Building a wall between research and products

As chief wealth management strategist for Merrill Lynch Global Private Clients, responsible for advising on investment of assets worth $1,400bn (?1,170bn), Tom Sowanick plays a very different role to the chief investment officers of Europe’s private banks and wealth managers. Whereas in Europe, the CIOs are typically very involved in the product creation process, American regulations prevent this, and US groups such as Merrill like to keep their research and fund construction departments separate. “We do not engage in product creation,” says Mr Sowanick, describing his role as head of the bank’s wealth management strategy unit. “What happens is that our product groups see our research and then structure accordingly. It is a very keen relationship. In effect, they are structuring products to go with our investment theory and ideas. In some institutions, somebody comes with a great product idea and thinks: ‘if only we had the research to support it.’ Let me tell you, it doesn’t happen that way here.’ “I may speak to Bob Doll [chief investment officer and Mr Sowanick’s counterpart at Merrill Lynch Investment Managers] and ask him what he is thinking about an issue, and tell him what I am thinking, so that we can exchange ideas, but I don’t say: ‘this is what we think, now can you create a product on the back of this?’” He calls for a wall between those who supply the research ideas, which are translated into products, and those who actually create the products and stresses that the links between the huge private client operation of Merrill Lynch and the product factory at MLIM are not as close as outsiders would think. “Even as an economist, I see no benefit to creating products in the same group. There is so much risk of challenging your integrity when you are responsible for creating both strategy and marketing products; which one are you really going to market, the strategy or the product?” Underlying influence However, Mr Sowanick’s role in product creation is clearly an influential one. He has been vociferously recommending commodities to private clients for over a year, and then in the fourth quarter of last year, MLIM finally came up with a natural resources fund. “Investors have not had enough exposure to commodities, largely because there hasn’t been a vehicle for private clients to easily transact in. That is no longer the case, as now we have those vehicles,” says Mr Sowanick. In order to make things easier for the product teams, he also tries to hone his often complex investment theories into manageable themes, so that they can be followed by those creating the products, those advisers selling them, and the end private clients who are looking for a profitable home for their assets. “Themes should have a long shelf-life,” believes Mr Sowanick. “They should not be tactical things. It allows the financial adviser (FA) community to have long dialogues over time with the investor base. Because they are theme-based, it’s easy to associate different solutions with these theories, whether from our structured products group, or from MLIM,” says Mr Sowanick. “We don’t recommend mutual funds, and it’s up to our FAs to choose the right vehicle for execution. But we should not come up with themes that are not implementable, and for the most part, we don’t.” For instance, Middle Eastern markets have soared, yet they are not easy to access for all but local clients, believes Mr Sowanick. “So for us to specifically recommend exposure to the Middle East is like broadly asking people to walk to the moon. You just can’t do it.” He also often sees the themes he patiently crafts from economic data turning up, almost word for word, in marketing prospectuses of rival fund managers, with whom he has absolutely no communication. “This feels quite pleasing, when I see my themes being lined up by other money managers. That’s if they’re working,” smiles Mr Sowanick. All themes are also matched with suggestions for investment ideas, to give product teams a few hints on how to satisfy private client queries. For example, reflation, powered by Asian and Japanese expansion, is a theme which can be played by investors buying commodities, inflation-linked securities and switching from US dollar assets to Asian currencies and Japanese yen. The theme of dollar weakness also favours exposure to Asian currencies, particularly those of Korea, Singapore, Taiwan and China. The “refined equity barbell” approach, resulting from a convergence of equity valuations and macro conditions, recommends pairing US growth stocks or growth sectors such as technology and healthcare with Asian equities. The “refinement” shows that although these are long-term themes, Mr Sowanick is not afraid to tinker with them to reflect changing economic conditions. “Last year, we had the policy that emerging market equity would provide the best returns,” explains Mr Sowanick, who believes that this asset class has only become robust enough for private client allocations during the last two years. “But we also found that companies had excess cash and would begin to increase dividends, so in order to decrease the risk of emerging markets, we married those stocks with higher dividend stocks. This year, we still like this strategy, but have a bias towards Asian emerging markets, teamed up with high quality growth companies.” The modification of this theme meant reducing weighting of Latin American emerging markets “where the number of elections is quite high,” says Mr Sowanick. He also felt it prudent to shave some Latin exposure because the region has enjoyed such huge growth, with Brazil up more than 20 per cent in dollar terms in the first three weeks of January this year. One recent arrival, which will aid the product manufacturer to follow these themes is the exchange traded fund (ETF), believes Mr Sowanick. Rather than proving a revolution in terms of investors’ use of products, he sees these vehicles as part of an evolution away from single stocks, bonds or commodities towards asset structures, which provide liquidity, transparency and diversification. “With the advent of ETFs, the adviser’s role becomes even broader and more complex rather than limited,” says Mr Sowanick. “He has more assets to allocate across. As opposed to stocks, bonds and cash, there are now commodities and alternative investments, in addition to a whole bunch of sub-classes.” Mr Sowanick is also not shy of praising the concept of structured products, which are the favoured, and most profitable solution for Ausaf Abbas, the bank’s head of global private client business for the EMEA region. “Structured products provide a cushion, plus they can be quite nuclear. They can be leveraged many times, with your principal protected,” he says. “I am quite comfortable that they can give you a whole menu that allows you to express your risk tolerance.” For a private client with a growth profile, Mr Sowanick’s research tool currently recommends a 55 per cent allocation to equities, 25 per cent in fixed income, 20 per cent in alternatives (including commodities, hedge funds and managed futures) with zero allocation to cash. Looking forward, he expects commodities to become a core investment, together with macro hedge funds. “My sense is that investors will become more sophisticated, that they will use alternatives to enhance returns and to minimise risks, as opposed to purely as an investment,” believes Mr Sowanick. “It’s an asset space which will continue to grow as investors become more educated about the use of unconstrained asset classes for reducing risk.”