Success in

Investment Management:
ßviíaivg ava Mavagivg tbe
Covpíete íirv
Merrill Lynch & Co., Inc.
BARRA Strategic Consulting Group
Jun. 1, 2000
Merrill Lynch & Co., Inc. is one oí the world`s leading íinancial
management and ad·isorv companies with oííices in +3 countries and total
client assets oí about :1.8 trillion. As an in·estment bank. it is the top global
underwriter and market maker oí debt and equitv securities and a leading
strategic ad·isor to corporations. go·ernments. institutions. and indi·iduals
worldwide. 1hrough Merrill Lvnch In·estment Managers. the companv is one
oí the world`s largest managers oí íinancial assets.
1he Financial Institutions Group FIG, at Merrill Lvnch pro·ides In·estment
Banking ser·ices M&A ad·ice as well as equitv and debt underwriting, to
banks. insurance companies. asset managers. íinancial technologv and other
specialtv íinance companies worldwide. O·er the past íi·e vears. Merrill
Lvnch FIG has been the leading íinancial ad·isor to the asset management
industrv. with a market share in merger and acquisition transactions oí +2°
and a market share in capital raising transactions oí ¯8°.
BARRA Strategic Consulting Group (BSCG) specializes in pro·iding
management consulting ser·ices exclusi·elv to in·estment management íirms.
BS(G deli·ers ·alue to its clients through a unique combination oí deep
industrv knowledge and experience. solutions-oriented thought leadership. and
a pro·en abilitv to create change within organizations.
BS(G`s ser·ices range írom de·eloping strategic ·isions through designing
and implementing tactical business plans. including merger and acquisition
assessment and post-merger integration. Vith o·er 10 vears oí experience.
BS(G has worked extensi·elv in all major íunctional areas including
in·estments. sales. and client ser·ice, íor both the institutional and retail
markets. BS(G`s client base represents manv oí the world`s leading
in·estment managers.
BS(G emplovs a team oí thirtv proíessionals that represent a purposeíul
blend oí management consulting. in·estment management. in·estment
consulting. and market research experiences. 1hrough an aííiliation with
BARRA Rogers(asev an in·estment consulting íirm representing clients with
o·er :+00B in assets, and BARRA. Inc. the world`s leading pro·ider oí
in·estment analvtics,. BS(G integrates a still broader set oí in·estment
expertise. analvtical tools. and global perspecti·es.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
Table oí Contents
Acknowledgements 3
Introduction and Executive Summary
• Vhv another industrv re·iew.
• Organizing our thoughts
• Primarv conclusions
1. Understanding Your Environment
• 1he emerging third generation
• Vhat's dri·ing change.
2. Primary Industry Implications
• 1he (lient-Partner-(ompetitor (P(, paradigm connects us all
• Manuíacturing qualitv reigns
• (lient segments matter
• Lííiciencv energizes true talent
3. Critical Success Factors: The Complete Firm
• Business management
• In·estment manuíacturing
• Distribution
4. Models íor Success
• Four ·iable business models
• Optimal size
• Managing íor growth
Conclusion 43
Appendix: Manage Embedded Alpha, Cut Those Hidden Costs 45
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
1his paper was jointlv prepared bv Merrill Lvnch & (o.. Inc. and BARRA Strategic (onsulting Group. and is based
on research conducted bv both íirms.
m.rr1II 1+n.h & Co., 1n.. .on:r1ou:oro 1n.Iud..
Gregorv J. Fleming lead. U.S. Financial Institutions Group
Da·id N. leaton Vice President. Financial Institutions Group
B. Andrew loo·er Vice President. Financial Institutions Group
(hristopher G. lirk Associate. Financial Institutions Group
Rahul Mehta Analvst. Financial Institutions Group
1A11A 5:ru:.«1. ConouI:1n« Grouµ .on:r1ou:oro 1n.Iud..
John F. (asev (hairman. BARRA Rogers(asev
(hristopher J. Acito Managing Director
Jeb B. Doggett Managing Director
le·in P. Quirk Managing Director
\. Vavne Lin Associate Director
V. Greth Lester Senior Analvst
Jenniíer M. Mel·ille Analvst
Jacob A. Stahler Analvst
Virginia (. Lutkins Administrati·e Assistant
Amv Videira Administrati·e Assistant
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
Ve would like to thank a number oí senior executi·es in the in·estment management industrv who pro·ided us with
thoughts and ideas on the opportunities and challenges thev are íacing. 1heir unique perspecti·es and insights
assisted us in shaping this paper.
5µ..1uI :hunLo :o.
Jessica M. Bibliowicz President & (hieí Lxecuti·e Oííicer National Financial Partners (orp.
Marshall N. (arter (hairman State Street (orporation
(hristopher M. (ondron President & (hieí Operating Oííicer Mellon Financial (orporation
Michael V.R. Dobson lead oí Asset Management Deutsche Bank AG
lenneth L. Dowd. Jr. Director oí In·estments (itigroup Inc. (onsumer Bank
Patricia (. Dunn (hairman Barclavs Global In·estors
Laurence D. Fink (hairman & (hieí Lxecuti·e Oííicer BlackRock. Inc.
Gregorv (. Fisher (hairman. Global In·estment (ommittee Deutsche Asset Management
(arol Gallev Joint (hieí Operating Oííicer Merrill Lvnch In·estment Managers
John l. Gav First Vice President & (o-lead oí (orporate Strategv Merrill Lvnch & (o.. Inc.
Roger lertog President & (hieí Operating Oííicer Saníord (. Bernstein & (o.. Inc.
Richard M. lorlick Managing Director. Global Institutional Group Fidelitv Institutional Asset Management
Villiam R. latz Vice President. Lquitv Research Merrill Lvnch & (o.. Inc.
Judah S. lraushaar First Vice President. Lquitv Research Merrill Lvnch & (o.. Inc.
Lawrence J. Lasser President & (hieí Lxecuti·e Oííicer Putnam In·estments
Bridget A. Macaskill President & (hieí Lxecuti·e Oííicer OppenheimerFunds. Inc.
Ldward L. Madden Vice (hairman Fidelitv Management 1rust (ompanv
Villiam J. Nutt (hairman & (hieí Lxecuti·e Oííicer Aííiliated Managers Group
Jeíírev M. Peek President Merrill Lvnch In·estment Managers
V. Allen Reed President & (hieí Lxecuti·e Oííicer General Motors In·estment Management (orp.
Robert L. Revnolds President Fidelitv In·estments Institutional Retirement Group
Villiam J. Rittling Director. Non-Proprietarv Funds Merrill Lvnch & (o.. Inc.
Jeíírev L. Shames (hairman & (hieí Lxecuti·e Oííicer MFS In·estment Management
John L. Steííens Vice (hairman oí the Board Merrill Lvnch & (o.. Inc.
1akejiro Suevoshi Lxecuti·e Vice President Nikko Asset Management (o.. Ltd.
Also. we are indebted to Joseph S. Nankoí. Robin S. Pellish. Gregorv 1. Rogers. Patrick J. Rudden. and
Villiam Sterling íor their critiques oí preliminarv draíts oí this paper. In addition. we wish to acknowledge the
assistance oí Nigel Adam. (hairman oí (ompton (onsulting Group. Inc.. a Boston-based íinancial communications
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
Introduction and Executive Summary
Why Another Industry Review:
1his paper is moti·ated bv our belieí that the in·estment management industrv is
rapidlv entering the next phase oí its maturitv. O·er the past decade. the industrv
has enjoved a period oí extraordinarv prosperitv. 1he long bull market in equities
and the increasing aííinitv íor proíessionallv managed in·estment products ha·e
allowed íirms to grow assets under management and re·enues with relati·e ease. An
emerging competiti·e en·ironment. dri·en bv new technologv and a re·ersion to
more tvpical rates oí market returns. will be íar more challenging. Succeeding in this
new en·ironment will require the most signiíicant shiít in business management
thinking since the íirst generation oí in·estment managers emerged in the 1960s and
1he goal oí this paper is to deíine the kevs to success in this new en·ironment.
Purposeíullv. the paper does not íocus on data and statistics: these are well
documented in other sources. Rather. we aim to pro·ide a comprehensi·e
prescripti·e strategic agenda íor senior industrv executi·es. Ve will deíine in detail
the capabilities required íor the next generation oí managers and how these
capabilities should be organized.
Vhile our analvsis draws hea·ilv on experience in the U.S. markets. we belie·e that
the paper's conclusions are applicable íor all geographies. Ve do not think that asset
management in other countries will necessarilv e·ol·e to look like the U.S.: howe·er.
the íoundations oí success in manv cases will be the same.
Organizing Our Thoughts
All íuture successíul íirms. regardless oí size. will share a common set oí
characteristics. Ve reíer to such companies as (omplete Firms. 1his paper
describes the (omplete Firm in detail. both the capabilities it possesses and how it is
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
organized. Ve belie·e that understanding these principles will help set the strategic
agenda íor senior executi·es in the in·estment management industrv.
(hapters 1 and 2 describe the íorces that are creating change in the industrv and the
resulting competiti·e en·ironment. Dramatic ad·ances in technologv and the
expectation oí more normal in·estment returns are dri·ing a rapid transition to the
1hird Generation oí in·estment management. 1his e·olution. which reílects
ine·itable industrv maturation. will demand eííiciencv and business management
As the industrv matures. íirms must íullv understand íour broad principles that will
dominate the new market en·ironment.
• The Client-Partner-Competitor (CPC) paradigm connects us all.
Managers will ha·e an e·er-increasing set oí opportunities íor alliances.
partnerships. and acquisitions. (ompeting íirms will íind it necessarv to
enter into relationships with one another in order to source in·estment
manuíacturing. le·erage distribution channels. and outsource operations.
Successíul íirms will íocus exclusi·elv on the acti·ities that thev do best.
using (P( relationships to deli·er the balance.
• Manuíacturing quality reigns. Unrelenting ad·ances in client and
intermediarv sophistication in all segments and geographies, will place a
premium on the highest qualitv in·estment manuíacturing. Qualitv will
be deíined not onlv in terms oí historic períormance. but will also
include an appreciation oí in·estment process e.g.. transparencv and
percei·ed repeatabilitv, and a greater recognition oí the risks taken to
produce a gi·en return.
• Client segments matter. listoricallv. the in·estment management
industrv has been product-dri·en. Going íorward. íirms that understand
and embrace the unique needs and preíerences oí their target client
segments will be critical to a competiti·e ad·antage.
