Ep. 168: Trust the Process: Why Advisors Should Let Rebalancing Software Manage Client Portfolios with Jerry Michael, Smartleaf

Come on in and sit back relax, you’re listening to Episode 168 of the WealthTech Today podcast. I’m your host, Craig Iskowitz, founder of Ezra Group Consulting and this podcast features interviews, news and analysis on the trends and best practices all around Wealth Management Technology.

Before we get into the interview, if you are listening now you’re an executive at a broker dealer, an asset manager or an enterprise RIA you should run not walk to a website, EzraGroupllc.com and fill out the Contact Us form on the homepage to meet with us about your technology platform issues. Our experienced team can assist with software vendor evaluations systems integrations, improving operational efficiency, software implementations and a whole lot more. You can take advantage of our free initial consultation offer by going to EzraGroupllc.com. Now, let’s kick this thing off.

Companies Mentioned

Topics Mentioned

  • Trends in Portfolio Rebalancing
  • Trust the Process
  • Real Time Tracking of Realized Gains and Losses
  • Promoting Rebalancer Tax Savings

Episode Transcript

Craig: I’m very excited to introduce our next guest on the program. It is Jerry Michael, founder and CEO of Smartleaf. Jerry, welcome.

Jerry: It’s a pleasure to be here.

Craig: It’s always a pleasure to talk to you my friend. It’s been a while. How’s everything going? Where are you calling in from?

Jerry: I’m calling in from Cambridge, Massachusetts.

Craig: Beautiful Cambridge. It’s still love this time of year, getting a little chilly though.

Jerry: Yeah, no, it is actually a beautiful, beautiful weather. Of course we tell ourselves in New England that it’s all worth it for the changing seasons, the beautiful fall colors. I’m not sure that’s actually true, but it’s what we tell ourselves.

Craig: And we tell ourselves the same thing here in the southern northeast in New Jersey, right so not as bad but still we get the same issues, but we’re still happy here. So thanks again for being here. Excited to talk to you about portfolio rebalancing trends and portfolio rebalancing is what we’re talking about today. Before we start, can you please give us a 30-second elevator pitch on Smartleaf?

Jerry: Smartleaf is an automated rebalancing system. Our purpose is to make portfolio personalized portfolios simple. Or maybe I should phrase you know, just to make portfolio personalization, simple. If we’re doing our job managing the direct index is literally as easy as managing an ETF and using literally in the way that your high school English teacher would approve. All forms of tax management tax sensitive transition ongoing tax loss harvesting your gains deferral all should be easy. ESG easy, personalized portfolio should be no harder to manage than any other portfolio.

Craig: That’s a great pitch. I’m ready to buy. Where do I sign?

Jerry: Well just give us a call.

Craig: I will do that. But let’s talk about trends. So you’ve been in the business for quite some time you started your company back in 1999, is that correct?

Jerry: That’s correct.

Trends in Portfolio Rebalancing  

Craig: So you’ve seen everything around portfolio rebalancing, when it comes to the financial advisory business. What are some of the things you’re seeing now? What’s changing around portfolio rebalancing. Now we’ve been so long in the industry things are mature.portfolio rebalancing software

Jerry: Well, I think the deeper trend is that is a change in the value proposition of wealth advisory firms themselves away from any value proposition that’s based on performance or product or trades or talking with the clients about whatever Cramer said on TV last night, and it’s more towards the idea of the advisor as a financial planner and we hear phrases like lifetime financial coach, now we have nothing to do with that trend. But if you embrace that trend, then you realize the advisor is not adding value. By taking on rebalancing themselves the correct amount of time for an advisor to spend. Rebalancing and trading portfolios is precisely zero. And that we are seeing that is the largest change that people realize that is the right amount of time for advisors to spend trading and rebalancing portfolios.

Craig: That is very different than what most many advisors thinking and think today that they need to be involved. They need to be reviewing trades, they need to be checking that everything’s working properly. Why is that something they don’t need to do with your system?

