Doll’s house

Bob Doll has bolstered laggard portfolio performance and profit margins at Merrill Lynch Investment Managers. Can he now restore growth?

This February in railway stations and airports throughout the U.K., a poster appeared featuring a two-handled silver trophy cup engraved with a bull. The none-too-subtle imagery was aimed at drawing customers to Merrill Lynch Investment Managers’ equity mutual funds. The bold-faced tag line: “Invest in Our Success.”

The last time Merrill Lynch & Co.'s trademark bull had dared to show its face in a U.K. ad was back in early 2000, just before the bubble burst.

The £1.2 million ($2.3 million) marketing campaign hinted at the steady -- but slow -- revival of Merrill’s $479 billion asset management business under Robert Doll. When the industry veteran took over as Merrill Lynch Investment Managers’ president and CIO in 2001, he took charge of an organization scarred by abysmal performance, meager profits and fleeing assets. In less than four years -- two of them marred by a bear market -- Doll has boosted portfolio returns, strengthened profit margins through ferocious cost-cutting and positioned MLIM to expand.

“I set out a plan that I called Merrill Lynch Investment Managers: A Play in Three Acts,” says the gregarious, broad-shouldered Doll, 49. “Act I was to fix investment performance. We wanted 70 percent of our assets to be above benchmark, and we have bettered that. Next we wanted profit margins of 30 percent, and we got there. The final act is to grow again.”

But although MLIM’s progress is unmistakable -- and deserves hearty applause -- the audience might want to withhold a standing ovation for Doll’s play until after Act III. MLIM’s two core businesses are still struggling. The U.S. retail operation continues to suffer serious outflows from its flagship money market funds, and the U.K. institutional group has only begun to stabilize, after years of client defections. Last year MLIM’s net increase in assets was a paltry 1 percent; the typical global asset manager’s was 9 percent, as reported by Boston Consulting Group. And MLIM assets fell 7 percent during the first quarter of 2005, largely as a result of money fund outflows; during the same period the Standard & Poor’s 500 index dipped 2.1 percent, and the MSCI Europe, Australasia and Far East index declined 0.8 percent.

Certainly, Doll has kept his house in order, despite these problems. In the first quarter MLIM earned pretax profits of $127 million on revenues of $414 million. Its operating margin of 30.7 percent was just a shade below the industry average of 31 percent -- and a marked improvement over the 23 percent it reported in 2000. But the challenge, Doll acknowledges, is to grow again, and MLIM’s asset mix remains overloaded with low-fee products: Cash and index funds account for 34 percent of the total.

MLIM must find its way in an industry that is very much in flux. Financial services companies that built themselves up into supermarkets in the 1990s, often acquiring asset managers as a central part of their strategy, are now having second thoughts about the virtues of size and sprawl. Fund management margins remain juicy, but earnings can be volatile and the challenges of running the business daunting, spurring some financial services companies to cut loose their money managers. American Express recently decided to hive off its financial adviser and money management arm, and last month Citigroup and Baltimore-based money manager Legg Mason agreed to a $3.7 billion deal in which Citi will swap most of its money management business ($437 billion of assets out of a $460 billion total) for Legg Mason’s brokerage business. Under the terms of the deal, Citi will get $1.5 billion in shares of Legg Mason, which will take on a roughly $550 million, five-year loan from Citi.

MLIM, like other brokerage-owned money managers, confronts a particular threat. In today’s hypersensitive regulatory climate, it may no longer be possible for brokerages to own money management operations without risking real or perceived conflicts of interest. Citigroup Asset Management’s desire to avoid even a perceived conflict of interest -- its funds are sold by its Smith Barney brokers, among others -- is one driver behind a deal with Legg Mason.

Doll acknowledges the threat of perceived conflicts of interest, though he is quick to dismiss it. “There are retail investors who believe that a Merrill Lynch adviser gets paid more for recommending an MLIM fund,” he says. “That is blatantly false, but that is the perception.”

