Pension funds and institutional investors have boosted Paradigm
Asset Management's assets under management more than 200% in almost two years in the belief that the insights of successful mutual fund portfolio managers can be divined by computer tools and replicated with indexes.
While the performance of Paradigm's portfolios is above that of the median manager in their respective styles over five years, during recent short-term periods, however, the firm has underperformed, and the alpha that owner James Francis said he tries to capture quarterly has been elusive.
Mr. Francis bought the firm in 1995 from Bernard Beal and has seen the assets grow to $1.2 billion. He attributes almost 70% of the growth to new business.
Pension funds and other tax-exempt institutional investors have warmed to Mr. Francis' style, in which the stock picks of a few active money managers are used to create 10 enhanced style portfolios.
Paradigm Asset Management was founded on the theory that style-consistent money managers best define an investment style.
Paradigm begins its investment process by using publicly available information from Morningstar Inc., Chicago, and other research tools to identify those style-consistent money managers and their stock picks. This yields the Paradigm universe of five to seven managers per style and 400 to 600 stocks.
An optimization model of 68 industry and economic factors developed by BARRA, a Berkeley, Calif., quantitative investment consultant, is used on the universe to determine the economic and industry bets the managers took when making their stock selections. This process yields an investible universe of about 150 stocks, said Mr. Francis.
"The 68 factors will allow us to identify the sweet spot of the market," said Mr. Francis. "We want to recreate a new portfolio of 150 names that will mimic that.
"We want to capture what that alpha is statistically through examination of the risk characteristics of the universe."
All of this is done without the knowledge of the portfolio managers, and at relatively low expense.
"Paradigm does no fundamental research on securities," said Mr. Francis. "We leverage on the research budgets of these institutions."
He won't disclose the identity of the money managers he is using to clients, their consultants or his own financial backers. It is proprietary and derived from publicly available information is all he says about the matter.
But it is working.
Paradigm's return objective is to outperform the median manager every quarter, a goal it has been more successful at over the long term than in the short term.
The firm's style landed its large-cap value and growth products in the third and fifth deciles, respectively, of the Pensions & Investments Performance Evaluation Report for the five-year period ended Sept. 30.
Paradigm's value product returned 17.4% annualized, with an alpha of 3.6, while the median manager in the PIPER large-cap value universe returned 16.1%. The firm's large-cap growth fund returned 15.6% for the period, compared with 15.1% for the median large-cap growth manager. However, the alpha was an unimpressive -0.4.
The S&P 500 returned 15.2%, and the Russell 3000 returned 15.4% during that period.
But for the third quarter, Paradigm lagged its bogey. The firm's large-cap value product returned 2.5%, a seventh decile ranking, compared with a 3.1% return by the median manager.
Paradigm's large-cap growth performance was just 3.3%, also landing it in the seventh decile. The median manager returned 4.1%. For the quarter, the S&P 500 returned 3.1% and the Russell 3000, 3%.
Mr. Francis was unfazed by the quarterly dip in performance.
"There will be quarters in which that will be the exception, and those are to be expected," he said. "If you look at our history, the product line has been able to outperform the median and the style specific benchmark over time."
In addition to large-cap growth and value portfolios, Paradigm offers small-cap and midcap growth and value portfolios and broad core, large core, midcore and small-core strategies. These products are not yet tracked by PIPER because of their short track records.
The theoretical underpinnings of Paradigm's investment strategy comes from William Sharpe and Harry Markowitz, who concluded 90% to 97% of return is attributable to asset allocation style, and only 3% to 10% is attributable to stock selection.
"It's hard to understand why people spend 75% of their time screening and researching securities to get 3% to 10% of returns," said Mr. Francis.
"We identify superior investors using statistical tools," he said. "We run a battery of statistical analysis on investors to identify in the four principal styles (large-and small-cap growth and value), who is consistent in performance and consistent in style adherence."
Consistency of performance is emphasized because top-tier managers often are the most volatile, said Mr. Francis. Paradigm's goal is to exceed the return of the median manager in the respective style.
"We want consistency over a home-run hitter," he said.
Hiring a collection of asset managers to collectively outperform a single benchmark is not a new concept. Plan sponsors have done it by hiring groups of active managers; consultants, using a fund-of-funds approach, have offered it to their clients.
Paradigm is unique, claims Mr. Francis, because the approach is contained in a single product. It is cost-effective, too, with fees starting at 50 basis points.
"In many ways this is how a consultant picks a short list of managers," he said. "With us, they get a consensus product at a lower cost."
Paradigm's origins date to 1988, when it was known as Beal Investment Management Co. and was part of M.R. Beal & Co., a small financial services company primarily involved in municipal finance.
Following a two-year research process to identify what plan sponsors sought in an investment product, the firm first offered its small- and large-cap value and growth portfolios in 1990.
The firm soon signed up the pension funds for New York City Teachers, General Motors, Pacific Gas & Electric and The Prudential Insurance Co. of America and had more than $200 million under management by 1993.
But the growth slowed and assets were just $368 million in May 1995.
Mr. Francis attributed the stasis to a lack of resources, not reluctance on the part of investors to use Paradigm's investment style. A lack of resources also inhibited the firm's growth, he said.
"If there was a reluctance (to invest), it was a lack of understanding where these products fit, he said.
"Now with an understanding of where performance is coming from, the attractiveness of risk-controlled style products is higher," said Mr. Francis.
"The marketplace is funny in terms of how products get integrated," he said. "You have to go out there and make the demand. Then it becomes institutionalized. It is not consultant driven."
Marketing is money driven, and Mr. Francis hooked up with Boston-based Affiliated Managers Group Inc., a private holding company that makes equity investments in small and midsized investment firms, to buy the operation from Mr. Beal.
AMG is backed by TA Associates, Boston, a prominent private equity firm.
Mr. Francis was early to the enhanced style indexing game. Its attractiveness to pension funds has brought competition.
In a search last year by the $8 billion San Francisco City & County Employee's Retirement System, Paradigm was dwarfed by its competitors. But the firm's longer real track record and sole focus on enhanced style indexing was attractive to the investment staff and trustees.
"Its track record was longest among the finalists: BZW, Goldman Sachs and J.P. Morgan," said Carl Wilberg, portfolio manager of equities for San Francisco. "The others had simulated returns going back. They had a live one."
Mr. Francis, predictably, is happy about the competition, claiming Paradigm will get its share of business.
The defined contribution and wealthy individual investor markets are receptive to "style-specific, risk-controlled, low-cost investment vehicles," he said, and Paradigm is cultivating an arrangement with a mutual fund distributor to take advantage of this interest.
"They (the big advisers) are going to exceed us," said Mr. Francis pragmatically. "But I have a five-year head start.
"If we can get to $20 billion, we will be a real player, and that's across all our product lines," he said. "It's just one product for them.
"It's a real focus for us."