Jerry: So there’s two reasons why the advisor would be involved. One is they’re talking to their client about whatever Cramer said on TV and whether they should buy or sell Tesla than obviously the advisor is involved. But apart from that, there was a belief that if you wanted customization if you wanted a great text management, that the lead advisor had to be the one rebalancing the portfolio there after all, the only ones who know what the advisor what the individual client needs to have people always recognize that so centralized rebalancing would be efficient and scalable, but it would be cookie cutter. And we’re here to say that’s exactly backwards. That if you want to deliver very high levels of customization and very high levels of tax optimization, the only way to do it is to centralize the rebalancing and trading is that’s the only way to automate it. And the only way to deliver either of those truly at a high level, even for individual accounts is through automation. Otherwise, it’s all it’s all compromise all the way down.

Trust the Process

Craig: Indeed, I mean, that’s those are the kind of rebalances we worked a lot with is the ones that require a lot of interaction. The the trades need to be reviewed or the rather the orders need to be reviewed before they become trades for their approval. There’s lots of finagling and fiddling, fiddling with the trade order list. So how do you get advisors to trust the process? And just let it go.

Jerry: So there’s nothing to that one. You have to be able to enable them to serve their clients give out if they’re not getting a solution, a customized solution that does fit their client’s needs well, there’s they shouldn’t trust the system. So you first have to be can’t be cookie cutter. The advisors still has to be involved. I’ll use the slightly clunky phrase designing a customized solution. That means this is the client  we’re not gonna have real estate is that outside holdings in real estate, they wanted tobacco screen. They are withdrawing $5,000 a month and we have to prepare for that we want tax sensitive transition we want to, a transition over three years. All of those options still need to be there for the advisor. They’re not the ones implementing it, but they are the one making those choices. So then beyond that, all right, we have this automated system, this black box blinking lights, why would the firm trust that? And the the answer is, well, you can show the data that actually it does, statistically a very good job of managing those portfolios. When we implement our system. We see not surprisingly when people go from sort of decentralized, decentralized, we see that on average, the dispersion of accounts goes down by 60%, which perhaps you would expect, the slight surprise is the level of taxes goes down by 60% as well. And you would think that’s impossible. We need to choose one or the other. Do you want to have lower dispersion, do you want to have lower taxes? For the accounts, you can have both. And that’s a measure of how much better this process is than having the advisors manage the portfolios themselves.

Craig: What do you mean precisely, when you say the level of taxes goes down by 60%, as well as that mean clients see a 60% reduction in their taxes?

Jerry: Correct, relative to what they were seeing before.

Craig: So the taxes that come from capital gains generated by the rebalance are is reduced by 60%, by the way, by moving to a centralized process.

Jerry: So before this is it means before the adviser wasn’t doing tax loss harvesting, they were occasionally selling things short term before they went long term. They were most advisors who were going after all doing this largely manual process, the more customized the more tax optimized, the more manual it was. It meant they were doing it fitfully, when they when they had time, they aren’t very good at trying to do this at scale.

Craig: We’re still seeing we’ve been in the industry for for 18 years, I’ll find services for 30 but specifically wealth management 18 years and we’re still trying to get advisors to realize their value add isn’t pushing the button, building models and trading but they still seem to think that why do you think that is?

Jerry: Well, I’m not sure I’m the best person to comment on that because, we Adana, our clients who have identified that their future is a value proposition based on the advisor as lifetime financial coach. As for why advisors will I think ultimately it’s probably as the customer I think many investors still believe that their advisor is someone who’s going to be more of an expert at picking stocks, the doctor is going to be better at picking which medicine I should get and well my advisor, they’re going to be better at picking which stocks are going to win. So I think that’s what a lot of investors clients are looking for. And so firms have no choice to some extent. Some of them feel they have no choice but to accommodate that. I’ve spoken to advisors who they don’t believe it at all, they have no they feel they have no choice. They have to sort of pretend that they are great stock pickers and sneak in sort of financial planning and lifetime coaching when the client isn’t noticing. And I think it’s that hybrid which is disappearing as firms realize. We’re not even going to pretend this is who we are. And we will work with clients who want who we are.

