A need for objective information about managers leads to the development of consulting businesses.
Given the amount of money companies were pouring into their pension funds in the late 1950s, fund executives naturally wanted to know they were earning decent returns.
Companies needed a way to calculate performance and, in the 1960s, a number of people began working on the problem.
Martin E. Segal Co.; the National Foundation of Health, Welfare and Pension Plans (later the International Foundation of Employee Benefit Plans); and A.G. Becker Co. all developed dollar-weighted rate of return measurement systems.
Becker took that measure a step further when it began studying the possibility of developing a database of the actual investment performance of pension funds.
That study came from a sales call John Mabie made at Whirlpool Corp. The company's treasurer had been examining the results bank trustees had achieved for the pension fund and said to Mr. Mabie: "Look at these results. I think they're doing a lousy job. What do you think?"
Mr. Mabie declined to venture an opinion on a cursory examination, but agreed to look more closely at the results. The more he thought about the treasurer's request, the more he became convinced it offered a business opportunity.
Mr. Mabie recruited 16 funds to participate in the first survey. The companies either supplied what data they had on asset values, dividends, yields, contributions and payments of their funds, or directed their managers to turn over the records.
At the end of the study, Becker executives decided to further develop the database. And in 1965, the Corporate Funds Evaluation Service was launched, followed soon after by the Institutional Funds Evaluation Service, which reported how well money management institutions were doing with the assets under their control.
Gathering the data was not easy. Many banks were reluctant to turn over records, even at company direction.
"Once it became evident to people that we were not going to go away, that we were going to be there and the corporations thought we were right, the reluctance factor went down on the part of the financial institutions," said Tony Cashen, a former vice president of sales for Funds Evaluation Group. "They began to be curious about what this (database) was going to be and they wanted to have it done correctly rather than incorrectly. Some of them were scared to death that it would be . . . damaging to their ability to retain and get business."
Even some corporate treasurers were reluctant to participate, afraid of offending the banks their companies often relied upon for financing. Others simply had no interest in knowing how the pension fund was doing, believing that was the trustee's responsibility.
With these executives, "It was like selling to a wall," said Roger Brown, who at the time was with Becker. "Some treasurers thought their job was to keep their banks happy."
By 1970, however, the dam had broken, and corporations were calling Becker to have their funds included in the database. The service was expanded to cover public pension funds in the early 1970s.
The more data Becker collected, the more effort it made to analyze it and understand what drove investment returns. At one time, Becker's data crunching needs were so great it was renting time on a NASA computer in Ames, Iowa.
By the mid-1970s, Becker was monitoring more than 3,000 pension funds, and sponsors had begun to manage their funds on a performance basis, albeit in a rudimentary fashion.
WHAT DO WE DO NOW?
But for pension executives, the Becker service wasn't enough.
Becker officials made the decision to be in the data analysis business -- not the advice business -- so its representatives were not willing to suggest alternative managers. And pension executives, seeing their money managers were underperforming, were left with the question: Now what do I do?
Frank Russell Co. stepped into that vacuum: Russell consultants were prepared to recommend changes to funds whose managers were underperforming.
(Not until 1975, when other consulting firms were well established, did Becker officials change their minds about consulting.)
FRANK RUSSELL CO.
The Frank Russell Co. started as a financial counseling and mutual fund company in Tacoma, Wash. When George Russell Jr. joined the company in 1958, the firm had one small mutual fund with $300,000 in assets and 175 customers, and 14 investment counseling clients.
Two months later, after the unexpected death of his grandfather, company founder Frank Russell, George Russell Jr. did his first manager search.
"I didn't know what to do with the 14 clients he was buying and selling stocks for. So I looked in the Yellow Pages of the Seattle phone book and found three money managers and wrote them down on 14 pieces of paper because at that time we didn't have a Xerox machine. I gave those names to the 14 clients -- their average account was $50,000 -- and wished them luck," he said.
Eleven years later, the company would list investment management consulting with investment manager search advice for pension funds as its primary business.