• Eííiciency energizes true talent. Barriers to entrv in in·estment
management will remain low. pro·iding emplovment alternati·es íor the
most talented indi·iduals. In response. in·estment management íirms
must craít proíessional en·ironments where this talent is most
producti·e. 1his will require more than just pro·iding an equitv stake to
kev indi·iduals. successíul íirms will not encumber true talent with
bureaucracv or a·erage colleagues.
(hapter 3 deíines the íactors that will determine success in the third generation.
Speciíicallv. we describe sixteen capabilities that deíine a (omplete Firm. (omplete
Firms bring to bear a broad set oí balanced capabilities in in·estment manuíacturing.
distribution. and business management. 1hev íocus on core competencies and
aggressi·elv le·erage the (lient-Partner-(ompetitor nexus to enhance and extend
their capabilities.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
Despite their common characteristics. (omplete Firms will not be homogenous. In
íact. as (hapter + describes. íour primarv business models will be ·iable in the third
• Distribution Specialist: a distributor oí primarilv third-partv in·estment
products through proprietarv channels
• Single Platíorm Manuíacturer: a single in·estment platíorm which
íocuses on more specialized asset classes or in·estment stvles and
le·erages third-partv channels íor distribution
• Franchise Conglomerate: two or more in·estment platíorms which
share a centrallv managed distribution capabilitv
• Financial Holding Company: collection oí non-integrated (omplete
Firms brought together íor íinancial reasons such as creating a liquid
equitv currencv,
Primary Conclusions
Among this paper`s more speciíic propositions. executi·es oí in·estment
management íirms should consider the íollowing:
• 1odav onlv a handíul oí companies are close to being (omplete Firms.
Manv oí the (omplete Firm capabilities are not incorporated in second-
generation in·estment managers.
• Distribution and manuíacturing must increasinglv be managed
independentlv to the highest qualitv períormance standards and
economic return. 1he cross-subsidization that tvpicallv results írom
·ertical integration will not be as ·iable in an en·ironment that allows íor
non-proprietarv alternati·es íor sourcing or distributing products.
• Vith regard to in·estment manuíacturing. managers must e·ol·e írom
product íirms into capabilitv íirms. (apabilitv íirms can ílexiblv support
a broad number oí products ·arving in stvle. acti·e risk. benchmark.
etc., with a single in·estment platíorm. 1his e·olution will create
increased specialization between portíolio construction and research.
• Management oí Lmbedded Alpha. the írictional costs oí running a
portíolio. will emerge as an essential contributor to in·estment
manuíacturing qualitv and períormance.
• Stvle is dead: long li·e stvle. Recent conditions in the equitv and íixed
income markets ha·e demonstrated the inadequacies oí simple stvle
boxes¯ and the common benchmarks associated with them. Going
íorward. stvle deíined more comprehensi·elv bv its underlving risk
íactors, will be ·iewed as onlv one oí manv acti·e bets to which a
manager can attribute skills. within an emerging risk budgeting
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
• 1o empower a íirm`s best proíessional talent. technologv should be
substituted íor anv human capital that does not diííerentiate the íirm:
also organizations will need to be continuallv streamlined meritocracv
through downsizing¯,.
• Potential acquirers oí in·estment management íirms must not be ·ictim
to the AUM íetish.¯ Acquisitions must increasinglv íocus on qualitv.
not necessarilv size. 1he likelv industrv consolidation in assets will come
graduallv as clients transíer assets to qualitv (omplete Firms.
• Successíul íirms must be prepared to regularlv recvcle equitv dvnamic
recapitalization¯, to continuallv pro·ide incenti·e and retain rising talent.
• 1he successíul integrated global business model will remain elusi·e. held
back bv signiíicant costs oí complexitv and the uncertaintv oí when
global opportunities will emerge. 1his creates a window oí opportunitv
íor local pro·iders to transition into (omplete Firms in order to maintain
and grow market share.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
Chapter 1
Understanding Your Environment:
The Emerging Third Generation
1he global in·estment management industrv is mo·ing rapidlv towards a new stage
oí industrv maturitv. Lííiciencv and proíessional business management will
characterize this 1hird Generation.¯ For perspecti·e. this chapter brieílv describes
the íirst two generations oí managers. It then analvzes the three primarv external
íorces dri·ing change in the industrv technologv. capital market conditions. and
global in·estment opportunities,. 1he U.S. experience is íeatured: howe·er. we
belie·e that this e·olution and these trends will be similar íor all geographies
importantlv. within a much more compressed time span,.
11ro: 1n+.o:n.n: munu«.n.n: uo u 1ro1.oo1on
In the earlv 19¯0`s three e·ents eííecti·elv triggered the proíessionalization oí
in·estment management. First was a growing realization in the U.S. that
demographic trends would cause the retirement svstem to become ·astlv under-
íunded ií action was not taken. Second was the poor market períormance in the
earlv 19¯0`s. 1hird. the enactment oí the Lmplovee Retirement Income Securitv Act
LRISA, in 19¯+ created enormous cash ílows írom pension íunds. initiallv in the
pri·ate sector.
As a result. institutions and then indi·iduals began looking íor in·estment
proíessionals to manage their assets. 1he banks and insurance companies that had
pre·iouslv handled institutional assets íound themsel·es se·erelv challenged in 19¯3-
19¯+. 1hereíore. a huge opportunitv arose íor indi·iduals with in·estment
management skills who íound that their ser·ices were in high demand and continued
pension cash ílows were assured. Further. buvers had a lower le·el oí sophistication
and reasonable expectations.
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
Gi·en the industrv`s low barriers to entrv. the íirst generation was marked bv the
birth oí boutiques. oííering mostlv core,balanced ser·ices to institutional clients.
1hese íirms tvpicallv íocused on one stvle oí management and consisted oí a small
team oí in·estment proíessionals. manv oí whom had leít the coníines oí larger
íinancial institutions. Although a ·olatile capital market en·ironment existed írom
19¯¯ to 1983. manv íirms attracted assets based on percei·ed proíessionalism and
5..ond An 1xµund1n« 1nduo:r+
1wo themes characterize the second generation: the continued proíessionalization
oí in·estment manuíacturing and an enormous expansion oí íranchises. In the
U.S.. the second generation began in the mid-1980s and has lasted through todav.,
O·er the course oí the second generation. buver sophistication graduallv increased.
íorcing a shiít írom a supplier-dominated industrv to one dri·en bv the buver.
In·estment management íirms responded bv de·eloping a wide range oí new
products enabled bv the widespread application oí modern portíolio theorv, and bv
in·esting substantiallv in manuíacturing inírastructures. 1o pro·ide better non-
in·estment ser·ices. íirms increasinglv began to recognize the dichotomv between
manuíacturing and distribution.
1he popularitv oí mutual íunds. the ad·ent oí deíined contribution plans. and the
globalization oí the world economv created an en·ironment in which in·estment
managers were presented with unimaginable opportunities to expand their
íranchises. Manv boutiques. íounded bv small groups oí indi·iduals and centered
around a narrow product line. grew into complex business organizations propelled
primarilv bv rapid organic growth. 1his resulted in massi·e accumulation oí assets.
signiíicant personnel growth. increasing technologv budgets. and multiplving
organizational complexitv.
1odav`s íirms are thereíore broadlv characterized as ha·ing o·erde·eloped
in·estment manuíacturing organizations relati·e to distribution,. immature business
management skills. high íixed costs. and a proliíeration oí mediocre products. 1hese
excesses oí the second generation ha·e persisted because the bull market`s riches
ha·e hidden the ineííiciencies and because manv clients ha·e not had the
sophistication or tools to íullv diííerentiate qualitv.
7h. 7h1rd 7h. ConµI.:. 11rn
Ve belie·e the global in·estment industrv has begun a rapid transition to a third
generation oí de·elopment that reílects ine·itable industrv maturation. Dri·en bv
new technologv. the expectation oí a lower return en·ironment. and global
opportunities each discussed in the íollowing sub-section,. íirms must de·elop a
broader set oí capabilities to be successíul. 1hev will need to balance qualitv
in·estment talent with sophisticated distribution capabilities. enabled bv the most
current technologv and operations. 1o deli·er the required eííiciencv. leading íirms
Future success will
require efficiency and
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
will possess superior business management skills íocused on enhancing core
competencies. Ve reíer to managers possessing all the critical success íactors to
thri·e in the third generation as (omplete Firms¯ see (hapter 3 íor a complete
deíinition oí the (omplete Firm,.
What's Driving Change:
1hree external íactors are íundamentallv reshaping the in·estment management
industrv: technologv. capital markets. and global opportunities. 1he coníluence oí
these íorces is accelerating the transition between the second and third generations
and will iníluence the capabilities required íor íuture success. Ve onlv brieílv
summarize these íactors as we belie·e that thev ha·e been well-discussed in other
industrv o·er·iews.
1echnologv is the most poweríul iníluence at work on both the distribution and
manuíacturing capabilities oí in·estment management todav. 1he magnitude oí this
impact should not come as a surprise: most in·estment management. like the rest oí
íinancial ser·ices. in·ol·es the processing oí digital iníormation. Vith regard to
distribution. managers must remember íour important aspects oí network technologv:
1. Instantaneous iníormation dissemination and discovery.
1echnological de·elopments ha·e led to the widespread a·ailabilitv oí
iníormation on product períormance that has dramaticallv changed buver
beha·ior. For example. in the mutual íund market. the abilitv to identiív
top períorming íunds on an almost instantaneous basis has encouraged
in·estors to place an unprecedented premium on percei·ed íund
períormance. (hart 1 shows the increased correlation between mutual
períormance and net ílows oí assets.,
2. Lower transaction and switching costs. Vith the growth in
alternati·e deli·erv channels. transaction and switching costs ha·e íallen.
1his is contributing. at least in part. to rapidlv rising redemption rates.
3. Standards íor inter-operability. Dri·en bv the common protocols used
bv the internet. iníormation can be more readilv exhanged.
+. Mass customization. 1he costs oí designing and deli·ering customized
ser·ice to anv indi·idual are íalling rapidlv.
