the benefits of using these types of portfolios? And using the Canvas platform? I think you had mentioned something about being able to exclude certain stocks, or if you have certain preferences that you want to express. Let’s talk about that a little bit.

Pat McStay (Guest):

Yeah, let’s come at that question in terms of customization. And customization can come in a number of different ways. ESG is one part of that, and I think we might touch on that a little bit more in a few moments, but customization in terms of, of managing the portfolio around securities that you either have that you want to bend the portfolio around, and to go down that that route for just a moment. Imagine a client or prospect that you have that, then maybe it’s an officer at a company, and they hold a large, concentrated position in their company stock. They want to build a portfolio that is taking that concentrated stock into consideration. They obviously don’t want to add to that concentration. And they don’t want to hold stocks that are similar to that concentrated position. So, we can take that TRIO portfolio and bend it around and take into consideration that concentrated security so we’re not adding to that concentrated risk.

Erin Hay (Co-Host):

That’s a really important concept here. I think what you’re describing, oftentimes, you’ll hear complaints about portfolios and investment managers that you’re just going to put me into a cookie cutter portfolio, a one size fits all. What this really says to me, and why we really like using the Canvas platform for our clients, is this is truly a one size fits one. There are no clients at Monument that had the same type of TRIO portfolio, because every client’s investment allocation is expressed differently because not all portfolios start from cash. We know this. So, if you’re a business owner or someone who has been investing in the markets for a while or has a concentrated stock position based off of working at a publicly traded companies, chances are, if you’re looking to invest your portfolio with another investment manager, you’re not going to be bringing someone fresh cash. You’re going to have an existing portfolio of individual stocks. It could be exchange traded funds, ETFs or mutual funds. And to us, and I think for clients, it doesn’t make sense to wholesale sell out of something that actually might be a pretty decent portfolio. Always to us, and I think to clients, it doesn’t make sense to sell something that might already be pretty good, but on top of that, in doing so, you would realize a lot of taxable gains in doing that.

David B. Armstrong (Co-Host):

Right. And I’ll even give you another example. And Pat, you probably hear this a lot, too. But when we get new clients that come in from another advisory relationship to your point, they already have a portfolio. And one of the biggest obstacles, or one of the biggest concerns, pain points, I’ll call it, that a new client will express to us is, if I decide to come over to Monument, are you going to sell the entire portfolio that I have to put it into one of your other models? Because as our clients know, but maybe listeners, don’t we run other models here besides the TRIO model right outside the scope of this conversation? But so, our answer is, we don’t have to. As a matter of fact, we probably won’t, because what we can do is we can import that existing portfolio with all of the cost basis that a client has, bring it in, coded as, that’s a technical term, sorry, but like, allocate it to the TRIO portfolio. Use Canvas and the software platform to say, okay, given this basket of stocks that we have just imported, and really importantly, its existing cost basis, we would like you, I’m using my air quotes here, because I’m talking to a computer, we would like you, Mr. Computer, Hal 2000, right? Okay, we want you to mimic the performance of the S&P 500. Just, right, basic, and how we’ll come back and say, well, if you want me to make this portfolio act like the S&P 500, I’m just going to make a really dramatic example here, you just imported 30 stocks that are made up of two sectors of the S&P 500. Energy and healthcare, right, let’s just say and Hal is going to say, all right, well, if you really want this thing to act like the biggest component of the S&P 500 is technology, so I’ve got to add technology stocks in here. And the computer will do its best job to try to add, trim some positions that are already at a loss or something like that, and get it going like that. And then over time, Hal is going to keep trying to come in and say I just keep needing to move this portfolio, or I need keep nudging it more towards the S&P 500. And thankfully, you know, one of the securities that was imported is now trading at a loss, and I can sell that, or one of the new stocks that I bought in the technology sector is actually trading at a loss so I can offset, and eventually how will make it look like the S&P 500 without really incurring a huge tax liability to the client. And that’s a huge advantage to people coming in, because if other advisors shops don’t use this sort of direct indexing program, the most likely answer that a new class is going to get is yeah, I’ll have to sell out of everything, because this isn’t my portfolio.

