Talk Your Book: Preserving Your Capital

0:00Today's Animal Spirits Talk Your Book is brought to you by Halo. Go to Halo. Go to Halo. Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:43Welcome to Animal Spirits with Michael and Ben. Michael, this is a trend you and I have been talking about for a while, this defined outcome, understanding your risks. I'd say it's bigger than that. It's customization. Yeah, custom. I actually wrote a blog post about this a couple of years ago saying how the 2000s were index funds, 2010s were ETFs slash robo-advisors. 2020s is going to be the decade of customization. And I think that's where we're at, where people can name their parameters much easier on their investing strategies and portfolios. Yeah. So let's just get right into it. This conversation went long and went deep.

1:24when, I don't know, pick another adjective, it was good. It's always fun to talk to Jason Barcima, president and co-founder at Halo. We are joined once again by Jason Barcima. Jason is the co-founder and president at Halo Investing. Jason, welcome back. Thank you guys so much for having me. Okay, I'm gonna talk about a bunch of stuff. I actually am glad we're talking to you. The timing is good. We talked to someone a couple of weeks ago who brought us this whole, basically book of structured notes is that here's what I'm invested in. Help me understand this. I was with an advisor. Here's the rate they're promising me.

2:00I can get 10 % or 12 % on this book, but I don't understand it at all. Walk me through this. And most of these structured notes were tied to individual stocks. It was one or two individual stocks, and it was a lot of tech stocks, right? Apple and Tesla and some of these high-flying stocks. So I was just curious to get your take on the additional risks you take when you're tying a structured note to an individual stock like this. And obviously, the yields are much higher because the yields on some of these structured notes were 12%, 15 % or something. And I was just about to ask, are they all yield bearing structured notes?

2:36So no participation rates, just yield? Right. They were yield-based. And it sounded like that was what they're going for. So I'm just curious from your side of things, what are some of the additional risks there when you're talking about individual stocks as opposed to using indexes like we've talked about in the past? It's a great question. I'll answer it in a few different ways because every advisor has their own unique perspective. Number one, Halo can help you review all of those products too, as my plug for the platform. But getting back to the risks and the considerations, when you're looking at kind of those, I call those tactical structure notes.

3:11So when they're off of tactical ideas, whether they're tech stocks, whether they're commodities, whether their interest rates, all very popular tactical ideas on our platform. Some advisors like to carve out a sleeve of their portfolio. They call it the Jim Cramer mad money sleeve, where they put it under alternative investments. I see that very common within the advisory space. I actually used to do that too, where 5 % of my own portfolio is allocated to tactical trades. The way I look at that of using a structured note, and this is what I used to do at Credit Suisse, was if I or my clients got a tactical thesis, at least wrap a structured note around it because they're usually higher vol, right?

3:48They're a little bit more risky. So at least you have that downside investment protection in case, you know, your tactical call is wrong. I remember I had a client who wanted to trade Alibaba, you know, at 150 bucks a share or 130, 150 bucks a share. It's like, let's buy a structured note around that because I'm not so sure about, uh, about Baba stock. And that turned out to be the right call. Wait, what do you mean by a structured note around it? Do you mean like buy the stock, but also buy notes on top of it or just buy the notes instead? Buy the notes instead. So instead of buying Baba Long, buy Baba with protection by buying a structured note.

4:21Does that make sense? Yeah. So for individual stocks, would you be more likely to buy one with the income feature or where there's participation caps with downside protection? I do a little bit of both. And so if I'm super bullish on the stock and it's a high vol stock, I would buy a growth note because you're going to get really nice participation rates. I'm bullish on the stock. So I'm going to get more than one for one on the upside, of course, depending on the level of protection. But with something that's got a lot of volatility to it, you can get that really nice enhanced upside plus a deep level of protection on the downside in case I'm wrong or I'm early.