Yet Doll is so eager to restore growth that he is contemplating some bold notions, among them eliminating the Merrill brand name for retail funds sold by non-Merrill brokers in third-party channels. In its place, Doll suggests he might revive Mercury, the brand of the U.K. institutional money manager acquired by Merrill in 1998. “Another option,” he says, “is a joint venture with another firm where we use their distribution. Option three might be a couple of small acquisitions where we get a mutual fund brand and distribution. We wouldn’t rule out a big acquisition, either. We are keeping all of our options open.”

All but one, that is. Doll, who sits on Merrill’s 32-person executive committee and reports directly to CEO Stanley O’Neal, dismisses any suggestion that his operation is not headed for the auction block: “I am absolutely sure no one at Merrill has ever had any intention of selling MLIM.”

That’s not just the party line, suggests veteran Sanford C. Bernstein & Co. analyst Brad Hintz. “Merrill Lynch has the most powerful sales channel in North America, and to me the idea that it will get rid of MLIM is absurd,” he remarks. “That distribution power is something every money manager CEO would trample over his best friends to get.”

But Ben Phillips, managing director and head of research at Boston-based consultant Cerulli Associates, believes that Merrill will eventually feel compelled to sell off its asset management operations. “This is no flash in the pan,” contends Phillips, referring to perceived conflicts of interest. “This is a fundamental issue; it is not going to go away.”

However the next act unfolds, the story of Merrill Lynch Investment Managers is central to the larger cautionary tale of Wall Street firms’ efforts in the 1990s to stake claims to asset management. They bought with great gusto only to discover that the business was more volatile, less profitable and far more difficult to manage than they had expected. And, indeed, Merrill’s $5.3 billion acquisition of the U.K.'s Mercury Asset Management Group, announced in 1997 and completed in 1998, was the classic ill-fated deal. Merrill bet that an expanded asset management division would kick in a greater share of the firm’s overall profits and -- this was the lure that attracted so many financial services executives at the time -- provide a steady earnings stream to counterbalance the inevitable ups and downs of investment banking and brokerage.

As the stock market bubble inflated, that scenario seemed plausible; other investment banks and brokerages operated on the same assumption. But five years after the bubble burst, it’s evident that there is nothing steady about asset management earnings in a bear market. The U.S. industry’s operating margins are down 8 percentage points from 39 percent in early 2000 (yes, they really did reach that improbable height). MLIM contributes 10 percent of Merrill’s overall profits and revenues, down from 14 percent in 2000.

Merrill, meanwhile, is profiting from a resurgence in investment banking, retail brokerage and private client banking, which together account for the remaining 90 percent of revenues and profits. The firm is also reaping the benefits of intense cost-cutting. Between late 2001 and the start of 2004, O’Neal slashed 24,000 jobs out of 80,000. The bottom line: Merrill reported net income of $4.4 billion for 2004, up 16 percent from the previous year and far ahead of 2001’s $573 million.

Those results could put added pressure on Doll to speed up the turnaround at MLIM. For now, Merrill appears to have no doubts that he has what it takes to get the job done. “Bob Doll has done a great job driving business discipline into MLIM,” says his vice chairman, Robert McCann. Until June, when he took charge of MLIM’s private client group, McCann was Doll’s boss. “Now when revenue comes in the door, it flows through to the bottom line. That is the hallmark of a good business.”

THE HEAD OF MLIM DEVELOPED HIS KEEN business sense over the course of a 25-year career in financial services. The son of a mechanical engineer, Doll earned his BA in accounting and economics from Lehigh University in 1976 and his MBA from the Wharton School of the University of Pennsylvania four years later. He then signed on as a research analyst at Citicorp Investment Management, where he remained seven years, managing U.S. equity portfolios. In 1987 he joined OppenheimerFunds and rose steadily through the ranks, from analyst to portfolio manager. He became CIO in 1998.

Though demanding, Doll admires truly talented stock pickers and inspires loyalty among his staff. “Bob has a clear idea of what he wants to achieve and how to get there,” says Anne Richards, CIO of Aberdeen Asset Management and a former MLIM fund manager.

Doll left Oppenheimer, albeit reluctantly, in 1999 when Jeffrey Peek, then head of MLIM, recruited him to become CIO for equities for the Americas. Peek, who was in the running to become CEO of Merrill, left the firm shortly after O’Neal won the race in July 2001. That same month, Doll was promoted to global CIO; he became MLIM president two weeks after 9/11.

