A Hong Kong investment group is suing TCW Group Inc. for not hedging two "market neutral" portfolios of mortgage-backed securities that sustained $70 million in losses, or more than 60% of their total value, according to legal filings.
TCW Group's TCW Funds Management Inc., Los Angeles, managed the two portfolios with full discretionary investment authority, the filings state.
TCW targeted a return of at least 12% annually compounded, "regardless of the direction of interest rates," according to the lawsuit filed in U.S. District Court in Los Angeles.
But the sharp rise in interest rates in 1994 - which created some huge, widely publicized portfolio debacles with other institutional investors - hit the TCW-managed portfolios with major losses.
The suit was filed in July by First Investments Ltd., a Bermuda corporation operating principally in Hong Kong, and three affiliates - FIL Leveraged U.S. Government Bond Fund Ltd., a Bermuda company operating principally there; MBS Securities Ltd., a Cayman Island company operating principally there; and FIL Investment Services Ltd., a Cayman Island company operating principally in Hong Kong.
A hearing is set for March 11 before Judge George H. King in the Los Angeles court on some aspects of the complaint, including whether 857 shareholders who owned upward of 89% of the FIL fund can effectively have FIL represent them in any of their potential claims against TCW.
John C. Morrissey, an attorney at McCutchen Doyle Brown & Enersen, a Los Angeles law firm representing First Investments and its affiliates, said the investors in the two offshore funds were mainly from Hong Kong with some from Europe; none was resident in the United States.
The plaintiffs are seeking a jury trial.
The FIL fund lost some $40 million, while MBS Securities Ltd. collapsed, losing $30 million, according to Mr. Morrissey.
FIL Leveraged replaced TCW as the manager last June; the name of the new manager wasn't available. The fund attracted more than $120 million from investors from its inception in 1992 to April 1994, when it sustained the losses.
Its price plummeted from $13.53 a share in February 1994 to less than $5 a share the following May.
MBS Capital collapsed because of the losses and no longer exists as an investment fund, Mr. Morrissey said. MBS raised $8.35 million from investors to invest in its leveraged fund.
The First Investments group hired TCW as the investment adviser for the two funds, which the Hong Kong company set up and marketed. First Investments set up the two funds and also a marketing company.
The group's legal complaint charges TCW mismanaged the portfolios through fraud and negligence. TCW was to receive a fee of 75 basis points for the assets under management for the FIL Leveraged fund; information about MBS Securities wasn't available.
TCW officials declined to be interviewed. They sent a one-paragraph comment through their public relations firm, Kekst & Co., New York, denying the charges.
According to the complaint, TCW assured the group it would manage the funds so they wouldn't suffer losses in the event of interest rate increases by hedging the investments.
TCW advised the group the portfolios "would perform well, even in the event of significant interest rate increases," according to the suit.
The group believed TCW "would implement a market neutral approach to investments."
The defendants charge TCW, however, "did not purchase adequate securities to hedge the funds." Its strategy "could not provide consistently positive returns regardless of the direction of interest rates."
TCW "had not developed a strategy, method, or model for (mortgage-backed securities) investing which controlled for interest rate risk or which permitted a realistic target return of 12%, regardless of the direction of interest rates," the suit says.
"In fac....their ability to achieve superior returns had depended upon ....their ability to time changes in the market and interest rates." TCW didn't employ "a hedging strategy to deliver at least a 12% return regardless of the future course of treasury yields."
In a 1993 fax to customers, according to the suit, TCW reiterated its "investment approach that will continue to outperform the market even if rates take a sharp upward swing. As we have said before, 'we maintain a neutral investment rate outlook and do not depend on rate timing to generate incremental return.'*"
TCW conveyed the impression that the funds "would be conservatively managed," the suit adds.
But "TCW had bet 95% of the funds' assets on falling interest rates," the suit says. The duration on the funds was 16 years, "far greater than could ever be expected from the neutral portfolio."
"The actual duration risk exposed the funds' shareholders to significant losses in the event of interest rate increases," it continues.
When the Federal Reserve began to raise interest rates in February 1994, prices in the bond markets fell.
That April, "in response to concerns raised by FIL, Eric Arentsen (vice president) of TCW assured FIL that the funds' assets were liquid and could be sold to meet the pattern of redemptions forecast by FIL and stated 'the entire portfolio could be sold at the prices they provided,'" the suit says.
But two days later, on April 9, "Arentsen admitted to FIL that the funds should be closed to redemptions by shareholders because 'no securities could be sold at all.'*" On April 13, the FIL directors suspended trading in the funds. When trading reopened Sept. 22, the price of an FIL fund share was $5.43, a loss of 60%.
The First Investments group offered the funds to individual and small corporate investors in Hong Kong who were seeking an alternative investment offering higher returns than low bank-deposit returns but at risks somewhat commensurate with those of bank deposits. TCW, in its statement on the suit, said the funds "performed extraordinarily well in 1993."
"The unprecedented market conditions of 1994, including the rapid and dramatic increase in interest rates and the sudden flood in the (collateralized mortgage-obligation) market, adversely impacted the fund's performance in 1994," the TCW statement continues.
"TCW consistently implemented the investment strategy chosen for the funds by Mr. Geoffrey Mansfield, the principal of FIL," it says.
"Mr. Mansfield is a very experienced and sophisticated investments manager who, in our view, is seeking to transfer responsibility from himself by blaming TCW for either the vicissitudes of the market or his own troubles with investors. TCW believes the allegations are unfounded and without merit and intends to contest them vigorously."