Money Masters, Part 1: The Winners

Robert Steers has been told ever since he co-founded New York–based real estate securities manager Cohen & Steers in 1986 that he couldn’t succeed within such a narrow niche. Steers and his partner, Martin Cohen, defied the critics for 26 years, building their firm primarily within real estate, and after going public in 2004 they now have $44.9 billion in assets. Their formula: invest in securities that produce income streams, sometimes by contract, such as real estate investment trusts and listed infrastructure companies. Although Cohen & Steers recently launched its sixth investment strategy — the Cohen & Steers Real Assets Fund — the firm is using two subadvisers to help run the portfolio because it doesn’t have sufficient in-house expertise in the commodities and natural-resource equities that are part of the fund, and doesn’t want to develop it. “We stay focused because we want to be in the 20 percent of managers that produces alpha,” Steers tells Institutional Investor. “Diversification is a formula for failure.”

As the Real Estate Investment Trusts Manager of the Year in II’s third annual U.S. Investment Management Awards, which honor money managers in 34 equity, fixed-income and alternative-asset classes, Cohen & Steers is not alone in focusing on what it does best.

Other winners, including Artisan Partners, Baron Capital Management, BlackRock, J.P. Morgan Asset Management, Pacific Investment Management Co., T. Rowe Price Associates and Vanguard Group — all chosen by the top echelon of institutional investors for their outstanding long-term performance and ability to weather market cycles — have also committed to doing one or two things well and sticking to that discipline through thick and thin. These outstanding investors recognize that they can’t be all things to all people.

The years since the financial crisis have tested that discipline. Investors have poured money into bond funds and withdrawn it from stocks, looking to ratchet down risk in portfolios decimated in 2008 and early 2009. The one source of inflows within equities has been into index funds, as investors look for low-cost managers that do exactly what they say: track a particular benchmark. But II’s winners have stuck to their knitting. They are the epitome of active managers — sometimes surprisingly so — and have consistently delivered returns above their benchmarks. Their processes are a lesson in how fundamental research, a long-term investing horizon and true talent can provide alpha even in tough times.

The winners were selected through a rigorous process that has been refined over the past three years. This year we added 11 new asset classes in fixed income and equities to better reflect the way institutions run their portfolios. We broke up small-cap equity, as well as mid- and large-cap, into value, growth and core, and added fixed-income buckets, including mortgage-backed, government, corporate and investment-grade bonds.

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II started by analyzing data from White Plains, New York–based Informa Investment Solutions, as well as other providers, on more than 30 strategies, sectors and product types. Data included returns for the past one, three, five and ten years, standard deviations and Sharpe and Sortino ratios. We then asked more than 1,000 investors overseeing the premier endowments, foundations, corporate and public pension plans and other institutions to vote on the top managers in each of the sector and strategy categories. Voters were instructed to pick their favorite firms based not only on performance but also on managers’ conviction and discipline, research capabilities, risk management, market knowledge and other factors that distinguish them. The awards also honor the best fiduciaries of small and large public and corporate pension plans, endowments and foundations. In contrast to the survey used to choose the leading money managers, our New York–based editorial staff independently researched and selected the top fiduciaries. This independence affords us the opportunity to identify individuals who have excelled in delivering the best long-term performance, displayed innovation in their portfolio policies and investment approaches, and been leaders in their fields.

If managers often earn their keep during uncertain times, some of this year’s winners found that the difficulties played to their strengths. Europe’s continuing debt problems, the shaky economic gains in the U.S. and questions surrounding China’s future growth were all weighing on managers as they entered the second quarter of 2012. But interest rates continue to hover at historic lows, and investors are looking for yield.

