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The II300: Passive aggressors

Led by State Street Global Advisors, indexers take the top two spots in our annual ranking of the biggest money managers in America. What does it mean?

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It started as a sideline. In 1978, when State Street Bank & Trust Co. launched an asset management division, the plan was to sell a few of the newfangled index funds to the bank's bread-and-butter custody customers. They were a captive audience, the bankers reasoned, so why not?

A quarter century later that once-peripheral business, State Street Global Advisors, boasts $1.1 trillion in assets and appears at the top of Institutional Investor's annual ranking of America's largest money managers, based on their reported assets as of December 31, 2003.

SSgA displaces Fidelity Investments, dominator of the II 300 for a decade. But this is no mere shuffling of the ranks among giant firms. The ascension of SSgA marks a symbolic turning point in money management -- the first time that an "indexer" has emerged as the largest U.S. asset manager. Underscoring the point, another indexer, Barclays Global Investors, places second on the II 300, with assets of $1.07 trillion.

What's more, this is the first time that the No. 1 firm, much less the second-place finisher, has reported assets of more than $1 trillion. In last year's II 300, which covered firms with assets under management at year-end 2002, then-leader Fidelity had assets of only (if that's the word) $794 billion. SSgA, on its heels, recorded assets of roughly $763 billion.

1The II 300 as a group set a pretty impressive record of their own last year: $21.7 trillion in combined assets -- an 18 percent increase over year-end 2002 and a 16 percent increase over peak-of-the-bubble 1999. Just to crack the list, a firm had to have $4.3 billion under management. (No. 300 is Philadelphia International Advisors.)

What makes the show of muscle by the big indexers in this year's II 300 all the more noteworthy is that No. 3 Fidelity had a strong year in 2003 (see box). The mutual fund giant's assets climbed more than 21 percent,

to $964 billion, and it captured 13 percent of the $232 billion that flowed into long-term stock and bond funds last year -- putting it third among fund families, behind Capital Group Cos.' American Funds and Vanguard Group.

That, however, wasn't enough to stave off the benchmark-peddling behemoths. SSgA's assets surged by about 44 percent, and BGI's rose close to 43.5 percent. Is this truly the triumph of the indexers? Yes and no. SSgA and BGI continue to gather large institutional indexing accounts, but, surprisingly, it is those firms' enhanced index and active products that have really taken off.

SSgA CEO Timothy Harbert says that 2003 "was a watershed year." BGI co-CEO Blake Grossman is more restrained. Referring specifically to breaking the $1 trillion mark, he says, "It's a nice milestone, something to take notice of, but there was no celebration."

Neither firm likes to think of itself solely as an indexer. "We're meeting needs across the risk-return spectrum, doing more different things for clients," says SSgA's Harbert. Indeed, not all of SSgA's 3,190 clients are plain-vanilla indexers, by any means; 950 of them go to the firm for more than one investment product. In fact, what's been driving the Boston-based indexer's spectacular asset gains of late are those enhanced indexing and active quantitative strategies. Harbert calls them one of the fastest-growing parts of the firm's business.

Of course, like most mainstream money managers, SSgA and BGI also profited from resurgent equity markets. How bittersweet to recall in mid-2004's torpid markets that in 2003 the Standard & Poor's 500 index was up 28.7 percent and the MSCI EAFE index gained 35.3 percent in dollar terms. Though less sensational, the bond market, too, had a solid year in 2003; the Lehman Brothers U.S. aggregate bond index rose by 4.1 percent.

Still, the indexers' outsize gains testify in part to what appears to be a pervasive dissatisfaction with traditional active money management. Frustrated pension fund managers are groping for risk-controlled investment strategies that function in all market environments, not just bubbles. The upshot has been a growing trend in which plan sponsors make asset allocations to systematically detach beta, or market return, from alpha, or better-than-market return resulting from (in theory) pure portfolio management skill.

"Plans have been increasingly separating out the alpha components in their portfolios from the beta," confirms Robin Pellish, CEO of pension consulting firm Rocaton Investment Advisors in Norwalk, Connecticut. That, she adds, "plays right into the hands of the indexers, because they are the logical choice for these risk-controlled strategies."

