Searching for alpha is a tricky business. Pension funds are eager to bolster their returns in choppy markets but know that they must vigilantly manage their risk-taking. One solution: The funds are snapping up all manner of risk-controlled quantitative strategies, fattening the coffers of such leading quant managers as Barclays Global Investors and Goldman Sachs Asset Management.
No money manager has exploited the surging demand more successfully than Intech, the Palm Beach Gardens, Florida, quantitative specialist, whose assets soared from $6 billion in 2003 to $28 billion at the end of the first quarter of 2005, a stunning gain of more than 350 percent. During the same period, reports consulting firm Casey, Quirk & Associates, assets in U.S. equity quantitative products nearly doubled, from $148 billion to $289 billion. Intech’s secret? A limited product lineup: just four risk-controlled equity strategies that deliver impressive performance while reducing risk.
That’s a rare bit of welcome news for beleaguered mutual fund company Janus Capital Group, which owns a 78 percent stake in Intech. A symbol of the giddy bull market, Denver-based Janus has suffered the steepest decline in assets of any large U.S. money manager. From their 2000 peak, assets have plunged roughly 60 percent, to $139 billion at year-end 2004.
Yet despite its connection to Janus, whose name remains a bête noire for many pension officers, Intech more than holds its own against larger and more entrenched rivals.
“It’s all about the search for alpha,” says Intech CEO Robert Garvy, 62. “And deliver alpha is what we do.”
Garvy, who joined Intech as CEO in 1991, four years after the money management shop was launched by Prudential Insurance Co., points out that the firm has also benefited from being in the right place at the right time. “As an old teacher of mine once said, ‘If you can position yourself in front of the demand curve, then you can be successful.’”
“For Janus, Intech has been the saving grace in a very tough environment,” says Matt Snowling, an analyst at Washington-based investment boutique Friedman, Billings, Ramsey Group who follows the money management industry.
“We believe that Intech’s growth is just beginning,” says Gary Black, Janus’s president and CIO.
And the quant specialist has been highly profitable as well. Janus doesn’t break out Intech’s financials, but Franklin Morton, a senior vice president in charge of portfolio management at Ariel Capital Management, which holds 15 percent of outstanding Janus shares, estimates Intech’s operating margins at a handsome 50 percent. Janus itself reported an overall operating margin of 20 percent for the first quarter of 2005. That’s far below the 31 percent margin reported by the average large money manager.
“Intech generates such high margins because it doesn’t need to pay a stable of investment professionals,” says Morton.
Certainly, Intech is a lean operation. Garvy runs the firm from a small suite of offices overlooking a marina. Here 32 staffers handle portfolio management, client servicing and administration. In Princeton, New Jersey, CIO Robert Fernholz, 64, a former Princeton University professor who joined Intech when it was founded, heads the five-person research department. Janus handles the marketing and distribution of the firm’s products.
Intech keeps it simple. It runs only large-cap equity strategies: the flagship $15 billion large-cap growth fund, a $10 billion core fund, a $2 billion index fund and a $1 billion value fund.
The strategies follow a proprietary mathematical model that Fernholz developed while he was an assistant professor of statistics at Princeton 18 years ago. He uses stochastic, or random, calculus to determine which stocks in an index have the highest volatility and the lowest correlation during a given time period. Then he increases the weightings of those stocks.
Intech’s core, value and index portfolios operate like enhanced index funds, which tend to steer close to their benchmarks and report low tracking errors. But Intech’s dominant product, its large-cap growth portfolio, deliberately posts a very high tracking error, averaging 5.5 percent versus the industry average of 1.5 percent.
Pension funds tolerate the firm’s high tracking error for one compelling reason: The risk is well rewarded. Over the past two years, Intech has delivered exceptionally high alpha -- 6.7 percent. By contrast, BGI’s top-selling enhanced large-cap index product, Alpha Tilts, aims for alpha of 2 to 3 percent.
On the strength of its high alpha, Intech’s information ratio -- alpha divided by tracking error, a key measure of portfolio performance -- is an impressive 1.22. This single statistic, more than any other, explains Intech’s phenomenal growth. According to a Mellon Capital Management survey of 43 managers with enhanced index funds, the average information ratio is far lower than Intech’s -- 0.48 percent.
“Intech sells enhanced indexing on steroids,” says Thomas Dodd, president of Chicago-based Stratford Advisory Group, an investment consulting firm.
“I can sleep very well at night with Intech as our manager,” says Robert Jones, executive director of the $1.4 billion Oklahoma Firefighters Pension & Retirement System. The plan has increased its allocation to Intech’s core strategy, from $70 million in 2002 to $120 million in 2004.
The Oklahoma pension system and other Intech clients have done well with the firm’s core strategy. Since its inception in 1987, it has returned an average annual 12.32 percent, versus 10.50 percent for the Standard & Poor’s 500 index. Intech’s flagship growth strategy has delivered even stronger results, returning an annualized 19.54 percent over ten years, compared with 11.44 percent for the S&P 500 Barra growth index. Last year it returned 15.83 percent, versus 6.14 percent for the growth index.
