Rachel Oliver reports from the US on the forces at work shaping the asset management industry

In one investment manager's words, you would have to have been living in a cave over the past few years not to make money in the US. Well, those days are over.

The Raging Bull, in its retreat, is forcing asset managers into delivering on their favoured phrase - that client service is more important than investment performance - they had better be right.

So, while many managers will shrug off the merger mania of recent years saying that consolidation activity is not really any stronger now than it was ten years ago, asset managers are in truth putting their all into accumulating assets, into persuading clients to weather the bad times by their side.

The US defined benefit (DB) market is, of course, a performance-driven business and is not growing in real terms, steadily turning into a world of waiting for the other guy to slip up on a mandate so managers waiting on the sidelines can move in.

That pool of assets isn't really growing...the investment management community is fighting for market share," says Frank Keeler, president and CEO of Invesco (NY). Very few brand new DB mandates are handed out these days and the plans have been in a negative cash flow situation for some time, though the market lift has helped growth, according to Ernst & Young.

On the other hand, the US asset management industry is all very aware of the very real growth of defined contribution (DC) schemes in the US market which are now neck and neck with DB plans both holding around $1.5trn in assets each. The majority of new plans being set up in the US are going down the DC route, so while managers are on the one hand are concentrating on keeping hold of their DB clients, they are also realising the need to get into DC. And fast.

"This is a performance-driven business and the really large firms are being forced to adopt a standard corporate planning kind of way of looking at the world and they are looking at growth in cash flows and there is no growth in cash flows in the DB market in the US so that forces this expansion," says Ernst & Young's Peter Marshall. "The DB market is a share shift market in the US as it is in the UK and you can take business from somebody else so you are always looking for someone to stumble."

And while there is no question of DB heading towards extinction, the attractiveness and growth potential of DC as the fairly young but pensions market of the future has steadily lured traditional DB managers such as JP Morgan, Morgan Stanley and Bankers Trust into the market. "It's still a market share game," says Keeler. "But at least you know all the assets are growing." He adds: "There is much more room for new growth as opposed to fighting this game."

One method DB managers are using, says William Hogan at Ernst & Young, is to adapt existing investment products to the new market. "They have been primarily taking DB investment management products and turning them into DC products, taking the investment performance records and the style records and turning them into DC products, and trying to access the distribution channels that DC products follow. Either by partnering up with a retail mutual fund distribution firm, acquisition, or partnering up with one of these supermarkets like Charles Schwab."

Morgan Stanley Asset Management which runs around $156bn in institutional assets is strategically focusing on the DC market, keeping the distribution issue an utmost priority. "We have a major push on to get into the DC business, by cross-selling to many of our clients," says Frank Minard, managing director, global sales and marketing. "We are using every distribution platform we can get our hands on."

One of the most publicised moves into was JP Morgan's recent partnership with US bundled service provider American Century. JP Morgan which currently runs $151bn assets worldwide has put DC at the top of its agenda as the major strategy for the organisation. "These were unimaginable outcomes 15 years ago," says Dennis Kass, vice chairman at JP Morgan Investment Management in New York. "No one would have thought that there would be this kind of extraordinary change in the structure of the market and this change has obviously very profound implications for firms such as ours who historically had a strong position in the DB market."

However he notes that the DB market will continue to be one of importance to asset managers. While the share of total DB plan assets may be shrinking there is absolute growth in the market, he says which JP Morgan forecasts to be approximately 4-5% per year. "So this remains a growing market and for firms that are well positioned, remains a very attractive market."

Approximately 80% of JP Morgan's institutional business is US-sourced and at least 90% is DB, exposing the lack of previous in-house experience in the DC market. The problem with DC has been that it has traditionally been dominated by the big providers such as Vanguard, Fidelity and T Rowe Price with State Street Global Advisors (SSGA) also experiencing some substantial success. DC Plans are not in the habit of changing their provider at the same rate on the record keeping side as DB plans do on the asset management side so bundled providers will have an uphill struggle to compete with existing providers. Some say the only real route in is purely offering investment management by offering mutual funds and separate accounts to DC plans.

The vast majority of United Asset Management's (UAM) business is sourced from DB plans and while it runs some DC money on an individual account basis it is not planning to offer fully bundled packages and in fact got out of that business fairly recently. "It's a black hole," says John Cook, president of UAM Investment Services in Boston. "The providers have already been established," warning newcomers that, "It's a tough business in which to make a profit".

