Are Structured Notes Right for Your Portfolio?

John Dean  0:00 — From the sales side to the buy side, Wall Street’s sphere of influence can put you on the outside looking in. This is where the ballot is growth legacy and investment banking is your advantage. In a rapidly changing world, the markets move faster than ever. Finding future growth opportunities requires a focus on the factors that lead to meaningful inflection. We are your source for the best information on growth investing. This is the growth investing podcast. Welcome back to the growth investing podcast. I’m your podcast host Johnny Dean, and I’m here once again with two of the smartest guys that I know. Well. Certainly Mark Scalzo, who is the Chief Investment Officer at Validus growth investing,

 Mark Scalzo  0:41 — I think, it’s just probably because I’ve known you the longest maybe that’s what it is.

 John Dean  0:45 —  You’re a smart guy. And I’ve learned a lot from you over the years. I’ve known you for a long, long time. And I don’t know how you do what you do. But you do it very, very well. Well, thanks. Yeah. And we’re here. We’re graced with the presence of Chris Mee, who’s the managing director in InspereX. Did I say that right?

 Chris Mee  1:00 — Yes, you nailed it.

 John Dean  1:02 — Good to see you never know, I got it right in rehearsal. But this is gonna be fun, too. Because I remember last time we were on, I just, I had a good time. And I thought everything really tied neatly together. And you guys kind of work as a team on this podcast here. So we’re talking about structured notes, structured notes. And this is something that’s, you know, a lot of people are, from what I can tell, and I was doing a little bit of research this morning, from what I can tell, there’s a lot of, I want to say confusion, but I guess there is,

 Mark Scalzo  1:32 — Oh, they’re complex financial instruments. I mean, you know, and yeah, and certainly that, you have to understand that. But in terms of being able to customize specific solutions, as an advisor for your clients, yes, deal with different aspects of risk and return. Yeah, they can be really, really useful. And we’ve used them in our portfolios as well.

 John Dean  1:55 — Can’t Yeah, now do you? Do you want to just take a quick moment and explain for people who need a refresher as to what they are? Chris, do you want to explain you want to give us that and just remind people that who don’t are informed people who may not know

 Chris Me  2:08 — Sure, when it comes to structured products of any kind, there’s actually three variations of it. They’re basically built as a fixed income product. But they have equity like components. So it gives you the best of both worlds. So for example, as far as the fixed income portion, it’s issued by a large bank, whether it be Goldman Sachs, JP Morgan, HSBC, Barclays, the largest banks that you know, out on the street, so they issued debt, and that debt has a maturity date, just like any kind that we’re used to. But what we’re used to is that there is normally a fixed rate of return, it’s a fixed income type instrument. Well, what we’ve done now is replace the fixed income portion of it. And we now tie it to an equity basket of some sort of investment, whether it be individual stocks, whether it be ETFs, whether it be some sort of algorithm type investment from issued by the bank, and so you have the fixed income component, and then you have the equity component. Why do we bother doing all that? For several reasons. One, the clients like to know that they have some sort of protection that’s involved, which comes from the fixed income side, they also like to know that there’s a day that they’re going to have a maturity, when something takes place, am I going to get my money back? Am I going to have some sort of an event that occurs? And what date does that occur on? However, at the same time, we like more than fixed interest rate type returns, we need growth. And so we have the growth component there, which makes it a very unique investment, which is why people are attracted to them. And the most sophisticated clients that are out there today, actually demand and look for.

 John Dean  3:43 — Yes, and I think for people who understand how that works, this is a this is a good question, I think to lead into you know, fixed income is, of course received a boost in in, you know, yield and rate of return. Right. So people desire, it is yeah, the

 Mark Scalzo  4:02 — Risk free yield is higher. And so I think our all of our investors expect higher returns as well.

 John Dean  4:08 — Exactly. So the question is, this kind of begs the question, is this a good time for structured notes? Or how would you know when it’s a good time?

 Chris Me  4:15 — You know, that’s always the question, right?

 John Dean  4:20 — Buy Sell?

