FTSE Global Markets

ASIAN HEDGE FUNDS COME OF AGE ISSUE ELEVEN • JANUARY/FEBRUARY 2006

Morgan Stanley steps out on the comeback trail Separating the myths and reality of Pooled Pension Funds Hong Kong Launches REITs

BT: ACTING LOCAL THINKING GLOBAL WHY HYBRIDS HAVE GROWIING APPEAL

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Andrew Cavenagh, Rekha Menon, Tim Steele, Bill Stoneman, Angela May Ward, Paul Whitfield, Ian Williams, Benedict Mander FTSE EDITORIAL BOARD:

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FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

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ransparency lies at the heart of this edition. Jim Horsburgh, chief executive of the Witan Investment Trust maintains that in the portfolio transitions undertaken by his fund: “I would have liked to have known the exact profit model for transition management, because you have no idea before, during or afterwards exactly how much profit anyone is making from transition management.” It is a consideration that cuts to the quick of asset owners and fund managers anxious (as ever) to preserve value in a transiting portfolio. In the first ever FTSE Global Markets Roundtable, this theme is articulated strongly. We brought together asset managers, transition managers and consultants to discuss the growing need for transparency in the transition management sector in particular. No-fee transitions, the T-charter, the role of the consultant and recourse when transitions go awry are just some of topics covered in a wide-ranging discussion that threw up some surprising conclusions.

Continuing with this theme we provide a short update on the latest UNEP Finance Initiative on the need for a legal framework for integrating social and governance issues into institutional investment strategies and, at the same time, asked Tom McGrath Ernst & Young’s global managing partner, Client Service and Accounts, to argue the case for improved transparency in corporate reporting of risk management strategies. If investors think they are not getting the full story, they may apply a risk premium to the cost of capital, or stay away altogether.

Our focus on investment services also alights on fund administration. Tim Steel explains that change is the watchword as European investment managers continue to push relentlessly into new asset classes and geographies. The product set offered by fund administrators is changing accordingly and, in our extended report, we look at the impact of pooling services as well as the rise of fund administration for alternative investments.

Bill Stoneman meanwhile analyses the efforts by Morgan Stanley chairman and chief executive officer (CEO) John Mack, to stem departures of the bank’s most productive bankers and traders, address legal setbacks and restore investor confidence. In an age increasingly pre-occupied with environmental protection, technology is being harnessed to help reduce pollution and protect the world’s supply of natural resources. It is a debate gaining ground in the US as gasoline prices regularly bump against historic highs and natural disasters, such as hurricanes Katrina and Rita damaged Gulf Coast refineries. The few beneficiaries have been auto dealers such as Toyota, Honda and Ford that have struggled to keep up with orders for its fleet of hybrids—vehicles that utilise both conventional fuel and battery power for energy. Dave Simons looks at the long term prospects for this specialist automobile sector.

For our Cover Story we look at British Telecom (BT). Hardly a day goes by without an announcement of a seminal merger or acquisition among the world’s telecommunications giants. Where is it all leading? Is this latest round of acquisitions and alliances providing market synergies – or simply an overly expensive way of securing market share? BT Group is standing out from the crowd, by seemingly doing very little. Is its chief executive Ben Verwaayen, overly cautious, or the smartest CEO in town?

Francesca Carnevale, Editorial Director November 2005

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Contents COVER STORY COVER STORY: THE WINNING FOCUS ..........................................Page 37 While the rest of Europe’s telecommunications giants are swept up in mergers and acquisitions fever frenzy, British Telecom is taking a more leisure stock of the market. BT it seems is focused on delivering value through business transformation rather than acquisition of market share. Is it prescient or foolhardy?

What does BT chief executive officer (CEO) Verwaayen know that the rest of the market doesn’t? Francesca Carnevale reports.

REGULARS MARKET LEADER

WHY THE PRICE SHOULD BE RIGHT

..........................................Page 6 Euroclear director Frank Reiss discusses the need for greater market efficiencies

INNOVATIVE FINANCING FOR SUSTAINABILITY ..........Page 10 IN THE MARKETS

Integrating environmental, social and governance issues into the investment mix

THE BENEFITS OF POSITIVE RISK MANAGEMENT ....Page 12 Ernst & Young’s Tom McGrath argues for more transparency

SEC SECURITIES OFFERINGS REFORMS

..................................Page 16 Karen Jones reports on the new offering processes for registered transactions

LATIN AMERICAN PENSIONS UNDER SCRUTINY

........Page 19 Ian Williams discusses the challenges facing Latin America’s pension industry

REGIONAL REVIEW

ASIAN HEDGE FUNDS BUILD MARKET SHARE

..................Page 25 Rekha Menon reports on an industry which has finally achieved critical mass

HONG KONG LAUNCHES REITS MARKET

..........................Page 29 The sparkling debut of Hong Kong’s LINK REITs presages a bright future

THE FRENCH APPROACH TO SYNDICATION

....................Page 32 Natexis Banques Populaires’ Olivier Gaudez analyses new issue volume

EQUITY REPORT

INVESTMENT SERVICES

THE DEEPENING RANGE OF EUROPE’S ETFS

..................Page 44 Karen Jones reports on the new offering processes for registered transactions

FUND ADMINISTRATION BREAKS NEW GROUND

....Page 48 Tim Steele reports on the new opportunities for fund administration providers

PENSION FUND POOLING BECOMES ESTABLISHED ......Page 59

What do pension fund pooling services really mean and who offers them?

INDEX REVIEW 2

Companies in this issue ..................................................................................................Page 85 Market Reports by FTSE Research ................................................................................Page 86 Calendar ............................................................................................................................Page 96

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

4HERE ARE SOME THINGS YOU JUST DON T WANT TO TRY SOLO

4RANSITION -ANAGEMENT

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BLOWING YOU RE A LOT SAFER WITH SOMEONE EXPERIENCED SCANNING FOR UNEXPECTED TURBULENCE .O MATTER HOW COMPLEX THE TRANSITION OR HOW MANY ASSET CLASSES OR MANAGERS ARE INVOLVED WE HAVE THE TECHNOLOGY AND THE PROJECT MANAGEMENT EXPERTISE TO BRING YOU IN FOR A SAFE LANDING 0UT THE DEGREE VISION OF #ITIGROUP TO WORK FOR YOU

'LOBAL "ANKING

'LOBAL #APITAL -ARKETS

'LOBAL 4RANSACTION 3ERVICES

4O CONTACT US DIRECTLY 4IMOTHY 7ILKINSON OR EMAIL TRANSITION CITIGROUP COM Ú #ITIGROUP 'LOBAL -ARKETS ,IMITED !LL RIGHTS RESERVED #)4)'2/50 AND THE 5MBRELLA $EVICE ARE TRADEMARKS AND SERVICE MARKS OF #ITIGROUP )NC OR ITS AFFILIATES AND ARE USED AND REGISTERED THROUGHOUT THE WORLD

Contents FEATURES AND ACCESS FOR ALL

..................................................................................Page 42 The ability to deliver information at speeds approaching 1.5 megabits per second (or about 40 times faster than the best dial-up rate) quickly revolutionised the communications world, making it possible to receive and send massive quantities of data ranging from state-of-the-art audio to high-resolution graphics within a few short minutes. As the need for speed continues to grow, tortoise-like dial-up connections are rapidly biting the dust. What follows? David Simons reports from Boston.

TRANSITION MANAGEMENT ROUNDTABLE

..........................................Page 59 In mid November 2005, the transition management experts at Citigroup and CSFB, together with FTSE Global Markets, invited a group of market specialists to a gathering at the Berkeley Hotel in Knightsbridge, London, to debate current issues in transition management. A broad range of subjects were discussed including the importance of transition manager research, the future of transition management, and the T-Charter code of practice.

WELCOME TO THE NEW KINGDOM ......................................................Page 68 The covered bond market has become the darling of European investors. An expanding pool of banks issuing covered bonds means total new issuance is likely to end 2005 at about €130bn; higher than the total €116bn of new issuance in 2004.

However, demand for covered bonds is outstripping supply, leaving order books oversubscribed, pricing tight and investors clamouring for more issuance- despite the likely arrival of Italy on the scene, 2006 looks like offering little relief. Paul Whitfield reports from Paris.

ON THE COMEBACK TRAIL ........................................................................Page 73 Months after harsh critics of the firm were quieted by the appointment of a popular former president as chairman and chief executive officer, it still is nowhere near clear whether Morgan Stanley is better off or worse for wear than it was a year or two ago. The firm’s stock price has moved little since John J. Mack made his triumphant return in June 2005. Bill Stoneman analyses the task ahead.

ON THE ROAD WITH HYBRIDS

................................................................Page 77 As Americans face the growing reality of unstable gas prices and continued foreignfuel reliance, exploring alternative modes of transportation is fast becoming a very mainstream pursuit and – for some savvy investors at least – a potentially profitable one at that. Dave Simons reports

TAMING INDIA’S MUTUAL FUNDS

........................................................Page 81 Although established way back in 1964, India’s mutual fund industry has only come into its own over the last ten years. The industry has grown from an initial asset size of $5.5m to over $45bn in 2005. There are now well over 400 products and 29 players in the market. Rekha Menon reports on the new controls and safeguards that are being built into the sector.

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JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

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Market Leader SETTLEMENT CLEARING

Consolidation of the region’s capital-market infrastructure is moving Europe closer to the formation of a single capital market. Exchange consolidation is already evident with the formation of Euronext and OMX, and in the clearing business with the creation of LCH.Clearnet and Euroclear in the settlement space. The driver behind the efforts to create a single capital market and consolidate the infrastructure is to make Europe more internationally competitive by reducing the costs of raising capital and investing across borders. Private and public-sector attention on these issues is gaining momentum. Frank Reiss, director and head of Equities Product Management at Euroclear delivers a stirring polemic on the need for greater market efficiencies.

Delivering lower transaction costs AVING IDENTIFIED THE barriers to the efficient delivery of clearing and settlement services in the European Union (EU), the Giovannini Group, appointed by the European Commission to look at these issues, concluded: “It is clear that fragmentation in the EU clearing and settlement infrastructure complicates significantly the post-trade processing of cross-border securities transactions relative to domestic transactions. The extent of the inefficiency that is created by these barriers is reflected in higher costs to pan-EU investors and is inconsistent with the objective of creating a truly integrated EU financial system.”

The European Commission has also not lost sight of this objective, as Internal Market commissioner Charlie McCreevy’s team is close to completing a regulatory impact assessment that will determine the need for a Directive on clearing and settlement.

The jury is still out on whether a Directive focused on the activities of settlement systems will reduce crossborder settlement costs. Fees charged by post-trade infrastructure service providers in Europe (including central counterparties and settlement service

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providers) represent no more than 5% of the cost of a transaction for the end investor. It is hard to see how regulatory action to further reduce these fees would make a material difference.

However, a large portion of the unnecessarily high costs for crossborder transactions stems from marketpractice fragmentation. Here the market is already making significant progress on removing the six barriers identified by the Giovannini Group for which it was assigned responsibility. The private sector is investing a great deal of time, money and effort to deliver marketpractice harmonisation and settlementinfrastructure consolidation. Misplaced or untimely intervention by Europe’s policy makers could slow or even stop progress in these areas.

Approximately €1bn of excess costs each year can be attributed to market inefficiencies that can be addressed by the market. Obviously, in spite of the progress made thus far, it will take time to deliver all of the elements for an efficient and robust single EU capital market. In the interim, both buy-side and sell-side firms can do more than they do today to control, if not reduce, transaction costs.

Tailoring services to meet individual client demands is where global

custodians showcase their true added-value. It is the commodity-like book-entry settlement and custody services at the low-end of the spectrum that custodians and sell-side firms need to investigate more thoroughly to better understand how their transaction costs can be reduced.

According to the Tabb Group, more than 90% of buy-side firms will have transaction-cost research tools in place by 2007 to aid trade execution.

However, minimising execution costs is no longer sufficient; trading firms need to look closely at the whole trade-tosettlement cycle to snip away excesses.

By combining back-office cost data, including the cost of clearing and settlement, with pre-trade execution tools, technology providers could create a full-cycle cost analysis model for securities transactions.

The bulk of the cost for a given crossborder equity transaction resides in the investor’s own middle and back offices.

To rein in this expense, some firms are turning to outsourcing or off-shoring as solutions. No doubt these firms have a good idea as to how much savings will be generated vis-à-vis the level of service they can expect to receive.

Outsourcing solutions, however, are not always successful. If a fulloutsourcing deal is not going to net savings of at least 25%, then it is not good business sense to pursue such an arrangement. Instead, trends indicate that custodians are managing specific parts of their clients’ business, i.e. where they can add value, with selective, customised solutions rather

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

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Regional Review SETTLEMENT CLEARING

Frank Reiss, director and head of Equities Product Management at Euroclear.

Photo reproduced with the kind permission of Euroclear, November 2005.

than the wholesale management of the clients’ entire middle or back offices.

We are also seeing more commodity-like functions, such as book-entry stock-exchange trade settlement, moving to the international central securities depositories (ICSDs).

The settlement and custody service levels – at Euroclear Bank, for example – are sufficiently comprehensive and robust to offer an alternative to the relatively more expensive portfolio of agent-bank equity services. With crossborder equity settlement costs seven times more expensive than domestic transactions in Europe, the merits of a single access point to settle trades from multiple stock exchanges is a real, present-day option to drive down post-trade costs.

With equity markets now enjoying a renaissance, it is all the more important not to forget the lessons of the past. Understand what your transaction costs are really costing you.

Do you really need value-added services throughout the trade-tosettlement cycle? How much of these costs comprise the commissions and margins that agents look to pass on down the chain? Making the right decision to change your service

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provider or move to an international or domestic central securities depository is vital. Meticulous preparatory work needs to be done in tandem with understanding the future direction of your trading strategies and post-trade business commitments.

With cost-analysis tools broadening into pre-trade and post-trade areas, and at macro and trade-per-trade level, market participants could be better equipped to rationalise dependencies on intermediaries, trim costs and improve service levels.

Broker-dealers engage in huge volumes of securities transactions via programme trading on behalf of their buy-side clients. Indeed, one leading investment bank shared with us the fact that just a few decisions on a typical trading day can result in a handful of programme trades accounting for as much as 10% of the entire daily transaction volume of the London Stock Exchange.

Programme trades often encompass several asset types and span multiple markets. The levels of complexity and potential risk inherent in the posttrade processing of these transactions can wipe out the trading profits if not managed with expert care. In addition, the more securities involved in a programme trade, the greater the potential for back-office processing mistakes in the collection of dividends, distributions or interest payments.

Therefore, it is particularly important that firms active in multi-location or foreign market programme trades are aware of the levels of post-trade support they can expect. Firms should avail of those service providers that can keep settlement fails to a minimum with, for example, low-cost, settlement-driven securities lending and borrowing programmes.

Indeed, business relationships are jeopardised due to settlement fails.

According to a survey by m.a.

partners, the financial consultancy, on post-execution service provision, 40% of leading asset managers implemented equity-trading reprisals against broker-dealers for poor posttrade servicing in 2004. Reprisals ranged from trading suspensions to the severance of relationships. Asset managers now commonly ask their agents to state up-front their preferred broker-dealers and posttrade service providers, together with data on historical service levels.

We are likely to see further diversification of the assets used in programme trading, with assetbacked securities and derivatives complementing the more established securities. However, no matter what securities are used, how sophisticated the algorithms become, or how much stock-exchange market share programme trading commands, the need to address post-trade issues to retain trading profits will not change.

The ultimate fate of the LSE will certainly have ramifications for Europe’s other stock exchanges and the post-trade market infrastructure.

Nonetheless, we expect that further consolidation among clearing and settlement infrastructure service providers will continue independent of potential stock-exchange consolidation activity.

It is vital for market participants to take an active role in creating - or at the very least, expressing their views about – the type of market infrastructure they want for the future. There are many working groups, trade associations, userowned infrastructure service providers, and fori in which to communicate and/or take action. It is equally important for market participants to appreciate that they need not wait any longer to discover alternative means of reducing crossborder transaction costs.

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

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Market Leader ESG AND RESPONSIBLE INVESTMENT

PROMOTING ESG TO INVESTORS Institutional investors have the opportunity and, in some cases, a legal obligation to incorporate environmental, social and governance (ESG) issues into their investment decision-making.

So says a special study compiled by leading international law firm Freshfields Bruckhaus Deringer on behalf of the United Nations Environment Programme’s Finance Initiative (UNEP FI). The results, coupled with the expected announcement of internationally recognised principles of responsible investment (PRI) in the spring of 2006, established under a special United Nations-backed initiative, will officially kick start an international discussion aimed at bringing ESG and PRI into the mainstream of global investment activity.

STUDY BY FRESHFIELDS Bruckhaus Deringer, commissioned by the United Nations Environment Programme Finance Initiative (UNEP FI) in March 2005 finds that the integration of ESG issues into investment analysis, to better predict financial performance, is “clearly permissible and is arguably required in all jurisdictions”. Paul Watchman, a partner at Freshfields Bruckhaus Deringer and senior author of the study, told more than 450 participants at a recent two-day UNEP FI 2005 Global Roundtable meeting that: “We are not suggesting that investors pursue a moral crusade but, in most jurisdictions, the law gives a wide discretion, encircled by general duties rather than exacting standards. A number of the perceived limitations on investment decisionmaking are illusory... Far from preventing the integration of ESG considerations, the law clearly permits and, in certain circumstances, requires that this be done,” he said. The study also says that it is arguable that ESG considerations must be integrated

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into an investment decision where a consensus “amongst beneficiaries mandates a particular investment strategy and may be integrated into an investment decision where a decisionmaker is required to decide between a number of value-neutral alternatives.”

The report's lead author concluded by stressing that: “Institutional investors have more freedom to integrate ESG issues into their decision-making than they think.

Whilst normally we find ourselves encouraging our clients to be more cautious, in this case we can instead say ‘be more imaginative’.”

Through 2005 the Freshfields Bruckhaus Deringer study has been working in parallel with a special UNbacked project that will launch a set of clear principles governing responsible investment in 2006. Advocates of PRI believe that the convergence of ESG issues is material to company performance over the long term. The project was originally convened by UN Secretary General Kofi Annan, under the umbrella of UNEP and the UN Global Compact, a group that

worked with 21 of the world’s major institutional investors, with combined assets under management (AUM) of just over $1.7trn, to develop PRI. Those principles have now been successfully negotiated, explains Paul Clements Hunt, head of unit at the UNEP FI, a global partnership between the UNEP and 170 banks, insurers, pension funds and asset managers, based in Geneva (please refer to FTSE Global Markets, Issue Nine, September/October 2005, pp. 20 to 21) for a more detailed summary of the background to the PRI initiative).

The principles are now embargoed while each of the signatories is striving to agree the final wording of the principles document with their legal and compliance departments and the final document outlining a set of six agreed principles will be published in March 2006.

The Freshfields Bruckhaus Deringer study, which is called A legal framework for the integration of environmental, social and governance issues into institutional investment was launched in October at the UN headquarters in New York. The 150page report focuses on the largest capital markets jurisdictions – Australia, Canada, France, Germany, Italy, Japan, Spain, the United Kingdom and the United States, and considers the likely evolution of the interpretation of the law with respect to investors and ESG issues. The parameters of the study were set by UNEP FI’s Asset Management Working Group (AMWG). The clear question asked was: Is the integration of ESG issues into investment policy (including asset allocation, portfolio construction and stock-picking or bond-picking) voluntarily permitted, legally required or hampered by law and regulation; primarily as regards public and private pension funds, secondarily as regards insurance

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

company reserves and mutual funds.

Klaus Toepfer, UNEP’s executive director, said that the study will “accelerate the integration of ESG issues into the mainstream investment community worldwide.

What was once considered a niche area is set to become mainstream …

As the world’s largest pension schemes, government funds, insurance reserves and foundations adjust, this will set in train a new dynamic along the investment chain.

When these large institutional investors move on ESG issues the broader markets will listen and react.”

Combined the launch of an unambiguous set of principles governing responsible investment and the publication of the legal study will,

says Clements Hunt, kick start a vigorous and global discussion which will result in bringing ESG into the investment mainstream. Clements Hunt explains that professional who promote a greater regard for ESG issues in investment decision-making often times encounter resistance from their colleagues, in the mistaken belief that institutional principals and their agents are legally prevented from taking account of such issues. “The value of the study is that it confirms the legal reality of how ESG is linked into the investment process. In many instances, firms are legally required to look at ESG issues when it comes to making investment decisions.”

According to Paul Watchman, “It is not everyday that commercial lawyers

have the opportunity to challenge industry to be more courageous, but that is the position in which we find ourselves having produced this report for the UNEP FI.” Exactly, says Clements Hunt,“the report has blown up a wide discussion space, particularly when you align it with PRI and already it has created an avalanche of interest from the investment, government, legal and financing communities, who want to understand the detailed repercussions of both the legal study and the eventual launch of PRI.” Clements Hunt explains that in the run up to “we will look to capitalise on the robust conversations with capital markets practitioners to lock-in the appropriate legal interpretations into their everyday thinking.”

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In the Markets RISK MANAGEMENT

Reporting of Corporate Risk Strategies Savvy investors have always understood the relationship between risk and reward. But now, are corporates seeing the benefits of a positive risk-management approach? We asked Tom McGrath Ernst & Young’s global managing partner, Client Service and Accounts, to argue the case for improved transparency in corporate reporting of risk management strategies. If investors think they are not getting the full story, they may apply a risk premium to the cost of capital, or stay away altogether.