Mark Weisdorf, head of infrastructure investments for J.P. Morgan Asset Management’s global real assets group, says his sector is benefiting as investors search for alternatives to low-yielding fixed-income investments and discover the attractions of infrastructure such as toll roads and airports. “Even in difficult periods people use utilities, gas and wastewater plants,” says Weisdorf, whose firm is the Infrastructure Manager of the Year. “Investors need a source of higher income but without too much risk: risk of volatility and risk of not getting their income.” He believes infrastructure will be as big a part of investors’ portfolios as real estate over the next ten to 15 years. Infrastructure is also a hedge against inflation, an increasing concern of investors.

Even as Newport Beach, California–based bond giant Pimco moves into equities, it is doing so in a focused fashion, by leveraging its fixed-income expertise. Neel Kashkari, head of global equities, says that from the beginning of its new strategy the firm wanted its equity portfolio managers to tap into the font of information available from its credit analysts. That way, Pimco — U.S. Fixed-Income Core, U.S. Fixed-Income Investment-Grade and Non-U.S. and Emerging-Markets Fixed-Income Manager of the Year — could differentiate its equity offerings.

Pimco’s approach to equities will defy traditional categorization in some cases, says Kashkari. He explains that the firm has launched four equity and fixed-income strategies that are unconstrained, with its portfolio managers not penned into style boxes. “You’re not going to see us offering some large-cap U.S. strategy,” says Kashkari, who joined Pimco in December 2009 to lead its push into equities. “Not all clients are ready for global unconstrained investment, but we think a go-anywhere mandate will achieve the best performance.”

The effects of the financial crisis are still reverberating within the money management industry. But Ron Baron, for one, has been benefiting from the tremors. While banks were laying off research staff, the founder of Baron Capital, the Midcap Growth Equity Manager of the Year, took the opportunity to expand and hire. Five years ago the New York–based firm had 77 employees; now it has 112.

Baron, a longtime fundamental growth investor who spends many hours with the CEOs and other top managers of the companies in which he invests, is still hiring. Prospective analysts and portfolio managers need to think long-term, because the flagship Baron Growth Fund holds its positions, on average, for seven years — compared with an average holding period of one year for the typical mutual fund. Baron also takes a long-term approach to running his business, doing everything he can to encourage employees to stay with the firm. “The most successful businesses invest in themselves during difficult times,” he says.

Sticking to a discipline doesn’t mean ignoring changes in the markets. Henry Ellenbogen, manager of the oldest small-cap fund in the U.S., Baltimore-based T. Rowe Price’s New Horizons Fund, looks for potential investments in unusual places, including the private market. Ellenbogen says that as a buyer of small-cap companies, he has to keep up with private businesses that may go public one day and become candidates for his fund. Some have dubbed Ellenbogen one of the most powerful people in Silicon Valley: If T. Rowe, the Small-Cap Growth Equity Manager of the Year, is paying attention to a start-up, it is likely to go public. The firm has made investments in once privately held companies such as Angie’s List, Facebook and Zynga, and led a $15 million financing round for oDesk Corp., which helps companies with virtual workforces.

This year’s top money managers are also well attuned to risk. Giri Devulapally, portfolio manager of the JPMorgan Large-Cap Growth Fund, goes so far as to say that how a portfolio manager oversees risk is as important as his or her ability to select securities. “I’m as much of a risk manager as a portfolio manager,” explains Devulapally, a trained engineer who designed and developed software systems after graduating from the University of Illinois and worked at T. Rowe Price for six years before joining J.P. Morgan in 2003. He says there are three risks in growth investing: missing the really great stocks, not missing the disasters and “just hanging in there” when times are challenging.

Last year was challenging for J.P. Morgan, Large-Cap Growth Equity Manager of the Year, even though its large-cap growth strategy is not driven by predicting big-picture trends but rather by analyzing fundamental characteristics of companies. “We navigated last year by trying to survive, not thrive,” Devulapally concedes. Currently, however, he is finding a lot more opportunities for investments.

