Weighing The Return To Equities

Investor's Business Daily

You wouldn't imagine that the biggest company in its field, with solid financials and its stock up 61% in 10 months, would be thinking about layoffs.

Nonetheless, that's the strategy at BlackRock (BLK), the world's largest asset manager. On March 19, the company said that over the next few months it would cut loose 300 employees — about 2% of its global workforce — including its entire private-equity team.

"We had a very strong direct private-equity team, but given our clients are looking to us for (other solutions), we are going to transition out of the direct PE business," BlackRock spokesman Brian Beades told Bloomberg at the time.

BlackRock's new longer-term focus: boost organic growth by targeting retail investors — that is, ordinary middle-income folks. BlackRock's management has described this market as "underpenetrated," and thus a prime target for growth. But in order to attract cost-conscious investors, the company needs to be able to offer lower fees. To achieve that, it must lower operating costs.

Some of the hottest stocks in IBD's Finance-Investment Management group are focused on retail investors. The group ranked a strong No. 20 on Thursday, and it's ranked in the top 50 among the 197 industries tracked by IBD through most of this year.

The small but fast-growing Financial Engines (FNGN) is another group member that targets retail investors. It shares are up more than 30% so far this year. Private equity still pulls its weight in the group, making big deals, such as Blackstone's (BX) current embroilment in the bidding war for ailing computer giant Dell (DELL).

Active Vs. PassiveInvestment managers invest other people's money for a fee. The more money they manage, the more they potentially earn. Hence a key metric for this group is assets under management, or AUM. BlackRock leads the way with $3.8 trillion in AUM, which it attained partly through two major acquisitions in the last decade: Merrill Lynch Investment Managers in 2006 and Barclays Global Investors in 2009. These buyouts not only enlarged the company but brought more equity exposure to a firm that had previously focused on fixed-income strategies.

Other leading companies in the group include some of the best-known names in investing, such as T. Rowe Price (TROW) (up 15% YTD) and Franklin Resources (BEN) (up 19%). These are generally called traditional asset managers, focused on putting clients' money in places where they can get a dependable return on investment. Those "places" include passive investments, such as index funds and exchange-traded funds, and active investments that involve active trading of stocks and bonds in anticipation of market moves.

The last decade has also seen the IPOs of several major alternative asset managers, who play riskier strategies such as buying up flagging companies and other distressed assets and turning them around for a profit. These are the private-equity giants such as Blackstone, Apollo Global Management (APO) and KKR (KKR). Private equity gained wide attention last year when one of their own, Bain Capital co-founder Mitt Romney, ran for president.

Private-equity investors buy companies — often large and respected but financially stagnant — through debt-based purchases called leveraged buyouts. Though they typically crank up the companies' operating efficiency they often sell them off heavily indebted, while taking a considerable profit for themselves.

None of the public private-equity companies do that as their only business, however. In fact, last year Apollo, perhaps the most focused on distressed assets of any company on the market, acquired Stone Tower Partners, making its AUM invested in capital markets larger than its AUM devoted to private equity. Blackstone has lately been talking up its real-estate division; it also makes substantial revenue from financial advisory and credit operations.

With so many opportunities and dangers around the world, it's best for a company to be playing a lot of fields at once, says Morningstar analyst Greggory Warren. "We continue to prefer the more broadly diversified asset managers, especially those that can offer a mix of active and passive strategies, strong equity and fixed-income franchises, and exposure to both domestic and international markets," he wrote in a March 5 report on the group.

Tracking Retail InvestorsRetail investors comprise one of three basic client groups for investment managers, the other two being institutions and high-net-worth individuals. As BlackRock's management noted, the latter two groups invest far more assets than the regular folks. But analyst Michael Kim of Sandler O'Neill says interest in capturing the retail market is rising as some of the traditional institutions are under pressure.

"One of the biggest areas of growth for (alternative asset managers) had been traditional pension plans and defined-benefit plans," Kim told IBD. "Those are in a secular decline as defined benefit transitions to defined contribution, which is a much more individual-led platform.

Investment managers are generally slaves to economic cycles, which affect both the quantity of assets flowing in from clients and the return they can get on their investments, especially if they're highly exposed to equities. Analysts say the strength of the equity markets is one major reason the industry group has been doing well lately, along with optimism about recovery in real estate.

Retail investors generally change their habits more quickly as the economy turns, since institutions and wealthy individuals are more long-term investors. During the Great Recession and its aftermath, assets moved disproportionately to fixed-income plays, which is typical in conservative times. This year so far has shown increased inflows to equity, although analysts say it's hardly an aggressive environment as of yet.

Passively managed U.S. and international stock funds are capturing almost all of the money flowing into equities, Morningstar's Warren wrote in an email to IBD. Fixed income continues to reign as the asset class of choice for risk-averse investors.

That is why, he said, "it has been the more broadly diversified asset managers, especially those with solid equity and fixed-income franchises, exchange-traded fund (ETF) platforms, and the ability to offer exposure to international markets that have held the strongest hand in asset gathering.

Analyst Jeffrey Hopson of Stifel Nicolaus says private equity is also in slow-build mode, making some big deals but playing more cautiously than during the pre-recession binge.

"Private-equity companies still have a lot of dry powder — capital they've raised in the last one to four years," Hopson said. "They're not raising as much capital, because they still have capital they're putting to work, and investors are waiting till they get returns from some of the capital they've contributed a few years ago.

Ear To The GroundThe analysts IBD spoke with expressed cautious optimism about asset managers' outlook over the next year. Warren sounded the most doubtful about the rotation to equity investments, saying this year's bump followed a late-2012 sell-off as investors feared an increase in the capital-gains tax. "We continue to be cautious on the equity-heavy names on our list — like Janus Capital Group (JNS) and Gamco Investors (GBL) — which have not had the best track record when it comes to asset gathering, relying almost entirely on market gains to lift their AUM levels," he told IBD.

Kim said he still favors the alternative asset managers, given how much capital they've got in the bank. "We're still very early in the whole realization cycle," he said.

Upside: A stable economy could help investors open up their wallets to higher-returning investments, especially on the retail side.

Risks: Economic stability has been hard to come by lately, especially on the global level. "Certainly as these things come up in Europe, to the extent they are material — more material than Cyprus — those would be the biggest risks," Stifel Nicolaus' Hopson said.

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