Tom McGrath Ernst & Young’s global managing partner, Client Service and Accounts. Photo: Ernst & Young.

NVESTORS SPEND THEIR transparency, accountability and negative surprises, greater financial professional lives balancing the effective communication can also stability, and ultimately it can lead to risks they take against the rewards improve their investor relations and, greater profitability.

Conversely, two-thirds of investors they can receive. Risk is neither good in some cases, their valuations. In a nor bad, just an accepted part of what recent survey of more than 130 major say they avoid companies that cannot successful risk they do. Corporate managers, on the global investors four-fifths of them demonstrate other hand, in the past have tended to told us that they are willing to pay a management and nearly half said they view risk as something to be avoided. premium for companies that manage have withdrawn their investments Their risk-management programs risk effectively. They believe reliable from these companies for this very have been driven by fear of business risk management offers fewer reason. Most importantly investors say companies need to failure and the need to have clear compliance risk comply with regulation.

The FTSE ISS Corporate Governance Index Series strategies.

While Corporate attitudes have 120 compliance alone does not begun to shift recently 110 ensure commercial though, and many 100 success, it is regarded as a companies are beginning 90 ‘license to operate’ and to understand how a more 80 helps to add value. The sophisticated approach to 70 implications of compliance risk can benefit their 60 now extend beyond business. These benefits 50 financial reporting and extend further than better 40 corporate governance to decision-making ability. encompass a range of Companies that base FTSE ISS US CGI FTSE ISS UK CGI FTSE ISS Japan CGI legal, statutory and their risk management on voluntarily adopted the principles of Price Returns (USD). Data as at 30 November 2005. Source: FTSE Group.

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To find out more about the FTSE/ASEAN Index Series please visit us at www.ftse.com/ASEAN, email info@ftse.com or call us BOSTON +(1) 617 306 6033 ~ FRANKFURT +49 (0) 69 156 85 143 ~ HONG KONG +852 2230 5800 ~ LONDON +44 (0) 20 7866 1800 MADRID +34 91 411 3787 ~ NEW YORK +(1) 212 641 6166 ~ PARIS +33 (0) 1 53 76 82 88 ~ SAN FRANCISCO +(1) 415 445 5660 ~ TOKYO +81 3 3581 2811 © FTSE International Limited (“FTSE”) 2005. All rights reserved. The FTSE/ASEAN indices are calculated by FTSE in conjunction with PT Bursa Efek Jakarta (Jakarta Stock Exchange), Bursa Malaysia Berhad, The Philippine Stock Exchange, Inc., Singapore Exchange and The Stock Exchange of Thailand (the “Exchanges”). All rights in the FTSE/ASEAN indices vest in FTSE and the Exchanges. “FTSE®” is a trademark of the London Stock Exchange Plc and The Financial Times Limited and is used by FTSE under licence. Neither FTSE nor the Exchanges nor their licensors shall be liable (including in negligence) for any loss arising out of use of the FTSE/ASEAN indices by any person. Distribution of FTSE/ASEAN indices index values and the use of FTSE/ASEAN indices to create financial products requires a licence from FTSE.

Regional Review RISK MANAGEMENT

requirements. The survey respondents think compliance is widening beyond external regulation to embrace internal standards as well.

Communication is vital. What investors want most of all is to understand is where a company has come from, where it is going and what the dangers might be along the way.

They do not expect to eradicate risk–after all, it is inherent to their own business model and the source of their livelihood. What they do want is to be made aware of the full range of risks which are inherent in their investments.

Viewed in this light, good risk management consists of knowing four things: • what risks the organisation faces; • who is managing those risks; • effectively managing those risks; and • communicating how those risks are managed.

In the survey 69% of our respondents identified ‘transparency’ as a top priority in considering an initial investment. Companies need a clear communication strategy therefore to ensure they are giving investors the information they want in the most effective way possible. These days, investors increasingly want communication beyond an annual report and accounts. They are looking for personal communication, where they can ask individual questions and raise concerns. The challenge is to respond to this desire for personal communication while adhering to regulatory requirements, which demand that any information that could have an impact on stock prices should be distributed to all shareholders at the same time.

Any communications program needs to be robust enough to withstand major events – both negative and positive – such as profit warnings, hostile bids, high ranking executive resignations,

14

RISK SURVEY RESULTS

E

rnst & Young’s recently released global survey of institutional investors’ attitudes towards risk reports that: • 61% of investors reported they had not made an investment because they considered a company’s risk management to be insufficient • 48% revealed they had withdrawn investments in companies where risk management performance was insufficient • 82% of major investors would pay a premium for a company that successfully demonstrates good risk management • 69% of investors rank transparency as the top priority when making investment decisions, ahead of the business model and track record of the company • Investors believe reliable risk management results in fewer negative surprises, greater financial stability and opportunity for profitability • Board-level ownership, understanding and communication of risk issues are considered the keys to risk management success

de-mergers or listings. It can provide a means to manage expectations and avoid surprising the investors. And if something does go wrong, it will help to contain the damage and maintain a company’s reputation.

Growing demand for direct communication is encouraging companies to decide who should be taking responsibility for risk and engaging in direct dialogue with investors. The emerging role of Chief

Risk Officer (CRO) is an obvious candidate. Some believe that risk is such a vast and important area that it warrants full time focus at a senior level.

The counter argument says that appointing a CRO could place risk in a silo and make it ‘not the Board’s business’. Many investors, however, believe that the only real CRO is the chief executive officer (CEO). CEOs make the decisions on their businesses’ risk profiles, and cannot delegate that responsibility. It means that CEOs need to feel comfortable talking about risk management and control, and be able to instil confidence in their audiences.

Investors have a perfectly reasonable expectation that corporate Boards should also take active roles in risk management. Just under one-third of the investors we spoke to believe that Boards should be setting the strategy for risk management, while around half think that the Board should provide guidelines. In both cases, a Board would need to ensure delivery responsibility was accepted by management and have sufficient, appropriate, and clear reporting from across the organisation.

The positive news is that companies and investors are talking about risk management. Investors want to make money, be profitable and grow.

Companies want the same thing, and they want to attract investors. It makes sense to be as open as possible, since demonstrating excellence in managing risk may attract a premium from investors. There is a risk-management value chain that leads from compliance to transparency to premium.

Companies need to strike a balance between over communicating a long list of potential risks, and the tendency to withhold information – a balance that identifies risks that are both specific and relevant. But if investors feel they are not getting the full story, they may apply a risk premium to the cost of capital – or stay away altogether.

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

MARHedge 11th Annual European Conference on Alternative Investments The Next Generation of Managers,Investors,Strategies and Markets February 6-8,2006 • Hotel President Wilson • Geneva,Switzerland The alternative investment market is swiftly entering a phase marked by new institutional and private client investors in markets as diverse as the Middle East, Asia and South Africa. At the same time, traditional investors in the U.S. and Europe are becoming far more sophisticated in what they want from managers and how they assess them.

SPEAKERS INCLUDE: Elena Ambrosiadou, IKOS Partners John Bailey, Spruce Private Investors, LLC Brett M. Bastin, Grail Partners LLP Simone Borla, GAIM Advisors

The MARHedge 11th Annual European Conference on Alternative Investments, February 6-8 in Geneva, Switzerland, will gather leading hedge fund and fund of funds managers, private banks, high-net-worth brokerage units, and institutional and high-net worth investors from all over the world to delve deeply into the next generation of alternative investments. Through keynote speeches, as well as general and targeted breakout sessions, investors and those who control the most lucrative distribution channels will reveal what they will be looking for from managers and how regional differences impact investment needs. Managers will also detail the challenges of executing strategies in emerging markets and unique investment styles in more established arenas-all against a backdrop of increasing competition, tighter regulatory scrutiny and market reforms that are opening up new avenues for investment.

During the event, attendees will also enjoy ample opportunity to network with managers, investors and service providers alike-be it skiing at world-famous Chamonix, cocktail parties at the Hotel President Wilson or dining throughout beautiful Geneva.

After three days at MARHedge's 11th Annual European Conference on Alternative Investments, attendees will not only have a firm understanding of what's needed to succeed in today's market, but more importantly, a clear idea of what's next.

Sebastian Dovey, Scorpio Partnership Ed Durkee, Portfolio Overlay Advisors Peter Fletcher, Club B and Parly Family Office Fred Fruitman, Loeb Partners Donna Gilding, Lowenhaupt & Chasnoff Roger H. Gordon, Quarry Point Partners Alper Ince, PAAMCO Andrew Klein, SkyBridge Capital LLC Saleem Siddiqi, Tapestry Asset Management LLC Dean Smith, Highland Financial Holdings Group, LLC John Trammell, Investor Select Advisors George Wilbanks, Russell Reynolds Associates

For more information, please contact Mark Salameh at +1.646.274.6268 or msalameh@marhedge.com.

Gary Witt, Moody’s Investor Service

Regional Review NORTH AMERICA: SEC REFORMS

In an ongoing effort to modernise the securities offering process, the US Securities and Exchange Commission (SEC) recently adopted a wide range of changes under the Securities Act of 1933. General wellreceived by a regulatory wary industry the changes, while comprehensive, do not constitute the implementation of an entirely new system. It is, however, a significant updating of the registration, communications and offering processes for registered transactions. Karen Jones reports from New York.

NTIL A FEW years ago, company communications in the run up to a registration statement or securities offering used to be a relatively straightforward affair.

In more recent times however, that has not been the case says Lorraine Massaro, partner at Kirkpatrick & Lockhart Nicholson Graham LLP. “It was becoming progressively more difficult to control what could be deemed ‘communication’.” It was also difficult for company communications to avoid being viewed – particularly by the SEC – as improperly conditioning the market for any impending securities (a process known as gunjumping). As a result, company communication has become “the bane of the public offering process, especially for lawyers,”explains Massaro.

Recent changes to the 1933 Securities Act should change all that.

According to the SEC the latest raft of changes which come into force at the end of 2000 introduce an important modernisation of rules governing corporate communications in the run up to the launch of securities offerings.

Gregory A. Fernicola, a partner in the

SEC reforms Securities Offerings

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Chairman of the U.S. Securities and Exchange Commission Christopher Cox, second right, walks through the grounds of Diaoyutai during the US-Sino talks in Beijing in mid-October 2005. US Treasury Secretary John Snow and other top American economic officials on Monday urged China to move faster in market-opening and currency reforms, laying out guidelines they said would make the country wealthier and more stable, while also reducing its huge trade surplus. Others are unidentified.

Photographer: Elizabeth Dalziel (Pool): Agency: Associated Press (AP), sourced from EMPICs, November 2005.

Corporate Finance Department at Skadden, Arps, Slate, Meagher & Flom LLP calls the changes “a positive development which reflects the SEC’s willingness and desire to review and revise regulatory regime as times change.” He adds that the revisions were based, on a large part, on the role that technology and electronic communications have played in the global economy. “They reflect the reality of the marketplace and allow for more flexibility.”

The changes are comprehensive and involve communications relating to registered securities offerings: shelf registration and other procedures in the offering and capital formation processes; prospectus delivery of information to investors, including timeliness, notices and delivery through access. According to official SEC blurb, the moves will mean improved and timelier information will be made available to investors in new securities.

Electronic dissemination of information

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

3rd ANNUAL CONFERENCE ON ASIAN SECURITIES LENDING March 22-24, 2006 Royal Orchid Sheraton Hotel & Towers Bangkok, Thailand The industry wide jointly sponsored conference in Asia developed by securities lending and borrowing professionals for securities lending and borrowing professionals

Presentations From Regulators, Le nders, Agents, Borrowers, & Business Leaders Discussing: N Collateral Management Issues N Hedge Fund Development & Opportunities in Asia N Regional Country Developments & Updates The conference will feature many regionalpractioners and specialists in the securities finance field. If you want toknow about securities lending and finance in Asia this is the conference to attend -DON’T MISS IT!!!

Planning to Attend: For registration materials or questions, call RMA, Kim Gordon, 215-446-4021 *E-Mail: kgordon@rmahq.org or visit our web site at http://www.rmahq.org/RMA/SecuritiesLending

Conference Chairs Risa Muroi Principal Barclays Global Investors Tokyo

Eugene Picone Senior Vice President JP Morgan Chase & Co. New York

Regional Review NORTH AMERICA: SEC REFORMS

over the Internet is also encouraged.

Under the old rules, it was unlawful to sell securities in a public offering unless the printed final prospectus was physically delivered to each investor, says Fernicola. Now, “physical delivery will no longer be required,”he explains.

The final prospectus only needs to be filed with the SEC and investors are notified that they are purchasing those securities in a registered offering “and that they can find the prospectus online”. He adds that the final prospectus is more a written record of the final terms of the offering, rather than a liability document.

According to SEC sources, the modifications will preserve investor protection while avoiding unnecessary obstacles to the capital formation process. Fernicola explains that the rules update and liberalise permitted activity regarding communication with investors allowing more information to reach them.“Before, it was unlawful to send any written information to potential investors except for the statutory prospectus filed with the SEC,” explains Fernicola, adding that the proliferation of email and hyperlinks, have made that restriction “antiquated.”Though information will now flow much more freely, investor protection will also be secured, continues Fernicola, because offering participants are still liable for all communications and will still need to be careful to ensure the accuracy of any supporting documentation.

Over 130 industry comment letters were received by the SEC after the initial proposal was posted. In general, they supported the changes. This did not come as a complete surprise: “… electronic communications are the norm,” said former SEC chairman William H. Donaldson in a recent SEC Open Meeting. “Advances in communications and information

18

technology are resulting in more information being provided to the market on a more non- discriminatory current and on going basis,”he added.

Donaldson also said that the changes will encourage an increased flow of information between issuers and investors and eliminate outmoded gun jumping restrictions while maintaining investor protection.

The new rules bring more clarity as to the kind of ongoing ordinary business course disclosures that would not constitute gun-jumping, says Massaro and permit greater use of written communications outside of the statutory prospectus around the time of a registered offering of securities.

A 30-day “safe harbor” period has also been introduced before the filing of the registration statement, says Massaro.

This permits any communication by any issuer made more than 30 days before the filing of any registration statement, which does not directly refer to the securities offering – as long as the issuer takes reasonable precautions to prevent the further distribution of the information during those 30 days. According to Massaro,“people were struggling with what they could talk about in their regular course of business during the pre-filing period.” She adds that “companies will always make some mistakes in certain of their communications around the time of a registered offering. But there is only so much the SEC can do in terms of guiding companies with bright-line safe harbors and rules; the rest is all a judgment call.”

The changes have also effectively created “automatic shelf registration” says Fernicola. Under the old rules, even the “Well Known Seasoned Issuers”(WKSI) were required to wait till the SEC cleared the registration statement before selling securities under that statement. Not anymore.

Gregory A. Fernicola, a partner in the Corporate Finance Department at Skadden, Arps, Slate, Meagher & Flom LLP. Now,“physical delivery will no longer be required,”explains Fernicola.The final prospectus only needs to be filed with the SEC and investors are notified that they are purchasing those securities in a registered offering “and that they can find the prospectus online”.

Photo source: Skadden, Arps, Slate, Meagher & Flom LLP, November 2005.

Since WKSI file regular reports with the SEC and are “well known” to the both the media and institutional and retail investors, they are now provided automatic clearance and immediate access to the capital markets.

WKSI are currently responsible for the vast majority of offerings. According to the SEC release, they must have a worldwide market value of $700m or more and “must have issued in the last three years, $1bn aggregate principal amount of non-convertible securities, other than common equity, in primary offerings for cash, not exchange, ” Automatic shelf registration will only be available to WKSI. As to whether the SEC will continue with further securities offering reform, Fernicola says the SEC has addressed “the most important issues and it will be interesting to see how market practice develops. Massaro concurs. “I think for the most part it’s a plus-plus.

There is always an area where you can say, ‘what a pain’, but no more than today. It many not be the perfect answer in all respects, but it’s a very positive step forward.”

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

06 SFC’ nce with nfere o C e anc st 2006 s Fin 1 Swis uary Febr .ch sfc06 . w ww

www.fonds-messe.ch info@fonds-messe.ch

Kongresshaus Zurich 1st to 3rd February 2006 Wednesday 09.00 – 18.00 h Thursday 10.00 – 20.00 h Friday 10.00 – 17.00 h

Organizer:

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Co-sponsors: Activest Schweiz · AXA Investment Managers · Bank Sarasin & Cie AG · Credit Suisse · DWS Investments Fidelity International · Fortis Investments · GAM Anlagefonds AG · Julius Bär · LGT Capital Management AG Liechtensteinische Landesbank AG · Pictet Funds SA · PMG Fonds Management AG · Robeco (Schweiz) AG Swiss Life · Swissquote · Wegelin & Co. Privatbankiers · Wegelin Fondsleitung AG

Regional Review LATIN AMERICA: PENSION FUNDS

The problem with multi-pillar pension systems Most of Latin America’s countries have converted their pension funds from government-run ‘pay-as-you-go’ funds, in which current workers’ contributions pay for previous retirees’ pensions, to private, individual capitalisation, so-called “fully-funded” schemes, such as mandatory individual private savings accounts. The result is a complex multi-pillar pension system that stretches across virtually the sub-continent. Ian Williams reports from New York.

N THE BOOK Keeping the promise of social security in Latin America, by Indermit Gill, a World Bank economic advisor in the Poverty Reduction and Economic Management Network, the author maintains that while each country in Latin America has modified the local pension system to fit its own circumstances, the region’s governments share common goals: to make the national pension scheme financially viable and sustainable; to make payouts equitable; to diversify the sources of retirement income and improve incentives to encourage individual contributions into local pension and social security schemes.

As a result, by 2015, Latin America’s privatised pension funds will be handling as much in assets as local banks do – the equivalent of some 40% of gross domestic product (GDP). Already combined on a regional basis, the funds amount to around 10% of the sub-continent’s GDP. In Chile in particular, approved pensions schemes make up 50% of GDP. However, from north to south

I

20

along the continent these pension funds are finding it more and more difficult to find assets of sufficient security and quality in which to invest.

Apart from bank deposits, and in some cases a limited degree of foreign investment, by and large, local regulators only allow the funds to invest a limited amount in equities and corporate bonds for companies.

Even then, they are strained to find any such outlets with a high enough rating to justify the risk.

So far the problem has been mitigated because government securities were paying high interest rates, but their yields have recently been declining. They are also expected to fall further, threatening the funds’ ability to pay the level of pensions their contributors have been led to anticipate. Liliana Rojas-Suarez, the Colombian former head of Latin American operations for Deutsche Bank says, “The pension funds are growing at a very rapid pace. They hold an enormous amount of resource that keeps growing, [but] the capital markets have not [kept] a

corresponding pace. So, with the exception of Chile they mostly hold government debt and similar assets.”

She speaks on behalf of the ominously named but well-intentioned Latin American Shadow Financial Regulatory Committee, a group of experienced financiers from the region funded by bodies as various as George Soros’s Open Society Institute and the World Bank. The group meets regularly to consider the continent’s financial welfare.“Five years ago we got together to consider the many financial problems and decisions being made at national and international levels that affect our region. The group has a fundamental rule – if any of its members resume office then their active membership is suspended as has happened to Colombia’s current Director of Finance,” Rojas-Suarez explains. They soon concluded that their regulations had been imported from the developed world with insufficient attention to the undeveloped state of the region’s capital markets.

While in OECD countries pension funds have been pressuring governments for longer term bonds to balance their portfolios of company securities, Latin America poses the opposite problem. The rapidly growing influx of assets from pension funds with few outlets is likely to cause serious distortions in the Latin American government bond markets, but no one is advocating that they rush off and invest in the local stock market’s equivalent of dotcoms. The new pension funds were supposed to lead to increased productive investment in the private sector, but, the group suggests, such hopes did not pay enough attention to the realities of the financial markets.

In fact, not only are funds constrained by regulations there is little demand for capital from the stock

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

Swiss Finance Conference for professional investors February 1st 2006 Kongresshaus, Zurich www.sfc06.ch

Eastern Europe

International real estate

Ernst Mühlemann Former Member of the National Council

Steven Patrick Dunn Chief Economist Richard Ellis

• Jean-François Kammer, Swiss Ambassador in the Czech Republic • Prof. Dr. iur. Karl Eckstein, Eckstein & Partner, Moscow, Russia • Benedikt A. Goldkamp, CEO Phoenix Mecano • PhD Volkhart Vincentz, Executive Director Institute for Eastern Europe, Munich • Günter Faschang, Head of Central and Eastern European Equities, Vontobel Europe S.A., Vienna branch

Commodities Prof. Kjell Aleklett Head ASPO Association for the Study of Peak Oil & Gas • Kui-Nang Mak, Chief Energy Branch United Nations, New York • Dr. Peter Gerling, Federal Institute for Geosciences and Natural Resources (BGR) in Hannover • Dirk Hoozemans, Senior PM Energy Equities Robeco Asset Management • Dr. iur. Rolf Hartl, Managing Director, Petroleum Union Switzerland • Raffaele Dominiconi, Vice President e’mobile

• Hannes Wüest, Partner and Chairman of the Board of Directors, Wüest & Partner AG • Prof. Dr. Jörg Baumberger, University of St. Gallen • Dr. Christoph Caviezel, CEO Intershop Holding AG • Kiran Patel, Head of Research and Strategy AXA Real Estate Management

MedTech Andy Rihs Chairman Board of Directors Phonak

• Prof. Thierry Carrel, Director and Head Physician Insel-Hospital Bern • Eric R. Perucco, CEO Olympus Schweiz AG • Dr. Ralph Schlapbach, Managing Director Functional Genomics Center Zurich • Anne Marieke Ezendam, Manager Threadneedle Global Healthcare Fund Detailed program: www.sfc06.ch Further information: info@sfc06.ch

Targeted participants Members of governing boards, general managers and members of foundation boards, as wells as managers and qualified employees of investment and fund companies, family offices, banks, insurances and asset administrators, as well as specialized lawyers and consultants.