4:57People do this a lot around earnings actually, is that they'll buy structured notes around stocks that they think are going to perform well post earnings and allows you to, again, get that upside advantage if you're right on that tactical call with the comfort of that cushion, the downside. Wait, I have to, I have to, but what's the catch here? Because you're telling me that in some cases you could do, you could have more upside with downside protection. That sounds like a free lunch and we know those don't exist. There's no free lunch. There's never a free lunch. Well, so let's think about, let's unpack that for a second, right?

5:29Like what is a structured note? At the end of the day, it's a wrapper and And inside that wrapper is a zero coupon bond and a derivative package. So there's really two major opportunity costs with structured notes. Sorry to interrupt. On the zero coupon bond side, is that a zero coupon? Is that a treasury bond or is that on the underlying security? So let's just say the, so an issuer of a structured note is a bank, right? Let's say that bank is Citigroup, just using them as an example. and you're buying a structured note linked to NVIDIA, right? To go back to Ben's tactical theme. Ultimately, what a bank would be doing if it's a growth note is that they're issuing a zero coupon bond and that's a Citigroup zero coupon bond.

6:12Oh, the bank is issuing this, okay. Correct. It's a Citi zero coupon bond and then Citi would be going out and doing the appropriate derivative package to give you that upside participation and the downside protection. So back to your question, Michael, of, well, how the heck can you get downside protection and enhanced upside? Well, you can do that based off the derivatives package and the zero coupon bond. What's really interesting is in a higher interest rate market, which we're in right now, the discount on that zero is wider than it normally is, especially as the 10-year treasury and rates have picked up year to date.

6:46So let's say a zero coupon bond traditionally is 85 % of the package with interest rates that are higher. It's lower. Now it's 75, right? And you have more room for the options to get that enhanced upside in the downside protection. But getting back to that opportunity cost is saying, let's say you want to buy a structure note on Apple, which has a dividend yield. Well, you're trading that dividend yield, that cash money yield that you'll be receiving from owning Apple stock. You're trading that cash money yield for that downside protection and the enhanced upside. And I always tell listeners, you're not sacrificing, you're not losing it, you're trading it.

7:24You're trading the income stream for the enhanced upside and the downside protection, which can be tax advantageous for a number of clients depending on their tax. So that's always the case. It's basically, okay, you're not getting the dividend, but instead you're using what would be the dividend effectively to buy more leverage. Exactly. And what I always educate advisors on, and I look at the same way with my own portfolio, is dividends are important. No one is saying that or no one's saying that they're not, right? But ultimately, you have to look at the yield of your portfolio. So if my family wants to derive a yield of three and a half percent of my portfolio to support our lifestyle and our taxes and everything else, great.

8:05We have to look at that in a portfolio-based approach. You don't look at it on an individual security by security approach. So if you are already generating enough yield within the entire portfolio through your long equities, through your bonds and other alternative investments that you may own, it may be advantageous for you actually to buy the structure note from a tax perspective. Forget about the downside protection and the enhanced upside because long-term capital gains tend to be more tax advantage than dividend income, depending on which tax bracket that you're in. So that leads to my next question.

8:34I was going to ask about the duration of these notes. So you're saying that you would go out over a year. And then a follow-up question is, what's my follow-up? I don't know. Answer the first question first. I'm answering the questions here, Jason. Where were you? And so from that perspective, I'd also like to loop your question and Michael back with Ben's original question of the why, right? Why do you want to do this? And is it prudent to actually think about it? But ultimately, when you look at the maturity of these notes, Michael, they can be three months to 10 years. A financial advisor picks it.

9:07Now, I don't give tax advice. And so please consult your own. Wait, they write these notes up to 10 years sometimes? Oh, yeah. Yeah. And we've got notes, more interest rate linked notes on our platform that are 15 years. Those are more kind of traditional fixed income. So there'll be like a fixed yield and then it floats after one year. But yeah, you can do equity linked structured notes up to 10 years. I remember the second part of my question. It was on the protection side or do you have a choice of using hard or soft? And if so, what would you be more likely to use? This came up in the example.

