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Index appeal

In the lively fraternity of money managers, indexers often seem to be the dull designated drivers. Sensible and sobersided, they charge low fees, earn modest profit margins and strictly adhere to the doctrine that since you can't consistently beat the market because it's efficient, you're better off mimicking it instead. Which they dutifully do.

Why, then, do these diligent toilers suddenly find themselves practically glamorous? During a supremely trying time for asset managers, Barclays Global Investors and State Street Global Advisors, the world's two leading indexers -- which together control 84 percent of the $1.7 trillion in global indexed assets -- are doing remarkably well at attracting new accounts.

Last year San Francisco­-based BGI reported $72 billion in net new inflows, while Boston-based State Street recorded $70 billion. That compares to an average net inflow of $5 billion registered by the universe of large, publicly traded money managers tracked by Merrill Lynch & Co. State Street, with $763 billion in assets, and BGI, with $746 billion, are gaining ground on the longtime top-ranked firm in Institutional Investor's annual list of the 300 biggest U.S. managers: Fidelity Investments, which handles $794 billion.

Because of down markets, BGI's overall assets fell $23.2 billion from year-end 2001 to 2002, making the firm the tenth-biggest dollar loser on the II 300, but the 3 percent decline is actually modest relative to those of many of its peers. State Street's assets, meanwhile, declined 2.4 percent during the same period.

"Our product is compelling. And we're happy to be dull," says State Street Global Advisors CEO Timothy Harbert.

These days, as more and more pension funds look for consistent and dependable returns in a difficult market environment, they are finding it useful to separate beta, the market return, from alpha, the excess return above a market index that reflects a portfolio manager's skill. Not surprisingly, indexers benefit from this calculus, because they provide the cheapest way to match the market.

Lee Thomas, chief global strategist at Newport Beach, California­based Pimco, believes that the focus on separating alpha and beta represents an inflection point in the history of money management. Says Thomas: "My sense is that the world is pregnant for a revolution in investment management. It feels like 1935, when people knew that the current macroeconomic thinking didn't work and then Keynes published his General Theory. The separation of alpha and beta is similarly powerful. But it will make life very tough for us active managers. There will be nowhere to hide."

What makes the two giant indexers' influx of assets so startling, and ironic, is that a good portion of it is intended for active, not passive, management. In an act of apparent apostasy that rivals a vegetarian restaurant's serving up filet mignon, both BGI and State Street, once boring benchmark trackers, have been making significant gains delivering higher-margin products beyond traditional passive investing -- enhanced index portfolios, exchange-traded funds and, at the far end of the risk spectrum, hedge funds and other high-octane active strategies. Last year BGI added $20 billion in active management mandates. In the past six months, it won a £110 million ($181 million) active U.K. equities mandate from the Fife Council, a local government authority. State Street, which has reeled in $41 billion in active mandates so far this year, recently won a £115 million active pan-European equity mandate from Exel Pensions Investment Fund.

With little fanfare, BGI has amassed $5.2 billion in 12 hedge funds since its first market-neutral strategy debuted in 1996. That total includes a U.K. hedge fund capped at $750 million that sold out in two weeks in June 2002 and a European hedge fund capped at $1 billion that opened and closed within a week last November. With about $500 million in long-short equity funds, State Street has been a little slower in developing alternative-investing strategies. "It's a top priority" to develop this business, says Alan Brown, State Street's global chief investment officer.

Significantly, nearly 30 percent of net new inflows at both BGI and State Street came from active mandates in 2002. Of BGI's fees, 55 percent came from active management last year, up from 40 percent three years ago.

Both BGI and State Street remain indexers first and foremost, and they're both far ahead of the No. 3 player, Chicago-based Northern Trust Global Investments. NT reports $180 billion in indexed assets, $120 billion of which came from the 2001 acquisition of Deutsche Asset Management's indexing business. Says Stephen Timbers, president of Northern Trust Global Investments, "We are a committed and credible third player."

Today passive strategies account for 80 percent of total assets at BGI and 60 percent at State Street. At BGI, 72 percent of assets are in stocks and 28 percent in bonds or cash; at State Street 60 percent are in stocks and 40 percent in bonds or cash.

Last year BGI's operating profit increased 41 percent, to $176.5 million. That showing may persuade BGI's parent, Barclays Capital, to abandon any lingering notions of selling off the money manager, a scenario it contemplated in 2001 and ostensibly scrapped last year. "There was a thorough strategic review, which brought home the importance and quality of this business," says Robert Diamond, chairman of Barclays Capital and BGI. "BGI is in a good situation, and Barclays is fully committed."

