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Brave New World of Money Management

In the wake of the worst financial crisis in decades, top money managers and investors reveal what it will take to succeed.

Legendary value investor Jeremy Grantham has never been part of the cool crowd.

The strident contrarian was stubborn enough to stick to his guns when the dot-com bubble was inflating — repeating his value mantra even as 40 percent of his business walked out the door because he refused to buy technology growth stocks. So, he certainly wasn’t going to alter his course during the cataclysmic market meltdown of 2008.

And in fact, he didn’t have to. This time there was little pressure for the 71-year-old chief investment strategist of Boston-based Grantham Mayo Van Otterloo to abandon his method of searching out underpriced stocks with strong fundamentals. Impressed by his call on the tech bubble and his loyalty to the value religion, investors have been flocking to GMO. The firm’s assets shot up to $150 billion in 2005 and eventually settled at about $100 billion today. “You make money by seeking out cheapness, and if you are patient you will win these extreme bets,” says the engaging British expat, adding: “You may lose a ton of business, but you will win the bet.”

[Click here to see the U.S. Investment Management Award Winners. Visit the awards dinner and ceremony for more information.]

The bet has clearly paid off for Grantham — and for his firm. GMO is the Value Investing Manager of the Year in Institutional Investor’s inaugural U.S. Investment Management Awards. On the heels of the worst financial crisis since the Great Depression — the U.S. money management industry lost nearly $5 trillion in assets from October 2007 to December 2008 — II surveyed nearly 3,000 institutional investors to find out not only which of their managers best navigated the stock market storm, but also which ones emerged stronger. The investors themselves also deserve recognition for surviving, and in some cases thriving, during the crisis, which is why our industry awards also recognize the top U.S. institutional investors whose innovative strategies and fiduciary savvy resulted in impressive returns over the past year.

[For more details on the investor winners, click here to read the Best in Show profiles of the top investors.]

The investors we surveyed were asked to rate their managers on five key attributes — client service, innovation, performance, reputation and risk management — as well as to rate the importance of each of those attributes. The result is an impressive lineup of U.S. money managers in 19 asset classes and strategies that stand out for their exceptional performance, risk management and service. The accolades are well deserved, but what’s crucial now is how these winners perform going forward. They face an uncertain future in which clients are much less trusting and markets are far more volatile. Asset management is a mature industry, and to succeed in future years the top players will not be able to sit back and remain content with business-as-usual strategies. Innovation will be key to survival in an environment in which the age-old “client knows best” rule still applies.

“We’re not in a growing business,” says Donald Putnam, principal of Grail Partners in San Francisco, a private equity and advisory firm that specializes in asset management. “It’s not railroads yet — but it’s not Avatar either.”

After enjoying profit margins of up to 50 percent as recently as 2008, the investment management industry is going to need to adapt to a new world order. Overall assets under management in the U.S. sat at $20.2 trillion in September 2007, according to Darien, ­Connecticut–based Casey, Quirk & Associates. By December 2008 they had fallen to $15.6 trillion as markets blew up. By December 2009 assets under management had risen to $18.9 trillion. But don’t be fooled, warns Putnam. He predicts that, going forward, even the top firms will struggle to produce margins higher than 20-odd percent. “Today, most firms are back up to 35 percent, but that will be short-lived,” he says. As a result, the industry is likely to experience a wave of consolidation, as money managers seek to either carve out a niche as specialized boutiques or opt for strength in numbers by buying other firms.

In the face of this challenging environment, many of the winners in the U.S. Investment Management Awards are fine-tuning strategies they believe will ensure future success. Their secrets? Some are obvious, such as providing solid returns using both alpha and beta products. Successful players will also have to change the way they do business, ensuring that through their actions — including compensation, fund transparency and public relations — they acknowledge the interests of clients, key employees, consultants and the public at large. As Putnam puts it, “We can no longer succeed as a business by riding the escalator of asset growth.”

The need to outperform the market has never been greater, following the crisis-induced double-­digit losses that most endowments, foundations, pension funds and other institutional investors suffered. Some institutions that had long refused to invest in hedge funds are now beginning to build new absolute return portfolios to help them neutralize market volatility, not just achieve higher returns. Longtime hedge fund holdouts such as the California State Teachers’ Retirement System and the Florida State Board of Administration recently hired hedge fund consultants to begin the process.

Even some of the industry’s most traditional mutual fund shops are rolling out new, active hedge fund products. “We’re more and more convinced, based on the last two years of experience our clients have gone through, that absolute return and market neutral strategies are going to go from fringe to much more relied-upon strategies,” says Kevin Uebelein, president and CEO of Pyramis, the institutional practice at Fidelity Investments, the Growth Investing Manager of the Year. And Putnam Investments, the Mutual Fund Manager of the Year, launched four absolute return funds in January 2009.

