Euro 100: Size smatters

European money managers face ever more demanding clients, who are suspicious of size -- and increasingly skeptical about the promises of active management.

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“It is no longer enough to walk into a client presentation, beat your chest and say ‘I’m huge,’” says Alan Brown, acting co-CEO of Boston-based State Street Global Advisors, the world’s largest institutional money manager. “When we make our presentations, we rarely mention our trillion dollars in assets. These days size can actually put people off.”

State Street, with $1.2 trillion in worldwide holdings, isn’t trying to shrink, and Brown isn’t turning away paying customers. But, as many other money managers will agree, in today’s tough market investors are leery of supersized firms and increasingly drawn to the concentrated focus of investment boutiques. At the same time, all managers, big and small, face intensified pressure to outperform their benchmarks -- to actually deliver the alpha they have promised (and billed for). As more and more pension funds turn to index funds for their beta and high-octane strategies such as hedge funds for their alpha, traditional active managers are feeling the pinch.

“It’s a very gloomy picture for the large, incumbent active asset managers,” says Hugh Willis, CEO of London-based bond boutique BlueBay Asset Management. Willis is hardly a disinterested observer -- his three-year-old firm now manages $1.5 billion in a mixture of hedge funds and aggressive long-only strategies -- but he voices a common refrain. “Clients are waking up to the fact that many so-called active managers are indexers in drag. These firms are going to struggle to justify their existence,” he adds.

“Good active management, the generation of alpha, is capacity-constrained,” contends Simon Davies, CEO of London-based Threadneedle Investments, a midsize firm with E77 billion ($97 billion) under management at year-end 2003. “There is more skepticism now about firms with hundreds of billions of euros than at any time in the past decade. That skepticism is healthy. There are some very dysfunctional firms around.”

Pain is being felt broadly across the industry as asset totals stagnate and profits come under siege. In the past decade, according to London-based consulting firm Mercer Oliver Wyman, average operating margins for fund managers worldwide have fallen from 32 percent to 23 percent.

Talented portfolio managers are decamping to hedge funds, and the impact can be seen in the most senior ranks of European money managers, especially at those firms buffeted by the U.S. mutual fund scandals. They are feeling acute pressure to increase revenues and bolster profits. Last year total assets of Institutional Investor’s Euro 100 grew by only 5.3 percent, to E14.5 trillion, despite strong equity market appreciation -- a 28.7 percent rise in the Standard & Poor’s 500 index and a 17.4 percent gain in the MSCI EAFE index.

Taking top honors for the seventh straight time is UBS, followed by Allianz Group, which appears in second place for a second consecutive year, followed by Barclays Global Investors, which soars from sixth place to third on the strength of both index funds and hedge funds.

Yet some of the biggest players in the Euro 100 reported asset declines, reflecting institutional and retail outflows. Credit Suisse Group saw total assets fall by 4 percent, from E798 billion to E769 billion, with its ranking slipping from No. 3 to No. 5. The total includes insurance portfolios and private banking accounts; its asset management arm, Credit Suisse Asset Management, fell by 10.7 percent in assets, in part because of the dollar’s weakness (overall, dollar assets rose from $297 billion to $318 billion). “The end of the bull market has changed client expectations, and we have worked hard to change our product range accordingly, emphasizing high-alpha specialist asset classes,” says Robert Parker, global head of institutional fund management at CSAM.

Amvescap, which in October paid $450 million to settle U.S. state and federal charges of improper trading, falls three places, to No. 12, reflecting a 7 percent decline in assets, from E317 billion to E295 billion. Amvescap reports in dollars and sterling, which made it one of several firms hurt in the rankings by the relative weakness of the dollar against the euro.

Merrill Lynch Investment Managers suffered the steepest drop in the rankings, moving from No. 32 to No. 44, with its assets down from E109 billion to E93 billion, as its European business, the heritage Mercury Asset Management -- bought with great fanfare for a hefty $5.3 billion seven years ago -- continued to struggle with poor performance, client dismissals and staff defections. At year-end 1997, just after the deal closed, Merrill ranked No. 11. “It looks like it’s in a critical stall,” says one London-based consultant.

