For whom the barbell tolls
Barclays Global Investors contend it’s done the heavy lifting necessary to make its odd-couple product lineup of indexes and hedge funds pay off. Numbers support it.
When Blake Grossman, then head of active investment management at indexing giant Barclays Global Investors, started talking to clients about using long-short hedge fund strategies in 1996, he was met with polite indifference. Grossman, now the San Franciscobased CEO of BGI, the world’s biggest institutional money manager, recalls those pioneering marketing efforts with a grin. “To say institutional interest was nascent would be overstating it,” he says. “It was practically nonexistent.”
Grossman can afford to smile. Today Barclays Global Investors is among the world’s biggest purveyors of hedge funds. The firm has more than $12.5 billion invested in a range of long-short strategies across equities, fixed income and currencies. Although that may pale beside BGI’s $1.4 trillion in overall assets, most of which are in passively managed index funds, the hedge fund business has helped spark a renaissance in the firm’s fortunes that is turning heads.
Last year BGI grew its profits by 82 percent and had net new asset inflows of $106 billion. And this eye-catching growth shows no signs of slowing down. In the first half of the year, profits grew by a further 60 percent, to £242 million ($436 million), with net fee and commission income rising 36 percent. BGI now contributes 9 percent of parent Barclays Group’s profits.
The turnaround has been fast and, to many observers, unexpected. Just four years ago BGI had a reputation as a stolid and rather dull indexer. Though big, managing $769 billion, it was barely profitable. Rumors circulated that Barclays would sell the business, which it had acquired in 1995 for about $440 million when the firm was known as Wells Fargo Nikko Investment Advisors, a division of the eponymous San Franciscobased bank. Selling would have had little impact on Barclays, as BGI then contributed a mere 1.7 percent of its profits. BGI’s profit margins were a meager 15 percent; today, at 41 percent, they comfortably beat the industry average of 33 percent.
Far from being a candidate for the ax, BGI is now one of the most admired businesses in fund management. Its strategy is shrewdly attuned to the demands of its institutional client base. On the one hand, it has a range of passive index funds and exchange-traded funds, which offer cheap replication of market returns, or beta. On the other hand, its hedge funds and enhanced index products hold out the prospect of market-beating returns.
This product strategy has profoundly changed the firm. Though index funds and ETFs make up $969 billion of the assets, they account for only 40 percent of profits. The other 60 percent comes from the firm’s $430 billion in actively managed products, the majority of which are enhanced index funds. Although BGI won’t reveal how much of its profits come from its more than $12.5 billion in hedge funds, it is clear that those funds are integral to the firm’s business strategy.
“The fact that BGI can say to a fund, ‘We will match your liabilities, and by the way, we also have a pure active hedge fund product to juice up the returns,’ is very compelling,” says Andrew Drake, chief operating officer of U.K. investment consultant PSolve Asset Solutions. “It’s a pincer movement against traditional active management.”
Competitors looking for a chink in BGI’s armor didn’t have much to get excited about until the surprise announcement in late September that former London-based co-CEO Andrew Skirton was leaving BGI as part of a broad management restructuring by Barclays president Robert Diamond Jr. across the company’s investment management, investment banking and wealth management businesses. Skirton had served as co-CEO with Grossman since June 2002, when former CEO Patricia Dunn stepped down for health reasons. Skirton’s departure marks a return to the more streamlined management reporting structure that was used under Dunn.
“This is one of the toughest decisions I have made,” says Diamond. “In terms of leadership, I thought it was the right time to make the transition to a single chief executive. This decision has nothing to do with what has happened since 2002. BGI has flourished since I endorsed the decision to appoint Andrew and Blake, and I have no regrets. This is about the future.”
Grossman insists that the management changes at BGI won’t affect its strategy. “It was a decision made by Bob Diamond on what was the best management structure for BGI in the future,” he says. “The change in the CEO structure does not change any of the strategic priorities for the business.”
Hedge funds are high on the list of priorities, and BGI’s commitment to them was born out of the same academic theories that gave rise to the firm’s index business. Huw van Steenis, a specialty finance analyst for Morgan Stanley in London, says BGI exemplifies what he calls an asset management barbell: the split between commoditized passive funds at one end and high-margin hedge funds and alternative investments at the other. “Our investment view is that the firms at either end of the barbell are those that will succeed in the future,” says van Steenis. “BGI is unique in that it is successful at both ends.”
But success is often a curse in the fund management business, because it is a magnet for assets. Although BGI can manage a virtually limitless amount of money in its index products, size can be the enemy when it comes to hedge fund performance. Very few hedge funds companies have prospered with more than $10 billion in assets under management.