In the fourth quarter of 2001, Merrill posted a record loss of $1.3 billion. CEO-designate O’Neal embarked on a campaign to slash expenses through layoffs, outsourcing, office closings and basic belt-tightening.

A team player, Doll wasted no time cutting costs at MLIM. By the first quarter of 2004, downsizing had claimed 1,400 out of 4,000 staffers; the ranks of investment professionals had shrunk by a third, from 900 to 600. Operating margins steadily widened, from less than 1 percent in 2001 to 20.3 percent in 2003 to nearly 30 percent last year.

Cutting costs to boost margins, though, doesn’t take much imagination. Doll’s other goal, bolstering investment performance, has been far more challenging. After Merrill acquired Mercury, U.S. equity funds and core U.K. balanced funds, the heart of the MLIM business, underperformed their benchmarks for three years running. By the time Doll joined in 2001, performance had picked up in some areas but was still poor overall. Just 21 percent of MLIM’s 100 U.S. mutual funds boasted four- or five-star ratings from Morningstar in 2000 versus one third of its funds now. In Europe the four biggest portfolios in MLIM’s Merrill Lynch International Investment Funds all rank in the top quartile of performance over one, three and five years, ended March 31, according to S&P.

How did Doll pull off this tough assignment? He shut down subpar funds and eliminated duplication between U.S. and U.K. fund rosters. He also sharpened discipline in the investment process, tightening risk controls and introducing a global research platform to support better the firm’s investment professionals.

“Asset management is a combination of art and science,” Doll says. “We are not a quant shop, nor are we just a bunch of stock pickers. There needs to be a balance.”

The fundamental asset breakdown that Doll inherited in 2001 is still intact. Institutional assets represent 51 percent of MLIM’s total, retail claims 41 percent and private clients 8 percent. About 67 percent of assets come from the U.S., 23 percent from Europe and 10 percent from the rest of the world.

Doll has not solved one glaring problem in MLIM’s asset mix: a pronounced dependence on low-margin money market funds. Of nearly half a trillion dollars in assets, $102 billion is in money market funds -- though recent outflows have been significant -- and an additional $48 billion is in low-fee index and enhanced index funds. The breakdown on the remainder: $123 billion in fixed income, $92 billion in active equities, $62 billion in balanced funds and $6.6 billion in alternative assets, including hedge funds, private equity and real estate. An additional $39 billion comes from Merrill’s private clients.

By contrast, Morgan Stanley Asset Management has a far more profitable asset mix, with less in money market funds and all of its $209 billion in equity assets actively managed. Although MSAM has failed to meet its goal of winning four- or five-star Morningstar rankings for at least half of its mutual funds -- the division’s weakness was one of the grievances of the dissident former Morgan Stanley executives before CEO Philip Purcell decided to retire no later than next March -- MSAM still earned $570 million in operating profits last year.

Where will Doll find growth? He holds out great hopes for an expanded retail presence in the U.K., but it won’t be easy to persuade independent advisers to give Merrill a shot. “In the retail world MLIM has been a bit of a joke, and I wouldn’t have touched most of their funds with a barge pole,” says Meera Patel, head of research at Bristol-based Hargreaves Lansdown, one of the U.K.'s biggest independent financial advisers. Still, she sees some improvement. “In March we added UK Dynamic, the first MLIM fund on our buy list that I can remember,” she notes.

Doll is also looking for an increase in mandates from European institutions. To that end, in April he struck a deal (the price was undisclosed) with Dutch giant Royal Philips Electronics to acquire Philips’s asset management division and manage its $16 billion pension fund. (Philips’s money management group had no external clients.)

In February, to help raise MLIM’s profile among U.S. institutional investors, Doll recruited Frank Porcelli, the former head of institutional sales at Putnam Investments, as COO for the Americas. Porcelli is devoting considerable energy and resources to boosting sales, focusing first on third-party channels. “We are very excited by the raw material we have in terms of product lineup and performance across a range of distribution channels and client segments,” Doll asserts.