“It is certainly a fashionable view that boutiques will outperform the big firms,” says CSAM’s Parker. “Size is seen as being a metaphor for slow-moving, mediocre managers. Fashion ebbs and flows.”

Boutiques, some decades old, others just start-ups, are thriving. London-based Marathon Asset Management debuts in the Euro 100 at No. 99, with E17 billion in assets. In the three years ended December 31, 2003, Marathon topped the charts of all global equity managers, with an average annual return of 27 percent. Launched 18 years ago, the equity shop derives 58 percent of its assets from U.S. pension funds, which have traditionally been more willing to hire boutiques than have U.K. and European pension funds.

That’s changing, though. Take the case of Majedie Asset Management. Founded 20 months ago by defectors from Merrill Lynch Investment Managers’ alpha team -- Christopher Field, Robert Harris, Adam Parker and James de Uphaugh, all of whom are U.K. equity managers -- the firm already manages £1 billion ($1.8 billion). It has notably snared clients from Merrill, with the pension funds of Ciba Specialty Chemicals and Firth Rixon awarding the team £26 million and £20 million, respectively. Three months ago Majedie won its first local-authority client, the Surrey County Council Pension Fund, which awarded it a £45 million specialist U.K. equity mandate. (Surrey also handed £100 million to Marathon.) The biggest loser with Surrey was No. 6ranked Deutsche Asset Management, which saw a £330 million balanced account terminated.

DeAM has been especially hard-hit -- assets dropped from E726 billion to E567 billion -- but these days many clients of big money managers are increasingly skeptical about the virtue of size and the promise of active management. As Paul Berriman, U.K. CEO of DeAM, sees it, clients have significantly raised the bar for active money managers. “In the 1990s the core product for active firms was aimed at beating indexes in bonds and equities by 1 percentage point,” Berriman says. “With markets going up by double digits year after year, that made sense to clients. It doesn’t any more. Pension funds want index plus 3 or 4 percent.”

Recognizing the harsh truth that most active money managers will underperform the market, pension funds are looking to gain market exposure efficiently and inexpensively with index or enhanced-index funds; they then devote separate slices of their portfolios to higher-cost alpha strategies.

In a June survey of U.S. institutional investors by Darien, Connecticutbased consulting firm Casey, Quirk & Associates, 37 percent said they expected to significantly reduce allocations to long-only active managers in favor of indexing or hedge funds or both.

Benefiting from the increased popularity of index funds, Barclays Global Investors and State Street Global Advisors have both moved up smartly in the Euro 100 rankings, which measures global assets of European-based companies and European-derived and European-invested assets of non-European-based firms. The biggest gainer in the top ten, BGI rises three places to No. 3, while archrival State Street rises from No. 23 to No. 18. Together the two indexers reported E189 billion in asset gains between 2002 and 2003. That’s more than 25 percent of the E728 million in total gains of the Euro 100.

In their search for alpha, more and more institutional investors are placing mandates with hedge funds -- which BGI and State Street also happen to peddle aggressively. Casey, Quirk projects that net flows to hedge funds from U.S. institutions will exceed $100 billion by 2005, up from an estimated $66 billion at the end of 2003. In 1998 assets of the entire hedge fund industry totaled $100 billion. Today hedge funds control an estimated $817 billion worldwide, according to Chicago-based Hedge Fund Research.

The struggles of the top firms represent quite a turnaround from the 1990s, when the prevailing wisdom was that bigger was better, a philosophy codified in a seminal 1995 Goldman, Sachs & Co. report titled “The Coming Evolution of the Investment Management Industry.” It concluded, among other things, that some two dozen global behemoths would emerge to dominate the industry, while boutiques would flourish. Many midsize players, firms with assets of less than $150 billion, would gradually disappear.