“The issue isn’t just that trying to run too much money kills alpha,” says Judith Posnikoff, a co-founder of Pacific Alternative Asset Management Co., an Irvine, Californiabased fund-of-hedge-funds manager. “Steering a battleship is also much harder. If you have to go through layers of people to make things happen, there is a huge danger you are moving too slowly in a fast-moving world.”
Posnikoff says the potential for problems may be exacerbated by BGI’s institutional heritage. “Institutions are not characterized by the speed at which they implement new ideas,” she says. “That can be a problem for any fund manager, but it is a particularly acute problem for firms that are driven by quantitative models. Quant firms rarely blow up. They tend to atrophy, to wither on the vine.”
Grossman hopes to avoid those problems. He has closed several of BGI’s equity hedge funds to new money, including the flagship 32 Capital Fund in the U.S. and the European Market Neutral Fund in Europe. In April 2004, BGI launched a line of fixed-income hedge funds under Peter Knez, the firm’s global head of fixed income. Grossman is also actively looking to develop new products around investment strategies, such as volatility trading, that could handle the increased demand for hedge funds from pension funds, foundations, endowments and other institutional investors.
BGI has a long history of investment innovation. In the 1970s its predecessor firm, Wells Fargo Investment Advisors, was a pioneer of index fund management, spurred by the academic theories of William Sharpe and Eugene Fama. They believed that markets were efficient and that therefore the optimal portfolio was one that reflected the entire market.
Since then BGI’s homegrown investment gurus -- head of global research Richard Grinold and head of equity research Ronald Kahn -- have pushed the firm into low-risk active investment management strategies. In the mid-1980s they introduced what BGI calls “alpha tilts,” which the firm uses in its enhanced index products to try to beat a target index by 150 to 200 basis points with lower levels of risk than traditional active management.
If that sounds dull, think again. In 2004 only 38 percent of active managers beat the Standard & Poor’s 500 index. BGI’s active equity funds in Europe, Japan, the U.K. and the U.S. all topped their benchmarks for the 12 months ended July 31.
“Enhanced indexing is posing a fundamental challenge to active managers,” says Stephen Nesbitt, founder and CEO of Cliffwater, a Santa Monica, Californiabased investment consulting firm. “BGI and other managers have demonstrated that these products work consistently, and not many active managers can make that boast.”
The Kansas Public Employees Retirement System has $1.5 billion of its $11.5 billion in assets invested in BGI products, mostly in enhanced indexing. “We just don’t believe it is efficient to use high-risk active strategies in developed, close-to-efficient equity markets,” says chief investment officer Robert Woodard.
BGI has also been at the forefront of liability-driven investing, where it has more than $17 billion in assets under management. LDI can be thought of as a new form of passive management that uses assets (principally bonds and swaps) to match the liabilities of pension funds.
Although most of BGI’s innovations have targeted institutional investors, one of the firm’s recent successes has been its IShares exchange-traded funds, which were conceived as a retail product. When BGI rolled out IShares in May 2000, however, investors barely noticed. “When I told people back in 2000 that there was no reason that ETFs couldn’t be as big in retail as indexation is in the institutional market, they didn’t even bother to suppress their laughter,” says J. Parsons, head of BGI’s U.S. intermediary business.
Much of the skepticism had to do with the market itself, which had begun a slide that spring that would turn into an almost three-year bear market. Still, BGI launched 56 IShare funds in its first year and hired 26 marketers to sell them to financial advisers. “It was a completely new world for us,” says Parsons, who ran the equity index management group before moving to the intermediary team in 1999 for the IShares launch. “We knew nothing about selling to retail intermediaries, so we hired people who did.” One key hire was Victoria Klein, who heads IShares sales in the U.S. and was a longtime Prudential Securities broker.
BGI now manages $121 billion in 100 different IShare funds worldwide, more than double the assets of its closest ETF rival, State Street Global Advisors. That includes $12 billion in six fixed-income IShare funds.
BGI reported $17 billion in net new ETF inflows last year. Only American Funds and Vanguard Group had bigger mutual fund flows, and both of their businesses are buoyed by sales to the 401(k) defined contribution market, an area in which BGI does not compete.
Overall, ETFs enjoyed record inflows in the U.S. in 2004 of $54.4 billion, up from $15.1 billion in 2003, according to Santa Rosa, Californiabased TrimTabs Investment Research.
There are now more than 3 million individual holders of IShares. But BGI’s fortunes are still tied to the institutional market. The firm has 2,700 institutional clients worldwide, up from 1,800 five years ago. More than 40 percent of them buy more than one product from BGI. Eighteen institutional clients have more than $5 billion invested with the firm.
“If you were to be picky, you might say it is difficult for BGI to get bigger, because clients don’t want all their eggs in one basket,” says Morgan Stanley’s van Steenis.
