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Waddell & Reed Financial Inc. (NYSE:WDR)

Q2 2010 Earnings Call

July 28, 2010 10:00 am ET

Executives

Hank Herrmann - CEO and Chairman

Nicole McIntosh - EVP of IR

Mike Avery - President, CIO and Portfolio Manager

Dan Connealy - SVP and CFO

Tom Butch - EVP and CMO

Analysts

Jeff Hopson - Stifel Nicolaus

Bill Katz - Citigroup

Michael Kim - Sandler O'Neill

Cynthia Mayer - Bank of America/Merrill Lynch

Robert Lee - KBW

Craig Siegenthaler -Credit Suisse

Roger Freeman - Barclays Capital

Mac Sykes - Gabelli & Company

Marc Irizarry - Goldman Sachs

Dov Hellman - Sidoti

Operator

Good morning. My name is Christy and I will be your conference operator today. At this time, I would like to welcome everyone to the Waddell & Reed Financial Inc. Second Quarter 2010 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question and answer session. (Operator Instruction). I would now like to hand the program over to Mr. Hank Herrmann, Chairman and Chief Executive Officer of Waddell & Reed Financial Inc. Please go ahead sir.

Hank Herrmann

Thank you operator. Good morning, with me today are Tom Butch our Chief Marketing Officer, Mike Strohm our Chief Operations Officer, Dan Connealy our Chief Financial Officer, Mike Avery our Chief Investment Officer and Nicole McIntosh our EVP of Investor Relations. Nicole, would you read the forward-looking statements?

Nicole McIntosh

During this call, some of our comments and responses will include forward-looking statements. While we believe these statements to be reasonable, based on information that is currently available to us, actual results could materially differ from those expressed or implied due to a number of factors including but not limited to those referenced in our public filings with the Security & Exchange Commission. We assume no duty to update any forward-looking statements. Materials relevant to today’s call including a copy of today’s press release as well as supplemental schedules have been posted on our website at waddell.com under the investor relations tab.

Henry Herrmann

Thank you Nicole. This morning we announce our company’s second quarter results. Given significant headwinds created by difficult markets, results were solid. Earnings per share of $0.40 declined less then 5% sequentially.

However, the decline was due to higher non-operating costs mainly losses on our investment portfolio and related higher tax rate offsetting these effects, earnings per share would have been on operating basis $0.43 per share. Let me back up here pretax income rose 3% on a sequential quarterly basis and operating income rose 6%.

Our operating margin expanded the 24.2% compared to 23.3% in the first quarter, net flows were positive across all three distribution channels, equity net flows were positive while the industry experience significant equity outflows. Long term front performance was solid, year-to-date relative performance improved. For the first six months ended June 55% of equity funds and 62% of all of our portfolios beat their Lipper peers this compares with 47% of equity funds and 51% of all funds with the three months ended March 31.

I should note that top to bottom dispersion of results in Lipper Groups is fairly narrow at this juncture. A condition that could well persist. The performance of our flagship fund the Ivy asset strategy improved and closed ahead of the S&P index by the end of the quarter. After being several hundred basis points or so behind earlier in the quarter. Within the wholesale channel, we continue to make progress in diversifying sales. During the quarter 26% of sales went to products other than our two lead funds.

Next looking at the individual parts of our business, sales on our Advisors channel are near historic highs. The quarters $954 million represents an 8% sequentially increased and a 22% improvement compared to the same period in 2009. That close of a $100 million were positive for the fifth consecutive quarter.

Advisor productivity continues to improve and while we have significantly reduced Advisor headcount over the past few years, those remaining are meaningfully more productive. Our headcount has shrunk roughly one third from it's peak.

Production is consistently exceeding the volumes achieved when the growth was larger. Market turmoil has had a more significant impact on our wholesale business. Sales of $3.5 billion declined 20% sequentially and 14% compared to the same period last year. Flows of $388 million remained positive however. Reduction pressure from a combination of poor investor sentiment and weak equity markets impacted overall flows.

Few things are worth noting, first equity flows were positive and as we mentioned in our release provided accurate levels with the 1.9% organic growth while the industry suffered a 1.4% organic decay.

Second, the challenges in the equity market provided us with an opportunity showcase, a solid line up of fixed income products. With 83% of our fixed income funds beating the Lipper Peers year-to-date, we are able to gain traction in the number of fixed income products and further diversify sales in the channel.

Finally, our institutional channel delivered positive results largely due to sub-advisor relationships. Sub-advisory mandates were responsible for $662 million of the $768 million in gross sales during the quarter and essentially all of the net flows.

The more traditional defined benefit side of our institutional planner channel remains positive. Post the quarter we won a sizable large cap growth mandate. During the quarter, we won several mandates but the net benefit was offset by Pictet outflows.

Overall, our financial and operational results during the quarter were inline with our expectations despite market action which was not. I am confident that in the strength of our investment process in the parallel well diversified challenges distribution will allow us to continue to increase share. Operator at this time I would like to open the call for questions.

