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And Northern makes three

In October Northern Trust Corp. became the first legitimate challenger to BGI and State Street Global Advisors when it announced plans to buy Deutsche Asset Management's $120 billion-in-assets index business.

Barclays Global Investors ranks as the world's No. 1 institutional portfolio indexer, overseeing a massive $770 billion in passive assets. Right behind BGI comes State Street Global Advisors, with $650 billion. The pair's overwhelming scale and combined 84 percent of the $1.7 trillion in global institutional indexed assets have pretty much left their competition in the dust. Now, for the first time in a decade, the two indexing behemoths have reason to glance in their rearview mirrors.

In October Northern Trust Corp. became the first legitimate challenger to BGI and SSgA when it announced plans to buy Deutsche Asset Management's $120 billion-in-assets index business. The $260 million cash deal, expected to close early next year, will catapult NT's index business to about $180 billion, making it the third-largest institutional passive manager and the fourth-biggest passive manager overall behind No. 3 Vanguard Group, a retail index fund titan.

"People have this misconception about passive management -- that it's a terrible, low-fee business -- but the truth is, if you have scale, it can be a terrific business," explains Stephen Timbers, president of Northern Trust Global Investments. "Now we have scale."

Currently, about $1.3 trillion is invested in passively managed equity funds, including both institutional and retail, designed to mirror indexes like the Standard & Poor's 500 and the style-specific Russell family. Greenwich Associates estimates that out of $5.8 trillion in U.S. pension assets, $1.1 trillion is passively invested in domestic equity. Fees typically run about 3 basis points for a $100 million account.

"BGI and State Street will still pretty much dominate, but by stepping up like this, Northern Trust is sending the signal that they intend to make a serious run at this business," says Joshua Dietch, a consultant at Cerulli Associates.

There's an increasing appetite for passive management. In the U.S. an increasing number of small and midsize plans are following the lead of the biggest institutions and indexing more of their core equity assets, and the same phenomenon has taken root in Europe in the past two years.

Despite the low fees charged by indexers, ancillary products such as securities lending and transition management can produce handsome profits. Money managers don't break out their business lines, so profits are difficult to measure. But consider that in August BGI was the only unit of U.K.-based Barclays to register a profit. And in the third quarter of 2002, State Street Corp. wowed Wall Street by announcing that its net income had increased to $182 million from $170 million a year ago, despite the dreadful market. Driving this growth, the firm reported, was an increase in "servicing fees," which rose 6 percent, to $427 million. A large part of these fees comes from securities lending.

NT is buying a business that traces its roots to a former archrival, Bankers Trust Corp. Led by Kathleen Condon, BT created one of the first institutional indexing operations in the mid-1970s, when passive investing was getting off the ground. At its peak in 1999, the BT squad, led by Frank Salerno, managed $200 billion in index assets, including roughly $70 billion for New York City Retirement Systems. But not long after Deutsche bought BT in the spring of 1999, Salerno and his team bolted to Merrill Lynch Investment Managers. Some $80 billion in assets left Deutsche shortly thereafter; roughly half followed Salerno to MLIM (Institutional Investor, February 2000).

If its new managers stay put, NT will pick up a 29-member team of indexing specialists led by James Creighton, the former BGI executive recruited by Deutsche to replace Salerno. The business comprises about 300 institutional relationships. Of the $120 billion in index assets at Deutsche, all but $16 billion is in equity. NT will likely make a special effort to hang on to Deutsche's major subadvisory assignments for Fidelity Investment's index funds. As of September 30 Fidelity had a little more than $22 billion in six separate index funds subadvised by Deutsche. Says a Fidelity spokesman, "We will closely evaluate the decision" to leave the assets or move them.

NT currently has $1.5 trillion in assets under custody, and this could be its ace in the hole going forward in the indexing business. "A lot of our largest custody clients have been telling us for years that they would like to use us for indexing but that we were just too small," says Terence Toth, head of NT's U.S. index business.