Technology will
create new
opportunities for
both distribution and
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
1echnologv also enables higher qualitv in·estment manuíacturing. Some examples
oí this impact include:
• Artiíicial Intelligence will increasinglv be substituted íor human capital
• Internet or intranet technologies íacilitate the sharing oí knowledge and
research across an organization
• 1ools íor risk control. attribution. and portíolio construction are
becoming more sophisticated and broadlv a·ailable
Chart 1: Percent oí Total Net Flows by Morningstar Rating
Net Flows
1, 2 & 3
Star Funds
1, 2 & 3
Star Funds
4 & 5
Star Funds
4 & 5
Star Funds
´ovrce: ´trategic Ivigbt ´ivfvva, Merriíí Iyvcb
Cuµ1:uI murL.: ChuII.n«.o
It is not generallv appreciated that the majoritv oí the industrv`s growth o·er the past
íew vears has resulted írom market returns. not net new ílows oí assets. (hart 2
presents the components oí growth íor mutual íunds.,
1hereíore. íor in·estment managers. the primarv capital market challenge is preparing
íor a normal. or quite possiblv a below normal. return en·ironment. As pre·iouslv
mentioned. the prolonged bull market`s consistent asset ílows and steadv íee le·els
ha·e ílooded manv managers with re·enues and shielded them írom addressing
business ineííiciencies. Lxisting cost structures will put manv managers under íinancial
pressure in a lower growth en·ironment. As shown in (hart 3. re·ersion to historical
growth rates implies a single digit growth rate íor the next decade.,
How many firms will
be economically
viable in a normal
return environment?
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
Chart 2: Components oí Mutual Fund Growth
Net New Cash Flows (Sales Plus
Reinvestments Less Redemptions)
Effect of Market
Increase (Decrease)
0% 30%
32.0% 68.0%
50.4% 49.6%
55.1% 44.9%
46.5% 53.5%
39.4% 60.6%
-172.7% 272.7%
79.5% 20.5%
´ovrce: ´trategic Ivigbt ´ivfvva, Merriíí Iyvcb
GIoouI Cµµor:un1:1.o
1he expected growth rates oí demand íor in·estment management ser·ices are greatest
outside oí the mature markets. Demographic trends such as the aging oí populations
and increase in liíe expectancv. combined with a general under-íunding oí retirement
schemes around the world. will íuel continued growth in the worldwide demand íor
in·estment management ser·ices. Regulatorv reíorm will enable in·estment managers.
both local and íoreign. to take ad·antage oí these opportunities. For managers in
mature markets. who are íacing more limited growth patterns. these emerging markets
are particularlv enticing.
Chart 3: Reversion to the Mean
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
S&P 500 Historical Average Since 1926 Historical Average Since 1970
S&P 500 Historic
Long Term
Long Term
7.1% Implied Return
3.4% Implied Return
´ovrce: ß.RR. ´trategic Covvítivg Crovp
Global opportunities
are greatest.
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
Uníortunatelv. there remains considerable uncertaintv as to how. when. and whether to
address these opportunities. Successíullv going global¯ is a tremendous challenge. 1he
cost oí directlv building distribution outside oí the U.S. is prohibiti·e íor most
organizations. 1his has led manv íirms to set in place alliances or joint ·entures with
local asset gathering íirms in major markets. 1hese relationships. howe·er. take time to
negotiate and de·elop. 1here are íew near-term solutions to the challenge oí global asset
gathering and íew íirms are successíullv generating anv real growth todav. Meeting these
challenges in the íuture will require sophisticated business management skills. arguablv a
signiíicant amount oí cash. and a strategic time írame i.e.. 3-5 vears,.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
Chapter 2
Primary Industry Implications
1he shiít to the third generation will be characterized bv greater buver sophistication.
increased competition and continued low barriers oí entrv. As a result. there are íour
aspects oí the e·ol·ing competiti·e en·ironment which all managers must
1. The Client-Partner-Competitor (CPC) Paradigm Connects Us All
2. Manuíacturing Quality Reigns
3. Client Segments Matter
4. Eííiciency Energizes True Talent
1his chapter will discuss in detail these íour concepts and the most important issues
that are directlv associated with each oí them.
1. The Client-Partner-Competitor (CPC) Paradigm
Connects Us All
(hanges in the traditional relationships between clients and competitors will deíine
the third generation: speciíicallv. íirms that were historicallv competitors will
recognize and take ad·antage oí important opportunities íor strategic relationships.
1hese relationships can take the íorm oí alliances. joint ·entures. open architecture.
or general outsourcing to le·erage the capabilities oí other íirms. 1his paradigm will
dominate the competiti·e en·ironment. and (omplete Firms will aggressi·elv íorm
and manage these relationships to strengthen their position.
listoricallv. the lines oí competition ha·e been clearlv deíined. but this began to
change in the 1990s. For example. the open architecture structure oí mutual íund
supermarkets and deíined contribution plans started to require cooperation between
íormer ad·ersaries. 1his new cooperati·e structure created an en·ironment where
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
clients. partners. and competitors became interdependent. 1he increasing buver
demand íor the best products. combined with the iníluences oí open architecture and
the need íor in·estment managers to identiív and build competiti·e ad·antages. will
continue to dri·e the extension oí the (P( paradigm.
1.1 Cµ.n ur.h1:..:ur. ¬1II µ
Open architecture will allow íirms with a competiti·e ad·antage in distribution to
oííer the highest qualitv products to their clients. (P( puts a premium on
relationships: open architecture is an excellent wav to le·erage those relationships.
L·entuallv. all networks will come under pressure to assume some degree oí open
architecture. For example. large mutual íund companies mav e·entuallv allow their
wholesaling organizations to represent non-proprietarv products. 1hat is because
supporting these distribution organizations is expensi·e and the opportunitv to
spread this cost across a larger product set mav be appealing particularlv in the
context oí international distribution,. 1he same principles might be applied to the
institutional market. where a more strategic relationship such as partial ownership,
between distributor and manuíacturer mav be desirable.
1.2 W1:h1n 1nd1+1duuI 11rno, 1n+.o:n.n:o und d1o:r1ou:1on ¬1II o. nunu«.d uo
o:unduIon. .n:.rµr1o.o
In the past. manv organizations ha·e tried to create both substantial manuíacturing
and distribution capabilities. In some cases. excellent manuíacturers lacked the size
and scope to be eííecti·e distributors. In other cases excellent distributors oíten had
a íirst class network in place but were unable to manuíacture a íull range oí qualitv
products. In the third generation. in·estment manuíacturing and distribution will no
longer be able to cross-subsidize each other. 1he eííiciencv oí the (P( en·ironment
will require that distributors pro·ide the best products while qualitv managers will
ha·e access to all channels.
1.J 1rundo ¬1II .onnun1.u:. .or. .onµ.:.n.+
In an en·ironment that ·alues specialized capabilities. organizations must careíullv
create a market perception that signals their core capabilities. 1o resonate with
clients. both retail and institutional. in·estment management íirms must de·elop the
appropriate brands,identities íor gi·en segments.
• Ditri/vtiov iaevtitie: Firms that íocus on distribution will de·elop brands
that assure access to best-in-class products and ser·ices. Intermediaries
will stress objecti·e ad·ice that helps in the selection oí appropriate
in·estment products.
• Mavvfactvrivg iaevtitie: 1hird-generation íirms that choose in·estment
management as their core competencv will need a brand image built
around manuíacturing qualitv.
Distribution and
manufacturing must
be exposed to a
market discipline.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
2. Manuíacturing Quality Reigns
All client segments. and the intermediaries who ser·e them. are becoming more
sophisticated about quantitati·e and qualitati·e product attributes. Successíul íirms
must create products that speciíicallv articulate the risks to which thev are exposed
and consistentlv deli·er returns appropriate to that le·el oí risk. 1o assure this
qualitv. managers with in·estment processes that are transparent and incorporate risk
management and monitoring capabilities will be increasinglv ía·ored.
2.1 11«h.o: o:undurdo 1or 1n+.o:n.n: µro..oo.o r.ou1r.d
In all market segments. in·estment process qualitv is becoming a more signiíicant
component in manager selection,retention. 1his qualitv is being recognized in all
market segments to be as important as períormance. Ve belie·e that the in·estment
processes oí leading managers will share some common attributes:
• Process will be transparent. consistent. percei·ed to be repeatable. and
risk controlled.
• Lach step in the process will ha·e a speciíic set oí objecti·es and metrics.
• Process will incorporate svstematic íeedback and monitoring oí each
Ve are not implving armies oí people in·ol·ed in these in·estment processes. but
eííicient and eííecti·e teams deíined bv the tasks to be done. not the perception oí
1hese standards ha·e been largelv de·eloped in the U.S. institutional marketplace.
1o date. the leading íixed income managers. and a select group oí equitv managers
ha·e been the most inno·ati·e practitioners. lowe·er. as consultants expand their
acti·ities both globallv and into high net worth segments. and as intermediarv
distributors enhance their internal manager research capabilities. these process
standards will be applied more uni·ersallv. A disciplined in·estment process does
not implv low-risk products: the same principles applv to managers who seek
substantial acti·e risk.
As e·aluation ser·ices and intermediaries begin to recognize the ·alue oí high qualitv
in·estment processes. the indi·idual in·estor will incorporate all a·ailable
iníormation into a better iníormed in·estment decision. Rating ser·ices will
increasinglv look at risk and return írom this perspecti·e. Sophisticated analvsis
írom leading risk tools will be incorporated into scrutinizing the in·estment process
in all market segments. 1he retail indi·idual will not emplov the same buving
beha·ior as institutions. but will use similar iníormation to make decisions.
Process matters as
much as past
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
2.2 1u+.r r1oL oud«.:1n« ¬1II o..on. nor. r1«orouo
Buvers will scrutinize the manuíacturers` risk budget.¯ In a domestic equitv
product. the manager can add ·alue through risk íactors¯ stvle,. industrv allocation
or stock selection. In a íixed income product. managers can add ·alue through
duration,vield cur·e. sector allocation. issue selection. etc. Scrutinv oí these alpha
contributions will become the norm. (hart + illustrates the emerging risk budgeting
Chart 4: Buyer's Risk Budget (emerging íramework)
Style (Risk
Allocation Currency
Manager 1
(Domestic Equity)
Manager 2
Manager 3
(Global Fixed
Equity Fixed Income
Total Buyer
Risk Budget
x x x x
x x x x x
x x x x x
´ovrce: ß.RR. ´trategic Covvítivg Crovp
An implication oí risk budgeting is that current equitv stvle categories will become
less rele·ant because thev o·er-simpliív the components oí acti·e risk. For example.