Mr. Russell kept the firm alive selling insurance and the mutual fund. In the process, however, he found pension executives really didn't want mutual funds, they wanted to understand money management.
In a phone call with J.C. Penney Treasurer Paul Kaltinick, Mr. Russell asked: "What if we were to research money managers and put that in front of you, and then you could make a business decision about who runs the money? Wouldn't that improve your performance?"
Mr. Kaltinick invited him to New York, and soon after hired The Frank Russell Co. as Penney's investment management consultant. A few months later, on Mr. Kaltinick's recommendation, Burlington Industries also hired the firm.
This initial success convinced Mr. Russell that investment management consulting could be a viable business, and he began traveling across the country selling the concept. Between 1969 and 1974, Russell signed up 38 more clients for his pension consulting service, and during that time the firm sold off the insurance and mutual fund business.
Mr. Russell also began collecting performance figures on managers, not that he understood how to use them at that point.
When interviewed by Penn Central Corp. pension executives, he was asked how he was going to measure performance. Mr. Russell remembered a few weeks before someone had mentioned work on performance measurement done by Peter Dietz.
He responded: "We use the Dietz formulas, don't you?"
He got the Penn Central job, and when Mr. Russell got home that Saturday, he set out to locate Mr. Dietz, who had published the first formula for measuring what became known as the time-weighted rate of return. He found him at the University of Oregon, interviewed him on Monday, and hired him as a consultant.
"He saved us a heck of a lot of startup worry," Mr. Russell said.
Mr. Russell quickly learned it was impossible to identify successful managers from their previous performance. So he hired a staff of researchers to visit managers to try to learn about their investment philosophies and how they selected the stocks in which they invested.
Helane Grill was Russell Co.'s first researcher, and set up the company's first New York office -- in a furniture storage closet rented from C.J. Lawrence Inc. Ms. Grill had worked at A.G. Becker and was familiar with its performance evaluation service, but she didn't know anything about researching money managers. Nor did anyone else.
But Mr. Russell had been a portfolio manager and knew how to research stocks. He applied the same concept to researching managers and developed the 4-P approach -- people, philosophy, portfolios and performance.
In 1971, Russell hired another researcher, Madelyn Smith, a Seattle housewife who ultimately was responsible for the development of Russell's style classification of large- and small-cap growth and value managers.
Frank Russell Co.'s manager recommendations performed very well until 1973 and '74, when these managers, and most others, fell out of bed. Russell analysts looked at the managers they had recommended and realized they were all "high-beta" managers.
"So we told our clients, 'Don't worry; they went down 20% more than the market, but when the market turns they'll go up 20% more than the market,' " Ms. Smith said. "Then when 1975 came along, the high-beta managers went up about 80% of the market, while other managers went up 20% more than the market. We said, 'Wait a minute, we've got to really examine these different portfolios.' So we had a couple of fellows go through and look at portfolio characteristics: beta; return on equity; yield; p/e; price/book; maybe 10 characteristics. Then we said, 'Aha, look at this. All the managers who were doing great in 1975 have the same characteristics. The ones that did poorly in 1975 had these kinds of characteristics.' "
The Russell group extended the analysis back into its historic database and into mutual fund data and found consistent performance patterns. This gave birth not only to style classification of managers, but also to diversification of managers across styles.
The managers didn't always like being classified by style.
"Managers liked to believe they were good for all seasons, and that their approach was always going to pick winners, more winners than losers," Ms. Smith said. "I remember Dodge & Cox particularly. They would come up and argue with us about their style, and they had one of the most pronounced styles of just about anybody . . ."
Russell was the first specialized investment management consulting firm designed to help funds select better investment managers, but just by a nose.
More information was needed about this fledgling industry. What were the needs of the pension executives? How did they feel about different products and organizations? And what could organizations do to meet the needs of clients and modify those perceptions where necessary?
Into the breach stepped Charles D. Ellis and a firm called Greenwich Research Associates, later Greenwich Associates.