The discipline exhibited by Artisan Partners, Midcap Value Equity and Non-U.S. Equity Growth (ex-Emerging Markets) Manager of the Year, reflects its belief that there are only so many good ideas in the investment world. The Milwaukee firm takes great care in both identifying good ideas and knowing when to sell. “What distinguishes us is that you have to take risk, but let’s be careful with the risk we take,” says James Kieffer, co–portfolio manager of Artisan’s Small Cap Value Fund, Mid Cap Value Fund, Artisan Value Fund and the firm’s U.S. value separate-account portfolios. “You’re wrong with greater frequency than your ego might want to admit, and you need a margin of safety,” he adds.

To that end, Artisan uses qualitative and quantitative screens. Some, such as low price-to-book and low price-to-cash ratios, are commonplace. Others, including insider activity at publicly traded companies, spin-offs and divestitures, are less so. Kieffer says one of Artisan’s most useful screens is a so-called daily downtrodden list, which includes stocks that have suffered a large percentage decline in their prices.

Kieffer, who has worked with fellow value managers Scott Satterwhite and George Sertl for 20 years, looks for cash-producing businesses that have strong balance sheets and are selling at deep discounts. He also seeks liquidity and flexibility. “We want better, safer, cheaper,” says Kieffer.

To protect the integrity of its process from marketing pressures, Artisan maintains a smaller client base than most managers, setting higher account minimums and building solid infrastructure. The goal is to make sure its portfolio managers are pulled away as little as possible from their jobs to meet with clients and do similar tasks.

Large-Cap Core Equity Manager of the Year GMO has long had a rich deep-value focus. “We’re trying to understand what areas of the market are currently undervalued and therefore what is the mechanism by which we can get paid for owning those segments in the market,” says Sam Wilderman, co-head of the Boston-based GMO quantitative equity team and lead manager for U.S. quantitative portfolios. In the middle part of the past decade, GMO determined that traditionally cheap stocks were no longer priced to give the return they had historically. In contrast, high-quality stocks of companies with very stable profitability and low levels of leverage were priced extremely attractively.

“Across our investment in U.S. equities, we’ve had very large exposure to the highest-quality names,” says Wilderman.

This past year GMO’s valuation process gave signals to position portfolios in the safest stocks. “Not that we predicted the events of 2011,” adds Thomas Hancock, Wilderman’s co-head and lead manager for international quantitative portfolios. Investors sold off riskier assets, and GMO eked out a small gain. Hancock emphasizes that the firm is not a closet indexer. “If we’re neutral on a stock, we don’t own it,” he says.

Investors have been looking to bond shops like Pasadena, California–based Western Asset Management Co., U.S. Fixed-Income Municipal Manager of the Year, to do good, old-fashioned fixed-income research, something that was missing in the run-up to the credit crisis. “People woke up to the risk in public finance,” says Robert Amodeo, portfolio manager on Wamco’s municipal bond team. He says investors are increasingly recognizing that the firm has long ignored credit ratings as factors in its analysis and instead has looked fundamentally at each credit, asking questions about a state or municipality’s budget and other fiscal measures.

Also receiving investor scrutiny are the managers of money market funds, those plain-vanilla investments designed for short-term cash that experienced chaos in 2008 when the Reserve Primary Fund “broke the buck,” its net asset value dropping below $1.00 a share. “Many years ago cash was perfunctory,” says Joan Payden, co-founder of Payden & Rygel, Cash Management & Short-Term Fixed-Income Manager of the Year. “But now it’s a consultative business.” Payden explains that her Los Angeles–based firm works with corporations’ financial and treasury teams to customize cash management products. She adds that although investors are interested in global strategies, there are new risks with that, including those surrounding local currency and the low-interest-rate environment.

Joshua Gotbaum, head of the Pension Benefit Guaranty Corp. and this year’s Outstanding Achievement Award winner, has turned his experience as an investment banker at Lazard Frères & Co. working with distressed companies into a job saving pensions. He too sees himself as more than a passive steward of other people’s money. “We know how to be an active creditor,” Gotbaum says of the PBGC.