Craig: So you said the hybrid so that’s in between the do it yourselfers Do It Yourself advisors, the ones who wanted to make all the trades themselves with you know and do all the rebalancing themselves. With the hybrids do some of the the the set it and forget it, crowd and then you’re the middle where they’re sort of in between, how do they what are the sort of in between ones do and why is that? Why is it that the best of both worlds?

Jerry: Well, actually, let me go backwards. I was actually using the word hybrid in a rather unusual way. It was hybrid of value propositions, it’s are we a financial planning? Are we about lifetime financial coach, are we about being the smart person you talk to about individual trades? And what we’re seeing disappearing is the firm’s that are trying to be all things to all people that, trying to do both of those, and it’s those firms that are likely to have both a hybrid I think in the sense that you were talking about Oh, two separate sort of rebalancing workflows. And I think firms realize this is no way to run a firm to have two separate workflows. Pick one or the other.

Craig: Yeah, the the firm that’s all things to all people is funny. I remember there was someone at a conference made a fake video ad for an advisory firm and it said, we are we are specialists. We focus on retirees, young people, middle aged people, people with kids, people without kids divorcees, newlyweds, on because they’ve basically every advisor wants to serve all all clients, they don’t realize they need to be in a niche.

Jerry: Interestingly, this is getting far afield, but because of the ability to be a virtual advisor, meaning you don’t have to have clients in your office, you can all be through zoom. We are seeing some hyper specialized firms, we we work with widowers and I’m actually fascinated by this because they are it’s clearly a very they are focusing on a lifetime needs the lifetime challenges that people who are going through these life changes have not been through them before but the advisor can develop great expertise. We’re seeing get out firms specialize not only in say doctors, but specific branches of medicine. And this is I personally find that to be a fascinating trend, not much related to what we’re doing but it is consistent with the focus on on being a lifetime financial coach.

Craig: I know there was a couple advisors one that works with just retired airline pilots. Excellent guy to conference he does that. Another one. Of course we see the ones that just do doctors or lawyers or dentists or other trade specialties, but this one advisor who only works who specializes in a bass fisherman I love it. Oh, it only does this. Do you have any bass fisherman type of rebalancing users in your system at all? What was the worst the bass fisherman button do you have that?

Jerry: We do not. And I do not know whether bass fishermen have specific needs in their portfolio. They might I mean, there might be  part of customization is risk customization. You’re already exposed to the certain industry risks so you shouldn’t have more in your portfolio and for all I know bass fishermen fall into that category. But the the part is what are the but I do believe I’m I don’t know what they are, but I’m confident bass fishermen have different needs than other people.

Real Time Tracking of Realized Gains and Losses 

Craig: Speaking different your product is different in one interesting way. A lot of firms use portfolio rebalancing, part of as you mentioned, to reduce taxes. And one of the things we’ll look at Ezra Group we spend a lot time doing research on advanced technology. portfolio rebalancing is one of our areas of expertise and we’ve been following your product as well as all your competitors products for many years. And one thing we liked about your product was its tax management capabilities. One of the things you have not only as a tax budget, living what the client wants to pay in taxes, how much need to offset, but you also have real time tracking of realized gains and losses and carrying forward losses. What was the impetus behind building that and and how much is that used by your clients?