BGI’S LATEST ATTEMPT TO PUT THEORY INTO practice is perhaps the most surprising. In the mid-1990s Grinold and Kahn discovered that their work was equally applicable to long-short hedge funds. The quantitative models they used to identify stocks to overweight or underweight for their enhanced index products could also be used to determine which shares to buy long or sell short in a hedge fund. And whereas enhanced index products typically get about 0.3 percent of assets in fees, hedge funds charge a management fee of 1 to 2 percent and a performance fee of 20 percent of the profits.
“It sounds odd, but we weren’t motivated by high fees,” says Grossman, a Stanford University economics grad who has spent his entire career with BGI since joining in 1985 to develop alpha tilt products. “We were enamored by the power of theory.”
BGI launched its first equity long-short hedge fund in 1996. The business limped along during the late 1990s with a few hundred million dollars in assets under management. But once the equity bubble burst in March 2000, investors learned that beta, which provides a nice ride to long-only, actively managed portfolios in bull markets, can have a nasty bite in bear markets.
BGI is now riding the wave of alpha and beta separation. Although competitors such as Los Angelesbased Capital Group Cos. and Boston-based Fidelity Investments blend alpha and beta in long-only active strategies, BGI’s investment offering is clear and unadulterated: If investors want beta, they can buy its index funds for a few basis points. If they want alpha, the firm has a full menu of enhanced index products and 15 long-short hedge fund strategies.
BGI’s approach is rare among institutional hedge fund managers. Although Goldman Sachs Asset Management and UBS Global Asset Management each run more money in hedge funds than BGI, much of that is invested through funds of hedge funds. Virtually all of BGI’s more than $12.5 billion in hedge funds is in single-manager funds. Of that, $8.7 billion is in equity long-short funds, $3.2 billion in macro (mostly currency) strategies, $350 million in fixed-income products and $300 million in multistrategy funds, which invest in BGI’s own single-manager vehicles.
“BGI has made a marked transition from a beta- and indexed-oriented shop to an alpha-oriented investment firm,” says Cliffwater’s Nesbitt. “I don’t know of any other firm that has done that.”
State Street has about $2 billion in hedge funds and vows to get even. “Hedge fund management is a natural extension for us, given our skills in quantitative management,” says Ronald Logue, chief executive of State Street Corp. For now, his Boston-based firm is playing catch-up with BGI, which has gathered $4.5 billion of it $12.5 billion in just the past 12 months. Of course, few hedge fund managers have managed to prosper for very long after their assets have grown that large -- not even Julian Robertson Jr. or George Soros. Grossman hopes BGI can buck that trend.
Part of his optimism is founded on BGI’s academic underpinnings. The central tenet of Grinold and Kahn’s active management approach is breadth of investment. They try to increase their probability of success by making lots of small bets on individual stocks or bonds. BGI’s hedge fund portfolios are made up of hundreds of individual positions. The hedge funds also avoid investing in such illiquid securities as convertible bonds or distressed debt.
Pacific Alternative’s Posnikoff says BGI’s approach gives it greater scope to grow than many managers. “Of course, if you are invested in liquid large-cap stocks, you have a more scalable business model than those of many hedge funds,” she says. “But I would also caution that no hedge fund strategy is infinitely scalable. It’s not like running an index fund.”
Grossman believes that BGI’s deep pockets will help it succeed where others have failed. “In our view hedge fund management is becoming a scale game,” he says. Grossman isn’t talking about assets, which he says will always be a constraint. “I mean the depth of resources that can be committed to research, information technology and data gathering,” he explains. “The best ideas are found between asset classes and regions, and that research costs a lot. Opportunities are arbitraged away very fast, and you need to be on the constant lookout.”
BGI expects to spend $100 million this year on research; its research budget has more than doubled in the past five years. The firm has long had a reputation as a brain trust and employs about 90 Ph.D.s.
Kenneth Kroner, head of global markets research and strategy at BGI in San Francisco, says that two thirds of the research is aimed at maintaining and improving existing products, and the other third is spent on trying to find new ideas. “Everyone here loves elegant theory,” says Kroner, who is also the North American editor of the Journal of Asset Management. “But this is a business, and what is even more rewarding is when that elegant theory or investment insight gets turned into market-beating portfolios and products.”
The firm developed its first active strategy in 1978, almost two decades before it launched its first hedge fund. The idea was simple: to overweight stocks paying high dividends. “Yield tilts,” as the strategy is known, was phased out last year despite at least one client’s insisting that it had been BGI’s best-performing active strategy for 25 years. “Pricing anomalies no longer persist for years, and naive strategies no longer work,” explains Kroner of the decision. “You have to dig deeper and look for complex cross-asset class and cross-regional opportunities, which tend to persist longer.”