9:38So I looked at my biggest risk that I was talking about when I saw this, all these different structure notes was they were all soft protection, but it was like 50%. But I looked at Tesla's in a 60 % drawdown right now. So that's, do you look at more hard protection for these? Because these high-flying growth stocks could have an actual, it's much higher likelihood that they're going to have that kind of drawdown as opposed to the stock market overall. And that's what I wanted to get back to that exact question, Ben, is that ultimately it depends on the advisor's thesis. So let me position this a separate way.

10:08If you, Ben, are bullish on Tesla, super bullish on Tesla, right? And as the financial advisor, right? You're naturally positive on the future of Tesla. So you might buy the stock of Tesla, which means you're one for one on the up and you're one for one on the down. So from an advisor's perspective, I might say, hey, Ben, I know you're super bullish on Tesla, but let's get some nice protection on the downside just in case you're wrong. At least it makes us feel a little bit better. Now on the soft protection side, naturally you could breach that protection of the 50 % Tesla's super volatile, but you would have owned Tesla long anyway, right?

10:47So you're actually taking a lot less risk by, you know, by having this 50 % downside protection on the soft side, because you would have bought Tesla long anyway. Now that's the way I look at it. That's just the way I look at it on the growth side. Now, when you're looking at the market right now, I would actually suggest advisors looking at hard protection because hard protection is really cheap right now. If you actually look at put premiums out in the market, which is what you're doing when you're having hard protection, you're buying out of the money puts, it's super cheap. And so take advantage of that right now and consider hard protection versus soft protection, given where valuations are at in the market.

11:25Now, Ben, it goes back to your original question, it depends on the client. If you have a client who's really worried about the market and Ben is recommending Tesla to his client, then I would say from an advisor's perspective, if it's advisor driven as the idea, think about heart protection to cover yourself and to cover your client. If your client's a little bit more conservative, especially given that heart protection is relatively cheap in the market. Those are growth notes. Now on the income side, income notes are traditionally just a trade. It's a bet. And when you're using those income notes on stocks like a Tesla, you're just betting that Tesla is not going to fall by X amount, right?

12:04It's usually not, I'm really bullish on Tesla. It's just, I'm betting that Tesla is not going to fall by X amount. So you'll see of a lot of advisors. So you're like selling puts. Exactly. You're selling puts and you're selling binary puts when you're using soft protection. And that's the premium plus the zero coupon bond premium that ultimately derives the yield that you're getting. We can move off this topic in a second, but I do have one more question. Just structure notes in general. So in terms of getting back to like the catch or the free lunch or anything, what do the banks get out of this?

12:33Why are they so eager to issue these notes? Banks issue these notes for three reasons. Number one is clearly they make a fee, but the fee is not as much as you think that it is. And so typically a bank's margin will be about 50 basis points on a structured note, which is traditionally the average maturity. You're asking that earlier, Michael. The average maturity for structured notes is around two to three years in this country. So when you annualize that fee, it's nothing to write home about for the bank. All right. So that's not the reason. Reason number two is because their clients want it.

13:05$100 billion of structured notes are bought in the United States last year. That's up from$50 billion when I started Halo in 2015. The market has doubled. It is the second fastest growing asset class, according to Cerulli, which I don't agree that it's an asset class. But it's the second fastest growing asset class behind alternative investments over the last seven years. And you're seeing that growth. In Europe, it's a$400 billion a year market. So clients want these products. But really, why banks issue these structured notes is it's really cheap funding. right? The interest rate on that zero coupon bond is cheap compared to going out to the market with just a normal bond.

13:43All right. So that's the crux of it. It's access to cheap capital. 95 % of structured notes are held to maturity, not to be too specific. And so for a bank, it's super sticky deposits. It's cheap deposits and the clients want it. And so when they're packaging these derivatives, that's not where the money is made. It's really cheap access to capital or cheaper than the market would bear otherwise. They're making money, obviously, but that's not really the major driver. It's something that's differentiated for their clients and that the clients want, and it's cheap funding. I know we've spoken this last time, but just walk us through this what if scenario.