Mr. Ellis graduated from Yale with a degree in art history and philosophy in 1959 and a year later entered Harvard Business School. Graduating in 1963, he "lucked into" the opportunity to work for Rockefeller Brothers Investment Management, managing the personal assets of the Rockefeller family and the endowments it had set up, including the one for Colonial Williamsburg.
Following other jobs, including one with Louis Harris & Associates, Mr. Ellis decided to set up his own firm in 1972.
Greenwich Research Associates started with Mr. Ellis and one other employee, whose key responsibility was to answer the phone. Mr. Ellis drew up the survey questions and got together the target list of interviewees. He subcontracted the actual survey work and tabulation to another firm.
The first survey asked 800 pension executives about their activities, interests and attitudes toward half a dozen institutional money management organizations.
Many of the management organizations were surprised when the survey revealed that pension fund executives thought investment performance was important and fees were not. This was at a time when a bank fee of 25 basis points was considered high.
Aside from surveying attitudes, Mr. Ellis offered consulting to money management organizations on opportunities and how to fix any problems pension executives perceived with the firms.
Greenwich provided an avenue for greatly increased information flow between pension executives and money managers. In addition, the company distributed summaries of its research to all participants.
Early in 1970, a young broker at PaineWebber named John Casey became involved in helping Consumers Power in Illinois select a money manager for its pension fund. While at PaineWebber, he had become interested in the investment management world.
Mr. Casey had suggested to his superiors that there might be a business opportunity in helping pension funds select managers. Dick Corrington, the partner in charge of institutional business, asked Bill Crerend to check out the concept.
Mr. Crerend at first was not impressed. But he read all he could about institutional investing and money management. Soon after, he found himself in the audience at a conference in New York on how to select a money manager, and found himself volunteering answers to questions from the floor when the panel was stumped.
Afterward, Mr. Crerend was approached by an executive from a brokerage firm who was impressed with his knowledge. The executive said his firm wanted to get into the manager selection business and asked Mr. Crerend to join the firm to help start it. Mr. Crerend told the story to Mr. Corrington, who placed Messrs. Crerend and Casey on commission and set them to building a manager selection business for PaineWebber.
"The first month I remember making $500, and the sixth month I made $15,000. I don't remember how much John made, but it suddenly became apparent to Corrington that this was a big thing," Mr. Crerend said later.
By 1976 Mr. Crerend's department had become so successful it was causing a problem for PaineWebber. At the same time PaineWebber might be trying to sell a private placement to one of the major trust banks, Mr. Crerend might be encouraging a pension fund to fire the bank and move its pension assets elsewhere.
James Devant, chairman of PaineWebber, asked Mr. Crerend to buy the unit. Mr. Crerend and three other employees did just that, and named the new firm Evaluation Associates.
Edwin Callan, who in 1973 founded the investment management consulting firm Callan Associates, first ran into the manager investment performance questions in the late 1960s, when he was selling research for the San Francisco brokerage firm Mitchum, Jones and Templeton.
He was in Pittsburgh when he called on an old friend at National Steel Corp. The friend said he had no use for securities research because the company's $100 million pension fund was managed by trust banks. However, the company didn't know how the fund was doing. "I heard some people are measuring that," the friend said.
Mr. Callan realized this was information someone would pay for, if he could deliver it.
He approached Martin E. Segal Co., which had developed a dollar-weighted return measurement system for the Air Line Pilots' Association, about providing performance figures for companies it might gain as clients. Segal agreed. Mr. Callan then called several friends at corporations with his idea for performance measurement, received encouragement and began to market the service.
He quickly picked up several clients, but then a storm cloud arose. The New York Stock Exchange ruled it was not appropriate for a member firm to buy outside research (i.e., the performance figures from Martin E. Segal), and to resell it for directed commissions. That led Mr. Callan's brokerage firm to hire a staff to gather the data and calculate the returns internally. Soon his department was generating about one-eighth of the trading volume of the brokerage office.
