Non-traditional strategies find a willing audience

Money managers are striking pay dirt with strategies that promise positive returns whether major stock and bond indexes are waxing or waning.

"The world is in flux right now," said Bill Schneider, a principal with DiMeo Schneider & Associates LLC, a Chicago investment consulting firm. Turbulent markets have left pension funds hungry for less volatile returns, and money managers will offer absolute-return products to meet that demand as well as to reap fatter fees than traditional products offer, he said.

Some see the weak outlook for U.S. capital markets behind the pickup in demand and supply of non-traditional products. Pension funds wouldn't be eyeing new strategies to this extent if expected returns from traditional strategies hadn't been in question, said John Wilson, executive vice president for institutional business at Pacific Investment Management Co., Newport Beach, Calif.

Others see less cyclical factors at work as well.

Ratings agencies now consider pension obligations when rating corporate debt, and the Financial Accounting Standards Board may impose a mark-to-market rule for pension assets in place of the current five-year smoothing convention, exposing corporate balance sheets and income statements to increased volatility, said Jeffrey Saef, senior vice president at Putnam Investments Inc., Boston.

Such changes boost the premium attached to predictable outcomes, pushing pension funds toward absolute-return strategies, including hedge fund, market-neutral, sector rotation and tactical asset allocation strategies, Mr. Saef said.

Industry watchers say capacity constraints in the alternative asset classes and strategies money managers are tapping will limit the potential bonanza. If the money management industry can be likened to a cake, absolute-return strategies "will become a layer, but a thin one at best," predicts Mr. Schneider.

For the moment, though, "uncorrelated alpha" is proving a money-spinner, with money managers pleasantly surprised at how quickly pension executives are warming to non-traditional products.

For example, when Grantham, Mayo, van Otterloo & Co. LLC, Boston, introduced its benchmark-less Absolute Return Portfolio five years ago, pledging to deliver annualized real gains of 5% a year or better over a market cycle, the money manager "got polite chuckles" but no institutional clients for over a year, said Chief Investment Officer Ben Inker. At first, GMO Chairman Jeremy Grantham's sisters were the only investors in the fund — which allocates money among a bevy of alternative asset classes offered separately by GMO.

But the company's expectation that only endowments and foundations would be adventurous enough to park money in such a fund proved wrong: In February, Mr. Inker told an investment conference the product had garnered $2.7 billion — much of it from pension funds. In early April, Mr. Inker said GMO expected to close its once-untouchable fund to new investors at $4.5 billion "within the next three months, maybe sooner."

For money managers, the willingness of investors to pay higher fees for alternative products is an added charm. The fees GMO charges investors in its Absolute Return Portfolio are higher than those for a traditional product but lower than for a typical hedge fund, Mr. Inker said. Clients can choose to pay a flat 110 basis points or 65 basis points plus 10% of any returns over a 2% hurdle.

PIMCO's recent absolute return products also have been popular.

The company's CommodityRealReturn Fund, which "ports" returns from an actively managed bond portfolio onto an underlying commodity portfolio, has attracted $4.2 billion in 20 months, said John B. Brynjolfsson, a managing director and portfolio manager. Its All Asset Fund — the asset allocation strategy offered in conjunction with Robert D. Arnott of Research Affiliates LLC, Pasadena, Calif. — has pulled in $2.1 billion over the same period. And PIMCO's Real Return Fund, launched in November 2001, has garnered roughly $4 billion over the past year, swelling its assets to $11 billion, said spokesman James Clarke.

That sort of asset growth leaves some traditional money managers predicting an ever-growing share of their business will come from non-traditional products.

"We think the marketplace is moving more toward alternatives and we continue to expand our capabilities there," said William F. Glavin Jr., managing director and chief operating officer with David L. Babson & Co. Inc., Boston.

Babson's structured finance, mezzanine debt and hedge fund products, currently about 15% of the company's assets under management, should account for more than 25% of the total within three years or so, Mr. Glavin said.

Others are trimming their sails as well. John Brown, Putnam's head of institutional management, said his company is repositioning its institutional product offerings this year with a three-pronged strategy. In addition to its traditional actively managed products, the money manager boosted its presence in structured and enhanced products last month when it raised its stake in PanAgora Asset Management, Boston, to 80% from 50%. For the third prong, Putnam will move more aggressively into alternatives, with the company likely to add a hedge-fund-of-funds capability, outside of Putnam itself, to its current small stake in leveraged buyout firm Thomas H. Lee Co., Boston, Mr. Brown said.

