Buy Thought Partnership, Not Investment Products

Like many, my career in the investment management world began at a brokerage firm. And, also like many, my first client came by selling an investment product. As a newly minted MBA who had undergone extensive Wall Street training, I was programmed to sell investments, even though I had very little investing experience myself. Opening my first account after a few months on the job gave me credibility among my peers as well as the confidence that I could have a future in the business. What it did not qualify me to be, however, was a thought partner.

After more than four years in the brokerage world, l left to pursue a career in asset management. Narrowing my focus had its benefits, including in-depth knowledge of our strategy and how it complemented other fixed income investments within diversified portfolios. But despite successes, this, too, did not teach me how to be a thought partner.

I have written in the past about my early career experiences in television news, where I saw firsthand how the media industry will stop at nothing to attract and retain viewers, most commonly through fear promulgation. I also recently opined about the challenges DIY investors face in the current market environment given the capitulation I witnessed in 2008 and 2009. A lesson I took away from my days in brokerage and asset management is that every investment product, no matter its virtues, will eventually have its day in the shade. With Covid-19 impacting economies and markets far and wide, this day has regrettably come for many products, particularly those tied to energy.

The recent oil price crash is perhaps unlike any other asset meltdown in history, as illustrated by the following chart.

Source: FactSet

Prices turned negative for a short period as the combination of a demand collapse and a positive supply shock inundated the world with oil to a point at which owners were paying investors to take crude stock off their hands to avoid short-term storage costs. The collapse in oil prices is well known and its impact on energy companies, refineries, and the great state of Texas will be felt for many years to come.

What is less known, however, is how the downfall is translating to investment portfolios. According to reports, hundreds of millions of dollars of structured notes—complex financial instruments sold primarily by banks and brokerages—have traded as much as 92% below their offering prices. In the first two months of 2020 alone, brokers, banks, and independent firms sold more than $200 million worth of energy-related notes.

A structured note is often sold as a yield enhancement or hedging strategy to amplify portfolio returns by using derivatives and/or leverage. In simpler terms, when investing in structured notes, if the price of the linked asset, or basket of securities, trades at or above its initial value, investors benefit from large coupon payments. If the underlying basket value drops, investors have little choice but to wait and hope for a turnaround by the note’s maturity date, exposing them to the potential of total loss. Importantly, structured notes are illiquid and unsecured, meaning investors take on the credit risk of the bank’s balance sheet. The collapse of Lehman Brothers during the Great Financial Crisis served as an excruciating reminder of this oft-overlooked aspect.

The derivatives underlying structured notes are potentially “financial weapons of mass destruction,” as Warren Buffet famously said, due to the misunderstood leverage they impart. The repackaging of stocks, bonds, and options also comes at a hefty price with embedded commissions as high as 3 percent, exclusive of the savings the bank realizes by not paying out interest (as it would to typical corporate bondholders). All told, the net economics of selling a structured note can be as high as 6 percent to the issuer, a real selling incentive under the guise of complexity and sophistication and by seducing investors with the potential of large upside and little to no downside, which unfortunately does not always hold.

Master limited partnerships, or MLPs, are another popular asset class favored by income seekers due to historically elevated dividend rates. But high dividends are no match for the recent oil price collapse. As of this writing, the Alerian MLP is down more than 40 percent year-to-date, and down more than 49 percent over the past 12 months. And it should come as no surprise that dividends are starting to get cut as a result.

If you are an investor with exposure to either MLPs or energy-related structured notes, this is a painful time. It may also be a time to evaluate whether your portfolio is based on principles designed to help you achieve your financial goals in a risk-adjusted way as opposed to an amalgamation of investment products haphazardly sold to you over the years.

A critical question to be asking right now is whether your advisor has been acting as thought partner or as a salesperson in disguise.

After my stint in asset management, I met with dozens of firms, both in asset management and wealth management, and my decision to join Balentine was framed by two outside conversations. The first was with a young hedge fund manager who could not have been more depressed despite amassing considerable wealth over his short career. After growing his fund to $6 billion in assets over the course of a decade, his stress was tied to the fund’s then-value of $2 billion, representing a $4 billion drop over 12 months. His quantitative strategy simply fell out of favor when correlations tightened across capital markets, and his clients valued him solely on recent performance. The second conversation was with an independent advisor operating under the fiduciary standard of care. Although he managed only 10 relationships, he knew his clients valued him as a trusted advisor who would help them make smart financial decisions across many asset classes and multiple market cycles. My choice to repursue wealth management, albeit this time as a fiduciary, was an easy one.

At Balentine, our most rewarding relationships seek our perspective as they navigate varying challenges and opportunities.

We work together to solve problems, and we learn from each other’s experiences to achieve optimal solutions. Simply stated, we serve as thought partners to our clients. There is not an investment sales culture at Balentine. We do not manufacture product, we do not earn commissions to sell product, and if we elect to implement active management (typically reserved for private capital and alternatives), we actively negotiate the associated costs lower on our clients’ behalf.

We take a disciplined approach to investment management. For equity and fixed income exposure, we rely on quantitative models which steer us in and out of “neighborhoods” (accessed via low-cost ETFs) based on momentum. Unlike those who unfortunately purchased energy-related structured notes, our models moved us out of energy after a profitable run in 2018, and out of REITs (which have swooned of late) in January despite strong performance beforehand. The models have kept us overweight to U.S. Large Cap Growth, which has outperformed the broader stock market for more than a decade.

If you are an investor with a portfolio of products, you may want to analyze how you got here. Is there rhyme or reason to your portfolio construction? Do you have multiple managers providing exposure to the same asset classes? Are you invested in strategies you do not fully understand? Do you see the same asset manager listed across multiple investments on your quarterly statement? Answers to these questions may help you to determine whether your advisor is acting as a thought partner or as a product salesperson.

Just as there will be no one-size-fits-all solution to the Covid-19 pandemic, an investor should not be seeking a panacea to cure a portfolio of its ills.

Be especially wary of strategies and investment products that sound too good to be true, as these are often the instruments which expose investors to the highest fees and the greatest unforeseen risk. Since it is no secret that yields are low in the current environment, beware of strategies which boost higher-than-average income, bearing in mind that any yield quoted above the prevailing rate of the 10-year Treasury is no longer “risk-free.” Active management should be reserved for inefficient asset classes in which manager insight tends to pay for itself. If you are exploring the use of derivatives, it should be for capital efficiency or hedging purposes, but not before you fully understand the risks. Most importantly, take time to study your allocation and portfolio holdings to ensure your advisor is serving as a thought partner and not merely a conduit to the Wall Street product machine.