The SEC’s investigation of former Western Asset Management co-CIO Ken Leech — for allegedly crediting a disproportionate share of winning Treasury futures and options trades to strategies in which he had the greatest personal interest — has prompted an exodus of institutional and retail clients from the firm.
For the moment, however, disgruntled investors appear to be focusing narrowly on the strategies Leech allegedly shortchanged, rather than concluding that Western’s very bad news cycle is making the firm's brand toxic.
Still, that could be a fine distinction, as the core and core-plus strategies regulators depicted as a dumping ground for Leech’s less successful trades over an almost three-year period through October 2023 accounted for roughly 30% of the fixed-income manager’s assets under management.
What regulators referred to as Leech's "favored" strategy — the Macro Opportunities fund he founded and presented as the purest representation of Western's investment skills — garnered management fees of more than 60 basis points, roughly double the 30 basis points the firm's core and core-plus portfolios charged clients, the indictment noted.
At all times, however, assets in the Macro Opps strategy remained a fraction of Western's core and core-plus AUM, with respective highs over that period of $13 billion, $44 billion and $122 billion, the indictment said.
News on Aug. 21 that Leech had become the target of an SEC investigation and would step down to focus on addressing any charges, followed late last month by an indictment alleging a "fraudulent cherry-picking scheme," saw billions of dollars of client money, both institutional and retail, flee all three strategies.
As of June 30, 2024, those asset totals plunged to $2.1 billion for Macro Opportunities, $66.8 billion for core-plus and $31.1 billion for core. Western ultimately opted to close Macro Opportunities at the end of October.
Western parent company Franklin Templeton, on a Nov. 4 earnings call, reported more than $50 billion in long-term net outflows from Western between August and October.
Still, Franklin President and CEO Jenny Johnson, told analysts on the call that Western remained a force in the fixed-income universe, managing roughly $330 billion in client money across 88 different strategies.
And as of Sept. 30, big business segments at the firm showing signs of stability included Western's U.S. investment-grade credit strategies, with $31.2 billion in AUM, up from $24.9 billion the year before; U.S. long credit, at $27.9 billion, up from $24.4 billion; and U.S. liquidity, at $60 billion, up from $54.7 billion the year before.
Western’s odds of extricating itself from what has proved a treacherous news cycle — ultimately dependent on the ability of newly appointed president Thomas Gahan to hit the firm's reset button and newly minted CIO Michael Buchanan’s ability to revive the performance of the firm's long-struggling core and core-plus strategies — could prove less daunting if other segments of Western’s business hold up relatively well.
A spokeswoman for Western declined to provide examples of business segments at the firm that continue to hold steady or garner net inflows.
Confined outflows
Still, some analysts say early indications on that score offer some hope.
Investor reaction to the negative news has been more focused on Western’s core and core-plus strategies than on the firm as a whole, noted Max Curtin, an analyst with Morningstar Research Services focused on fixed-income manager research.
Data on institutional and retail flows show well over 90% of outflows from Western strategies in recent months “confined to those two strategies,” aggravated in turn by their poor performance in the years leading up to the Leech news, Curtin said.
Still, brand and reputation undoubtedly matter, and if Leech’s legal woes spawn additional uncertainties for Western’s brand, outflows may yet “bleed into other strategies,” he said.
Western's role
Meanwhile, the role Western played in identifying potential issues in the firm’s trade allocations could likewise help the firm sustain a modicum of investor confidence in the organization.
The current episode, however painful for Western, can still be considered a success story for the firm’s compliance program, noted Igor Rozenblit, a partner with New York-based Iron Road Partners, which advises investment managers on how to make those programs effective.
While overseeing investment allocations from a compliance standpoint is both challenging and a drain on limited resources, Western identified the end-of-day allocations as a potential risk area and communicated multiple times with their portfolio managers about the way they should be allocating, Rozenblit said.
Their move to ultimately confront the firm’s co-CIO and launch an internal investigation — a politically fraught endeavor at any organization — suggests a pretty solid compliance effort, he said.
The SEC’s Nov. 25 indictment of Leech, months after the regulator announced that the high-profile investor was the target of a Wells notice, alleged that between January 2021 and October 2023, Leech would often wait until late in the trading day before allocating Treasury futures and options trades conducted on behalf of multiple strategies to specific accounts.
And that, the SEC alleged, gave Leech the opportunity to see which trades were ending the day with initial gains or losses, setting the stage for allocation outcomes that looked anything but random.
Roughly 90% of trades with the biggest gains ended up being allocated to Leech’s relatively high fee, best ideas Macro Opportunities strategy, while 90% of trades with the biggest losses were funneled to Western’s core and core-plus strategies, the SEC said.
“Statistically, the probability that these differences in first-day returns occurred by random chance is less than one in one trillion,” the indictment contended.
In response, Leech’s counsel, Jonathan S. Sack of Morvillo Abramowitz, issued the following statement: “Ken Leech has an unblemished record over nearly 50 years as a trader and portfolio manager. These unfounded allegations ignore key facts, including the fundamental differences between distinct fixed-income strategies and the irrelevance of first-day performance to managing these strategies.”
The SEC, by contrast, argued that first-day performance is indeed relevant, even if the gains in question aren’t realized by selling — or closing the position — at day’s end.
Allocating winning trades to “favored portfolios” such as Macro Opportunity, permits those portfolios to end the day at a gain, and starting a trading position with a gain rather than a loss ultimately increases the likelihood of successful performance, the indictment said.
The statement by Leech’s lawyer concludes by saying: “Mr. Leech received no benefit from the alleged misconduct. We are confident that he acted properly at all times,” and he will defend himself vigorously.
SEC argument
Alec Lucas, Morningstar’s director of fixed-income strategies, predicted that proving the key allegation that Leech had a financial motivation in favoring the Macro Opportunity strategy could be the biggest challenge for regulators, as the numbers the SEC presents seemingly don’t provide an unambiguous boost for its arguments.
For example, Lucas noted, the indictment showed Western’s combined revenues in 2020 for the core and core-plus strategies coming to $91 million, or 62% more than that year’s $56 million draw for the much smaller Macro Opportunities.
“In other words, on the whole, economic incentives would have still run in the opposite direction of what the complaint alleges,” and Morningstar data suggests the imbalance in favor of core and core-plus remained true throughout the period of alleged favoritism, Lucas said.
That, in turn, could leave the reputational argument, that Leech sought to favor a Macro Opps strategy he founded and touted as the purest representation of his investment skill, as a focus of the case, Lucas said. But that, he added, is a harder thing to prove.
Lucas said Morningstar’s take on the SEC charges is that “they are extremely complicated to assess.”