·alue¯ is a stvle oí in·esting that has exposures to multiple risk íactors. 1hese
exposures ·arv signiíicantlv between managers. e·en between those in the same
stvle categorv.¯
1he emergence oí sophisticated risk management tools has introduced a clear and
accurate wav to measure acti·e portíolio risk in equitv. 1hev break down the
elements oí acti·e risk into risk íactors¯ which are íactors representing íundamental
characteristics that deíine a companv`s stvle.¯
In·estment consultants in the institutional market. and rating ser·ices in the retail
market. ha·e reiníorced the popularitv oí these categories. Managers ha·e been
placed in one categorv and their períormance judged relati·e to their similarlv placed
peers and,or the stvle-speciíic benchmarks e.g.. S&P,BARRA Value. Russell 2000
Growth,. Sophisticated buvers,intermediaries will migrate írom the traditional
allocation oí stvle categories to a core-and-satellite allocation based on le·els oí
acti·e risk and co·ariance. As an alternati·e. clients will supplement a low acti·e risk
core strategv with a series oí managers using ·arious in·estment philosophies that
take. and are rewarded íor. acti·e risk. Managers will be chosen íor their abilitv to
consistentlv deli·er excess return. especiallv in wavs that are less correlated with the
client`s other in·estments.
Traditional style
categories will
no longer
define equity
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
2.J 11oL und .x..oo r.:urn ¬1II r...1+. :1«h:.r
A major consequence oí greater buver sophistication is the broad recognition oí a
basic principle oí íinance: the trade-oíí between risk and return. 1he períormance
component oí in·estment qualitv is no longer deíined as rate oí return. but as some
measure oí rií aaivtea return. Not onlv do íirms appreciate that greater risk should
produce greater expected return. but thev are becoming more knowledgeable about
the sources oí risk. Less sophisticated buvers recognize onlv o·erall ·olatilitv and
the more basic risk exposures such as duration íor íixed income. and sector and stvle
íor equitv. Going íorward. thev will recognize more detailed risk exposures as well
as the impact oí indi·idual products on their o·erall portíolio.
Along with increased scrutinv oí sources oí risk. buvers will require managers to
identiív their core strengths and deli·er alpha ·alue added, accordinglv. Managers
will be asked to accuratelv articulate the sources oí alpha. For example. thev can no
longer claim íundamental research as the primarv generator oí excess return ií thev
are onlv adding ·alue through screens. quantitati·e model. or proprietarv data. 1o
maintain a competiti·e ad·antage in in·estments. íirms must be aware oí their
potential opportunities íor alpha generation. íocus on and highlight their alpha
generation ad·antage capabilitv. and neutralize areas where thev ha·e no ad·antage
risk budgeting,.
1his phenomenon is being dri·en bv two íactors. First. the tools that allow detailed
períormance attribution are being applied to all market segments. 1hese tools are
now used directlv bv clients themsel·es. or bv their intermediaries. and are becoming
embedded in íinancial planning soítware applications. Second. clients ha·e a much
wider awareness oí their own íunding needs: assets must match the risk proíile oí
2.4 1.n.hnurLo ¬1II o..on. nor. ooµh1o:1.u:.d und .uo:on1z.d
As the scrutinv oí qualitv in·estments increases and risk budgeting becomes more
rigorous. benchmarks will e·ol·e to become more sophisticated measures oí how
eííecti·elv a manager adds ·alue. 1he widelv accepted benchmarks used todav. in
manv cases. o·ersimpliív the dvnamics oí risk in the equitv market. Stvle
benchmarks. such as growth and ·alue. are usuallv based on simple methodologies
that do not account íor the complexities oí risk. 1hese benchmarks cannot adjust
íor changing market dvnamics. 1he result: each equitv benchmark is íar írom stvle
pure. In íixed income. as managers expand the opportunitv set írom in·estment
grade domestic securities into more speculati·e and,or íoreign securities.
benchmarks that accuratelv represent the appropriate opportunitv set will dominate.
In the íuture. standard¯ benchmarks will likelv decrease in popularitv to measure
risk. Rather. a customized benchmark with exposure to speciíic risk íactors similar
to the product might be used. As a result. the normal¯ benchmark will measure the
eííecti·eness oí a manager along a speciíic dimension oí risk. A normal¯
benchmark is a purer representation oí a manager`s philosophv and will more
benchmarks will
become commonplace.
Know where your
Alpha comes from.
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
accuratelv reílect the stvle. Using a normal¯ benchmark is the most accurate wav to
measure a manager`s true períormance. and can also be used as eííecti·e marketing
2.3 AI:.rnu:1+. 1n+.o:n.n: o:ru:.«1.o ¬1II o. nu1no:r.un
Another direct consequence oí growing appreciation íor the risk-return trade-oíí will
be greater interest in alternati·e¯ strategies. 1hese will become increasinglv
important in the context oí e·ol·ing buver risk budgeting techniques. 1he most
appealing aspect oí these products is deli·erv oí excess return with a lower
correlation to more traditional asset classes. Vhile these strategies can oííer high
absolute returns. thev also di·ersiív a portíolio and decrease o·erall risk. In
institutional portíolios. alternati·e strategies ha·e had the largest growth rate oí all
asset classes in the past íi·e vears. In the íuture. these asset classes will be
increasinglv less alternati·e¯ as thev gain broader acceptance.
1raditional alternati·e in·estments include hedge íunds. market neutral strategies.
real estate. distressed and pri·ate equitv. 1hese strategies which íocus on marketable
securities will be subject to e·ol·ing manuíacturing qualitv standards. 1hat is. thev
will need demonstrated process transparencv and percei·ed repeatabilitv. It will be
critical íor them to justiív current íee arrangements and íuture íit.
Newer concepts oí mixing and matching diííerent asset classes íor a desired risk-
reward proíile. or Strategic Solution Portíolios.¯ will become more pre·alent in
most íuture client segments. As buvers become more educated. sophisticated wavs
oí adding alpha to core holdings will become pre·alent. 1he concept oí portable
alpha is the abilitv to add ·alue to a benchmark or index through deri·ati·es and
adding a component oí another asset class. For example. a manager can buv index
íutures to gain exposure to the benchmark. and use the remaining cash in the
portíolio to gain alpha through a manager`s core competencv. 1he beneíit oí
emploving this approach is the abilitv to de·elop an enhanced index product with
lower correlation alpha. 1he source oí alpha is less important than the low
correlation and high consistencv.
2.ñ 1r1..o ¬1II o. ru:1onuI1z.d
As product qualitv becomes a more íullv appreciated concept. managers will be
under greater pressure to align their íees with their ·alue-added. Management
incenti·es will be more closelv aligned with períormance. (lients create this
alignment bv paving higher base íees to managers with higher excess return targets
and a more pre·alent use oí períormance íees relati·e to customized benchmarks.
Also. those managers who de·elop speciíic client solutions will be able to create
more dvnamic íee structures.
3. Client Segments Matter
A íirm`s abilitv to understand the needs oí its kev existing and potential clients will
become signiíicantlv more important in the third generation. listoricallv. as in most
e·ol·ing industries. in·estment management íirms ha·e been product-dri·en. íirst
Low correlation,
portable alpha.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
de·eloping products and then íinding the markets in which to sell them. As the
industrv matures. and growth requires taking market share awav írom competitors.
íirms will begin their product de·elopment írom the perspecti·e oí strategic markets
and client preíerence. Ultimatelv. íirms will increase their abilitv to de·elop and
enhance products and ·ehicles to meet the specialized needs oí their target clients.
J.1 7h. roI. o1 1n+.o:n.n: +.h1.I.o ¬1II .hun«.
As clients become more sophisticated. thev will begin to require the most
appropriate in·estment ·ehicles. In considering target client segments. íirms will
ha·e to design and deli·er the most suitable in·estment ·ehicle íor each segment.
Some examples oí aligning in·estment ·ehicles with client segments are presented
í·avpíe ]. In the high net worth and institutional segments. clients will demand wavs
oí exchanging customization íor cost. Some clients will desire model-based separate
accounts that are less customized and less costlv. 1his trend will require íewer
portíolio managers to support anv gi·en number oí accounts. pro·iding non-
portíolio managers are in place to deli·er the required client ser·ice. (ombined with
more eííecti·e technologv íor account administration. these eííiciencies will íurther
reduce the costs íor separate account management.
í·avpíe 2. For client segments that are not attracted bv the cachet oí separate
accounts. co-mingled ·ehicles will become increasinglv popular. (o-mingled pools
can oííer institutional ser·ice at lower íees than separate accounts. Skilled managers
will be able to deli·er some degree oí customization bv designing pools that meet
some common restrictions.
í·avpíe ². Increasinglv sophisticated clients. including deíined contribution
sponsors. are attacking mutual íund expense le·els. Institutional pricing will be
extended to additional markets. 1o stav competiti·e. mutual íund companies must
increasinglv make a·ailable alternati·e ·ehicles. Ií the buving patterns oí the
intermediaries start to dri·e the market-place. the supremacv oí the mutual íund
·ehicle mav be ·ulnerable in all but the least sophisticated market segments.
4. Eííiciency Energizes True Talent
1rue talent will remain a scarce resource in the in·estment management industrv. In
the third generation. barriers to entrv will remain low. pro·iding emplovment
alternati·es íor the most talented indi·iduals. 1hese indi·iduals will continue to
migrate to where proíessional satisíaction including salarv. culture and caliber oí
colleagues, is maximized. listoricallv this has led such people to hedge íunds and
other smaller boutiques where their talent can be most íullv expressed and egos
1o successíullv compete íor these indi·iduals. the third generation will require larger
organizations to create a proíessional en·ironment where talent is most producti·e.
Ve íoresee three trends as a result oí the third generation`s war íor talent.
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
4.1 7..hnoIo«+ ouoo:1:u:.o 1or hunun .uµ1:uI
Rapid ad·ances in technologv. including the application oí new technological tools.
will increasinglv substitute íor human capital. Automation can be ad·anced in areas
such as data collection and cleansing. client ser·ice report generation. portíolio
construction and trading. 1here are two reasons íor this change. First. industrv
salarv le·els. e·en íor moderatelv skilled indi·iduals. ha·e risen so substantiallv that
íirms will ha·e increased interest in íinding alternati·es. particularlv in a lower
growth en·ironment. Second. increased technologv will increase producti·itv oí the
most talented indi·iduals.
4.2 1ou1:+ o¬n.roh1µ ¬1II o..on. nor. µr.+uI.n:
1o align long-term interests between íirms and indi·iduals. third generation íirms
will pro·ide their best emplovees with equitv ownership. Ve discuss ownership in
greater detail in (hapter +.,
4.J Cr«un1zu:1ono ¬1II o:r.unI1n.