In 1969 Mr. Callan conducted a performance study of Bankers Trust for Pacific Lighting Service Co.'s $110 million pension fund. When the study was complete, he was asked to fly to New York with Pacific Lighting executives to meet with Bankers Trust officers. The bank's one-, three-and five-year performance was poor, and bank officers declared they didn't approve of the study.
As the Pacific Lighting group left the meeting, Mr. Callan, depressed by the bankers' reaction, said: "What are we going to do?"
Replied a Pacific Lighting executive: "We're going to pull all of the money" from BT.
Mr. Callan helped the executives select new managers. Soon after, he did a manager review for International Paper Co., which then also decided to drop Bankers Trust.
Unfortunately, the bank was doing business worth $1 million with Mitchum, Jones and Templeton at the time, while Callan's study delivered only $15,000 in fees -- not a healthy tradeoff for the firm. Mr. Callan was directed to stay away from Bankers Trust.
"We had a conflict of interests," Mr. Callan said. As a result, Mr. Callan broke away from Mitchum, Jones and Templeton in 1973 to establish Callan Associates as an independent investment management consulting firm.
In 1967, a young MIT and UCLA graduate, John O'Brien, joined Planning Research Corp. as a systems analyst. Planning Research had a profit-sharing plan run by a bank, which told the company everything was going well. Company executives asked Mr. O'Brien to analyze the fund's performance just to make sure.
Mr. O'Brien looked into the literature and noticed William Sharpe was doing interesting work on risk and return, and hired Mr. Sharpe as a consultant to the fund. In effect, it was a $500 contract for a private tutorial on the capital asset pricing model.
As a result, Messrs. O'Brien and Sharpe built a CAPM-based risk measurement model to help Planning Research understand its fund's investment performance.
Then Mr. O'Brien suggested Planning Research market the model, and soon after he and his associates developed the first book of betas for stocks, again using Mr. Sharpe's methodology. Unfortunately, Planning Research was trying to sell its product for cash, while prospective customers wanted to pay in commissions, so the business did not grow.
In 1969 Mr. O'Brien joined Oliphant & Co., where aside from offering books listing the betas of stocks and risk-adjusted performance measurements, he marketed simulations of how portfolios would behave in different market environments. Mr. O'Brien also recruited a strong staff for the department, among them Dennis Tito, who had worked on the U.S. space program at the Jet Propulsion Laboratory; Gifford Fong, who later started his own fixed-income consulting firm developing analytical tools; and Gil Beebower, who later joined A.G. Becker and wrote a number of ground-breaking research papers on investment returns and diversification.
Oliphant & Co. decided to go public in 1972, and wanted Messrs. O'Brien and Tito to trade their partnership percentages for stock ownership. When they resisted, the firm fired them and locked the doors of the operation over the weekend.
The two rented office space on Wilshire Boulevard and started O'Brien Associates to continue to develop and market the service. Most of the staff, including Mr. Beebower and Richard Ennis, joined them. The team expanded the portfolio measurement service, created what they believed to be the first asset/liability modeling product for pension funds, and produced the O'Brien 5000 stock index, now known as the Wilshire 5000 index.
When fixed commissions were abolished by the New York Stock Exchange May 1, 1975, the whole world of "soft dollars" was in doubt. The "soft-dollar" payment was easy to calculate when commissions were fixed, but much more difficult when every trade was negotiated. Further, ERISA could be interpreted as saying any trade had to be done at the lowest possible price. Did that leave any room to pass on part of the commission payment to the consultant or other vendor?
At least one leading consulting firm -- O'Brien Associates -- split up over the question of whether soft-dollar payments would survive, and if they did, whether a consulting firm could survive in a negotiated commission environment without either its own strong trading execution capabilities, or a close affiliation with a firm that had such capabilities. John O'Brien, Gil Beebower and Richard Ennis left O'Brien Associates to join A.G. Becker, while Dennis and Suzanne Tito, Larry Cuneo and Wayne Wagner acquired control of the firm, which soon was renamed Wilshire Associates.