 Chris Me  4:21 — Yeah, when’s the right time? Well, when you have when you have the best of both worlds, that’s, that’s part of what you’re looking for. And what’s also important when you look at risk free rates, you also need to look at buying power. At the end of the day, when we look at inflation, and we have challenges today in the inflationary world. Is that risk free rate going to get me where I need to go to and if it doesn’t, if I’m losing purchasing power, then what have I really gained? So we normally buy even though

 Mark Scalzo  4:47 — You might have a 5% yield, inflation might be 4%. And therefore your buying power is very limited.

 Chris Me  4:54 — Correct you maybe you gained a little. Maybe you lost, depending on what region of the culture lion are watching. So as we look at that, it’s very tempting to pull in and want to get into fixed rates. But if you look at the this year alone, if we look at the beginning of the year, people were going into, you know, 5%, fixed rate, whether it was annuities, whether it CDs, whether it’s corporate bonds. And then we were having months where the S&P was up 5%. Yeah. Early on this year, we have more days. Yeah. Right.  So, could you could you make an argument for risk free rates of return? If you look at my mother at two years old, maybe that’s very attractive, and she doesn’t have time to, you know, 5% makes sense to her. And she doesn’t need to maybe invest for growth because she doesn’t have time for growth. She needs to she’s happy to see interest rates higher. It also embed

 Mark Scalzo  5:43 — A narrative earlier this year, which was the for the bears, right, which is what the markets going down the best to take your 5% and just and just go home and take your chips off the table.  And certainly if you did, if you’ve done that you’ve lost this year.

 Chris Me  5:56 – As a pro, anytime it’s obvious, you have to question it, right? When it’s when someone comes and says it’s obvious that why don’t you take your 5% We’re good after last year, they maybe they look at it and say, You know what, five, I’ll take that in my accounts not going down. But then you look and say, What have I given up to accomplish that, and that’s been the challenge.

 Mark Scalzo  6:17 — And with structured notes, you may be able to do both. And that’s the beauty of it. You can leave some chips on the table, you can protect yourself on the downside. And it could sometimes — a lot of the time — it can end up being the best of both worlds.

 John Dean  6:33 — Does this does this in many, in some ways, take the timing question off the table for you.

 Mark Scalzo  6:38 — And the reason for that, I guess it should say just let me finish.  I just had a thought that I think I wanted to finish which is that that’s happening because there’s an entity standing in and intermediating risk for you, which is the bank, right, their balance sheet is allowing for a different risk reward structure than otherwise would occur. Sure, now they’re gonna exact a cost for that is always right. But you know, we know nothing has been sacked. So the Morgan Stanley’s of the world aren’t going into this for nothing — their investment bankers, right?  But that’s the real reason. I think that it’s not magic. There is there is someone that’s interceding to help you manage some of that risk.

 John Dean  7:19 – Yeah that’s, I think that’s a helpful point. Things have changed over the last two years. I hear you talking about 5% that I hear the word 5%. In the CD in the same sentence?

 Mark Scalzo  7:29 — I mean, we haven’t seen that in a while. Right?

 John Dean  7:31 — How long has it been? Exactly? So as far as these as far as the structured notes go? Where would you say they fit inside an asset allocation portfolio? You know, we talked about certain investments, there are alternative investments there are, you know, in the structure products, where do they fit? And is this is this considered an alternative investment?

 Chris Mee  7:50 — Well, the beauty of structure products is they take many forms. So when you say where do they fit? You could have some something as simple as the S&P 500. Where are you now put some sort of protection on it like a buffer, where we can protect it by 15, 20, 25% on the downside, and still give you 100% of the upside of the S&P. So how would you structure that you would put it in and maybe replace SPY or SPX, you could have a position now where it fits very generically, like anything else you own. Then you could also say, Well, I want something that is going to offset risk in a portfolio. And I want, I want total return. And so now I go in there, and maybe I use it as a alternative, as you say, use it as an alternative. So if the markets down, this actually returns a positive return on the upside. So now I’ve used it as an alternative. Then I come in and say, Well, what am I going to do about fixed income because as interest rates rise, we know what happens to bonds. So I’d like to have one that is going to pay whether the markets flat, whether it’s down or whether it’s up, and I have a maturity date. Now it acts like fixed income, maybe we even have a coupon on it, we have one and a half, 2%, coupon and some upside of the market. So you can structure these to be an alternative to a portfolio, you can make it a sidecar to a portfolio and say I just want to have something that has three or four indexes in it. I want some downside protection, and it’ll help offset any losses that happen in a portfolio. It’s what we used to do with 60/40. Until now, we sit here and look at a 60/40 portfolio today. All the things that was designed to do it’s doing the opposite, right? We have bonds that are going down faster than stocks, we have stocks that are heading up and when there’s volatility and they move in the same direction there we have days last week where the market was down and bonds were up in yield but down in value. So you sit there and you have these bonds to protect you but at the same time, they’re moving in correlation. So I would say that you could you can build this product or look at a menu of these products to fit any situation. Now sounds a little too good to be true. The reality is it’s not it can be built, it can be structured the way you want it, or you can pull off of a menu.