Jerry: So let me go backwards. This was the purpose of the system was to make personalized portfolios, simple, and so it was it was the origin was actually to make directed to automate managing direct indexing was indexes was actually the original conception. So the focus was on automation, first and foremost. For the tax and tax management was always one of the advantages of owning a direct index and ESG was also always another and some of those were there as part of the system from day one. And so part of the the, we think we do think our tax management is is very good, but part of it is actually just the automation you can do. It turns out more is more if you can do year round tax loss harvesting, you’re going to do better than if you just have a workflow that does it in December. The people talk a lot about tax loss harvesting and it isn’t important but actually gains defer risk adjusted gains deferral turns out to be in the long run and even more important thing and it’s very hard to do unless you have an automated system. So we set out first and foremost we wanted tax management. It wasn’t we never defined ourselves as a tax management software. It was just one component of personalization. And so the other things  like tax budgets, tax sensitive transition it all just sort of dropped out of let’s take the standard parts of tax management and automate them. There’s nothing I would say it’s some we haven’t invented any new new theory of tax management. There’s no fancy derivatives involved in what we do. It’s pretty standard loss harvesting, gains, defer all that sort of thing. What’s new is the level of automation.

Craig: It can do anything.

Jerry: In some sense, if you had one portfolio. I actually I even believe that even with one portfolio we could do better than most advisors who sat there who had one job, which was just to manage one portfolio and they had eight hours to do it. I still think we could do a better job. But it wouldn’t be that wouldn’t that that’s not our client. The real issue is most people they have more than one portfolio. So the real win is that you can do stuff that people already know how to do, they can just do it on every portfolio.

Craig: Knowing that and knowing that you can now scale your personalization. How is that helping firms deliver more value when they include they do things quicker, but how much quicker actually can they do it? Do you have any examples of how fast now firms can work when they’re using a portfolio rebalancing engine?

Jerry: Alright, so I’ll tell a story which I think illustrates two sides of it first, probably the single most important thing it does is free up the advisor to not spend time rebalancing and trading portfolios as I mentioned, earlier the right amount of time for advisors to do that is zero. So a story that goes back to March 2020, when the markets became, very volatile and they sort of, they crashed. We had a firm the client facing advisors who spent no time trading portfolios in the month of March they reached out to the average client five times. At the same time, the they rebalanced their entire book at least once and multiple accounts were traded more than once in the month of March. And that was all done by one person working part time. So we’re illustrating two things here. One, the adviser the client facing advisors have the time to reach out to clients five times because they’re not rebalancing the portfolio. But also the firm had no trouble rebalancing 100% of their book in a day if they wanted to.

Jerry: And at the end of the month, the last phone call, they went back to the clients and said, Well, this is kind of a hard month, but this is what we did. It’s what we promised we would do. When there was loss harvesting opportunities and taxable accounts, we did that. And by the way, the value of the tax loss harvesting we did in this month alone will reduce your tax bill by 3.5% of your portfolio value on average, if you’re able to use those tax losses against future gains, which they were. At the same time they were able to report it oh, by the way, we were able to actually reduce overall dispersion. And the reason was that when you do tax loss harvesting you’re selling something and you have cash and it’s in our system, you’re not constrained to the scope, put that in cash or put that in SPY, it’s cash and you can just use that to fill in the valleys of underweighted securities sectors and industries so they can use the tax loss harvesting not only to do tax loss harvesting, but actually in the month of March. I think it was most volatile period in something like 20 years to actually reduce dispersion. That’s an example of the system doing what it’s supposed to do, both freeing up the advisors and the firm has no problem trading 100% of their accounts in a day.

Promoting Rebalancer Tax Savings 

Craig: Well, the interesting part of your system is that tax management number that you keep tracking and maybe you send out newsletters, and you say here’s the amount of percentage tax saved across our entire client base. And you constant push that out there. How does that help to help to help drive sales to do prospective firms respond to that number?