Daniel Fuss, Lifetime Achievement Award winner and vice chairman of Loomis, Sayles & Co., is the epitome of an active investor. He’s obsessed with what he calls specific security selection, negotiates for a low price when buying and holds bonds for four or five years.

Bridgewater Associates, which wins the Hedge Funds category for the second straight year and is also the world’s biggest hedge fund firm (see story, page 70), is employing the same sort of broadly strategic thinking that it has been using for the past 30 years. Bridgewater’s global macro Pure Alpha Strategy fund is one of the top-performing hedge funds in the world. “We’re systematic,” says co–chief investment officer Robert Prince. “So we work really hard to try   and understand how the economic machine works and how that connects over to the markets.” What’s changed now, he adds, is “the world’s receptivity to some of these things,” referring to most portfolio managers’ bias toward being long equities. “The world is coming away from that and thinking about how to structure a portfolio that doesn’t have those kinds of systematic biases,” says Prince.

Indeed, Bridgewater has a so-called risk budget tool that includes a bias finder so clients can pinpoint systematic biases — say, the tendency to be long small-cap stocks — in their portfolios’ or their managers’ returns. Prince says the firm has seen a huge increase in the number of clients using the tool. “It used to be that when we would bring up that topic, people would look at us and say, ‘Yeah, that’s interesting,’ ” laughs Prince. “Now you bring it up and they say, ‘Oh, of course.’ The world has come a long way. There is a big shift in the way people think about what drives returns, and there’s been a big shift in trying to avoid those systematic biases.”

Though BlackRock, U.S. Fixed-Income Mortgage-Backed and Exchange-Traded Funds Manager of the Year, has expanded into equities and alternatives through acquisitions and organic growth, the firm was launched on the back of its founders’ mortgage expertise and still uses these fundamental analytical abilities to give it an edge in the mortgage markets.

Randy Robertson, co-head of securitized assets at New York–based BlackRock, says the firm’s process is still defined by two primary characteristics. One is its ability to take a fundamental and technical approach to analyzing securities. “We look at what’s going on on the ground with mortgage origination and mortgage services,” he says. “We incorporate that into our performance views.”

The second is BlackRock’s ability to capture and analyze data on mortgage bonds and other fixed-income instruments. Looking forward, though, Robertson says the biggest issue facing the industry is the changing rules that have resulted from the politics surrounding the mortgage crisis. “It’s hard to play the game when rules are changing,” he says.

A changing Wall Street, however, has created openings for the buy side, notably GSO Capital Partners, the credit arm of Blackstone Group. Bennett Goodman, co-founder of $48 billion GSO Capital Partners and II’s Money Manager of the Year, describes how the firm is leveraging Wall Street’s new constraints from regulations and other changes. Goodman, who started his career at Drexel Burnham Lambert doing what are now called leveraged-buyout financings, says New York–based GSO has become one of the biggest providers of capital as Wall Street has shrunk. “We marry our capital with their clients,” he says. “We work very closely with the Morgan Stanleys and the Goldmans and the Deutsche Banks of the world.” GSO, for instance, provided financing last year for the Citigroup deal to take control of EMI from Terra Firma Capital Partners and sell the music publishing unit to a Sony Corp.–led group.

Even Vanguard, the shareholder-owned mutual fund company founded by John Bogle, the inventor of the index fund, is extolling the virtues, within limits, of active investing. To be sure, the Valley Forge, Pennsylvania–based firm, Mutual Fund Company of the Year, remains the biggest purveyor of increasingly popular index funds, including exchange-traded funds. And its passive offerings have been gaining investor money, while its active funds have been net losers. But the firm has a research group dedicated to finding the best active managers, who then subadvise Vanguard funds. “There’s a place in investor portfolios for active funds,” says CIO George (Gus) Sauter, adding that “active is a nice complement to many portfolios.” • •