For a start, they already have huge client bases, along with ready-made infrastructures to handle enhanced indexing and risk-controlled active quant. Nonetheless, Pellish suggests that as pension plans seek ever-more-sophisticated ways to cordon off alpha, indexers could come out on the losing end. Many successful alpha strategies now employ managed futures to achieve equity exposure. These typically take just 5 percent of alpha-designated assets, leaving 95 percent for hedge funds.

This is mixed news for indexing firms. On the one hand, they stand to lose some passive money to alpha gambits; on the other, they can go after alpha money themselves by offering hedge funds. Usually, plan sponsors carve out new alpha mandates for things like hedge funds from their active management allocations -- putting more pressure on traditional managers. Both BGI and SSgA already sell hedge fund strategies.

That market is on a roll. For the II 300 firms, alternative assets totaled $649 billion at the end of 2003, up 23 percent from $525 billion in 2002 and a dramatic 280 percent jump from 1998's $171 billion.

"I'm seeing three types of institutional clients looking for hedge fund-of-fund strategies," says Joel Katzman, CEO of J.P. Morgan Alternative Asset Management, which manages $8 billion in funds of hedge funds. "The first camp I'd describe as conservative; those pension funds strictly looking for diversification -- mainly a lot of arbitrage strategies. Then there's the return-enhancement crowd, which tends to be willing to put up with more volatility and prefers directional strategies. The third camp likes a blend of the first two approaches."

Although both SSgA and BGI have been busily hawking their alternative-investment strategies, San Francisco­based BGI has made the greater headway. About 77 percent of its $780 billion in equity assets is in index funds, and 23 percent is in active strategies. That includes $6.9 billion in 12 hedge funds and various risk-controlled active quant strategies. By contrast, of SSgA's $621 billion in equity assets, 91.3 percent is in traditional or enhanced index accounts and 8.7 percent is in quantitative active strategies, including $2.3 billion in hedge funds.

"Both BGI and SSgA have been able to successfully break out of the pure index mold in recent years and are going to be strong competitors for alternative mandates in years ahead," says Rocaton's Pellish.

The two indexers have also been pulling in more and more new mandates for their enhanced index funds, whose portfolio managers closely follow but do not perfectly track the benchmark. Using quantitative or fundamental research to make a few strategic and risk-controlled bets, enhanced index funds report a tracking error of between 75 basis points and 200 basis points.

The indexers can charge pension plans a 28-basis-point fee on a $100 million enhanced index account, according to Darien, Connecticut­based consulting firm Casey, Quirk & Acito, which is a lot richer than the 5 basis points they would be collecting on no-frills indexes of the same size. Of course, that's still less than the 45 basis points or so that active managers can command.

SSgA and BGI have been, moreover, aggressively and quite successfully putting themselves forward as managers of exchange-traded funds. ETFs, which State Street introduced in 1993, are now a $160 billion market. SSgA's ETF assets total $63 billion, slightly behind BGI's $67 billion. Bank of New York ranks third, with $20 billion in ETF assets; Merrill Lynch and Vanguard Group run a distant fourth and fifth, with $5 billion and $1 billion in ETF assets, respectively.

Healthy long-term asset growth is also taking place on the opposite end of the alpha-beta barbell -- the boring core beta side. Greenwich Associates estimates that 40 percent of the $2.5 trillion in U.S. institutional equity assets was passively invested as of June 30, 2003, the most recently available data. That's up from 30 percent a decade ago. Still, although conventional indexing continues to generate steady business for firms like BGI and SSgA, both are seeing active inflows starting to catch up to index flows. BGI, for instance, reports that its net inflow into traditional equity and fixed-income indexed assets was $37 billion last year. By contrast, the firm pulled in $33 billion net in active money, in active quant and hedge fund strategies.

In the U.K., where institutional equity assets totaled $530 billion as of June 30, 2003, indexing claims a 31 percent share, up from 22 percent in 1994. Analysts estimate that in Asia indexed assets accounted for less than 10 percent of market share.

