Talk Your Book: Customizing Your Assets

0:00Today's Animal Spirits Talkie book is brought to you by Halo. If you are an advisor, go to Haloinvesting.com to learn more about how they have created the first marketplace of the first market. HaloInvesting.com.

0:44Welcome to Animal Spirits with Michael and Ben. We've been talking a lot on the show lately about trade-offs, risk, reward, that sort of thing. And one of the tricky things about the relationship between reward and risk is that it's not static. Or is it static? Wait, am I using that right? No, it's not static. There we go. Thank you, Ben. In William Bernstein's new book, which I've mentioned a bunch of times lately, He talks about how different markets behave correlation-wise in inflationary, non-inflationary environments. And in inflationary environments and high-rate environments, you see the correlation between stocks and bonds rise, which makes sense from last year, right?

1:22Stocks and bonds both fell. The non-stat, it's a double negative. It threw me off. Yeah. I'll give you an A for effort. So I think that really threw people off last year, is that the supposed hedge you thought in a down market didn't happen because stocks fell, because bonds fell. And so I think maybe some people have rethought their relationship with bonds or are starting to rethink about how they find more of a one-to-one correlation as a hedge. So we talked to Matt Radgowski from Halo today, and they created a hedge that does that, that like it up to a certain cap as the market falls it hedges you and you get a reverse return for that.

2:09Does that make sense? Not explaining this correctly. Well, guess what? We do a great job explaining it on the show. So without any further ado, here's our conversation with Matt Rutkowski.

2:23We're joined today by Matt Rutkowski. Matt is the CEO of Halo. Welcome to the show, Matt. Great to be here. I appreciate it. So we've had Jason Barsima on the show a few times, But for those listeners that might have missed previous episodes, if you wouldn't mind just a refresh of who Halo is, what are you all about, who do you work with, and then we'll take it from there. Yeah, for sure. So Halo Investing is a two-sided marketplace. Our job is to bring protective investment solutions to the marketplace and connect the issuers of structured notes, annuity products with advisors, as well as the enterprises that they serve.

2:59And so our job is really to try and create solutions whereby advisors can easily integrate those products that, quite frankly, aren't as commonly used today. We're certainly hoping to grow their adoption and utilization, but create efficiencies in the operations as well as ways they can better use these product solutions inside portfolios. Matt, one of the things that Jason has talked to us about in the past that surprised Michael and I is that the structured product market is places way bigger outside of the US. You'd think a lot of the financial products would be used more in the US because of how big and robust our markets are.

3:38Not to brag. What is the reason for that? Why did they take off in other countries and why hasn't that expanded so much in the US yet? Yeah, I think it comes down to the investors themselves, how they're wired, how they think about the markets, what's important to them. And so I think if we look at utilization of structured products in Europe, for instance, I think you have an investor base that, if you think about the pension schemes that are common, the insurance-based schemes that exist within those markets, where you have an investor base that's very focused on disciplined accumulation of assets, pension-type security of income in their retirement phase, the note is a natural solution in those environments.

4:25And so if we think about the stock market in the US and how it came about, quite frankly, it's more of a speculative environment, right? Trying to find that next big stock, get that hot stock tip, capitalize on it to grow your investments. And so we saw really, again, an outsized usage outside of the U.S. based on just the way those investors are wired. Here in the U.S., again, focused more on accumulation, most on driving return. Less interested, quite frankly, at least in the past, I'll say, on the protective nature of the solutions that are offered. That makes sense. It's a risk tolerance type of deal, basically.

5:10You got it. That's it. Yeah. So defined outcomes have been growing in popularity, particularly in the ETF world. Structure notes are a different wrapper, a different investment vehicle. Can you talk about some of the trade-offs between some of the things that we're seeing come to market on the ETF side versus what a structured note delivers, just some of the pros, cons, or whatever? Yeah, absolutely. I think getting to the center or really the heart of the matter, it really comes down to ease of implementation within a client portfolio. And that's really why I think the ETF, you've seen obviously tremendous growth.

