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The II300: Hollowing out the core

The separation of alpha and beta is good for indexers and hedge funds. But traditional active equity managers have little reason to cheer.

Like a pair of elephants dancing a pas de deux, two huge indexers change places at the top of Institutional Investor's annual ranking of America's biggest money managers: State Street Global Advisors, No. 1 last year, yields the top spot to Barclays Global Investors, which was No. 2 in the 2004 ranking. BGI's total assets? A formidable $1.36 trillion. Nor is this the only show of passive power in the II 300: Northern Trust Global Investments, the world's third-biggest indexer, moves into the top ten, at tenth, for the first time, up from 12th last year and 17th in 2001.

As more and more pension funds opt to separate beta, or market return, from alpha, or excess return traceable to manager skill, they naturally have greater demand for beta-generating index funds on the one hand and alpha-pursuing alternative investments on the other. J.P. Morgan Asset Management reports that 41 percent of U.S. defined benefit plans now split beta and alpha and a further 14 percent are considering doing so.

"The businesses that are succeeding are index and high-performance providers," says Huw van Steenis, a London-based Morgan Stanley specialty finance analyst. "As funds increasingly separate alpha and beta, the middle ground, the traditional long-only players, will be squeezed."

BGI has shrewdly positioned itself at both ends of the investment spectrum, as attested to by its 27 percent gain in assets in 2004. (Assets for the II 300 as a whole grew 12 percent last year.) Although best known for passive management, having pioneered indexing in the 1970s, BGI has built one of the world's biggest hedge fund businesses, with $10 billion in assets (it ranked 15th in II's 2005 Hedge Fund 100).

Of course, BGI was hardly the only manager to enjoy an alternative-asset boom. Last year assets in this no-longer-exotic investment category soared 25 percent in the II 300, to $813 billion. As recently as 1998 the figure was $171 billion. Three percent of the II 300's $24.3 trillion in total assets under management in 2004 was in alternatives, up from 1 percent in 1998.

Traditional core asset categories have fared less well. Among the II 300, U.S. equities grew by 14 percent last year, versus a 10.9 percent gain in the Standard & Poor's 500 index. But that still leaves this basic portfolio building block ahead by a meager 8 percent since 2000. What's more, the best-positioned managers in domestic equities are the indexers: Passively managed stocks now make up more than half of the pension fund dollars in the asset class for the first time. Consulting firm Greenwich Associates reckons that pension funds allocated 52 percent of their assets to U.S. stocks in 2000 but only 47 percent in 2004. International allocations grew from 11 percent of all U.S. fund assets in 2003 to 13 percent in 2004, according to Greenwich. Average fixed-income allocations declined from 26.8 percent in 2003 to 23.7 percent in 2004.

One clear beneficiary of the separation of alpha and beta is Westport, Connecticut­based Bridgewater Associates. Founder Raymond Dalio has been preaching the benefits of alpha and beta separation -- and managing his own hedge fund and alpha overlay strategy -- for 15 years. Now, he says, pension funds are taking heed. Bridgewater's assets jumped 49 percent, from $32 billion at the end of 2003 to $47.6 billion a year later. The firm shoots up 20 places in the II 300 ranking, to No. 79, the largest rise of any firm that ranked in the top 100 in both years.

"Funds are recognizing that this isn't just elegant theory, it is a better way to manage money," Dalio says. "I can take my alphas from currencies and bonds and add that on to equities or any other asset class." Two years ago 80 percent of Bridgewater's new client money was destined for traditional long bond management. Now, says Dalio, 80 percent of clients are buying alpha overlays and hedge funds.

"There is a profound change going on that isn't going to reverse," he asserts. "The winners and losers in asset management that will emerge over the next five years will be a very different set of firms than those that look like the winners and losers today."