Most oíten. talent is most producti·e when unencumbered bv bureaucracv and
a·erage personnel. 1op in·estment proíessionals will continue to seek eííicient
organizations. In the transition írom second to third generation. íirms mav be
íorced to reduce personnel in certain íunctional areas. especiallv in in·estment
manuíacturing. 1his streamlining is to increase eííiciencv. not to achie·e cost
A challenge íor the industrv is that its dri·e íor eííiciencv does not recreate a star
svstem. 1he third generation will demand that indi·iduals be excellent at working in
concert with their colleagues. grounded bv sound process.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
Chapter 3
Critical Success Factors: The Complete Firm
1he pre·ious chapter described the industrv`s emerging third generation. 1o achie·e
success in this en·ironment. we belie·e that all in·estment management íirms.
regardless oí size. will share a common set oí capabilities. 1hese capabilities will
enable íirms to:
• Focus attention on their core competencies bv íullv le·eraging
outsourcing and alliance relationships to pro·ide other capabilities
• Assure product qualitv
• Design and deli·er optimal product and ser·ice oííerings to their target
• Identiív. attract. and retain the best human capital
As listed in (hart 5. we identiív sixteen critical third generation capabilities. Ve reíer
to organizations that possess these capabilities as Complete Firms.¯ Ve propose
that the (omplete Firm checklist become a benchmark íor e·aluating a íirm`s íuture
competiti·e position.
1echnologv is not deíined as a separate capabilitv. 1his is not to downplav its role:
rather technologv is an implied component oí all sixteen íactors. For example.
lnowledge Management capabilitv number 5, requires a network inírastructure to
capture and disseminate iníormation about markets. clients. and the íirm itselí.
Suííice it to sav. the (omplete Firm must be íullv technologv enabled.
Business Management
(omplete Firms must emplov excellent and broad business management acumen.
Business management is essential to íullv de·eloping and maintaining two oí a íirm`s
primarv assets: its people and its competiti·e ad·antage.
Complete Firms will
dominate the Third
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
Putting in place the appropriate business management resources will be a challenge
íor manv second-generation íirms. First. the industrv`s general business
management skills are in short supplv. Secondlv. manv in·estment proíessionals.
who dominate second generation íirms. oíten are reluctant to or do not, recognize
the importance oí business management skills.
Chart 5: The Complete Firm Capabilities Checklist
1. Vision and
8. Clearly Defined
Added Value
2. Strategy and
9. Institutional
13. Channel
3. Corporate
10. Quantitative
Skills & Tools
4. Integrated
15. Strategic
11. Embedded
16. Thought
5. Knowledge
7. Human Capital
6. Corporate
12. Protected
14. Coordinated
´ovrce: ß.RR. ´trategic Covvítivg Crovp
1. 11o1on und 1.ud.roh1µ
Industrv leaders must possess a clear and compelling ·ision oí what will make their
íirms unique and highlv ·aluable to clients. 1he elements oí a compelling ·ision
include a clear mission statement. a ·alue proposition. identiíied target markets and
clients. and a well-structured business model. 1o date. leading íirms ha·e been good
tactical managers: exceptional market conditions ha·e not required much more than
adequate execution oí duties to produce strong íinancial results. lowe·er. in an
increasinglv competiti·e business en·ironment. a poweríul ·ision is crucial in order
to moti·ate emplovees. set strategic priorities. and remain ílexible and responsi·e as
a íirm.
In addition to articulating a clear ·ision. business managers must also be leaders.
acting decisi·elv and with con·iction. ser·ing as the spokespeople íor their
organization and leading bv example.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
2. 5:ru:.«1. 1Iunn1n« und Journ.+ munu«.n.n:
Manv asset management companies ha·e grown without a structured planning
process. Going íorward. strategic planning will be an essential capabilitv íor
implementing senior leadership`s ·ision íor the íirm. 1he successíul management
team íocuses on answering three primarv questions:
• ´trategic 1iiov: !bere aoe tbi firv ravt to /e a av orgavi.atiov?
De·elopment oí a strategic plan requires an understanding oí the options
a·ailable in ser·ing ·arious market segments with existing and potential
products. Management must then select priorities based on the size oí
the opportunitv. as well as the risks and costs associated with attaining a
gi·en market position.
• Cap .vaíyi. !bat i tbe firv` cvrrevt covaitiov?
1he íirm must ha·e a realistic perspecti·e on the strength oí its
capabilities relati·e to industrv benchmarks.
• Ivpíevevtatiov Píav: Hor aoe tbe firv get frov bere to tbere?
Mapping a course between the íirm`s current and ideal condition requires
detailed and disciplined business planning. In addition. resources must
be allocated to monitoring the on-going implementation oí that business
plan. Ve reíer to the latter acti·itv as journev management.¯,
J. Corµoru:. 1.+.Ioµn.n: und AII1un.. munu«.n.n:
1he (lient-Partner-(ompetitor paradigm will pro·ide unprecedented options to
outsource capabilities. create strategic alliances. and acquire other íirms. Dedicated
corporate de·elopment resources are essential to svstematicallv search íor such new
opportunities and e·aluate risks. In this regard. traditionallv insular in·estment
management íirms must challenge themsel·es to be as externallv oriented as todav`s
technologv companies., Firms must also recognize that there is enormous ·alue in
the corporate de·elopment process itselí: e·en ií (P( arrangements do not
materialize. the íirm gains signiíicant market intelligence. Rigor should supercede
In addition to identiíving new alliances. in·estment management íirms must also
become adept at diligentlv managing the eííecti·eness oí these relationships
alliance management¯,. At all times. dedicated and íocused alliance managers
should ha·e a detailed understanding oí the goals oí each relationship and its o·erall
·alue to the íirm. (lear expectations must continuallv be communicated to each
4. 1n:.«ru:.d 1uo1n.oo 1.r1ornun.. mon1:or1n«
ligh qualitv iníormation will be critical to maintaining the third-generation íirm.
1his iníormation includes client data and contact records. competitor research.
in·estment períormance. and risk management. 1o be eííecti·e. this iníormation
should be deli·ered centrallv through a common technologv inírastructure.
Tactical management
will be insufficient.
High quality information
is the backbone of
business management.
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
As an example. consider in·estment períormance and risk monitoring. Leading
in·estment management íirms must be able to measure. attribute. and control their
risks. both íor indi·idual client portíolios as well as the o·erall business. 1here are
three components oí such a períormance monitoring capabilitv:
• Defivea Procee: a íull understanding oí the períormance and risk
management needs oí the íirm and the processes íor deli·ering this
• Cevtraííy Cooraivatea Proceivg: a single operational unit de·oted to
monitoring the processes íor analvzing data and deli·ering this
• ´ytev ava Data/ae: technologv that integrates disparate data sources
and distributes to a wide ·arietv oí end-users
As illustrated in (hart 6. the aggregated portíolio characteristics are svstematicallv
collected. analvzed and reported to the critical senior business management
Chart 6: Períormance Monitoring Framework
Internal Data
Data Aggregation
Data Aggregation
Processing & Analytics
Development Compliance CIO
Senior Business Management
Performance Measurement Attribution Models Financial Reporting
Financial Pricing
Processing and Analytics
Internal Data
External Data
´ovrce: ß.RR. ´trategic Covvítivg Crovp
3. Lno¬I.d«. munu«.n.n:
1he time between the birth oí an idea and when it is acted upon can ha·e signiíicant
impact on the períormance oí anv organization. Strong communication
inírastructure and eííicient iníormation dissemination is critical íor high qualitv
organizations. and is a potential area oí competiti·e ad·antage to manv íirms. Vhile
related to Business Monitoring. lnowledge Management diííers in that it íocuses on
eliciting and capturing the insights oí emplovees. not simplv the pro·ision oí data.
Most firms leave their
own knowledge
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
ñ. CI.ur Corµoru:. Go+.rnun.. und C¬n.roh1µ
Retaining talented emplovees requires them to ha·e coníidence that their íirm will be
managed eííecti·elv. 1hereíore. the corporate go·ernance structure particularlv the
managerial control aííorded to the íirm`s principles, must be clear and íullv
communicated to all emplovees.
Also. kev emplovees must ha·e a direct equitv stake in their íirm. lowe·er.
successíul íirms must not simplv extend equitv ownership once: thev must be
prepared to regularlv recvcle equitv in order to continuallv attract and retain talented
indi·iduals. Ve reíer to this on-going process as dvnamic recapitalization.¯,
7. 1unun Cuµ1:uI munu«.n.n:
In·estment management íirms must manage human capital as eííecti·elv as their
in·estments. 1he goal oí these eííorts is to maximize the proíessional de·elopment
opportunities within the íirm íor all emplovees and. thereíore. increase retention.
1hird generation íirms will de·elop programs to enhance an emplovee`s entire career
path: recruiting. training. e·aluation. and mentoring. (learlv. such acti·ities require a
signiíicant in·estment oí resources. Leadership in and structuring íor personnel
de·elopment will be a deíining element oí the (omplete Firm.
Investment Manuíacturing
Qualitv requires consistentlv deli·ering períormance in line with a íirm`s stated
risk,return expectations. (omplete Firms will ha·e the tools and processes in place
to assure superior manuíacturing. Ve belie·e these managers will share íi·e
8. CI.urI+ 1.11n.d Add.d 1uIu.
(omplete Firms will clearlv deíine the manner in which thev will deli·er added ·alue:
1o be diííerentiated in the marketplace. this added ·alue must be proprietarv.
thoughtíul. and compelling. (ompetiti·e ad·antage can be generated through
se·eral core skills. including portíolio construction. depth oí research. proprietarv
quantitati·e modeling. or scale.
9. 1no:1:u:1onuI 1n+.o:n.n: 1ro..oo
For all asset classes. (omplete Firms will ha·e in·estment processes which are
transparent. consistent. risk-aware. and percei·ed to be repeatable. A clearlv
articulated in·estment process establishes credibilitv among buvers and
intermediaries because it establishes their coníidence that períormance will be
consistentlv deli·ered within the agreed-upon risk parameters. 1his set oí standards
is reíerred to as the institutional in·estment process¯ because it has traditionallv
been associated with managers ser·ing the most sophisticated institutional client
segments particularlv in the U.S.,.
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
(hart ¯ illustrates a generic in·estment process íor domestic equitv. 1hird
generation íirms will ha·e an articulated ·iew on how thev can or cannot, add ·alue
at each step in the in·estment process. Also. appropriate resources must be
dedicated to each process step. particularlv those where the íirm expects to be
diííerentiated in the marketplace.
