Federated Joins Quantitative Realm: MDT Play Reflects Industry's Institutional Push

If the mainstream media were any indication, you'd think quantitative portfolio analysis would be to the mutual fund industry these days what technology stocks were in the late 1990s.

Although bubble-like enthusiasm is building, don't expect it to inflate overnight, experts say. And perhaps no recent industry development more accurately captures the nature of the "quant" upswing in the last few months than Federated Investors' acquisition of MDT Advisers, a relatively unknown stock picker in Cambridge, Mass.

Federated, based in Pittsburgh, said earlier this month that it would acquire the privately held MDT Advisers, a unit of MDTA, for a purchase price of up to $240 million. The sale is expected to close in July.

MDT is the advisor to roughly $6.8 billion in separately managed account portfolios and institutional accounts and about $300 million in mutual funds. All three leverage MDT's proprietary quantitative investment process, a bottom-up fundamental approach that can size up nearly 3,000 domestic stocks in a day. It leverages six variables and controls risk through diversification constraints within the portfolio, company officials said. A human overlay examines all decisions generated by the process.

Industry-wide, activity on the quantitative side of the business in recent months has been relatively brisk. For instance, Janus Capital Group recently increased to 83% its stake in INTECH, an institutionally focused quant shop in Palm Beach Gardens, Fla., and launched the INTECH Risk-Managed Stock Fund for retail customers. INTECH now manages six funds for Janus in the U.S. and two international plays. INTECH's separate account strategies are also enjoying strong institutional demand from Asian and European pension funds, company officials noted.

Vanguard Group, which operates an in-house quantitative equities group, recently added a small-cap offering to complement its finely performing mid-cap Strategic Equity Fund. Charles Schwab just added three more quant funds to bring its lineup of mathematically driven products to 20. Schwab is also about to close its $1.4 billion Schwab Premier Equity Fund to new investors.

AllianceBernstein is said to have also joined the fray, while American Century reportedly plans to add three more quant products to bring its lineup to 10. Firsthand Capital Management, a quirky boutique shop that rode the tech-bubble to prominence, now offers a product with a quantitative twist, and a number of similarly sized firms are dabbling in quantitative methods.

But the activity, by and large, isn't product-driven, said Jeff Tjornehoj, a senior research analyst with Lipper of New York.

"It responds to two precursors," he explained. "One, the industry's dearth of talented managers and, two, a need to fill out the lineup for institutional clients."

Management firms like the quantitative model because it's cheaper than a team of research analysts and the computer-driven models can analyze far more stocks in many more regions than humans could ever muster. Institutional clients, Tjornehoj said, like the fact that quantitative analysis removes the human bias from the stock selection process. Their trained management teams also understand the complex mathematical models behind the process better than the everyday investors.

"I think we'll see a few more of these acquisitions here and there, but not a lot of them," Tjornehoj added. "The larger players, if they don't have their own [quantitative divisions] already, are either shopping around or at least testing the waters. It's usually cheaper to buy than to build it out yourself."

With MDT, Federated gets a marginal boost to its retail fund business, but instant credibility on the institutional side. Federated, which currently has $217 billion in assets under management across 140 funds, has made it known it intends to grab a bigger piece of the institutional market. For that reason, Rachel Barnard, an analyst who covers Federated for the Chicago investment research firm Morningstar, applauds the deal.

"They get a great manager in a real hot growth area among institutional clients," Barnard said. "It offers them a lot of momentum and should help push their asset management operations to become more institutional."

Whether Federated got a steal, remains to be seen. Reflecting a recent trend in the asset management industry, the ultimate price Federated will pay weighs heavily on the post-acquisition performance of MDT. The transaction includes an initial purchase payment of $110 million, the majority of which will be paid at closing, and a series of contingent payments totaling as much as $130 million over the next three years based on growth.

"It mitigates risk for the buyer and encourages the acquired firm to maintain their focus. It seems like a fair deal," said Barnard, who added that the transaction has neither improved nor dampened her outlook on Federated, which itself has been the target of acquisition speculation.

For MDT, the transaction provides them with the Holy Grail that so many boutique shops seek, which is access to a massive distribution network.

"Combining the proven investment acumen of MDT's team and process with Federated's distribution muscle will give our firm a powerful new growth opportunity," said J. Christopher Donahue, president and chief executive of Federated, in a statement announcing the deal.

Gordon J. Ceresino, president and chief executive of MDT, said a key reason his firm chose to collaborate with Federated was its "longstanding reputation in the industry and distribution strength." He also said their core business values were a good match.

Federated, known mostly for its excellent money market funds, could also use some punch in its mutual fund business, said Reginald Laing, a mutual fund analyst with Morningstar.

"Federated doesn't have a terribly outstanding set of funds right now," Laing said. We take a pretty dim view of their governance, and their strategies aren't particularly bold. They're a little more benchmark-orientated than we like to see."

Federated did take its share of lumps in the scandal three years ago. Senior officers at the firm approved a deal in 2003 that allowed the infamous New York hedge fund Canary Capital to market time six domestic Federated funds, although the firm's prospectus stated that it prohibited such activity.

Late trading was also a problem. The company's in-house transfer agent improperly processed trades after 4 p.m. between June and September 2003, an action that exposed Federated fund shareholders to potential dilution. The late trades were performed for the Texas hedge fund Veras Partners, while it was timing 12 Federated funds.

Federated settled with regulators late last year for more than $90 million.

With its regulatory problems behind it, perhaps MDT will offer Federated the investment expertise it appears to need. The quant firm's flagship fund, the MDT All Cap Core Fund, was created as a separately managed account in 1991 and was spun into a mutual fund in 2002. It has since earned an overall five-star Morningstar rating among the 1,472 large-blend funds in the category. The MDT Balanced Fund is another five-star Morningstar product. Both rankings are for institutional shares.

"MDT's relentlessly disciplined approach to investing has provided investors with consistent investment performance over the last 14 years," Ceresino said.

The wild card in the marriage, Laing said, would be whether Federated allows MDT the autonomy it needs to retain that focus.

"A lot of times, when bigger fund companies buy smaller ones and try to bring them closer into the fold, it just doesn't work," he observed.

Federated's recent history on this front, however, hints that it could be a successful union. It bought the Kaufmann Funds six years ago and has left its managers largely to their own devices, Laing noted. In announcing the MDT deal, Federated officials said the firm's existing employees would remain in Cambridge and continue to manage portfolios for Federated.

Completion of the mutual funds transaction, however, is subject to approval of the boards of directors of both MDTA and Federated, as well as shareholders in the nine MDT funds. Those shareholders must also approve reorganization of the funds into the Federated complex and allow for the creation of Federated MDT funds for the deal to be finalized.

In addition, MDT must seek consent from its separately managed account holders to continue to permit MDT to manage their assets after the closing, officials said. Based on current asset levels, once the separate account and mutual fund transactions are completed, Federated would manage about $38.7 billion in equity assets, an increase of 22% from $31.6 billion as of March 31. At closing, officials added, Federated would own approximately 90% of the outstanding equity interests of MDTA, with the right to buy the remainder by June 30, 2007.

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