With double-digit stock returns now just a sweet memory, pension funds are reassessing some of the basic tenets of their investing strategies. They're paying particular attention to their mix of active and passive management, a trend that BGI and State Street have both managed to exploit.

"Funds are under stress. Instead of continuing on a steady course, they are asking what they should do differently," says Robert Litterman, head of quantitative resources at $309 billion Goldman Sachs Asset Management in New York.

Many institutional investors are focusing on one fundamental question: How much of a fund's return should be defined by the market, and how much should be defined by the excess return above the market index that demonstrates a manager's skill. Increasingly, funds are more deliberately and explicitly separating beta and alpha, with many plans choosing to use index funds for their beta exposure and hedge funds for their alpha.

Separating alpha and beta is conceptually straightforward, yet the strategy can be fiendishly difficult to execute. Says Leo de Bever, head of investments at the $45 billion Ontario Teachers' Pension Plan, "In the search for alpha, many funds will simply buy more risk and exacerbate their problems."

BGI and State Street make a persuasive case that their history as indexers, coupled with their more recent forays into active money management, leaves them well positioned to deliver low-cost beta with index funds and dependable alpha strategies with their roster of actively managed products. Says Ronald Kahn, global head of equity research at BGI: "Being active managers in a firm that offers indexed products means we are very aware that there is an alternative. It is up to us to demonstrate that the returns we offer more than make up for the added risks and costs of active management. Our heritage imposes that discipline."

Why go to a BGI or State Street for alpha instead of, say, a hedge fund? Kahn argues that the "systemization" of the investing process at BGI provides real value. "We utilize all the fundamental stock selection tools of any active fund manager," he says. "The difference is that as quants we harvest those insights in a systematic way."

Plan sponsors often underestimate how much of their returns -- and their funds' risk -- reflect market exposure and not a stock picker's choices. Says Goldman Sachs' Litterman, "What people find when they go through the process of separating alpha and beta is that 95 percent of their risk is coming from the beta of the market and only a tiny part from active management."

By definition, an index fund offers beta. Says BGI co-CEO Andrew Skirton, whose father was a winger for England's Arsenal Football Club between 1959 and 1966: "Indexing appeals to the minds of clients rather than their hearts. The case for indexing is undeniable." Adds State Street Global Advisors CEO Harbert, whose father worked as an executive on the original Tonight Show and whose brother is the head of NBC Studios: "I make presentations to pension plans with half a dozen active managers in style and market capitalization boxes. If these funds separated their alpha and beta, they would find risks and returns are nearly all beta. All they have is an expensive index fund."

And that's in no investor's interest.

BACK IN 1970, WELLS FARGO BANK introduced indexing to the money management industry. Two of the bank's financial analysts, William Fouse and Thomas Loeb (who later co-founded Mellon Capital Management), studied the work of Nobel Prize­winning economists Harry Markowitz and William Sharpe. Joining forces with academics Fischer Black and Myron Scholes, the team produced the world's first index fund. Tracking 1,000 stocks that traded on the New York Stock Exchange, the bank's index fund debuted in July 1971.

In 1975 one-year-old Vanguard Group launched its First Index Investment Trust, which tracked the Standard & Poor's 500 index. During the Roaring '80s, mutual funds took off and equity index funds came into their own. U.S. pension funds poured some $200 billion into passive strategies between 1980 and 1990; Vanguard's index fund amassed $4 billion in retail assets during the same period.

A decade ago just 19 percent of U.S. institutional equity assets were passively invested in funds that tracked the S&P 500, Russell 1000, Morgan Stanley Capital International Europe, Australasia and Far East or other popular indexes. By the end of 2002, that share had risen to 38 percent, according to consulting firm Greenwich Associates. (The comparable share for alternative strategies, including private equity: less than 10 percent.) At the same time, only 10 percent of U.S. retail equity fund assets were indexed. In the U.K., meanwhile, indexing's share of total institutional assets grew from 5 percent in 1994 to 20 percent.

Among European investors, though, indexing has never quite caught on -- it claims just 2 percent of total assets -- partly because the institutional marketplace is generally less well developed than its U.S. counterpart.

Over the years, in up and down markets, indexing has offered a simple, powerful lure: a low-cost means to match the market. Of course, since the bubble burst, money management fees have become a more pressing concern to both institutional and retail investors. Fees for an institutional index fund typically run about 5 basis points for a $100 million account, compared with 44 basis points for an active fund. Says industry veteran John Casey, chairman of consulting firm Casey, Quirk & Acito, "If the market goes up 16 percent, you don't notice paying fees of 1 percent. You do if the market is only up 8 percent."