5:46When BlackRock decides to get into space, you know it's gaining in popularity and momentum. And so I think it's really around the access, right? You have a ticker-based ETF that an advisor can easily purchase through their platform of choice today. There's also just the perpetual nature of the ETF, Jeff, right? There's creation, redemption that's ongoing. Doesn't get called away. It doesn't get called away. That's exactly right. And so that perpetual nature of the product, I think, creates an attractiveness to it. Now, I would say on the other side, right, in terms of the note, just the customization, right, the ability to create and deliver unique structures, the nimbleness of them and how they can be brought to market, whether we're talking about a calendar-based option or a very custom reverse inquiry-based option, there is additional flexibility in terms of the types of risk and return profiles that can be achieved in the note.

6:45Obviously, then you need to manage that lifecycle. And we can talk a lot about how we try and enter that equation. But those are, I think, the biggest differences between the two. The perpetual nature of the ETF, right, as you point out, lack of callability, ease of consumption, right, just in terms of buying it on an exchange relative to buying that note with a set duration. There is the prospect of callability. You need to manage the lifecycle in general in terms of when it's going to mature or when it might be called. That's a great answer. Two of the trends in investing, as I see it, are customization.

7:19That's a big one. And I would put this certainly way further down the spectrum in terms of relevance, but still gaining in popularity is defined outcome. Now, not for everybody, of course, but there are a lot of investors that are willing to trade off whatever upside they may be cutting off for wherever they set their personal risk tolerance on the downside. There's trade-offs, everything else. One of the nice things about notes is that you know the trade-offs. You define them, right? With stocks and bonds like 60, 40, 70, 30, you could define your risk tolerance, but you can't really define the outcome.

7:54So what Halo is doing, It's really in the sweet spot of those two trends. Maybe talk a little bit about the customization that you offer on the platform. Yeah, for sure. So, and just to get it, I'll take a big step back. This is actually why I am at Halo. You know, I've spent my entire career, you know, developing, building, delivering, selling, you know, portfolio solutions. And so that customization you talk about is one of the key reasons. You know, I will go back into the defined outcome as well, if it's all right. and dig in as to why I think that is actually hugely relevant. And I would say moving up in terms of its relevance to both advisor and investor.

8:31And so from a personalization perspective, I think that just in general, the consumer, if we even zoom out from financial services, think about us as consumers. We are very demanding. We're very fickle. We want what we want, when we want, how we want it. You can create your own custom pair of Nikes, get it tomorrow. Just in general, the demand for products that speak to the individual are there. It extends right into the portfolio. That individual wants to know that their portfolio that is being developed for them reflects what exactly they want, what they're after in terms of return, risk, and outcome.

9:15And so the ability to personalize, the note, I always make the comment, what could be more personalized than your own Q-sit? If you think about reversing query, building a note for yourself, nothing more personal than your own QSIP there. But the ability to set those parameters very specifically in terms of what is the exposure you're looking for in terms of the underlier, whether it's an individual stock or index or elsewise. What are the characteristics of both upside participation and downside risk? To your point, those tradeoffs, quite frankly, are welcomed by a lot of investors. and it actually speaks to the planning process that we can potentially dig in on as well.

9:56And so, again, the ability to tailor in that experience for that investor gives that advisor a definite advantage in terms of how they market themselves to their clients. The technology we've built allows them to do it at scale, which is obviously key. You could build the best personalization infrastructure, but if it doesn't scale, there's just no way that practice can grow as they'd like. Matt, you mentioned your background. Were you on the banking side of things? Were you creating these products? Were you in the financial advisory world? Where did you come from? Yeah, so in the retail advisory and wealth management world.

10:30So I spent a bulk of my career at Morningstar, a great place. I had a wonderful opportunity to build traditional portfolios, mutual funds, ETF-based solutions, as well as software solutions there, whether it's financial planning or other types of investment planning tools. And so, you know, and, Marco, you pointed it out, right? Like the process that an advisor usually goes, you know, heads down, right? They're trying to target some rate of return, maybe through a financial planning tool, maybe elsewise. They come out with a return hurdle, right? 7%, 8%, 9%. And then they take a 70-30 and hope, right, that the performance over time aligns with it.

