Derivatives, once famously labeled by Warren Buffett as “financial weapons of mass destruction,” have once again spotlighted the risks associated with these complex instruments.
Franklin Resources (BEN) witnessed a sharp 13% drop in its stock on August 21, following news of an ongoing Securities and Exchange Commission (SEC) investigation into Treasury derivative trades managed by Ken Leech, co-chief investment officer of Franklin’s Western Asset Management division. For wealth advisors and RIAs, this case serves as a critical reminder of the potential impact derivatives can have on client portfolios, especially when leveraged positions backfire.
Leech, a prominent figure at Western, took a leave of absence following the announcement of the investigation. The inquiry centers around three strategies under Leech's management: Western Asset Core Plus Bond (WAPAX), Western Asset Core Bond (WABAX), and Western Asset Macro Opportunities (LAAAX). These strategies, encompassing mutual funds and separate accounts, were key components of Franklin’s $1.6 trillion asset base, with $380 billion managed by Western.
The heart of the issue is Leech’s use of Treasury derivatives—financial contracts linked to Treasury bonds—that added leverage to the funds he managed. Derivatives, by their nature, introduce significant risk, as they can amplify both gains and losses. For RIAs managing client portfolios, the lesson here is clear: while derivatives can be valuable tools for hedging and enhancing returns, they must be approached with caution, particularly when leveraged exposures are involved.
The SEC’s investigation focuses on a series of 17,000 Treasury derivative trades executed between 2021 and 2023. The trades, which have been described as opaque and complex, were part of an aggressive strategy that increased the funds' duration—a measure of sensitivity to interest rate changes—well beyond that of their benchmarks. For instance, Western Asset Core Plus Bond extended its duration by as much as 20% beyond the Bloomberg U.S. Aggregate Bond Index, amplifying its exposure to interest rate movements. When rates rose sharply in 2022, the fund’s long-duration position backfired, resulting in a 19% decline compared to the benchmark’s 13% drop.
For RIAs and wealth advisors, the importance of understanding the role derivatives play in a portfolio cannot be overstated. While derivatives can enhance returns in favorable markets, they also heighten the potential for significant losses, particularly when market conditions shift unexpectedly. Leech’s strategy, which aimed to profit from interest rate movements, highlights the risks inherent in attempting to time the market—especially when using leveraged instruments.
Franklin Resources has acknowledged the SEC investigation and indicated that it is evaluating Western Asset Management’s compliance systems, particularly around derivative allocation. In a statement, spokeswoman Jeaneen Terrio emphasized that Franklin is reviewing its policies and procedures, though the firm remains confident in its existing framework. This review process will be critical for RIAs to monitor, as any changes in compliance standards or regulatory expectations could have broad implications for how derivatives are managed within client portfolios.
The funds under Leech’s management had already been experiencing weak performance and significant outflows even before the investigation. Western Asset Core Plus Bond, for instance, saw $6.3 billion in outflows over the 12 months leading up to Leech’s departure, while Western Asset Core Bond lost $2.9 billion. Western Asset Macro Opportunities, a smaller fund, experienced such substantial losses that Western has announced plans to liquidate it in October. The fund, which employed the most aggressive derivative strategies, fell 21.3% in 2022, underscoring the risks associated with Leech’s approach.
For wealth advisors, the underperformance of these funds serves as a cautionary tale about the dangers of overreliance on derivative strategies, especially when paired with aggressive interest rate bets. While Leech’s top-down approach to macroeconomic shifts was once a key selling point for Western’s funds, the poor results highlight the difficulty of consistently predicting market movements. Advisors should take this opportunity to reassess the role of macroeconomic forecasting in their own investment strategies, particularly when derivatives are involved.
Morningstar has placed Western Asset Core Bond and Core Plus Bond’s institutional shares under review for potential downgrades, citing concerns over the funds’ recent performance and the departure of Leech. Although Western has a deep bench of 117 investment professionals, Leech’s departure creates uncertainty, particularly given his central role in shaping the funds’ macroeconomic outlooks.
One key takeaway for RIAs is the importance of diversification and risk management, especially when utilizing derivatives. Leech’s strategy, which significantly amplified the duration of his funds, resulted in outsized losses when interest rates rose faster than anticipated. For advisors managing bond portfolios, this underscores the need to balance duration risk, particularly in a rising rate environment. While extending duration can enhance returns in a falling rate scenario, it also increases sensitivity to rate hikes, as demonstrated by the steep declines in Leech’s funds.
Expense ratios have also played a role in compounding the underperformance of Leech’s funds. Western Asset Macro Opportunities, for example, carried a high 1.57% expense ratio for its retail shares, further dragging down returns. In contrast, bond index funds, which charge as little as 0.03%, offer a stark comparison. For RIAs, this serves as a reminder to carefully consider the cost structures of the funds they recommend to clients. High expense ratios can erode returns, particularly in underperforming funds, making it even harder to deliver competitive results.
Looking forward, the SEC investigation could result in broader regulatory changes that impact how derivatives are managed in client portfolios. Advisors should stay informed about any potential updates to compliance requirements or best practices for derivative usage. In the meantime, focusing on transparency and clear communication with clients will be key. Ensuring that clients understand the risks associated with derivatives, particularly in volatile markets, is essential to maintaining trust and managing expectations.
Many investors have already chosen to exit Western’s funds, with outflows continuing as uncertainty surrounds the investigation. For wealth advisors, this case provides an opportunity to engage in proactive risk management, reassessing the role of derivatives in client portfolios and considering alternative strategies that offer better downside protection.
As the industry navigates the fallout from this high-profile investigation, RIAs should focus on building resilient portfolios that can weather market volatility without exposing clients to excessive risk. This may mean dialing back on leverage, reducing duration risk, or shifting to more transparent, liquid investments that offer greater clarity in times of stress.
In conclusion, the Ken Leech case serves as a powerful reminder of the risks inherent in aggressive derivative strategies. For RIAs and wealth advisors, the focus should remain on prudent risk management, transparent client communication, and adherence to regulatory standards as the landscape of fixed income investing continues to evolve.
