Safety in numbers.

• Author: Davis, Lisa
• Position: Smith Breeden Associates Inc. - Profile - Company Profile

Smith Breeden Associates turns an academic exercise into a formula for success by showing investors how to hedge their bets.

In 1982, the Chicago Board of Trade gathered some of the nation's top finance professors to discuss futures markets. Gregory L. Smith was invited, too. After 17 years in the brokerage business, Smith knew a lot about futures - he'd even consulted for the board. But he felt out of place in this brainy bunch. "I'm the one non-Ph.D. in the room," he recalls. "The resident dummy."

He watched in amazement as the academics started doing their stuff, some of them scratching out their theories on a long blackboard. "One dude gets up and starts writing a formula full of sigmas and deltas and strange symbols. He starts at one end of the room, he writes this formula all the way to the other end, all 30 feet. He gets to that end and says, 'Therefore,' walks back to the other side and starts again. I was roaring with laughter."

The formulas went over Smith's head, but the basic ideas did not. This academic research, he realized, had important implications for the thrift industry, which was reeling from soaring interest rates. "I'm sitting there listening to these guys, and they had the answer. The answer was hedging the interest rate of a financial institution, and that's what these guys knew how to do."

He slipped a note to Doug Breeden, one of the bona-fide professors, that read: "We must have dinner tonight. We have been sitting on a gold mine." Breeden was teaching classes at Stanford University on interest-rate risks and how banks and thrifts could use offsetting positions in futures, options and other financial derivatives to hedge the risks. He listened while Smith pitched the idea of starting a consulting company together. He told Smith, "Everybody already knows how to do this. Nobody will pay us to do it."

He's had to live down those words, which are well-known around Chapel Hill-based Smith Breeden Associates Inc., the company they launched that same year. It turned out that "everybody" - particularly thrift managers - did not know what finance professors know. "I guess I was just a naive academic, somewhat," Breeden admits. Since then, he's managed not only to build a thriving consulting company but also to turn it into a money-managing powerhouse. Although little-known in its home state, Smith Breeden is a big player in its arcane but fast-growing niche - mortgage-backed securities.

Slow to see that first business opportunity, Breeden hasn't missed many since. Smith Breeden has a knack for finding new markets in which to peddle its specialized expertise. "It's amazing what they've done," says Robert Eisenbeis, Wachovia professor of banking at UNC Chapel Hill.

At first just a risk consultant, Smith Breeden soon started offering investment advice to banks and thrifts. It advises on $17 billion in assets. Its principals own an Indiana thrift and shares in several banks. It also manages $1.2 billion for clients such as Unisys, the Rockefeller Foundation and Eastman Kodak Co. It has $300 million in three mutual funds, one of which produced the best return among all government-bond funds last year.

Since Smith retired in 1988, Breeden has had the CEO spot to himself, and the company is molded in his image: smart, methodical, in control. Rather than hire Wall Street stars, Breeden brings in bright young M.B.A.s and schools them in the Smith Breeden way: Do careful research and don't try to outguess the market.

"What you are dealing with in other organizations are people who have maybe more of a trading mentality and less of an academic mentality," says John Sherman, an analyst with Standard & Poor's Corp. in New York. "Traders tend to be wheelers and dealers, the kind of people who work on a gut feel. These guys are much more deliberative and disciplined than your typical mortgage-backed-securities manager."

Derivatives have been the downfall of so many managers over the past year - just the word is enough to send shivers down conservative investors' spines. It's not a dirty word at Smith Breeden, which has turned the brouhaha over derivatives into a marketing plus, touting itself as a low-risk alternative in a high-risk market. The company says it steers clear of many of the riskier, illiquid securities and their derivatives. Still, its hedging and investment strategies are so complex even regulators don't always know what to make of them.

Smith Breeden is counting on its sophisticated yet conservative approach to keep it in the game as the highfliers strike out. "They aren't trying to hit home runs," Sherman says. "They are trying to outperform [the market] on a consistent basis every year. ... They are looking to build a business over...