11:11And I think, you know, the note, again, to me, is a very beautiful structure. And basically, to your point, taking a bit of the top side, removing that uncertainty on the downside, really driving towards that outcome that an investor says they want. And for me, I'm always looking for the next best mousetrap. And when I was sitting there in my traditional mutual fund and ETF world, it was exposed to what the structured note could offer. It really changed my mindset and thinking. And that's quite frankly, through a series of conversations, how I ended up here at Halo. One of the biggest inputs to the note that dictates the outcome are interest rates.

11:51And given that the market rate environment looks vastly different today than it did maybe a year ago, can you talk about how advisors are changing how they use notes and how the level of starting interest rate impacts the outcomes either way? Yeah, this is actually a hugely important topic. And I think actually, in my opinion, if we get through, right, there's this shift in terms of product usage that we've seen. And I really do believe it could actually lay the foundation for dramatic increase of usage. I'm shocked to hear you say that, Matt. Yeah, I know, right? I know. I mean it. And I'll try and give you some reasons other than optimism as to why I think it will happen.

12:36But, you know, if you think about a lot of usage of notes, great source of income, right, in that low interest rate environment, it was a great source of alternative income. And so you saw some pretty great yields that could be generated through that structure of the note. As we've seen yields rise, if you think about traditional fixed income markets these days, you actually saw, and we've seen, you saw it through back half of last year into this year, a dip in note volumes in the US. And that obviously gives some cause for concern. Is the structure still appropriate for the investor base today?

13:17Given this heavy, heavy focus in terms of income-oriented notes. And so what we're seeing, though, is a shift in utilization. And so to your point, you can participate in the growth of a underlier. Let's just say S &P 500 or a combination of the indexes you're using as your strategic asset allocation policy. The shift to growth note, the growth note allows you to participate in that upside but set a buffer or barrier on that downside. And so it really does, in my opinion, shift towards making the note a core allocation to your equity portfolio. So it's an equity replacement. You're layering in a hedge within that portfolio.

14:03And that's where, again, I do think there's an attractiveness to the solution for core portfolio allocation. And so what it's being used for has shifted, right? So we're seeing shift from income notes to the growth notes. we're actually seeing the markets running up. And that does two things. One is it creates the FOMO, right, of the person with the cash on the sidelines that's trying to figure out when to come into the market. And the note itself can be a great tool to say, hey, look, you come on in, right, get that equity exposure, but do it with your downside protection. And for the individual that was, you know, I'll say smart enough, right, to participate in this massive run up in the S &P 5, they now may be a little bit more concerned around where valuations are.

14:49Have we topped out? What do I need to do in order to make sure I maybe take some risk off the table? And the note, again, can be a product used in that situation to say, let's allocate to the note. We can still maintain our equity exposure, but then mitigate that risk on the downside. if we do in fact see, again, volatility return and maybe some profit taking within the equity markets. And so, again, I think its utilization has changed. We're seeing volumes catch up to the levels we saw through last year. But again, I think the way it can be used in a portfolio is such that it can be a strong, you know, kind of, let's call it, you know, omnipresent allocation.

15:40It's not the sledgehammer to every nail, like you say. It's, again, it's, there's no panacea, no free lunch, right? But it can be used in a disciplined way to either entice investors that are kind of, you know, a little bit of trepidation about getting back in, or those that are in can create some, you know, some protection against, you know, downside swing there. Can you explain some of the similarities and differences between the growth and income notes that you were mentioning? Yeah. So the biggest difference, right, and we'll kind of keep it at its core, is what is actually produced in terms of outcome.

16:14And so when you price an income note, right, the output from that issuer, so the issuer basically says, for this underlier, for this duration, I will effectively pay you a coupon, you know, an annualized yield of X percent. And so that's kind of the basics of it. So it's, again, similar to a traditional fixed income instrument in that it has a yield that it is willing to pay. Again, still based on certain parameters of the market in terms of its performance. It's subject to the performance of the market. But again, the outcome is delivered in the form of a yield. where as opposed to growth note says, okay, if you give a duration, and there's ways to set different parameters, but for a simple example's sake, if you give it a duration and you give it a level of downside protection that you're seeking, 10, 20, 30, 40, 50%, you know, in the form of, you know, there's hard protection, soft protection we can get into if we'd like, but you basically set that protection level you're looking for, and the output or the return is the participation in that market.