Chart 1: Investment Process Framework (Domestic Equity)
Important Characteristics
• Transparency
• Consistency
• Repeatability
• Risk Management
Themes You Can Buy
You Will Buy
Research for product
innovation and validation
S1, S2, .., Sn
S1, S2, .., Sn
, S
, .., S
Quantitative & Qualitative
S1, S2, .., Sn
S1, S2, .., Sn
´ovrce: ß.RR. ´trategic Covvítivg Crovp
10. Cuun:1:u:1+. 5L1IIo und 7ooIo
Quantitati·e research skills and tools ha·e taken on a signiíicant role in the
in·estment industrv. An appropriate le·el oí quantitati·e support íor the research
and decision-making processes can pro·ide signiíicant le·erage to the in·estment
team and can add ·alue. Leading managers can integrate quantitati·e tools into
se·eral parts oí the in·estment process:
• Screening and idea generation
• Fundamental research support
• Portíolio construction
• Attribution analvsis and períormance monitoring
(omplete Firms will master and le·erage quantitati·e tools. e·en ií their core
processes are íundamental in nature.
All firms should
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
11. 1no.dd.d AIµhu munu«.n.n:
Lmbedded Alpha reíers to the írictional¯ costs oí managing an in·estment
portíolio. 1hese costs include brokerage commissions. the opportunitv cost oí not
equitizing cash tax liabilities. and the negati·e market impact oí trading. Lmbedded
Alpha reduces net reported períormance.
1o date. manv acti·e equitv managers ha·e not explicitlv managed Lmbedded Alpha.
Fixed income and index managers. íor whom e·erv basis point oí excess return is
crucial. ha·e been most conscious oí these íactors., In the íuture. (omplete Firms
will diligentlv seek to minimize these períormance detractors. as onlv a íew hundred
basis points separates top quartile írom lowest quartile managers: Lmbedded Alpha
costs can be large enough to svstematicallv span this períormance gap. 1hese costs
become e·en more rele·ant in a lower return en·ironment.
1he appendix to this paper discusses Lmbedded Alpha in greater detail.
12. 1ro:..:.d 1n+.o:n.n:
In manv íirms. in·estment proíessionals ha·e historicallv had manv responsibilities:
portíolio manager. administrati·e oííicer. relationship manager. researcher. and new
business de·eloper. 1o assure consistent períormance. (omplete Firms will maximize
the amount oí time in·estment proíessionals spend exclusi·elv on in·estment matters.
1o achie·e this íocus. we belie·e that third generation íirms will be organized around
the in·estment platíorm structure. An in·estment platíorm is deíined as being one or
more portíolio construction teams which share a common in·estment process and
which le·erage a common pool oí research. 1his structure is illustrated in (hart 8.
In·estment platíorms can ·arv substantiallv in their composition. depending on the
tvpe oí products manuíactured.
Chart 8: The Investment Platíorm
Team 1
Team 1
Product 2
Product 2
Product N
Product N
Team 2
Team 2
Team N
Team N
Quantitative Research
Quantitative Research
Fundamental Research
Fundamental Research
Product 1
Product 1
´ovrce: ß.RR. ´trategic Covvítivg Crovp
Investment platforms
provide focus and
accountability while
preserving autonomy
and culture.
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
1here are two primarv beneíits oí the in·estment platíorm structure. First. most
non-in·estment acti·ities are remo·ed írom the dailv liíe oí researchers and portíolio
managers: this íocus assures that accountabilitv íor manuíacturing qualitv is clear.
Second. the platíorm structure preser·es the managerial and cultural autonomv oí
the in·estment team.
1he appropriate scale in in·estment manuíacturing is clearlv platíorm-speciíic. Some
platíorms such as index and core-plus íixed income can beneíit írom scale. For
other platíorms. particularlv those íocusing on less liquid asset groups. scale as a
concept is highlv questionable.
In general. we expect third generation íirms to be highlv client-íocused. Strategv
de·elopment must begin írom the perspecti·e oí a target client`s needs. Firms must
be ílexible enough to design the most appropriate products and ser·ices íor these
segments and to le·erage the most eííecti·e channels íor reaching them. 1his
process is illustrated in (hart 9. listoricallv. in·estment íirms ha·e been product-
dri·en: that is. íocusing on clients onlv aíter products ha·e been created. 1he third
generation in·estment management íirm requires a multitude oí distribution
capabilities. 1he best organizations will be able to both de·elop attracti·e products
and le·erage both proprietarv and non-proprietarv channels. while eííecti·elv
managing and nurturing their relationships with clients. partners. and learning írom
their competitors.
Chart 9: Understanding Client Segments
• Which client segments should be
• Through which delivery channels?
• What non-investment services?
• In what investment vehicle?
• What specific products must be
• What investment capabilities are
´ovrce: ß.RR. ´trategic Covvítivg Crovp
1J. Chunn.I munu«.n.n:
(omplete Firm distribution organizations will be structured around channel teams.
Lxamples oí channel teams include wholesalers to retail brokerage. as well as
institutional sales people. A channel management team should include sales people.
client ser·ice personnel. and administration. ·arving in size. depending upon the
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
importance oí the channel thev are ser·ing. lowe·er. regardless oí the size oí the
team. the principles required íor channel management remain conceptuallv the same:
dedicated specialized resources with a íocused mission.
Lííecti·e channel teams require dedicated client ser·ice resources. (lient Ser·ice is
deíined to include all ongoing ser·ices to existing clients: administrati·e and
operational support. relationship management. and ad·isorv ser·ices. A well-
structured client ser·ice capabilitv oííers two primarv beneíits. First. it increases the
probabilitv oí retaining clients. Secondlv. it allows the sales íorce to íocus on new
business de·elopment and the in·estment team on managing monev. Vhile this
íunctional specialization will be culturallv challenging íor manv íirms. it will support
the eííiciencv required oí a third generation íirm. Oí course. all clients should not
recei·e the same le·el oí client ser·ice: to be most eííicient. (omplete Firms must
eííecti·elv segment clients and prospects based on criteria such as current and
potential opportunitv and proíitabilitv.,
14. Coord1nu:.d 11o:r1ou:1on
1hird-generation íirms must present to each oí their target market segments a
coherent. coordinated identitv and a well-deíined product set. Also. because oí the
increasing cost oí ser·icing clients. distribution scale can be an important
competiti·e ad·antage. Both oí these requirements implv a centrallv managed.
coordinated distribution organization ser·ing both retail and institutional markets,.
Ve use coordinated¯ to implv managerial authoritv. Our distribution scheme does
not implv that all channel teams use the same brand or a need íor phvsical proximitv.
1he (omplete Firm will emplov a matrix structure íor its distribution organization.
1hat is. the specialist within all channel and segment teams should also ha·e credible
íunctional reporting lines in order to maintain standards and assure coordination.
1o achie·e sales. these teams should be supported bv a centralized set oí íunctions.
including marketing and operations. 1his organization structure is illustrated in
(hart 10.,
1o achie·e scale. channel and segment teams ser·e all in·estment platíorms. acting
as a client`s single representati·e íor each oí these underlving capabilities. 1hev work
with in·estment personnel to understand the platíorm`s products and underlving
13. 1ro1.oo1onuI und 5:ru:.«1. murL.:1n« 1un.:1on
As industries mature. high-qualitv marketing skills become increasinglv ·aluable
capabilities. 1hese skills allow íirms to identiív target markets. deíine their needs.
and de·elop the appropriate products and ser·ices to ser·e them. 1hird generation
managers will recognize the importance oí the marketing íunction. acquire or rent
marketing staíí. and deíine clear strategies íor addressing their target audience.
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
Chart 10: The Complete Firm Distribution Organization
Channel Team 1
•Client Service
Channel Team 1
•Client Service
Channel 1
Channel 2
Channel 3
Administration and Operations
Administration and Operations
Channel Team 2
•Client Service
Channel Team 2
•Client Service
Channel Team 3
•Client Service
Channel Team 3
•Client Service
´ovrce: ß.RR. ´trategic Covvítivg Crovp
Ve highlight three critical marketing skills:
Product Development. In designing the right products and ser·ices íor each target
market segment. (omplete Firms will emplov a structured product de·elopment
process. 1he product de·elopment eííort must create a strong communication link
between the manuíacturing and distribution organizations. pro·iding ideas íor new
in·estment strategies and íeedback on market trends. 1he product de·elopment
team should also plav an acti·e role in the ongoing assurance oí product qualitv.
Ve are not dampening the concept oí inno·ation. but most in·estment management
íirms ha·e not succeeded purelv bv íocussing on the cutting edge oí product
Brand Management. 1he marketing íunction will also ha·e the primarv
responsibilitv íor managing a proper. positi·e. and meaningíul brand identitv that
communicates the core competencv oí the íirm. Importantlv. brand management
can be as poweríul in de·eloping íocus internallv as it is íor projecting an image
externallv. As such. we belie·e the industrv has onlv begun to creati·elv íeature
manuíacturing qualitv. rather than product attributes.
Training and Education. Leading íirms will put in place íormal processes íor
educating their emplovees so that thev eííecti·elv communicate the complex íeatures
and nuances oí the products and capabilities thev oííer. articulating more than the
simple product proíile. 1hev will need the abilitv to educate sophisticated
intermediaries and clients on the tangible beneíits oí their íirm and their products.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
Vhile these three marketing skills appear as a larger íirm model. smaller
organizations with strong collaborati·e cultures can íulíill this process.
1ñ. 7hou«h: 1.ud.roh1µ
1o maintain 1hought Leadership as a core competencv is to think ahead¯ íor vour
clients. Leading in·estment management íirms will be required to operate in a
consultati·e and educational manner with their target markets and clients.
Le·eraging proprietarv intellectual capital as a means oí iníluencing the buver market
will be an enormous competiti·e ad·antage in the third generation. 1hought
Leadership is the most eííecti·e dialogue generation tool¯ to reach the íirm`s target
audience. primarv or intermediarv.
1hought Leadership has traditionallv been considered as new thinking on
in·estment-related acti·ities. (omplete Firms will continue to lead the wav on such
progressi·e and. ultimatelv. industrv-accepted in·estment practices. 1hought
leadership includes both inno·ation and new thinking on new subjects.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
Chapter 4
Models íor Success
1he pre·ious chapter described the capabilities that will characterize successíul third-
generation in·estment management íirms. lowe·er. these shared critical success
íactors do not implv that (omplete Firms will be homogeneous. In íact. we belie·e
that íour basic business models will be ·iable. 1his chapter describes these models
and the methods bv which thev will achie·e continued growth.
Four Viable Business Models
A business model¯ is a speciíic organizational design that pro·ides beneíits bv
·irtue oí its particular structure. Ve identiív íour distinct business models that will
be pre·alent in the third-generation. Leading íirms will adopt one oí these models.
or emplov se·eral simultaneouslv.