Media partners:

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Bank Sarasin & Cie AG · LGT Capital Management AG · Oppenheim Pramerica · Robeco (Schweiz) AG

Regional Review LATIN AMERICA: PENSION FUNDS

Constrained by markets. Apart from the risk regulations and lack of level, economic growth in choice in the markets, the Latin America has not been pension funds, willy-nilly, very rapid, so there is less have been major buyers of demand for equity government paper, and investment – although in a while international better balanced system, the bankers can tolerate the availability of such funds for US Social Security Fund investment could lead to churning its contributions growth in itself. Few of Latin into treasury bonds, they America’s major companies tend to be less generous rely upon equity investment with Latin America, not for finance, and the small least in the course of an and medium enterprises experiment that was that make up the majority alleged to divert resources go to banks for finance into the private sector. rather than a risky and They did not always see expensive public offering. lending money to The degree of transparency governments to pay involved in a publicly quoted pensions as one of their company goes against better investments and the traditions of discretion that increased public sector are often well founded in Liliana Rojas-Suarez, the Colombian former head of Latin borrowing requirements in countries where accurate American operations for Deutsche Bank says,“The pension funds Latin America were a major information would assist are growing at a very rapid pace. They hold an enormous amount of factor in their increasing competitors, and lay resource that keeps growing, [but] the capital markets have not risk assessment from rating companies open to the [kept] a corresponding pace. So, with the exception of Chile they agencies. In Argentina, the depredations of sometimes mostly hold government debt and similar assets.” Photo supplied by transition costs from corrupt governments, and Mrs Rojas-Suarez, October 2005. privatising pensions Rojas-Suarez points out, even organised crime. Conversely, many governments that used to administer doubled the increase in public debt of the companies that are quoted do not the pension funds as bonds instead of between 1993 and 2000, and led to meet the strict credit rating criteria of pension contributions – for example, in more than half of the public sector the case of Mexico 80% of the pension borrowing requirement. It is chilling the pension regulators. example of what can happen when That atmosphere of distrust for funds end up in government hands. solutions from Indeed, the regulations for the new off-the-shelf equities led government regulators to set quantitative limits for pension fund pension systems designedly included a developed countries are adopted generous allocation for without being adapted to suit local investment in the stock markets rather very than allowing the discretion of the government securities, since they had in circumstances.

The financiers’ group developed some fund managers to pick suitable secure mind not only the security of the system stocks, “the prudent man” for future pensioners, but also the need imaginative solutions, as well as rule of Anglo-Saxon regulatory to fill the gaping fiscal hole caused by enumerating the problems facing the new assumptions. The easiest solution, “generational transfers.” That is the regimes.They chose not to look at some of adopted by most of the funds, has been transition to “fully–funded systems,” the other problems that have been ascribed to buy government bonds, which in during which the governments still have to the new schemes, their high overheads some measure defeats the purpose of to pay out their old commitments to and commissions and their lack of social privatisation, which was intended to older workers and pensioners but do security content for poorer workers and take the pensions away from the not collect the contributions that have unemployed, but rather to look at the sphere of government. Instead it now been diverted from the pay-as you go macroeconomic consequences.

Rojas-Suarez comments “One of hands the money back to the systems to the privatised schemes.

22

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

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Regional Review LATIN AMERICA: PENSION FUNDS

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first recommendations is to allow the downstream income ensures a steady investments meet the needs of the pension funds. In Chile explains pensions to invest abroad to avoid long term flow of funds.

The key point, advise the financiers, Rojas-Suarez private insurance of such distortions,” and Chile, whose funds are allowed to do just that, has is to bundle the liabilities into some such projects gives them an invested heavily in neighbouring different risk structures, so that the AAA rating.

To help the private sector, and to markets making it one of the pension funds can also take the senior trailblazing developing country cross tranches. Whoever takes on the assets, take account of the predominance of border investors. But otherwise, some “they relieve the pressure on the bank financing for small and medium creativity is called for. “We could wait balance sheets of the originating company borrowers, Rojas-Suarez collateralised loan for a long time to see how the banks, which can now make further suggests financial structure development loans?” Rojas-Suarez explains, while obligations (CDOs),“100, or 200, loans progresses,” she says, but they the banks continue to use their to companies in a pool, with different decided, “Let’s see now how to expertise to administer the loans in seniority, duration and risk,”she adds, “thus transforming risky loans, that preserve the safety of the pension return for fees.

Similarly, the experts allege that the corporate sector needs to grow, funds, while allowing them to invest Latin American banks traditionally into a combination of investment in a wider range of asset classes.”

Other recommendations include “shy away from”mortgages in various grade assets for pension funds, and higher risk, higher gain, some innovative, but assets for others.” productive financial Building Latin American capital markets for the future Despite the imaginative instruments involving FTSE Argentina vs. FTSE Mexico and FTSE Latin America Index input of the Latin American productive collaboration 300 Shadow Financial between the banks and 250 Regulatory Committee the pension funds, and 200 Team, the biggest hurdle building on some they face is the need to instruments already 150 change the regulations of available, securitised 100 the funds which set bonds, mortgage 50 minimum and maximum securities, infrastructure investment allocations. finance bonds and 0 However, the team must collateralised loan reconcile keeping the funds obligations. The aim is FTSE Argentina Index FTSE Mexico Index FTSE Latin America Index secure with the need for new both to increase the investment outlets. quality of the pension Total Returns (USD). Data as at 30 November 2005. Source: FTSE Group.

“These instruments will not fund portfolios while returning to the original claimed aim forms. However, long term loans meet all the needs of the pension funds of privatisation, building capital secured on real estate are perfect for but it is part of a process,”Rojas-Suarez markets and boosting the economies pension funds, and the ability of explains, adding that while they pension funds to provide capital, recommend a general outline, we of Latin America.

Their suggestions include which can be securitised and thus suggest that the individual countries securitised Bonds, mortgages and once again taken off the banks’ adopt their own variants, and form Market Development collateralised loan options each of balance sheets may encourage them Financial to explore the which has the potential to unite the to help develop the Latin American Commissions possibilities. Since the InterAmerican pension funds’ assets and the banks’ real estate industry.

In addition the financiers also see Development Bank and the World Bank expertise in putting resources to productive use. The securitised bonds the growing demand for infrastructure are among the backers of the involve a sale of claims, usually from development in Latin America as an Committee, there is a high probability banks, to a separate institution, which opportunity. Reined-in governments that the suggestions will be acted on. can then pool them for investment are increasingly turning to private And they certainly make more sense from the pension funds. The risk is finance initiatives to finance major than some the early forcible advice from shared and can be insured, while the projects. Once again, these long-cycle international institutions to the region.

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

ASIA: HEDGE FUNDS

After over a decade of low key performance, the Asian hedge fund industry has finally achieved critical mass in recent years and is charging full steam ahead. Rekha Menon reports.

Asian hedge funds build market share EARLY 100 NEW hedge funds have been launched each year for the past two years in Asia, and in that time overall investment in the industry has nearly doubled. The Singapore-based specialist hedge fund research firm EurekaHedge estimates that the total number of hedge funds in the region has increased from 162 funds managing $14bn at the beginning of 2002 to 670 funds with $75bn in assets in 2005.

The turning point for the industry came in 2003 when hedge funds in Asia had a spectacular run. The EurekaHedge Asian Hedge Fund Index rose 26%in 2003, compared to 10% in 2004 and 8% in 2005.

“Between 1998 and 2002, most Asian economies were going through serious difficulties due to the Asian crisis. But post-SARS, interest returned in these markets, which was complemented by massive inflows relative to the size of the sector at that

N

Charles Beazley, head of global institutional and alternative investment at Gartmore. Asia has become an attractive destination for hedge fund managers because of a “higher degree of inefficiency and illiquidity in the market,” says Beazley. Photo: Gartmore, November 2005.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

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Regional Review ASIA: HEDGE FUNDS

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are of Asian origin, and the time. This trend is now The FTSE Hedge Index Series 150 industry is dominated by continuing with the recent 140 international players that resurgence of the 130 have to date preferred to Japanese economy and 120 manage the funds out of market,” states Harvey 110 their offices in London or Twomey, director and 100 New York. This mass head of prime brokerage 90 movement of hedge fund and equity finance sales in 80 70 managers to financial the Pacific Rim Region at 60 locations such as Hong Merrill Lynch.

Kong, Singapore, Tokyo Asia has become an and Sydney is therefore a attractive destination for FTSE Hedge Index FTSE Hedge Directional Index remarkable development hedge fund managers FTSE Hedge Event Driven Index FTSE Global Equity Index Series and indicative of the way because of a “higher FTSE Hedge Non-Directional Index perceptions about Asia are degree of inefficiency and Total Returns (USD). Data as at 30 November 2005. Source: FTSE Group. being remodeled.“Many of illiquidity in the market,” says Charles Beazley, head of global and its existing 6% to 7% share of the these funds have been active in the institutional and alternative hedge fund market proves there is region for some time, but they realise investment at Gartmore. He explains enormous room for growth. Analyst that to take full advantage, they need that with the right information, a fund firm Financial Insights, for instance, to be on the ground and fully manager can more easily exploit these predicts that the Asian hedge-fund engaged,” comments Twomey of inefficiencies to derive a positive market size will expand by as much as Merrill Lynch.

In 2004, nearly 50 international excess return, the much sought after 38% to reach $90bn by the end of this ‘alpha’. “Asia offers far richer year and will surpass $130bn in assets hedge funds set up offices in Asia opportunities for alternative under management over the next three including large players such as Pequot investments today. The US and years through a combination of asset Capital Management and Millennium Partners. Citadel Investment Group, European markets have in flows and performance.

Sensing the tremendous one of the largest US hedge funds comparison become more efficient and for funds investing in those opportunities residing in Asia, several with an office already in Tokyo, is countries, there is hardly any chance international players have now started reportedly planning to hire around of achieving abnormal returns,” adds setting up offices in the region. Only 100 investment professionals for its Alexander Mearns, chief executive around a quarter of Asian hedge funds new Hong Kong operation.

Such aggressive officer (CEO) of strategies are a EurekaHedge.

Worldwide and Asia Pacific Hedge-Fund Investments, 1990-2005 double-edged sword Despite the high 1400 for the fledgling rate of growth in the hedge fund industry past two years, Asia 1200 in Asia. On the one still accounts for a 1000 hand they provide a very thin slice of the t r e m e n d o u s $1trn global hedge 800 opportunity for fund industry. But 600 growth for the region; this is expected to 400 on the other it change over coming exposes the dearth of years.

Industry 200 talent available. Many experts explain that 0 hedge funds setting the obvious huge up operations in Asia discrepancy between are therefore staffing Asia’s 15% market Worldwide Asia Pacific themselves with US share of global and European market capitalisation Note: Values represent assets under management (AUM). Source: Financial Insights, 2005.

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

expatriates. “The capital markets industry in this region is still developing and there is a limited pool of qualified resources available. The explosive growth of the industry is creating a situation where it is extremely difficult to find suitable people but that should change over time,”states Twomey.

“From a commercial and economic standpoint it might not prove viable to sustain operations by sourcing experienced staff from the US and Europe,” adds Beazley of Gartmore.

He disagrees with the popular opinion that being ‘on the ground’ is essential to understanding the market’s fundamentals and ensure high returns. Out of Gartmore’s seven funds that focus on Asia, only three are managed out of its Tokyo office while the remaining four are managed out of London. “It really does not matter where the fund manager is as long as they get the right information and know the right sources on the ground. It is the general perception that being on the ground helps funds extract alpha, but this is not proven,” he says.

According to Beazley, with institutional investors accounting for a majority of investment flows in Asia, one of the main challenges faced by funds today is ensuring adequate levels of compliance and risk management controls. “There is a shortage of institutional quality fund managers in Asia. Most of them are boutique operators that might not be able to afford the high levels of transparency, compliance and operational risk standards demanded by institutional investors.”

The Asian hedge fund industry is still at a relatively nascent growth stage and it is not surprising that there are only around 100 funds that have more than $200m under management as compared to the US market where

Harvey Twomey, director and head of prime brokerage and equity finance sales in the Pacific Rim Region at Merrill Lynch. “…post-SARS, interest returned in the market, which was complemented by massive inflows relative to the size of the sector at that time. This trend is now continuing with the recent resurgence of the Japanese economy and market,” states Twomey. Photo: Merrill Lynch, November 2005.

around 200 funds have in excess of $1bn under management. But a young industry with participants that are not very big does not automatically translate to lesser controls, counters Christophe Lee, chief executive officer for SHK Fund Management and chairperson of the Hong Kong chapter of the Alternative Investment Management Association (AIMA), a global hedge funds organisation. On the contrary, he says that the Asian hedge fund industry has gained the benefit of learning from others

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

mistakes and is implementing best practices. For instance, in the US, some funds manage their fund administration in-house. In Hong Kong on the other hand, 99% of hedge funds have an independent fund administrator and auditor.

The Asian hedge fund industry is often criticised as being rather unsophisticated.

Unlike their counterparts in US and Europe who engineer highly varied and sophisticated trades, the most common trading strategy adopted by

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Regional Review ASIA: HEDGE FUNDS

Strategies in Asia/Pacific Hedge Funds, 2004 Event driven (4%) CTA (6%) Macro investing (6%) Relative value (10%) Long/short equities (59%) Multiple strategy (15%)

Total = US$65bn Note: Values are based on the percent of AUM. Source: Financial Insights 2005.

funds in Asia is the straightforward equity long/short that allows managers to short-sell shares they deem to be overvalued. Li-May Chew, analyst at the Capital Markets Advisory Service at Financial Insights explains that the relative simplicity is a function of Asia’s developing equity markets being much more volatile and the region’s debt markets being lessdeveloped. In contrast, she says that large US and European funds tend to struggle to find enough market inefficiencies to sustain the initial performance of long/short strategies, which explains why only 35% of global hedge fund’s AUM are invested in these strategies.

Twomey of Merrill Lynch notes that although long/short strategies may dominate at present, there are indications that funds have started diversifying in the developed Asian markets such as Japan, Hong Kong, Singapore and Australia. Multiple strategy funds are coming in the picture and funds are even adopting event driven strategies, such as distressed debt.

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The main challenge, he states, is in emerging markets such as India, China, Korea and Taiwan, where there is need for regulators to further liberalise existing short-selling rules.

Regulators in these particular markets have been rather wary of hedge funds since the Asian financial crisis of 1997-98, when Dr Mahathir Mohammed, then prime minister of Malaysia famously called hedge fund managers the “highwaymen of the global economy”and blamed them for causing the crisis. “Those concerns might have been justified at the time, but over the years there has been a change in the acceptance of hedge funds. But just like [sic] regulators in Singapore and Hong Kong, some jurisdictions need to relax regulations much more to drive growth of the hedge fund industry which ultimately benefits the overall economies of these countries,”argues Twomey.

However, some industry experts believe that it is wise for regulators to err on the side of caution. In recent years hedge funds in Asia might not have encountered as much negative

publicity as US hedge funds – although there have been the odd incidences of failure. One of the most recent and high-profile incidents was the sudden closure earlier this year of one of Singapore’s largest funds, which led to regulatory authorities in the region revisiting their rules and policies. Aman Capital’s global fund reportedly incurred heavy derivatives trading losses amounting to one fifth of its total asset value despite (allegedly) having state-of-the-art risk management controls. Singapore is regarded as having the most relaxed rules for hedge funds in the region and Aman Capital Management, manager of the failed fund, is one of more than 200 Singapore-based investment firms exempt from regulatory control, as long as it caters to fewer than 30“accredited”investors.

The hedge fund manager operated a $240m hedge fund, which invested in currencies, bonds and equities. After the debacle the Monetary Authority of Singapore (MAS), the city-state’s central bank, said in a statement: “Under amendments to the Securities and Futures Act, which take effect on July 1, MAS will be able to revoke the exempt status of an institution if we do not consider the entity or its staff fit and proper.”

While regulators try to find the right balance for monitoring hedge funds, the buck finally stops with the investor. And industry experts urge investors to tread cautiously. “With regulators in Asia opening the door to more hedge products and the sector facing less regulatory oversight than mutual funds, fund consumers should remain vigilant”, says Li-May Chew adding, “In an industry characterised by sporadic failures, picking the right hedge fund is a risky business, and investors take on the gamble of selecting a very poorly performing, or worse, failing fund.”

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

ASIA: HONG KONG REITS

Real-estate investment trusts (REITs) are fast gaining popularity throughout Asia because of their reputed high dividend payouts.

Japan, Korea and Singapore have launched REITs in the past few years and in late November the Hong Kong local Housing Authority (HA) Supervisory Group on Divestment (SGD) launched the initial public offering (IPO) of the Link REIT, raising $2.6bn in the world’s largest REIT to date.

Irrespective of obvious pent up demand on the island for REITs market watchers also think that the Hong Kong REITs market will become a preferred method of investing in mainland Chinese property.

“…the structure of the Hong Kong property market means that much of its commercial and residential property assets are concentrated in the hands of very few companies that regard them as a prime asset and are unlikely to want to hive off any shareholdings through REIT structures.”

Photo: Istockphotos.com, November 2005.

Strong debut for Link REIT ONG KONG’S FIRST real estate investment trust (REIT) had a strong market debut in late November. The REIT also enjoyed buoyant first day’s trading on the Hong Kong Stock Exchange, rising almost 15% to $1.50 following the HK$19.8bn (around $2.6bn) share sale. The trust will pay almost its income as dividends and investors expect it to offer higher yields than bonds in addition to its potential for stock-price gains. At launch, the official release stated that Link REIT shares will yield 6%, compared with Hong Kong’s benchmark 10-year government bonds, which currently yield 4.38%. The trust’s Hong Kong property portfolio comprises some 151 shopping centres and 79,000 parking spaces. HSBC Holdings, Goldman Sachs Group and UBS

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arranged the sale, while JPMorgan Chase acted as the financial adviser to the Housing Authority. Investors will receive a fixed return, financed by rental income.

The successful debut of the Link REIT may be a catalyst for REITs in the wider Asian region to rebound from a second-half slump. Although still popular as investment vehicles REITs shares have languished in Asia somewhat in the latter part of 2005 as rising interest rates have tempered their appeal. Even so, 14 out of 25 Asian trusts with a market value of more than $1bn, rose in value in the last week of November, after the Link REITs debut.

There is no doubting, however, the appeal of REITs in the local market.

When the Link REIT idea was originally floated in December last

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

year, it reportedly achieved commitments of some $36bn in retail money alone and as the Link REIT debut showed (the IPO was oversubscribed 18 times) there is still a huge amount of pent up demand in Hong Kong and not just as a local property play.

In particular, recent changes to Hong Kong’s Code on Real Estate Investment Trusts (the REIT Code) have made it even more attractive for REITs to be authorised and listed for retail distribution. Hong Kong REITs can now invest in property outside the territory which, say market watchers, in turn will inevitably lead to a boom in REITs investing in the People’s Republic of China (PRC). Alex Lynch is business development manager at Simmons & Simmons, the specialist corporate law firm that advised the

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Regional Review ASIA: HONG KONG: REITS

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trustee of the Link REIT. He thinks that recent legislation, which allows REITs established in Hong Kong to buy property overseas, will mean that investor appetite for the securities will remain strong over the longer term.

This is particularly true, he says, if, in the short term, they are seen as a viable vehicle to gain access to the PRC commercial property market. “It is a natural evolution for REITs established in Hong Kong,” explains Lynch. The structure of the Hong Kong property market means that much of its commercial and residential property assets are concentrated in the hands of very few companies that regard them as a Financial Secretary Henry Tang, left, and Secretary for Housing Planning and Lands Michael prime asset and are unlikely to want Suen, right, pose for photographers as they celebrate the listing of Link real estate investment to hive off any shareholdings through trust, the territory’s first and the world’s largest REIT sale at the Hong Kong Stock Exchange REIT structures. The obvious next Friday, Nov. 25, 2005. The Link REIT made a strong debut on the stock, with its shares gaining move is on to the mainland,”he adds. as much as 11% on its first day of trading.

There are a number of advantages to Photo: Associated Press/EMPICS, Photographer: Vincent Yu. the Hong Kong REIT structure that make it appealing to investors, Kong market also illustrates how far the Australian LPT market. In Europe, explains Lynch. One of the attractions REITs have entered into the Germany and Britain are expected to of Hong Kong REITs is that “it is a investment mainstream. Today, the launch their first REITs in 2006.