Toth might be on to something. Pension plans, many of them facing asset shortfalls and reduced investment staffs, are increasingly looking to consolidate relationships, which could play right into the hands of Northern Trust. "For a plan looking to index, the ideal situation is to have the custodian do it," notes Kelly Cliff, head of manager research at San Francisco­based pension consultant Callan Associates. "You get a single point of contact and a bundled fee, not to mention automatic rebalancing."

That will help NT compete against smaller players. But it won't give the bank an edge against State Street, which itself is a huge custodian (II, November 2002), or Barclays, which is, after all, the largest indexer in the world.

Action alert

As exchange-traded funds have become an appealing alternative to mutual funds, money managers have been busy cooking up new versions of the popular investment offerings.

Their latest concoction: an actively managed ETF. At the moment, this is still just a promising idea, since no firm has asked the Securities and Exchange Commission for approval to sell such a fund, but it's likely just a matter of time before the product makes its debut.

Essentially mutual funds that trade on an exchange like stocks, passively managed ETFs contain stocks matching most or all of those in an index, such as the Standard & Poor's 500 or Nasdaq-100. ETFs charge no annual management fees, versus a 100 basis point fee for the average retail stock index fund, but investors do, of course, pay brokerage commissions (anywhere between $8 and $30 per trade) to buy and sell the funds. Another positive: Investors can buy and sell ETFs all day long, while mutual funds can generally be bought or sold only at the market opening or close.

Since ETFs made their debut -- the first, dubbed Spdr (for Standard & Poor's depositary receipts), was introduced by a subsidiary of the American Stock Exchange in 1993 and tracks the S&P 500 -- sales have steadily grown. The Investment Company Institute estimates that as of September $82.3 billion in assets was invested in ETFs; that's up from $65.6 billion at the end of 2000. Not surprisingly, however, mutual fund assets still dwarf those of ETFs. As of September some $6.1 trillion was invested in retail mutual funds, according to the ICI.

To fuel future growth, some money managers are eyeing actively managed ETFs. Last year, in response to growing industry interest, the SEC asked for comment on the viability of the instruments. The agency raised concerns about potential regulatory issues. But the biggest stumbling block to SEC approval is the issue of transparency.

For investors, knowing exactly what securities are held in an ETF is a crucial part of their appeal: Mutual funds only reveal their holdings when the portfolio manager chooses to, and that may only happen a few times a year. This advantage might be lost with an actively managed ETF, because portfolio managers are loath to tell the market what shares they intend to buy or sell, for fear that other investors could take advantage of that information. The problem for actively managed ETFs is that managers will presumably have to disclose their holdings, and therefore their strategies, on a more regular basis.

"Managers of actively managed funds generally avoid telegraphing their portfolio management movements, while, on the other hand, information about the contents of an index underlying an exchange-traded fund is easily obtained," Paul Roye, director of the SEC's Division of Investment Management, said in a speech earlier this year. "It is not clear how, or whether, an actively managed exchange-traded fund would communicate intraday changes in its portfolio to investors." Bruce Lavine, director of IShares product development at Barclays Global Investors, the largest provider of ETFs, agrees. "The average portfolio manager, all things being equal, prefers to work anonymously," he says.

Adds Michael Maras, head of Merrill Lynch & Co.'s global equity-linked research group: "The beauty of exchange-traded funds is their transparency. With an actively managed fund, how do you know what the fund manager holds at 11:00 a.m. that day? The logistics are going to be very difficult. Now what makes ETFs so appealing becomes a big question mark."

One way to provide transparency would be to require ETF managers to disclose their holdings -- say, twice a day, Maras says. That would provide investors with the information they need, and it would allow portfolio managers time to implement their strategies.

Since issuing its concept release, the SEC hasn't indicated whether it will approve actively managed ETFs for consumption by the public. In all likelihood, the agency won't rule on the topic until a firm submits an application. Maras figures regulatory approval is at least 18 months away. "We're looking at the possibilities," says Barclays' Lavine. "At this point, it's a work in progress." -- Justin Dini

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