Smith Breeden keeps the faith, but consultants cautious

Smith Breeden Associates lost more than 75% of its assets under management since the global financial crisis, but executives there say flows into higher-margin strategies have sustained the company and left it poised to rebound.

Some investment consultants, however, say it's too soon to begin recommending the money manager again.

Smith Breeden's AUM plunged to $6.4 billion as of Dec. 31, with net outflows of roughly $5 billion a year in both 2009 and 2010, according to Marietta, Ga.-based eVestment Alliance. The firm's assets had reached a record high of $33 billion as markets began unraveling in late 2007.

In interviews, Smith Breeden executives said a changing business mix — with more money flowing into higher-margin opportunistic credit strategies, both long-only and long-short — has helped the firm weather a historic period of uncertainty and volatility for the mortgage sector, where the bulk of its assets were invested.

While overall AUM has fallen, flows into the firm's newer alternative, absolute-return strategies have lifted those strategies' assets from “very little” at the start of 2009 to close to $2 billion today, helping make 2010 “one of our more profitable years,” said Stephen A. Eason, executive vice president and director of marketing and client service.

Chairman and CEO Michael J. Giarla said much of the heavy outflows Smith Breeden saw in recent years reflected decisions by big, non-U.S. clients — such as central banks and sovereign wealth funds — to allocate away from the U.S. mortgage sector. Mr. Giarla became CEO on March 23 after the firm announced that longtime CEO Eugene Flood Jr. was joining TIAA-CREF.

That reallocation — amid concern that U.S. support for government-sponsored mortgage entities such as the Federal National Mortgage Association was less than rock solid — resulted in Smith Breeden losing a number of hefty, but lower-margin, index-like mandates, Mr. Giarla said.

For example, in the first quarter of 2010, a Japanese bank client decided to move a $4.8 billion mortgage-focused portfolio in-house - accounting for the vast majority of Smith Breeden's net outflows for the year, according to information the firm provided to eVestmentAlliance. Mr. Eason declined to name the client.

Messrs. Giarla and Eason said as the dust continues to settle from the post-financial crisis confusion, the picture emerging of the new U.S. mortgage market — while not completely clear — looks set to favor Smith Breeden.

More and more U.S. mortgages are likely to fall outside the umbrella of government-sponsored entities, and that will play to the strengths of a firm such as Smith Breeden, with a 30-year track record in mortgage-related research, said Mr. Eason.

Some clients will reallocate money to beta-type strategies, and a growing number will look to complement those allocations with mandates to absolute-return strategies, and Smith Breeden can compete at both ends of the spectrum, said Messrs. Giarla and Eason.

One executive with a large investment consulting firm, who declined to be named, said his team continues to have confidence in some of the firm's key strategies, including its investment-grade core offering, with $3.1 billion in assets as of Dec. 31.

But a number of consultants — including some who have counted themselves as fans of the firm — say they want to make sure Smith Breeden, with its much-reduced assets under management, will be able to marshal the resources needed to sustain its investment organization.

“We've got respect for the shop,” but given the tough cycle they've gone through, some recent downsizing and now the change at the top, it would be “tough for us to consider allocating to them now,” said Bryce Anderson, a manager research analyst with Chicago-based Dimeo Schneider & Associates LLC.

In an e-mail, Mr. Eason conceded the size of the firm's staff had dropped to 70 by the end of 2010 from 113 at the end of 2007. However, those reductions were focused on back-office and support functions, leaving “all of our key investment professionals” in place, he said.

Asked about Smith Breeden executives' assertion that the firm has managed to survive the mortgage crisis and emerge in fighting trim, another consultant from a firm that recommended Smith Breeden in the past said, “I would love to believe that, but I'm concerned.”

He said it's difficult to see how “you can have that significant a dip in assets” without considerable fallout on morale and operations.

Meanwhile, a number of observers say while the margins on Smith Breeden's newer strategies might well have offset the loss of a substantial amount of more index-like business in recent years, the favorable mortgage environment — with a strong recovery in residential and commercial mortgage-backed securities prices over the past two years —can't be counted on in years to come.

In a subsequent interview, Messrs. Giarla and Eason said while the falloff in AUM makes such concerns understandable, Smith Breeden is talking to many institutional investors, both in the U.S. and abroad, and the firm's business is likely to improve during the coming year. Smith Breeden has had “a couple of years of very good performance numbers,” said Mr. Eason. “That makes our clients happy, and it makes us happy.”