14:20What if the bank that issued the zero coupon bond is not there when the note matures? Yeah. So before I answer that, I just want to go back to one more thing that Ben said, because we are seeing a lot of interest in single stock structured notes. But given where volatility is for a lot of these underlyings and where interest rates are on our platform, Halo, you're seeing a lot of demand for growth notes. So ones that don't provide the income, but upside participation rate and a fully capital protected wrapper. So on our platform, I've seen fully principal protected notes on NVIDIA, on Microsoft, on Tesla, on Apple.

15:02individual names too. And I think that those are quite compelling, right? Because you might not get all of the upside that you want by owning Apple outright, but it gives you that comfort of the cushion of the full capital protection. And the annualized returns, like if you cap out on the upside, right? The annualized returns obviously vary between underlying, but Ceteris Paribus, it's around 10 % to 13 % per annum. That's not too bad to have the full capital protection. So I don't know, man, that sounds really good. So my antenna goes up, please. Well, think about the volatility in Tesla, right?

15:36Like, okay. So, you know, as Ben just said, Tesla can fall by 50 % in the span of three months. Tesla can also be up 50 % in the span of three months. So you are sacrificing that potential upside, right? That Ben was just talking about. Stop thinking about the downside. Start thinking about the upside. So let's stipulate that nobody cares. Let's say that somebody says, okay, principal guarantee or principal protection guarantee, 10%, give or take, for an individual security. If it caps out. Yep. Who says no? Oh, if it caps out. Okay. Got it. Got it. Got it. So it's not a guaranteed 10%. No, it's not.

16:13Got it. Okay. It's a growth note that caps out at a 10 % to 12 % annualized return. Got it. So if you have someone who's super bullish on Tesla, it's like, well, geez, Tesla was up 50 % over a two-year period, you're up 20%. That's your trade-off for the full capital protection. So advisors, the punchline is think about buying the structured note and pairing it with the stock. So if you want to put$50 ,000 in Tesla, think about$25 ,000 in this capital protected product and the other$25 ,000 long in Tesla stock or NVIDIA stock, whatever stock that you're looking at as a nice little insurance around the equity.

16:54So does that make sense? Yes, totally. So are people using these wrappers or different vehicles to hedge the downside? Let's say that you're like, I own a video forever. I'm never selling. However, it's gone parabolic and I'm afraid that it's going to fall 30%, but I don't want to sell it. Why not just use an option? Why use a structured note instead of a simple option? Well, in that particular case, it all depends on the client's tax situation and it depends on their view of the stock and the view that you're saying, I was saying you've got a huge unrealized gain and they don't want to sell because they don't want to recognize that gain, which is totally normal.

17:30I get it. I had a lot of clients that were like that as well at Credit Suisse. What you can do is you actually can create an option strategy around that to your point, like a variable prepaid forward and other types of derivative packages to help protect the downside. And a lot of times you can have those costless callers around the stock and we can help you with that. So we have partnered with a third party firm to be able to help advise you on these strategies and implement those strategies on concentrated positions. So the main point, the main takeaway here is like, there's a lot of different routes you can take for this stuff.

18:01Think about ultimately, this is what I always tell advisors. What do you want to do? Right? What do you want to do for your client? If I'm your client, what do you want to do for me? I'm going to say, I want to grow my wealth at a reasonable rate of return. I want to preserve my wealth because I worked my ass off. Right. And ultimately I want to generate income for all the needs that we need to generate income. Start from there. And then ultimately, when you're looking at structured notes, think about them as when you drive a car, you would never drive it with insurance, right? That would be reckless.

18:30So what I always advise advisors to consider, say that 10 times fast, is take 30 % of your long equity exposure, whether that's to Tesla or whether that's to the S &P 500, and put a growth note right on top of that So you have the comfort of a cushion. Valuations are not cheap right now. Right. There's a lot that's going on in the market as we continue to hit all time highs. Protect yourself, protect your book, protect your client, protect yourself from the markets by using this downside investment protection while still getting enhanced upside. What's the risk, as Michael said, for you to consider is counterparty risk.