Ve do not underestimate the challenge in adopting anv oí these models. (urrentlv.
íew íirms are close to these designs - most must undergo signiíicant organizational
change in order to implement one oí the third-generation structures. De·eloping the
required attributes e.g.. íunctional specialization and pooling oí distribution
resources, will put signiíicant strains on organizations attempting the transition.
1. 11o:r1ou:1on 5µ..1uI1o:
Distribution Specialists use one or more proprietarv distribution channels to supplv
primarilv third-partv in·estment products. Distribution Specialists ha·e minimal or
no proprietarv in·estment manuíacturing capabilities. 1o be successíul. these íirms
must create a competiti·e ad·antage in relationship management oí a client segment.
including both sales and client ser·ice. 1o meet the demands oí their target clients.
howe·er. Distribution Specialists must ha·e a thorough understanding oí and
appreciation íor in·estment manuíacturing qualitv: thev must identiív and represent
onlv highest qualitv products.
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
Ve belie·e that manv multi-line íinancial ser·ices companies including banks and
insurance companies, will increasinglv consider emploving the Distribution Specialist
2. 51n«I.-1Iu:1orn munu1u.:ur.r
In the industrv`s third generation. manv íirms will be organized around a single
in·estment platíorm. 1o distinguish themsel·es in the marketplace. thev will tend to
íocus on more specialized asset classes or in·estment approaches. Manuíacturing
qualitv will be the deíining íeature oí Single-Platíorm íirms. 1hev will be dependent
on intermediarv channels. and managing relationships with these open-architecture
partners will be an essential core competencv.
J. muI:1-1Iu:1orn munu1u.:ur.r. 7h. 1run.h1o. Con«
1he Franchise (onglomerate will incorporate two or more in·estment platíorms that
share a common distribution capabilitv. As illustrated in (hart 11. the multiple
in·estment platíorms can remain autonomous oí each other. Lach platíorm mav
ha·e a unique brand identitv. though single brand will be most common.
Ve use the phrase Franchise (onglomerate¯ to characterize the multi-platíorm
business model. For eííiciencv. each platíorm should be largelv unique: that is. each
platíorm has an eííecti·e íranchise in a particular in·estment capabilitv. Similarlv.
the channel and segment teams ha·e monopolistic íranchises in de·eloping a unique
set oí clients.
A single distribution group represents all in·estment platíorms to the marketplace.
Vhich products recei·e the most distribution attention will be leít to the discretion
oí marketing strategv and the sales íorce. 1his internal competition will eníorce
manuíacturing qualitv standards and place an onus on the in·estment platíorms to
educate and ser·ice the sales íorce. In addition. we belie·e that e·entuallv the
channel and segment teams should not be dependent solelv on internal producers:
thev mav source products írom external pro·iders ií thev deem the qualitv to be
A well-resourced executi·e oííice is responsible íor the coordination oí all acti·ities
between in·estment platíorms and centralized íunctions. 1his oííice pro·ides
leadership and strategic guidance to the o·erall íirm. As discussed in the íirst
chapter. a signiíicant shortcoming oí the second-generation íirm was an inabilitv to
manage an organization oí signiíicant scale and scope.,
Relati·e to Single-Platíorm íirms. there are two primarv beneíits to ha·ing multiple
platíorms. First. to the extent that the platíorms` períormances are not correlated.
business risk is di·ersiíied. Second. a larger product and asset base can support a
larger distribution íorce. lowe·er. as discussed later in this chapter. the costs oí
complexitv associated with larger organizations can work to oííset these beneíits.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
Chart 11: The Multi-Platíorm Business Model (´Franchise Conglomerate¨)
Executive Office
Platform 1
Platform 2
Platform 3
Responsible for all Investment Platforms
´ovrce: ß.RR. ´trategic Covvítivg Crovp
4. 11nun.1uI 1oId1n« Conµun+
A íinal third-generation business model is the Financial lolding (ompanv. 1hese
íirms build their relationships around a íinancial commitment but take limited
managerial roles in one or more in·estment management íirms. 1he core
competencv oí these companies will be selecting in·estment management
companies. supporting their senior management. and creating the íinancial
engineering required in order to pro·ide liquiditv and assure continuitv. 1he
Financial lolding (ompanv is not a (omplete Firm per e: rather it is a collection oí
(omplete Firms.
Vhile Financial lolding (ompanies. bv deíinition. will not work to centralize core
acti·ities such as creating a single comprehensi·e distribution group, thev can
beneíit írom limited coordinated acti·ities. As examples. Financial lolding
(ompanies can share some technologv ser·ices. íocused channel teams such as
mutual íund wholesaling,. and general best practices. (oordination will be based on
the alignment oí selí-interest on the part oí each aííiliate.
1hird-generation Financial lolding (ompanies will not be limited to the stand-
alone¯ conglomerates. In íact. manv large íinancial ser·ices íirms with more than
one in·estment management subsidiarv are closer to this business model than to the
Franchise (onglomerate. Going íorward. these íirms must assess the beneíits oí
integration relati·e to the risks and costs - either model is sustainable: partial íorced
integration is combustible.
In addition to the íour business models outlined abo·e. we belie·e 1ransaction
Pro·iders will proliíerate. 1odav. these íirms include custodians and mutual íund
administrators: in the íuture. thev will include all íunctions that can be
commoditized.¯ including íund accounting and deíined contribution record-
keeping. 1he (lient-Partner-(ompetitor paradigm will dictate that these capabilities
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
will be more ·aluable as industrv utilities. 1remendous scale will be a deíining
íeature oí the 1ransaction Pro·iders.
Optimal Size
A surprisinglv commonlv accepted principle is that in·estment management íirms
must become increasinglv bigger to sur·i·e. Ve belie·e that scale is one oí the most
misunderstood concepts in the industrv. It is worthwhile to remember that size
brings both beneíits as well as oíísetting challenges.
Firms can realize three primarv beneíits írom increased size:
• Business Risk Diversiíication. Bv increasing the number oí in·estment
platíorms. íirms are less susceptible to períormance íluctuations bv stvle or asset
class. Also. a broad product oííering mav be ·aluable to ·arious market
• Economies oí Scale. All things being equal. being larger can potentiallv increase
the eííiciencv oí some but not all, in·estment management íunctions.
• Economies oí Scope: A broader asset base. achie·ed through multiple
in·estment platíorms. can support larger. more sophisticated distribution teams.
As discussed earlier. clients are demanding an increasing le·el oí ser·ice. resulting
in greater research. technologv. and marketing costs. In this en·ironment.
proíitabilitv is progressi·elv more determined bv the abilitv to spread these rising
íixed costs o·er a larger base oí assets under management.
Gi·en that bigger can be better. what is the optimal size oí an in·estment
management íirm. Strategists must consider three oíísetting íactors:
• Cost oí complexity: Ve deíine cost oí complexitv¯ as the additional
management time taken to coordinate and de·elop excellence throughout a more
di·ersiíied organization and the missed opportunities resulting írom sub-
standard management o·ersight. Uníortunatelv. in manv second-generation
in·estment íirms. management talent has been in short supplv. Manv oí these
íirms ha·e alreadv exceeded their management bandwidth.
• Diseconomies oí scale: íor se·eral asset classes. small cap equitv íor example.
scale can detract írom períormance.
• All scale is not equal: scale must be considered relati·e to each in·estment
platíorm or channel team. not in aggregate. As a simple example. a single-
platíorm. single channel íirm with :10 billion under management will likelv be
more cost eííecti·e than a multi-platíorm. multi-channel organization with :10
billion under management.
The benefits of scale can
be offset by costs of
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
(osts oí complexitv are e·en more signiíicant when operations are located globallv.
As a result. it will be diííicult íor most íirms to take ad·antage oí global in·estment
management opportunities. As markets become more sophisticated. managers must
keep up with rising standards oí excellence. 1o the extent that complex organizations
inhibit this de·elopment. global íirms can increasinglv lose out to more íocused local
pro·iders. Vorld-class managers do not vet exist in e·erv countrv. but ií and when
thev emerge. local boutiques mav command market share at the expense oí global
plavers in local oííices.
Relati·e to second-generation íirms. we are optimistic that (omplete Firms will be
better able to minimize the costs oí complexitv and realize the beneíits oí scale.
Managing íor Growth
Gi·en the beneíits oí scale. generating consistent growth will be a competiti·e
ad·antage íor third-generation íirms. Vhat. then. is the best mechanism íor
deli·ering growth: alliances. organic growth. or acquisitions.
1he (lient-Partner-(ompetitor market en·ironment will allow alliances and
partnerships to be an increasinglv attracti·e option íor growth. 1hrough alliances.
distributors will source a broader range oí high qualitv products íor their clients:
more íocused in·estment managers will ha·e access to multiple client segments
through shared channels. Also. economies oí scale will be more easilv realized bv
outsourcing oí operations to íirms that are specialized transaction pro·iders.
1o assure qualitv standards and to reduce the costs oí organizational complexitv.
organic growth will continue to be a compelling option íor manv íirms.
Uníortunatelv. this method oí growth can be slow and costlv. Particularlv
challenging is the creation oí a global organization through organic growth.
lowe·er. while organic growth mav be slower. the resulting qualitv and soundness
oí culture mav be the winning combination íor the long term.
m.r«.ro & A.ou1o1:1ono uo u 5:ru:.«1. 7ooI
For manv íirms. acquisition is the most direct and quickest method íor expanding
their in·estment management capabilities. 1his is particularlv true oí íinancial
ser·ices companies who are drawn to the annuitv-like íee income and relati·elv
attracti·e growth rates generated bv in·estment management.
1he extraordinarv U.S. bull market and the resulting positi·e asset ílows ha·e helped
create a scarcitv oí qualitv and willing sellers. as well as ele·ated price expectations at
which those íirms are willing to sell. Among deals that ha·e been completed.
·aluation le·els and implied acquisition multiples ha·e trended higher. reílecting the
percei·ed strategic ·alue and underlving economics associated with asset managers
see (hart 12,.
In the industrv`s third generation. we belie·e that growth through acquisition can be
an increasinglv important strategv. Strong business management will better equip
The truly global firm will
remain elusive.
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
(omplete Firms to e·aluate purchase candidates within the long-term strategic goals
oí the íirm. In addition. the modular organizational structure oí the (omplete Firm
will allow íor easier integration. Finallv. we belie·e that acquiring íirms are becoming
more knowledgeable about the requirements íor success in in·estment management.