MERRILL LYNCH’S ASSET MANAGEMENT GROUP entered the 1990s in a position of strength. At the end of 1991, it had assets of $123 billion, almost all raised by its brokers. MLAM ranked sixth on the 1992 Institutional Investor 300 list of the U.S.'s biggest money managers. However, more than half of those assets ($69 billion) were in cash and money market funds. Its ambitions were limited. This was a predominantly retail firm -- institutional assets totaled just $14 billion -- and all of the assets came from inside the U.S.

In early 1995, David Komansky, Merrill’s president and CEO-designate, proclaimed that the firm should become a major force in global financial services, including asset management. At the time, Merrill’s pension assets totaled $25 billion, mostly in cash accounts, out of overall assets of $189 billion.

Merrill took a modest step toward raising its profile in institutional asset management in 1996, when it paid $200 million to acquire $10 billion-in-assets Hotchkis and Wiley Capital Management, a respected Los Angeles institutional boutique. But the value of the deal was soon undermined by internal feuds, client defections and a noisy clash of corporate cultures. Five years later Merrill shut the business down.

In 1997, Jerome Kenney, Merrill’s chief strategist and one of Komansky’s top aides, engineered the $5.3 billion acquisition of $176.7 billion-in-assets Mercury. When the deal closed in early 1998, it created a $450 billion money management operation that ranked third in the II 300. The two operations were complementary: Merrill was retail- and U.S.-focused; Mercury was institutional- and non-U.S.-focused.

The awkwardly named Merrill Lynch Mercury Asset Management (the group was rebranded Merrill Lynch Investment Managers in April 2000) was certainly a major pension player. In the U.K., Mercury claimed a remarkable 16 percent of pension assets, managing more institutional accounts than any of its rivals.

Many deals look pricey in hindsight, but this one seemed rich even at the time. Merrill paid the equivalent of 3 percent of assets and about 25 times historical earnings for Mercury. But bull markets cover all sorts of sins. By the end of 1998, MLIM assets had jumped to $557 million; a year later they had reached $594 billion.

Still, those gains masked troubles in Merrill’s U.S. retail funds, which suffered net redemptions of $4.4 billion in 1998 and $11.2 billion in 1999, according to Financial Research Corp., a Boston-based mutual fund research firm. Merrill was hurt in part by its value equity bias, which fell out of favor as the bubble inflated. The U.S group also lost accounts because of poor performance.

Meanwhile, the U.K. business was feeling the effects of a major industry shift. In the late 1990s, U.K. pension funds began to move from assigning balanced mandates, in which one manager handles many asset classes for a single plan, to awarding specialist mandates -- that is, distributing specific assignments among several firms. As Britain’s biggest balanced manager, the former Mercury suffered the full force of this change.

Merrill’s newly acquired U.K. team made a bad situation worse. Mercury had long been known for its expertise in equities but began to falter in the wake of the Merrill acquisition. Poor performance was at the heart of a lawsuit that struck Merrill’s U.K. operation. In 1999 the Unilever Pension Fund, one of the firm’s biggest institutional clients, sued MLIM for £130 million, alleging that it had been negligent in managing £1 billion of Unilever’s pension assets over a 15-month period beginning in January 1997, costing the pension plan £130 million. In December 2001, Merrill settled out of court for £75 million, without admitting any liability.

The timing of the Unilever settlement could scarcely have been worse for Merrill. Six months earlier MLIM had accepted the resignations of Carol Galley and Stephen Zimmerman, the co-heads of Mercury and longtime leaders of the business. And in late 2001 and early 2002, many senior staffers left to set up their own firms or retire.

As the bear market continued to bite, Doll was named president and CIO of MLIM. He focused first on cutting costs but soon made improved portfolio performance and the integration of the old Mercury and Merrill operations top priorities.

“What Bob has done is change the culture,” says Merrill vice chairman McCann. “MLIM now has a strong performance culture and one of investment excellence.”

Doll shut down many of MLIM’s weaker funds. Under his aegis more than 100 have been closed, including such bull market babies as the Premier Growth Fund and Focus Twenty, a portfolio that concentrated on technology stocks and held a significant position in Enron Corp. (Premier Growth fell by 53 percent in 2001 and Focus Twenty by 70 percent, both landing in the bottom quartile for large-cap growth funds.) To simplify choices for European investors and salespeople, Doll merged three retail platforms into one, Luxembourg-domiciled Merrill Lynch International Investment Funds, slashing their combined roster of funds from 97 to 68.