The Link REIT was in fact mooted listed security. Another is that the REITs market, which is still dominated dividend yield, particularly for retail by the United States, is reckoned to be last year, but it was pulled from the investors is relatively high, compared worth $650bn. The combined market market in December 2004 as a legal to local interest rates. Many investors capitalisation of REITs in Japan and challenge was mounted against the therefore will see it as a pure yield Singapore, for instance, is already lawful sale of commercial property play,” continues Lynch. Up to half a close to $40bn – nearly half the size of linked to residential lets in Hong Kong. Interest in the stock dozen trusts, including exchange listing of the REIT potentially one or two REITs gaining popularity throughout Asia – was huge, with the original with mainland Chinese FTSE EPRA/NAREIT Global Real Estate Index Series 10% of units offered for property assets, are 2500 public sale oversubscribed likely to launch in Hong 2250 130 times. Just under $600m Kong over the next year, 2000 worth of interest was according to local press 1750 1500 garnered from cornerstone reports, and while Lynch 1250 investors, including AMP says that Simmons & 1000 Capital Investors and Simmons has been 750 Colonial First State. The approached by a 500 withdrawal was seen as a number of firms 250 major embarrassment for the interested in government. establishing REITs in FTSE EPRA/NAREIT Hong Kong Index FTSE EPRA/NAREIT Asia Index Investor interest in Hong Hong Kong, he would FTSE EPRA/NAREIT Global Index FTSE Hong Kong All Cap Index Kong REITs began to step up not be drawn on names. again as soon as the Hong The introduction of Total Returns (USD). Data as at 30 November 2005. Source: FTSE Group.

Kong Court of Final Appeal REITs into the Hong

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

unanimously ruled back in early September that the Hong Kong Housing Authority (HA) did indeed have the power to sell its retail and car-parking facilities to the Link REIT, a special vehicle established by the government to hold the assets.

Hong Kong’s highest court had dismissed an appeal against the government’s sale of publicly owned shopping centres and thousands of parking spaces that are a common feature of Hong Kong central property. The appeal was brought by 67-year-old welfare recipient Lo Siulan who wanted to have the $3bn selloff declared unlawful. The suit claimed the proposed sale undervalued the assets and would inevitably force up rents for public housing tenants. In the event the five judges on the appeal panel decided that the government

had the right to sell the assets and thereby ended the appeal. “The Housing Authority plainly has the power to sell the properties, being retail and car park facilities, to the Link Real Estate Investment Trust (REIT),” Chief Justice Andrew Li said in a court statement after the verdict was announced. Although Lo’s two previous attempts to prevent the sale had been thrown out by lower courts, she claimed a moral victory last December when her challenge forced the government to shelve its plans until their legality had been established in the courts.

REITs buy and operate or manage a real estate portfolio where profits are passed on to investors without attracting corporation tax, provided certain conditions are met. REITs pay dividends to their shareholders based

on rental streams and their share prices rise and fall along with the overall property market. Real estate trusts are often structured as a corporation or business trust. REITs are liquid and tend to be stable, as the correlation of the value of a REIT to other financial assets is low. Shares in the trusts trade on local stock markets.

They also share some performance characteristics with small cap stocks and fixed income investments, although often dividend yields are much higher. Popular property assets held in REITs include apartment buildings, shopping centres and offices. So why not just buy shares in a property company?

The key difference, REIT investors say, is in tax.

Because they are trusts, REITs do not pay corporate tax, leaving more profits to divvy up among shareholders.

HONG KONG REITS: WHAT THEY CAN AND CANNOT DO

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Hong Kong Retail REIT can be managed by either a domestic or overseas based management company, provided that it is regulated in an appropriate overseas regulatory regime, such as Australia, Germany, Ireland, Luxembourg or the United Kingdom.

While the management company may delegate its property management and investment functions (including those relating to overseas investments) to third parties, it must remain responsible for the acts and omissions of its delegate and for performing its responsibilities and duties as a management company under the Hong Kong REIT Code.

The Hong Kong Securities and Futures Commission (SFC) will generally only permit a Hong Kong REIT manager to manage one REIT at a time, unless it can demonstrate adequate experience and resources to manage more than one REIT and that appropriate mechanisms are in place to deal with conflicts of interest.

An application for a REIT management licence must be made in connection with a specific REIT authorisation application and the maximum borrowing limit for a HK retail REIT is 45% of gross asset value.

The SFC may, in some circumstances, also allow more than two layers of special purpose vehicles (SPVs) to

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

be used in limited circumstances – for example where an overseas jurisdiction requires an entity that is domiciled in that jurisdiction to own property jointly with an offshore entity. This is important, as the use of more than two levels of SPVs can facilitate more efficient tax structures. The SFC says however that the REIT must maintain majority control of all SPVs. In mid June 2005 the prohibition on Hong Kong REITs investing in overseas property portfolios was lifted, however all REITs wishing to invest abroad must be licensed by the SFC. The REIT management company is responsible for the conduct of due diligence investigations and implement appropriate governance policies relating to its investments overseas, such as accounting risks, foreign ownership and foreign exchange restrictions, and the local tax and regulatory framework. It must also guarantee that the REIT maintains ownership and control of more than 50% in each property at all times.

The SFC may require legal proof of this at any time. As well, the property valuer appointed by the REIT will be responsible for conducting the valuation of all properties owned by the REIT, including any overseas properties, in accordance with the REIT Code.

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Regional Review ASIA: CBC’s IPO DEBUT

THE ALLURE OF CBC’s IPO China Construction Bank’s (CBC’s) $8bn initial public offering (IPO) is the world's biggest this year and China's largest ever. The state-owned bank has 14,250 branches and commands a 13% share of total deposits in China. When asked what he thought about the French Revolution, former Chinese premier Zhou Enlai once said “It is too early to tell.” It is the same with CBC’s IPO, writes Ian Williams. He explains why.

HINA CONSTRUCTION BANK was the first Chinese bank to publicly list its stock overseas with its Hong Kong IPO in late October. With reported profits of $6bn and over 300,000 employees, its launch was bound to make a splash. Investors oversubscribed the Hong Kong IPO of the China Construction Bank paying $8bn for 39m shares which put a value of $70bn on the mainland giant. With orders of $80bn, the offer was expanded and eventually raised $9.2bn, Shortly after the debut Moody’s, following in Fitch’s footsteps upgraded the bank’s rating from E+ to D-, partly in expectation of more transparency in the bank’s financial reports. It was a significant move.

While the listing was in Hong Kong, much of the take-up came from local offices of American institutions On the surface, that element of foreign interest was staggering, even given the enthusiasm for anything Chinese in today’s marketplace. After all, why would investors want to buy a minority stake in a state-owned business whose managers had a proven track record of running it into the ground, making thousands of bad loans under strong political influence

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from government officials, and who have in times past regarded the banking system as a font of free money? Some reassurance for investors could perhaps be found in the candour of the Bank’s disclosure documents prior to the listing which stated that some of its senior managers had resigned for allegedly taking bribes and that since 2004 its staff had notched up over than 100 criminal offences that had reportedly netted them at least $60m. If such behaviour continues, can the shareholders do anything about it but sell – and if they did in such circumstances, how much for?

For many investors, however, the temptation of CBC shares is obvious – a holding in the bank is a stake in the seemingly unstoppable Chinese economy, and, for some of the institutions at least, a gesture of goodwill and faith that they hope that Beijing will reciprocate in later deals.

Issuing banks, such as Morgan Stanley reaped gratitude and large fees because of the deal – $80m at says at least one estimate. The Bank of America meanwhile did indeed see a big value-added to the 9% stake they had bought for $3bn a year ago.

However, like Temasek, the Singapore government-owned institution (that had also bought a large holding) there is more to the deal than quick profits.

Overseas banks that assisted in the process will certainly expect some degree of cooperation as China fulfils its WTO obligations and removes the current 25% ceiling on foreign ownership. The intensely political nature of the process is suggested by the involvement of luminaries such as ex-US treasury secretary Robert Rubin, ex-secretary of state Henry Kissinger in bidding for the underwriting franchise. From the side of the bank itself and of the Chinese government, the oversubscription was a vote of confidence in the loan restructuring and the revamping of the banking system which many observers had seen as a huge potential pitfall for the future of the new Chinese economy. So far Beijing has taken over some $100bn of bad loans from all the major governmentowned banks, in advance of their anticipated listings as they follow in the massive footsteps of the CBC. CBC itself accounted for US$22.5bn of the 2003 bad debt bailout.

The Hong Kong Stock Exchange was also very happy to host the second biggest IPO of the century and the largest in four years. The US Securities and Exchange Commission’s (SEC’s) promise to lighten the burden of Sarbanes-Oxley reporting requirements for foreign companies may reflect some anxiety from the New York Stock Exchange (NYSE) and the NASDAQ at the fact that this very big one got away.

On the other hand, the IPO’s initial value did not appreciate considerably during the first day’s trading, closing at the offer price. Sympathetic analysts said this was a result of the bank’s advisors pitching the issue at the top of the range, while others say it was

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caused by some investors expressing pumping out the water if you don’t fix the initial stake in the CBC was sold the leaks in the roof. It is premature for to Bank of America, and the similar reservations about the issue.

Prominent among these was David the state controlled banks to be listing, deals being offered to other Webb, the Hong Kong corporate but nevertheless investors seem to international investors in the Bank of governance activist, who was want them, and it’s a free market and China, the Agricultural Bank of China, and the Industrial and scratching his head at the people have bought them.”

“Someone who buys into one of Commercial Bank of China. involvement of American banks. “I The authorities have been fairly think investors often forget that banks the big Chinese banks is really While the minority are simply highly geared companies buying ten thousand local banks candid. and it only takes a small amount of with a lot of autonomy,”he said.“The stakeholders are officially supposed to deterioration to wipe out their equity,” managers have short, or no history of lend their expertise and influence in he commented on the “value” credit analysis and credit driven reforming the banks management, lending, but an extensive history of they are also lending their good name. established by the IPO. Webb has often campaigned against policy driven lending and political Like the underwriters, all have considerable interest in accentuating the neglect of the interests of minority influence, up to bribery.”

The government bail-out reduced the positive and telling other investors stakeholders in Asian companies, a caution which is compounded when the CBC’s non-performing loan ratio and institutions about how deep the to just less than 4% – which is better reforms in Chinese banking have the majority is held by the state.

“I really do not know what they see than the ratios enjoyed by some of the become. Indeed, their good word and in it,” he commented of the American Chinese major banks yet to be floated, involvement will tempt many other banks involved, “In a few years time, but Webb thinks that a worst case investors, who may not have the same according to the WTO agreements outcome should, in all fairness, be opportunities for cheap prior private signed by China, the banks will be considered. It may be, he argues that, placements and underwriting fees.

Eyes are now closely watching CBC, able to open operations directly in the “in five to ten years time, they will country.” In his view, companies such have to have a big clear out of new particularly in the run up to further as Citibank would be better off bad debt, and the alternatives will be bank IPOs. If the Chinese government working to set up wholly-owned that foreign banks step in (which the and regulators have really cleaned up operations in the country, rather than government is unlikely to tolerate) or their act, then it would be wise to let trying to turn round fifty years of that the government comes and overseas investors digest the results of dilutes the public shareholders’stake.” the CBC before encouraging them to mismanaged banks.

But concern flows not only in one take the plunge with the other big On the other hand buying a strategic stake may be a canny move. direction. There have been critics in state-owned banks. Not only do they In fact, when the deal with Bank of China itself of the low price at which need further work on their loan portfolios, many investors America was signed, the who are more agnostic CBC’s chairman had Capturing the international interest in China about the prospects for announced that Bank of FTSE/Xinhua China 25 Index vs. FTSE Developed Index minority overseas America had pledged not 225 stakeholders in China will to open any more 200 want to see just how branches in China and 175 transparent CBC’s would close its retail 150 operations are. Within the operations there: an 125 next twelve months at least interesting pointer to the two other IPOs are expected. future perhaps. Even so, 100 Despite the sceptics, the as Webb points out,“They 75 oversubscription for the [Chinese banks] have got 50 CBC IPO suggests there will rid of the bad loans, but indeed be a market for their not the bad lenders,” by FTSE/Xinhua China 25 Index FTSE Developed Index stocks, but they may not get which he means the the early bird bonus of high managers who made all valuation that CBC did. those loans. “It’s no use Source: FTSE Group. US Dollar price returns

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Regional Review EUROPE: FRENCH SYNDICATED LOANS

French Syndicated Loan Volume Maintains a Strong Outlook 2005 is proving to be a record year in the French loan market. Yet given the dominance of refinancings, could market activity be peaking? Olivier Gaudez, head of loan syndications at Natexis Banques Populaires takes a look at the figures.

points (bps) over Euribor. Indeed, margin levels in France, as in other markets, have reached their lowest point since 1997.

Yet this leads to the first notable distinction between the French YNDICATED LENDING IN investment grade French borrowers market and the wider world, which is France reached unprecedented declined to less than 1% (on a one- not the trend itself but its depth. As levels in 2005. In the run up to year moving average) in 2004. And Graph 3 shows, French market pricing September 151 syndicated while they have since notched up to remains consistently lower than the transactions generated total lending above 1%, the market is a long way average for Western Europe. Both A volume of around €156bn (see Graph short of the default rates recorded and BBB rated French borrowers are 1), surpassing the 181 deals that raised just a few years ago – such as the winning margins some 14-15% lower €151bn in 2004 and dwarfed the 22% recorded in Q1 2003 and than their non-French counterparts in €75bn volume raised in 2003 (against through much of 2002. This dramatic Western Europe. And in 2003 this improvement in default rates – differential stretched to nearly 30% for 112 deals).

With such stellar figures, it is little combined with low borrower BBB rated French borrowers – hardly a wonder the French loan market has appetite and high lender liquidity – compelling market enticement for been attracting a lot of attention led to the familiar story in the US foreign lenders!

Few analysts will dispute the globally – with many non-French and European loan markets of lenders scrutinising the market as a declining pricing. This year, even reason for this. French banks are way to absorb the bank liquidity non-investment grade BBB3 French some of the largest and most liquid that is a feature of banking in nearly borrowers have been winning one- in the world. They are big lenders on all OECD countries. Yet a deeper year pricing of around 20 basis the world stage and expect to dominate at home, even if look at the French that costs them a little in market reveals a The FTSE Euro Corporate Bond Indices terms of basis points on the different picture and 150 margin.

Graph 4 one not as enticing for 140 compounds the trend that non-French lenders as differentiates loan the figures suggest.

130 maturities between France In many respects, the 120 and Western Europe. As French market reflects 110 competition from foreign trends that are 100 lenders intensifies, French prevalent throughout lenders have not only Europe – not least 90 dropped their margins falling default rates compared to neighbouring leading to a decline in FTSE Euro Corporates AAA Index FTSE Euro Corporates AA Index markets, but have extended pricing. As Graph 2 FTSE Euro Corporates A Index FTSE Euro Corporates BBB Index tenors further than demonstrates, FTSE Eurozone Government Bond All Maturities Index comparable markets in percentage bond Western Europe. Seven-year defaults for nonTotal Returns (Euro). Data as at 30 November 2005. Source: FTSE Group.

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JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

these types of money, for instance, has relationships are not in 2005 made up a 10% Graph 1: What the loans are used for apparent in other markets higher share of the French could suggest that nonloan market by volume Gen Corp Refi & Debt repayment Acq & Spin-off LBO/MBO Others Nb. Deals 180 200 French lenders have yet to than the Western 180 160 fully recover their European average, while 160 relationship focus after two-year money makes up 140 140 having adopted the US a 6% lower market share 120 120 style transaction-led in France than elsewhere.

100 100 business model that Additionally, both the 80 80 dominated the late 1990s. pricing and tenor graphs 60 60 With defaults down, show such favourable 40 40 pricing down and longer lending by French banks 20 20 tenors the norm, few to French borrowers to 0 0 French borrowers were be a consistent feature of 1998 1999 2000 2001 2002 2003 2004 Sept 2005 likely to miss this clear the market, at least in signal to refinance their this lending cycle. French Source: Natexis Banques Populaire existing loans on more banks have been determined to keep the exercised after year one which in favourable terms. Graph 1 starkly differentiation and thereby retain effect allows borrowers to lock in demonstrates this sea change. As a their French corporate client seven-year money at five-year result some ?95bn of lending was relationships. By and large they have pricing. French banks have been refinanced in 2004, followed by a succeeded. Of the 1,745 total loan- more than willing to allow this, to similar amount this year (?95.5bn in fact), equal to around 60% of the market participations in 2004, 761 strengthen their client relationships.

Of course, it is not a simple total loan market in both years.

(43.6%) were from French banks. No other Western European loan market formula to retain market share. There Indeed, remove refinancings from remains this dominated by its is also the natural inclination of the 2004 and 2005 totals and the domestic banks. This domination has French credit committees to enjoy an market has barely moved.

Even so, all is not what it seems. its price however. Between 2000 and extra margin of comfort in lending to 2003 the most favoured loan domestic companies they have What the graphs do not show (and structure was a combined five-year, known for many years. The fact that what individual banks are unlikely to report) is the extent of plus one-year extension drawings under the agreed revolving credit, which Graph 2: The risk profile of French Syndicated Loans loans. Intuition would helped banks with their 2002 to 2005 suggest, that a large capital adequacy (or 140 bp 25.0% A1 proportion of the loans Cooke) ratios. Yet in 2004 A2 22.5% A3 remain undrawn. The bulk and 2005 this has been 120 bp BBB1 20.0% of recent refinancings have replaced by more BBB2 BBB3 been revolving credit borrower-friendly five100 bp 17.5% % Bond Default WE Non Investment Grade facilities, with commitment year revolving credits, (1 yr moving average source Moody’s)(RHS) 15.0% fees for the undrawn plus two further one-year 80 bp portions usually calculated extensions, as well as 12.5% as an agreed percentage of seven year bullets.

60 bp 10.0% the drawn margin. French Iindeed seven-year loans 7.5% market commitment fees now make up 33% of the 40 bp have recorded a marked market, compared to 5% 5.0% decline since they peaked at in 2004. The ‘five-year 20 bp 2.5% 50% of the margin in the plus’ structures usually summer of 2002. By June include clauses that allow 0.0% 0 bp Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 2005 the average extensions to be 18 8

3,5 5,4

7,4

9,3

151

1 9, 3

3 0, 4

13 0

Mid Euros

12 4

13 0

1 30

Nb. Deals

11 2

4, 3 3, 3

2,1 9,0

3,5 3,1

6 6

58,3

3, 4 6, 0

2 4, 3

38,2

1,5 4,8 5,0

9 5, 0

9 5, 5

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2,9

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19,9

17,6

2 ,, 3 0 3

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2 0, 6

16,1

21,2

2 8, 3

1 4, 2

Source: Natexis Banques Populaire

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

35

Regional Review EUROPE: FRENCH SYNDICATED LOANS

EDF, state-railways commitment fee was just Graph 3: French Margin Pricing Differential versus Western operator SNCF, flag-carrier 32.5% of the margin—a Europe (excluding France) expressed % of margin Air France, and France slight improvement from 20% Telecom are all mooted for the 31% it had averaged A BBB 10% sale, although union for much of the previous protests have created an year. This makes the 0% increase in media commitment fee for a speculation regarding a 20bps margin loan (for a -10% reduction, delay or even BBB3 borrower) just 6bps– -20% shelving of plans in many a very cheap price to pay cases. Indeed, protests have for what is effectively an -30% already complicated the option to borrow funds at -40% plans for the sale of SNCM, 20bps!

Given such a highly indebted Corsican economics, most French -50% ferry operator, that has in company treasurers are 2001 2002 2003 2004 2005 2006 turn generating a general likely to take notice.

Source: Natexis Banques Populaire air of pessimism among So where does all this place the market for 2006? Will businesses with a strong need for commentators regarding the planned borrowings remain at these working capital, the percentage of loan privatization of some of the unprecedented levels – in terms of volume that states working capital as government’s larger assets.

And while M&A activity should both market activity and the terms the loan purpose has remained steady being won by borrowers? The answer, and unexciting since the loan market increase, whether it will reach the of course, will depend on the supply recovery in 1999 (ranging from levels prior to 2001 is questionable.

From 1998-2001 the most common and demand of the French loan €16.1bn to €28.3bn each year).

For 2006, most observers are purpose for French borrowers to tap market. From the supply side there are already signs that the French market expecting demand to be driven by the loan market was for acquisitions may peak in 2006. For instance, the M&A activity and privatisation. Yet – the peak being the €59.3bn number of banks declining invitations whether this will materialise to the borrowed in 2000, equal to 63% of into syndicates increased as the year extent required to meet market the total. Yet by 2004 that was down progressed. Earlier in the year, the expectations for the French loan to €18.3bn, a mere 12% of the total. decline rate was around 10% to 20% market remains to be seen. Certainly, there is a renewed buzz of of banks invited into syndications, yet Government stakes in power utility activity in the French mergers and acquisitions market, which decline rates in Q4 2005 has led to an attendant may reach 40%, on Graph 4: France Evolution vs Western Europe, Syndicated rise in lending to $30.4bn average, and up to 60% Loan, Maturity (19% of the total) between for the deals with the 1 year 2 year 3 year 4 year 5 year 6 year 7 year 30% January and October 2005. most stretched terms.

Indeed, there is a healthy And in terms of 20% pipeline of potential demand, the expectation transactions that should is that the cycle of 10% push the figure for refinancings is passing. acquisition based lending The market has almost 0% even higher in 2006. entirely refinanced itself in However, to maintain the past two years – except -10% overall borrowing rates at for some mid-cap deals – 2004 or 2005 levels, this leaving little room for any -20% pipeline is likely to have to further improvement in generate a three-fold terms. And while the -30% increase in current merger French corporate market 1998 1999 2000 2001 2002 2003 2004 Sept 2005 and acquisition activity – a retains a healthy number tall order. of manufacturing Source: Natexis Banques Populaire 3%

0%

20%

10%

4%

5%

6%

6%

9%

6%

6%

13%

6%

4%

4%

10%

11%

5%

0% -2 %

-2 %

-5 %

-9 %

-9 %

-9 %

-1 2 %

-6 %

-3 %

-2 0 %

0%

-2 %

0%

36

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

COVER STORY: BT GROUP

ACTING LOCAL THINKING GLOBAL While the rest of Europe’s telecommunications giants are swept up in mergers and acquisitions fever frenzy, the United Kingdom’s British Telecom is taking a more leisurely stock of the market. BT it seems is focused on delivering value through business transformation rather than aggressive acquisition of market share. Is it prescient or foolhardy? What does BT chief executive officer (CEO) Ben Verwaayen know that the rest of the market doesn’t?

