Eugene Flood Jr. was named president and CEO of Smith Breeden Associates in January 2000 after 13 years as a portfolio manager at Morgan Stanley. Located in Chapel Hill, in the heart of North Carolina's Research Triangle area, Smith Breeden counts among its staff a long list of professionals with advanced degrees from the nation's leading business and finance schools. Mr. Flood was on the faculty at Stanford University prior to joining Morgan Stanley and the academic world remains a central part of his professional life. Aside from heading the research-based fixed-income firm, Mr. Flood holds a number of high-level academic positions including the dean's advisory committee for Massachusetts Institute of Technology's Sloan School of Management. He also is on the board of visitors for the University of North Carolina at Chapel Hill and the Duke University Fuqua School of Business. He spoke with P&I's Fred Williams about Smith Breeden and his view of the fixed-income markets.
Q Your firm isn't as well known as some other fixed-income managers. Why?
A We haven't had a strategy where we try to be all things to all people. We haven't had a mass distribution strategy, and we are not going to have one in the near future. We're large enough so that we can enjoy good economies of scale. We have well-functioning teams of the right size and we've got good infrastructure in terms of operations, compliance, technology and our investment teams. But we don't have a large senior partner like a large bank that owns us. ... We like being at a size where it's really the partners that drive the business, and our clients drive us. All of our attention is focused on our clients and not on fitting into somebody else's larger distribution strategy where there is a larger full-services financial services firm that has other things going on. Our business is purely investment management and that's all we focus on.
Q What has changed since you took over Smith Breeden?
A The firm already had close to 20 years in the active management industry. The reason I came into the firm's strategy was to add some more legs on the management side. The progress that we've made has been to continue to deepen what we're doing in the research on the investment side, to continue to expand the product line. We've increased the work we've been doing in the corporate bond side and have moved the firm more from a focus on mortgages to becoming a more diversified fixed-income management firm.
Q How do you factor in the risk of war with Iraq?
A There are two important ways that comes into play. One is that it affects the returns we expect on any asset class because it's going to affect economic growth. Our central expectation for economic growth this year is about 2.25% real GDP growth in the U.S. in the first half of the year and about 2.75% for the second half. Now, if the conflict is resolved quickly and we move past this situation by the first part of the second quarter - that we have a resolution and kind of know how things are going to shake out - we could have growth of 4% in the U.S.
If these problems drag on and other things stay on the radar screen, whether North Korea or Venezuela, we could have 1% growth. So, there is a large spread around the central forecast and that spread is really determined by what happens with these geopolitical factors.
The biggest driver of returns and economic growth this year is the geopolitical situation. The way it affects us from an investment perspective is that it means there will be a lot of volatility in the market ...we basically have to play things more cautiously than we would under normal economic circumstances. We talk about this every day.
Q If you were managing a $1 billion pension plan, how much would you have in stocks? In bonds?
A Let's assume I'm fully funded and not trying to catch up. (If) a normal mix might be 65-35 or 60-40, I'd be somewhat lower in equities because it's my expectation that economic growth is going to be below trend for a while. Corporate profitability will remain under pressure for a while.
So, my stock exposure would be somewhat lower than normal right now. My bond exposure would be a little higher than normal and I'd have a larger than usual allocation to alternatives, total-return-oriented assets.
The reason I have that perspective is because we think in this post-bubble economy where there's a lot of excess capital and excess capacity, it's going to take awhile for that capacity to be redeployed and put into more productive areas so that corporate profitability can start to grow at a healthier clip. That's what will bring stock returns back. Expected returns for stocks have to be low right now because corporate profitability growth is low. There's nothing to cause corporate profitability to snap back very quickly right here.
Q Smith Breeden started as an interest rate and risk advisory service. Why did asset management start?
A It's a natural scenario. Doug (Breeden) and Greg (Smith) started advising banks and thrifts on asset-liability management. Then, one of the things banks and thrifts (said) was `OK, you've helped us understand how to manage these potential mismatches that arise, now have a look at our securities portfolio and give us some advice on what we should be doing with the bonds in that portfolio.' So, they started providing advice on the management of bank portfolios. Then it evolved into `Well, we're providing advice on managing these portfolios, we could actually be managing the portfolios.'
Q With your academic background, what made you want to get into money management?
A I was studying economics as an undergraduate at Harvard and received a Ph.D. in economics where I focused on finance and international. When I went to Stanford to join the faculty, I taught finance. While I was at Stanford, I wanted to get out and spend some time in business, and Morgan Stanley asked me to take a sabbatical and work there. I really enjoyed being in the markets, and eventually left Stanford and went full time into the markets. Doug (Breeden) and I taught together at Stanford. We were both on the finance faculty at the business school in the early 1980s. So when Doug and Greg Smith founded this firm ... I used to talk with Doug about it way back then. As time went on and the firm grew, they added a board of directors and I was a member of that board so I stayed in close touch with the firm. Then, three years ago I decided to make the change and work with this team on a full-time basis.
Q What would you be doing if you weren't doing this?
A I've played music all my life. But I could see it would be pretty hard to make a good living being a musician. The other thing I looked at - I grew up playing soccer. I love soccer. I was pretty good in New England but when I got to Harvard there were guys from Italy, Brazil and Argentina. They were very good and knew the game very well, so I decided to go into varsity economics.
Eugene Flood Jr., president and chief executive officer, Smith Breeden Associates Inc., Chapel Hill, N.C.
Assets under management: $26.4 billion
Performance (as of Dec. 31): Return (benchmark)
investment-grade Core Bond:
1 year 11.38% (10.25%)
3 year 10.90% (10.10%)
Mortgage index plus:
1 year 9.74% (8.86%)
3 year 10.01% (9.45%)
1 year 4.45% (1.84%)
3 year 5.21% (4.25%)
Benchmarks (respectively): lehman aggregate; salomon mortgage; one-month libor