How to Manage $3 Trillion

Shawn Tully at Fortune has a fun article recounting the rapid rise of Blackrock, which will soon be the largest asset manager in the world.

He contrasts the firm’s fixed-income investment strategy with other firms (e.g., Pimco) as follows:

BlackRock does not invest by forecasting which way interest rates are headed. Instead BlackRock wonkishly focuses on the other factors that drive bond values: prepayments and default risk. As a result, BlackRock was better equipped to analyze the complex mortgage securities that came to dominate the fixed-income markets and that caused so much havoc last year.

BlackRock’s approach works like this: Say mortgage bonds are selling at a big discount because rates recently rose. BlackRock’s models are expert at judging if those bonds are “rich” or “cheap” based on its technology for predicting prepayment trends and defaults. If the model predicts, for example, that prepayments will be higher than most investors expect, BlackRock can garner extra returns because homeowners will pay off their loans at full value, and the fund can reinvest the proceeds at higher rates.

The firm’s analytical modeling gets so granular that BlackRock found that people living near IBM offices prepay frequently because IBM executives are often dispatched to new cities.

I find that IBM tidbit very telling. It’s a great example of the information-processing that can, in principle, allow investors to earn super-normal returns (alpha, in the lingo). And if enough investors do it, market prices could approach the efficiency that finance theory often predicts. On the other hand, the need to get that “granular” suggests just how difficult it is for normal investors to value these kinds of securities. (Of course, experience has shown that many investors in mortgage-backed securities made much more basic errors — like trusting the ratings granted by the credit rating agencies — but that’s a topic for another day.)

P.S. For those too young to remember, the old joke is that IBM stands for “I’ve Been Moved.”