Talk Your Book: Upside and Downside Customization For Your Portfolio

0:00Today's Animal Spirits Talk Your Book is brought to you by Halo Investing. Go to Haloinvesting. dot com to learn more about their platform for structured notes for financial advisors. Welcome to Animal Spirits, a show about markets, life and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz 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.

0:38Welcome to Animal Spirits with Michael and Ben. Ben, we were at Inside ETFs earlier this week and we were talking about, there was like, remember when, I don't know, five years ago, all, it was just index funds, index funds, index funds. And index funds have not gone out of vogue at all, but you can only talk about them so much, right? They are what they are. There's no innovation with an index fund. It tracks the market cap weighted. They're just sort of accepted at this point. It's a core holding for most people. So while index funds have continued to do what they do, there's another part of the world where customization is really valued and specialization and niche opportunities.

1:25And so on today's show with Jason Barcema from Halo, who we've had on multiple times. One of the things that I love about the platform is it can be totally bespoke. The way that they've created it is so easy for advisors to use. You could put in the underlines. You could say, no, you know what? I don't like this protection. Do this. No, it's not soft. Give me hard. Show me what this looks like. I want this amount of protection. I want this amount of income. I want this upside, this downside. to be able to like turn the knob so easily is a huge value add that could not have happened. I don't know when the technology was created, but 20 years ago, this was just a non-starter.

2:01Right. I think that's the biggest leap forward we've made in the last decade, decade and a half call is the ability to pull different levers and maybe define some of your outcomes to give yourself or your clients better look through to see like, these are the risks. And that was much harder to do in the past. So I think that, and that's only going to get better from here. I think the customization for the next one or two decades is going to be a huge theme, especially for the huge amount of retirees we have now who have most of the money, big portfolios. And now they're looking at, okay, I'm done making money.

2:33I have no more income coming in. I'm spending down my portfolio. I'm nervous about the uncertainty. Just give me a little more certainty, even if I'm paying some sort of insurance or whatever on that. And I think that's why it's going to be such a big thing going forward. That's the thing, because to be able to define an outcome, even if it's mathematically suboptimal, I'm not saying that it is, but just there's a huge premium for certainty, for being able to sleep at night knowing that, okay, this is my investment vehicle, and whether a scenario X, Y, Z, you know how some people say Z? I don't know if that's a red flag, but that's a little bit weird.

3:09But no matter what happens, you at least know beforehand what you're getting into. And if something doesn't sound good to you, you don't do it until you get to something that works for you. So, all right, enough stepping on material. Here's our conversation with Jason Barcima from Halo.

3:27We are rejoined today by Jason Barcima, who is the co-founder and president of Halo Investing. Jason, welcome back. Thank you guys so much for having me. All right. We've done this a bunch, but I think this is timely. I'm going to start with a question about the actual nature of a structured product. Tell us what happens. And this is a leading question. So this is a two-parter, kind of a quarter question, if you will. What happens immediately after a bank creates the structured note? And so what immediately happens is a bank creates a structured note, which define create, first of all, right? And so how is ultimately the proverbial sausage made?

4:09Although I I don't eat meat, but we'll still use it as a metaphor. There's three different parts to a structured note desk, right? And so it's not just some Oz behind the curtain. You have the structuring team, which think about that as the packaging. So they package it all together. You have the hedging desk, and then you have the treasury desk. Remember a structured note is the combination of a zero coupon bond, which is the treasure, and a derivative, which is the hedging desk. And then the structuring desk packages it all together with a nice bow. And so when an advisor buys a structured note, what happens is in through Halos technology, all of that is automated.

4:46So the funding rates are paired with the derivatives desk and ultimately all packaged up, documents are generated. The note is actually registered with the SEC. So in most instances, people are buying registered structured notes. So that gets registered through the SEC. And then what is created ultimately is what's called a DTCC eligible product. That may mean nothing to you, but it is very important because when it's DTCC eligible, that means it's treated and cleared and processed, for lack of a better word, just like any other security out there. And so if you, Michael, buy a structured note issued by JP Morgan, JP Morgan goes through everything that I just told you.