N SOME RESPECTS, these are heady days for BT. At the World Communication Awards (WCA) in London in early October 2005 BT won the award as 'Best Global Carrier' and its chief executive officer (CEO), Ben Verwaayen was recognised as the 'Most Influential Person in Communications'. The telecommunications giant enjoyed a strong showing at the awards, as it also walked off with the crown for Best Brand and emerged as a strong finalist in the customer care and best managed sections. David Molony, editor in chief at Total Telecom, one of the sponsors of the awards, acknowledged that BT’s “efforts in reorganising its business and promoting networked IT services have all come together in major contract wins, profits and significant acquisitions. The WCA judges set great store by customer testimonials, and BT's were exceptional.”

It has worked hard to do so, following a downturn three years earlier in which the company reported losses of £550m. Andy Green, chief executive of BT’s Global Services division acknowledged in to a presentation to telecommunications analysts in the early summer of 2005 that the company has come off its “the best year ever.” At that same presentation CEO Verwaayen outlined BT’s approach that underpinned both the turnaround and the

I

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

37

COVER STORY: BT GROUP 38

firm’s growing success: “you have to produce added value BT’s managed voice and data services, the majority of on a local basis to be effective on a global basis,” he whom are not BT customers. [BT officials say they have only 25% customer overlap.] Two, to expand its portfolio of repeated to the audience at least three times.

In early November, BT Group reported second-quarter services—Infonet's flagship managed network services 2005 pre-tax profits before specific items and leaver costs of aren't offered by BT, which has focused on outsourcing and £596m compared with £557m a year earlier. “The systems integration deals in recent years. Three, BT was transformation of BT is right on track with the delivery of keen to expand its global reach. Infonet has network another successful quarter,”announced Verwaayen, adding access in 10 countries where BT does not, including that “Revenue has again grown by 5%, with new wave locations in central Europe, Latin America and Asia, with revenues up 39%. Earnings per share has now grown for local operations in 70 countries and network access in an fourteen consecutive quarters and we are encouraged by additional 180 countries.

But BT wasn’t just spending on acquisitions. Just prior to the trend in underlying EBITDA.Our order book remains strong with networked IT services contract wins again the mid-summer presentation to analysts, BT had launched being over £8bn for the last twelve months. Continuing, he a £26m global marketing campaign to position BT firmly in adds: “Our traditional business continues to operate in the same commercial space as companies such as IBM, what remains a challenging environment. Our new wave Accenture and HP by further increasing awareness of its businesses show strong growth both in the UK and international ICT capabilities amongst senior business and internationally. We expect to continue to see the benefits government executives. It was the biggest business-tofrom our investment in new wave activities and cost business marketing campaign in its history. The move transformation plans.” In the latest figures issued by BT at showed BT’s growing confidence following significant IT the beginning of November, covering the first half of the and networking services contract wins for BT with 2006 financial year the company reported that revenue organisations such as the NHS, Unilever, Abbey and the from major corporates, both domestic and international, UK’s National Air Traffic Control Services.

But it wasn’t just about marketing spend. It has also been grew by 15% compared to the second quarter of last year, with continued upswing in new wave revenue (up 34% on a year of continuing change, as the company continues to the same period in financial 2005) and most of that was a migrate its customers to new wave services and result of the impact of the acquisition of Albacom and competition continues to bite. The group’s 2005 financial Infonet. New wave revenue now represents 55% of all results (for the year ending March 2005) reflect growth in those new wave services, including network IT services, major corporate revenue.

In the early part of 2005, securing new market share broadband and mobility, which combined grew by 32% to appeared a priority, exemplified by the Infonet acquisition, £4.5bn; although turnover from traditional businesses, was which received final approval in mid year. BT announced it down 7% to £14bn. As well, BT Group’s turnover of would buy Infonet of El Segundo, California, for $965m. £18.6bn was up only a modest 2% on 2004, excluding the Since Infonet had $390m in cash, BT will pay only $575m impact of acquisitions and regulatory reductions to mobile for the company —which is less than Infonet's annual termination rates, according to its annual report. Operating revenue of $620m. Why so cheap? Due to heavy profit meanwhile (before goodwill amortisation and competition and aggressive pricing in IP services, Infonet exceptional items) was down by 1% to £2.9bn, reflecting had been losing money in recent years even though it has the cost of supporting networked IT services contracts and grown its revenue by double-digit amounts. The BT/Infonet investment in new wave activities.

BT is taking an important gamble. In a converging combination will affect the purchasing decisions of network managers at multinational corporations based in environment, the company is focusing on investment in the US, Europe and Asia, said Green at the analysts technology over the purchase of market share – a strategy that meeting. At first glance, the Infonet acquisition seems like is not necessarily shared by some of Europe’s successful telecommunications companies (Spain’s Telefónica among a smart move for BT as it is straight consolidation play.

As well, the Infonet purchase attempts to build a strong them). Virtual markets, electronic commerce, broadband and global IP services capability. BT had already had a failed mobility are now the watchwords which are changing joint venture with AT&T called Concert that split up in radically the way companies and people do business. BT’s strategy is to exploit its 2001. When the split took technology to underpin its place BT took the European business relationships, assets and AT&T took the In the early part of 2005, securing generate revenues and Asian assets. The Infonet new market share appeared a priority, minimise costs. For BT, the purchase means that BT can exemplified by the Infonet willingness to embrace new rebuild its Asian acquisition, which received final relationships, both technical infrastructure. BT says it and commercial, will be key to bought Infonet for three approval in mid year. maintaining its reasons. One, to acquire its competitiveness.

As 1800 corporate customers for

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

Verwaayen says, “Convergence is not just about technology, it is about bringing sector specific skill sets in a special way to markets.”

BT was created in 1981 when the telecommunications network arm of the United Kingdom’s General Post Office (GPO, now part of the Royal Mail Group) was spun-off as a separate entity. The company was transformed from a state-owned enterprise into a public limited company in 1984, under the aegis of the Telecommunications Act which was passed that same year and shares in the business were sold in a series of public offerings between 1984 and 1993. All of BTs shares are now publicly-traded.

Competition for BT was initially established in the form of a second operator—the short-lived Mercury Communications, controlled by the then Cable & Wireless plc back in 1981, but it was not until early 1991 that the UK’s telecommunications market was fully liberalised. A corporate reorganisation was implemented in 2000, resulting in the creation of separate service provider units which could be spun-off or partially-privatised in order to generate cash that would reduce the company’s debt burden. BTs principal activities include local, national, and international telecommunications services, broadband and Internet products and services, and IT solutions. In the UK, BT serves over 20m business and residential customers with more than 29m exchange lines, as well as providing network services to other licensed operators. The Group has three principal lines of business: BT Retail, serving 20m residential customers and businesses in the UK; BT Wholesale, which provides network services and solutions to over 600 fixed and mobile operators and service providers (including broadband and private circuits) and finally, BT Global Services, which offers international carrier services and networked IT services to of multi-site organisations in over 130 countries. Its global networked IT services business is however growing strongly and BT’s global capabilities have been strengthened by strategic acquisitions, including Albacom, Infonet and Radianz.

Although half year figures were comfortable, if not entirely comforting, analysts have generally taken a tough stance over BT. Mid year the Group was downgraded to hold from buy at Deutsche Bank, with the broker saying that valuation is “full.”

Nomura Securities also cut the British telecommunications company to sell from neutral, arguing

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

Photo of Ben Verwaayen, chief executive officer (CEO), BT Group.

Photograph courtesy of BT Group, November 2005

that recent share price performance leaves it trading at a premium to the sector “that looks increasingly unwarranted given better results elsewhere.”At the end of July BT Group was downgraded to under-perform by Goldman Sachs. The broker cited weak margin development in the fiscal first quarter and the likelihood that some of its out-performance versus its European peers over the last six months will unwind for downgrading the telecom stock. The jury remains ambivalent about BT’s strategy, citing whether the company has been aggressive enough in finding synergies in its acquisition profile and expressing surprise that so far it appears to have done little to secure a significant acquisition in the mobile sector. These days however analysts are much more positive about BT’s outlook.

On the other hand, the Group has had much to contend with. In November last year, the stakes were raised for the company. BT senior executives at BT eagerly scrutinised regulator Ofcom's long-awaited report that was meant to usher in a new era of telecoms regulation in the UK. Ofcom had launched its wide-ranging review of the UK telecommunications sector in April 2004, amid widespread concern that BT's dominant position was stifling competition. The regulator went so far as to look at whether BT Group should be broken up into separate retail and wholesale operations. After the report was released BT quickly agreed to offer rival operators equal access to its UK fixed line network, thereby killing two birds with one proverbial stone. The deal meant that the Group avoided being referred to the Competition Commission while it also simultaneously announced several cuts in wholesale prices for its rivals in exchange for lighter regulation. It was a signal indication of the future. BT had been Britain's dominant fixed-line telecoms provider, and the prices it charges competitors to access its network can determine the services they offer and the prices they charge. The move

39

COVER STORY: BT GROUP 40

subscribers. Ofcom could would also mean, longer force mobile operators in the term, a wider choice of phone UK to reduce the prices they providers for consumers, with charge overseas networks greater price competition. but it has no power to get Ofcom’s regulatory overseas operators to do the blueprint certainly represents same so that prices for fundamental changes to consumers in the UK can Britain's telecommunications come down. This issue is now service provision and being studied at the required BT to introduce European level but there has sweeping changes to its been slow progress so far and organisational structure and there is no easy solution on encourage it to open up its the cards. The situation monopoly network to rival becomes more complex as suppliers. BT was essentially merger and acquisitions forced to offer the same redraw the business wholesale services to its boundaries in Europe. But rivals as it sells to its own there are also technological consumer arm. Historically, advancements that will all of BT's retail services for shape tomorrow’s business and residential telecommunications: consumers have been subject Andy Green, chief executive of BT’s Global Services division. convergence is one of them. to regulation, but these days Photograph courtesy of BT Group, November 2005 this regulation is applied to a relatively narrow set of BT's services. Other services such as BT Fusion: delivery and expectations national and international virtual private networks and Convergence is set to drive fundamental change in both data services such as frame relay are free of retail fixed and mobile industries and is gaining significant regulation, as are all international calls for businesses. BT is market traction among operators and vendors worldwide. still restricted in its ability to offer discounts across the full The market is set to grow massively to a value of $74bn by range of services but further deregulation here will need 2009, according to specialist telecommunications more consultation. consultancy Visiongain. And here BT Group has tried to The report aimed to tackle three developments in the steal a march on the competition, aiming to generate £1bn market, which affected consumer and business use of a year by 2009 from converged services. At the end of June telecommunications services, as well as reviewing the role 2005 BT Group announced it intended to launch a of BT within UK telecommunications provision. The first pioneering internet phone service allowing users to switch was the fact reliance on mobile telephony is increasing, between mobile networks and fixed-lines using a single with mobile voice traffic accounting for almost 50% of total handset. Called BT Fusion, the service combines the telecommunications traffic in the top five European convenience of a mobile phone with the lower prices markets. Second, the number of mobile-only households is associated with fixed line telephony (customers will be able growing, although, for the present, it does not look to to call UK landlines at its off-peak rate of 5.5 pence a endanger traditional home phone use due to convenience minute and 3 pence a minute at peak hours). Fusion is a and cost; and finally and perhaps most significantly for BT, phone that flexes between working as the fixed line at fixed-only players need a mobile presence and despite home or in the office and a mobile phone through an broadband growth, fixed-only operators have inferior access point called a BT Hub, which the company hopes revenue growth and poorer margins to integrated players. will be convenient for customers and promote cost savings.

On the mobile side, there is virtually no regulation of “For the first time customers will be able to get the best of retail prices paid by consumers. The wholesale price paid by both worlds in one service, combining the convenience and other operators for calls to mobile phones has been strictly features of a mobile with fixed-line prices and quality,”said regulated for the past few years, and has driven these prices BT head of retail business, Ian Livingston, at the time. down. An area of concern remains the price of mobile calls The BT hub also works as a wireless router, providing made abroad, the so-called 'roaming' prices. Regulators users access to PCs, laptops and games consoles wirelessly have struggled for years to find a way of addressing high around the home. The mobile can be switched to a charges for roaming. broadband line using Bluetooth wireless technology. On A continuing structural problem is the need to bring the move the hybrid service will connect to Vodafone's down the wholesale prices operators charge each other but wireless network. BT hopes that the service will counter here regulators can only affect the prices being charged in both mobile networks and start-ups offering cheap the home country and this doesn't benefit the home internet telephony. BT has been focusing on broadband

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

5

05

v-

No

M

ay

-0

04

4

-0

v-

No

ay

3

03

M

v-

No

ay

-0

02

M

v-

2

-0

ay

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

No

01

M

-0

v-

No

ay

M

No

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00

1

technology recently in a bid to offset a decline in its consolidation in the European telecommunications sector traditional fixed-line services. Analysts have called BT and where the smaller, independent carriers are rapidly Fusion an important “watershed”that intertwines the so far falling prey to globe-straddling giants. As 2005’s cold separated fixed and mobile telephone systems. A mid year October turned to wintry November, the pace did not flag.

BNP Paribas telecommunications sector report noted that The same day Telefónica announced its O2 bid, Norway's its analysts did not expect much from Fusion and expected Telenor agreed to buy the Vodafone Group PLC's Swedish only £200m or so in revenue (and probably less) in 2006. wireless operations for $1.2bn. At the same time, two Investors were equally sanguine about the product. Shares private equity firms were circling Danish telecom TDC A/S and Ireland's eircom in BT Group were down reported at the beginning more than 1.5% at 219 Capturing the international interest in China of November that it was pence in late trading on the FTSE/Xinhua China 25 Index vs. FTSE Developed Index being pursued by an London Stock Exchange 225 unidentified buyer, which on the news and by year 200 turned out to be Swisscom end, it was too early to tell 175 and then didn’t as the whether Fusion would 150 Swiss authorities provide significant uplift 125 intervened and forced for BT. And by that time 100 Swisscom to withdraw its other factors were coming bid. But then Telefónica into play.

75 surprised everyone again 50 announcing it had Market consolidation withdrawn from the The stakes for BT were FTSE/Xinhua China 25 Index FTSE Developed Index bidding for a 35% stake in raised at the end of Tunisia's largest telecoms October when Spain’s Source: FTSE Group. US Dollar price returns carrier, Tunisie Telecom.

Telefónica announced its bid for London-based cell-phone provider O2 Plc. The The emerging markets, it seems, were looking to begin announcement took the market by surprise as until then losing appeal in the growing fight for market share in the Telefónica, which already has 145m wired and wireless all-important European theatre.

Telefónica’s bid was also interesting from another angle. subscribers worldwide and 68m mobile customers outside Europe, has previously favoured targets in emerging O2 had been spun out by the BT Group in 2001 in an markets, particularly Spanish-speaking ones, having spent $11bn de-merger – although it was under the hammer as at least $50bn on Latin American telecommunication soon as it went out on its own because of its size —it is companies over the last fifteen years. Signs that dwarfed by rivals such as Vodafone, Deutsche Telekom's TTelefónica’s strategy was about to change came early in Mobile, and France Telecom's Orange. Telefónica's move 2005 when it beat Swisscom to the punch in a last-minute for O2 also may have been defensive. Like other fixed-line operators, it sees a huge long-term threat from Internet bidding war for Czech operator Cesky Telecom.

The cash cow that is Telefónica is supported with telephony, which could savage prices for conventional $36.4bn in 2004 revenues, up 6.8% on its 2003 phone calls. By picking up O2, with its 25m customers in performance, and first-half 2005 revenues that are 20% Britain, Ireland, and Germany, Telefónica gets quick access ahead of last year which created almost $3.4bn in free cash to two top mobile markets. “O2's integration in the flow. These days Telefónica is outperforming many Telefónica group will enhance our growth profile,” said European peers, even BT. If the O2 deal becomes final, Chairman César Alierta Izuel in a statement,“[allowing] us with a reported $31.4bn price tag, it will rank as the to gain economies of scale and balance our exposure second-largest all-cash offer in telecom history, after across regions.”

The surprise, says Lionel Parisot, telecommunications Cingular Wireless LLC's purchase of AT&T Wireless. It also would be the largest British acquisition since 2000 and specialist at Société Générale Asset Management in Paris, the second-largest proposed takeover this year in Europe is that BT did not bid for O2. A problem for the giant after Gas Natural of Spain's $51.7bn bid for electricity telecommunications companies going forward, he thinks, giant Endesa, according to information services provider is that not all acquisitions appear to be reducing the Dealogic. Telefónica’s move is but one in a flurry of recent competition in the mobile market. “Where are the merger-and-acquisition activity in Europe, but serves to synergies in the Telefónica and O2 deal?” he asks, provide a microcosm of developments throughout the suggesting also that perhaps BT’s focus on technology will beat out its apparently more successful competitors over European continent and beyond.

Deal-making in the first nine months of this year topped the long term. The question now for many is BT’s next $763bn in Europe, and third-quarter 2005 deals outpaced move: perhaps a play for Virgin Mobile, or taking a gamble merger and acquisitions value in the US by a factor of two on the emergent economies in Eastern Europe. For the to one. It is also an indication of the moves towards market time being at least, Verwaayen is not saying.

41

TELECOMMUNICATIONS: BROADBAND

And Access for All Sun Microsystems Inc. chief executive Scott McNealy, left, and Google Inc. chief executive Eric Schmidt, right, smile during a news conference in Mountain View, California, Tuesday, Oct. 4, 2005. Google took a big step toward challenging Microsoft Corporation's dominance in computer word-processing and spreadsheets with the announcement Tuesday that it would distribute Java technology from Sun Microsystems. Photo: Associated Press/EMPICS, Photographer: Paul Sakuma. November 2005.

42

It was not all that long ago when users of the Internet considered themselves lucky to have a snappy 56 kilobytes per second dial-up connection at hand. Then along came the first flush of broadband Internet technology.

Initially, it arrived through digital-subscriber lines (DSL) and later by way of cable modem.

The ability to deliver information at speeds approaching 1.5 megabits per second (or about 40 times faster than the best dial-up rate) quickly revolutionised the communications world, making it possible to receive and send massive quantities of data ranging from stateof-the-art audio to high-resolution graphics within a few short minutes. As the need for speed continues to grow, tortoise-like dial-up connections are rapidly biting the dust. What follows? David Simons reports from Boston.

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

IGH SPEED DATA services continue to gain based Internet access.“The lag is arguably the result of the momentum,” says Kagan Research senior analyst Bush administration’s failure to make a priority of Ian Olgeirson, who expects broadband usage to developing these networks,”he says.“In fact, the US is the continue to marginalise dial-up access and ultimately reach only industrialised state without an explicit national policy 80% of the market within three years. “Although we for promoting broadband.”

A well-structured broadband system has numerous anticipate growth rates to tail off going forward, cable and DSL providers face considerable opportunity in the fight and far-reaching economic and cultural benefits, says Bleha, ranging from for market share,”he adds.

Internet-based phone and Indeed, broadband access video connectivity, to faster has become a lucrative In its most recent quarter, Google and easier teleconferencing, prospect, as well as a hotreported revenues of $1.578bn or telecommuting, remote button issue for politicians about a 96% increase over the third diagnosis and medical and interest groups alike. services, interactive And it’s not all about how quarter of 2004. Business has been distance learning, quickly you can download so good that in September the multimedia entertainment, U2 or nail down a winning company offered an additional 14mdigitally controlled home bid on eBay. In many regions plus shares at $295 apiece. By appliances, and more. across the globe, government November, those shares had already “There are myriad benefits leaders see a link between appreciated well over $100. Even at across the economy,” says the proliferation of Bleha who adds, “In broadband and economic, $400, many analysts say Google, corporate communications technological and cultural which trades at a forward earnings alone, data transfer, advancement. multiple of about 45, is still a collaborative working and Not surprisingly, countries reasonable buy. telecommuting amount to a with the most to gain from a big competitive advantage.” strong Internet presence While the majority of have taken a lead in countries that lead the US broadband deployment.

Amazingly, the United States (US) does not rank nearly in per-capita broadband usage are smaller and therefore as high as one might expect in terms of high-speed Internet able to establish networks faster and cheaper, lack of service. According to some analysts the US has actually competition among domestic Internet service providers ceded territory to countries with a more aggressive – and (ISPs) has helped keep broadband pricing above the affordable – broadband program. At 47m, the US has more global average. Despite some regionalised rate cuts, broadband subscribers than any other single country. overall Americans currently pay between $40 and $60 for a month for broadband However, on a per capita services – nearly three basis the US, which once Google “the single-greatest financial phenomenon”? times the lowest rate for ranked in the global top Google vs. Yahoo and FTSE US Internet All Cap Index broadband leader South five league table, currently 250 Korea. Rather than cut lies 16th behind countries fees, in many instances such as Japan, Norway, 200 providers have instead Switzerland and Canada, opted for a multi-tiered based on data compiled 150 speed menu, charging the from the Organisation for most for the highest rate Economic Co-operation 100 of throughput. and Development (OECD).