“We had too many products, we were in too many markets, and we were chasing too many clients in too many channels,” confesses Robert Fairbairn, COO for Europe, the Middle East, Africa and Asia Pacific. “Now we’re more rational managers.”

To impose greater top-down discipline on what had traditionally been a decentralized investment process, Doll relied on the expertise of MLIM’s global head of risk, Brian Fullerton. The former chief risk officer of Putnam arrived at Merrill shortly after Doll, in 1999.

Doll also constructed a global research platform. In the past, in-house research had not always been available to Merrill staffers. The new system allows research to be posted on a global platform called Bull$,¥¤, which can be accessed by any Merrill investment professional.

But Doll wants to keep power in the hands of portfolio managers. MLIM analysts don’t run their own portfolios, as analysts do at firms intensely focused on research, such as Capital Group. Nor do they dictate which stocks portfolio managers can buy.

Indeed, Doll continues to run money himself, managing the $1.6 billion U.S. Flexible Equity Fund. For the 12 months ended March 31, it returned 9.8 percent, versus the benchmark Russell 1000 index’s 7.2 percent.

“I would find it humiliating to have someone peering over my shoulder,” Doll says. But he also believes that once a fund manager has clearly defined how he will manage money, he owes it to his firm to stick to it. “I’ll give people rope, but if they start doing things they shouldn’t be doing, I’ll be all over them.”

To motivate portfolio managers, Doll ties compensation to performance against benchmarks -- a strategy common to many money management firms. But he also offers profit-sharing to the best of the bunch: The top teams share in earnings above a preset threshold. In essence, Doll opts for decentralized investment decision making coupled with centralized risk management and marketing. “We think of the organization as boutiques with backing,” he explains.

Still, Doll’s turnaround started slowly. In 2002, his first full year as president and CIO, MLIM’s U.S. mutual fund business suffered net outflows of $2.5 billion, a slight improvement over the $3 billion in net outflows during 2001. The former Mercury operation continued to bleed both clients and talented investment professionals, among them Anne Richards, head of the alpha team, and equity chief Andreas Utermann.

Then, not a moment too soon, stock markets came back to life. In 2003 the S&P 500 index returned 28.7 percent; the EAFE rose 35 percent in dollar terms. MLIM’s third- and fourth-quarter earnings improved for the first time since 2000. Stock market gains in 2004 were more modest but still provided a solid base on which to build.

Yet in spite of improved performance, MLIM’s U.S. mutual fund business continued to shrink. Last year the firm recorded $1.8 billion in net outflows, according to Financial Research. During the same period, reports the Washington-based Investment Company Institute, U.S. mutual fund families collectively reported modest net inflows of $43 billion, less than 1 percent of industry assets of $8.1 trillion. For Merrill the good news is that about 80 percent of its net outflows came from its low-fee money market funds.

To strengthen retail sales, Doll is enlisting the help of Merrill’s 15,000 financial advisers, along with third-party distributors. Under the leadership of Daniel Dart, COO of MLIM’s nonproprietary U.S. distribution business, Merrill now fields a team of 15 wholesalers who are trying to spark sales among third-party brokerages. (In 1999, MLIM had no wholesalers on its payroll.) They’ve more than doubled assets, to $20 billion, since 2003.

When MLIM raised $234 million for a closed-end fund, Diversified Income Strategies Portfolio, in February, 26 percent of the total was brought in by third-party distributors, the largest percentage of an MLIM fund that had ever been raised through nonproprietary channels. Still, the prospect of selling a Merrill Lynchbranded mutual fund on a rival brokerage platform remains remote, which limits the potential for third-party sales growth.

In the next few years, as Doll looks to grow MLIM and direct his third act, he sees promising opportunities in two areas in which Merrill currently has only a modest presence: U.K. and European retail and U.S. institutional.

Strong performance in U.K. and European retail funds has already boosted assets. Overall, retail assets in Europe rose from $11 billion in 2000 to $34 billion last year.