Between them, SSgA and BGI lord it over the benchmark business, controlling 57 percent of the global indexing market. Still, the passive powerhouses face serious competition. Northern Trust Global Investments looms as an ambitious No. 3 among institutional indexers, especially after having paid $124 million last year to acquire $65 billion of Deutsche Asset Management's $80 billion in indexing assets. In this year's II 300, Northern Trust jumps from 19th place to 12th place, with its assets having grown nearly 59 percent, to $479 billion.

"Before the Deutsche deal, when an institutional investor did a search for an indexer, the list of candidates was always two firms long -- BGI and SSgA," says Terry Toth, president of Northern Trust. "What the industry needed was a solid No. 3, and that's where we come in." Like its bigger rivals, Northern Trust is also pursuing active quant and enhanced index business.

Vanguard, meanwhile, is a mighty indexer in the U.S. retail market. At the end of May, its total fund assets (including those farmed out and therefore not counted in II's tally) stood at $728 billion, of which $297 billion was indexed, up from $225 billion a year earlier.

In the U.K. and Europe, BGI and SSgA face only one significant rival: Legal and General Group, a U.K.-based insurer, which had $245 billion in worldwide assets at year-end 2003.

The very first index fund was created by a team at Wells Fargo Bank, which had enlisted leading finance theorists Fischer Black and Myron Scholes. The bank's index fund, an equal-weighted compendium of 1,000 stocks that were traded on the New York Stock Exchange, made its little-remarked-on debut in July 1971.

Four years later, in the spring of 1975, Vanguard introduced the first index fund geared toward retail investors; this product, dubbed the First Index Investment Trust, was based on the increasingly popular S&P 500 index. After a slow start -- Vanguard's index fund assets totaled just $80 million by 1980 -- passive investing began to gain more acceptance in the 1980s. Total assets invested in passive strategies grew from less than $10 billion in 1980 to $270 billion ten years later. Indexing remained a fringe strategy in the U.K. and Europe until the 1990s, when it caught on just as its popularity was growing in the U.S. By the end of 1995, indexed equity assets totaled $400 billion worldwide.

SSgA was tough-minded in its pursuit of indexing, occasionally playing hardball to win new accounts. In the mid-1990s, for example, the firm decided to charge the California Public Employees' Retirement System no fee for its index portfolio management services, a move aimed at landing the huge pension fund's securities-lending business. Rival indexers cried foul, but SSgA refused to back down. To this day it charges exceptionally low fees, leveraging its indexing business by making money in securities lending, transition management and capital markets businesses.

"There were people who said we were lowballing," says SSgA's Harbert, "but you know what? Our technological infrastructure allowed us to offer such competitive fees."

For years SSgA struggled to make inroads in the U.K. and European pension markets. Through 2001 it had garnered just $40 billion. But State Street's 2002 purchase of Gartmore Global Investments' $25 billion indexing business gave it a major boost, and last year alone European clients delivered $25 billion of new assignments to SSgA, up from $5 billion just three years earlier. State Street's early 2003 acquisition of Deutsche Bank's custody operation, which boasts a dominant market share in Europe, should help open even more doors.

"Nothing comes easy," says Harbert, "but we were always prepared for the long haul."

Rival Barclays PLC acquired an indexing business that had been in the game a long time. In June 1995 the British bank announced that it would pay about $440 million for Wells Fargo Nikko Investment Advisors, which at the time had more than $170 billion under management, most of it in index funds. Barclays merged WFNIA with its own, smaller indexing operation, which had been selling passive portfolios in the U.S. and Europe since the mid-1980s. By the end of 1996, the combined entity, Barclays Global Investors, reported assets of about $400 billion. Four years later assets at BGI hit $800 billion.