5:29JP Morgan will deliver that structured note through the DTCC to Halo's broker-dealer. It's got a Q-SIP, just like any other security. And then we deliver that and book that directly into wherever you have custody, Schwab, Fidelity, Pershing, TD, you name it. That was a really good answer. What I was looking for is there are several components to a structured note. There's downside protection. There's hard and there's soft. I'm sure there are more variables, but one of the most important variables is the maturity. And at maturity, who is paying you your money back? So the bank who issued it, right?

6:10So very, very good question. And ultimately, when you buy a structured note, there's a few things that you want to consider. Obviously, you want to consider what the structured note is linked to, the asset it's linked to. Think about when you're buying a structured note, you should be willing to buy that individual asset outright. Right. With a structured note, you're just wrapping a level of insurance or protection around it. Right. That's the only thing that you're doing. So you have a thesis on the asset and you're wrapping a level of protection around that. So that's the first thing to consider.

6:41The second thing to consider is the counterparty risk. And so when a structured note is issued, it's ultimately an obligation of the issuer who issues it. OK. And so forget about what happens, all the sausage that was just made that I told you, forget about that. Actually, when you look at the annuities market and there's annuity products out there, which Halo also deals with annuities, if the listeners prefer annuities, you can access those on the Halo platform as well. A lot of those annuity providers that offer investment products that look like structured notes, they're actually not hedging out into the marketplace.

7:17They're not doing all that sausage manufacturing. It's just a contract to say, I'm going to pay you X on Y date. So to come full circle, Michael, who pays you those proceeds? Ultimately, it's the bank. Doesn't matter how they pay you. So that's where I was leading this ship. For the first time, certainly not ever, but for the first time in a while, counterparty risk is something that people are thinking about. So you tell me, if Deutsche Bank was my counterparty, and they issued me a structure note, and then they're not there to, you know, they got absorbed by UBS, is now UBS on the hook. But talk us through, when advisors are considering these products, how do they view B &P Paribas versus JP Morgan versus Credit Suisse?

8:06I'd also like to hear a good example of actual counterparty risk and what that looks like. Because people always say that's the big risk, but then I don't think they really define it. Yeah. And so absolutely. And so you're giving the example of Credit Suisse and UBS. Was it Credit Suisse that got bought? It was. Oh, okay. My bad. I don't know why I said Dodgy Bank. My bad. And I know that example very well because that was my former home bank. And so if there's anyone who knows how Credit Suisse issued structured products, it was me. And to that point, right, and that's the important part, you have to understand with some of these banks, how they actually issue the structured note and from what vehicle.

8:42When you look at Credit Suisse, it was a separate operating co that was completely different from the Holtco. It had its own capital that was reserved for their structured notes. So there was a lot of noise out there of saying, oh my gosh,$17 billion of cocoa bonds just went up in flames. Those cocos have nothing to do with structured notes. Those COCOs are part of the holdco. They're not part of an operating company that is specifically designed and only designed and capitalized and separately rated just for that structured note. So think of a lot of these European issuers have that design after midfit too, not to get too far in the weeds.

9:22But that's a really important thing to understand is that, yes, it's an obligation in many instances to the parent company, but for many European issuers as you're naming, it's actually its own separate entity that has its own separate capitalization. Now, how do you know that? You don't, except for if you want to read through an 80-page term sheet and be completely bored to death. That's what Halo does, right? So yeah, we're a fintech company. Yeah, we were just named to the world's top 10 most innovative fintechs for the second year in a row, which I was very excited about. Not to brag. Congrats.

9:53Humble brag, but I'm very proud of the team in regards to that. Definitely a team effort. But to that point, We also have humans that can walk you through all of this stuff, including yours truly, right? We're structured note junkies. We know everything about how these structured notes are manufactured. Getting back to Ben's question in regards to what does it mean to counterparty risk besides just, hey, can this bank pay me or not? Well, counterparty risk impacts the pricing of the structured note, right? So think about what we were talking about earlier. A structured note is a package of a zero coupon bond and a derivative.

