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Jan. 27, 2003, 12:01 a.m. EST

Merrill Redux

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By Erin E. Arvedlund

Scoreboard | Fund Scope | Cash Track

MERRILL LYNCH HAS BEEN BESET by change, both by the ascension of Stan O'Neal as its chief executive officer and by the devastation of its operations in lower Manhattan. But it's still standing. One question nags at investors and financial advisors: is more upheaval due at Merrill Lynch Investment Managers?

Barron's sat down with Bob Doll, head of Merrill Lynch Investment Managers, who says a new compensation system and slimmed-down line-up of funds should calm the upheaval at the fund giant.

Wall Street firms across the board are paying for a three-year-long bear market. Take state pension-fund clients: Led by the behemoth $130-billion California Public Employees' Retirement System fund -- which dismissed Goldman Sachs /zigman2/quotes/209237603/composite GS +2.78% , Merrill Lynch and Credit Suisse in 2002 -- states around the country are firing asset managers. Calpers' action followed Merrill's embarrassing out-of-court settlement with Unilever /zigman2/quotes/204685760/composite UL +0.56% 's pension fund, which had filed suit after being outraged by Merrill's poor performance.

Meanwhile, Merrill was rocked by defections, retirements and massive staff cuts. Gary Lowe, who managed the Fidelity American fund from 1984 to 1992 and then joined Mercury Asset Management, which Merrill subsequently took over, left last year to start his own hedge fund. So did five former members of MLIM's so-called Alpha team, forming Majedie Asset Management. At one point last fall, the situation became so serious that Stan O'Neal reportedly flew to the U.K. to persuade clients and consultants that MLIM was getting back on track.

Back in the States, Stephen Silverman, who took over Merrill Lynch Growth in 1999, set about remaking the portfolio. But the fund was merged out of existence, and Silverman retired. James McCall, a once-celebrated manager of aggressive growth funds, resigned after running Merrill Lynch's worst performing funds. His Merrill Lynch Focus Twenty /zigman2/quotes/200534594/realtime MAFOX +2.06% and Premier Growth Fund were down 72% and 55%, respectively, at the time of his departure in 2001. Then came the Calpers bomb: Calpers terminated a contract under which Merrill managed $543 million of international bonds, specifically saying personnel turnover at Merrill had hurt performance.

Calpers "was a disappointment to us, in that it was high profile," says Doll, who, in addition to leading MLIM, runs about $2 billion of mutual-fund assets, including Merrill Lynch Large Cap Value /zigman2/quotes/205392918/realtime MALVX +1.30% . "But it wasn't a huge surprise because we'd underperformed," he says. "That fixed-income mandate was among the 30% of our assets below benchmark. But we don't need to make any manager changes" as a result. "We're a play in three acts: performance, profitability and growth of the business, meaning the top line."

Overall MLIM staff has dropped to about 3,000 from 4,000 people, he says. So what will stem the defections? For fixed income in the U.S. and equities in London, for the last year, Doll imposed a compensation package under which half of a fund manager's pay is based on one-, three- and five-year investment performance; 25% on assets and 25% on peer reviews such as the "partnership voting" scheme, under which managers have 100 "points" to award each other.

On the markets, he sees stocks returning 8% annually, bonds 5% and cash 2%, although he adds that currently, "pricing and valuation levels are not all that cheap." As for complaints that MLIM forced managers to hew too closely to benchmarks, Doll says he wants large-cap series fund managers to stick within a tracking error of about 600 basis points, or 6%. Among funds he brands successes: Fundamental Growth /zigman2/quotes/204255627/realtime MAFGX +1.91% , run by Larry Fuller; Global Allocation /zigman2/quotes/205546109/realtime MALOX +1.20% , run by Dennis Stattman and Global Small Cap /zigman2/quotes/201778545/realtime MAGCX +1.60% , run by Kenneth Chiang. Among those he says need work: Balanced Capital /zigman2/quotes/202930755/realtime MACPX +1.10% ; U.S. High Yield /zigman2/quotes/212183317/realtime MACHX 0.00% , which has lagged its benchmark and peers; and Merrill Lynch Global Value -- Stephen Silverman left the fund also after he retired. Quips fund-tracker Morningstar of Silverman's successors: "They have big shoes to fill."

The industry has trimmed the number of funds, and, as a byproduct, that may get rid of some bad track records. "We've merged a lot of funds away. We had too many products and we're streamlined," down to about 125 funds from 165 three years ago, Doll says. For example, Merrill Lynch Premier Growth and Mid Cap Growth Fund were merged into Merrill Lynch Large Cap Growth. "In the muni area, some of our smaller municipal funds will be merged over time," he says. MLIM's total asset base stands at $462 billion and Doll expects overall flows will be flat this year.

The Era of "Masstige."

From opposite ends of Wall Street, two reports on separately managed accounts arrived at some fascinating conclusions: while growing, these mutual funds with personal service don't amount to the next goose laying golden eggs. Profit margins on separate accounts are solid, for now, but likely will fall as the concept grows more popular and competitive. And their attractiveness could actually hurt some asset managers' bottom lines.

According to a report by Morgan Stanley analyst Henry McVey, asset managers "tell us not to worry, because managed accounts are a small part of the overall market, but $700 billion of existing assets are expected to grow at 15%-30% per annum."

Citing data from Cerulli Group, McVey says managed accounts add up to 13.2% of assets at leading broker-dealers and 19.4% of total retail brokerage revenues. "Looking ahead, we wonder whether the managed-account business is taking us down the wrong road on several fronts," McVey writes.

Meanwhile, broker dealers pay asset managers an average of 35 basis points to 40 basis points now, from 65 basis points just two years ago, for these products. As a result, pretax operating margins for asset managers fell to 33.1% on average in the third quarter of 2002 from 39.2% in the first quarter of 2000, the analyst adds.

Soon, investors may demand lower fees on separate accounts. Asks McVey: "Will customers continue to pay an annual freight of 1.75% or more on their investment in today's low-return world?"

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