Some money managers have opted to build alternative products capabilities in-house, while others have moved to supplement theirs through acquisitions or liftouts.

Ron O'Hanley, president of Mellon Institutional Asset Management, Boston, said Mellon has opted to build "virtually all of ours … from the ground up," to meet the critical needs of institutional investors for transparency and measurable risk. Mellon now has five or six market-neutral strategies, as well as event-driven strategies and global macro strategies involving asset allocation and currency overlays, he said. Demand for those products has been "growing quite fast over the past couple of years," with more than $2 billion now in those hedge strategies, he said.

Similarly, State Street Research & Management Co., Boston, is gearing up to market its LIBOR-Plus strategy, which hedges out interest rate risk and uses structured finance securities backed by consumer loans and residential and commercial mortgages to offer an alpha overlay of 70 basis points over LIBOR to the client's choice of index. State Street Research is shooting to garner $1.5 billion by the end of 2005 and $5 billion within five years, said Ron D'Vari, director of fixed-income research. The company's Collateralized Debt Obligation strategy, launched in October 2002, has $1.9 billion under management, and an additional $1.9 billion "under engagement." Within five years, the company aims to have $8 billion to $10 billion in the product, he said.

Others are developing in-house strategies but open to acquiring other capabilities as well. Timothy Harbert, chairman and chief executive officer at State Street Global Advisors, Boston, said recently that although SSgA and its affiliates offer clients a fairly comprehensive range of products along the risk-return spectrum, a hedge-fund-of-funds manager may be one piece of the puzzle it still could use.

Babson's Mr. Glavin said his company also will look to acquire new investment capabilities as opportunities present themselves. Acquisitions may be preferable to liftouts because a money manager can "get out into the marketplace and market that capability" without having to build up a two- to three-year track record, he said.

The trend toward fielding more absolute-return products appears to fit the industry vision, outlined recently by Lee Thomas of PIMCO and others, of a world where pension funds will spend less time worrying about asset allocation "beta" decisions and more time identifying and coordinating "alpha" producers.

Putnam's Mr. Saef says the pickup in demand for absolute-return strategies is consistent with his expectations of how corporate defined benefit plans are likely to overhaul management of their assets. Over the next three to five years, those funds will face growing pressure to hedge up to half of their liabilities, turning to asset classes such as Treasury inflation-protected securities, real estate investment trusts, timber, high-yield debt and mortgage-backed securities, he said. Another quarter of assets will gravitate toward portable alpha or "target return" strategies, which charge little for "beta" and higher fees for alpha. A big chunk of the remainder will go to absolute-return strategies, he said.

Such predictions call into question the outlook for money managers who have focused on traditional core equity and bond products.

"It's an interesting question: If this kind of thinking continues to gain traction, how will people use long-only managers?" asked Bernard Winograd, president of Prudential Investment Management, Newark, N.J. "Taken to its logical extension ... you can talk yourself into not needing any." But that's an unlikely outcome: if delivering consistent alpha were that easy, life would be a lot simpler, he said.

For a pension executive, pursuing an alpha-focused strategy "only makes sense if you're highly confident that you can pick good managers," said GMO's Mr. Inker.

Capacity constraints should also serve as speed bumps on the road to absolute returns. Christopher M. Pope, senior principal at SSgA, said while the firm has its own proprietary absolute-return strategies and is looking to develop more, "there really are finite limits to this. We're never going to be able to run as much money in long-short equities as we're going to be able to in long strategies."

Executives at traditional money managers note that their core equity strategies have been enjoying strong inflows as well over the past year. Edward C. Bernard, president of T. Rowe Price Investment Services Inc., Baltimore, said his company isn't deaf to the changing needs of the marketplace, but to date T. Rowe sees plenty of opportunity in traditional products.

As demand for alternatives rises, however, the business opportunities there must appear more compelling. "Every traditional money management firm is thinking very hard about alternative investments," said Christopher J. Acito, a principal at Darien, Conn.-based vendor consultant Casey, Quirk & Acito LLC.

"We have not felt the need to have these alternative" products, but with the chunk of institutional portfolios parked there probably approaching 20%, "you have got to be wondering," said Mark Fetting, president of Legg Mason Inc., Baltimore.