Question-and-Answer-Session

Operator

(Operator Instructions). Your first question comes from the line of Jeff Hopson with Stifel Nicolaus.

Jeff Hopson - Stifel Nicolaus

Okay, thanks a lot, good morning. So I guess the question is from here if the asset strategy flows remain more modest? Is there any change of effort and/or strategy and I guess for Tom, beyond the handholding that’s probably past any change of message out there, in the field? I know you have been focusing on products besides asset strategy and have had some success but any rededication in one direction or another I guess?

Tom Butch

I’ll have a couple responses to that, Jeff and Mike Avery, but as you know as the portfolio Manager might also want to respond relative to the messaging on asset strategy. I’ll start there and say, messaging remains highly consistent and our outreach to our clients remains highly consistent which is to say we have opportunities for them to talk to the portfolio managers on a regular basis, the portfolio managers are out in the market on a regular basis and after a period where the fund was under some pressure relative to redemptions that has abated substantially, the gross flows have not come back to levels of the past few years but remain relative to the size of the organization quite robust. So, I don’t think there is any change of messaging or tactics relative to the sale and support of the asset strategy product.

What I would tell you is that the market environment has opened the window for us to tell more of the stories that exist in the product line and as Hank indicated in his opening remarks, the breadth of the products that are gaining meaningful traction among our advisors is expanding and it would tell you that if there is a not a change in tactics as such but an opportunity to add to the breadth of sales efforts, the fixed income products are gaining momentum and are becoming more meaningful contributors to what we are doing.

And so I would say that one of the things that we watch carefully is the gross flows outside the asset strategy and secondly the global natural resources product and that lock of sales continues to move in the right direction.

Just to point out few of the funds that have really gathered traction in the second quarter and sustained it in the third. Our municipal high income product, we continue to gather good flows in our international core product, our limited term bond product, our science and technology product and our high income product those would be the ones which are gathering the most momentum and as it is suggested in there, there is good breadth inherence in that with a core international product a sector based equity fund and fixed income fund.

So I think the upside of the recent past is it gives us the opportunity to take more of our products to market, while, certainly continuing to tell the asset strategy story and support that product.

Hank Herrmann

I think you have several questions, so I want to go back and make sure that we answered at least part of it and find out what we didn’t hit.

Jeff Hopson - Stifel Nicolaus

No. I think that was good. That's what I was concerned about this is kind of what you are talking about out there in the market and sounds like that you are working hard to kind of diversify the story a little bit.

Operator

Your next question comes from the line of Bill Katz of Citigroup.

Bill Katz - Citigroup

May be one technical question. So looking at the gross sales which fell on wholesale channel, by about 20% sequentially but if you looking your direct expenses I think they were flatter sequentially, I’m just sort of wondering if you talk me about some of the dynamics underneath that and then how that might play out if you, saw any kind of further slowing in sales?

Dan Connealy

A lot of the expenses there are asset based, while the markets did decline some and you did mention a decline in sales, the asset base fees still make up aligned a big part of that expense. Alright, really payments to our wholesalers during the quarter were down quite a bit.

Bill Katz - Citigroup

Okay, you haven’t changed the structure of the payouts in any way?

Dan Connealy

No.

Bill Katz - Citigroup

Okay, other question just G&A looked like it was a little bit high than maybe would have been expected, just sort of wondering if you could talk about the outlook to that business particularly as the advisor business and in terms of any kind of fiduciary standard changes or just general investment trends that still need to be made?

Dan Connealy

For G&A this quarter, one of the main increases there was dealer costs. These are costs that we paid to our distribution partners that would be on the wholesale side and they are mainly passed through to the funds. But these costs grow when our customers go to omnibus accounting and therefore they are doing all the processing and we are not and sometimes our visibility into that process as it occurs is not as good as we needed to be and part of the charges this quarter were related to some past months as well.

But this is kind of normal that this occurs. And a bit of a catch-up was involved in it this quarter. So, and that we have a task force now that keeps the track of each new client that might go omnibus to try to avoid that in the future.

Bill Katz - Citigroup

You talk a about the institutional business, just wondering if you could talk me around the dynamics of what you are seeing in terms of what products you are seeing the demand, and then maybe to mention the risk with Pictet given where the dollar is when the markets were done most recently?

Hank Herrmann

Pictet first, we had pretty heavy outflow in the month of May and it slowed down in June looking at July so far and I don’t have it to the whole month. Looking at July it was slower again but still outflows.

I’m not sure how much of that is related to the currency and how much of that is related to fund performance which has been lagging some. I would have to say that I have to get an update to predict weather or not there is any risk in acceleration. At the moment I don’t think so the one reason that relative performance has been improving particular in the last quarter. So, that’s part of the question. What was the other half?

Bill Katz - Citigroup

Just the dynamics of what you are seeing, you mentioned that you I guess a nice win into the new quarter here. DB is still little bit soft but maybe the dynamics just underneath what’s driving the volumes overall?