Jerry: They do and actually, I think was an interesting story. So we have clients they they have they we can measure the taxes saved for each individual client through active tax management, and the numbers are not small. And we actually recently had a firm did a case study and they actually asked the question, what percentage of our accounts? Did we save more in taxes for the client than the than the client was paid in fees? And the answer was 68% of the accounts 90% on $1 weighted basis. And what makes this interesting is yes, it’s very nice to be able to tell clients Hey, by the way, I save you more in taxes and I charged fees, but that’s not the interesting bit. I mean, it’s nice, but I don’t think that’s the greatest value. The greatest value is that the firm is able to say look, tax management is not my primary or even my secondary value proposition. But it is important and it is one of the things I do and here is documentation of the quality of our tax management.

Jerry: And so it is a I think a useful and sort of true signal of this firm has its act together that not only do they do tax management, not only they talk about tax management, which every firm does, and oh by the way, and here is the documented evidence. And so these firms will I think slightly slightly encourage clients to of course even if you’re working with another firm, we encourage you to ask them well how good is their tax management with the expectation that the other firm probably will not be able to respond. And when our clients they are the ones that are able to measure their wallet share through some sort of aggregation service, they can measure what is our share of wallet share and consistently, they’re winning. And they attribute actually, the taxes saved report as much as anything else, even though it’s not representative of the core service that they’re providing. But it’s the an easy point of comparison between them and another firm. It’s hard to compare, say financial planning and am I going to be able to retire in 30 years? Well ask me in 30 years, it’s it’s a harder thing to measure, but the quality of the tax management is measurable.

Craig: That is good. So just to reiterate, you said in one case study one client 68% of their clients saw tax results, basically reducing their capital gains taxes by more than the fees they are paying the advisor.

Jerry: Correct and that’s actually inclusive of fees paid to third party models.

Craig: Even more impressive. Because it’s it’s harder to do.

Jerry: That’s harder to do. The answer is yes, it is valued I think interestingly, the most important aspect of that value is simply that demonstration that this is an organization that is buttoned up.

Craig: We talked about around the financial crisis, how advisors were trading their entire book, in one day or less. And so how many advisors are currently trading on your platform and how many accounts do you currently process?

Jerry: So I think we have about $50 billion has managed to the platform about 350,000 accounts. And actually I do not know offhand how many actual advisors that is less you’d probably find that out.

Craig: Could be useful. Well, we love stats. So any kind of statistics we think are useful and also useful for getting firms may not be familiar with you on an understanding where you fit in the market.

Jerry: So I can go through some of our clients, the investment management unit of SEI, Apex Clearing has rebalancing functionality that is powered by us there is a new firm on the market Altruist their rebalancing is powered by us. Altium is an RIA that was recently joined Hightower. And I think they’ve been anointed by Hightower to be the direct index provider to the Hightower family of firms. Advisor, another firm where the rebalancing component is powered by us. There’s then a slew of banks and other RIAs that are direct clients.

Craig: That’s great. I was just reading it down. And that’s where you did have a lot of clients in the banking space for many years as sort of one of your primary client bases but you’ve since expanded into the RIA space.

Jerry: That is correct.

Craig: And how did that transition go?

Jerry: Well, so the transition, banks, there’s a couple of things that banks have sort of taken this holistic approach to investing in sort of less, they put a greater emphasis on the holistic management of the account and last on trades, that’s historically been true. And so that was partly sort of the natural cultural fit with banks. They’re also tend to be larger. And so that was, started where the larger organizations were for to serve RIAs. We have launched some advisory service, where we will do the rebalancing and trading for the investor the client facing advisors experiences the same. The Investment Policy Committee is experienced as the same, but will take over the role of that one or two person rebalancing group. We’ve also integrated directly with some custodians currently fidelity and Schwab, which makes it easier for RIAs. There’s just no software integration. So it makes it possible for us to serve smaller firms. And that means that opens up more of RIA space.

Craig: Would you say, what’s the breakdown of your clients from the enterprise space to the independent RIA space?

Jerry: It’s still so the the Tamsin banks don’t want the majority the fastest growing is RIAs. Just the story of the industry.

