BlackRock Adds Indexing to Active Funds With BGI Deal (Update1)
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By Christopher Condon

June 12 (Bloomberg) — BlackRock Inc.’s purchase of Barclays Global Investors for a record $13.5 billion is the first attempt by a top-ranked fund manager to unite two opposing investment philosophies.

Managers at New York-based BlackRock, who oversee $1.31 trillion, select investments based on research, and have a reputation for spotting value in hard-to-sell fixed-income securities. BGI, based in San Francisco, has $1.5 trillion in assets, mostly in funds whose holdings are determined by the indexes they are designed to mimic.

“If you want to be a dominant money manager, you have to be agnostic about style and strategy,” Dan Culloton, an analyst at fund research firm Morningstar Inc. in Chicago, said in an interview. “You have to offer everything a potential client might want.”

The debate over which style produces better returns for investors over the long term has carried on since index-based funds first appeared in the mid-1970s. Money managers focus primarily on one approach or the other. Active managers look for companies they expect to beat the market. Passive investors try to track benchmarks such as the Standard & Poor’s 500.

“For BlackRock, which is renowned in fixed-income investing, this will be a significant departure,” Geoff Bobroff, president of Bobroff Consulting Inc., an East Greenwich, Rhode Island, firm that advises mutual-fund companies, said in an interview.

There has never been a marriage of this scale between managers with differing investing styles, he said.

Topping State Street

BlackRock, which acquired Merrill Lynch & Co.’s asset- management business in 2006, will become the world’s biggest money manager with BGI. The combined company, with more than $2.7 trillion under management, will dwarf Boston-based rivals State Street Corp., which oversaw $1.44 trillion as of Dec. 31, and Fidelity Investments, with $1.25 trillion.

BlackRock will pay $6.6 billion in cash and the rest in stock for Barclays Global Investors. London-based Barclays Plc will hold a 19.9 percent stake in the combined company. Financing will include $2.8 billion from the sale of equity to unnamed institutional investors and as much as $2 billion in loans from Barclays and other banks.

‘Big Enough’ World

The new BlackRock may thrive if Chief Executive Officer Larry Fink can combine sales efforts without forcing too much integration between the investment-management operations, said Scott Burns, an analyst at Morningstar.

“The world is big enough for both,” Burns said in an interview. “Although you don’t want to put someone used to active managers in charge of passive.”

Fink, in a conference call today with analysts, rejected the suggestion that the deal was an “indictment” of active investment management.

“In the retail space, passive strategies are going to take up more momentum,” Fink said. “But I do believe that active strategies are just as important in the future.”

Fink’s attempt to unite two investing philosophies under the renamed BlackRock Global Investors, fits with the view of Princeton University professor Burton Malkiel, who said the debate between asset managers has become much less divisive in recent years.

“It’s not active versus passive anymore, it’s active and passive,” said Malkiel, author of “A Random Walk Down Wall Street,” a book examining efficient-markets theory. “Even people who believe strongly in active management realize there’s an advantage to” a mixed strategy that includes index funds at the core, he said

Merger Risks

Combining the two big firms may present other risks that could cause customers to leave, investment consultants said.

Marc Friedberg, a managing director at Santa Monica, California-based Wilshire Associates Inc., said any large merger between asset managers can make big clients of both firms nervous.

“It might spark getting put on a watch list, and it can slow down a firm’s pipeline of new business, especially in alternative investments, until they see what is the outcome,” Friedberg said in an interview.

He said investors will watch for changes in personnel and the processes they follow in handling clients and their money.

“Those are two major red flags — people and processes. If those are being changed it can be viewed as a negative and cause departures,” he said.

Beating Indexes

Diversified U.S. equity index funds declined 38 percent in 2008, edging out their active peers, which fell 39 percent. That helped persuade more investors to move to passive investing.

Index funds attracted $34 billion in net deposits last year while all U.S.-registered stock and bond mutual funds lost $230 billion in redemptions. Exchange-traded funds, which also follow indexes and trade throughout the day like stocks, added $177 billion through new sales.

Active funds have performed better so far this year. Diversified active U.S. equity funds returned an average 10 percent through June 10, compared with a gain of 7.3 percent for diversified equity index funds.

Index and exchange-traded funds had a combined $1.14 trillion in assets at Dec. 31, or 18 percent of the U.S. fund industry. That compares with 11 percent in 2003, according to data compiled by the Investment Company Institute in Washington.

Vanguard 500

Vanguard Group Inc. founder John Bogle opened the first index mutual fund, the Vanguard 500 Index Fund, in 1976. He believed index funds would outperform most active competitors because of their lower management fees and trading costs. State Street opened the first ETF in 1993.

Vanguard managed about $1 trillion, excluding money-market funds, at the end of May. About two-thirds of assets managed in- house, rather than by outside firms hired by Vanguard, were in passive strategies, according to company data.

Yale University investment chief David Swensen, the top- ranked college endowment officer in the past decade, endorsed index funds for individual investors because they provide diversification and low fees.

“They’re a low-cost way of getting exposure to the market,” Swensen said in a May 22 interview with the “Consuelo Mack WealthTrack” television show. In the mutual-fund industry, the quality of management “is not particularly high and you pay an extraordinarily high price for that not-very-good management,” he said.

Index and ETF companies preserved more of their assets than active investors in recent years as markets fell.

Retaining Assets

In the three years ended Dec. 31, BGI’s assets, excluding money-market funds, declined 18 percent. The S&P 500 Index fell 28 percent during the period. State Street, the second-biggest index-based investor, saw assets dip 2.8 percent. Fidelity, which has about 90 percent of its mutual fund-money in active strategies, saw those assets fall 34 percent.

State Street and BGI have both focused on providing index- based investing for institutional clients and ETFs for retail customers, helping to attract inflows during the decline in financial markets.

Fidelity, which continues to embrace active management, has suffered outflows. Its stock and bond funds have seen an estimated $1.7 billion in net inflows this year through April, according to Morningstar. They lost $32 billion in net withdrawals last year, according to Fidelity.

“Passive strategies have been gaining inexorably over the years as people realize the benefits of their low cost and diversification,” Morningstar’s Culloton said.

Index funds charge fees averaging $81 per $10,000 invested, compared with $137 for active funds, according to Morningstar. ETFs charge $56 per $10,000.

“Each has an important role to play, but honestly I don’t think there is a debate,” Bogle, now head of the Bogle Financial Markets Research Center in Valley Forge, Pennsylvania, said in an interview. “Indexing has a role because of simple mathematics. They give you your share of market returns.”

To contact the reporter on this story: Christopher Condon in Boston at ccondon4@bloomberg.net

Last Updated: June 12, 2009 11:15 EDT

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