 Mark Scalzo  10:09 – I think it’s a reflection of how you’ve invested your existing portfolio in traditional equity and fixed income. And one of the beauties about structured notes is that you can, it can take into account how you’ve allocated a portfolio for a client already, right. And most of most structured notes aren’t bought to meet the entire portfolio needs, right? They’re bought as an adjunct or as an enhanced mirror to an existing portfolio. But that provides opportunities like Chris was saying.  Maybe you had a really good year much more quickly than you thought you might have had, right, in investing in the S&P.  Yeah, well, now I can find a way to book some of those gains that were at least reserved those future years, while limiting my downside, well, I’m going to want to do that and replace that as part of my allocation, my equity allocation inside of my portfolio. And it reflects what my goals and objectives are for the client and how I’ve allocated that portfolio already. And the beauty and we can we can talk about it further. But the beauty of structured notes is, is you can you can tailor it very specifically for a client’s specific portfolio.

 John Dean  11:22 – Well, yeah.  And I think you speak what you’re speaking about. Also, this is why the timing element is I think, off the table, if I don’t have to worry about the downside. You know, what do I care? Right? I mean, go down, whatever I’m not, I’m not really as a client. Personally, if I were speaking about that, I’d say I don’t care all that much. Now, structured notes is, you know, people want some type of better fixed income, they liked that the like something with a little, you know, as high I guess, a high yield as they can possibly get. You know, some people look at annuities, right. And they say, Well, I can I could get a certain type of annuity sometimes for a long time, I could do better than a than a CD. Would you say that these structured notes? Could they ever replace annuities? Or should they replace annuities? What’s your thought on that? Chris? Well, I’ve

 Chris Me  12:07 — been involved in the annuity business for 37 years, I’ve spent a tremendous amount of time I lead distribution for variable annuity companies, I started selling annuities in 1986. So the reality is that annuities are a very, very important part of a portfolio for clients that are seeking income or tax deferral. If they’re seeking some sort of guaranteed income, there is nothing better than an annuity to give someone guaranteed lifetime income. It’s what they’re designed to do. They’re backed by insurance companies, the insurance companies know exactly how to do that. However, if you’re looking for downside protection, and you would like to get lump sums of cash, or you’d like to have a shorter period, and you don’t need to build up taxable gains inside there, then that’s where the structure product really comes in, you now take the insurance company out of the picture, and you now put an investment bank, it is now more of an investment, and away from strictly an insurance company. And now you’re being backed at a lower cost. You’re doing it with a much different tax structure. And you’re also doing it in a way that you can be much more nimble with your client. Once you’re in an annuity. It’s very challenging to get out. Because if you’re going to be very challenging to get in to, I mean, operationally, no, yeah, just trying to Yeah, that’s a whole, you know, Nago. And the forms and this is, this acts much more like an investment. And when a client looks at it, they it’s actually easier for a client to understand it’s very, it’s quite simple. If you say that we’re going to be in the S&P 500. And we’re protected for the first 20% of loss, or we’re going to invest with Goldman Sachs. And they’re going to set up an investment that allows you over the next five years to participate in these three indexes.

 Mark Scalzo  13:50 — I’ve always felt, Chris, that when I look at annuities, it’s almost more about your buying into a structure that someone else has already established, like you’re almost picking from a list. And there are a lot of creative and innovative structures there. Don’t get me wrong. But there isn’t a way to customize those structures in a way that directly reflects potentially the needs of the client, you have to decide which one is the best fit almost for the client. Whereas with a note, you know, depending on the circumstances, you can you can structure something very, very specific.