But marketers at BGI and State Street also contend that higher-fee and potentially high-alpha strategies deserve a separate place in investor portfolios. In recent years both BGI and State Street have become more aggressive in marketing a range of strategies beyond plain-vanilla passive funds.

Both indexers have done well selling exchange-traded funds, a product that State Street launched in 1993. About $145 billion is invested in ETFs worldwide. State Street is the leading player with 32 percent of assets, compared with 24 percent for BGI. But BGI is making strides: Last year its assets under management in ETFs grew from $24 billion to $35.2 billion.

Although ETFs have a strong retail following, fast-growing enhanced index funds are increasingly popular with pension funds, foundations and endowments. Known as active quantitative strategies at BGI, these funds closely follow but do not perfectly track the benchmark index. Managers use quantitative or fundamental research to make a few targeted and risk-controlled stock bets. These semipassive, semiactive portfolios tend to have tracking errors of between 75 and 200 basis points.

Enhanced indexers typically charge about 28 basis points for a $100 million account, reports Casey, Quirk & Acito -- a little closer to an active-fund fee than a passive one.

For both BGI and State Street, those fees add up. Barclays' enhanced indexing assets totaled $96 billion at the end of 2002; State Street's hit $25 billion. Last year BGI added $19 billion and State Street $11 billion in these products. As institutional investors pare their rosters of money managers in an effort to cut costs, enhanced indexing offers an appealing middle ground between active and passive management. With relatively low risk for the returns they generate, these funds have been able to deliver fairly dependable alpha.

ABP Investments, the E130 billion ($149.5 billion) fund management arm of Europe's biggest pension fund, is an advocate of enhanced indexing. Introduced three years ago, enhanced index strategies now comprise about 22 percent of ABP's equities portfolio. Though Jan Straatman, head of equities at ABP Investments, won't comment on ABP's external managers, he does believe that indexing specialists enjoy a natural advantage in running such strategies: "These products are all about implementation, and implementation is what indexers understand best."

BGI got into the enhanced indexing game early, launching its first active quantitative strategy, U.S. Alpha Tilts, back in 1985. With an annualized alpha of 1.17 percent, it ranks in the top decile of active fund performance since inception, though it has one third of the tracking error of the average active fund. Outside the U.S., BGI's European and U.K Alpha Tilts products boast 11-year track records with annualized alpha of 1.27 percent and 2.24 percent, respectively.

Looking to draw on BGI's expertise as a quantitative money manager, BGI co-CEO Blake Grossman decided in 1996 to try the manager's hand at hedge funds. Says Grossman: "Our active quantitative models ranked thousands of stocks a day, but we couldn't sell any of them short. Half the available alpha was just being wasted."

Consultant Casey notes that "BGI learned the importance of dependability in their indexed products and made it a basic tenet of its active strategies. It took the technology of indexation, portfolio construction, cost control and optimization and moved it into the mainstream of active management and hedge funds."

Although both BGI and State Street aim to raise their profiles as active managers, the bulk of their assets will continue to be indexed. In the U.S, where indexing claims nearly four out of every ten institutional dollars, the category may gain some market share but probably nothing dramatic. "Indexing in the U.S. institutional arena is a mature business," admits BGI's Skirton. In the U.K. indexing's 20 percent share of institutional assets might reach 30 percent in the next few years, suggests Nigel Wightman, head of State Street Global Advisors in the U.K. On the Continent indexing's market share should grow, suggests ABP's Straatman. "I don't think indexing in Europe will reach the levels it has in the U.S.," he says, "but it will certainly grow from here, perhaps to U.K. levels."

At Northern Trust Global Investments, Timbers sees opportunity in the privatization of social security systems -- if and when that happens. "Indexing, because of its low cost, is the natural default option for governments," he says.

Whether or not the recent gains in global equity markets prove to be lasting, investors will continue to reassess their investing strategies in an environment of modest returns and heightened risk awareness. If institutional investors continue to focus on a separation of alpha and beta as part of that reassessment -- a likely bet -- the world's two largest indexers can look to consolidate their already strong positions.

Says BGI co-CEO Skirton: "Investors want dependable, low-cost beta, and where there is alpha, they will pay for it. We offer both. The firms that are under threat are those that don't have an alpha proposition and can't offer beta. That's a lot of mainstream money managers."