JP Morgan is often viewed as going it the 'right' way if not the only way in accessing the market. Rather than try and learn the business for yourself, simply buy an established provider, American Century. "This has positioned us to compete for business which we never could have competed for before and with success," admits Kass. He adds: "We are going head to head with Fidelity and other very well established providers with sizeable plans and winning so that is obviously very important evidence of the strength of the partnership."

Since the partnership agreement, JP Morgan has been developing its skills in areas outside the traditional areas of its expertise: "We are obviously needing to become more expert in addressing different sets of issues, that tend not to be the investment performance issues so much but the HR...and obviously we have to become much more retail in the understanding of the individual investment making decision process."

The subject of size of course is more prevalent in the DC market, for those who wish to offer bundled servicing. But warns Marc Rosenblum of Ernst & Young, scale is no signal of success. "Scale is not proven to be a guarantee of low costs in administration," he says. "There are several examples of even larger record keeping shops just haemorrhaging money in technology investments that don't always pan out."

The size issue of course is one that seems to drive the global asset management industry, where a manager's worth is measured far more by its assets under management than its profit margins. And the recent high profile mergers over the years of Dresdner and RCM, UBS and Brinson, Citigroup and Salomon Brothers, have given a clear message that you have got to be big to make it in America (see pages 17-20).

"The people who are really threatened are the mid-sized and lower with core performance," says Ernst & Young's Marshall. "If you are a giant firm, most of them sooner than later have to come to the recognition that sustaining superior performance when you are that big becomes incredibly hard so you are trying to build relationships that are going to endure tough patches. Then you are investing to follow your plans around the world, investing greater service capability."

He adds: "So you are trying to compete on a level of service and relationship in acknowledgement of the fact that there are going to be times when the performance is going to fall off."

Size is of course essential on the indexed side of the business, points out SSGA's John Grady, principal, based in Boston. "On the indexed side they say tactic is nothing, the more you have the more leverage you have."

The subject of size is of evidently of great importance to the investment manager, and one would assume these economies of scale is best fitting for the giant plan. As Jack Miller, vice president of business development of the $75bn General Motors plan investment management arm (GMIM) in New York, says, "If you looked at our manager line up you would probably find more large managers than small managers. I don't think we would ever truly deal with a boutique - because of our very size we cannot give somebody $10m."

He continues: "In large cap or in bonds, fixed income, or even international equity, you'll find a lot of big names in our manager line up and that is again down to the fact that these people have been very successful, we do believe that a global presence is beneficial," he says.

So how important is size within the US institutional asset management arena? "I think it is very dangerous to seek to be the biggest or trying to be big for bigness sake," argues JP Morgan's Kass. "The key of course is being able to demonstrate investment skill in what is and what will remain a specialised world." He adds "I don't see boutiques going out of business."

"There is absolutely no proof that a large organisation can perform better than a small organisation," insists UAM's Cook. "Smaller firms that are committed to a certain type of investing, are going to get the returns." UAM, famously owns 50 firms and adopts the multi product philosophy. "I think it is a sounder business approach, to have a broader base of investment products."

However on the DC side to be a bundled provider requires serious investment and this managers concede will be the domain of the giants. And this has been an area where UAM has moved out of.

Comments Ernst & Young's Hogan: "They recently chose to exit the bundled DC business after a five year start-up here in the US as they realised that there was no way within five to six years that they were going to build up the scale to be able to accommodate to make it a profitable venture for them."

This of course applies to many of the mid-sized managers who do not have the economies of scale to compete across the board. "A lot of the middle players today who provide both investments, maybe a small supermarket capability, and administrative performance are just going to be pushed out of the market." He adds: "They are not going to be able to make the expense to be able to continue to provide that fully bundled product."

As a result they will be either acquired or will relinquish the administration capability to someone and concentrate on core investment management capability, UAM being an example of this.

"There is a strong argument for scale in many practices," concedes Kass. "The question that often does arise is are there limits to investment capacity, in particular a market sector with a universe of securities, that puts a ceiling on how much can be actively managed in a particular strategy." One of the many benefits of scale of course is that it allows you to invest in developing strategies to get the best out of your investments, he says. "You can benefit from scale in terms of the investment that you can make in core capabilities."

DC plans themselves have been busy consolidating their businesses behind the scenes. Within many, the treasury departments are more and more taking over the responsibility for the DC plan away from human resources, as concerns over performance become ever more prevalent following recent market volatility and the very real possibility of a bear market looms.