Chart 12: Rising Transaction Value to EBITDA Multiples
Jul-92 Feb-94 Sep-95 Apr-97 Oct-98 May-00
´ovrce: Merriíí Iyvcb
Going íorward. we predict that acquirers oí in·estment management íirms will be
more selecti·e. Vhile an AUM íetish¯ detrimentallv distracts manv íinancial
ser·ices íirms. acquiring íirms will begin to place qualitv abo·e current market share
and size. Smaller íirms with speciíic distribution or in·estment capabilities will be
desirable as components to 1he Franchise (onglomerate model. 1his íocus on
qualitv mav also trigger a wa·e oí spin-oíís as third-generation managers rationallv
di·est their non-core acti·ities. 1he result oí these strategic combinations can be
stronger buvers and sellers.
1he íocus on acquisition oí qualitv íirms implies a somewhat slower pace oí industrv
consolidation than the radical changes implied bv manv industrv prognosticators.
Focusing on qualitv implies a commitment to win market share o·er time. not
necessarilv through one decisi·e purchase. Also. consolidation oí assets mav not
implv a reduction in the number oí íirms: as discussed earlier. smaller íirms will
clearlv thri·e in the third generation.
Consolidation will come.
smarter, not
necessarily bigger.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
ConµI.:1n« u 5u...oo1uI 1n+.o:n.n: munu«.n.n: A.ou1o1:1on
Ve recognize that change in the ownership oí in·estment management íirms is
diííicult. and possiblv ampliíied when the new owner is a large íinancial ser·ices
companv. lowe·er. we belie·e that new owners can take speciíic actions to ensure
retention. íuture períormance. and build enterprise ·alue within a purchased
in·estment management companv.
1. Articulate a clear strategic rationale íor the purchase. 1his statement should
present a compelling ·ision íor achie·ing success - a more sophisticated notion
than simplv .we must be in the in·estment management business.¯
2. Be willing to be íully iníormed. Senior managers írom the acquiring companv
should in·est time in getting to understand their speciíic purchase and the
in·estment management industrv more broadlv ií necessarv,.
3. Make asset management a core business. Organizationallv. the in·estment
management group will report directlv to the (hieí Lxecuti·e Oííicer. Be
prepared to make required in·estments.
+. Grant an appropriate level oí independence to the in·estment management
subsidiarv e.g.. allow íor unique compensation schemes,. Perhaps an appropriate
mindset is to ·iew the group as a non-integrated subsidiarv i.e.. as a ·enture¯ or
portíolio in·estment¯,. A well-deíined go·ernance structure is essential to
assuring operational autonomv and maintaining cultural ·alues.
5. Set realistic períormance goals íor the new aííiliates. Goals mav be both
íunctional e.g.. make speciíied impro·ements to the in·estment process, as well
as íinancial. Also. successíul measurement regimes speciív clear and equitable
transíer prices between the in·estment management subsidiarv and the parent
6. Proceed with integration in a cautious manner ií the acquiring institution
alreadv owns an in·estment management subsidiarv. Integration is oíten a sound
decision: howe·er. the correct process íor combining two or more in·estment
management íirms requires techniques which are signiíicantlv diííerent írom
those used in combining other less human-capital-intensi·e íinancial institutions.
¯. Provide principals with an equity stake. Lquitv interest should be granted to
secure kev personnel. Vhether through direct equitv or tracking stock. this
incenti·e must be tied closelv to the períormance oí the subsidiarv and onlv
partiallv to the institution as a whole. Also. the incenti·e plan must be broad
enough to appeal to the next generation oí talent. not just current senior
management. oíten requiring ownership stakes oí 20° or more. Finallv. as best
as possible. these ownership agreements should remain ·alid in the e·ent oí
íuture mergers or acquisitions. including the parent companv itselí.
Oí course. an acquired in·estment management group must reciprocate in order to
make the new arrangement producti·e. 1hese eííorts include de·eloping channel
management teams that can íullv le·erage the distribution reach oí the acquiring
íinancial institution.
Acquirers must recognize
the challenges in owning an
investment firm.
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
As the global in·estment management industrv rapidlv transitions to its 1hird
Generation. we encourage senior leaders to take íi·e actions:
1. Recognize the competiti·e en·ironment that will characterize the 1hird
• 1he (lient-Partner-(ompetitor paradigm connects us all
• Manuíacturing qualitv reigns
• (lient segments matter
• Lííiciencv energizes true talent
2. Assess vour íirm against the sixteen (omplete Firm capabilities outlined in
(hapter 3 and begin to address gaps.
3. Identiív vour core competencies e.g.. in·estment manuíacturing. distribution.
transaction processing,. low can these core competencies be le·eraged within
and outside the íirm. Vhat alternati·es exist íor deli·ering non-core acti·ities.
4. Align vour business ·ision with the íour ·iable business models discussed in
(hapter +.
• Distribution Specialist
• Single-Platíorm Manuíacturer
• Multi-Platíorm Manuíacturer: 1he Franchise (onglomerate
• Financial lolding (ompanv
5. Manage growth careíullv and with con·iction.
Ve are ·erv optimistic that. properlv managed. the 1hird Generation will oííer great
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
Manage Embedded Alpha, Cut Those Hidden Costs
In·estment proíessionals. particularlv those managing equities. ha·e generallv
ignored the svstematic costs oí running their portíolios. 1hese costs reduce net
reported períormance. As acti·e managers come under increasing pressure to
demonstrate their ·alue relati·e to their peers and to index competitors. controlling
these costs is critical.
Whu: 1o 1no.dd.d AIµhu·
Ve use the term Lmbedded Alpha to represent these hidden costs oí managing an
in·estment portíolio. Alpha¯ is a portíolio`s return in excess oí a rele·ant
benchmark., As (hart 13 illustrates. Lmbedded Alpha detracts írom a manager`s
potential Alpha. the return that can be theoreticallv produced in a írictionless
securities market with optimal portíolio construction choices. Lmbedded Alpha
consists oí three broad categories oí costs:
• Tangible costs are expenses that are explicitlv recognized. 1he most
prominent tangible costs are management íees and trading commissions.
Lach dollar gi·en awav íor. sav. management íees is a dollar explicitlv
detracted írom the portíolio net return.
• Managed costs result írom sub-optimal portíolio construction. 1here
are three primarv managed costs. Acti·e Risk (osts result írom
unintended risk exposures. 1ax (osts are the capital gains consequences
íor taxable accounts. Managers with an institutional background are
oíten too neglectíul oí these considerations., Not-Lquitized (ash creates
an opportunitv cost írom not keeping íunds íullv in·ested. Lach oí these
costs can be managed through the portíolio construction process. íor
which there exist manv analvtical tools that can support this decision
making process.
• Invisible costs are the costs associated with buving and selling securities.
including both the ad·erse market impact oí trading and the opportunitv
cost oí delaving trade execution. 1hese costs can be managed through
expert trading skills and technologv.
Vhv should managers be concerned about these costs. Simplv put. e·erv
incremental basis point increase in rate oí return translates into competiti·e
ad·antage: bv managing and controlling Lmbedded Alpha. a íirm impro·es its
absolute períormance and its ranking relati·e to its peers. Lach basis point becomes
increasinglv important in a lower return en·ironment. where these detractors make
up an e·en larger portion oí absolute returns.
Lmbedded Alpha costs are signiíicant and represent a ·erv real opportunitv íor
managers to svstematicallv increase returns. As an example. consider not-equitized
cash. In a market return en·ironment oí 15°. an a·erage 5° cash allocation reduces
Embedded Alpha
can systematically
improve returns.
BARRA Strategic (onsulting Group Merrill Lvnch & (o.. Inc.
the net return bv ¯5 basis points. Also. in some less liquid markets. market impact
can cost hundreds oí basis points. In all. reducing Lmbedded Alpha can easilv make
the diííerence between a·erage and superior períormance.
Chart 13: Three Components oí Embedded Alpha
Net Reported
Market Impact
Opportunity Cost
Active Risk
Not- EquitizedCash
Trading Costs
Management Fees
´ovrce: ß.RR. ´trategic Covvítivg Crovp
1.I.uo1n« 1no.dd.d AIµhu
In order to release Lmbedded Alpha. in·estment managers must de·elop a
disciplined scheme that includes the íollowing principles:
• Take a Holistic View. Some managers ha·e addressed the components
oí Lmbedded Alpha in a piecemeal manner. whereas a single íramework
is preíerred to ensure suííicient management íocus. Lmbedded Alpha
should ha·e a single champion within the íirm. tvpicallv the (hieí
In·estment Oííicer.
• Take an Alpha Inventory. 1hree questions need to be answered to
de·elop a coherent Lmbedded Alpha policv. Vhich indi·iduals impact
Lmbedded Alpha most bv their actions. Vhat processes do thev íollow
in making decisions. low do thev work together to reach those
• Set Priorities. Few íirms ha·e the managerial bandwidth to address all
aspects oí Lmbedded Alpha at once. Identiíving priorities requires an
understanding oí the opportunities within each component. 1his
opportunitv will ·arv bv asset class and in·estment philosophv.,
Merrill Lvnch & (o.. Inc. BARRA Strategic (onsulting Group
• Develop a Strategic Agenda that:
1. States and demonstrates how managing Lmbedded Alpha will
become an integral part oí the íirm`s added ·alue.
2. Sets out a timeline íor addressing each component.
3. Makes someone responsible íor de·eloping policies and
+. Sets goals bv which to measure success.
• Make it Real on the Shop Floor. All personnel - portíolio managers.
analvsts. traders. product de·elopers. and sales and client ser·ice staíí -
must be íullv committed to managing Lmbedded Alpha. 1his implies
educating e·ervone as to the opportunitv. communicating the strategic
agenda. and aligning incenti·es accordinglv.
• Tell the Market. A credible approach to managing Lmbedded Alpha
will diííerentiate a manager írom competitors and should be aggressi·elv
promoted. Properlv executed. this approach can impro·e the probabilitv
oí superior returns.
Tbi vateriaí i /aea ov a paper rrittev /y Cbritopber ]. .cito, Mavagivg Director, ß.RR. ´trategic Covvítivg
Crovp tß´CC), ava Cregory T. Roger, forveríy of ß´CC ava vor Cbief Operativg Officer of ]obv Ieriv ava
Covpavy. Copie of tbe paper are araiía/íe ov reqvet.
June 1. 2000
Copyrigbt 2000 Merriíí Iyvcb c Co., Ivc.
ß.RR. ´trategic Covvítivg Crovp
Merrill Lynch & Co., Inc.
4 World Financial Center, New York, NY 10080
BARRA Strategic Consulting Group
3 Parklands Drive, Darien, CT 06820