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How Custom Indexing Can Help Clients With Complex Tax Needs

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Right now — tax time — clients may be wishing that last year they’d designed a portfolio for themselves with a tax strategy tailored specifically to their individual needs. A new software-based tool, Canvas, makes that possible. 

In test mode by nine RIAs since late 2019 and launched last month, the platform for portfolios of publicly traded equities was created by O’Shaughnessy Asset Management. It lets advisors build custom indexes for investing in separate accounts tailored to clients’ preferences. 

Custom indexing is “the next evolution of indexing and direct indexing,” Patrick O’Shaughnessy, the firm’s CEO and portfolio manager, tells ThinkAdvisor in an interview. He expects “a majority of all advisors in the U.S.” to use web-based software to design and manage custom indexes by 2025.

OSAM now manages $1.2 billion in assets for about 600 clients through Canvas.

In the interview, O’Shaughnessy, 35, describes how Canvas can greatly help clients with complex tax needs, including harvesting losses and reducing a concentrated stock position.

The front-end system has proven particularly popular for environmental, social and governance investing since it allows clients to design portfolios based on their personal preferences.

The tool screens for company names, industries and sectors, among other criteria, as well as for factor exposure.

The platform has roots in quantitative research conducted by OSAM’s founder, and Patrick’s father, Jim O’Shaughnessy, now chair and co-chief investment officer. A pioneer in quantitative analysis, he wrote the bestseller “What Works on Wall Street.”

ThinkAdvisor recently held a phone interview with Patrick, whose popular twice-weekly podcast, “Invest Like the Best,” has 7 million listeners. The CFA said OSAM named the platform Canvas because “investment strategy should start with a blank canvas. It shouldn’t be, ‘Here’s something off the shelf that we’ve modified a little bit for you.’”

In creating the software, the firm “took heavy inspiration” from car-design websites, where one’s ideal auto can be personalized according to key features, price, speed and so on, to, O’Shaughnessy said, “make it your own.”

Here are highlights of our interview:

THINKADVISOR: How does custom indexing differ from direct indexing?

PATRICK O’SHAUGHNESSY: Direct indexing uses a top-down model. It starts with something off-the-shelf from a third party, which you can modify slightly. Custom indexing goes several steps beyond that. It’s bottom-up and allows you to build whatever you want.  

What are your expectations for widespread use of custom indexing?

It’s the direction that direct index platforms will have to go in. They’ll have to build the ability for clients to get exactly what they want versus an approximation of it through some third-party index.

Is your platform useful for tax strategies? 

Taxes is a huge one. Very complex tax transition is one of the most popular features. You can run a tax transition analysis based on holdings and see the expected tax cost/benefit [and other metrics] in seconds.

How else can Canvas help with clients’ complicated tax needs?

For example, “I want to generate as many losses to my portfolio as possible this year because I’m selling a company and want to offset my gain with losses.” Or, they’ll say, “Next year I can only pay $100,000 of capital gains tax. So in trading activity, put that as a limit.” 

What’s another scenario related to tax management?

If a client has a concentrated position, the advisor can say, “Here’s how we can work out of it and how much we think it’s going to cost to do so.” That puts [the FA] on the same side of the table as the client because they’re designing the strategies together, with the client’s goals in mind. 

Is Canvas’ capability something an advisor can talk up with clients?

Yes. This is a front-end system designed to be seen and used by the advisor with their clients. They can show it to them and walk them through designing a strategy. 

What can Canvas screen for?

Company names, industry type, sub-industry, sector [among others]. For example, an energy investor might say, “I want to exclude the entire energy sector from my custom index — I don’t need more investments in that space; so I want to reduce my risk in this portfolio.”

What does the software provide most significantly?

You can do two things with our research- [based tool]: rule out companies that are the worst offenders — which is, kind of, the old way of doing it. Or you can lean into an overweight and put more money with companies that do the best job, based on our screening.

What’s another dimension advisors can manage with Canvas?

We adjust for factor exposure in the custom strategies: If they want income, some people prefer to own higher dividend yields. Some prefer to own value equities. Some like more growth or momentum equities.

What’s your main goal for Canvas at this stage?

Our focus now [early on] is to make sure we’re the leading edge of custom equity portfolios — and then start to build additional features beyond that. Some of those, like diverting assets into a charitable foundation, will come later. Right now Canvas is for publicly traded equities — scoring each on a company’s activity on a given issue.

What are some other strategies you can customize?

ESG investing. We have more than 50 different issues that people have asked us to build into the strategies. We found that investors like choosing their issues. They don’t want to be told, “Here’s your ESG portfolio.” They like to say, “These are the issues I care about,” such as [female] corporate board representation or carbon emissions. It’s pretty powerful to let people control their portfolio this way.

Can an investor request big umbrella themes?

Yes. Sometimes [preferences] cluster into themes like climate [change], or there could be clusters of issues such as deforestation. Carbon emissions is a very popular one. For instance, the client may say, “Put more of my money in companies that do an incredible job of being carbon-neutral.” 

Can your platform replicate a particular requested design, or must you execute it from scratch every time?

Once we do it for one person, we can do it for everybody because it’s all in software.

What’s the basis of the software?

It all goes back to a very strong quantitative research theme, which has been our history for more than 20 years.

How much does Canvas cost?

It’s meant to be competitive with index or direct index strategies — and the key part of their success is that they’re low cost to the end investor. The software is free for the advisor to use. We do all the trading. We charge an asset management fee to the client, like any money manager.

How easy is it to use Canvas?

The advisor just needs a computer with a web browser and a telephone — no other infrastructure. Making it easy for advisors to use is our North Star for how we built the software. That was critical. The entire [platform] was built with the advisor in mind so they can design a strategy and generate a performance report in seconds.

Canvas is a web-based tool. So can one just download it from the Web? 

No. It’s not an open model. For now, it’s gated. Eventually, you’ll be able to sign up online and go through an onboarding process. But right now we’re pretty heavily vetting each new partner and working with them very closely. We want to make sure that advisors know how to use it. Every advisor has a dedicated team [that we provide]. So it’s a pretty high-touch model. 

You have a popular twice-weekly podcast, “Invest Like the Best,” which you started in 2016. It has 7 million listeners, and your guests are investors, CEOs and company founders. GMO’s Jeremy Grantham was recently on. What audience do you aim to attract with the program: financial professionals or consumers?

I aim it at insatiably curious people.