Of course, the headlines in money management last year were not about solid growth but about the unprecedented mutual fund scandals. The story broke on September 3 when New York State Attorney General Eliot Spitzer announced that he was issuing a complaint against New Jersey hedge fund manager Canary Capital Partners. Spitzer charged that Canary had engaged in late trading in collusion with Bank of America Corp.'s Nations Funds. Spitzer later charged three other major mutual fund groups -- Janus Capital Group, Bank One Corp. and Strong Capital Management -- with abetting market-timing of fund shares by hedge funds and other favored clients who in return committed large amounts of longer-term assets. Spitzer's investigation spurred the Securities and Exchange Commission as well as Massachusetts Secretary of the Commonwealth William Galvin to follow suit. Soon MFS Investment Management and Putnam Investments were dragged into the mire.

Although the news sparked client defections and investor redemptions, some scandal-tarred fund families eked out asset gains for the year. Once again market appreciation wielded a power of its own. In addition, as one money manger after another became implicated in the widening scandals, investors seemed to become inured to the bad news.

Says Christopher Brown, an analyst with Financial Research Corp., a Boston-based provider of fund industry data: "When it became clear that more and more firms were being implicated, the pension plans had to stop and say 'Hey, wait a minute. Are we going to fire every manager that gets hit?'"

Despite the market-timing charges against Alliance Capital Management, parent company Axa saw its assets grow from $430 billion to $547 billion; its ranking jumps from No. 9 to No. 8. Its AllianceBernstein Institutional Investment Management reeled in major new accounts in the pension arena. Bank of America, one of the original four fund families charged with wrongdoing -- it later settled charges of late trading -- saw assets increase from $306 billion to $330 billion; its ranking moves down a notch, from No. 17 to No. 18. Even Janus Capital managed a small gain, from $138 billion to $151 billion, though its ranking slips from No. 39 to No. 41.

On the other hand, Strong assets fell from $39 billion to $38 billion, its ranking dropping from No. 79 to No. 89. Putnam Investments' assets declined from $251 billion to $240 billion, and its ranking falls from No. 23 to No. 27.

By and large, individual investors appear to be a forgiving bunch. But will institutional investors be as charitable toward lackluster active managers when eager indexers are ready to chase alpha and bank beta for them? Ron O'Hanley, institutional chief of Mellon Financial Corp, No. 6 on the II 300 list, insists that the current trend of setting allocations to indexing, enhanced indexing and risk-controlled quants on one side of the plate, and hedge funds and other alternative investments on the other does not doom active managers. "They can still add alpha -- not all can, but some can," he points out. "The key is to be part of the group that can." How hard can that be?


Fidelity passes the baton

Fidelity Investments' decadelong run as America's biggest money manager is over: The Boston-based mutual fund giant has been pushed to third place by State Street Global Advisors and Barclays Global Investors. But Fidelity still enjoyed a terrific year in 2003, with assets up from $794 million to $964 billion. Peter Lynch's progeny, the flagship $65 billion Magellan Fund, may have lagged the Standard & Poor's 500 index by more than 400 basis points over the past 12 months, but performance has been strong across the board at Fidelity's more than 500 mutual funds. According to Lipper, nearly 40 percent of Fidelity funds with three-year histories are ranked in the top quartile.

Although the privately owned firm remains focused on its core mutual fund business, over the years it has moved into related endeavors that are now kicking in meaningful revenues. In 2003 roughly half of Fidelity's operating revenues came from sources other than asset-management fees, such as pension outsourcing and brokerage. "It's all about diversity -- new sources, new products, new markets," says COO Robert Reynolds. "You don't grow just to grow. But at the same time, if you aren't growing assets . . . well, that is a dangerous sign."

Fidelity's growth and diversification didn't happen overnight. A quarter-century has passed since the firm opened its discount brokerage arm; its 401(k) recordkeeping operation debuted in the mid-1980s; and total-benefits outsourcing followed in the mid-1990s. Fidelity's open-architecture 401(k) platform, which has been expanded in recent years to include more than 800 non-Fidelity funds on top of 143 Fidelity funds, is increasingly being used by plan sponsors to offer rival investment products. In addition, the firm's total benefits outsourcing business has grown considerably.