Experts agree that providers of alpha will be the biggest winners in the next five years, whether they find it by going short or long. They also predict that buyers will increasingly want to access both alpha and beta from one trusted source. Five years ago industry observers and participants predicted that private equity and hedge funds were converging. Instead, hedge funds are moving toward producing mutual fund products and long-only funds in the same way mutual fund firms are serving up hedge fund products. Putnam CEO Robert Reynolds says he believes that this convergence trend will continue for the next five years. “The idea that you’re only an equity and fixed-income shop will become more difficult,” he adds.

The traditional ways to outperform a benchmark can still work, but doing so has become harder in today’s volatile new world of investing. Although large-cap core managers have become used to having the epithet “closet indexer” hurled at them, there continue to be some who can wring alpha from the basic array of Standard & Poor’s 500 index stocks. Those managers, such as J.P. Morgan Asset Management’s Thomas Luddy, have consistently found a way to beat the S&P benchmark. Luddy takes home Institutional Investor’s Money Manager of the Year Award, in part for his ability to produce returns 600 basis points over the benchmark and hold a first-­percentile position among U.S. large-cap core managers.

Like Grantham, Luddy has had a clear investment philosophy for a long time — in his case 34 years — believing in the power of a deep bench of fundamental and quantitative researchers to forecast future company value and then stick to the results. “You couldn’t sit around in 2008 and 2009 wondering what you believe in, because the world was moving so quickly,” he explains. “You could not react to the volatility, because you would constantly be caught up in the behavioral risk, doing what feels right at the time but not core to your fundamental belief. That core belief was absolutely critical in the last few years.”

If managers cannot always provide alpha, then they’d better be good at serving up beta. In the new world order, there will be a significant commitment to providing lower-cost beta and quantitative products as investors clamor for more passive strategies — in large part because they’re cheaper.

“I think we’ve reached an inflection point,” says George (Gus) Sauter, CIO at Vanguard Group, the Indexing Manager of the Year. The domain of a few academics and institutions when introduced 30 years ago, index investing has grown substantially in recent years. “It surprised a lot of people that it never leveled off,” adds Sauter.

Exchange-traded funds, a newer form of index investing, have been dubbed the great leveler — they’re one of the only financial products in which retail and institutional investors are in the same fund. New ETF products are in the works at BlackRock, reports Michael Latham, the head of U.S. iShares at BlackRock, the Exchange-Traded Fund Manager of the Year. Look for a future that includes ETFs for emerging-markets stocks, small-cap and even high-yield bonds. Debt instruments can be notoriously difficult to price, but bond ETFs offer the possibility of tighter spreads on the quoted bid-offer when deal flow exceeds that of the actual instruments, says Latham.

Future leaders in asset management will have to do more than simply provide good alpha and beta products to succeed. Money managers have to get their own houses in order. The industry is currently experiencing sweeping structural evolution as smaller and midsize firms either disappear or get gobbled up by larger players and formerly bank-owned shops become newly independent.

The future will favor two kinds of companies: the global, ­diversified investment management powerhouse and the smaller boutique that provides niche products and services such as high-­alpha-­generating, nimble performance, specialized mandates and access to new services like Internet-­based investing. “We’ll see a barbelling of the industry,” posits Michael Kim, a financial services analyst with Sandler O’Neill + Partners in New York. Given the major damage many firms sustained in the market downturn, as well as the rising cost of distribution and regulation compliance, scale will become more important than ever. A lot of the players in the vast middle — anywhere between $100 billion and $1 trillion in assets — will be increasingly squeezed and forced to partner up with larger firms. As firms consolidate, entrepreneurial managers will start their own firms, adding to the growing stock of new boutiques.

The cycle of life and death will come full circle as asset management returns to its roots as an independent industry. Twenty years ago managers were independent, founded by entrepreneurs, but over time banks and insurance companies acquired these firms as a way to expand into the asset management business. Now, desperate for capital, those same companies are selling them. Five years ago 60 percent of assets were owned by big banks and insurers. Today, over 70 percent are independently owned, according to McKinsey & Co. Last year, Barclays Bank sold its Barclays Global Investors asset management unit to BlackRock. The $15.2 billion sale gave Barclays much-­needed capital, and BlackRock CEO Laurence Fink moved a giant step forward in his quest for massive global reach (Click here to read more about Laurence Fink, our Money Management Lifetime Achievement Award winner). In a much smaller deal, Bank of America spun off Columbia Management’s asset management business earlier this year to Ameriprise Financial in Minnesota for $1 billion.