19:08What happens if one of the banks goes kaput? Right. We saw that with Lehman Brothers in 2008. And knock on wood, I didn't have any Lehman Brothers exposure. So that was really good. Structured products really helped save my business in 2008 and helped me make a lot of money because of the capital protective products that I was using. Now, ultimately, what is a structured note? It's a combination of a zero coupon bond and a derivative, as we just talked about. But it's a debt obligation of the bank. And so with Lehman Brothers, you got in line with the rest of the credit holders within the bank.

19:39Do you have any idea how many structured don'ts they had offered at that point? I don't. I don't know the answer to that. I can tell you that at the beginning. So when Lehman collapsed in the fall of 08, you were getting 33 cents on the dollar as all Lehman bonds at that time were about 30 cents on the dollar. Now, over time, the course of a few years, people recouped the vast majority of all of that because there was obviously the bailout by Barclays and there was a lot of things that were going on with Barclays assuming Lehman's assets. It wasn't as clean as JP Morgan's takeover of bear in March of 08.

20:16And so there was a lot to work through with that deal. But ultimately, people got the majority of their money back, if not all on those structured notes. So I'm going to butcher this story, but Howard Marks tells a story about risk and betting at the horse track and handicapping which horse was going to win. And he said the horse that he and jumped over the track and ran away. That's like sort of the risk with these things. It's not necessarily like, yeah, if the stock goes down and it's below the floor maturity, investors understand all of that. It's the counterparty risk. That's what blows this up catastrophically.

20:51Well, so what I always think about, right, and it's important to consider all considerations. There's counterparty risk, there's market risk, there's liquidity risk. We give you liquidity on a daily basis at Halo, which is great. We've really pioneered a lot within the secondary liquidity space or market within structured notes. But the terms only matter at maturity. So you're only going to get the full benefit of the upside and the full benefit of the protection at maturity date. When you get back to your question, Michael, is I look at it in two ways. Number one, if you're new to structured notes and you're not a bank credit expert, which is totally cool and reasonable, stick with the majors.

21:26Stick with the JP Morgan. Stick with the Citigroups. Stick with the, as I always joke, they're not too big to fail. Now they're too big to save. So think with the too big to save banks. Think about UBS. It's twice the size of the Swiss National Bank, their balance sheet. They're too big to save. So think about the too big to save banks. And what do those banks do? They're the ones who ultimately fund and support the FDIC. So if you're worried about those banks are going under, then you should be worried about the FDIC. And if you're worried about the FDIC, then God help us all. All right. So we've done a pretty thorough examination of structure notes.

21:57One of the things that's appealing to me about the structure of these structure notes is that while there are potentially a lot of moving parts, you can control your risk, which is something that obviously you don't get in a lot of places. And of course, there's trade-offs, like obviously, but the fact that you can decide, no, I don't like that trade-off or, oh, I actually, that sounds attractive. That's the part of it that I enjoy. Structured notes are, that's a very important point. Structured notes are a vehicle. I was recently on TV and they were asking, well, how did structure notes do in 2022?

22:28Yeah, it's not an asset class. It's a wrapper. So I said, how did ETFs do in 2022? And they're like, well, what kind of ETF? I was like, what kind of structure note? They can be linked to whatever you want them to be. They can do whatever you want them to do. That's what's so beautiful and elegant. And always start with a thesis of what do you want to do? Come to Halo and we will help you both through our technology and through our personnel to be able to put on that investment or that trade and construct something that matches your investment thesis. Now, let me give you an idea of some of the things that I'm looking at right now, structured notes that we have not talked about to your listeners.

23:06If I can, it's your show. Please, no. Ben's a big idea guy. Just throw it at him. Yeah. Well, no. So one of the things Michael and I have been talking about for a while is just you have 10 ,000 baby boomers retiring every day from now until 2030. So there's going to be 70 million, 70 million of them that are retired. They have more wealth than any older age cohort ever, especially for that size. So they're going to want this kind of risk control. A lot of them are at least. And so you have these other products that aren't maybe as exciting as putting a structured note on a NVIDIA or Tesla, but things like annuities and fixed income that they're going to want to look at as more of a wealth preservation or more certainty on their cash flows.