The Merrill Lynch International Investment Fund’s US Basic Value Fund, a facsimile of the U.S. mutual fund run successfully by Kevin Rendino, reports total assets of $2.3 billion, up from $770 million in 2002. The fund has ranked in the top decile over the past five years.

U.K. equity funds, a traditional strength for MLIM, have continued to outperform their peers. MLIM’s leading U.K. equity portfolio, the $870 million UK Dynamic Fund, returned 26.5 percent in 2004, beating the FTSE all-share index by a whopping 13.7 percentage points. Managed by Mark Lyttleton, a 12-year veteran of Mercury and MLIM, the fund reported net inflows of $227 million in 2004, up from $115 million in 2003.

Doll and his deputies are convinced that growth outside the U.S. will come through third-party distributors -- independent financial advisers in the U.K. and banks and insurers in Europe. Merrill’s partners now include some first-tier distributors: BNP Paribas, Citigroup, Deutsche Bank, ING, Skandia Insurance and UBS. All were brought in during Doll’s tenure. Their sales clout is a key reason assets invested in Merrill’s Luxembourg funds hit $26 billion at the end of March, up from $12 billion at the end of 2002.

“We are doing more retail business in the U.K. than ever before,” says James Charrington, MLIM’s European head of retail and an old Mercury hand. “But this is just the start.”

MLIM is also winning new subadvisory business. For example, in January the 3i Smaller Quoted Companies Trust, a London-listed investment trust company, transferred an internally managed $332 million portfolio to MLIM. “There was a beauty parade, and some were more beautiful than others,” says William Govett, chairman of the trust. “The performance record of MLIM speaks for itself.”

Certainly, the Philips deal should help Doll expand European institutional business. As MLIM becomes the sole manager of Philips’s $16 billion retirement plan (20 former Philips investment professionals will join MLIM when the deal closes), it will instantly acquire a higher profile among European pension funds. It will also gain expertise in asset-liability matching, a growing trend in pension fund management (see page 36).

Doll and his colleagues think it’s a good bet that other big pension plans will follow Philips’s lead and outsource portfolio management to MLIM. Says Maarten Slendebroek, head of sales for Europe and architect of the Philips deal: “I think a lot of other CFOs with in-house managed pension schemes will think about picking up the telephone to call MLIM. CFOs are spending more and more time worrying about their pension funds, and outsourcing takes away one headache.”

The other area Doll has targeted for growth, the U.S. institutional market, will likely prove a greater challenge. Of MLIM’s $127 billion in U.S. institutional assets, $87 billion is in short-term bond and money market funds; the remainder is in passive and enhanced equity funds. Merrill has high hopes for a core bond strategy it seeded in mid-2001 and began offering to institutions in the second half of 2004; that fund is in the top quartile of the InvestorForce U.S. core fixed-income universe over one and three years ended September 2004.

To succeed in this market, however, MLIM must win over investment consultants. Here the Merrill name has little resonance. “MLIM is a largely unknown quantity,” says Jeffrey Nipp, head of global manager research at Watson Wyatt Worldwide in Atlanta. “I think Bob Doll knows what it takes to be credible in institutional, but he needs to execute.”

To persuade the pension crowd, Doll will develop more institutional versions of the firm’s strong retail funds. He will further cultivate relationships with key consultants. If the right opportunity presents itself, he’ll also consider a liftout -- a deal in which a team of portfolio managers defects from one money manager to another, bringing their performance record with them.

Doll would also like to boost MLIM’s presence in hedge funds. Currently, the firm has only $3.7 billion in funds of hedge funds. That’s a far cry from Goldman Sachs Asset Management and UBS Global Asset Management, each of which manages more than $10 billion in hedge fund assets. “We want alternatives to be a bigger part of our asset total,” says Doll. “Not so long ago it was zero.”

To pull in more hedge fund assets, MLIM is giving some of its top managers the scope to run hedge funds. In May, the firm launched the UK Absolute Alpha Fund, managed by U.K. equities star Lyttleton.

Merrill CEO O’Neal may yet decide to sell MLIM before its president and CIO completes his mission. But Doll refuses to consider such a denouement to his four-year drama. “What I would say is that everyone at Merrill, from Stan O’Neal down, wants MLIM to succeed,” he says. “It is a core part of the overall business, and it will be a growing part of the business.”