Investment conundrums

The decline of long-term interest rates to near-historic lows at a time of robust economic growth and monetary tightening by the U.S. Federal Reserve Board is truly extraordinary -- a conundrum, as Fed chairman Alan Greenspan has put it. To understand this phenomenon, it helps to follow the money, in the apocryphal words of Deep Throat, and see who today's bond buyers are.

Senior Editor Andrew Capon does just that in this month's cover story, "Balancing Act" (page 36), about the growing popularity of liability-driven investing among pension funds. The introduction in Europe of international financial reporting standards, which require pension fund managers to mark their assets and liabilities to market, is forcing managers to fundamentally rethink their strategies. Similar regulatory moves are afoot in the U.S. As a result, managers are increasingly seeking to match their assets to their pension liabilities instead of focusing on maximizing returns. The shift means they are buying more, and longer-dated, bonds.

Recognizing the big pension funding deficits that are widespread in Europe and the U.S. is a good thing, of course, but liability-driven investing is only an analytical framework, not a panacea. It's clear that the predictable income flow of bonds can help pension managers match their future obligations. Much less clear is whether loading up on bonds at today's low rates is a wise investment. For fund managers the need to generate good returns is as important as it has ever been.

Few fund company executives know that as well as Robert Doll, president and chief investment officer of Merrill Lynch Investment Managers. In 1998, Merrill paid $5.3 billion for Mercury Asset Management Group, then the premier U.K. institutional firm, envisioning the creation of a mighty global fund company that would contribute a steady share of profits to offset the volatility of the U.S. brokerage giant's core businesses. Instead, as Capon documents in "Doll's House," beginning on page 24, the money management arm struggled. Since taking over as MLIM's head in 2001, Doll has boosted portfolio returns and strengthened profit margins through ferocious cost-cutting. Now he faces the challenge of growing the business again, even as financial rivals like Citigroup hive off their asset management businesses. Might Merrill follow suit? Doll says that such a scenario is not in the cards. "It is a core part of the overall business, and it will be a growing part of the business," he insists.