SSgA defends its ‘low-risk’ funds

Bad bet on mortgage-backed securities prompts consultants to question controls

BOSTON — State Street Global Advisors has some explaining to do if it hopes to limit the fallout from its ill-fated bet on mortgage-backed securities.

With a number of SSgA’s supposedly low-risk strategies suffering steep losses in July and August, consultants and clients are rightfully questioning whether SSgA’s internal risk-control processes worked, and the firm will remain under a cloud until it provides a full explanation, said a West Coast-based consulting veteran, who declined to be named.

That full explanation, which consultants say has eluded them thus far, now looks likely to come out in court.

On Oct. 1, Prudential Retirement Insurance and Annuity Co., Hartford, Conn., sued SSgA, Boston, saying in its complaint that its 401(k) clients lost a combined $80 million when SSgA’s intermediate bond and government credit bond funds dropped 25% and 12%, respectively, in “just two months starting July 1, 2007. Materials Prudential claims it received from SSgA said the money manager would guard against “unpredictable exposure to random events,” the lawsuit alleged.

Prudential dropped SSgA’s funds from its portfolio of 401(k) options at the end of August.

The suit cited SSgA’s “deceptive, imprudent and incompetent performance of its obligations as a fiduciary.”

Meanwhile, attorneys for Alaska, Idaho and Ohio, where SSgA has managed money for state retirement plans, say they are looking into the details of what happened and why.

In a telephone interview, Michael Barnhill, an attorney in Alaska’s Department of Law, declined to predict either the length or outcome of Alaska’s review. He said he didn’t recall the Juneau-based Alaska Retirement Management Board ever having “a bond fund collapse like this.”

On Aug. 23, the Alaska board said in a news release that it had dropped SSgA’s Daily Government/Corporate Bond fund from its defined contribution lineup. As of that date, the SSgA fund had fallen 18% year-to-date, compared to a 3% gain for its Lehman Brothers Government/Credit Bond index, the release said.

On Oct.9, Seattle-based law firm Keller Rohrback LLP asked plan participants who suffered losses recently on SSgA-managed funds to contact them, citing the Prudential lawsuit.

Vigorous defense

SSgA executives say they intend to respond vigorously to Prudential’s suit.

In an Oct. 5 letter to clients, William W. Hunt, SSgA president and chief executive officer, said the decision by PRIAC and other clients to pull out of SSgA’s actively managed fixed-income products at the worst possible time — a moment of unprecedented volatility — contributed to the losses. He added that clients who “did not panic” are now seeing a steady recovery in the value of their holdings.

Some market veterans saw the letter as putting the onus on clients for the losses they suffered. “It’s sort of surprising that they would go out and blame clients,” said a San Francisco consultant who declined to be named.

In an interview, Mr. Hunt said SSgA “isn’t looking to place blame, but we believe it’s important to defend ourselves” against Prudential’s accusations. SSgA will file a detailed response to Prudential’s complaint “soon,” making clear the efforts it made in navigating a very difficult market environment, he said.

Rebuilding SSgA’s active fixed-income business after unprecedented turmoil in the mortgage-backed market remains a strategically important goal, but the setback there won’t affect the broader firm’s strength, said Mr. Hunt. “We’re not expecting any slowdown in our business.”

In September, SSgA’s active fixed-income strategies managed to win at least three mandates with $850 million in combined assets from non-U.S. institutional clients, noted State Street spokeswoman Hannah Grove, who declined to name them. Parent company State Street Corp. (STT) will announce its third-quarter results on Oct. 16.

Market watchers say assets in SSgA’s active fixed-income strategies dropped to about $36 billion by the end of September from roughly $40 billion on June 30. The firm ran $1.93 trillion in total worldwide assets on June 30. Ms. Grove declined to confirm the September figure.

Still, pension consultants say the steep losses suffered when the mortgage-backed market seized up in August have raised broader questions about SSgA’s risk controls and investment models that the money manager has yet to answer fully.

SSgA’s limited duration bond fund, an institutional offering with $2.8 billion in client money as of June 30, is a prime example. Investment consultants say more than 65% of its assets were in mortgage-backed securities when that market crumbled in July and August. Marketed as a low-risk alternative to a core cash fund, that limited duration fund dropped as much as 44% in value during the month.

According to one East Coast consulting veteran, who declined to be named, by mid-August the number of clients in the fund plunged to 29 from 53 and assets dropped to around $1.2 billion. SSgA officials declined to confirm those figures.

Other strategies were decimated as well, including SSgA’s short-term, stable value, pooled, intermediate bond, commodities and government credit bond funds, either because they invested directly in mortgage-backed securities or because they parked a chunk of their portfolios in other SSgA strategies that had exposure to mortgage securities.

Arlene Roberts, another SSgA spokeswoman, said a number of the firm’s fixed-income strategies which suffered in August have rebounded in September, with the limited duration bond fund posting an 18% gain for the month.

At least one strategy — SSgA’s Daily Bond Market fund — continues to struggle. According to information on SSgA’s website, that fund was down 24% for the year through Oct. 10, compared to a 21.5% decline for the year through Aug. 31.

A marketing executive who worked for an SSgA competitor said the issues surrounding SSgA’s fixed-income setbacks will all focus on “truth in labeling — did they manage the money the way they told people they would?”

Guidelines followed

Mr. Hunt said all of SSgA’s active fixed-income strategies were managed in accordance with their respective objectives and guidelines.

Still, even if a close reading of the investment literature reveals no outright transgressions, SSgA’s judgments will remain open to question, said Michael Rosen, a principal at investment consultant Angeles Investment Advisors LLP, Santa Monica, Calif.

Several consultants said they haven’t put SSgA’s actively managed equity operations — which have doubled to 20% of the firm’s overall equity assets over the past five years — in the penalty box.

Michael Travaglini, executive director of the $50 billion Massachusetts Pension Reserves Investment Management board, Boston, which has both active and passive equity portfolios with SSgA, said news of the losses suffered by some SSgA strategies hasn’t affected his view of the firm.

PRIM makes sure it knows what it’s getting when it hires a manager, and SSgA is delivering exactly what it promised on PRIM’s actively managed portfolio. “It’s always a buyer-beware situation,” said Mr. Travaglini. People caught by surprise over the past few months have to ask whether they really knew what they were buying, he said.

But consultants say SSgA’s handling of the situation during the coming months could affect their thinking about the broader organization. SSgA’s response so far “starts to call into question the management of the organization, and that could potentially affect all of their products,” said the West Coast-based consultant.