Hank Herrmann

Well, the slow business we got on a major platform in the second quarter that had a significantly positive impact, I think there is more to go on that addition. And then early in July, July 1, I guess it was really, pretty close to it, we won a sizable mandate from a traditional like DB piece of business.

I had said earlier probably when I talked to you last in others that I thought DB would be a better in the quarter in terms of new adds, I believe we had four new adds in the quarter, the aggregate other than the one flow account I mentioned, putting that aside just a great traditional DB business. The aggregate, approximated the size of the outflows out of Pictet in the quarter.

Operator

Your next question comes from the line of Michael Kim with Sandler O'Neill.

Michael Kim - Sandler O'Neill

Hey guys good morning. Just a few question, first in terms of the asset strategy fund, it seems like the redemptions peaked in May and have subsequently improved since then, can you just talk about some of the reasons why you are optimistic about flow trends for the fund going forward, was it really kind of just a function of new investors maybe driving the bulk of the redemptions and some other color on that would be helpful?

Hank Herrmann

I’m going to go first and then I’m going to let Mike flesh it out if you will. Just to give you the flow sense the strong inflows in April, good inflows in the early part of May, then about for seven or eight business days in the later part of May some pretty significant outflows and then very modest outflows in June some days in, some days out and that pattern continues in July some days in, some days out. Now I’ll turn it over to Mike to try to get to the rest of the questions.

Michael Avery

I would just say that in terms of what mix my partner and I feel better about the direction for flows of the funds is that we find that people investors in general are extremely confused and they are looking for some leadership. My partner is on the road this week I was out last week and what you find is that the financial advisors are feeling a lot of pressure to go into either cash fixed income the most risk adverse alternatives available to the FA is where they are feeling the pressure and what we are finding is that people are looking for leadership in terms of what next, where do we go now because at a time when on cash which is where people want to increase their holdings, they are beginning to realize that they are getting a negative real rate of return.

They are beginning to realize that the Bull market in fixed income products which has been in place for 30 plus years maybe close to a terminus. And they are looking for where to go next and as an organization, I think we can help him with that answer and the answer lies in the fact that equities as in asset class, US in particular which has not performed well over the last 10 year period maybe at a point where as people calm down, look at their options, look at their alternatives, will begin to look where in the world there are opportunities for growth, where there are economies that are continuing to do well and are amenable to being led to those places.

And so, I think that gives us some hope particularly as you can see people hungry for help us discover, learn, take us down the path to where the worlds head next. So I’m fairly optimistic about that.

Michael Kim - Sandler O'Neill

Okay, maybe along those lines, I think in the past it seemed like investors in the asset strategy fund weren’t all that concerned about near-term performance trends and then maybe that hasn’t been so much the case more recently. So I’m just wondering if that trend that you see continuing going forward?

Hank Herrmann

I will just say that in the last couple of months, pretty big on that anomaly. The equity outflows, the whole pretty significant time. So I think even asset strategy was part of that as people totally confused and ran for the hills.

So I’d be a little at least I’m not ready to buy into the idea that there is a significant difference in point of view specifically to asset strategy fund more broadly maybe applicable but maybe not too.

And I also want to go back and make another point just to set the table. In the environment we are in where markets are extremely thin and volatile, where you had a market that was up eight, market that was down eight is essentially flat all within six months.

You really put into position, having to take a stand or position and so that’s where we find ourselves and I think probably a lot of others do too. So I just wanted to use your question may be one or two by just to be clear about where the organization stands and from that you can kind of reduce the positioning but the stance is slower but no double dip, Europe was overblown and that the emerging consumer is the locomotive to drive growth going forward.

And by in large that’s how our portfolios are positioned. And as you know from the following it there is been a time when the market has embraced those ideas and did a very quick reversal and rejected them all and in the last two weeks is sort of drifting back toward maybe the idea of embracing them again we all have to see. Now conclusive of evidence comes a long one way or another say, yay or nay we’ll see that adapt but at the moment my senses conclusive doesn’t exist and so I just want to put that out there for maybe some help in terms of given the idea where our head is. Mike might want to add to that I don’t know.

Mike Avery

I would say Michael we have been managing this product now for a long time, we do a monthly call with our investors which tends to generate 900 to 1000 people call in every month. And so I think we do a pretty good job of keeping people updated on a monthly bases.

How the fund is positioned, how we performed, what we are doing in the fund, so there is very few surprises there. Sure you are always over the last, this is our fourteenth year of managing the product and you always get somebody who is disappointed by their purchase particularly if the next trade is less than joyful but I don’t think it’s any greater than it's ever been in the past.

I think that to Hanks point what you are seeing is people more concerned and again more under pressure by their clients to be as defensive as possible and unfortunately or fortunately or unfortunately I guess it is leading them to heavier fixed income allocations and when they look at how the asset strategy fund is structured.