 Chris Me  14:25 — Well, the interesting thing is that when you really look at most advisors portfolios, they’re almost 100% long only. Right? Almost everything that an advisor or even a client owns is long only, right? There’s three things that can happen in the market. We all know it right? It can go up, it can go sideways, it can go down. That takes care of one item only if it goes up and an advisors view could be totally different. Maybe they say I think the markets gonna go sideways for the next 612 months. Someone else might say I think the markets going takeoff, someone else says, I think the markets gonna go down over the next six months, it’s gonna be very challenging. If you look at their portfolios, only, you would have a struggle to figure out which one of those falls into which category, maybe someone has a little less bonds, a little more cash, maybe someone has a little more, but market implemented, just buying things correct? Yeah, when you have structured products, you can have a specific view on the market. If you think the markets gonna go sideways for the next 12 months, and you’re not sure where it’s gonna land, you can get an investment that will pay a guaranteed digital return, we call it, whether it’s down, whether it’s sideways, or whether it’s up. So those three scenarios now are covered by a structure product, you look at that, and you say to somebody, hmm, there’s somebody who thinks that the markets can be range bound, they don’t know there’s gonna be up down or flat, but they have an opinion, is very clear. When you look at that there’s an opinion, you see someone else who maybe has what we call a dual directional. Now, you look at it, and if it goes down, it’s gonna go up. And you start looking at it saying that person thinks that we got some challenges ahead of us, but they don’t want to give up the upside. So they think normally, if you’re long only, you have to go to cash. But with structuring products, you can say I’m going to go dual directional, I’m going to make money when the markets down. So now when you’re sitting when your best client is sitting on the first tee, and talking to three of their buddies, and they’re saying, hey, my advisor thinks that the market is going to be rough over the next 6-12 months.

 Mark Scalzo  16:36  — So we’re in cash, and they’re bragging about it. I’m in cash, hey, it’s earning me 5%.

 Chris Mee  16:38  — I’ll take it right. And then the other one says, Yeah, well, I’m not sure what its gonna do. So we own bonds, right? We know what bonds have done this last 12 months. And the other one says, Well, my advisors pretty sophisticated, they actually went to Goldman Sachs. And they built me a product, an investment with Goldman Sachs, that says, if the market goes down, the amount that it goes down, I go up, if it’s sideways, I’ll make as much I’ll make market returns if the market doesn’t return anything. And if it goes up, I’m uncapped. Now the conversation starts to change a lot. Now people start saying, Well, what exactly is the name? Who’s your advisor, because now it’s different. It differentiated the financial advisor, because they have something managed accounts, they’re terrific. But they don’t all, they don’t look tremendously different. They’re, they’re wonderful at what they do. They’re amazing. But you need a little differentiator, maybe as a sidecar something that’s in that portfolio that gets the client talking. And then they’ll get in your managed account, the most important thing about the managed account is that they stay in it. Yeah. And the way you keep them in it is you have a plan for the market going up, which they’ll never call you about, they’re not going to congratulate you. But when it sits stagnant for 612 18 months, and you’re going up, it’ll change their attitude. And when it goes down, and they see their statement go up, it’ll change that will help keep them in those managed accounts, and you’ll be unique.

 Mark Scalzo  18:01 — And advisers are always looking for a way in this world to differentiate themselves. Everyone has basically the same traditional asset allocation models, right? Maybe you throw in a little bit of alternatives with that, but how do you really tell a story, that you’re different, you know, even if you have a view about where the markets might go, about what you’ve done for the client, yeah, to make sure that that isn’t a problem for them. And I think that for me structured notes, if you’re an advisor is about a tool to differentiate yourself into and to implement a view that, as Chris said, is easy to identify for a client. Here’s what we did and why. Here’s why it’s different. Here’s how your portfolio looks different than all of your buddies on the golf course. Right? And whether you’re wrong or right, a lot of the times and the nice thing about these products is you don’t have to take a lot of risk. You know, they’re not often betting that the markets gonna go up five times from here kind of thing. Or you’re going to participate more in the downside, it doesn’t work that way. Right. So the nice thing about these products is most of the time they work pretty well for what the objective is. And so, then you’re not only doing something that’s very forward thinking for your client, but you’ve also actually, you know, protected them from the thing you were worried about.