17:27So if you have a S &P 500 growth note, it will say you can participate in the S &P 500 at a 150%, 120 % participation rate subject to some cap, right? So that's kind of the resultant output or experience from the note. So if you kind of think about it, it's yield, right? I'm going to deliver a yield or I'm going to deliver a participation in that equity underlier with some downside risk mitigation. Now, let me push back a little bit or see some clarity on a potential hedge. So let's say that you've got 30%, or let's just say 40%, whatever, it doesn't matter. 40 % downside protection, no matures in two years, right?

18:15So if the market falls 50%. So I buy the note over the next six months, the market falls 50%. It recovers and the market is down 20 % at maturity. So great. You get your money back at maturity, but the hedge didn't necessarily kick in because there was like a timing mismatch. It's obviously no fault of anybody's, but you're not hedged against downside really, unless you get, unless the downside corresponds with the maturity date. What is wrong with that line of thinking? Or maybe add some context to it. Yeah, so I guess just I'm going to kind of replay the question to make sure I'm getting it right.

18:54And so you're basically saying, really, I'll sum it up by saying the protection only matters at maturity, right? Is that kind of, yeah. Yeah, I guess the pushback to what I just said is, well, listen. So if the market falls 50%, your note doesn't drop 50%, right? So you could look at it that way. But the hedge, to the extent that the hedge exists, it's at maturity. That's correct. Yeah, yeah. So you are, in fact, enticed to hold that note to maturity. Now, in that example, right? So if you hold that note to maturity in the market when you come back, so say over the duration of that note you described there, the market is down 20 % at maturity, right?

19:35You're paid back at par, right? So your initial investment is protected. You've insulated yourself from that 20 % downside. And so that is where, you know, in terms of the ultimate strategies, you may want to, you know, similar, quite frankly, let's call it to a laddered bond scenario. Maybe you want to ladder in notes with differing maturities, right, at differing levels of protection, given what you've seen in that market. But to me, I think, you know, and just want to make sure we're on the same page there. Like, you know, yes, you're absolutely right. The only thing that matters in terms of that protection is what happens at maturity.

20:11However, that protection is there for that full duration of your hold. Yeah, I guess said differently. It's not like a liquid hedge. It's not as if the market falls 40 % and you could then cash out, right? It's not like tail risk insurance or anything like that. That's exactly correct. You're exactly right. Yeah. Yep. And that's where, again, I think some of those laddering strategies can come into play, right? where as you're seeing things happen in the market and you're seeing just where your note performance lies relative to your time to maturity, that may cause you to make additional decisions around additional note purchases.

20:53Actually, here is a direct hedge that it's not liquid, but here's a hedge that we've never spoken about with Jason. I don't think maybe we have. Can you talk about how absolute notes work? We actually have, I'll say, an interesting note idea that's gained a lot of traction. Pitch us. Yeah. So I'll give you an example, right? So this note I'll share as an example, and I hope that's OK. We'll sort that out later if we need to, guys. But so in this case, right, for example, a note tied to the S &P 500. And basically, it says if that note trades down more than 25 % from when it's issued, that note is immediately callable.

21:31Sorry, when you say that note, do you mean like if you buy, you mean if the S &P 500 drops by that amount? That's correct. Yeah. So it's an S &P 500 linked note. So S &P 5 is the underlier, right? In this case, if the note itself, I'm sorry, if the S &P 5 declines by more than 25%, that note is called and your principal is returned. All right. Now, here's where the absolute comes in. Where's the caveats? Wait, hold on. I want more color on that. Yeah. So what's the time horizon of that note? Yeah, it's 18-month note, right? All right. So if the S &P 500 falls 25 % or more in an 18-month window, you get 100 cents on the dollar.