While cable remains the Topping the list is South 50 leading provider of Korea, where nearly one in broadband with an four citizens is a Google Yahoo FTSE US Internet All Cap Index estimated 60% of the broadband subscriber. market, DSL is expected “Today, most US homes Price Returns (USD). Data as at 30 November 2005. Source: FTSE Group/FactSet Ltd. to close the gap can access only ‘basic’ broadband, which is among the slowest, most expensive, considerably by the end of the decade – helped in no small and least reliable in the developed world,” claims Thomas part by a new ruling from the Federal Communications Bleha, former foreign-service officer in Japan and Abe Commission (FCC), an independent agency, directly Fellowship recipient, who takes aim at US Internet policy responsible to Congress, which regulates interstate and in a forthcoming book about global broadband access. international communications by radio, television, wire, Bleha cites a particularly significant gap in mobile-phone- satellite and cable.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

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TELECOMMUNICATIONS: BROADBAND 44

dramatic movement in the Beginning in 2006, phone productivity rate? I don’t companies will no longer be Although Google has said that it think so.” required to lease their highTheroux does not believe speed lines to smaller has no plans to expand its Wi-Fi that outright government competing ISPs at belowreach beyond the Bay Area, some intervention is the key to market, governmentbelieve that San Francisco could in creating competition among backed rates. FCC chairman fact be the start of a bold new providers. “History shows Kevin Martin believes the nationwide initiative for the that when you get the decision will give DSL government involved in the providers the incentive to technology giant. matters of the private sector, upgrade their networks and there tends to be a one-sizeremain competitive. fits-all kind of solution – Others, however, say the which in this case is FCC’s ruling reinforces the high-speed duopoly that currently exists within the US definitely not going to work. Again, that kind of approach (at present, most major markets have just one provider certainly won’t lead us down the road to improved each for DSL and cable). By comparison, in the United productivity by any stretch.”

To date, industry lobbyists have been successful in Kingdom increased competition and a new regulatory environment have helped cut high-speed access rates keeping politics out of broadband commerce. But there are nearly in half over the course of a year. “The major signs that the market may be changing, with or without impediment to US adoption is price, rather than a lack of government involvement, thanks in part to a seemingly availability,” observes Charles Golvin, a senior telecom unstoppable company from Silicon Valley that threatens to shake up high-speed access by delivering the goods analyst at Forrester Research.

Additionally, the FCC’s Martin has indicated an without wires – and without cost. unwillingness to beef up broadband-based competition through government intervention. “Cable and telephone Wi-Fi high flyer companies have led the way in bringing broadband to Its name: Google. Since going public at $85 a share in millions of Americans,” says Martin in a policy statement August 2004, the search-engine titan has become the this past fall. “The evidence today is that their Internet single-greatest financial phenomenon in recent memory, access consumers have the ability to reach any Internet racking up one astounding quarter after another on its content. Indeed, cable and telephone companies’practices way to a current market cap of nearly $130bn – on par already track well the Internet principles we endorse with IBM and nearly twice that of competitor Yahoo. In its today. I remain confident that the marketplace will most recent quarter, Google reported revenues of continue to ensure that these principles are maintained. I $1.578bn or about a 96% increase over the third quarter of also am confident, therefore, that regulation is not, nor 2004. Business has been so good that in September the will be, required.” company offered an additional 14m-plus shares at $295 apiece. By November, those shares had already appreciated well over $100. Even at $400, many analysts Productivity boost Many economists see high-speed access playing an say Google, which trades at a forward earnings multiple increasingly larger economic role in the years to come. A of about 45, is still a reasonable buy.

When it comes to capital expenditures Google has new study co-authored by economist Robert Crandall declared that a ramp-up in broadband usage could boost spared no expense. The company will likely close 2005 the economy by $500bn while creating 1.2m new jobs having topped the $700m mark, according to Standard & over a 10-year period. Meanwhile, Brookings economist Poor’s, the ratings agency. While most chief executive Charles Ferguson says that upwards of $1trn is at stake if officers (CEOs) were out on the links, in late August the current broadband development model in the US is Google’s CEO Eric Schmidt was busily announcing an assortment of new ventures, including an instant not improved.

However, James Theroux of the University of messaging and telephony service. Then came the big one.

Massachusetts’ School of Management is less convinced In September, Google announced that it would join the list that an increase in broadband availability and efficiency of companies bidding to provide the city of San Francisco would have a meaningful impact on domestic with universal wireless high-speed Internet services (Wiproductivity.“For one thing, the companies that stand to Fi) at the request of the city’s mayor Gavin Newsom. If benefit the most from having an efficient flow of online selected, Google’s Secure Access system would offer up to communications are already leading the pack from a 300 kilobits per second at no charge, with customers technology standpoint,” says Theroux. “And while it may paying incrementally for higher speeds. Google has already be important on some level to make high-speed access tested the Wi-Fi waters by partnering with Feeva, a San more readily available, is that going to result in a Francisco free hotspot start-up.

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

Although Google has said that it has no plans to expand its Wi-Fi reach beyond the Bay Area, some believe that San Francisco could in fact be the start of a bold new nationwide initiative for the technology giant. Observers point to Google’s recent purchase of highcapacity fiber-optic lines as proof that the company has bigger broadband business in mind. Investing in Wi-Fi access points nationwide would allow Google to develop a regional advertising strategy.

Moreover, Google’s latest move could have earth-shaking implications for the broadband service industry. According to In-Stat analyst Amy Cravens, if the free Wi-Fi trend takes off, consumers could expect to see the average price-perconnection fall sharply as providers scramble to stay competitive.

Internet observers like Simon Buckle believe that the Google model is the wave of the future. “We are moving towards a services-based approach – the basic offering is free but if you want more, whether it is bandwidth or features, you have to pay for it. This turns the current ISP model of charging for Internet access on its head. Sure, there will be a market for those who want higher bandwidth, but if the basic offering is good enough, why pay for more?”

Broadband backlash Wi-Fi fever has spread to other regions as well. In Philadelphia, city officials are pushing ahead with “Wireless AT&T chairman and CEO Edward Whitacre, Jr., talks to employees during a ceremony Philadelphia,” a $15m project that will where the new AT&T Corp. logo was unveiled at the headquarters in San Antonio, Monday, use EarthLink to deliver wireless access Nov. 21, 2005. The new AT&T logo follows the merger of AT&T and SBC Communications to a majority of the metropolitan region Inc. Photo: Associated Press/EMPICS. Photographer: Eric Gay, November 2005. at an estimated fee of $19 per month, or about half of the going rate from the major broadband providers. Full deployment is expected by pipes for free, but I’m not going to let them do that because we have spent this capital and we have to have a return on the fourth quarter of 2006.

Sensing a trend in the making, the major telecoms have it.” Whitacre is now chairman and CEO of AT&T and the attempted to fight back at the local level. Both SBC combined company will retain the AT&T name.

The question remains, can Google make it happen? For Communications and Verizon Communications have come out against Mayor Newsom’s San Francisco project. An a company that began operations out of a garage in SBC-sponsored bill that sought to prevent Texas California just seven years ago, morphing into a fullmunicipalities from offering telecommunications services fledged service provider might seem like an awesome was struck down, but in Pennsylvania, an effort by Verizon undertaking – but these days, nothing seems too awesome to regulate the development of publicly funded broadband for the gang from Mountain View. “Depending on how networks was supported by the governor. Recent comments Google adapts to these challenging areas and how

by SBC Communication’s CEO Ed Whitacre, prior to its committed it is to the space, it could become a home run or $16.9bn acquisition of AT&T in late November, suggesting could break the bank,” reasons Ovum analyst Roger that Google and others should have to pay to use SBC’s Entner. “But considering the billions of dollars Google network was telling.“What they would like to do is use my could throw at the situation, it could become reality.”

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

45

A NEW SHAPE Exchange traded funds (ETFs) were an instant success when they came to Europe in 2000. By September 2005, ETF assets under management exceeded $48bn in 142 funds backed by 19 sponsors. While Barclays Global Advisors (BGI) dominates the market in the United States, universal banks with captive distribution networks took an early lead in Europe. Now BGI is catching up and may be poised to take the lead again. Neil A. O'Hara reports from Boston.

O

under management account total just under $56bn. ETFs had proved their worth in the US, so why not in Europe?

European investors were indeed quick to adopt ETFs, though not the way the sponsors anticipated. “In Europe, you had the houses with retail distribution come out as the product sponsors, but the market in Europe was and I think still is largely institutional,” says Gus Fleites, chief investment officer and head of exchange traded funds at ProFund Advisors LLC, a money management firm that specialises in index-related products targeted at

European Listed ETF Growth 60

160 140

50

120 40

100 80

30

ETFs

N BOTH SIDES of the Atlantic, ETFs are growing into a substantial and diverse offering. The growing range of new ETFs is exemplified by the recent listing of a PowerShares ETF on the New York Stock Exchange, based on the FTSE RAFI 1000 Index, offering access to a basket of companies selected not by market capitalisation, but by fundamental factors, such as sales, cash flow, book price and dividends. ETFs, it seems, have come of age. So when European sponsors launched their first exchange traded funds they had a huge advantage over their American cousins. They knew they were backing a winner. The American Stock Exchange created the original ETF back in 1993 when it introduced SPDRs—depositary receipts designed to track the Standard & Poor's 500 index. The product struggled for the first few years, but according to figures issued by Bloomberg and State Street SSgA Advisor Consulting Services, by 2000 SPDR assets under management reached almost $20bn. Today SPDR assets

Assets USD Billions

INVESTMENT PRODUCTS: EUROPEAN ETFS 46

TAKING ON

60 20

40

10

20 0

0

Assets USD Billions ETFs

2000

2001

2002

$0.68

$5.88

$10.69

6

71

118

2003

2004

$20.44 $33.97 104

114

Q1 2005

Q2 2005

$38.92 $40.48 122

139

Q3 2005 $48.06 142

Source: Morgan Stanley, November 2005

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

Active or passive funds? Surely it’s active or passive investors. iShares exchange traded funds are index funds that can be used in an active strategy. Add weight to the core of your investment strategy with fixed income or mid-cap funds. Equitise your cash to the benchmark you want at the touch of a button. Dip into the potential of emerging markets or small-cap funds – without paying the premium of actively managed funds. Be pro-active, be reactive; just get active with iShares.

Institutional enquiries: +44 (0)20 7668 8007 or www.iShares.net or ISHARES <GO>

Exchange Traded Funds This advertisement is intended for institutional investors who subscribe to FTSE Global Markets magazine. The value of investments may fluctuate and investors may not get back the amount invested. Barclays Global Investors Limited (BGI) and/or its affiliated companies and/or their employees may, from time to time, hold shares in the funds included in this publication or any underlying shares held within the funds, and may as principal or agent buy or sell the funds or securities.

This advertisement has been issued by BGI, authorised and regulated by the Financial Services Authority in the United Kingdom (“FSA”). iShares plc and The Exchange Traded Fund Company plc (the “Companies”) are investment companies with variable capital incorporated in Ireland and are authorised by the Financial Regulator. The iShares funds are authorised by the Financial Regulator. Any application for shares in any fund is on the terms of the relevant prospectus, copies of which can be obtained from: www.iShares.net or by calling +44 (0)20 7668 8007. The iShares funds may not be registered in your jurisdiction. This advertisement is not intended to constitute an offer to sell or a solicitation of an offer to buy shares of any fund (nor shall any such shares be offered or sold to any person) in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. In particular, none of the shares has been or will be registered under the United States Securities Act of 1933, or as an investment company under the 1940 Act, or the laws of any of the states of the United States, and, therefore, may not be offered or sold, directly or indirectly, in the United States or to or for the account of any U.S. Person, as defined by the 1933 Act, except pursuant to an exemption form, or in a transaction not subject to, the regulatory requirements of the 1933 Act, the 1940 Act and any applicable state security laws. In addition, the Companies have not been, nor will they be, qualified for distribution to the public in Canada as no prospectus for the Companies has been filed with any securities commission or regulatory authority in Canada or any province or territory thereof. This document is not, and under no circumstances is to be construed, as an advertisement, or any other step in furtherance of a public offering of shares in Canada. No person resident in Canada for the purposes of the Income Tax Act (Canada) may purchase or accept a transfer of shares in the Companies unless he or she is eligible to do so under applicable Canadian or provincial laws.

“iShares” is a trademark owned by Barclays Global Investors N.A. © 2005 Barclays Global Investors Limited. All rights reserved.

INVESTMENT PRODUCTS: ETFS

independent financial advisors.

Fleites, a veteran of the ETF industry from its inception, believes European sponsors' efforts to gather retail assets through their captive sales forces stumbled over compensation. In the US, many financial advisers have abandoned commissions in favour of fees calculated as a percentage of clients' assets. Feebased advisers have taken to ETFs in droves because their income no longer depends on commissions embedded in high-cost actively managed mutual funds. “In Europe, fee-based is not completely unknown but it is definitely the minority view,” says Fleites, “It is limited primarily to the private banks.”

In a sense, the ETF is a victim of its own success. “The ETF structure is so efficient there is no true commission to incentivise distribution channels to sell the product,” says Joe Keenan, a managing director at The Bank of New York who is head of sales for the bank's Global Fund Services. Brokers earn a one-time commission on settlement of the purchase and that is all. They do not share a front-end load or receive continuing tail commissions from the sponsor as they do from mutual fund companies. Keenan believes the retail market for ETFs in Europe will not realise its full potential until fee-based Isabelle Bourcier, ETF global coordinator at Lyxor Asset Management, a subsidiary of compensation spreads.

Societe Generale. Photo: Lyxor Asset Management, November 2005.

That shift is happening, but more slowly than in the US – or than Mark Roberts, head of shine. “It is pointless for us to tackle the distribution product strategy at Barclays Global Investors (BGI) would channels that require the payment of a commission,” like.“It is taking some time to disenfranchise the traditional Roberts says, “If brokers are not getting paid they are not commission-based distribution structures,” he observes. going to sell our products.”

The fragmented market for financial services has BGI favours a fee-based model because advisers have an incentive to find the right products for their clients hampered the development of European retail interest in regardless of commissions, an environment in which ETFs ETFs, too. Although the latest EU directives implementing

Top 10 ETFs in Europe by AUM, as of End of Q3 2005

Top 10 ETFs in Europe by Average Daily US$ Trading Volume, as of End September 2005

AUM Manager (US$mm) Lyxor DJ Euro STOXX 50 4,383 IShares DJ EuroSTOXX 50 3,561 Lyxor CAC 40 3,244 IndEXchange DAX EX 2,972 IndEXchange DJ EuroSTOXX 50 Ex 2,745 XMTCH on SMI 2,421 SPDR Europe 350 1,752 IShares FTSE 100 Index Fund 1,555 DJ EURO STOXX 50 DVG 1,263 IShares S&P 500 1,242

Ave daily Manager US$ vol (mm) IndEXchange DAX EX 111 IndEXchange DJ EuroSTOXX 50 Ex 37 IShares DJ EuroSTOXX 50 33 IShares FTSE 100 Index Fund 24 Lyxor DJ Euro STOXX 50 22 Deutsche Bank DAX DVG 20 Lyxor CAC 40 19 IShares MSCI Japan 13 XMTCH on SMI 12 DJ EURO STOXX 50 DVG 11

Ave daily Ave daily share vol US$ vol (mm) 509,676 22 801,589 33 347,381 19 1,885,592 111 885,676 37 229,078 12 4,929 1 2,459,966 24 257,625 11 603,076 7

Source: Morgan Stanley, November 2005

48

Ave daily Share Vol 1,885,592 885,676 801,589 2,459,966 509,676 334,412 347,381 1,110,752 229,078 257,625

AUM (US$mm) 2,972 2,745 3,561 1,555 4,383 835 3,244 869 2,421 1,263

Source: Morgan Stanley, November 2005

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

the Undertakings for the Collective Investment of Transferable Securities (UCITS III) provide a framework for the cross-border distribution of financial products throughout the EU, funds must still comply with local regulations in each country.“Listing is still local. Taxation is still local. Demand is very local,”says Isabelle Bourcier, ETF global coordinator at Lyxor Asset Management, a subsidiary of Societe Generale and a leading European sponsor of ETFs. She explains that a French investor who wants to invest in Italy will pay three times as much in brokerage fees than for a trade on the French market, a price few are willing to pay.“Each time we come out with a fund which is authorised for distribution in France and listed on Euronext we have to start the same process for Germany, for Italy, for Switzerland,”Bourcier says.

Like Lyxor, BGI tries to make its European ETFs look and feel as much like a local investment as possible by listing them on six or seven major markets, which involves translating the prospectus, marketing materials and sales literature into five languages. “That doesn't happen for free,” Roberts notes. European ETFs have higher expense ratios than their US counterparts as a result, although ETFs retain a significant cost advantage over mutual funds.

Figures compiled by Lipper Fitzrovia show that average total expenses for a European equity index fund amount to 101 basis points (bps) compared to 42 bps for an equity ETF. These additional costs preclude the blanket ETF coverage BGI offers in the US market.“We want to be a little more thoughtful about each fund,”Roberts says,“It is a bigger bet than English only, one regulator, one stock exchange in the US.” BGI has just doubled the number of ETFs it offers in Europe to 28, a move Roberts believes will soon vault BGI into a clear lead in ETF assets over its current peers, Lyxor and INDEXCHANGE, a subsidiary of HVB Group.

Retail interest in ETFs so far has focused on funds that track local indices, leaving ETFs based on international benchmarks such as the FTSEurofirst 80 almost entirely to institutional investors. Unlike the US market, where the first ETF to market tracking a particular index usually grabs the lion's share of assets, the obstacles to pan-European trading allow multiple ETFs based on the same underlying index to co-exist.“If you are a client of BNP Paribas, you go into their branch and buy their product even though you might be able to get an equivalent product at a lower expense ratio or better price from UBS,”says Keenan.

A liberal attitude toward licensing by STOXX has encouraged proliferation, too. Deborah Fuhr, executive director for investment strategies at Morgan Stanley in London, believes duplicative products have hobbled the market.“Having one very liquid EuroSTOXX 50 ETF would have promoted faster growth in Europe,”she says,“The fact that we have seven products with 22 listings makes it a bit of a challenge for people to understand why so many alternatives are necessary.” BGI’s Roberts, meanwhile, believes European institutions use ETFs for the same purposes as their US counterparts: to manage transitions, equitise money flows and for hedging.“It is all the reasons

Mark Roberts, head of product strategy at Barclays Global Investors (BGI).“It is taking some time to disenfranchise the traditional commission-based distribution structures,” he observes.

Photo courtesy of BGI, November 2005.

why someone might want to take a short or medium term view and not want to sit down and work out a stock by stock plan,”he says.

ETF Managers in Europe ranked by AUM as of End of Q3 2005 Manager ETFs Lyxor Int. A 18 IndEXchange AG 45 BGI (IShares) 14 Credit Suisse Asset Mgmt (XMTCH) 5 Credit Agricole Asset Mgmt (SPDR Europe) 3 DVG-Deutsche Vermoegensblldung Gmbh 2 AXA Gestion FCPV BNP (EasyETF) 17 SSgA (streetTRACKS) 13 XACT Fonder 5 UBS Global Asset Management 8 Beta1 ETFund plc 3 UNICO Asset Management 2 Nasdaq Financial Product Services 1 Sellgson Asset Management 1 Dexia Asset Management 1 Bank of Ireland Asset Management 1 Finans Portfoy Yonetimi AS 1 Kaupthing Bank Asset Mgmt Company 1 DnB NOR Asset Management 1

AUM (US$bn) % Total 11.43 23.8 10.63 22.1 10.12 21.1 3.92 8.2 2.91 6.1 2.10 4.4 2.13 4.4 1.39 2.9 1.25 2.6 1.12 2.3 0.28 0.6 0.24 0.5 0.23 0.5 0.19 0.4 0.05 0.1 0.03 0.1 0.03 0.1 0.01 0.0 0.01 0.0

Source: Morgan Stanley, November 2005

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

49

growth

curve HE EMERGENCE OF alternative investments as a recognised asset class – taking in hedge funds, fund of hedge funds, real estate funds and private equity funds – has ensured that the once prevalent practice of servicing fund administration needs internally, much like in-house custody 15 years ago, is fast being consigned to the dustbin of history.

“The growth in the fund sector across the European markets, and the fact that they are now routinely offering products on a cross-jurisdictional basis to order to capture the broadest possible audience, is putting more pressure on managers’ back offices,” says Rob Wright, managing director of RBC Global Services in London. “That is only exacerbated by the complexity of some of the newer, alternative products now being offered.”

In turn this development poses new opportunities and challenges for third-party administrators. “We have certainly seen our larger investment management clients move into alternatives and specifically OTC derivatives,” says Jeremy Hester, senior vice-president, Global Fund Services business development, at Northern Trust. “The continuing institutionalisation of the hedge fund industry is driving change in this area and managers today rightly expect a range of competitive and effective administration services that support their business in the same way, and to the same level, that a long only fund would be serviced by the fund administrator. This includes shorter reporting cycles, increased transparency and access to wholesale distribution for their hedge funds as well as traditional products.” Consequently providers have been forced to reappraise their fund servicing proposition, and its delivery, to ensure they can service these new instruments more efficiently and effectively, he adds.