Impressive portfolio performance was far from Fernholz’s mind when he was acing his math classes as an undergraduate at Princeton. Fernholz had followed his parents into academia. After fleeing Nazi Germany in 1934, his father taught chemistry at Princeton; his mother was a research assistant in the university’s economics department. Fernholz received his AB in mathematics from Princeton in 1962 and his Ph.D. in mathematics from Columbia University in 1967. Following teaching stints at several colleges, Fernholz in 1979 took a job at Princeton as an assistant professor of statistics.
A year later, with his 40th birthday looming, Fernholz was eager for a life change. The business of money management appealed to him, and in 1980 he landed a job as a consultant at Arbitrage Management Co. in New York. Its director of research, Harry Markowitz, who would win the Nobel Prize for economics in 1990, admired Fernholz’s academic work. Two years later, Markowitz helped Fernholz publish his paper “Stochastic Portfolio Theory and Stock Market Equilibrium,” co-authored by Brian Shay, in the Journal of Finance.
In the article, Fernholz introduced the finance theory that would later become the basis for Intech’s investment models. At the time, expected rates of return for an asset class were typically calculated using arithmetic formulas. Fernholz was the first to use logarithmic formulas to look at volatility and to predict returns.
His work became well known, and in the spring of 1987, an executive-search recruiter approached him with an intriguing proposition: Prudential had recently set up a money management shop called Intech, which was charged with developing a guaranteed equity product -- the industry’s first -- that Pru could sell. Fernholz’s work with risk-controlled strategies made him an attractive candidate to help create the product.
Fernholz signed on as Intech CIO in July 1987. Although Prudential owned Intech, Fernholz owned 50 percent of Intech’s proprietary investment models (today Janus owns them outright).
The new CIO was just settling in when Black Monday struck. “After the crash my biggest concern was whether there would even be a stock market,” Fernholz recalls. At the time, he ran Intech’s core strategy, which ended the week of the crash with a tracking error of 10 basis points against its benchmark, the S&P 500.
Over the next few years, Fernholz refined his models, and Intech reeled in assets. Then in the fall of 1991, Fernholz met Garvy, who was working as an executive at Wilshire Associates; a money management recruiter had thought the two might be interested in working together.
The son of a real estate broker, Garvy grew up in Lansing, Michigan, and Melbourne, Florida. In 1961 he enlisted in the army and was stationed at Fort Bragg, in North Carolina. A few months later, as a member of the 82nd Airborne, he was shipped off to an army installation outside of Mannheim, Germany, as part of the U.S. military buildup during the height of the Berlin Crisis. When a U.S. truck convoy was stopped by Russians in East Germany and detained for several days, Garvy drove an
M-60 tank in a unit sent to rescue it. “We entered East Germany and headed toward the detained group,” Garvy recalls. “Fortunately, the convoy was released as we approached, and a major crisis did not erupt into a shooting war.”
Following his military service, Garvy enrolled at the University of South Florida, where he received his BA in 1968; he earned his MBA in finance from Georgia State University in 1976. After three years as an actuarial consultant, Garvy helped launch Wilshire’s pension consulting arm in 1979. He was senior vice president when he left to join Intech.
Garvy and Fernholz complement each other: Fernholz is an intense academic working quietly behind the scenes; Garvy is a gregarious and well-connected industry executive.
“They need each other,” says Lawrence Davanzo, who started Wilshire’s pension consulting business with Garvy and is currently senior managing director of the firm. “Garvy is one of the only guys who can articulate Fernholz’s process to investors.”
By 1993, Intech had begun to gain traction. That year the Teachers’ Retirement System of the City of New York gave the firm a $75 million mandate. In 1998 assets hit $5 billion. When the bubble burst in 2000, Fernholz’s mathematical models protected Intech from much of the fallout. Its funds returned an average 5.0 percent that year, versus 9.1 percent for the S&P 500.
Then in January 2002, Prudential sold Intech to Denver-based Berger Funds. The sale was part of Prudential’s effort to consolidate its equity business in anticipation of a December 2001 IPO. Intech was adopted by yet another new corporate parent in February 2002, when Stilwell Financial, Janus’s parent, acquired Berger Funds.
As part of that deal, Intech became a limited liability company. In exchange for relinquishing their stakes in the firm’s technology, Fernholz and Garvy received a combined equity stake in Intech of between 40 percent and 45 percent. Seven months later the Stilwell holding company was eliminated and its other money management divisions were merged into Janus.
The senior management of Janus has left Intech alone, choosing only to increase its ownership position when it can. In June 2003, Janus exercised an option to raise its equity stake to 78 percent, leaving Garvy and Fernholz with a combined 22 percent interest in the firm.
“For the most part, Janus lets us do our own thing, subject to board approval,” says Garvy, who reports to the six-person Intech board, which includes Janus CEO Steven Scheid.
Intech has not only given Janus an engine of growth; it has also provided its corporate parent with a toehold in the institutional market, where Janus has had a low profile. At the end of last year, just 19 percent of Janus’s assets (excluding the Intech business) came from institutions.
Through its network of financial advisers, Janus now offers five U.S. retail mutual funds managed by Intech whose combined assets total just under $420 million.
That retail business can probably grow at a steady pace, and Intech’s institutional business will almost certainly continue to sizzle. Intech can’t save Janus -- but it can help Janus save itself.
