Western asset funds were downgraded upon manager exit

Lukas Strobl: In August, US bond fund manager Western Asset was rocked by the sudden absence of its co-CIO, Ken Leech. Leech was also a manager behind some of Western Asset’s flagship rates strategies. I’m here with Morningstar fund analyst Shannon Kirwin. She is part of the team covering Western Asset’s strategies globally, and in the past month they have had time to reassess their ratings for those potentially affected funds.

But first, Shannon, let’s talk about how much trouble Western Asset and Ken Leech might actually be. The SEC had sent the so-called notice to Wells. What exactly does this tell us?

Shannon Kirwin: Yes, hi Lukas. It’s great to be here. So a Wells Notice means that the SEC has concluded a formal investigation into a person or company and means that they believe they have grounds to bring enforcement action against that person or company. So at this stage the individual then has 30 days to respond, basically make their case as to why there shouldn’t be an enforcement action.

So we actually don’t know anything about what the SEC thinks it found. There has been no official release from them. We have to wait for an official statement from the SEC to know exactly what they determined. In cases like this in the past, where the SEC has investigated an asset manager, sometimes it can end with a whisper, other times it can end with a bang. There really is a wide range of outcomes we could expect to see here. Sometimes it’s a minor record-keeping error, other times it’s a more serious offense.

So what we do know in this particular case is that so far the investigation has been limited to one individual, Ken Leech, rather than the trading of the entire Western Asset, for example. And we also know that Western Asset launched its own internal investigation into the same transactions before the Wells notice became public.

Strobl: So nothing definitive yet? How did investors take it?

Kirwin: Investors did not take it too well. In the past four weeks since Wells’ announcement became public, there have been about $13 billion in assets that have left Western Asset funds, according to Morningstar data. The vast majority of these flows came from some of their flagship strategies, Core Bond and Core Plus Bond, where Ken Leech was co-manager.

In a way, this is just the acceleration of a trend that had already been visible for the past two years. These strategies have had exits for several years after a disappointing performance in 2022, which was due in part to contrarian duration bets that were placed in those strategies that actually worked against them in the bond selloff. So sometimes for investors, when you have a few years of poor performance, then you have a prominent manager leaving and now sort of the scale of the regulatory issues, that can be just too much of a blow against the strategy and they choose to move. assets elsewhere.

Strobl: So, apparently, they’re not waiting to hear what the SEC will actually do. Now, over the past few weeks, your team has also had the chance to speak to Western Asset and take a closer look at their funds. Have you taken any evaluation actions?

Kirwin: That is correct. So our global manager research team, we are active on four continents. And together we produce valuations for 13 different strategies that are managed by Western Asset. As soon as this news broke, I reviewed all 13 strategies. And that means our analysts take the time to gather information and reassess each individual strategy if anything has changed in terms of our core belief.

So for 10 of those strategies, we ultimately came to the decision that we didn’t want to change any of our pillar ratings, so our people or our process ratings for those strategies. And this primarily came down to the view that Ken Leech’s departure should not be a major disruption to these strategies. These are strategies where Ken Leech did not take major risks, so his contribution was primarily through his role as CIO or co-CIO of the company. And Western Asset was already in the process of what appeared to be a fairly orderly handover of responsibilities from Ken Leech, who has a 40-year career in asset management and was heading into retirement, and his named successor, Mike Buchanan , who was named co-CIO alongside Leech about a year ago.

So Mike Buchanan was well positioned to step into the CIO role. He now heads the various investment committees where PMs formulate their macro views that ultimately lead to positioning in their strategies. So we didn’t feel that Ken Leech’s departure would be disruptive – that includes some US municipal bond strategies that we cover, some global bond strategies that are managed primarily from London, Asian bond strategies, bond strategies Australian. These strategies all maintained their ratings.

Then there are three strategies where we downgraded our ratings. And these include the two I mentioned earlier, Core Bond and Core Plus Bond. There Ken Leech had actually been an important member of the management team leading the strategic positioning. And we think his departure leaves teams in a weaker position than where they were before. And that’s especially true if Ken Leech’s departure followed the departure of another co-manager from that team, John Bellows, who had been sort of a newer, up-and-coming member of the team. So with those two departures, it looks like the succession planning at that team took a bit of a hit. So we’ve downgraded our people pillar rating from above average to average for both strategies.

Then the third strategy is Macro Opportunities. This is a strategy in which Ken Leech was the prime minister. It had been a kind of pure expression of his macro views, some would describe it that way. And there, the company, Western Asset, has actually taken the extraordinary step of liquidating this strategy and they will return the assets to investors by the end of October. So, we narrowed down our views there as well. We would never recommend anyone to invest in a strategy that is being liquidated.

Strobl: I understood. So it looks like the main bad news we’ve been working on in our ratings is that Ken Leech is no longer there to manage those funds. That is, are you optimistic about their succession mechanism leading to strong management going forward?

Kirwin: For many of these strategies, we have positive ratings, so either above average or even high in some cases. So we think there are a lot of fundamental strengths that are still intact. That said, of course, this is a dynamic situation and we are following very closely any new information that comes out about this situation. And if necessary, we will reevaluate again.

I guess it’s worth mentioning that we also reaffirmed our parent rating. So the parent rating of Western Asset’s parent company is Franklin Templeton. And there we came to it with an average rating of the parents, and we re-evaluated and reaffirmed this rating in the average. This has not resulted in any downgrading of our parent vision. But it highlights some of the complications that can arise when a company follows the kind of multi-affiliate model that Franklin Templeton does, where Franklin Templeton has grown very rapidly over the past few years through many acquisitions. And now they oversee about 19 what they call specialist investment managers, which are sort of boutiques. So when you have that multi-affiliate model, there’s kind of a tightrope walk between, on the one hand, you want to preserve the autonomy of your investment teams and the culture that has made them successful. And on the other hand, you want to enforce company-wide rules and standards.

Strobl: I think we’ll probably talk again when we really know what the SEC is going to do. This seems to be the biggest variable in the situation so far. But this was a great update on the situation. Thanks for that, Shannon. For Morningstar. I am Lukas Strobl.