22:12You got it. What happens at maturity if that's not the case? Okay. So if the S &P 500 is down between 0 % and 25%, it will actually pay the absolute value. So if it's down 15%, it will pay you 15%, right? So that's where the absolute note comes in. Okay, I got it. And what if the market's up 20 %? I assume there's a cap on the upside? There's a cap. On this note, you're capped at about 6 % to 8%. So it's a bearish note. Let's be honest here. But it is, if you have concerns about where the market is, if you think it's overheated, overvalued, that absolute note will, again, pay you the inverse. So up to a point, you were at a negative one correlation to the market.

22:58That's correct. Yep. Yep. At maturity. At maturity. This is why I am a fan. Obviously, this is not investment advice, but I am a fan of customization. Now, there's a limit. I don't want clients moving all the dials and stuff. Obviously, as the advisor, you want to control the outcome and present them with reasonable options. But what you described to me, for a portion of a portfolio for somebody who is a little bit on the nervous side, that's a reasonable way. Now, could somebody say there are better ways to, oh, fine, fine, fine. But I think that's a reasonable hedge. I agree with all the caveats you mentioned.

23:35I'll double down on those and then say, of course, right? And I mentioned, it's no hammer to every nail. There's no silver bullet. But again, yeah, it is a very strong tool that can be utilized really in many different ways within that client's portfolio. In this case, again, like you said, if you have some trepidation, if you're concerned about where the market is, it's a way, quite frankly, to engage the investor and keep them in the market, keep them investing, which I think is absolutely critical in terms of their overall ability to fund their needs in the future. The thing we want to emphasize is, again, not to get too soapboxy, but keep that investor, get them in the market, keep them invested in the market, and make sure that they don't, again, miss out through timing miscalculations, which, again, can be crushing to portfolio performance.

24:27There are obviously ways to get opportunistic here. And I think one of the things that Jason has mentioned to us in the past, that he's always kept a sleeve of structured products in his portfolios. Are there any strategies that advisors apply to their portfolios, their client portfolios, where they're agnostic to what's going on in the market or levels of rates, where they just say, this is the strategy that we're going to implement come hell or high water. Are there any interesting or unique strategies that advisors are doing that way where they're just saying, we're keeping a sleeve of structured products and this is the way that we're looking at it?

24:56Yeah, it's funny. I say this a bit tongue in cheek. I don't know if they're interesting, but they're definitely utilized, right? And that actually, I think, in a way, speaks to the utility of them. And so, yeah, I'm sure Jason has talked a lot about hedged equity strategy or just notes within his portfolios. And so we have seen note programs that basically utilize that note, I'd say almost like if you think about, and I lived a lot of my life in that target date world, where as your horizon, as you move through your horizon and you move towards ultimately the point when you're moving from accumulation to decumulation, you're basically systematically taking risk or what you perceive as risk off the table by moving into fixed income from equity.

25:42And so we've seen a lot of advisors utilize a core allocation to that growth note with downside protection throughout their asset class exposures. You know, you see it varying in terms of size, and we'll talk about how Horizon impacts that. But basically, as a core allocation, just to say, regardless of what's going on in the market around me, I basically want exposure to those asset classes, but I want to do so in a risk-managed way. Now, what changes over time is as that individual progresses through time or valuations or other outside factors indicate, they'll actually increase the level of protection.

26:22So if you think about instead of a Goliath path where you're trading off equity risk for fixed income risk or shortfall risk or other risks, the risks just don't go away. They're actually using them to increase the protection level as they progress towards retirement date. So again, they stay invested in the market, so they continue to accumulate, which manages shortfall risk, while also, again, keeping that downside protection. This is interesting. There's something Michael and I were talking about recently. What was the Bloomberg chart last week, Michael? Like the put option protection is as cheap as it's been in how long?

26:57I can't remember. A couple of years, I think. Yeah. Is that something that you're seeing in the options, which kind of seems bizarre considering the market's going up? But there are some dynamics going on in the market where it's actually cheaper right now to buy protection than it has been in the past. Yeah, and we're seeing that for sure. And, you know, again, I'm going to raise my hand and say no expert, right, in terms of the underlying causation of that, right? I don't want to – definitely don't want to put myself out there as such. But, you know, it definitely, again, seeing that, you know, there are some, you know, very strong, interesting, right, pricing there, you know, in terms of these growth notes.