Craig: Yes, it’s been I think that story’s been the same for 20 years. Now, think about it. They’re constantly telling us that advisors are going faster than the rest of the industry. Yeah, so we’re seeing that as well. And we still have to keep plugging away. But how fast they’re growing. Looking at tax management, you mentioned something that’s going to get you to define our silver tax management, test budgeting, and you mentioned real time was our risk adjusted gains deferral? Can you explain how you tackle that?

Jerry: Well, it’s what I mean is, gains deferral is not selling something. Because motivated by the your desire to avoid capital gains taxes, and well, in some sense, that’s trivial, just don’t sell anything and presto, you have gains deferral, but you’ll end up with a wreck of a portfolio. You can’t have super concentrated positions are super concentrated sectors or industries. So it’s constantly a balancing act. On the one hand, I don’t want to sell something with that’s overall weighted that has gains because I don’t want to realize the gains. On the other hand, the darn thing is over weighted and therefore, by definition, over weighted I have more than I wanted, and therefore I am creating risk, possibly unnecessary risk for this client. And so that is a constant balancing act. So when we say sort of risk, whisk away or gains deferrals, maybe the better phrase is it’s not something you do and forget about it. In some sense, tax loss harvesting is much simpler. All right, I have some algorithm and some for when do I sell something at the what percentage of basis and then I do something for 31 days and then probably I go back and then I’m kind of done. Gains deferral could be months, years, decades, but constantly constantly making sure that you do not have an unbalanced portfolio. Sure. And that’s probably why I think you hear less about gains deferral, I think it’s because it’s fundamentally harder.

Craig: Knowing when something’s gonna go down.

Jerry: Well, rather than I’m going to do something and most likely I’m done in 31 days, and you can have their loss harvesting done well is not done by mechanical rules. But you can do a decent job of loss harvesting by just following some mechanical rules. You can’t do a decent job of gains deferral using mechanical rules.

Craig: So why can’t you do that? What is so complicated about tax loss harvesting that you can’t just do it by mechanical rules?

Jerry: Actually loss harvesting you can I mean, I don’t think you can do a great job of loss tax loss harvesting by using if I mechanical rule is I will sell any tax law at 80% of basis. I will then buy SPY for 31 days and then I will go backwards. That’s a simple rule. It’s it’ll do an okay job. It won’t do a great job. However, gains deferral I get to you, if this mutual fund is overweighted well, is that good or bad? You can’t have a simple rule of never mutual fund can be overstated by 10%. Right? Well,  can your large cap mutual fund that’s overweighted by 10% actually be a decent substitute actually for the mid cap. So maybe you can underweight and mid cap will plausibly. But you won’t get that through any sort of mechanical works.

Craig: You’re talking about a wash sale rules, mechanical wash sale, where if I sell something, automatically buy this other thing until 31 days and sell it and buy the old back.

Jerry: So it’s their loss. Harvesting, you could do something not great, but you’ll get something from it. I don’t know of any way to do long term, especially, possibly decades long approach to gains deferral,  holding on to overweighted positions with large capital gains and do that well by any sort of, I’m going to apply these simple rules and call it a day because nothing is that simple. It’s, you can Oh, yeah, tax management fee,  the interesting thing is, the individual components, they’re well known. Yeah, this has been originally nothing new here. But doing it, well, automating it, doing it at scale that isn’t

Craig: We’ve run out of time. You’ve said it all. Could you please tell everyone’s listening where they can find more information about Smartleaf?

Jerry: You can find more information on our website at Smartleaf.com

Craig: Jerry, thanks so much for being on the program. Appreciate it.

Jerry: Craig, thank you so very much.



The Wealth Tech Today blog is published by Craig Iskowitz, founder and CEO of Ezra Group, a boutique consulting firm that caters to banks, broker-dealers, RIA’s, asset managers and the leading vendors in the surrounding #fintech space. He can be reached at craig@ezragroupllc.com