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Our Take on Ivy Asset Strategy's Flash-Crash Fallout

What are the takeaways for shareholders?

Kevin McDevitt, 10/26/2010

Since the SEC and the Commodity Futures Trading Commission, or CFTC, issued their Oct. 1 postmortem on the May 6 flash crash, a lot has been written about Waddell & Reed, which is the subadvisor to Ivy Asset Strategy WASAX, and its role in that event. In most cases, the focus has been on whether or not the fund triggered the crash itself. Not much has been said, though, about what this means for shareholders.

He Said, SEC Said
For those unfamiliar with the back story, the SEC's report was designed to assess the causes of the flash crash. The report lays much of the blame on the fund's May 6 selling of $4.1 billion in futures contracts linked to the S&P 500 Index, the now infamous E-Mini contract. The fund sold the E-Minis in order to hedge some of its equity exposure, which it does frequently given its somewhat defensive, absolute-return approach.

The problem, according to the SEC, was poor trade execution. The report claims that the trades were initiated by a computer algorithm and were sold into a falling market without regard to time or price. Rather than scaling back its orders in response to that day's volatility, the algorithm accelerated its trading. While selling 75,000 E-Minis would normally take five hours, these contracts were dumped in just 20 minutes. There weren't sufficient bids for the contracts, and the heavy selling ultimately spilled over into the equity markets. At least that's the SEC's take.

There is hardly consensus on the SEC's magic-bullet theory. Many market observers believe that the SEC assigned far too much blame to Waddell & Reed and not enough to high-frequency traders, the specialized hedge funds, and market makers who largely abandoned the equity market during the sell-off. It was their rapid trading of the E-Minis that afternoon which may have led Waddell & Reed to believe that the market was more liquid than was actually the case.

Regardless of where blame truly lies, the market's structural defects that led to the debacle remain. Such an event could certainly happen again. But where does this leave Ivy Asset Strategy's shareholders? What should be their take-aways?

Is This the Best Way to Control Volatility?
From a shareholder's standpoint, Ivy Asset Strategy's role in the flash crash is something of a red herring. As we have noted in the past, the fund did not perform that much worse than the overall market on May 6, losing just 60 basis points (0.60%) more than the S&P 500 Index. Its underperformance that day, moreover, owed more to extensive holdings in China and other markets in emerging Asia than E-Mini misadventures.PAGEBREAK

Ultimately, our concerns about the fund stem from its at-times reactionary approach to risk management and the rationale behind its hedging strategy. The fund's activity leading up to and including the flash crash reinforce those concerns.

Starting with the crash itself, the management team, led by Michael Avery and Ryan Caldwell, has said on several occasions that it placed these hedges on May 6 due to concerns about the European banking system. The Greek debt crisis was coming to a head at that time, and the team worried about the fate of French, British, and German banks, which owned a large chunk of Greece's debt.

But that explanation raises several issues. First, the fund didn't hold any European-focused banks to begin with. At the end of March, it did own shares in British bank Standard Chartered, but most of Standard's operations are in Asia. Besides, the fund had added hedges to its existing European exposure in the days surrounding the crash.

Second, given that the team had directly hedged part of the fund's European exposure, why did it then use S&P 500 index futures to hedge against a European banking crisis? Granted, global stock correlations have risen in recent years, and the team may have feared a broader market contagion; but we suspect that these trades were placed partly in response to the volatility in U.S. markets on May 6. If that was the case, this strikes us as a somewhat frantic response, particularly for a $23.5 billion fund.

This is the sort of highly active, tactical hedging that leaves us uneasy. Such moves are made because Avery and Caldwell are attuned to downside risk, but other defensive-minded funds that hedge their equity exposure tend to be more strategic in their approach. They establish longer-term hedges and make adjustments more gradually over time. Several of the funds engaging in tail-risk hedging, which is designed to protect against extreme market moves, such as world-allocation peer PIMCO Global Multi-Asset PGMDX for instance, often buy long-dated put options, which they then typically hold until expiration. By contrast, this fund has made several significant tactical shifts this year alone.

Coming into 2010, the fund had a nearly 80% unhedged equity position. By the end of February the team had reversed course, entirely hedging its domestic-stock position and reducing its net equity exposure to just 18% of assets. These hedges were then removed by early April, and the fund's equity weighting rose to 87% of the portfolio, with nearly half that weighting in emerging Asia. The team then restored some of its hedges on European and U.S. equities in early May, around the time of the flash crash. This all took place within a five-month period.

Such rapid shifts in positioning leave the fund vulnerable to getting whipsawed by the market, as it's very difficult to consistently anticipate the market's short-term movements. The fund would have fared better in May, for example, if it had not reduced its hedges this past April. What's also notable is that these hedging decisions are driven primarily--and somewhat nebulously--by the managers' reading of global policy risks. Valuation is a secondary concern. This again gives us pause, considering how hard it can be to anticipate the short-term impact of macroeconomic events and policy decisions on securities markets.

Uncertainty and Risk
There's no arguing with the fund's results. It has one of the world-allocation category's better trailing 10-year returns. Plus, despite its large emerging-markets weighting and the fact that it rarely holds much fixed income, the fund's returns have been no more volatile than its average world-allocation peer. That suggests that the fund's hedging activities and its occasionally large cash stakes have helped damped volatility.

Nevertheless, it's hard for us to get comfortable with the team's approach. Beyond the risk of getting whipsawed and the attendant opportunity cost, the portfolio's frequent, large swings in net exposure introduce significant uncertainty and make it difficult to use the fund in a broader portfolio. Furthermore, although the fund's hedging tactics can help diminish volatility, the portfolio's substantial emerging-markets position still carries significant potential risk. These risks are real even if they haven't manifest themselves yet in past performance.

An investor in the fund therefore needs to be comfortable with its special brand of uncertainty. Trying to be defensive has rarely looked so aggressive.

Kevin McDevitt is a senior mutual fund analyst with Morningstar.

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