 John Dean  19:26  — Well, you know, that’s true. You are correct. I hadn’t thought of that. But it is true. When you when the markets are going up. They aren’t calling you saying Great. Thanks for the ride. Yeah, you know, but when the markets are going down, and they’re not they’re going up or they’re making money.

 Chris Mee  19:45  — Wow. Right. I mean, that sticks out well, and that’s when most of the talking happens. Right? The absolute everyone likes to brag when it’s going up, they talk about what stock they owned, right? But that’s not their portfolio. It’s a stock that maybe they put some money in, but when it goes down, they’re talking a lot and they want to talk They’re friends. And they’re asking questions. And that’s where you really differentiate yourself. Or if you’re trying to raise assets, how do you get someone to invest today? We’ve got geopolitical risks, we’ve got inflation we’ve got the bond market moves 50 basis points, which is Mammoth. It does that in a few days. Now, it used to take 612 months for to do that well. And it doesn’t matter what the Fed does, the Fed can do one thing, the long end of the market does something totally different. So how do you get someone to invest today, if you can invest in a way where you can’t be wrong, if the market goes up, down or sideways, we can make money, then now all of a sudden, the client looks at you totally different. They know they need to invest, they know they need to reach their goals, the goals have not changed, they’re not going to ring a bell and tell us today’s the day you get in its turmoil like this, that we look back on, and we say that was the time to invest, you look back on Oh 809 When nobody wanted to invest. That was when you’ve made four or five times your money in that period of time, that changed the whole dynamics of the market. If you bought then it’s during times like this, you need some confidence, you need something that will hold your hand, you need something that will get you into the deeper water, but you have a life jacket on. And that’s where the structure product comes in.

 John Dean  21:07 — Isn’t it all about your client resting easy, that’s it and not having to make the guess that’s all I can guess it’s gonna go up sideways or down? I could be wrong. Right. But if we’re covered on each, each of those in some way, then hey, we’re all doing okay. And

 Mark Scalzo  21:22 — That’s a great point, because we’ve seen bond volatility, unlike we’ve seen in most of our lifetimes, right? Where now most of us weren’t alive. or managing money, I should say, you know, when bonds were a lot more volatile in the 70s, or whatever it might have been, right. So, you know, we really, bonds have had only gone one way, you know, for a long period of time, we’ve had a thirty year bull market in bonds, where I think investors were kind of lulled to sleep by this idea that you could just consistently earn 5, 6, 7 percent total returns on your portfolio, and, and it was going to move in an opposite direction to equity. So you it would also protect you at the same time. We’re in a different world for a lot of different reasons. And we don’t have all the time to go into it. But you know, in a world of additional bond volatility, where bonds aren’t playing potentially the same role, or providing the same comfort that they did in the past, structured notes can be a great alternative.

 John Dean  22:31 – Well, you get somebody who says, you know, I had a safety net, I had my bond portfolio, my safety net failed me. Pretty much all of what last year, last calendar year, right? I mean, now I’m lost. What do I do? My parachute didn’t open. Right.

 Mark Scalzo  22:44 — Right. And by the way, advisor, what did you do? Yeah, after that experience last year, right, where a 60/40 portfolio was down meaningfully — what did you do?  So that we wouldn’t see the same kind of result this year?

John Dean  22:58 — You’re supposed to help me, right? I mean, that’s, that’s why I come to you. You’re supposed to…

Mark Scalzo  23:02 — you’re supposed to think about whether or not there’s a change you should make. Yeah, so that I’m not faced with the same kind of situation in the future. No guarantees. But, you know, and 60/40 portfolios have done better this year, but almost exclusively because of the equity return, of course, and not the bond portion — bonds have actually hurt you. So depending, but for the most part, if you just invest in a typical bond strategy, like a Bloomberg AGG, something like that, it has hurt you.

Chris Me  23:33 – Well, this has been fascinating for me, is there anything else you want to add? I mean, well, I always got to make sure I put in a couple of disclaimers, please do arrays do. First of all, I sense this, whenever you’re in a structured product, is going to be the full faith and credit of obviously the bank that you’re that’s issuing the product you need to have secured though, yep, it’s a senior secured debt. You also need to, you need to understand you’re not collecting the dividends. So on SP y, you’re not going to get 1.5 or whatever that’s not going to be because you’re owning a derivative of the actual market, you’re owning an option. Then the other portion of it is that you want to make sure that when you buy them, you’re holding them to maturity, because anything that happens in between you don’t it’s going to be based on whatever market value is at that time. Right. So which is by the way, many people don’t realize this, but when you sit in, if you buy a treasury bond, or Treasury note, it’s guaranteed the day you buy it, and the day it matures, anything can happen in between. These are no different.