Consolidation has given just five firms control of more than 60 percent of the assets on the retail side of the industry, up from 40 percent five years ago. Today, Morgan Stanley Smith Barney, Merrill Lynch, Bank of America, Fidelity, Wells Advisors (Wachovia) and Charles Schwab have a stranglehold on distribution of retail assets, says David Hunt, a director at McKinsey in New York.

For firms that don’t want to merge but still want a strong backstop, there is another option: the multiboutique asset manager. This model offers the best of both worlds — firms give up some of their independence to benefit from the cost efficiencies associated with being part of a larger group. Examples of this structure that herds numerous boutiques under one umbrella include Affiliated Managers Group, the Prides Crossing, Massachusetts–based giant, with more than 50 investment platforms, and Old Mutual Asset Management, which has 18. Small firms receive support such as access to wider product distribution, technology and risk management help, and some of the equity is kept in the hands of their managers. “It’s crucial to keep the entrepreneurial zeal,” notes Churchill Franklin, COO of Acadian Asset Management, which was acquired in 2000 by London-based Old Mutual. The parent company, in turn, builds a diversified portfolio of investment strategies and styles. In the end, asset management firms get to maintain some of their independence, but they also enjoy the benefits and cost efficiencies associated with consolidation.

As the investment management industry adapts to structural reforms, its top performers must also make changes in the way they do business. The healthiest asset managers will revise the way they compensate portfolio managers, salespeople and other staff, to align it with their firms’ actual value. In the past, at private partnerships, teams were incented to drive the value of the franchise, but once ownership shifted the new owner companies had to come up with a properly aligned compensation structure or risk losing valuable teams, observes John Casey, founder of Casey Quirk, who advises managers on such frameworks. “Equity in the hands of managers is really important to align the interests,” adds Roger Hartley, principal of Mitchell Hartley Advisers, an investment banking advisory firm in Sonoma County, California.

The proper alignment of external relationships will also be important. To succeed in a lower-return, lower-fee environment, the industry will become more about service and value and less about just managing money.

One way to better align a firm with its clients is to offer a solid advisory capacity. Advice concerning asset allocation will be especially critical in the next five years. Sorting out alpha from beta and mitigating risk will take solid advice, and investment managers are gearing up to provide it.

Investors are also going to be much more opportunistic. There are signs today that the traditional investment policy model of static asset allocation is giving way to a more tactical regime. Lyn Hutton, CIO of Commonfund, is urging investors to think more in terms of bottom­-up asset selection, taking the risks of their institutions’ mission into consideration in selecting, for example, a company’s stock or its senior secured debt. (For more on Hutton, the Investor Lifetime Achievement Award winner, click here.) Plan sponsors and other institutional investors are more willing to consider things that don’t fit neatly in an investment style box. Funds like the Oregon Public Employees Retirement Fund, Alaska Permanent Fund and New York State Common are setting up “opportunity buckets” to enable them to go after new ideas quickly. Managers ranging from Fidelity’s Pyramis to Greenwich, Connecticut–based AQR Capital Management have already begun providing such advice. Firms are also looking to create products that will dampen volatility in future catastrophic events.

In a more complex world, investors will increasingly continue to off-load the decision-making process by outsourcing and forming strategic partnerships. Successful firms will need to be able to provide a full array of services, not just products, to meet investors’ demands. For example, the Alaska Permanent Fund recently hired five global managers, including GMO and Westport, ­Connecticut–based Bridgewater Associates, to be co-CIOs on a portion of its active assets. According to a 2009 survey by Pyramis of more than 400 corporate and public pension plans in 12 countries, 21 percent of the corporate plans said they have engaged in a strategic partnership or are seriously considering doing so.

As alpha becomes scarcer, fees will continue to come under pressure. Investors want to mitigate the risk of buying beta, or market, returns that come packaged as alpha. “Beta should be very near zero,” says Carl Hess, global director of asset allocation at consulting firm Towers Watson in New York.

Change is already happening. State Street Global Advisors offered to manage the indexed mandates for the $43.8 billion Massachusetts Pension Reserves Investment Management for fees well below what its competitors were offering. “Fee structures are performance-­based,” says Young Chin, CIO at Pyramis. “Everything we’ve done is on new levels.”

Asset managers that succeed in the future will have to lower fees while improving client service. Connecting with clients on every level is going to be more important than ever, given the huge disappointments suffered by most investors during the recent crisis. “Trust and confidence have been frayed,” notes McKinsey’s Hunt. “The real winners will reestablish the moral high ground for their clients.”

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