Intuitively they agree but when they see no fixed income exposure very little cash it may now meet their current allocation need and so you are getting a little bit of that but I really don’t think a little but I don’t think its any different than it’s ever been in my experience.

Michael Kim - Sandler O'Neill

And just finally kind of switching gears, I think on the last call Hank you talked about you are thinking that spending increases this year would likely be below the increases in revenues but now that the markets have obviously come under some pressure, has your thinking changed about maybe hiring or the budget for the rest of the year?

Hank Herrmann

Not yet, but I would say that we tried to stretch out through the year, our headcount increases and we’ve been little bit more careful about other expenses as a result of market pulling back. Indirectly you are probably asking me a question about where I think margins are going I guess, and I think we did a pretty good job in the second quarter, I’m hopeful that the third quarter will also do well.

There are a couple of headwinds but hopefully the market little better action in July will offset some of that. So, we are certainly cognoscente of the impact on AUM fees as a result of market pull back but at this moment, I haven’t done anything significant but we are always looking on.

Operator

Your next question comes from the line of Cynthia Mayer with Bank of America/Merrill Lynch.

Cynthia Mayer - Bank of America/Merrill Lynch

Maybe just a very quick follow-up first on the G&A question which is, can you just quantify the amount of the catch-up or give a sense of what the run rate G&A is at this point?

Hank Herrmann

Well we probably have of our charges in there this quarter there were probably at least 1 million that were catch-up. That would be my estimate.

Cynthia Mayer - Bank of America/Merrill Lynch

Okay and Hank with the stock price here, what’s your outlook for further share buybacks. I know you brought back 1.5 million I guess, but isn’t that a good short of the close to the shares that are in restricted given out in comp?

Hank Herrmann

I think on a year-to-date basis we purchased just a little under 1.9 million shares and you know the commitment to reduce or offset restricted share grants I guess about a 1.5 million, so we have gone beyond that our normal guideline just because of weakness in the share price and we’ll just have to assess things going forward but we do have the ability to take advantage of share price depression if you will one and if we so choose. In other words, I’m not done necessarily.

Cynthia Mayer - Bank of America/Merrill Lynch

Got it. And maybe just a follow-up on the question with the assets strategy and sort of investor attitudes which is. Is there one benchmark you think that investors hold it to, is there anything that people tend to have in mind?

I know obviously negative performance of any kind has its own impact on people but as you talk to people about it, do you talk about a particular benchmark so that people would say, this constitutes under performance but here they are out performing.

Mike Avery

Cynthia this is Mike Avery. What my partner and I find in discussions on that particular question is how we are doing or not doing relative our peer group. As you are aware we are in Lipper in the flexible global, global flexible or whatever it’s called.

But frankly we get in conversations about a sub-group of that, that are funds that some of them are larger than us, some of them are managed by a larger shops that you would recognized the names of and it comes down to four or five other peer type funds that tend to be the focus of discussions when we go into, visit with the financial advisors around the country and so we’ll give specific questions related to sub set of the global flexible universe. I would tell you who those are, but Mr. Butch sitting to my left would recoil with the idea of mentioning a competitors name, so I’m not going to do. But it would not surprise you who those funds, I mean, think about global allocation funds at large firms and you got the list.

Cynthia Mayer - Bank of America/Merrill Lynch

And I guess last question is just on the advisor headcount, it sounds like the productivity is really up even though the head count is down and I’m just, what's the outlook there?

Tom Butch

If historical trends and our projecting mechanisms hold true which we don’t have reason to believe that or not, we should have bottomed at this point relative to headcount and we would anticipate that over the balance of the year then negative number would decrease although our current outlook as suggested on prior calls would be that we would end 2010 with fewer advisors then 2009.

Operator

Your next question comes from the line of Robert Lee with KBW.

Robert Lee - KBW

First question I had is, if I remember correctly last quarter, you guys were set to launch a offshoot of the asset strategy fund, I don’t know if that occurred in Q2 or did the market environment put that on hold. Could you update us on that and maybe how you actually position that compared to the asset strategy fund? That will be the first question.

Tom Butch

This is Tom and again Mike may want to elaborate, but yes we did launch the fund and I would call it a kind of a soft launch as you know well, it takes little time to get the fund up on platforms at this juncture, it’s up on all virtually all of the meaningful platforms, it has had a modest inflow on a daily basis. We’ve probably had sales in neighborhood of 15-ish million. To-date, the positioning of the fund and Mike may again want to elaborate but essentially is using the asset strategy portfolio construction process and investment thesis and populating the equity portion of the fund with small to mid-cap holdings versus the large cap buys of the asset strategy fund. Mike did you want to add anything?

Mike Avery

We, did start a fund called the asset strategy new opportunities fund which is managed by our team and so far the reception has been very good, people are very interested in it and I think what they are interested in is how we talk about the asset strategy process and how we are managing the fund because it fits into a theme that we have developed with our clients overtime while we take them through.

