Can a Great Stock Also Be a Great Fund Family?

Morningstar recently issued a new Stewardship Grade for BlackRock. The firm's overall grade--which considers corporate culture, fund board quality, fund manager incentives, fees, and regulatory history--is a C. What follows is Morningstar's analysis of the firm's corporate culture. This text, as well as analytical text on the other four Stewardship Grade criteria, is available to those who subscribe to Morningstar's software for advisors and institutions: Morningstar Principia®, Morningstar Advisor Workstation(SM), Morningstar Office(SM), and Morningstar Direct(SM).

 BlackRock (BLK) is a great entrepreneurial story and has been a terrific stock, but its investment culture has lagged its business successes.

BlackRock began as a fixed-income manager at private equity firm  Blackstone (BX) in the early 1990s, and through a combination of transformational mergers and organic growth, it has become the largest asset management firm in the world with nearly $4 trillion in assets at the end of March 2013 and more than 10,000 employees in 30 countries. It is a globe- and strategy-spanning colossus with more than 100 investment teams plying almost any investment discipline conceivable--equity, fixed income, or cash; active or passive; quantitative or fundamental; traditional open-end or exchange-traded; long-only or long/short and alternative. Fortune 500 companies, large foundations and institutions, sovereign wealth funds, governments, and even other asset managers come to BlackRock for risk management and advice. The firm's executive leadership includes shrewd operators and investors who know that their fortunes are tied to how well they manage their clients' wealth. No less than Vanguard founder Jack Bogle, known for his unsparing critiques of the investment industry, has called BlackRock a worthy competitor. Given its scale, breadth of capabilities, leadership, and focus on asset management, it would be easy to assume that BlackRock also exhibits a superior investment culture.

Yet BlackRock's operational triumphs belie the challenge it still faces nearly four years after its last big corporate combination: forging a cohesive, effective, fundholder-friendly culture and delivering superior fund returns while growing rapidly and mainly through acquisitions.

To its credit, BlackRock has avoided many pitfalls that have made hash of other large asset manager mergers, but a look at few objective measures indicates that, as a fund family, BlackRock remains a work in progress. The firm's three-, five-, and 10-year success rates, which measure the percentage of funds that survive and outperform their category averages during the time period, were all less than 35% on March 31, 2013. That means nearly two thirds of the family's funds were below average, liquidated, or merged away. Those that rank highly over periods longer than five years have seen manager and/or strategy changes that render those records moot. Indeed, the family's average manager tenure of four years and five-year manager retention rate of 88% rank among the lowest of the top 20 mutual fund families by assets. Managers' investments in the funds they run have improved in recent years but could be higher. The firm's fund fees, while not high relative to other similarly sold offerings, are on average no bargain, either.

Drill below these broad quantitative measures and you find both progress and concerns. The firm has gone to great lengths to foster and present "One BlackRock"--its longtime mantra--to employees, clients, and shareholders. It has consolidated dozens of funds it accumulated via combinations with Barclays Global Investors, Merrill Lynch, State Street Research and Management, PNC's asset management arm, and other shops; this has simplified its lineup. BlackRock promotes communication across its collection of independent investment teams via a daily morning meeting and its BlackRock Investment Institute, which publishes on a wide variety of investment topics. All of those squads also use the firm's vaunted risk management tools and trading systems, which links them further. To vet the performance and appropriateness of existing funds and new fund ideas, BlackRock has formed a product review committee. With an eye toward helping advisors build better portfolios, the family also has combined its ETF and traditional fund sales forces and has started paying them based more on how they sell rather than on how much. BlackRock reorganized its investment operations around strategy type (that is, beta or passive, alpha or active, alternatives, and multiasset) instead of by investment vehicles. The theory is that the salesforce amalgam and restructuring better enable BlackRock to be a provider of appropriate portfolio solutions rather than a pusher of the latest, hottest funds.

