Unlocking Real Value Blog

Published on May 19, 2010 – Ignites – An Information Service of Money-Media, a Financial Times Company
By Gregory Shulas

Mutual funds that embrace alternative investment strategies will face tougher scrutiny in the wake of the May 6 “flash crash.” That’s according to a vast majority of Ignites poll respondents.
 

Roughly 74%, or 124 voters, said mutual funds that use derivatives will face tougher reviews in the months ahead from regulators and investors. That made it the most popular option selected in an Ignites survey that asked whether the mysterious market gyration will result in more scrutiny of alt-style mutual funds.

Of the majority vote, 43%, or 72 voters, expect a moderate increase in scrutiny, while 31%, or 52 voters, said a significant increase in oversight awaits such funds.

In contrast, 26%, or 44 voters, said it will be business as usual for mutual funds that use alternative strategies, such as futures contracts, swaps or commodities. That made that option the survey’s least popular choice.

Waddell & Reed’s Ivy Asset Strategy fund came under a microscope after Reuters reported that it was responsible for an unusually large wave of futures selling that allegedly contributed to the “flash crash.”

The Kansas City area-based firm unloaded 75,000 e-mini contracts, or S&P 500 derivatives, during the 20-minute equities plunge, according to a Chicago Mercantile Exchange document that Reuters obtained. The document apparently identified Waddell as the unnamed trader that Commodities Futures Trading Commission chairman Gary Gensler mentioned in congressional testimony this month.

Waddell & Reed has refuted claims that it was responsible for the disruption. The company has cited an analysis showing how its trading accounted for 1% of the volume traded in the S&P 500 on May 6. The gyration at one point caused the Dow Jones Industrial Average to fall by nearly 1,000 points while temporarily pushing well-established companies into penny stocks.

Regardless of what investigators ultimately find, the incident is spurring questions about the effect alt-oriented funds can have on the market, acknowledges Andy Klausner, principal of AK Advisory Partners, a Boston-based consulting firm.

Until the pending financial reform bill is finalized, it’s hard to know where regulators will stand on retail funds that emphasize derivatives, Klausner says. A legitimate concern for the industry is whether Congress and other government agencies will rush to judgment and impose unnecessary restrictions on alt-oriented products, he says.

“I think there is still so much uncertainty with what happened on May 6,” Klausner says. “Let’s hope regulators don’t react too quickly to what happened. We… need to determine what exactly happened first.”

Alternative-oriented mutual funds have grown in popularity as financial advisors have sought exposure to asset classes that have low correlations with traditional equity strategies. By accessing alternatives in a mutual fund structure, investors receive lower fees and more transparency than they would in a hedge fund, industry experts argue. Further, alt-style mutual funds are free of the hedge fund gates that lock up clients’ assets until performance recovers.

Nearly 170 readers participated in the survey as of 3 p.m. Tuesday. The survey is an unscientific sampling of Ignites subscribers, who include money managers, service providers and financial advisors. Participants were self-selected and voted only once.

Published on May 13, 2010 – FUNDfire – An Information Service of Money-Media, a Financial Times Company
By Tom Stabile 

Two formerCredit Suisse advisors who left the brokerage with nearly all of their $1.2 billion in client assets have formed an independent shop in Baltimore. Harbor Investment Advisorynow has $1.3 billion in assets just a few months after launching, and is aiming to hire advisors – especially wirehouse veterans – to join the founders, Robert Black III and Stephen Kelly.

Efforts to recruit wirehouse advisors could be buoyed by Harbor’s dual-registered model, which has a unique element: the partners not only filed as a registered investment advisor with the Securities and Exchange Commission but also built their own broker-dealer arm under Financial Industry Regulatory Authorityrules. Becoming a FINRA member is a somewhat cumbersome step for new independent advisor firms, and therefore uncommon, but it resembles the mix of fee-based and transaction-based services the advisors offered beforehand, says Betsy Brennen, who is the firm’s third partner and serves as its COO and chief compliance officer

“We didn’t want to disrupt the relationships we had with customers who have been working with us for 25 years,” she adds. The firm, which has 10 employees, serves high-net-worth clients, foundations and endowments.

Harbor opened its doors on Feb. 1, a few weeks after Black and Kelly left Credit Suisse, though Brennen already had been on board helping to set up the firm. All three had worked together at Alex Brown & Sons in the late 1990s, and remained when Bankers Trust bought it in 1997 and later when Deutsche Bank bought the whole organization in 1999. Black and Kelly left a few years later, at separate times, for Donaldson, Lufkin & Jenrette Securities, which Credit Suisse later bought.

“The vast majority of our clients migrated from Credit Suisse to Harbor, and that’s a reflection of the longstanding relationships Rob and Steve have with their clients,” Brennen says.

Harbor’s website states that the partners value the advantage of “having the focus and professionalism to deliver superior service” over being part of a large organization, and touts how it can “concentrate our efforts to provide a sophisticated suite of products and resources.”

Brennen says Harbor’s investment approach spans across options such as separately managed accounts, hedge funds, private equity, mutual funds, exchange-traded funds, and individual equity and fixed income securities. The firm custodies with BNY Mellon’s Pershing unit, and connects to a few of its managers through Pershing’s managed accounts platforms, but it does most resemble the set-up that Harbor’s clients previously had with the team. “It’s a bigger undertaking both financially and operationally,” she adds.

The partners assessed various other options, including joining existing platforms, before choosing to build the broker-dealer unit to handle transactional business from scratch. “This certainly wasn’t the least expensive option, primarily because of the net capital required [by regulators] and the capital outlay to build the infrastructure,” Brennen says. “Many advisors look into it and decide not to go forward with this approach. That’s why you see growth in the market of firms that cater to independent advisors with platforms and services. We simply wanted to be as independent as possible, and in this structure, we are beholden to no one.”

Among the added responsibilities of starting up and running a broker-dealer are extensive reporting, interview and filing requirements through FINRA, as well as the designation of partners for specific oversight functions and ongoing compliance duties. For instance, FINRA member firms have to designate specific principals or others responsible for compliance, financial affairs and operations. Harbor has outsourced some of its functions initially, but intends to fill all posts with internal resources as it fills out staffing, Brennen says.

Setting up a separate broker-dealer is a rare step for a new independent advisor firm, says Andrew Klausner, principal of AK Advisory Partners, a Boston-based consulting firm. It’s far more common for such firms to affiliate with another independent brokerage, he says.

Klausner says the move could make sense if the team plans to trade extensively or if the transactional side of the practice is a significant profit center. “But it’s a lot of work, a lot of expense,” he adds. “You don’t just do this as an accommodation for clients.”

He adds that there are some institutions that now are specifically seeking advisors that are separate from a broker-dealer arm, to ensure an “arm’s length” separation between advice and trading functions. But he says advisors in most brokerage formats will use external trading platforms when they need such access.