"In the last two,three years, the treasury function is trying to take control of defined contributions which historically was done on human resources," says Marshall. The reason being behind this is as assets increase a scrutiny on fees heightens. "A lot more of the expertise which has resided in treasury in order to support DB plans can be transported, and really those financial topics really tend to be beyond the ability of the HR department to cope with. They need people that have sophisticated investment analysis capability," adds Hogan.

Some are even using the same managers for both DB and DC schemes in an effort to tighten control over their resources.

"There is clearly a consolidation going on," says MSAM's Minard, "Where they are trying to reduce the number of managers that they deal with and give them greater mandates." He adds: "Some organisations are unifying that so you can actually have one pool of money managed by the same person and then you would have units for DB and units for DC."

SSGA notably won a $650m indexed mandate recently for both the DB and DC plans of US consumer company Fort James in Chicago. Fort James which has a total of $3.1bn in pensions assets is currently using many other of the same managers for its DC plan as it does in its DB plan.

On the DB side, mandates appear to be growing in size and at the same time the number of managers being employed are said to be decreasing, as DB plan sponsors themselves undergo their own internal overhauls of cutting resources and seeing the benefits of employing less managers with greater capabilities as opposed to many managers with single competencies, not forgetting of course that they will be cutting the fee expenditure in the process.

In response to this, asset managers in their quest for size are at the same time either creating or realising a pressure to reinvent themselves as 'multi-product' managers. On first glance the idea of being all things to all people does not bode well with sustained outperformance, and in fact looks to be more of a hindrance in the DB market unless you have been hired from a smaller plan to manage a balanced-type mandate. But on the flip side, it is a definite must for those looking at the DC market. From GMIM's Miller's point of view, "Depending on their corporate business plan, they need to be multi-product managers. If you are going to operate in the DC environment, being a multi-product manager is a definite plus".

Invesco's strategy worldwide is to have a very wide product line and markets itself as a multi-product manager. "There are several strategies but to keep it simple in the investment management business, you can either do one thing and do it well," he says, "or be firms like us which are truly global in scope...we have decided we are going to be big and we are going to have a long line of products to distribute to every conceivable buyer" .

"There continues to be some very strong forces at work favouring manager consolidation, using fewer managers to do more and as a result of asset concentration," adds JP Morgan's Kass. "We have seen our business change or evolve in the last few years to include many more multi-product mandates for our clients."

JP Morgan has over the years added resources and capabilities to both manage multi asset class portfolios for clients and "drawing on that same expertise from those large relationships to be able to counsel clients". He adds that the emerging preference, particularly of large plans, seems to be to use fewer managers for more, for reasons of simplicity in their manager structures, for what they perceive to be a higher quality information that they obtain with managers and for reasons of cost savings. "There really does seem to be a preference to work with fewer rather than more managers... And we are benefiting from that trend."

In many cases, managers have ceased to be known as just managers, taking on the rather grander title of 'strategic partners' which in itself signals a less temporary relationship, while in essence they are doubling up as investment advisers to the scheme. MSAM, JP Morgan and SSGA are examples of asset managers adding 'manager of manager' capability as another string to their bow.

"More and more large pension plans are willing to pay for asset allocation advice," says MSAM principal in charge of product development, Paul Klug. Morgan Stanley has been developing this side of the business acting as an adviser of sorts. "We have had a number of assignments where we have been hired to be the asset allocater over other asset managers." MSAM also recommends other managers as part of this advice which Klug admits is "a difficult situation". "We have a pretty substantial part of our business, where we are paid only in a fiduciary capacity to provide an assessment of the clients needs, to recommend an asset allocation for the long term, to interview and monitor managers and then to assist the client in its activities of putting the money out with these different firms, and monitoring the performance of those managers."

Klug insists however that this is not stepping on the toes of the consultants, as MSAM would be acting solely as a fiduciary also performing the recordkeeping tasks. "Consultants will not necessarily be involved with the allocation and recordkeeping," he says.

While SSGA operates on a manager of manager basis in certain cases, John Grady, principal, admits it has its conflicts with the consultant community, but adds "I don't see it as a conflict frankly, because the reality is we are responding to what they need, no more then Frank Russell who has a manager of managers and SEI which does the same."

MSAM has been performing this role for around 10 years but this activity is not common amongst the investment management community. In more recent times, MSAM has expanded this business overseas and doing asset liability studies for some Dutch funds "In fact we are going even deeper into the needs assessment than we are here," he says. "The difference in Europe is that we are also using our asset management capabilities, whereas here we have made a very clear separation up to this point anyway."