According to Kroner, BGI no longer uses many signals that were once core elements of the firm’s active investment products. One example is earnings surprises. Stocks whose earnings beat the consensus forecasts of analysts used to perform better than the market for several months. Now the market reacts so quickly that the potential for investment gain is arbitraged away in a matter of hours.
KRONER AND AN ARMY OF 130 full-time researchers are continually looking for new strategies in BGI’s established specialties, such as equities and currencies. At the same time, the firm is making a big push into fixed income, using its familiar barbell strategy. At one end of the barbell, BGI has developed a range of passively managed fixed-income products that replicate the liabilities of pension funds, principally in the U.K. and Europe. At the other end, it has launched a U.S. credit hedge fund called 3D Capital, which has raised $500 million in a little more than three months.
Knez, appointed global head of fixed income in March 2004, is keen to stress that his products share the same intellectual foundation as BGI’s better-known equity products. He says he spent the first few months of his tenure thinking about the best strategy for the business before concluding that Grinold and Kahn’s fundamental law of active management, with its breadth of investment bets, could readily be applied to the fixed-income world, especially using derivatives.
Although the global cash equity and bond universes are of a broadly similar size -- $22 trillion and $26 trillion, respectively -- the fixed-income derivatives market dwarfs all others, with a value of $194 trillion. As a result, Knez says, there is a greater opportunity to build portfolios with precise bets, both long and short.
“The change in the fixed-income market in the past five years is nothing short of a revolution,” says Knez, who trained at Goldman Sachs in the early 1990s and is an adjunct professor of finance at the Kellogg Graduate School of Management at Northwestern University in Evanston, Illinois. “Derivatives, such as credit default swaps, have exponentially increased the type, frequency and precision of views a fixed-income fund manager can express.”
BGI is backing Knez’s vision with plenty of money. More than 30 fixed-income professionals have been hired in the past nine months. Tim Webb, who runs the London-based active fixed-income team, says the depth of resources rivals those of even the biggest investment banks. When Webb joined BGI five years ago, the London team had fewer than 20 investment professionals; now there are 60.
With $1.4 trillion under management, it would seem natural for BGI to grow complacent, but the firm continues to push hard into such new areas as volatility trading. Kroner believes that volatility -- simply put, the fluctuation of returns for a stock, bond or other security -- has the potential to become a substantial asset class.
Volatility is a key determinant in options pricing, and Kroner says there are plenty of opportunities to exploit mispricings. He believes that returns are being left on the table by such market participants as corporations that use options to hedge -- buying and selling the instruments to minimize risks rather than to maximize profits. BGI is designing products to pick up what’s being left on the table.
The firm’s rivals have taken note of its success. Northern Trust Global Investments has hired two senior staffers from BGI in recent months -- former head of index research Chad Ravkin and senior equity trader Timothy Misik.
BGI’s hedge fund business has also been subject to turnover. Kevin Coldiron, who established the firm’s European equity market-neutral funds in 2002, left the following year to team up with BGI’s former head of global equity research, Peter Algert, to establish a hedge fund in San Francisco. The firm, Algert Coldiron Investors, specializes in systematic equity trading strategies. In addition, John Demaine, the former head of BGI’s alternative strategies in Europe, quit the firm this August for what a BGI spokesman calls “personal reasons.”
Some observers say that the departure of co-CEO Skirton last month could have an impact on the firm. Although the Grossman and Skirton double act was unusual, it had its admirers. The ebullient and charismatic Skirton was a perfect foil for the more cerebral and softly spoken Grossman. “There is no doubt that people will be very sad not to have Andrew to work with day to day,” says Grossman. “He is a very popular figure.”
Despite the recent management change at the top, Cliffwater’s Nesbitt says BGI has been remarkably stable. “All things being equal, I would have expected more turnover,” he notes. “That there hasn’t been, I believe, comes down more to culture than to compensation. Smart people like working with other smart people, and there are a lot of very smart people at BGI.”
Still, the firm must hope all those smart people can continue to innovate and find new wrinkles that will allow them to create new hedge fund and other active strategies as it is forced to close existing funds to new money. As Morgan Stanley’s van Steenis puts it, “A firm whose success or failure is driven by quant models is only as good as its last algorithm.”
Regardless of how fast Kroner and his team of quants can push out new products and new ideas, Grossman says the firm will continue to maintain and enhance its existing products. “We will not trade alpha for assets under management,” he insists.
That’s a noble claim. In a business where revenues are a product of funds under management, there is a strong temptation to grab business while your products are hot. Few firms have resisted it.