Noting that in Luxembourg the majority of fund launches over the past year have been focused on nonexchange traded securities, Ravi Thakur, general manager, Luxembourg at ABN AMRO Mellon Global Securities Services, highlights the increased specialisation within the funds market. “Such specific funds require a very specific set of skills,” he says.“Just as launching in these ‘hot’ areas

T

As European investment managers continue to push relentlessly into new asset classes and geographies, so the product set offered by their third-party administrators has expanded commensurately.

Formerly conservative European investors are hungry for products that will allow them to assume greater responsibility for their retirement planning and this, coupled with the growth in the levels of saveable income in some markets, has been a potent engine for change within the funds market. By Tim Steele.

Photographer: Jackie Eggington, Agency: Dreamstime, November 2005.

INVESTMENT SERVICES: FUND ADMINISTRATION 50

Leveraging the

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

© 2005 Northern Trust Corporation. Northern Trust is authorised and regulated in the UK by the Financial Services Authority.

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piles a lot of pressure on already large and complex fund m a n a g e m e n t organisations.

It pushes them either to invest or to divest in their back and middle offices [and] the emergence of so many important asset classes means it is hard for administrators to be successful in all spaces.”Servicing fund Rob Wright, managing director of of funds vehicles can RBC Global Services in London. be particularly tricky, he notes, “a nightmarish spaghetti situation” involving a mix of fund types drawn from diverse onshore and offshore jurisdictions, all with different settlement and processing requirements.

Mark Kelley, head of fund services, EMEA, at Citigroup identifies new corporate governance and other regulatory requirements as further Jeremy Hester, senior vice-president, reasons why Global Fund Services business administrators’ services development, at Northern Trust. are in ever greater demand.“The challenge for administrators will be to balance the technology needs for business development and service requirements with a capability set that ensures your clients can rely on you to provide the necessary level of comfort in respect of corporate governance issues,”he says. Adds Gavin Nangle, director of new business development (Ireland) at State Street: “This certainly places pressure on administrators to ensure they are staffed with the right type of people and skill sets firstly to allow them to interpret the breadth of new regulation coming down the pipe and secondly to leverage the new opportunities inherent in that regulation.”

Although there has been enormous regulatory change, coupled with the emergence of more complex asset classes that are more difficult to service, the entities which sponsor funds have made it through that period of flux and are better placed to identify which providers are capable of helping them grow their businesses, says Ravi Thakur.

“Asset managers have also had to look hard at their product set to determine how they were going to have to respond to the changes taking place, and determine which domiciles they wanted, or needed, to be in,” he says. “For

instance, the administrators in Luxembourg have to deal with new bespoke cut-off times demanded by US managers who want net asset values (NAVs) cut at 10pm CET to synchronise with the US market, and so ensure are not breaking their own internal guidelines about market timing Gavin Nangle, director of new business and late trading.” development (Ireland) at State Street As Kelley highlights, even ‘downstream’ within the value chain, providers are coming under pressure in respect of more traditional, core services, such as the calculation and publication of NAV, investment, as well as regulatory compliance, domiciliary services and financial reporting. “As the reach for return drives managers into new Mark Kelley, head of fund services, products and markets, EMEA, at Citigroup. so there is an added burden upon the service provider in respect of how specifically they price the assets,”he says.

Equally, as the operating environment has become more complex, so clients have come to expect more from their administrator in terms of other, less commoditised services such as reporting. Jeremy Hester notes that – much as on the custody side – greater timeliness and flexibility of reporting has become a priority, with the emphasis firmly on intra-day information delivery as managers build and deliver products that demand daily rather than weekly or monthly pricing.

Stephen Turner, head of global fund services at BNP Paribas Securities Services, agrees: “There is definitely a move to daily attribution and analytics, which is in itself a pressure, but on top of that there is the added complication that arises as traditional long funds embrace synthetics, which unless of course it is a pure passive portfolio, will become the norm,”he says.

Adds Mark Kelley: “Given the increased focus on fiduciary requirements due to all the changes in corporate governance we have seen, clients are very aware that as they reach for greater return it is vital that they protect

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

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INVESTMENT SERVICES: FUND ADMINISTRATION 54

themselves.”Accordingly, administrators are being asked to generate much more comprehensive risk and performance reporting. “Where information was once only for internal use, managers are now becoming increasingly reliant on us putting together the performance and commentary packages they distribute to clients,” says Rob Wright.

“Certainly, we are in the position to do that more efficiently and effectively, perhaps in a more timely fashion and perhaps offering higher quality.”

Similarly, transfer agency – which broadly speaking involves the transfer of subscriptions and redemptions, the movement of money and the notification of cash agents – has shrugged off its reputation as an unglamorous retail back office processing task to ensconce itself firmly on the client agenda.

“A number of years back people were less inquisitive about transfer agency, perhaps because it was tricky to understand,” says Gavin Nangle.“However, we are increasingly seeing now something of a commoditisation of custody and accounting in the eyes of the more sophisticated managers, and that is resulting in a more specific focus on the transfer agency piece as a useful differentiator between providers.”

If there is a lack of harmonisation or homogeneity in respect of clearing and custody across Europe, “when you get to retail products like transfer agency you are miles out”, says Stephen Turner. “Managers can start thinking about centralising data centres and so on, but you are going to struggle to pull it off – you can’t have call centres spanning Europe run out of, say, Dublin because there is a lack of the necessary skill and country specific technical understanding in any one jurisdiction, not least when it comes to language considerations.”

Manually intensive and not particularly scaleable, transfer agency services will be in ever greater demand as the privatisation of savings gathers pace across Europe, says Wright: “Indeed, as the proliferation of new products continues, they will all need recordkeeping or transfer agency type facilities.” The emergence of new products, such as the platforms seen in Australia and South Africa, will force the business to evolve, he adds: “For instance, the consolidation of individuals’ pension plans, along with their personal savings plans, within a single platform that will provide them with a holistic view is perhaps three or five year away, but that centralisation of information pertaining to investments spread across different vehicles or managers or institutions is nonetheless inevitable.”

Transfer agency is the only point where a third-party administrator is directly touching a fund’s end-customers, “which is why you cannot afford to make mistakes,” says Mark Kelley. Increasingly providers of transfer agency services are offering two different information streams on behalf of the managers: to the distributors and to the end investors.“We can expect to see analytics and performance measurement being applied to distributors via transfer agency,” he adds,“which will really allow managers to get to the bottom of who exactly is getting the investment flows into their funds.”

Given the diversification – both in terms of products and

geography – witnessed in recent years, has the balance of power in the administration space shifted towards the larger providers? “Our clients are focusing on a couple of things,” says State Street’s Nangle. “Increasingly global managers and multinationals have a breadth of requirements across multiple jurisdictions, and by that I don’t just mean out of Luxembourg and Dublin as the principal domiciles of funds.

Additionally, they need in-country services in those markets, largely dependent on where they are distributing their funds but also based on additional work they may be doing in those markets and where they need a global partner to lean on”. The capacity to take on new business is also key, adds Nangle – and not just today, but for the foreseeable future: “They want to ensure that their chosen provide is truly committed to the provision of a funds administration services on an ongoing basis.”

Consolidation within the administration space has already begun, and will continue, says Nangle. The proposed merger of Dexia Fund Services with RBC Global Services, announced over the summer, is a notable example of such consolidation. Says RBC’s Rob Wright: “While it is difficult to talk about a European marketplace, as there is still a lack of homogeneity between markets, I do think that custodians such as us possess capabilities and resources and synergies that can be leveraged to create good value for clients across the wider European geography.”

Northern Trust’s Jeremy Hester agrees that there is “definitely a place for the smaller guys” – even if the asset servicing landscape in Continental Europe is increasingly aligning itself with the Anglo-Saxon model, there is still room for specialist providers who can fulfil a niche role.

“Not everyone wants a super-tanker style processing solution,” he maintains. “We just took on a client who parted with their previous provider not because of poor service quality, but rather because they wanted slightly more flexibility and a more personalised service. It may be a cliché, but in the end it is a case of horses for courses.”

Citigroup’s Mark Kelley is not convinced, however.“In the custody world scale is really the primary driver, but at the moment you can still be a bespoke player in the fund administration space and still do very well,” he says.

“However, within the next 3 years that will no longer be enough.”The ability to offer multi-market servicing and to commit to heavy investment in technology – especially in the context of Basel II and operational risk compliance – means it will become ever more difficult for smaller players to keep pace, he adds: “Accordingly I expect we will see many more deals like Dexia & RBC over the next few years.”

However, Stephen Turner warns that – despite their scale, reach and general clout – custodians cannot afford to be complacent. “One of the threats some of the more traditional custodians face is from the non-bank players out there,” he says. Going up or down the value change makes commercial sense, especially where existing revenue is being commoditised, but people forget the downside is a changing competitive environment bringing in new players.“At some point the two are going to collide.”

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

PENSION FUND POOLING

The emergence over the past couple of years of common funds that allow cross-border investments to be ‘pooled’ within a single tax transparent structure – notably Luxembourg’s Fonds Commun de Placement (FCP) and Ireland’s hastily conceived riposte, the Common Contractual Fund (CCF) – has seen pooling inevitably anointed as the ‘next big thing’ in asset servicing. Tim Steele reports.

THE QUEST FOR

Pool balls. Photographer: Scott Rothstein, Agency: Dreamstime.com, November 2005.

SCALE & EFFICIENCY HE ABILITY TO manage and administer diverse investment products across multiple domiciles as a single portfolio of assets, that eliminates duplicate processes, enhances efficiency and reduces costs, is obviously enormously appealing given the inexorable process of diversification and globalisation seen over the past decade. The emergence in recent years of common funds that allow cross-border investments to be pooled within a single tax transparent structure is today’s ‘big thing’ in asset servicing.

Never mind that an iteration of the cross-border pooling concept has been under development by Credit Agricole Investor Services (CAIS) since the mid-1990s. CAIS’s proprietary clonage (or cloning) offering allows for “the globalisation of management and administration of assets or parts of assets belonging to several independent legal entities” in order to reduce management and administration costs. That the Dutch equivalent of the FCP/CCF, known as the FGR, has been used for tax transparent pension pooling for over a decade also seems to have gone unnoticed.

Be that as it may, a number of custodians – Northern Trust, State Street, Citigroup and ABN AMRO Mellon

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FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

among them – have succeeded in generating significant heat and light around multinational pension pooling over the past 18 months. Nonetheless, there are plenty of providers still happy to watch how things develop from the sidelines – either because they are still not convinced by the basic concept, or because they cannot yet countenance the corporate governance workload and costs involved in gaining the necessary tax clearances. While there have been some recent useful developments, such as the extension of the CCF to include non-UCITS mandates, at this stage the transparency test still has to be done on a case-by-case basis.

The case for pooling on the part of multinational corporates is on paper quite compelling. Setting up and maintaining multiple pension plans across a range of different jurisdictions, each subject to indigenous regulations and requiring local personnel, clearly poses significant operational and tax challenges. Where a pension fund invests in a standard collective investment scheme, it will typically attract the withholding tax status of the domicile of the scheme, resulting in considerable tax drag. There is a significant difference between the most favourable rate applicable to pension funds and the standard withholding tax rate.

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PENSION FUND POOLING 56

assets of one country’s As Kathy Dugan, senior pension fund whittled product specialist, pooling at away by poor investment Northern Trust, notes, a decisions while another multinational with multiple country does extremely plans could do without well”. having to make multiple However, Bernard investment management Hanratty, director, Global decisions.

Better to Transaction Services at streamline the process and Citigroup also put their best management acknowledges that there is talent in one place to an “inordinate” amount of address investment policy internal corporate and hire and monitor governance work required managers. That result is a to firstly educate trustees scale enterprise enjoying about pension pooling considerable administrative Bernard Hanratty, director, Global Transaction Services at and secondly win their and cost efficiencies, and Citigroup acknowledges that there is an “inordinate” amount support for it. opportunities for enhanced of internal corporate governance work required to firstly Pension pools may also risk management and educate trustees about pension pooling and secondly win be sponsored by stronger corporate their support for it. Photo, Citigroup, November 2005. investment managers governance. “Investment explains Hanratty. “In this managers have long scenario, the corporate understood the advantages governance issues are less of combining assets within a onerous, but the demands single fund vehicle. of setting up the structure Managing one large asset and getting the approvals pool instead of a number of remain,”he says. small accounts promotes If an investment management efficiency – manager creates a pension not least in improving the pool that it wishes to sell to costs associated with the Dutch market, it is not trading, back office support, a case of the investment custody and fund manager submitting the administration,”says Dugan. application to the Dutch For the smaller investor in regulator or tax authorities; particular, pooled funds may rather its first pension fund be the only practical and client must go through this cost-effective way to laborious process. “Until diversify their investments, we start getting broad she adds. brush approvals – for “The concept is most instance, the UK decides to definitely gaining traction, accept that all CCFs are and for three reasons, says Kathy Dugan, senior product specialist, pooling at Northern Trust. transparent and begins Kerry White, head of Photo, Northern Trust, November 2005. waving them through, no multinational business development at ABN AMRO Mellon Global Securities questions asked – then pooling will remain a select club,” Services.“Cost efficiencies are an obvious driver, but just as says Hanratty.

For his part, Gavin Nangle, head of business importantly there is the burgeoning mismatch between assets and liabilities – if a single firm in a single country is development, Ireland, at State Street, concedes that – with enough of a concern, then multiplies that in the case of a only one multinational pension pooling having so far multinational operating in eight different European actually been launched, and that only recently – there have markets. The third issue is control, with a lot of firms been rumblings in the market that pooling is more sizzle viewing consolidation within a single structure of entity than steak.“Admittedly, we have quickly reached the point pooling as offering them greater control over their assets.” where people started asking how come, given that FCPs A multinational gets the benefit of better buying power, and CCFs are so great, why aren’t there more pooling broader asset diversification and improved performance for deals?” says Nangle. “That said, a vehicle has now been its pension funds. In particular, it doesn’t want to see the launched, other significant names are on the brink of doing

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

so themselves, and there is a significant group of multinationals and pension advisors who are looking very hard at using asset pooling vehicles both in Dublin and Luxembourg.”

Nangle is confident that the next 12 to18 months will see “an explosion”of asset pooling vehicles in both jurisdictions, involving significant levels of assets. “Initially there were concerns over proprietary information and intellectual property, but once products start coming on-line, multinationals and investment advisers will see that they are not just a theoretical solution and that it will not be a particularly lengthy or expensive process to get these vehicles off the ground.”

Moreover, custodians believe that asset managers are now looking more seriously at exploiting the full potential of the CCF and FCP for themselves by using these structures as a launch pad into true crossborder pooling. “Winning and retaining mandates is tough today, and a key element is fund performance, which is where the rubber hits the road,” says Ian Baillie, managing director at Northern Trust’s Luxembourg office. “You can enhance that performance by reducing tax drag through a ‘look through’ pooled vehicle that allows the advantages of direct investment rather than via co-mingled funds.” In addition to benefiting from operational efficiencies and reduced costs, fund manufacturers can use such vehicles not only to target existing clients but also to extend their product range by offering multi-manager mandates to which they can easily add new managers. “They are looking at greater complexity as they seek to bring on new managers and new markets,” says Baillie.

The drift towards greater specialisation by asset managers means there has been a sharp rise in the number of funds offered to clients, and the result has been vast amounts of duplication when it comes to mutual fund processing, says Ravi Thakur, general manager, Luxembourg at ABN AMRO Mellon Global Securities Services. “Pooling allows you to define how you want to break up asset allocation among your managers, and fix that in one pool structure managed by one manager,”he says.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

Kerry White, head of multinational business development at ABN AMRO Mellon Global Securities Services.

Photo: ABN AMRO Mellon, November 2005.

“You can then easily split that allocation or pool into however many sub-funds, each with a different name, but centrally managed and administered. Ultimately it is about preventing overload on your star portfolio managers, who are increasingly leaving to run hedge funds because they are tired of mundane equity assignments for large numbers of institutional portfolios and funds,”says Thakur. For this reason, he adds, their workload is “reduced without compromising flexibility in terms of meeting emerging needs for specialised funds and tailored products.”

As Gavin Nangle notes, single domicile pooling allows a fund manager to run both a FCP and a SICAV in Luxembourg, or a trust or company form from Dublin alongside a contractual CCF while pooling those fund assets together. As a result, fund sponsors would no longer have the expense or inconvenience of running separate legal entities and multiple products as they have traditionally been required to do in order to satisfy specific investors’ desire for particular product structures.

Stephen Turner, head of global fund services at BNP Paribas Securities Services, remains markedly unimpressed, however.

“Pooling has to be the most disappointing product ever,” he

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DELOITTE REPORT BACKS GROWTH IN MULTI-NATIONAL PENSION FUND POOLING

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ENSION POOLING ALLOWS international businesses with employees across several jurisdictions to establish a pooled pension fund. Instead of holding underlying investments directly themselves, an international pension funds invest into a pooled vehicle which in turn holds the underlying investments on behalf of the pension plans.

Advocates say the benefits can be substantial and include economies of scale, increased governance and oversight through central co-ordination and reduced administration. A recently published Deloitte report, Pension Pooling for Multinationals, shows that interest in pension pooling has increased dramatically over the last year and a half.

Deloitte says the results of the survey reflect the fact that pensions are of critical concern for the boards of multinationals. Pension pooling is increasingly seen by CEOs and CFOs as fundamental to improving oversight and financial performance of pension plans. According to Gavin Bullock, head of pension pooling at Deloitte, “80% of the multinationals in our survey indicated that they are currently considering pension pooling solutions.”

“Companies considering implementation varied in size and geographical coverage, and 20% of these were planning to do so within the next 12 months and a further 33% in the following year,” he adds. Given a lead time of up to a year to establish a pooling vehicle, this timetable provides a strong indication of how far many multinationals are down the implementation process.

There are a number of benefits to pooling. Deloitte’s survey in particular identifies financial benefits as a key driver for establishing a pooling plan. Pension pooling allows economies of scale from a number of sources including custody, brokerage, netting transactions and administration costs. As well as these financial benefits, it is clear that multinationals also view improved risk management and governance as important. Equally, “every participant identified improved risk management as an important driver for pension pooling,” adds Bullock. Furthermore, 36% of the multinationals surveyed indicated that withholding tax is not an important consideration when selecting an investment vehicle for their pension plans. Deloitte expects that as awareness of the tax costs associated with different vehicles becomes better understood by multinationals, tax will become a more important consideration.

“Around three quarters of multinationals currently considering pension pooling have total assets in excess of $1bn, and 80% also had plans in over ten different countries,” says Bullock. These results support the assumption that larger multinationals with operations in a number of countries are most suitable for pension pooling – and is unsurprising given that these companies will have the most to gain.

Pooling is not only for the larger funds. Smaller plans can often achieve the financial benefits from joining a pension pooling programme. It is an important consideration given that smaller plans are likely to be paying higher rates of fees and are sometimes restricted in areas such as manager diversification or yield enhancement strategies (including stock lending) because of their size. Taxation was identified as a significant barrier to pension pooling by 70% of multinationals. To those who have been involved in pooling projects, this will Core Portfolios – Equity, Bonds and Active come as no surprise. No matter which vehicle is 325 chosen, which country the participating plans are 300 located in or which investments are being pooled, 275 250 tax invariably plays a central role in all decisions.

225 Pension schemes of multinationals have typically 200 175 concentrated on pooling equity investments and 150 bond investments. Interest was also shown in 125 100 pooling alternative investments such as real 75 estate and hedge funds. “In the case of real 50 estate, the growing interest is due to the stable returns and high income yield that this asset class FTSE Asia Pacific ex Japan All Cap Index FTSE EPRA/NAREIT North America Index affords. In addition, some multinationals showed FTSE Eurozone Government Bond All Maturities Index FTSE Hedge Index interest in pooling other investments such as private equity,” says Bullock.

Total Returns (USD). Data as at 30 November 2005. Source: FTSE Group.

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PENSION FUND POOLING

already extremely efficient and alphas in any case don’t make for good pooling because of all the synthetics and need more multiple managers,” he says. He is adamant however that while“pooling works where you have some fairly core, equity and bond, active funds, as the fund management industry moves away from that I can’t see it taking off. Plus given all the tax and income issues and the complexity involved, you really have to ask what your payback is.”

says.“I remember a large Swiss corporate working with one of the largest custodians 15 years ago to get a pooling product off the ground and it never happened. Certainly, some providers say they have a pooling product, but do they really? As soon as you kick the tyres it falls down in my opinion.”

Turner argues that the rise of portable alpha – whereby alpha and beta portfolios are segregated – renders the argument for pooling largely irrelevant. “Passive funds are

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

Roundtable In mid November, the transition management experts at Citigroup and CSFB, together with FTSE Global Markets, invited a group of market specialists to a gathering at the Berkeley Hotel in Knightsbridge, London, to debate current issues in transition management. A broad range of subjects were discussed including the importance of transition manager research, the future of transition management, and the much awaited T-Charter code of practice. Presented here are some of the highlights of that discussion.