10:27That zero coupon bond is an obligation of the bank who issues it. Clearly, zero coupon bonds have interest rates that accrete to par, right? And so the higher risk the credit, the better the terms that you're going to get because that zero coupon bond is sold at a larger discount when you look at the structured note side. So again, a lot of technical jargon to say the counterparty risk and the bank who issues it will directly impact the pricing of your structure note when you buy it. You will get better terms for a counterparty that has a worse investment grade than the too big to fails, or I like to say now too big to saves, like a JP Morgan.

11:09Jason, that was great. Thank you for that. We'll move off this in a second. My last question is - I feel like I was pretty boring. Was that boring? No, but maybe. Yeah, in fact, it was boring, but guess what? It's important. So I would imagine that in the days and weeks in the aftermath of the Credit Suisse mess that you guys were fielding a lot of questions about kind of risk. Yeah, very proactive. And again, that goes back to being the humans. We set up calls with our issuers to talk to all of our clients. We set up webinars. One of our senior advisors at Halo was the global former global chief economist of Credit Suisse and the vice chairman.

11:46And so we had a lot of good perspectives and a lot of differentiating perspectives to make sure that our clients felt comfortable. Now, on our platform, yes, we do not personally advise on counterparty risk. You are fiduciaries. You have to feel comfortable about the counterparty that you want to take. But of course, we're here to help you, right? So we're here to walk you through the pros and the cons of each counterparty. The benefit, Michael and Ben, as you know about Halo, is that I don't get paid by the issuers. and I'm not owned by any of the issuers. So I have no incentive to tell you JP Morgan versus BNP Paribas.

12:22You do what you do and we will help you advise on the pros and the cons of each issuer in regards to pricing, in regards to counterparty risk experience, et cetera, et cetera, et cetera. But actually it was really good for us because we only work with the world's largest banks. And so, you know, if you think about it, it was an interesting market because you had the noise out there with First Republic and SVB and obviously Credit Suisse, la, la, la, la, la. But, you know, the biggest counterparties are assures on our platform, like a JP Morgan, like a Citigroup, like a Bank of America. And so there was in like the Canadians.

13:01And so there was a flood of demand into the structured note market, speaking for our platform, because people were scared. So they wanted protection. Volatility was high. So they wanted to take advantage of the good yields and the good participation rates and the deeper amounts of protection they can get. You know, when times are volatile, those are the best times to buy structured notes. Now, you just saw the flood to kind of the too big to saves, as I call them. Jason, when you're thinking about structured notes, there's all different sort of products and you can get creative with how you want to use them.

13:36Let's start the conversation on the actual structured notes. Let's start with the income one. the level of interest rates have a big impact on the amount of income, obviously, or maybe not obviously, on the amount of income that an end client can receive. The equation though, mentally for clients must be different when they can get risk-free rate of say 5%. And now granted, there is role risk there. I'm talking about like the one year that's not laid out on the curve, but that has to change how people are thinking about income. If it's just right there in front of you, why not just pick it up instead of locking up your money and having counterparty risk?

14:13What type of conversations are you having with advisors? On the income side, we'll talk about the equity side after this, but just in terms of the income notes, what do those conversations look like? Great question. And let's hope you're right that it's risk-free. I guess we'll find out on X date, as I guess now we're calling it at the treasury. And so all jokes aside, it's about, and I'll answer this in two parts. When you look at a structured note, yes, interest rates impact the pricing of the structured note. Absolutely. Volatility impacts the pricing of the structured note. But whenever you're making an investment, right, you're pulling from something and allocating to something else.

14:49You know, in this particular question, Michael, and we get this a lot from a lot of our clients is saying, hey, well, if I can buy a one-year treasury at four or so percent, why would I buy an income note? I say, well, geez, you know, perhaps you should think about it differently. Because in my personal opinion, and look, you every advisor thinks about things differently. I don't take from my fixed income allocation, and I've never advised taking from my fixed income allocation and putting it to income notes. Income notes are within your equity allocation, in my very respectful opinion, because you're taking downside equity risk.