​It is still early days for many of these efforts, though. The firm started the strategic product review committee, salesforce combination, and investment unit operations in 2012, and it will take time to evaluate whether they lead to better investment results for clients. Also, BlackRock isn't the only large investment firm declaring that it will be more of a solutions provider than a product seller, and it still wants to sell its products as part of its solutions. Indeed, it's a huge asset-gathering operation as well as an asset manager. Institutional accounts make up two thirds of its assets under management, but BlackRock wants a bigger share of the retail channel, including mutual funds, which accounts for about 12% of assets but a third of the fees it collects. President Robert Kapito recently boasted that the firm has the largest salesforce in the industry, and while it doesn't cough up a new fund with every passing investment fad, there are few secular asset management trends it's not involved in. In recent years, the family has launched dividend, long/short, emerging-markets, income, commodity, real estate, and multiasset funds. In 2012, iShares introduced 46 funds.

There also is still a lot of flux among the firm's global investment teams. In 2012 alone, BlackRock replaced all or part of at least five equity investment teams and made adjustments to several other funds in that and other asset classes. The first quarter of 2013 saw more changes at U.S.- and European-sold funds. Much of that turnover affected offerings with poor to middling records and may ultimately lead to improved performance. But it's hard to maintain and nurture a consistent investment culture with this much change. Indeed, ethically questionable behavior that the firm failed to catch precipitated one awkward change. In 2012,  BlackRock Energy & Resources  manager Dan Rice left the firm in the wake of revelations that a large holding in the fund had business relationships with a company his family ran and he helped start. After leaving Rice's comanagers in charge for less than nine months, BlackRock replaced them with a London-based squad that lacks a public record running portfolios with a similar small-cap strategy. 

Furthermore, the changes may not cease at BlackRock. The firm has shown in word and deed that it will have less patience with underperforming managers in the future. Kapito has said a three-year slump would be sufficient cause for action ranging from a close review of personnel, process, and performance to outright replacement. That is not necessarily bad. It could promote accountability. But it could also engender fear and encourage managers to focus too much on achieving short-term results rather than executing their long-term processes.

BlackRock's retail asset-management ambitions point to another pressure that the firm faces to a degree that many other fund firms do not: the tension between serving its fund owners and clients and its equity shareholders. Nearly all asset management firms wrestle with this, even privately held ones. A boutique with a small circle of partners, however, may be more patient with temporarily slumping managers and the pace of asset growth or the size of profit margins than a publicly traded company. BlackRock's rapid growth and strong corporate execution, for example, have set public shareholders' expectations high. They've come to expect industry-leading 40% margins, consistent dividend growth, and annualized total returns of more than 25% since the company went public in 1999, through March 31, 2013.

A healthy profit margin is not inimical to an investor-friendly culture, but the pursuit of it can lead to some curious decisions. When iShares, for example, launched a mix of new and rebranded low-cost "Core" ETFs in 2012 for buy-and-hold investors, it rolled out a new  iShares Core MSCI Emerging Markets ETF (IEMG) that charged a very reasonable 0.18%, but it didn't reduce the 0.69% levy of the existing and essentially identical  iShares MSCI Emerging Markets Index (EEM), which has $45 billion in assets. Doing the latter would have meant forgoing more than $200 million in fee revenue, but it would have benefited shareholders by improving the fund's performance. Similarly,  iShares Core MSCI EAFE ETF's (IEFA) 0.14% expense ratio is less than half the 0.34% levy of  iShares MSCI EAFE Index (EFA), which has $41 billion in assets.

These are serious reservations, but BlackRock gets a C for culture rather than a lower grade because it has much going for it, too. The firm has strong, stable leadership that consistently states that the client comes first; plus a clear vision for the future, a focus on asset management, and deep financial and operational resources that can attract talent. BlackRock has made a concerted effort to recruit accomplished investors from other firms to improve performance and has adjusted its compensation plan to better align managers' interests with fundowners'. BlackRock is on a positive trajectory but still has more work to do before it exhibits the traits of a topnotch investment culture throughout its complex structure.

Click here to see Morningstar's Stewardship Grade methodology.