Advisors, be careful what you wish for with interest rates

Lots of financial advisors and clients are feeling good as the first half of 2023 closes. As of Friday at noon, the S&P 500 stock market index was up more than 15% for the year to date. And investors are making money in low-risk cash, with the fed funds rate above 5%.

But the recent spike in interest rates, which sat at almost zero percent at the start of 2022, is a problem for some advisors and clients who invested in interest-rate-sensitive products, particularly as many professional investors failed to foresee the startling increase in rates.

Last year, investors, jittery about rising interest rates and fearful of a recession, rushed for the doors of some nontraded real estate investment trusts, including the mammoth, $70 billion Blackstone Real Estate Income Trust Inc. The recession hasn't yet happened, but higher interest rates make real estate transactions more expensive, reducing profits.

Investor demand to sell back shares of certain REITs was so strong that late last year, some companies limited the process, which the industry calls share redemption. So some investors were stuck.

Advisors should be careful what they wish for when it comes to interest rates. One financial advisor wondered whether they're thinking about the potential for a downward move in rates and what that means for clients.

"When an advisor or client stretches for yield, that’s when they can get hit," said Doug Flynn, partner and co-founder of Long Island, New York-based Flynn Zito Capital Management, which manages almost $600 million in client money.

"Last year was the worst year ever for fixed income, and people were taken aback," Flynn said. "And short-term bond funds right now, their yields aren’t much greater than money market funds, which are yielding at 5%."

Which brings us to two investor complaints filed in June by clients of Sanford C. Bernstein & Co. who invested in a proprietary, in-house fund called the Options Advantage Fund, which had the purported goal of generating a 2% return after fees and was launched in 2017, according to the plaintiffs' attorney, Kristian Kraszewski.

At the time, interest rates were in the historic doldrums of 1%. And financial advisors will recall that back then, clients were hungry for yield.

"Sanford Bernstein pitched this fund to their best clients, and the strategy was for investors to borrow money on margin," Kraszewski said. "Bernstein then would sell short-term options and collect the premiums. It was designed to generate around 2% per year net of the fees Bernstein earned."

One client in the fund suffered "significant damages" in 2022, Kraszewski said.

"Bernstein had some hiccups along the way when volatility spiked because the strategy couldn't work with high volatility, and in 2018 and 2020 the fund suffered when volatility increased," he said. "When rates started rising in early 2022, Bernstein should have abandoned the strategy. Investors could get 2% in a money market, [certificates of deposit] or short-term Treasuries without the risk."  

A Sanford Bernstein spokesperson declined to comment when asked about the recent investor complaints about the fund.

It's anyone's guess as to the outcome of investors filing complaints seeking damages against firm like Bernstein. Sometimes investors win, and often they don't.

But the broad takeaway is clear. Financial advisors should be paying attention to the potential risk if interest rates take another turn, particularly if they are using specialty products.