15:22Now, why you buy an income note is not to just say, okay, I'm going to get a yield pickup over treasuries. That's a double bonus. And it's a double bonus. Why is because I I don't care if you're a family officer or a firefighter. We all need to do three things with our portfolios. And I'm talking to financial advisors out there on behalf of your clients. And only three things. You need to grow your wealth. You need to preserve your wealth that you work so hard for. And you need to generate income. Again, no matter if you're a firefighter or a family office, you need to do those three things for your clients.

15:53And so ultimately, when I look at these structured notes of income structured notes, they tick my boxes to say, great, on the equity sleeve of my portfolio, because income notes are typically linked to major stock indices with a level of downside protection. I'm generating income, which I like, and I might not be getting from my equity portfolio. I'm locking in a return, an equity-like return that is appropriate and suitable for me. I'm looking at products personally right now linked to the S &P, the Russell and Eurostoxx 50, three-year maturity, 30 % soft protection. It's got a call feature and contingent coupon of 30%.

16:30I'm getting 12 % per annum. The way that I look at that, Michael, is saying, well, geez, where are my equity portfolio over the next three years? Do I feel reasonably confident that I'm going to get 12 % per annum? That's the exercise that I do. My bonds are my sleep at night money. I'm just talking about for my family. That's my sleep at night money and my bonds are my bonds. I'm buying those income notes because I'm protecting against the sideways market. I want to generate income and I want to hit my customers or my clients, you know, return hurdle. But you're not locking that in because you said it is, it's callable.

17:04Can you talk about what that call feature looks like and how it works in practice? Yeah. So in this particular example, it was a one-year non-call on this particular case, but you're absolutely right. It's callable. Now this goes into an approach that we've been really advocating for at Halo and really educating our client based on, which is called a hedge equity strategy. And it's gotten a lot of attention and very, very popular within the thousands of advisors that we serve in the United States. And it's a strategy that I implemented at Credit Suisse, and I've been implementing it for 15 years and a strategy that I implement within my own family, which is about layering structured notes throughout the portfolio.

17:43Right. So on these calls, you've asked me saying, hey, what's the right allocation of structured notes within the portfolio? And I say, hey, you know, Michael and Ben, it's Ceteris Paribus. It's around 20 percent because I like to have about 20 percent of my portfolio protected. And more specifically, I like to have about 30 percent of my equity allocation protected. OK. And so when I look at these income notes, Michael, I typically target yields of eight to nine percent. And in a normalized market, meaning vol and the VIX around 16, 17, and interest rates in a somewhat normalized way of what we've had over the last 10 years.

18:21I mean, the historical 10-year treasury rate is 6.5%, as we all forget. But over the last 10 years, a normalized rate of, you know, call it more of 2 % to 3%. I'm clipping an 8 % to 9 % yield on my income notes. Sometimes a little bit less, sometimes a lot more that we're seeing in this. And just like car insurance, Michael, I never drive my car without insurance because I don't know what's going to happen. So when I get called, I roll. When I get called, I roll. And so I don't try to tactically time the market. These structured notes are core parts of my portfolio that I always have. Now, when volatility spikes or interest rates shoot up like they've done over the last 18 months, heck yeah, just like I do with my equity portfolio or my bond portfolio, I'll say, great, let's take some of that dry powder.

19:11Let's take some of those long equity exposure that I've got, and let's allocate it to structured notes because, man, the terms look juicy. Now, that's just the tactical side. It doesn't take away from the vast majority of my structured notes, vast majority meaning 90 % of my structured notes are just core equity positions within my portfolio. So you like to over-rebalance when rates get higher for a number of reasons. Yeah, exactly. Because I'm just going to get some pickup, especially in regards to my income notes, right? And we've got consultants here that can advise you on all of this. And ultimately, the thesis is, and just to finish that point, the thesis of the hedged equity strategy is very simple.