Bob Shultz, who at the time was general financial supervisor with New York Telephone, had an appointment one Monday morning to make a final decision about whether to commit $20,000 to O'Brien Associate's asset/liability model.
Said Mr. Shultz: "I can recall very well this person I had never seen before came in very apologetically . . . saying, 'Gee, I'm sorry to upset things here, but my name is Dennis Tito and I just bought Wilshire Associates over the weekend, and I was just wondering whether you want to continue with this asset/liability study we were talking to you about.' I remember myself and the staff fellow, Frank Greenberg, sitting there and saying, 'Oh, what the hell. We've gone this far, we might as well do it.' "
The newly named Wilshire Associates went on to become one of the leading quantitatively oriented investment consulting firms serving pension funds and money management organizations.
COMPETING WITH CLIENTS
In October 1980 Frank Russell Co., the most influential of the nation's pension consultants, put itself into competition with the money management community by launching the Russell Trust Co. The firm, in effect, was putting its ability to select the best investment managers on the line. If the four commingled funds, each managed by several of the best investment managers its consultants could identify, failed to provide superior performance, Russell's consulting reputation would suffer.
In starting the trust company, George Russell, in part, was responding to the demand for his firm's services. When he started the consulting operation he had promised his first clients he would never take on more than 40 consulting clients. But after those first 40 were on board, and as the firm gained in stature, more pension funds sought its help, especially small and medium-sized funds.
Even if he had been able to take on more clients, the Russell approach was impractical for smaller funds because it necessitated employing a number of money managers with different styles.
At a meeting with Burlington Industries in 1979, Russell was challenged by Burlington executives. The company had just bought a subsidiary with a $35 million pension fund that it could not for some reason include in the parent's master trust. "What are you going to do for the subsidiary's fund?" the executives asked Mr. Russell. He responded that he would set up some commingled funds using multiple managers in which their small fund could invest. But first Russell had to clear it with his other clients and also develop the legal structure.
Mr. Russell visited all of his clients and three objected, fearing the firm would quickly make more money from the trust company than from consulting, and their consulting services would be diluted. Russell promised he would return in five years to prove it had not happened. He also promised the marketing targets for the new operation would be small and midsize pension funds.
He then borrowed a conference room in the Citibank headquarters in New York and locked the lawyers in it. He told them he would give them the bathroom keys when they had finished developing the legal framework for a multimanager trust company, and what it was going to cost. They finished in four hours.
One year later, Frank Russell Investment Management Co. was launched; it manages mutual funds on the same basis as the trust company manages commingled funds.
Needless to say, Frank Russell Trust Co. was not greeted with enthusiasm by the money management community. Most viewed it as direct competition. Even those who had been recommended to pension funds by Russell consultants feared the company would recommend the trust company to its clients rather than them. Many felt it was a conflict of interests for Russell to be both consulting and managing money.
The growth of Frank Russell Trust Co. was rapid. A decade later it offered 15 commingled funds and managed $9.3 billion.
Russell's move into money management was soon followed by several other leading consulting firms, among them Rogers, Casey & Barksdale Inc. and Evaluation Associates Inc.
In November 1983 Wilshire Associates joined the money management bandwagon when the Minnesota State Board of Investment hired it to manage $1 billion in an index fund that would track the Wilshire 5000 index. Again, trust banks that bought Wilshire index fund tracking software and consulting services were not pleased at having a supplier suddenly become a competitor.
The consultants realized consulting was a low-margin business because it was difficult to leverage the consultant's expertise. Each consultant could service only so many clients, and the clients would pay only so much.
At the same time, the pension investment world was becoming more complex, requiring more research into such topics as active management styles in stocks and bonds, not only for U.S securities, but also international securities; expertise in real estate and oil and gas deals; knowledge of options strategies; and, just on the horizon, fixed-income and stock index futures.