In December, after a six-month search, the California State Teachers' Retirement System selected three fund-of-funds managers to handle a $600 million equity mandate. That's business as usual for the 90-year-old public pension fund, but this time there is a twist: For the first time, the fund-of-funds managers are doling out the $600 million to a group of emerging money managers -- firms with less than $2 billion in their portfolios.
"We are trying to reach for the stars of tomorrow," says Real Desrochers, director of alternative investments at $107 billion-in-assets CalSTRS.
CalSTRS joins a growing group of institutional investors turning to emerging managers. For example, the $24 billion-in-assets Colorado Public Employees' Retirement Association recently allocated $60 million to small money managers. Traditionally, plan sponsors have excluded small or young firms from their searches because they worried that the firms' executives didn't have the experience or industry knowledge to run a money management business.
In a recent study San Franciscobased Progress Investment Management Co., a manager-of-managers, found that the industry's big players, U.S. asset managers with $20 billion or more, handle 87 percent of total assets.
When they do turn to small money managers, many pension funds (like CalSTRS) rely on the expertise of managers-of-managers to make choices, but others select the stock pickers on their own.
Many emerging managers boast superior performance. According to a study of 756 U.S. equity money managers by Chicago-based Northern Trust Global Investments, emerging managers beat the Standard & Poor's 500 index by 310 basis points from year-end 1997 through 2002. During the same period bigger firms outpaced the S&P by 170 basis points.
A separate study by United Investment Managers, a unit of Gray & Co., an Atlanta-based consulting firm that offers a fund-of-funds emerging-manager product, found that smaller firms comprised 43 percent of the top-quartile performers of 508 large-cap equity managers while only making up 38 percent of the overall sample.
"Plan sponsors have been missing out on these managers," says Ivory Day, managing director at UIM.
Consultants and plan sponsors point to several advantages of hiring small money managers. They're often able to move more nimbly in and out of stocks, because their smaller positions tend not to affect prices. Small firms can also buy less liquid stocks than larger money managers might accept, and they can be less bureaucratic and more focused, in part because their top investment professionals often own equity stakes in the firm. That gives them an added incentive to deliver strong returns.
In addition, small managers often provide more personal client service, such as access to senior management, especially a firm's chief investment officer.
"Some consultants or funds actually prefer dealing with smaller firms because with them they will be a much higher profile client," says Michelle Clayman, managing partner and chief investment officer at New Amsterdam Partners, a New York emerging manager. Adds John Krimmel, chief investment officer at State Universities Retirement System of Illinois, "They are certainly more quick to respond."
When the three owners of Piedmont Investment Advisors set up shop in Durham, North Carolina, back in August 2000, they knew they would have to offer better client service than larger rivals. What they didn't anticipate was the most prolonged bear market in stocks in 70 years. Nonetheless, Piedmont managed to grow its assets under management to $315 million as of November. The firm's core product has beaten the S&P 500 index by an average of 300 basis points a year for the past three years.
How did Piedmont do it? Credit a simple, effective investing strategy: Holding a concentrated portfolio of 30 to 35 stocks, screening for revenue growth rates, profit margins, return on invested capital and cash flow.
To succeed, emerging managers need to distinguish themselves, says Isaac Green, Piedmont's president and chief investment officer. "You have to be able to offer plan sponsors something different," he notes. Among Piedmont's clients: Durham's $211 million-in-assets North Carolina Mutual Life Insurance Co., and $98 million-in-assets Mutual Community Savings Bank, as well as North Carolina's $52 billion-in-assets retirement system.
"If you look at a smaller group, they are much hungrier, have a lot to prove, and haven't typically enjoyed a lot of the success and financial rewards that a lot of the large firms have," says Christopher Reilly, portfolio manager of alternative investments at Colorado PERA.
Of course, large money managers offer greater breadth in research and, typically, a longer track record than small firms. "Large firms bring industry expertise and depth of knowledge," says Bill Stromberg, director of equity research at T. Rowe Price Group. "They have the experience and tenure of people across styles to help develop the next generation of managers."
To identify the best boutiques, many plan sponsors use managers-of-managers, who typically charge their own fees of 12 to 50 basis points for equity funds, in addition to the individual fund manager fees. Among the leaders in this field are Gray, Northern Trust and Progress Investment Management Co.
Generally, these firms track data on new money managers, keeping an eye on the talented professionals within a large asset management firm who may someday want to go out on their own. "They often are managers who have been very successful in an organization," says Kevin Rochford, managing director of global sales and client servicing at Northern Trust. "You have to identify them early so that you are ready when he or she makes his move."
When Piedmont's Green made his move in 2000, he was working as the chief investment officer in the Detroit office of Loomis, Sayles & Co. Earlier in his career he had managed all investment activities at Durham-based NCM Capital Management Group and had a similar role at one point at Loomis. He was eager to get back to stock picking.
"At a big firm one has no choice but to dance to the music that is being played," Green says. "We didn't want to run money that way. We wanted to articulate a new investment product."
Piedmont's first clients were Green and his two partners, who poured the bulk of their retirement money into an IRA at their new firm. North Carolina Mutual Life Insurance and Mutual Community Savings Bank liked what they saw in terms of performance and experience, tapping Piedmont in 2001. It was followed a year later by FIS Funds Management, a Philadelphia-based manager-of-managers.
Emerging managers like Piedmont are always on the lookout for funds like Illinois's $11 billion-in-assets SURS. It started an emerging-managers program in 1997, investing in firms with $500 million in assets or less. One mandate, valued at $122 million in December, was placed with Northern Trust, which directed the money to a group of 13 emerging managers, including Bramwell Capital Management, Kenwood Group and Keeley Asset Management Corp. Collectively, the funds have equaled a customized benchmark based on the Russell 3000 and Lehman Brothers aggregate bond indexes, with an average annual return of 10 percent since inception in 1997.
Still, other plan sponsors don't feel the need to add an extra layer of fees for a manager-of-managers. The $14 billion Ohio Bureau of Workers' Compensation, for example, has handpicked its own roster of 30 emerging managers who run $500 million for the Ohio bureau. "We typically see little need to pay a middleman to manage the funds on our behalf," says chief financial officer Terrence Gasper. "We are confident that our internal staff is very capable of executing manager selection and monitoring."
Recently, one of the Ohio bureau's emerging managers, Prima Capital Management Advisors, a Scarsdale, New Yorkbased firm that specializes in commercial-mortgage-backed securities, graduated and received its own full-fledged mandate as a money manager from the state plan.