Overseas, Fidelity continues to expand with determination. Fidelity International runs $182 billion for non-U.S. investors. After more than a decade in the U.K., the firm ranks as the country's biggest retail fund manager, with assets of £15 billion ($27 billion) at year-end 2003. In Japan, Fidelity is the 19th-largest money manager (retail and institutional), with $7.6 billion in assets.

And the firm has even stolen a page from the rivals that overtook it: Last fall, Fidelity launched its first exchange-traded fund. Built like index funds and as liquid as stocks, ETFs appeal to investors as lower-cost alternatives to mutual funds. Fidelity's ETF, the ONEQ, tracks the Nasdaq composite index; it had pulled in $126 million as of May 31.

Still, Fidelity faces certain constraints that indexers can ignore. State Street and BGI have quantitative models that allow for assets to grow without limit; Fidelity's active management approach is limited by the need to close funds to new accounts when they become too large. At the end of July, the Fidelity Advisor Mid Cap Fund, which has doubled to $7.4 billion during the past two years, will close to new investors. -- R.B.


Grantham, Mayo: Against the grain

Few value managers suffered as much during the bubble years as did Grantham, Mayo, Van Otterloo & Co. As performance lagged and clients fled, the privately held firm saw assets plunge from a 1998 peak of $31 billion to a mid-2001 low of $20 billion -- roughly a 35 percent decline.

But instead of cutting costs and laying off staff, the famously contrarian Jeremy Grantham, co-founder and chairman of the Boston-based firm, chose to invest in client service, sales and marketing. He boosted his firm's head count by some 50 percent and diversified the business into hedge funds and timber management. GMO pulled in new mandates and delivered good performance, and assets grew to $27 billion by year-end 2002. Last year, on the back of strong performance, with portfolios positioned defensively, assets soared to $55 billion.

The firm, whose ranking moves up from No. 97 to No. 73, won more than $13 billion in net new mandates in 2003, by far its best year ever. GMO's red-hot emerging-markets equity portfolio, managed by Arjun Divecha, pulled in $3 billion in net new assets alone, bringing its total to $9.6 billion. Thanks to shrewd bets on top-down country allocations, the fund returned 70 percent in 2003, versus a 51.5 percent dollar gain for the MSCI emerging-markets index.

Although other managers would happily let the money roll in, Grantham closed the strategy to new investors at the end of September 2003.

"The damage that size does to performance is the dirty little secret of the fund management business," Grantham says. "It is a killer. We will close everything if we believe size is inhibiting our ability to add alpha."

Although emerging-markets equity was the star sector, the firm attracted new mandates across all asset classes. U.S. equities portfolios drew $2.7 billion, asset-allocation strategies $2.0 billion and non-U.S. equities $1.7 billion.

New clients include the State of Wisconsin Investment Board, which hired GMO to run $300 million in emerging-markets bonds; the Nebraska Public Employees' Retirement System, with a $200 million active international equity mandate; International Paper Co., which handed GMO an $80 million emerging-markets equity mandate; and the Stockholm-based ABB Foundation, which hired GMO to run $100 million in international equities.

After a year like 2003, is Grantham optimistic? Not particularly. After last year's 28.7 percent rise in the Standard & Poor's 500 index and the 35.3 percent dollar return for the MSCI EAFE index, the S&P 500 index was up just 2.1 percent this year through mid-June, and the EAFE index was up only 1.5 percent. Grantham expects equity markets to test new lows. "This has been a major league bear market rally, classic in every way," he says. "The speed of the market rise, the redemption of old heroes, the leverage in the system and the boom in emerging markets and junk bonds are exactly the flavor of a bear market rally. This is not the end of a bear market. That will be characterized by capital preservation and risk avoidance at all costs."

Though he turns 65 this year, Grantham has no plans to retire and remains fiercely committed to preserving GMO's independence. "What we did when we were losing money, the stance we took, would have been impossible if we were beholden to an owner demanding quick results," he says. "The stance we are taking now of closing winning strategies would have also been difficult. I am convinced independence is in the best interests of the firm and our clients." -- Andrew Capon