If you look around the globe and think about how people groups about economically, you can come up with very distinct categories and in the larger assets strategy fund we have tended to stay with large cap names that come up, that make a product or service that or focused on those people groups that are in the higher ends of the economic bracket if you will, in another words people groups that are well into or moving into a domestic consumption phase of economic growth or an urbanization phase of economic growth is where the larger asset strategy fund has been focused for some time.

With the new opportunities fund what we will be able to do is focus on opportunities emerging in people groups that are at the very beginning of the economic development chain if you will. Those people groups that are still in or entering in agrarian phase of economic growth moving to an export phase of growth and so with a new fund we are able to take our applied opportunities that are small mid cap names in geographic areas that wouldn’t surprise you.

But in the larger fund we have focused primarily so far on Eastern Asia, Southern Asia in the newer fund, you would see a greater focused on where prosperity is heading next which is Central Asia, the Middle East Africa, South East Asia is the focus of the newer fund at the moment.

And again it fits in with the strategy that our shareholders have heard for a long time now and are excited to have another way at playing that story.

Tom Butch

Okay, thanks. Tom, Mr. Connealy has tapped me on the shoulder to remind me that my answer was Wholesale channel centric you could probably double that number of sales if you added the Advisors channel, I apologize.

Robert Lee - KBW

While I have for you Tom, maybe another question for you I mean the 12b-1 fee proposals that came out about a week ago, could you maybe give us some of your initial thoughts and then I’m I guess particularly interested in the what you think of the provisions that would allow distributors like yourself to decouple, I’m really excited your own kind of sales commission schedule versus whatever is in the fund, I mean, kind of what impacts if any do you think that does or doesn’t have just kind of your general thoughts?

Tom Butch

Let’s start with that part of the provision and if you like I can back to some of the others. Certainly, it would appear the motivation of that is to bring down transaction cost on behalf of investors and that would suggested there is inadequate choice or inadequate pricing options for investors today and given the abundance of share classes available and the degree to which we and our broker dealer, distributors have embraced a broad stand of pricing options already. It would seem to us that there is adequate choice in the market.

Looking outside our organization and having spoken preliminarily because that’s the only conversation which at this point you can really have in any case with some of our larger broker dealer partners.

There is certainly no sense of unanimity that I detect relative to the degree to which this will or will not be embraced by broker dealers. The other thing that I would say is that the overarching emphasis on sales commission structures comes at a time when those are a lesser part of the business as a whole.

With the ongoing migration of client accounts to fee-based, asset based fee accounts as you know already employed no-load shares and utilize an asset based fee in place of the commission. So, it seems that in that instance as well, it’s a solution to an issue from which the market may already be moving away.

Robert Lee - KBW

Okay, one last question just back to capital management, Hank I know you mentioned your thoughts around share repurchase, just curious you have the debt coming due in about six months and I know you have the flexibility to pay down part of it and roll it over but maybe any thoughts on where you are leaning at this point and how you want to deal with that going forward?

Dan Connealy

This is Dan Connealy, Rob, we are in the process of looking at that right now and so with this debt-coming due in early January, we are looking at that very closely and are looking at our alternatives and you are exactly right, we can roll back 190 over or we can rollup a lesser part of that because we do have additional cash and that is exactly what we are looking at and I think the market is feeling good about issues like our issue would be and so we are confident we’ll be able to roll that over and have a good result.

Operator

Your next question comes from the line of Craig Siegenthaler with Credit Suisse.

Craig Siegenthaler -Credit Suisse

Good morning everyone. Most of my questions were answered but I had one and I think maybe Mike's the best one for this one. Just thinking about, Mike if you are in our shoes really kind of forecasting net flows, asset strategy funding, you looked at kind of the tools we had like Morning Star ratings, near term performance, performance at Chinese equities macro environment. What do you think of the biggest determinants or net flows for the asset strategy fund? And maybe you could also highlight some of the drivers at the May volatility?

Mike Avery

Well Craig you got a couple of questions there. Looking at trying to come up with. I think all of those things that you mentioned certainly play into peoples minds because the people asked questions about it, but I think what I would do and Ms. Mayer asked a question earlier and what I would look at if were doing, what you were doing and that is focus on what our primary clients think about.

They think about the subset of the flexible global managers that have a long track record, good distribution and are thinking about the world in a similar fashion because when it comes down to it, that’s what people seem to think about when they ask us what we are doing, why are we doing it, Mike you sound like this guy or this guy sounds like this, saying what’s the rebuttal to that.

So, if you pay attention to what the group is the subset that is the key group I suppose of how people structure the individual portfolios to have a position in global flexible funds, that’s probably the best way to do it. Surprisingly enough, I don’t get that many questions about Morning Star ratings or Lipper ratings or as much as you would think it really never comes up with me, now maybe for the sales force it comes up a lot but I never get it.

And again, what I get the questions most about is and when, I think flows are going to be dependent upon to answer your question is Hank said it earlier, I mean people expect us to have a position, they don’t expect me to talk in and say, “well, this is tough” what do you think I should do? Outflows would be unbelievable, but what they expect me to do and again looking for someone to do is help us understand where the world is headed.