Mark Scalzo  24:33  — There is a secondary market, not for every single note – it isn’t necessarily robust for every single note. But for most notes, especially where there’s been sufficient amount of volume in dollars, there is a secondary market for them.

Chris Me  24:48  — And actually, that’s something that in InspereX we’re very well known for we’re the leading market for that, but a lot of the issuers will purchase some back or there’s a there’s an institutional marketplace that’s out there, but for The majority of people you want to hold it to maturity, you want to, you want to invest in it for the for the goals you’re trying to achieve. And for advisors that are out there today, I would recommend that you learn more about these for the good of your client. And for the good of your practice.

John Dean  25:12  — How can they get in touch with you, Chris? Or what’s the best way to do that if they want some more information, or you get…

Chris Me  25:18  — A hold of in InspereX, and we’re available in InspereX.com. And that will give you an entire wholesaler map or get you directly into our internal desk, or work with Mark always, Mark Scalzo.

Mark Scalzo  25:30 — And I would say also, get their information that they send to folks, get on their distribution list because there’s a lot of real helpful information there. There’s educational pieces, there’s topical pieces about certain types of structures that are new and interesting. So I would say do that.

Chris Me  25:55 – And the thing to understand, too, is that you can be unique. I know we’re wrapping this up, but the reality is, this is an explosive market, it’s growing very quickly. It’s been used for many, many years with ultra high net worth clients, they use them constantly. It was never available to Main Street until the last decade or so. Yeah. And so now, advisors who are used if you have someone who’s coming over from a wire house, chances are they’ve seen these, if they’ve been at a bank, they may have seen a CD that’s a structured product. But in the independent world. This is a fairly it’s less than 10% of the financial advisors utilize them. So you can set yourself apart now by understanding these products now and be able to gather assets from not only the banks, but also from the wire houses by having these available. Yep,

John Dean  26:39 — Yeah. And that’s good. And when you as an advisor, understand it makes sure your client understands it too, so that you can get some of the credit when it’s right. Right. It’s all about education.

Mark Scalzo  26:47 — To use neat terms like snowball, auto call…

John Dean  26:52 — Oh, wow.  Did they get like five free terms they can throw?

Mark Scalzo  26:58 — They’ve got a whole glossary.

John Dean  27:00 — Chris me it’s managing director at InspereX. I’m never gonna get that right. But it’s the word inspire with the letter X after That’s it. That’s it. And Mark Scalzo, of course, at Validus, I appreciate you guys being here. I really do. It’s always fun. We got to do this more often. Yes, absolutely. Yeah. So next time you’re in town, Chris, let’s we’ll grab you again.

Chris Mee 27:21 — You got it. I love being here. Thank

John Dean  27:23 — All right. For these guys. I am your podcast host Johnny D. And thanks for listening. We’ll talk to you again next time. Valid is growth investors LLC seeks to invest in companies at every stage of their growth. from startups to publicly traded companies. Our research identifies inflection points that have the potential to produce meaningful growth and income for the clients we serve. Investment Advisory services are offered through Validus growth investors LLC valid is an SEC registered investment advisor. No offer is made to buy or sell any security or investment product. This is not a solicitation to invest in any security or any investment product valid is valid. This does not provide tax or legal advice. Consult with your tax advisor or attorney regarding specific situations intended for educational purposes only and not intended as individualized advice or a guarantee that you will achieve a desired result. opinions expressed are subject to change without notice, investing involves risk including the potential loss of principal no investment can guarantee a profit or protect against loss in periods of declining value. All information is believed to be from reliable sources. However, we make no representation as to its completeness or accuracy. opinions and projections are as of the date of their first inclusion here in and are subject to change without notice to the listener. As with any analysis of economic and market data, it is important to remember that past performance is no guarantee of future results. information presented on this program is believed to be factual and up to date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Discussions and answers to questions do not involve the rendering of personalized investment advice, but are limited to the dissemination of general information. A professional advisor should be consulted before implementing any of the options presented.