Erin Hay (Co-Host):

It doesn’t just have to be with individual stocks, though, and that’s the beauty here. So Pat, let’s talk about this a little bit. Canvas can actually use existing, not just stocks, as Dave laid out, you know, you brought in 30 individual stocks. This can be done with existing exchange traded funds, ETFs, or even mutual funds. So, how does that work at a high level, like can Canvass actually look under the hood of the exchange traded fund or the mutual fund to determine what’s in those funds, like X-ray it?

Pat McStay (Guest):

So, X-ray is actually the term we use,

David B. Armstrong (Co-Host):

Okay, you’re also allowed to use Hal 2000 if you want that analogy.

Pat McStay (Guest):

I actually am going to use it. So, Erin, you’re totally right. Our optimizer, that engine that uses 51 different metrics to assess how different stocks are relative to the model that we’re optimizing towards, that optimizer has the ability to look through wrappers, whether they’re ETF wrappers or mutual fund wrappers, and we can actually see some of the underlying securities in those strategies, and that’s an important differentiator for Canvas is that we can see what’s under the hood for lack of a better term, and optimize around that, which a lot of our competitors cannot do.

Erin Hay (Co-Host):

So we’ve talked about some of the benefits, and even opportunities, I some of the benefits we’ve talked about is, of course, taxes, being tax aware for clients who are are hugely tax sensitive, or clients that have existing portfolios that, believe it or not, might have a lot of really good things in them that we would want to in essence, move around at the margins. Let’s talk about some limitations, though, like we talked about who this might be good for, who would this not necessarily be? You know, if you had a client who said, you know what, this might not be a great fit, Canvas optimized portfolio might not be the best fit for this type of person. What would you say?

Pat McStay (Guest):

So, I think from a limitation perspective, the fact that it’s an SMA vehicle, kind of limits who it’s appropriate for. And by that, I mean, the smallest account size we can accept on the platform is 250,000. And so, it’s currently relegated to that high net worth, ultra-high net worth clientele. But hopefully as technology continues to advance in topics like fractional share trading become more and more commonplace, hopefully that minimum account size will be able to be reduced, and we can open up the platform to a wider audience. But, I would say that’s the major limitation currently we’re up against.

Erin Hay (Co-Host):

Okay, just to back up for a second little jargon alert. SMA, for listeners, stands for separately managed account. So that’s just industry terminology there for you. So, let’s kind of take this back, and we’re going to talk a little bit about the history and the inspiration behind Canvas and O’Shaughnessy and OSAM. I think clients, they know there are definitely different access the markets and by markets here, we mean, for the most part stocks, although this can be applied to different asset classes to bonds or fixed income. But for our purposes, here, we’re talking mainly about stocks. And I think of the evolution of how our clients have invested in the markets would be back in the day, mutual funds, were sort of the hot new, technology is not the right word, but mutual funds definitely came back into vogue. They came into vogue several decades ago, slowly, but very surely, and we’re still going this direction. And you’re seeing a lot of mutual fund companies actually convert their mutual funds into an exchange traded fund wrapper, which we’re, as our clients know, exchange traded funds have characteristics of individual stocks, and that they are traded on an exchange, and you can see them price throughout the day. But they’re also pooled investment vehicles like a mutual fund. And now we’re seeing things go from exchange traded funds into these type of direct indexing or factory based portfolios, like what Canvas does. So, what do you see kind of on the horizon? Do you see this type of way of investing? Again, direct indexing, factor-based investing? What inning are we in with this type of evolution of accessing the markets?

Pat McStay (Guest):

Yeah, I think we’re in the early to mid-innings. I think people are more and more accustomed to having customized solutions for more and more aspects of their lives, whether it’s customized clothes, houses, many other variations, and I think their investment portfolio is no different. And as technology continues to grow in an enable different aspects, I think that more and more clients will demand some sort of customization to be ingrained into their investment portfolio. And you’ll see more and more of a move towards this concept of direct indexing or, or where Canvas is, you know, we invented the category of custom indexing, which is just the next iteration after direct indexing. And if you look at some of the industry experts, what their opinions are, you know, Cerulli and Associates estimates that this sector will grow at a little bit more than 12% per year over the next five years, which is the largest growth area in the wealth management space. So, I certainly think we’re in the early to middle innings. And you know, Patrick O’Shaughnessy, our CEO speaks about how, you know, in five years he thinks this will be where most of the industry is at.

