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Morgan Stanley’s asset management business is enjoying the first positive signs of change for years under group chief executive John Mack. No longer a neglected backwater, the division has new management, which is launching funds, hiring teams and making acquisitions.

After walking away from a deal with fund manager BlackRock last year because it would have been too dilutive on the bank’s share price, Morgan Stanley has made five acquisitions, spending $1 billion on fund management.

Mack said last May the bank had $3.3 billion of unallocated capital to invest in its growth strategies, which included its “unsatisfactory” asset management business. Recent returns from the division have been disappointing but president Owen Thomas said Morgan Stanley Investment Management is only in the first part of a nine-innings game. Thomas, who ran Morgan Stanley’s successful real estate business for more than a decade, replaced Mitch Merin in September 2005.

He established a five-year plan, which includes developing alternatives and private equity, expanding outside the U.S., rebuilding its reputation with U.S. institutional investors and stemming outflows from its retail mutual funds. He said: “There’s a big opportunity for us to leverage our parent and so having experience and relationships across the bank has been helpful.”

Thomas joined Morgan Stanley in 1987. After working in a transaction-driven business like real estate, he is an experienced acquirer. Since he assumed responsibility for the real estate business in 1994, its global assets under management rose from $2 billion to more than $30 billion. His experience will be useful as he expands asset management outside the U.S. Rival managers account for about 40 percent of their business from non-U.S. clients while Morgan Stanley has about half that percentage.

Much of Thomas’ job will be about using the bank’s resources and brand to the advantage of the sector. “Access to relationships and the dealflow from Morgan Stanley has been an important differentiator in real estate and I’m sure this will be the case in our other direct investing businesses, such as private equity and infrastructure,” he said.

He has got the game under way faster than many of his rivals believed possible. He put in a management structure that gives greater autonomy to investment teams. He closed a deal to acquire FrontPoint Partners, a hedge fund group the bank had been in talks with for more than a year, and quickly integrated its team into positions within the management structure. The acquisition helped him fill the vacant role of head of U.S. institutional distribution – one of the division’s most important client channels – with Dan Waters, who was head of FrontPoint’s client advisory group.

Thomas said: “Cultural fit is important, so the fact that many of the people from FrontPoint had worked at Morgan Stanley made it easier. We filled a product gap in alternatives and we got leadership talent. People see the firm making a big investment in the asset management business and they like that commitment.” Several hedge fund partners spent a large part of their careers at Morgan Stanley before founding FrontPoint.

Other bank staff have been persuaded to move to asset management. Stu Bohart, former global head of prime brokerage, was named head of alternatives; Dennis Shea, head of equity research, took over as chief investment officer for equities; and Ray Tierney, head of North America cash sales trading, became global head of equity trading. Proprietary trader Bob Jordan moved to run U.S. long/short equities last year.

Thomas said: “We had a lot of talent internally. Now that we’ve made it clear we’re open and accommodating to ideas, we’ve been able to seed new products.”

Last year his division financed 50 new products. It hired teams to cover areas in which the bank was weak, such as European equities. A team from SG Asset Management, led by Matthew Leeman, joined in September. Acquisitions of more expertise are planned.

Amid this hiring and buying frenzy, rivals are puzzled by Morgan Stanley’s timing. Valuations of asset managers, particularly hedge funds, reached a six-year high last year while hedge fund performance was relatively poor, which has implications for the price of deals.

Thomas said: “One side of the market feels alternatives have run their course but the inquiries we get, particularly from institutional clients, are accelerating. We could have built this organically but it would have taken much longer.”

He has also faced criticism for his strategy of buying minority stakes in hedge funds, such as Lansdowne Partners and Avenue Capital, which each have $12 billion in assets. Bankers said unless there is the option to secure control, these holdings are unlikely to be successful in the long term.

Morgan Stanley is treating the stakes as investments that provide capacity for clients in strategies where it has nothing to offer. Thomas said: “These companies took many years for their partners to build. The investment will create an attractive return for shareholders and we’ve got access to world-class investment capacity. We’ve expanded important relationships for Morgan Stanley.”

Analysts have cautioned that the money Morgan Stanley is spending on its asset management unit might drag down group profits. The deals have coincided with deteriorating revenues and falling margins from the unit.

Asset management reported pre-tax income of $190 million last year, 50 percent lower than the previous year’s $383 million. The bank said the decline reflected a 19 percent fall in net revenues, driven by lower investment income, mainly in the private equity business.

Assets rose to $478 billion at the end of last year, up 11percent on the year before, but this came from market appreciation, rather than flow of new assets. Performance in mutual funds has deteriorated: over one year, 40 percent of the unit’s funds rank in the top half of information provider Lipper’s mutual funds list, compared with 69 percent over three years and 77 percent over five years.

Although Thomas said asset management margins will be under pressure for the next three years, they have fallen further than many anticipated. They dipped from 43 percent in 2005 to 27 percent in the fourth quarter last year. As a result, the division contributed less to group revenues, falling from 11 percent in 2005 to about 8 percent last year.

The division’s poor performance is taking place as other asset managers report record revenues and margin expansion. Some are concerned that this boom cannot continue indefinitely, so, although Thomas is making the right noises, the investment Morgan Stanley is making might take too long to pay off.