I have maybe it’s only because I’ve been doing this for only 30 years but I’ve never seen a period in the last 30 years where people intuitively feel like we are at some type of a major inflection point in terms of how policy makers use the macro economic tools at they have employed for the last 65 years.

I’ve never seen people more confused about do I stay with what appears to be safe to me which is surprisingly US Treasury Securities or is this the point in time where I should really be thinking hard about looking at other places around the globe where there is growth occurring and it’s still early days for that surprisingly I know Craig you and I, and certainly the people on this call have had at the locus of what they think about is emerging little classes Hank alluded to but I’m still surprised that I get questions as it pertains to whether it’s China or some other part of Asia that are fairly basic if you will and coming from sophisticated people.

So I don’t think folks are quite yet ready to think hard about major allocations, but I believe they will and I believe that strongly otherwise we wouldn’t have started the new fund that’s focused on that theme specifically, I think when people settle down, as they will and think about the returns that they are getting on the portfolios that they currently have demanded that they’ll begin to rethink 2004 is a recent example where that occurred, they’ll begin to rethink where in the world is growth going to come from and they will follow the people who have been there and seemingly know the path to get an acceptable return.

Now going back to May, in particular, in particular I think May was, if you think about May in the broad sense, I mean the, I’m just going to use the S&P for talking point. The S&P pick, peaked out April 21, April 24, around the time of a lot of attention being directed towards Goldman Sachs, it was the point at which a lot of the investor’s psyche was conflicted by events occurring in the Gulf, events occurring in Southern Europe and the market began rolling over fairly hard towards the end of April.

So when we got into May, the market was already rolling over fairly strongly. When we went into the second quarter as Mr. Herrmann alluded to, well say it differently, we have the, the asset strategy fund was trailing the S&P by about 500 basis points going into the second quarter anyway and in regards to Robert’s question, there is always somebody looking at what you did last as an indicator of what they should do next.

Markets particularly volatile rolling over more of an interest in moving out of what has not worked and into what has worked in another words the thing that people want to sell is equity doesn’t go into fixed income, I think all played a part.

Certainly the publicity that we received are surrounding the so called flash crashed didn’t help. I think the anxiety was misplaced, people who understand the markets and understand how we manage the fund have dismissed it as a nonevent but certainly it didn’t help particularly as it pertains to people who maybe thinking about new allocations into the fund but that has a long passed in terms of being a focus of interest and again I think people are looking forward now and a little bit more calmed down and more focused on again where will growth in the world be?

Operator

Your next question coming from the line of Roger Freeman with Barclays Capital.

Roger Freeman - Barclays Capital

Hi, good morning. I guess just to add a thought and a question around this whole discussion which I will give something back to, if you look at the monthly flows on asset strategy back in 4Q '08 which and from many respect 2Q has probably been equated more to 4Q '08 than any other quarter since then.

Sort of given macro headwinds but the monthly flows were obviously quite negative then, there was a more over an outflow across the market, at that point in time obviously the sort of phase was much bigger macro questions.

But I guess from what we have been hearing from others in the capital markets base, it seems like this go around, its been more sort of a lack of allocation to risky assets rather than sort of run for the hill and I guess it sounds to me like your view is that the investors have been more in the run for the hills camp is that fair I’m trying to equate now versus then?

Mike Avery

Well, if you are equating now versus the fourth quarter of ‘08, well, yeah, you are right, the fourth quarter of ‘08 was definitely panic run for the hills type of mindset and if that’s your benchmark and then yeah that was more run for the hills and now if you are using that as a benchmark it’s more I'll wait and see before I make any big allocations.

Roger Freeman - Barclays Capital

I guess the point I was trying to make is just that the flows in asset strategy have were negative in May and June and sounds like sort of tutoring in July, but is that I’m just sort of trying to get back to how much of that is people moving away from risky year assets, you talk a little bit about maybe they don’t see fixed income in there and think they should etcetera versus any comparative performance analysis they are doing on you versus competitors?

Mike Avery

I don’t really, I understand what you are asking me and I don’t have the ability to look in the people’s minds and quantify it the way that would be joyful to you but I would say that the way people are thinking is that and again I’m just reflecting to you what I hear from our clients and again our clients are financial advisors who serve either high end investors, high net worth investors or the average middle class person and the anxiety across that spectrum is the same, and the anxiety is I'm fearful may be I benefited from rising markets in ‘09 but I know I inherently benefited for perhaps the wrong reasons and that was the injection of a lot of liquidity that went into paper assets as opposed to the real economy.

And I think that anxiety is still, I mean just look at the flows in to fixed income products in general, we certainly benefited from flows in the fixed income product all year and to me that’s a reflection of it in that group’s mind, to some extent yeah I need more income but probably a larger part and I’m just basing it on the questions that I get, it’s in their mind applied to safety and again when I was trying to communicate with in Craig’s question was that I think it’s still early for people, we are not at the point yet where people are saying okay, I’ve gone into a safe harbor, I've gone home and now I’m looking at my situation and saying wait a minute, this is not, this maybe quoted safe but its not going to get me to the destination where I need to end up, how do I get there?