19:52It's just about taking a structured note and layering it on top of your long equity. And this is how I built my business at Credit Suisse. And I built my businesses into one of the largest practices at Credit Suisse using this specific strategy. And what that was was saying, hey, Michael and Ben, I got a great large cap value manager. Man, we're Credit Suisse. We've got the best and brightest large cap value managers around the world. And that's why you bank with me. Now, the reality is over the last 12 years, active management has absolutely stunk. But I still believe in active management. So what I would do is I'd say, I'll take a growth note, three-year growth note linked to the Russell 1000 value, the benchmark of a large cap value manager.

20:35I'm going to have some protection on the downside, say 30 % protection, and I'm going to get enhanced upside. And in this market, you'll probably get 120 to 125 % uncapped upside. Why do I do that? Well, active management has stunk, as I just said. So the enhanced upside of that growth note will make up for the performance drag that your active manager may have had over the last decade. Right? Does that make sense? Yeah. How do you think about from an advisor, Most advisors' clients are fully invested already, or maybe they're spending down their portfolio. How do you think about the advisors that are looking to get clients in for the first time?

21:13How do they leg into a strategy like this? Great question. So no matter if you're fully invested or not, it's really the same answer, Ben. I think utilizing structured notes in a market like this, and I know I'm talking my own book, but I guess that is the point of the segment. But again, all jokes aside, using structure notes at a time like this are really, really good and really, really powerful. Why? It's because the market lost 20 % of its value last year, right? And hopefully we all outperformed the market on a fully diversified portfolio. But if you look at a fully diversified portfolio in 2022, 60-40 portfolio, you're down around 20%.

21:51Looking at a client and saying, hey, Michael, you just lost 20 % of your net worth, right? a fifth of your value that you worked so hard for in 12 months is a very hairy conversation to have with your clients. But oh, by the way, Ben, I'm going to take that dry power that I have. And I think it's a great time to invest. And I'm going to put in the markets now. You'll be like, are you out of your mind, man? I just lost a fifth of my value. Those are very difficult, even if it's the right thing to do. It's very difficult. I dealt with this during the GFC. And so I use structured notes to say, hey, Ben, now is a good time to buy because we're at a lower base and you want to buy when there's blood in the streets.

22:30I recognize that you're anxious about losing more money because you've worked hard for that money. And here's a structured note that will give us downside investment protection in case I'm early, in case the market continues to go down. But if we are at a bottom or near a bottom, it's going to give you that enhanced upside. So not only do we participate in the rally, oh, by the way, you have enhanced upside. So you'll actually be better off than buying SPY or any other long equity manager that you might be allocating to. So I love doing that in this type of market because it's a more conservative and prudent way to invest.

23:04And it's a heck of a lot easier to talk to your client. Do you find that this message goes over way easier with older retiree boomer clients that don't have as much time to have income or savings make up for any shortfall in a bear market? Well, there's actually been a lot of studies that have recently done that the millennial generation is the most risk averse. And probably because you start to learn about stocks during the tech wreck. Really? Have you heard of shit coins? Well, I like to think that that's just the Jim Cramer mad money part of someone's portfolio. That's hopefully a small part of someone's portfolio as tactical bets.

23:41I chalked that up to your DraftKings account. I think that's fair. I think that's fair. Yeah. And so, you know, to that point, ultimately, I think it resonates with everybody because, again, you wouldn't own a home without insurance. You wouldn't live in an apartment without insurance and you wouldn't drive a car with insurance. It's not only dangerous, it's irresponsible. And so a lot of people say, and I get there's differing views. Well, I have a differing view. I'm about to share it. Oh, I know. And that's what I love about this show. But just to finish my point, right, is that if you can buy a three-year note on the S &P that gives you 25 % downside protection, and again, in this market, 125 % uncapped upside.

24:24So in three years for round numbers, the market's up 100 and you're up 125. If the market's up 50, you're up 62 and a half. But price only, no dividends. Right. But still, to that last point, if the S &P is up 50, right, unless it's price only, and you gave up 6 % of dividends, so you have 56 % on the total return, technically less because the S &P yield is at 1.86, but we'll say 2%, so 56%, that note would have gotten you 62.5%. You still would have been better off. For sure. I just threw that in just for clarification because I know people are going to poke at that. Yeah, yeah, no, absolutely.