Lukas Strobl: Back in August, U.S. bond fund manager, Western Asset, was shaken by the sudden leave of absence of its co-CIO, Ken Leech. Leech was also a manager behind some of Western Asset’s flagship rates strategies. I’m here with Morningstar fund analyst Shannon Kirwin. She’s a member of the team that covers Western Asset strategies globally, and in the past month, they’ve had time to reassess their ratings for those possibly-affected funds.
But first off, Shannon, let’s talk about how much trouble Western Asset and Ken Leech might actually be in. The SEC had served him a so-called Wells notice. What exactly does that tell us?
Shannon Kirwin: Yeah, Hi Lukas. It’s great to be here. So, a Wells notice means that the SEC has concluded a formal investigation into an individual or a company, and it means they think they have grounds to bring enforcement action against that individual or company. So, at this stage, the individual then has 30 days to respond, basically bring their argument for why there shouldn’t be an enforcement action.
So, we don’t actually know anything about what the SEC thinks that it has found. There hasn’t been any official release from them. We need to wait for an official statement from the SEC to know exactly what they have determined. In cases like this in the past, where the SEC has investigated an asset manager, sometimes it can end with a whisper, sometimes it can end with a bang. There’s really a wide range of outcomes that we could expect to see here. Sometimes it’s a minor record-keeping error, sometimes it’s a more serious infraction.
So, what we do know in this particular case is that so far the investigation was just limited to one individual, Ken Leech, rather than trading across all of Western Asset, for example. And we also know that Western Asset launched their own internal investigation into the same trades prior to the Wells notice becoming public.
Strobl: So, nothing final yet? How have investors been taking it?
Kirwin: Investors have not been taking it very well. Over about the last four weeks since the Wells notice became public, there’s been about US$13 billion in assets that have left Western Asset funds, according to Morningstar’s data. The vast majority of those flows have come out of some of their flagship strategies, Core Bond and Core Plus Bond, where Ken Leech was a co-manager.
In some ways, that’s just the acceleration of a trend that had already been visible over the last couple of years. Those strategies had had outflows for a couple of years following some disappointing performance in 2022, which was partly due to some contrarian duration bets that were on in those strategies that really worked against them in the bond sell-off. So sometimes for investors, when you have a couple of years of poor performance, then you have a prominent manager departure and now sort of the width of regulatory issues, that can just be one strike too many against the strategy and they choose to move their assets elsewhere.
Strobl: So, it sounds like they’re not waiting to hear what the SEC is actually going to do. Now in the weeks since, your team has also had a chance to speak to Western Asset and take a closer look at their funds. Have you taken any rating actions?
Kirwin: That’s right. So, our global manager research team, we are active across four continents. And collectively, we produce ratings on 13 different strategies that are managed by Western Asset. As soon as this news came out, we put all 13 of those strategies under review. And that means that our analysts are taking time to gather information and reassess at each individual strategy, whether anything has changed about our fundamental conviction.
So, for 10 of those strategies, we ultimately came to the decision that we don’t want to change any of our pillar ratings, so our people or our process ratings on those strategies. And this primarily came down to the opinion that the departure of Ken Leech should not be a major disruption to those strategies. These are strategies where Ken Leech was not a major risk taker, so his contribution was primarily through his role as CIO or co-CIO of the firm. And Western Asset had already been in the process of what seemed to be a pretty orderly handover of responsibilities from Ken Leech, who has a 40-year career in asset management and was sort of moving towards retirement, and his appointed successor, Mike Buchanan, who was appointed co-CIO alongside Leech about a year ago.
So, Mike Buchanan has been well-positioned to step into the CIO role. He is now running the various investment committees at which PMs formulate their macro views that ultimately drive the positioning in their strategies. And so, we didn’t feel that Ken Leech’s departure would be disruptive to – this includes some U.S. municipal bond strategies that we cover, some global bond strategies that are primarily managed out of London, Asian bond, Australian bond strategies. Those strategies have all maintained their ratings.
Then there are three strategies where we did actually downgrade our ratings. And those include the two that we had mentioned earlier, Core Bond and Core Plus Bond. There Ken Leech had actually been an important member of the manager team driving positioning in the strategy. And we think that his departure leaves the teams in a weaker position compared to where they were before. And that’s especially true with Ken Leech’s departure coming on the heels of the departure of another co-manager in that team, John Bellows, who had been kind of a newer, up-and-coming member of the team. So, with those two departures, it seems like succession planning at that team has kind of taken a hit. And so, we downgraded our people pillar rating from above average to average on both of those strategies.
Then the third strategy is Macro Opportunities. That’s a strategy where Ken Leech was the primary PM. It had been kind of a pure expression of his macro views, some would describe it that way. And there the company, Western Asset, actually took the extraordinary step of liquidating that strategy and they will be returning assets to investors by the end of October. So, there we downgraded our views as well. We would never recommend that anyone invest in a strategy that’s being liquidated.
Strobl: Got it. So, it sounds like the main piece of bad news we’ve actually worked into our ratings is that Ken Leech is no longer there to manage those funds. I mean, are you optimistic about their succession mechanism leading to strong management going forward?
Kirwin: On many of these strategies, we do have positive pillar ratings, so either above average and even high in some cases. So, we think that there are a lot of fundamental strengths that are still intact. That being said, of course, this is a dynamic situation, and we are watching very closely any new information that comes out about this situation. And if needed, we will reassess again.
I guess it’s also worth mentioning that we have reaffirmed our parent rating as well. So, the parent rating of the parent company of Western Asset is Franklin Templeton. And there we came into this with an average parent rating, and we reassessed, and we’ve reaffirmed that rating at average as well. This hasn’t led to any downgrade of our parent view. But it does highlight some of the complications that can arise when a company follows the type of multi-affiliate model that Franklin Templeton does, where Franklin Templeton has grown very rapidly over the last few years through a lot of acquisitions. And they now oversee about 19 what they call specialized investment managers, which are kind of like boutiques. So, when you have that multi-affiliate model, there’s sort of a tightrope walk between on the one hand, you want to preserve the autonomy of your investment teams and the culture that has made them successful. And on the other hand, you want to impose company-wide rules and standards.
Strobl: I think we’ll probably be speaking again when we actually know what the SEC is going to do. This sounds like the biggest variable in the situation so far. But this has been a great update on the situation. Thanks for this, Shannon. For Morningstar. I’m Lukas Strobl.