Much of the report has come true: Subsequent years saw a rash of multibillion-euro cross-border deals, which created many of the big firms that lead this year’s Euro 100. Among the recently configured giants: Allianz Group, fourth-ranked AXA Group and UBS.

The late 1990s deal making set off an initial wave of industry consolidation: The top 25 firms in the Euro 100 saw their share of total assets increase from 55 percent in 1993 to 69 percent in 2001. But since then the industry has grown decidedly less concentrated, with the top 25 firms in the current ranking controlling 54 percent of assets. Despite the rash of mergers and acquisitions, the industry is actually slightly more fragmented than it was a decade ago.

Yet the middle ground has not disappeared. Indeed, it’s home to some thriving businesses.

Some midsize firms, such as Milan-based Pioneer Investments, which rises three places to No. 32, benefit from a captive distribution network -- in Pioneer’s case, the banking network of its parent, Italian bank UniCredito, which sells a wide range of Pioneer investment products to its customers.

Other midsize firms are reaping the benefits of strong stock pickers. No firm jumps more places than Edinburgh-based, E38.5 billion-in-assets Baillie Gifford & Co., which moves up seven places to No. 76 on the strength of exceptional performance in U.K. and international equities. An old-fashioned partnership, the firm has won mandates from the likes of Bank of Scotland, Indiana Public Employees’ Retirement System, Ontario Public Service Employees Union and the City of Zurich Pension Fund. In fact, the firm has gotten so much new business -- E6 billion in 2003 alone -- that earlier this year it closed two portfolios to new accounts.

“Quite a lot of our success must be put down to focus,” says Ross Lidstone, one of the firm’s 27 partners and the head of international marketing. “We have no ownership distractions, our people stay with us, and we only do asset management. So managing our clients’ money is absolutely at the top of our list.”

Not surprisingly, the big money managers are fighting hard to defend their turf. In March, DeAM’s Berriman introduced seven semiautonomous investment teams, where portfolio managers and research analysts, who had been separated, work closely together. That’s an increasingly popular move at large firms, one designed to create boutiques within the behemoth (see box, page 105). “The aim is to capture the benefits of a boutique structure -- in particular, accountability,” says Berriman.

Credit Suisse Group and London-based Henderson Global Investors (ranked No. 38), among others, have adopted similar strategies.

One effect of the renewed popularity of boutiques is a rise in the compensation of sought-after portfolio managers. After several years of bear-market-induced cost-cutting, firms are once again paying up for virtuoso stock pickers. According to Andrew Doman, head of the asset management practice at McKinsey & Co. in London, asset management pay has risen by about 17 percent since the end of the bear market in early 2003; today an equity portfolio manager earns an average E345,000 in salary and bonus.

How might the big money managers yet prevail? Imran Gulamhuseinwala, a consultant at Mercer Oliver Wyman, calls for a radical restructuring of giant asset management organizations. He thinks firms should separate their businesses between professional clients (broadly, institutional) and nonprofessional clients (broadly, retail). He contends that professional investors buy performance and nonprofessional investors buy brands. Currently, most money managers segment their investment groups by asset class, with sales, marketing and client service as separate organizational units.

“In a bull market firms could blur the issue, but that’s no longer true,” says Gulamhuseinwala. “You need a very different style of business to succeed in retail and institutional marketplaces.”

On the other hand, John Ghillies, director of European consulting at investment consulting firm Frank Russell Co., believes that the current sentiment against big firms will run its course. Russell, he notes, continues to find good fund management across a broad array of firms. Still, the notion that size is a good in itself should be jettisoned, he says.

“Money does not buy success. There are very big organizational issues that need to be gotten right,” Ghillies says. “The big players have to make their resources work for them, but making size work for you is tough. In the period between 1793 and 1810, the Austrians could put more men in the field, but they didn’t win a single battle. Why? They didn’t have Napoleon Bonaparte.”

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