Erin Hay (Co-Host):

It’s funny you bring up Patrick O’Shaughnessy, which, great podcast, by the way, Invest like the Best, if you’ve if you’ve never heard of that podcast, brings on some really interesting guests, does business breakdowns. So, definitely a good podcast outside of Off the Wall. If you’re looking for something here in the in the new year to check it out.

David B. Armstrong (Co-Host):

Listen to that one second. After this one after though. It’s a good second.

Erin Hay (Co-Host):

There’s a really good video on YouTube actually. And this is going to sort of re-wrap what we’ve already talked about here, but Patrick was asked I can’t remember who, I think it was Howard Lindzon, who Stocktwits… is he the Creator, I believe he was the creator of that. Just asking about what Canvas is like the inspiration for Canvas, how it came about? And I think he might even asked where Canvas sort of sits in in the O’Shaughnessy family, so I know we’re kind of going in reverse order. But can we just talk about the history of Canvas and how that’s spawned out of O’Shaughnessy, and you know, why you guys are doing this and why this platform has become such a good tool for clients.

Pat McStay (Guest):

Yeah, that question often comes up when I’m speaking to clients, and I say, no, I’ve been with O’Shaughnessy Asset Management for the last two years, but Canvas is only about three years old, so invariably the question we’d say, well, what were you doing in those five years prior, and we were essentially delivering style box specific strategies to our end clients, whether it’s large value, small value International, we were plugging a hole in clients’ portfolios. And we had spent the last three decades perfecting that art of, I mentioned our expertise in factors in figuring out which combination factors will give investors in hedge. And we kind of got to the point where we said, most of our clients are pairing us with some sort of index replication. Why don’t we create a platform that allows them to pair passive with our proprietary factor strategies, do so via a web-based user interface, and allow them to create those customized portfolio solutions to their clients’ exact specifications, and then layer over that individual tax preferences, and maybe even customize for things like ESG, or in Howard Winston’s case, I think he just particularly didn’t want to own Wells Fargo. And so, give me the ability to kick Wells out of my portfolio as well. Yeah, you said the ability to customize and talking about going back to these factors. I’d like to talk about the TRIO strategies that we have using Canvas as such, which is, we have access to really good investment strategies that are not completely dependent on taxes, taxes are definitely a big part of the equation, but it’s not the end all be all, as Pat, you’ve talked about, there’s various different factors, which could be a podcast and of its own, which we can talk about, we often talk about this with individual clients and their portfolios, but actually having access and the ability to execute consistently, very mechanically. Again, it’s not just a one-time thing, but being able to implement the momentum factor over and over and doing that in a very thoughtful manner. And having the ability on top of that, to pull out tax losses along the way to have some sort of a environmental social governance preference, if a client has that sort of a preference. So it’s, it’s not just a tax thing. Taxes are definitely a component here. But these are good investment strategies.

David B. Armstrong (Co-Host):

