WAMCO's early bets on risk drag down returns

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CIO Stephen Walsh remains confident the firm will bounce back.

PASADENA, Calif. — When the Federal Reserve moved to fix panicked fixed-income markets last fall, WAMCO officials thought credit was safe again.

They were wrong.

In fact, the upshot for Pasadena-based Western Asset Management Co. has been negative performance that has continued to dog its strategies across the board.

Some pension funds — including the $227.7 billion California Public Employees’ Retirement System, Sacramento, and the $38.4 billion Teachers’ Retirement System of the State of Illinois, Springfield — have cut WAMCO from their manager lineups.

“Could we get a do-over,” joked Stephen Walsh, chief investment officer of WAMCO, one of the big three fixed-income shops with $624 billion in assets under management.

Despite the missteps, WAMCO officials are confident of a turnaround in their performance. The firm's fundamental analysis is strong and performance will turn around once investors put risk back on the table, said Mr. Walsh.

But WAMCO executives now regret their early moves to hike exposure to credit issues.

“When we saw the Federal Reserve moving in, attempting to address the problem, we certainly felt that was like the cavalry coming over the hill,” said Mr. Walsh. “That addition to risk (in our portfolios) in the fall of last year is one we'd like to have over because obviously, it was early. Again, (we) underestimated, as they did, the nature and the extent of the problem.”

WAMCO managers added to the firm's high-yield positions, an area of the markets “that has continued to struggle,” said Mr. Walsh. And staff began to add mortgage risk in the fourth quarter. WAMCO's biggest overweight in mid-2007 was agency mortgages, said Mr. Walsh, which the firm thought was a lower risk move but proved to be otherwise.

Non-agency mortgages — subprime, prime and Alternative-A — have been pummeled since the liquidity crunch. Coming into “this tsunami,” a lot of the firm's exposure was on the high end of the capital structure, he said.

“As we sit here in August, we're overweight investment-grade credit, agency mortgages (and we) have a position in non-agency mortgage,” he said.

Meanwhile, the firm missed out on investors' flight to quality because it typically has very little exposure to U.S. Treasuries.

Hardest hit has been the firm's $10 billion U.S. Index Plus strategy, an enhanced equity indexing portfolio, which has lost more than 30% of assets since year-end 2007 when it totaled $14.4 billion, according to data from eVestment Alliance, Marietta, Ga. The strategy had a higher concentration in non-agency mortgages than some of WAMCO's other strategies, explained Mr. Walsh, and that hurt performance. Client outflows accounted for 20% of the drop in assets with the rest coming from market fluctuations.

In the year ended June 30, the strategy was down 26.96%, falling short of the Standard & Poor's 500 index by a staggering 1,384 basis points. The strategy ranked in the lowest percentile for its one-year returns, according to eVestment.

Pacific Investment Management Co., Newport Beach, Calif., one of WAMCO's biggest competitors, posted one-year returns of -12.78%, for its $27 billion PIMCO StocksPlus strategy, which gets its alpha exposure from short-duration bonds and overlays an S&P 500 futures contract. The $1.6 billion Equity Plus strategy of BlackRock (BLK) Inc. (BLK), New York, the third bond heavyweight, returned -19.71% for the year ended June 30. The S&P 500 returned -13.12% in the same time period. Both strategies are enhanced indexing portfolios that compete with WAMCO's U.S. Index Plus.

PIMCO has benefited by making bets on the Treasury markets, WAMCO lost out by betting against the government and BlackRock is known for being risk controlled and will generally land between the other two, said one consultant, who spoke on the condition of anonymity.

Since the start of the year, CalPERS shifted WAMCO's $600 million domestic enhanced equity portfolio in-house. Staff had discussed moving some of its external enhanced equity assets in house since the pension fund's internal program had been outperforming the external one. Also, the Illinois Teachers fund terminated WAMCO from a $1 billion enhanced portfolio in January. Illinois' chief investment officer, Stan Rupnik, told Pensions & Investments at the time that performance and high tracking error had been a concern.

WAMCO's largest strategy, the $96.5 billion U.S. Core Full, a core-plus fixed-income strategy, lost nearly 5% of its assets in the first half of 2008. The strategy returned 0.68% in the year ended June 30, underperforming the Lehman Aggregate Bond index by 644 basis points. The strategy ranked in the 90th percentile for its yearlong returns.

WAMCO's $29.7 billion U.S. Core strategy returned 0.56% for the 12 months, underperforming the Lehman Aggregate index by 656 basis points. WAMCO ranked in the 97th percentile for its one-year returns.

Too late to jump

Despite the poor returns, some consultants said it's too late to jump ship now.

“They've stayed the course in their involvement with mortgage-backed securities to their detriment as well as to ours,” said Leonard Yerkes, managing director in the Seattle office of consultant Canterbury Consulting Inc. “Now, we'll probably stay with them because they are so far down.”

Officials at WAMCO have persuaded Mr. Yerkes and his clients that the securities in their portfolios are undervalued and will eventually come roaring back. Mr. Yerkes has not recommended his clients terminate the firm, but those whose exposure to WAMCO is worth 60% or more of their fixed-income portfolios have reduced their allocations as a way to reduce risk, he said.

Roberto Peña, retirement administrator at the $2.7 billion Fresno County (Calif.) Employees' Retirement Association, said staff members at his fund are concerned about WAMCO's performance but believe it has more to do with the current market than WAMCO's skill. “We feel strongly” that the recent poor performance is not reflective of the actual value of the securities, but of mispricing in the markets, he said. WAMCO runs a $150 million core-plus fixed-income strategy for Fresno.

Richard Holbein, president of consulting firm Holbein Associates Inc., Dallas, agreed. “If they've selected (securities) well, that's going to come out on the other end,” he said. One of his clients, whom he declined to name, invests in WAMCO's U.S. Core strategy and has not put WAMCO on a watchlist.

WAMCO's exposure to non-governmental mortgage-backed securities is about average compared with other fixed-income managers, but it has been large enough to make a dent in returns, said Michael Herbst, mutual fund analyst at Morningstar Inc., Chicago.

Across its broad-market portfolios, WAMCO has about a 15% exposure to these instruments and it could be increased to 20%, said Mr. Walsh.

PIMCO, however, moved early in the credit crisis to take credit risk off the table, and the numbers show it.

PIMCO's $257 billion Core Plus Total Return Full Authority, the counterpart to WAMCO's U.S. Core Full strategy, returned 10.62% in the year ended June 30. BlackRock's $29.7 billion Core Plus portfolio returned 6.57% for the year, while the Lehman Aggregate retuned 7.12%.

Contact Raquel Pichardo at rpichardo@pionline.com

Updated with correction