And where do I look, where do I go to that’s going to help me get to my final destination based on relying on people who have been there before and have a track record in helping average people generate a satisfactory return and I think, I think the financial advisors are on-board with it, but it’s a reeducation process of getting people to come out of the covers and say look, now that you feel secure, let me help you take you to your destination and that’s going to mean a greater allocation in equities in general and focus on what we, we in the business call developing markets as opposed to just focus specifically on developed markets meaning the US, Japan, and Europe.

Roger Freeman - Barclays Capital

That’s helpful. And just you mentioned sort of the subgroup within Lipper that you look at. If you were to sort of recast just sort of anecdotally your relative performance with who you consider to be your real peers. How do you think it would look where as Lipper is kind of showing in the seventh and ninth, that’s all over the past three, six and nine months, over three, six and 12 month period?

Mike Avery

Well, I don’t want to give you a misleading answer because the peer group that I'm thinking of that I get questions about maybe a different group than you maybe thinking of or you may go and look at. But, I would just say that based on our customers, they seem to be very satisfied with our performance relative to our peer group.

Roger Freeman - Barclays Capital

Okay, last question. 12b1 I understand sort of your position around it and it sounds like the SEC is beginning to get a lot of sort of protest comment letters around this but I'm assuming they knew that when I proposed this rule. I guess if it goes through what do you think your options are to release some of the revenue pressure?

Hank Herrmann

I don’t know that we need any options, I'll tell you that one part that sort of an open switch and that is this idea that the brokers will compete on the basis of fees in the future with the new regs. I guess I'm doubtful well that’s going to happen of course it could be wrong and if I were wrong on that, then we have to examine it and see what to do.

But I really think that in the commodity environment which is what I would define mutual fund sales with broker dealers, cutting the rates will do nothing because everybody else will cut their rates and you'll accomplish nothing. And passing on anything of substance to the investment mangers aren't going to work.

Because its just not that much vigorous left in the game.

Operator

Your next question comes from a line of Mac Sykes with Gabelli & Company.

Mac Sykes - Gabelli & Company

Just to circle back on the IV question, in your conversations with sales people, is there any concern about capacity, could you do something differently in order to leverage the track records of the managers maybe closed the main fund opened another? And then I just had one follow-up.

Tom Butch

The short answer is, no. And I think there is a concern about capacity, the question comes up from time-to-time but it’s certainly not an overwriting concern that it comes back to us and relative to closing the fund and opening another I think as we talked about before really what we are intent would rather be leveraging the process into other smart executions of it as we hope we've done with its new opportunities version.

Mac Sykes - Gabelli & Company

In the last couple of years, the asset division quite steadily, in your portfolio process are you finding it more difficult to make allocations to some of your better ideas or do you still feel like there's plenty of room there?

Mike Avery

Let me just back up, I think we’ve got in the capacity question the whole journey, when our team started managing the product I think we were managing 50 million, now we are managing 26 billion and the question came up the whole journey. So my answer to that is so far we haven’t run up into a barrier and I would say the only place where we are seeing an inability to put good ideas to work which is why we have started a new fund is that the very small mid-cap into the range in markets that are not yet developed, doesn’t have as much liquidity but again that’s why we have another fund to have, and that’s, the same process, the same thought process but have a place for those ideas to go.

The way we've managed the asset strategy fund all along and maybe this is a better way to get at your question and all along we have intentionally stocked a large cap ideas, why? Because I have got a diversion, you can buy anything but I’ve got, you can necessarily sell everything and so I’ve had a personal aversion to names that I can’t get in and out, get in and get out of fairly quickly that’s just a bias in how we manage money.

So we have tended to stick to the large cap ides, I think what’s helpful to know is that this is a flexible portfolio fund, I mean we are not always constrained nor have we always been in just equities. We have had large allocations to cash where there is obviously no size constraint, we’ve had large allocations to fix income particularly as defensive move, there is no constraint there and in terms of equities, to some of the other questions there, there are other funds that are global allocation funds that we get compared to, that are multiples of the size that we are.

And so that makes me hopeful that there are still a lot of capacity available. The only place where we would truly run into capacity type issues is if we found that our ability to use hedging as an effective defensive strategy is constrained by either what appear to be increasingly fragile markets and to our liquidity constraints placed on its by the exchanges and where we are doing futures trading. But so far that has not been an issue yet.

Operator

Your next question comes from the line of Marc Irizarry with Goldman Sachs.

Marc Irizarry - Goldman Sachs

Great, thanks. Just trying to reconcile some of the investment beams with your positioning and maybe question for Avery, for asset strategy in particular, Mike can you talk about the gross exposure versus the net exposure in the fund right now?

