Wall Street's world turned upside down

Financial firms scramble to find their path in a fear-driven investing environment

May 3, 2009 @ 12:01 am

By Jeff Benjamin 

The day of reckoning has come for the financial services industry.

The industry “has a lot to answer for,” said John Bogle, founder of The Vanguard Group Inc. in Malvern, Pa. “This industry creates products that will sell, rather than products that are good for clients to buy.”

Although it is far from over, the worst financial crisis in generations is already reshaping the financial services industry.

Gone are the days of expensive, hard-to-understand products that lean heavily on stocks to fulfill a promise of fast appreciation. Gone, too, is the ability to sell almost any product on the hope that it will eventually reward investors who are patient enough to ride it out through the market's ups and downs.

There is a run for the exits on Wall Street — and not just the once-surefooted wirehouse brokers who are defecting to smaller, more nimble investment advisory firms. As the economy and the stock market struggle to get off their knees, investors are moving fast, away from stock allocations and toward vehicles that are perceived as “safe” like corporate bond funds, fixed annuities and certificates of deposit.

Stock mutual funds, as a percentage of U.S. mutual fund assets, dropped to 40% in March from 55% a year earlier, according to Strategic Insight Mutual Fund Research and Consulting LLC in New York. Over the same period, money market fund assets climbed to 41%, from 30%, and assets in fixed-income strategies jumped to 19%, from 15%.


Banks, brokerage firms, mutual fund companies and insurers will be forced to compete in a world of lower profit margins, thanks to demand for lower-risk and lower-priced products. They will also compete in a world where they are viewed more as scoundrels than saviors.

“Right now the financial services industry is like a vampire that has sucked all the blood out of the American public, and is now standing over it, saying, "Trust us again,'” said Edward A.H. Siedle, president of Benchmark Financial Services Inc., an Ocean Ridge, Fla., pension consulting firm. “Nobody is saying they will return what you've already lost; they're just saying, "Trust us again.'”

Nowhere is the massive restructuring of the industry more apparent than behind the closed doors of the firms that create and market investment products. There, executives are considering products and services that speak to investors' new conservatism and their yearning for positive returns regardless of what happens in the stock market.

Consider, for example, absolute-return funds. The funds, which aim to make money in up and down markets, jump in and out of different investing styles and asset classes in pursuit of gains.

If value stocks are on the rise, they might emulate a value fund. If energy stocks are on a roll, they might look like an energy fund.

“Absolute return is going to be big, and right now those strategies make up less than 5% of the mutual fund space,” said Robert Reynolds, president and chief executive of Putnam Investments.

Early this year, the Boston-based mutual fund company, which has $100 billion in assets, launched a series of absolute-return funds de-signed to provide returns above those of Treasury bills by 1%, 3%, 5% and 7%, depending on the fund. Other companies that have recently launched absolute-return funds include The Dreyfus Corp., a unit of The Bank of New York Mellon Corp. of New York, and Natixis Global Asset Management LP, based in Boston.

Then there are funds that promise to protect an investor's principal or provide a steady stream of income.

Principal-protection funds guarantee to return at least an investor's initial or principal investment, after fees, several years down the road. The funds first gained popularity in the early part of this decade, after the technology bubble burst.

Conservative allocation funds — which includes most principal-protection funds — gained an average 4.2% in 2000, outpacing a 9.1% loss for the Standard & Poor's 500 stock index, according to Morningstar Inc.


Soon after, however, many investors found themselves regretting their decision to seek solace in these ultraconservative funds when they found themselves left in the dust of the ensuing rally.

In 2003, the average conservative allocation fund gained 12.3%, significantly less than the 28.7% gain posted by the index. That said, the latest downturn has already re-ignited interest in these funds.

“This industry will continue to create principal-protection and guaranteed-income products, but we have to go back to a more reasoned approach of the highest probability of being able to deliver the performance,” said John Cammack, head of third-party distribution at Baltimore-based T. Rowe Price Associates Inc., which manages $269 million. “We all have to stress-test our product suites so we understand how they perform in extreme situations, and we have to make sure they are marketed properly.”

In this new era of fear-driven investing, corporate bonds are expected to do well in the short term, according to Craig Callahan, president of Icon Advisers Inc., a $2.5 billion fund complex in Greenwood Village, Colo. “Equity shareholders have taken a hit and balanced funds are the alternative to long-only stocks right now,” he said.

Thus, even as stock valuations become more attractive on a fundamental basis, the industry is showing signs that it will first find hope and opportunity in the temptations of bonds.

“Right now, you don't need to be in equities when you can get equity-like returns from fixed income,” said Tom Sowanick, chief investment officer for Clearbrook Financial LLC, a Princeton, N.J., firm with $22 billion under management.

“This industry should have sorely learned by now the need to re-balance when things are going well, and to re-balance when things are going horribly,” he said. “It will be incumbent on Wall Street to help investors.”


In yet another sign of the shifting tide on Wall Street, simplicity has become the new black.

Investors, and financial advisers, are far less willing to put money into products that can't be explained —and understood — easily and quickly.

“What I see right now is a financial services industry that is lost in terms of which products to offer, and you've got an investor base that is not interested in anything they don't understand,” said Robert Levitt, president of Levitt Capital Management LLC, a Boca Raton, Fla., firm with $350 million under management.

That sentiment, of course, will have an indelible effect on how new and existing products are marketed for years to come.

In April, Legg Mason Inc. of Baltimore raised $250 million with the launch of the Western Asset Municipal Defined Opportunity Trust, a non-leveraged closed-end fund.

“Nothing fancy, just significant potential return,” is how the fund is described by Joel Sauber, head of U.S. products at Legg Mason, which has $698 billion in assets under management.

Genworth Financial Wealth Management, a Pleasant Hill, Calif.-based managed-account platform with $15 billion in assets, this month will begin offering government-insured indexed CDs that offer the security of guaranteed principal along with the potential to generate returns beyond normal CD market rates.

“In general, people like simplicity,” said the company's co-chairman, Gurinder Ahluwalia.


The events of the past 18 months will also have a long-lasting effect on the investing psyche of advisers. The downturn, coupled with the fact that baby boomers are barreling into their sunset years, has forced advisers to completely rethink their approach to investing.

“For the last 20 years, people have focused on the appreciation part of total return, but now it is just the opposite and people are going to be focusing on income,” said Don Phillips, managing director at Morningstar Inc. in Chicago.

“Yield will be the avenue that brings people back, because right now they want income and stability,” he said. “Expect more products that appeal to the income side and are able to limit downside.”

Although many advisers have long shunned the meager returns of the most conservative products, such as government bonds and CDs, their clients are living through the punishing reality of a stock market that seems completely out of sync with the industry's marketing materials.

For example, the idea of sticking with a diversified allocation of stocks and bonds — the long-time mantra of much of the financial advice industry — meant a 50% loss for anyone holding the S&P 500 index over the past year.

More to the point: an investor who sat in the benchmark index for the past 10 years would be looking at a 45% decline over the period.

“People feel like the traditional asset allocation models didn't work,” Mr. Sauber said. E-mail Jeff Benjamin at -jbenjamin@investmentnews.com.


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