Client service has in some ways overtaken investment performance in terms of priority for asset managers, which according to GMIM's Miller can only be a good thing for future sustained growth. "I think the successful firms are going to be ones that define their business as very good at relationship building with clients as well as good at investment, because the plan is really looking for a well-rounded relationship, well beyond just the investment performance."

He adds: "There are a number of good managers out there - how do you differentiate yourself? How do you secure that loyalty? I think it is through a strong relationship and excellent, excellent client service."

So the industry on the DB side is in a situation of what is known as 'asset gathering' whereby, foreseeing the stormy markets ahead, managers are putting their all into improving service and client relationships to retain the clients, to weather the storms. "About 65% of our incremental new venue comes from existing clients" says SSGA's Grady .

With large money managers looking for longer term relationships which will endure the bad times, there will be increased pressure to find new and improved investment methods to achieve the results which would have been relatively easy over the past 10 years. And recent events will have undoubtedly impacted on plan sponsors' asset allocation outlook. "I think it's changed people's attitudes," says Miller. "It may not be a sea change, but I think they are going to give risk more prominence."

As such, style analysis, risk management and an overall awareness of structured products are becoming of paramount importance to plan sponsors, and also compounds the reason perhaps behind the move to taking the responsibility of running the investments side of DC schemes out of the hands of the human resources departments into those of the Treasury. SSGA recently went so far as to patent a quantitative stock selection method, giving them the upmost protection from rival managers imitating their style.

While more and more plan sponsors are becoming interested in risk management, this is not by any means a recent phenomenon, though recent shakes in the world's markets, the emerging markets crisis and most recently LTCM, has compounded the belief in keeping a check on risk.

"If you believe that the markets are not going to be that kind to us over the next few years, which doesn't mean they are going to go down, it just means they are going to be more difficult and challenging to make money, then manager risk is going to be an important element," says Klug.

More surprising then, that alternative investments continue to be the darling of the asset management industry, enjoying sustained growth. Investments in private equity, hedge funds and market neutral techniques continue to grow steadily amongst plan sponsors (see page 15). Chase Manhattan has recently set up a new division in the US dedicated to alternative investments. And mid-sized Boston-based manager Standish Ayer & Wood is currently running around $800m in market neutral strategies alone.

Warburg Pincus recently raised $5bn for its private equity fund - Warburg Pincus Private Equity Partners - over a 6-month period. "Most of it is pension money, but there is some bank and insurance money," says Brady Lipp, marketing director, in New York. Much of private equities' attraction stems from its historical returns combined with its diversification benefits. "There hasn't always been a strong correlation between private equity and the S&P500 for example," he says adding "A lot of the publicly traded stocks have grown quite expensive".

"They are much more opportunistic than they used to be," says MSAM's Minard. "Whether this meltdown in the emerging markets will change this approach I am not sure but they are clearly recognising that absolute rates of return are more important than relative rates of return. Purely beating the S&P isn't something they are solely concentrating on."

The General Motors plan invests around 12% in the private markets and real estate and has obviously not been swayed too much by the recent emerging market shakes and the more recent hedge fund crisis.

"We can always be caught by certain surprises like emerging markets not doing well," says Miller, "And I don't think there's any way to avoid that kind of tidal shift, but I think we try to make sure that things like reputational risk or systems and model risk, I think we have seen several examples, I think the LTCM issue was one of modelling risk, they just did not believe truly that they had a risk exposure"

He adds: "Increasingly quantitative systems and highly numeric investment choices really createa different kind of risk that we are really trying and working very successfully up to now of trying to introduce a risk management system that will cover all our exposures."

US plan sponsors are also looking to diversify more internationally, and many US plan sponsors are now viewing the world more in terms of sectors than countries, though this cannot be applied across the board as many plans' exposure internationally will be too low to analyse it in such detail.

Joseph Trainor, managing director at MFS Institutional Advisors in Boston, sees incredible growth in international equity exposure from large plan sponsors. "There has been a convergence of thinking that before you had some plan sponsors who only had 20% in domestic equities and some had as high as 70%, that range has narrowed now," he says. "The real surprise has been international equity where you have seen it go from 2-4% up to 12% for the average large plan sponsor."

Small caps continue to grow in popularity at an astronomic rate, so much so, that it is a common occurrence for managers to refuse new funds, for fear of losing the liquidity and performance. "Most good small cap managers are closed," says Trainor. As a result plans are looking to mid caps. "That is a trend that is going through the industry that people are looking at mid-cap managers to fill a small cap mandate because small cap managers are closed." MFS is closed itself and is not planning to launch a new small cap fund, one of the reasons being that 50% of the holdings of its mid-cap product is in its small cap product.