Yeah. We say it’s a Monument all the time. Right. So, here’s my disclaimer: unfiltered opinions, straightforward advice. Here’s some Dave Armstrong unfiltered opinion doesn’t mean you need to agree with it. Erin, you don’t even need to agree with it. This is just me. I don’t love the ESG thing. clients ask about it all the time. I’m not a fan. I’m not saying that if you’re doing it, you’re doing something wrong. I’m just saying that I don’t love it. And here’s an example of why I don’t love it. People will say, I’m going to pick on the oil industry for a second. Right, Erin, because, you know, I like to pick on the oil industry, right? Well, you’re talking before about the person who doesn’t like Wells Fargo, I’m the Exxon Mobil hater, right? Because every time I’ve bought that, or the energy ETF in the past, I’ve always been on the losing end of the timing of that investment. So, it’s an inside joke with Erin and I, but I’ll use the energy sector as an example. Somebody will say, hey, ESG, I’m going to hire a manager. And that manager will say like, Well, the big evil oil industries, right? Just not my opinion. Just saying it. I don’t want those in my portfolio. ESG, right. 75% of the ESG funds own Amazon, want to talk about a carbon footprint. So 75% of these ESG funds own Amazon, which has a massive carbon footprint. And by the way, Amazon is down this year, but they exclude Exxon Mobil, which is like up, like 11-ty percent. To me, it’s just it is fairy dust. Okay. personal opinion, right? However, for people who do really say like, okay, Dave, I got it. I disagree with you. I want it anyway. Great. This can do all of that, which is fantastic. Because if somebody says I want it, I can say, I don’t agree with you, but we can still help we still do it. I still won’t love it. You’ll never get me to say I love it. Right. But I think it’s fantastic, because if somebody does come in and say, okay, it’s not so much that I want ESG, but I don’t want telecom stocks, or I don’t want I don’t know gambling stocks. Now I’m just picking stuff out of the air. Right? Great. All of this can facilitate this. This is such a robust software platform, that it can accommodate anybody’s goals and objectives and wishes in terms of what they do or don’t own. I think that’s really, really powerful.

Pat McStay (Guest):

Yeah, I agree. And for those that do want ESG in their portfolio, and it remains the minority, about 15% of our accounts have some sort of ESG component into their portfolio. But what we’ve learned is ESG is so specific to the client’s personal preference. And what I mean by that is what’s important to Joe, which is carbon footprint. I’m just hypothetically saying, Joe may not care about diversity and inclusion to just select on another random ESG screen. And so, we have the ability to screen out his portfolio from stocks that are the worst offenders from that carbon footprint theme, but not use any other ESG screens. And so, the challenge with the package products, I think you mentioned ETFs, or even mutual funds is it’s one size fits all, and that’s, that’s a real challenge, because it’s so personal preference driven, that that one size fits all approach just doesn’t work.

David B. Armstrong (Co-Host):

Right. That’s my dig on the ESG thing where you hire an ESG manager, and you’re going to get their perspectives on things. And here’s my free advice to a listener. Okay, Dave, I still want to be responsible with my investing. Okay, idea, this may not fit everybody. Disclaimer, go to the website, read everything. I’m covering my blood on this, right. But some advice, have a great portfolio. Let a portfolio manage it to grow and do well. And then take some of your profits and donate to charity. There you go. There’s another way of getting around it kind of like make yourself feel good, but not necessarily because I do think that people really impact, they create friction in a portfolio when they start to put ESG constraints on it. Just another idea, but you know, the mutual fund thing too. I’ll say this, the one size fits all which is why I think the TRIO start, the Monument TRIO strategy using the O’Shaughnessy, the Canvas platform, this is something else that makes it really powerful too, because one of the not so well publicized or talked about detractors from a mutual fund, or not a great benefit to the mutual fund is that it’s this embedded tax situation, right? So, you go out and you buy a share of a mutual fund, you’re automatically buying all of the profits that have been accrued in that mutual fund. So, let’s just say you buy a mutual fund, and that mutual fund owns Amazon, and they bought it 10 years ago, right? So, you’re buying that tax liability, even though you just bought it today. So, if that mutual fund sells Amazon, you’re going to get a tax bill, at the end of the year, on profits that you didn’t participate in. That’s a big downside to a mutual fund. Here’s what I’m scared about. And here’s what I think is going to be the big ugly envelope that people open up in the first quarter of 2023. If their mutual fund investors, I think this year has probably been a really heavy redemption year with mutual funds and people saying like I want out right, the panic selling. Well, to meet those redemptions, those mutual funds are going to have to start selling securities that have been going up for a decade, because the market has been a bull market for a decade. And you’re going to, if you sold your mutual fund, it’s possible that you are you have a 20% loss in your actual investment, and then you’re going to get a frickin tax bill. Talk about the double whammy. And I think that’s common for a lot of people.