Are you sort of taking data out of the fund while opting sort of pro-cyclical bets if you will on the areas that you really like. Can you just address sort of that gross positioning versus what you are doing on in that basis?

Mike Avery

What we have been talking, what we have been telling our clients our shareholders is that the gross position in the fund has not changed dramatically over the last I would say six to nine months. If you look at the gross exposure to equities during that period of time, we have been in the range 80, 85% fairly consistently.

The size of the hedge has changed in some dramatically during that period of time, we have gone all the way from being almost completely hedged with net position of maybe around 18% at the most extreme hedge to totally un-hedge during that period of time.

I don’t know if I can talk about where we are at presently or not but I would I'm getting a lawyers headshake no. I would just say that the gross position has not changed dramatically over the last six to nine months. We do have a hedge in place on the fund that would not be inconsistent Marc with how we’ve talked about managing the funds in the past six to nine months.

Marc Irizarry - Goldman Sachs

And then can you talk about the flow trends and maybe sales versus redemptions around the days of the flash craps news when it came out and just maybe differentiate what you saw on sales versus redemptions around those days?

Hank Herrmann

I think, I already gave you a shot on that but the second half of May redemptions which is little bit after the flash crash redemptions picked up pretty sharply, you know the redemptions for the entire environment to the extend that I can tell picked up pretty sharply in other words it’s a little hard for me to figure out exactly what was related to who.

At the end of May things started to settle down and basically all of June and early part of July we seen a big decline in redemption activity and some days during that period were positive flows and some days in negative flows and the net result is with, basically a flat environment on right here in the middle of July.

Marc Irizarry - Goldman Sachs

And then again obviously some of the themes out there the emerging middle class and demographic trends in the US not being perfect, when you think about the business model and you think about non-US distribution, do acquisitions come into your thinking at all and maybe you can just address how your positioned for non-US clients?

Hank Herrmann

Well, we have a relationship with Pictet which give us exposure in Europe and we have been on again, off again trying to develop relationships elsewhere in Asia. Mostly I would tell you the initiative of the other side, that sort of on the effect of overview, government policies, those things have come close to attrition fruition but haven’t closed so, I would just say that that we find ourselves in that situation pretty frequently.

And so the answer is we are thinking about it, am I likely to buy something to accomplish it at the moment, I don’t think so, I think it’s more likely we will solve that problem or address the issue. We had sub-advisor relationship, with joint venture relationships.

Marc Irizarry - Goldman Sachs

Okay great and then just question for Tom on the wholesaler incentive sort of broaden out the distribution, is there anyway to affect the behavioral change of the wholesalers and what are you doing on that front to help broaden out the gross sales outside of asset strategy?

Tom Butch

Well the answer is yes, I think that compensation structure is always something that is utilized to influence behaviors of sales force. And our program does recognize the need to broaden the product line and it's structure reflects that.

And so as I think I said earlier, one of the things that we watch very closely is the gross sales volume in other products and as I indicated that, that is moving nicely in the right direction.

I think what’s interesting about the current period is that the openness to the remainder of the products is probably at an all-time high both because of the creditability that has been established by the asset strategy, successes and the fact that as Mike has indicated people are looking at a whole span of potential solutions and its really been a benefit to us and our ability to go to market with things that we have long wanted to, but who's identity for the longest time was sort of trumped by our asset strategy presence. So, I think in a sort of counter intuitive sense, the brief pause in the asset strategy flows has really enabled us to do things we wanted to do relative to getting other products, other stories, other managers to market.

Operator

Your next question comes from the line of Dov Hellman with Sidoti.

Dov Hellman - Sidoti

Hi, everyone just a quick question. Can you remind me maybe just looking back at 2008 no wonder at then end of 2008 when also I guess the similar situation with asset strategy under performed for few months and then it's outflows. How long after it I guess the peak of under performance it started to generate flows again. If you could maybe just remind me on that?

Hank Herrmann

Well, I'll remind you that we had a period in June and July where the firm July and August maybe where the fund under performed pretty good recovered and then flows fall back through the rest of third quarter into the fourth quarter.

I just don’t think that however that's an indicator of what might happen in the future because their circumstances are so much different at that time, there was wide scale, broad panic and a product that was only beginning to get full recognition for its value. So, its just not a good comp.

Dov Hellman - Sidoti

So you would say the situation then was obviously mare extreme and then in terms of looking at your overall gross sales for asset strategy I don’t know if you mention that number, if you would be just willing to mention that number?

Hank Herrmann

I think we probably want to hold off on specific fund gross sales, so.

Operator

That concludes the answer-and-question portion of our conference. Management I'll hand the program back over to you for any closing comments.

Hank Herrmann

No. I just want to express our appreciation for participants on the call, thanks so much and look forward to talking to you soon or in the next call. Take care. Thank you.

Operator

And this concludes today’s conference call. You may now disconnect.

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Source: Waddell & Reed Financial Inc. Q2 2010 Earnings Call Transcript
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