Erin Hay (Co-Host):

That’s some really good practical advice. We’re a little bit past that stage now at this time of the year, but just something to be mindful of if you are purchasing mutual funds – be mindful of when you actually purchase them, because it’s usually around this time of year that those gains start to come through. So might look to if you’re looking at a specific mutual fund, you might wait on the timing to, you know, into next year, so that way you’re not hit with those gains, because as you said, you’re buying into the gains of the fund. But back to your comments earlier, Pat, on ESG. And let’s just toss ESG aside. You talked about you know, quote unquote, off the shelf products like an ETF – is this a fair analogy, I kind of have this in my head, that if you’re using a TRIO portfolio, it’s powered by the Canvas platform here, we’re almost, in essence creating a client’s customized ETF. There’s not an ETF wrapper, I don’t want to, I don’t want to confuse anyone, we’re not actually creating an ETF for you. It’s almost a de facto ETF type structure for a client in that we’re able to control the timing and magnitude of taxes. In addition to having these customizations in the portfolio, whether it’s certain factors, indices, you’re allocating to, ESG preferences, or more practically, for other clients who might work for a publicly traded company and have concentrated positions. Hey, please don’t own any of my company stock. So, is that a fair characterization of Canvas type portfolios?

Pat McStay (Guest):

Yeah, yeah, I think it is. And I think when you think about through the lens of the arc of innovation, for lack of a better term, you go back 100 years you had the invention of the mutual fund, which was a great advance for the retail investor, allows them to access a broadly diversified portfolio of stocks, pretty cheaply and efficiently. And then you had call it 25 years ago, the advent of the ETF, which takes that concept of the mutual fund and adds a greater degree of tax efficiency. And then fast forward a few years after that, you know, you have the direct indexing birth, which gave the highest, largest households, from a network perspective, the ability to own the underlying stocks at scale. And custom indexing, I think, is really the next portion or the next iteration of that theme, where to your point, you are going to have the ability to customize your portfolio for the amount of passive versus active strategies, do so with a tax overlay on it, where you will be able to tell us exactly how much in taxes I want this account to pay every year. You’ll be able to transition that portfolio and stage that transition, as we mentioned a few moments ago, over however many number of years that you and your client are comfortable with from a tax realization, we call it a tax pain threshold internally, where we’ll stage that transition over potentially a number of years, and then customize it for individual preferences. So, I think that flexible backbone is an important aspect to the offing where it fits really nicely in that arc of innovation. It’s really where the industry is, is headed.

David B. Armstrong (Co-Host):

Well, we’re coming up on our wrap up question. Thanks so much for spending some time with us. But I’ll turn it over to you to close us out here and tell us is there is there anything new on the horizon, or anything coming up with Canvas that’s going to be new and exciting? Can you tease us out with a little bit of hey, coming up next here is Season Two of Canvas for Monument and the TRIO portfolio?

Pat McStay (Guest):

Yeah, what I think we’re really excited about is Canvas is primarily an equity solution. But coming down the pike through our ownership from Franklin Templeton, we’re going to be able to access different strategies that fall under the Franklin Templeton umbrella, one of those being municipal SMA ladders. So, we’ll be able to integrate individual municipal bonds into the portfolio, blend that with your equity exposure, do it all in one separately managed account, and have that tax in preference overlay over that entire allocation, have one portfolio solution in one account, encompassing many different aspects of the overall portfolio. So, really excited about that innovation. And we’re going to continue to iterate and build and increase the offing.

Erin Hay (Co-Host):

That’s great. Getting excited about bonds. Who would have thought?

David B. Armstrong (Co-Host):

I know, right, exactly. Whoo. That’s great. Well, hey, Pat McStay. Thanks so much for having us on. I’m sorry, we didn’t get to the question that the dogs wanted to ask about 10 minutes ago, but we’ll bring them on next time and see if we can get some more questions from them, but this has been great. Thanks for coming down and came down from Connecticut. That’s not an easy lift. So thanks so much for coming down here and being a part of this and really enjoyed getting to know a little bit more and hear more about Canvas and O’Shaughnessy.

Pat McStay (Guest):

Thank you so much for having me on the podcast and really appreciative of our partnership. And thank you very much.

About "Off The Wall"

OFF THE WALL is a podcast for business professionals and high-net-worth investors who want to build wealth with purpose. A little bit Wall Street, a little bit off-the-wall; it’s your go-to for straightforward, unfiltered wealth advice on topics that founders, business owners, and executives care about.

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