TRANSITION MANAGEMENT ROUNDTABLE

TRANSITION MANAGEMENT

ATTENDING From Left to right: Jim Horsburgh, chief executive, Witan Investment Trust Philip Read, Financial Services Authority (Observer) Tim Wilkinson, Managing Director & Global Head of Transition Management, Citigroup Emily McGuire, Hewitt Associates Graham Dixon, Managing Director, Transition Management CSFB Matthew Stanesby, Senior Manager, Investment Operations, Aon Asset Management Ben Gunnee, Mercer Consulting Francesca Carnevale, Editor, FTSE Global Markets Rick de Mascio, chief executive and founder of Inalytics

FTSE GLOBAL MARKETS â&#x20AC;˘ JANUARY/FEBRUARY 2006

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TRANSITION MANAGEMENT ROUNDTABLE 60

CLIENT RESEARCH & THE ROLE OF CONSULTANTS FRANCESCA: (Francesca Carnevale, Editor, FTSE Global Markets) Is it important that consultants do the hard graft of constantly researching the transition management marketplace on behalf of the client? What should clients expect from you?

BEN: (Ben Gunnee, Mercer Consulting) It is a fact that clients tend to search for a transition manager at the last minute and sometimes it is not given perhaps the same consideration accorded to, say, choosing an investment manager.

They can spend three to six months debating that particular decision. It is important therefore that consultants carefully explain all the issues related to transitions, what can occur if they go wrong, and why it is important that clients selecting a transition manager give it their full consideration.

EMILY: (Emily McGuire, Hewitt Associates) As a preliminary step consultants need to advise whether it is, in fact, beneficial to use a transition manager. In certain cases, such as a simple one-to-one transition, or where there is a fair amount of pooled funds use involved, it may not be the most appropriate solution for a client to appoint a transition manager. In many cases the transition can be executed efficiently with the consultant alone advising the client how best to work with both the exiting and incoming managers.

GRAHAM: (Graham Dixon, CSFB) If you hold a beauty parade and give us half an hour each, I think we all sound the same. The differentiating characteristics among transition managers are deep down in the system and involve technology, systems, and the transition manager’s business model. Only a fairly sophisticated client can pull those nuances out without help. So we rely absolutely upon the consultants to explain these very important differences.

MATTHEW: (Matthew Stanesby,

Aon Asset Management) The client should not have to spend months or weeks thinking about which transition manager to choose, but they do need to make an informed decision. It is a different type of decision to a manager selection. The transition period is short and if you get it wrong there could be a substantial cost, but if the consultant has done the work then you should not get it wrong. The consultant will have to spend a lot of time researching transition managers, but I think it is very, very important that it is done.

FRANCESCA: Jim, if you have worked with a number of transition managers, do you need a consultant?

JIM: (Jim Horsburgh Witan Investment Trust) We have been through two transitions in the last year or eighteen months. If we undertake another two in the next eighteen months what do I do? Second time around, we deliberately did not use the first manager because I felt I wanted to find out exactly how other people did it to get a better perspective. And maybe the third time I will choose someone else, but beyond that I am not sure there is a need to look elsewhere, unless there is something very specific about the transition. However if someone is only doing a transition once every four or five years then I think they will always use consultants.

RICK: (Rick de Mascio, Inalytics) It is horses for courses, not only in terms of the asset structure, but also in terms of one’s experience. It doesn’t surprise me to hear when you say maybe next time around I could probably do this myself just as easily.

JIM: There is another level of comfort in using a consultant and it was quite important to us during the second transition because it was very public. When you speak to two or three transition managers and explain what you are thinking of doing, even in vague terms, they can go and front run if they want to and if they are not chosen. The comfort level in using a consultant then is that woe betides anybody who even tries that, because the consultant will just strike them off their list. And that is a huge safety margin for anyone doing a transition.

WHY & WHEN CLIENTS WORK WITHOUT CONSULTANTS BEN: Research shows that somewhere between a half and twothirds of pension schemes say that they do not rely on a consultant. They go out direct. It is quite an interesting statistic and we will have to work to reduce this ratio. Most pension funds really only carry out a restructure, or a serious manager change, once every three to five years. On that basis therefore you cannot rely on who you dealt with previously.

GRAHAM: I think that is a shocking statistic and find it difficult to believe it could be that high. I wonder whether it is distorted by a US or even a European experience. However, I see a large segment of clients, particularly local authorities that go out to public procurement, who work without a consultant. They see a beauty parade of transition managers and feel they are equipped enough to make a decision but I know they are not.

EMILY: But, often local authority pension funds do have an individual or independent investment advisor sitting on the board so they are getting advice, but maybe not from a consultancy house.

MATTHEW: If only half the pension funds go to the consultants, what do the others do? Do they just rely on the fund managers to sort it out themselves?

GRAHAM: They pick one.

MATTHEW: So you are saying that they just randomly pick a transition manager?

GRAHAM: It’s not random but it may as well be.

BEN: The survey asks a simple question: Do you use a consultant: yes or no? The survey results change over time, but it roughly stays within the half to the two-thirds area. So what else do clients do? If they have an existing relationship with someone, that is always a key driver. If the client has a relationship with an asset manager or with an incoming asset manager and one of these parties offers a transition service that is something that the client seems to be happy to use in a lot of instances. In strict terms, that

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

is not using a consultant. Equally, I am sure there are other clients who simply go out into the market and pick one.

GRAHAM: We can see when pension funds make changes because public procurement is very open, so we phone up and ask. We learn from the consultant that they have not been invited to participate in the transition manager search.

TIM: (Tim Wilkinson, Citigroup) It is a concern that there is so much reliance on existing relationships. If you select someone just because you know them it does not mean necessarily that they are best placed to manage your transition. Certain providers are running around saying: “This or that model is flawed”when in reality the debate is not about the type of model but about the underlying quality of the people and systems and the integrity of the overall service.

GRAHAM: If a pension fund is going to use an existing relationship to execute a transition, say with a corporate broker, there is always the danger that they contract out of best execution without realising it. The fund might not have the breadth of coverage in the market to see whether the dealing has disadvantaged them or not. Very little is disclosed and another seven years will pass before the pension fund has the opportunity to redress any damage done. Pension funds need more protection than they currently enjoy.

JIM: After each transition I have spoken to all the fund managers involved – including the outgoing ones – to get their feedback on the individual transition managers because I think it is a terribly important piece of input.

TIM: I am positively encouraged by talking to fund managers. The incoming and outgoing managers are well placed to know exactly what is going on, especially if they have professional dealing desks that take a very active interest and they both care intensely about the success of a transition. And if we don’t take account of their intelligence, their liquidity, their preferences, and their expectations, then I think we fail the ultimate client.

RECOURSE WHEN THINGS GO WRONG FRANCESCA: Rick, have you built up a detailed database of successful, or even unsuccessful, transitions?

RICK: Yes. We clearly see trades go through the market and have a clear sense of where the costs are at any point in time and we also know who is doing a good job and who isn’t. We are fortunate in that we are part of the post-mortem, and we know what clients think of the manager and how well they have done.

By and large I think most people are actually quite satisfied.There are very few instances where people have been unhappy. I think that there is a sort of realisation that shortfall can go either way. Clients know that if ultimately if they have selected a decent transition manager then the project management skills which got them to that point have really helped and the fact that they are through the other side, with all the loose ends tied up, means that they have picked the right manager. There is also the bullet proof audit trail to back it up. I think a lot of clients actually want to get through it and then just put it to bed actually and just move on and get on with their lives really. But maybe we have just been very fortunate that the transition managers we have been dealing with have actually been pretty satisfactory.

FRANCESCA: Do you think Jim that poor transition managers, rather like old soldiers, just fade away?

JIM: I was wondering that as well. I think I would actually quite like them to disappear very quickly! One of the questions I was going to ask the consultants was that if I phoned them up and told them that I found the transition management firm I had used was incompetent, would that be sufficient to get a firm off any lists?

BEN: Feedback is definitely an important part of the process but it is not the whole process. One client’s feedback would not necessarily determine what we feel about a transition manager. There is a lot more to it. We look at many aspects, qualitative aspects of course, but also quantitative aspects and we need to take that all into account and acknowledge that there may be valid

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

EMILY MCGUIRE Hewitt Associates “[commenting on the T-Charter] it is not there to say who is good and who is not. As consultants we have to say who we believe are competent transition managers, but we welcome more information.”

GRAHAM DIXON, managing director, transition management, CSFB “Breaking news! There aren’t 27 transition management teams out there. Some are virtual transition management teams. And if I am a consultant and meet the transition team unannounced, I think I would be shocked.”

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TRANSITION MANAGEMENT ROUNDTABLE 62

reasons that explain the mistakes /incompetence in that one case.

TIM: Would you typically give the transition manager the opportunity to respond to a fund manager’s interpretation of events? Would you go back to the transition manager and say: “this is what the feedback was.”?

BEN: If we find something with the parties involved that could improve the process, I think it is important that consultants feed that information back into the investment community.

JIM: I used the word incompetent deliberately. I wasn’t saying that the transition manager may have pluses or minuses. I am actually saying this transition manager should not be in this business. I would expect therefore that the consultant treats this comment extremely seriously. I would like to assume because of that strength of feeling that the transition manager doesn’t get short-listed unless there are extenuating circumstances for doing so, rather than the other way around. In any industry, there has to be a way of weeding out the bad players and in the transition management industry – because so much of it is one-off – that power really lies with the consultants and I think they have to be responsible and use it.

GRAHAM: There is a bandwagon rumbling along here, so I have to get on it! There is a lot of information out there that consultants could benefit from. For example, I know absolutely which transition managers I would and would not use and why. If a consultant asks me: “What things do you think are powerful and useful and what are the issues that concern you and might actually lead to a scandal in your industry?” I would give that information, as it would help them ask better questions during their next research trip. Furthermore, when transition managers move to another firm and they see other ways of doing things, they invariably reassess the way in which they work. That reservoir of knowledge and experience is perhaps going untapped.

FRANCESCA: Have consultants ever eliminated one or more transition managers from recommendation

lists? If you have, what kind of criteria might encourage you to do that?

BEN: Yes. It would be certain issues or considerations that would encourage that to happen. One of them, for example, would be a change in personnel. If, as Jim suggests, a manager is totally incompetent then client feedback of that sort could also cause us to remove someone from the list. But there are no hard and fast rules.

MATTHEW: My take on it is a bit different because I am representing a multi-manager. I probably do more transitions than most and, as we do our own research, I do not feel I need to use a consultant. One of the points that I think consultants should take on board is the insight that fund managers and other transition managers can add regarding a particular provider. I really believe that comparing and contrasting different approaches can help to ask questions at a deeper level. I am sure consultants do that anyway, but I have certainly found that things I have learned from conversations with alternative providers have prompted me to go back and re-evaluate my point of view.

RICK: I tend to come back to numbers. One of our clients put out an RFP recently and I think they got 27 replies. I am trying to think of an instance where someone has actually disappeared. The irony is (for whatever reason), I think it is the reverse problem – that the industry has not been weeding out the undesirables, or the people who are no good. In fact it has gone the other way.

THE BUY-SIDE VERSUS THE SELL-SIDE DEBATE FRANCESCA: An ever-widening range of business models are touted in the market, for example, the investment banking approach, the fund management approach; or the broker/dealer approach. What do these models mean to a pension fund that is about to undertake a transition?

TIM: One word: confusion. The unfortunate reality is that there is much inconsistency in the approach of different transition managers as to how best to evaluate the transition and the

provider, whereas performance is very straightforward in the investment management industry. You have a benchmark; you are measured against it.

You do well or you do badly. In our industry, there are very few firms out there with five or ten year track records.

Additionally, some providers are telling the client that they have performed extremely well versus this or that benchmark and then client finds out that they are very behind the eight ball fund performance-wise. We simply do not have that wealth of historic data in the transition management industry just yet.

FRANCESCA: Jim and Matthew, does it matter to you whether your transition manager comes from the buy-side or the sell-side?

JIM: It didn’t no. We interviewed both types for both transitions. We ended up – in both cases as it happens – appointing investment banks, but the model itself wasn’t the reason for choosing them. At the end of the day it was how well the organisation concerned showed us they understood the transition we were trying to achieve.

MATTHEW: I agree. I don’t really mind if it is buy-side or sell-side. For me the debate has provided some extra questions to ask. Getting to the bottom of what buy or sell side means, for example, is pretty difficult in itself. Once you understand how the transition manager is remunerated you should not have to worry about it at all. It is whether the transition manager can do the job and how much you are going to pay in both explicit and implicit costs.

RICK: I accept that this issue is far more important to the sellers than the buyers of the service. If we wind the clock back four or five years ago there was a distinct difference between the buy and the sell side providers. There was no question that basically one set had a series of strengths and the others had other strengths and vice versa. Now there has been a complete cross pollenation of skills. Firms have been recruiting from each other. As well, the project management skill sets from both sides is now immeasurably stronger and also the execution quality from both sides is now immeasurably stronger – primarily because of the

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

need to have best execution.

Consequently buy-side providers look more like investment banks by the day and the investment banks look more like buy-side providers – because they are both providing a lot of the fiduciary comfort that clients are looking for. As a result, any distinction is more in the minds of the sellers than of the buyers.

The real question for the transition manager is: can you really do this?

BEN: What you actually want is the best firm for the job and from our point of view it does not really matter what side that is from. We just want the best firm for that particular transition. If a transition manager has specialist strengths, then that may help him/her in the particular transition manager selection we are working on for our client. Their background is largely irrelevant.

TIM: Even now some providers are offering transition management services, but bringing neither execution nor portfolio management skill sets to the table. Yet, they are still doing good volumes of business. What they are doing is leveraging their existing relationships to get business and while this is perfectly understandable, it does sometimes result in both the quality and the integrity of the service being compromised.

IMPLEMENTATION SHORTFALL & NO-FEE TRANSITIONS FRANCESCA: Margins have been very tight. Revenue for transition management teams is not what it could be. Are transition managers under much more pressure these days as competing firms in the market make promises that if they exceed predicted implementation shortfall, the client pays nothing? How much is that affecting your remuneration?

GRAHAM: There is huge pressure which can lead to a situation where the bad get rewarded and the good go to the wall. If you work on the basis of explicit fees and the market says the fees for doing a transition are close to zero, then the temptation is to find other ways to make money. This is not what the client is trying to achieve. We

maintain the same transparent rate throughout and we lose business as a result. If someone offers to do your transition for free and guarantees all the prices, a pension fund should be very, very afraid.A‘guaranteed close’structure makes no sense at all to a pension fund because a particular market close has no relevance. A guaranteed price has in effect handed control over to somebody who can make a lot of money on the back of that certainty. And I think that is something that we all must stop.

TIM: I think that if it sounds too good to be true, it invariably is. What is also happening is the introduction of some innovative structures and you refer to one of them whereby the transition manager forgoes the fee if the implementation shortfall, or what we prefer to call ‘realised impact cost’, comes in above the provider’s forecast. The underlying concern is that if the fee is just one or two basis points and the provider’s firm sees $3bn of flow go through the books of its affiliate, does it really care about the one or two basis points? The client risks entering an agreement with a self-defeating fee structure here. Unfortunately the legacy of the investment banks’ large-scale entry into this space three or four years ago is still with us and by that I mean very, very low margins. And as we all know, margins are oh so slow to expand….

BEN: In the discussions about the TCharter I think we have seen that people are willing to talk about a minimum price. As Graham said, there are people in the market that are willing to go outside of the normal pricing structure or offer something for ‘free’. Whether they would be willing to come to the table and discuss it is another matter.

JIM: Explicit price isn’t the issue here, is it? In the transitions I have done I would have liked to have known the exact profit model for transition management, because you have no idea before, during or afterwards exactly how much profit anyone is making from transition management. The more explicit transition managers are about the profit model, the more I think clients might be comfortable with saying, “I would rather pay you explicitly than

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

MATTHEW STANESBY, Senior Manager, Investment Operations Aon Asset Management “One of the points that I think consultants should take on board is the insight that fund managers and other transition managers can add regarding a particular provider. I really believe that comparing and contrasting different approaches can help to ask questions at a deeper level. I am sure consultants do that anyway, but I have certainly found that things I have learned from conversations with alternative providers has prompted me to go back and re-evaluate my view-point.”

TIM WILKINSON, managing director and Global Co-Head, transition management, Citigroup “How do Custodian and other non-Investment Banks make money on the other side of transition flow and, at the same time, demonstrate best execution? If they don't make money, how on earth do they justify charging only one or two basis points, or even zero!”

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TRANSITION MANAGEMENT ROUNDTABLE 64

implicitly”. However, I personally believe that project management skills are by far the most important aspect of a transition. Bad project management absolutely terrifies the client. Whether he/she pays two or three basis points too much, at the end of the day, won’t worry him/her too much.

TIM: Providing transparency on our total take is precisely what some of us are trying to do. But seven out of ten clients out there will still say “If you will do it for two basis points, you can have it.”We hear that all the time and it is a source of great frustration. So I think that as much as we would like to think that the industry better understands that it is not about explicit pricing, our anecdotal experience continues to suggest otherwise.

RICK: This whole issue of fees and charges is an important one, and I agree with Graham and Tim, in that clients must focus on the total cost and not on just the explicit fee. Otherwise, they are leaving themselves wide open. Having said that, both total implementation costs and explicit fees have been falling over the past three years. This has been for a number of reasons, competition, better project management and execution capabilities, and finally lower volatility in markets generally. On a wider note, this has also been true of the securities industry as a whole JIM: I do wonder if the investment banking industry went through some sort of recession, whether they would value flow quite so highly.

RICK: Yes, I agree. This issue about value of flow is not just pertinent to the investment banks; it is also pertinent to the other players within the transition management industry, such as custodians and the other players here. I think that there is value in transitions which all the players get.

So it is not fair just to single the investment banks out in this one.

GRAHAM: It matters vitally to the client that they know how much they have paid either explicitly or implicitly to their transition manager. I can see the appeal in knowing with certainty how much you have paid for your transition.

The question is: how much are transition managers willing to disclose

about how they make their money?

TIM: I think it is very easy to demonstrate that the investment banks are well placed to monetise flow and still observe best execution. But is the same true, for example, of the custodian banks? Can the custodian bank monetise the flow and still demonstrate best execution? This comes down to the whole ethos of how we do our business.

The investment banks are in the business of executing flow. Their direct access to the massive liquidity of the stock market presents multiple opportunities to cross with other flow.

Where they do so, whilst still observing best execution, they will invariably make money on the other side of that, but this is to the benefit and not the detriment of the transition client. How do the custodians and other non-investment banks make money on the other side of transition flow and, at the same time, demonstrate best execution? If they don’t make money, how on earth do the justify charging only one or two basis points, or even zero!

RICK: Good question.

TIM: I would love to know the answer.

RICK: It is quite a tricky one to answer of course, without talking about any particular transactions. If we approach the question in a roundabout manner: if you were to talk to Record Currency Management say, you would be pretty clear that custody banks make a lot of money through foreign exchange trading TIM: But if we can not answer the question, then how can the business models of certain providers in the market make any commercial sense?

There are several non-investment banks out there charging low or zero fees or commission, and as far as I’m aware none of them are registered as charities.

RICK: But there are investment banks also quoting zero commission as well!

TIM: Absolutely and that’s surely not right either, but at least the flow can be demonstrated as being of some value to the investment bank. How do the non-investment banks that charge one basis point or zero – how on earth do they justify that?

RICK: The answer to that is clearly the remuneration is not zero.

I mean nobody in their right minds believes they are getting something for nothing. Nobody believes that.

FRANCESCA: Matthew, as long as you undertake a transition that meets your own internal criteria, does it matter to you that your transition manager may be making some additional money on the back of your resources?

MATTHEW: No. As long as you know what it is.

TIM: As long as it doesn’t take away from your pie …

MATTHEW: Absolutely …

TIM: But if you take away from your performance pie, you care hugely, don’t you?

MATTHEW: Absolutely …

RING-FENCING TRANSITIONS FRANCESCA: A key selling point of transition management is that it is a ring-fenced operation within a financial institution – which I have not actually been terribly convinced of when I’ve actually been to see some transition managers by the way.

Sometimes, that ‘fence’ consists only of a door and it is not always closed …

BEN: A key point of our research covers how independent transition manager teams are compared with the rest of the organisation. If they are all on the same trading floor next to the dealers then that would cause us great concern and we would affectively mark them down. I think that transition managers know that and have moved to the model of being independent within their own organisation.

FRANCESCA: What are the physical requirements for this and is it checked? There is so much in this business that appears to work on trust.

RICK: One very large transition put out recently did check and actually used photographic evidence.

GRAHAM: Quite right too.

TIM: That is good to hear.

RICK: That is the only one though.

BEN: There is an element of trust because you can not be there 24/7. The physical check is an on-site visit that is part of our due diligence. We go in and

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

walk around the trading floor, walk around the transition manager area and understand what systems they have, look at how the operation is set up and that will then determine how independent we feel they are. I think that is as far as you can go.

MATTHEW: I would definitely visit. But also I would actually ask if I could sit and watch the transition. I would be wary of someone who said, “Maybe not this week, but come in next time.”A large part of the decision is based on trust, but you can certainly do the visits and ask the questions JIM: I don’t think that there is any way that the client can rely on the best execution rule. When you are doing a £1bn transition, it all falls away.

Clients have to ask enough questions that allow them to make a judgement.

GRAHAM: I think this discussion has shown how important those research trips are. There are some consultants advising on transition management that certainly haven’t been to our offices anytime recently.

Others spend lots of time with us, even as Matthew suggests, when there is a transition underway, to see exactly what goes on. Invariably we say to the consultants that they have to go into institutions and kick tyres to understand the process.You can’t be invited into an office and accept a half an hour presentation as a de facto statement.You actually have to get under the bonnet to see all of these things in action.

THE BUSINESS OUTLOOK FRANCESCA: Emily, do you think that transition business per se is going to grow over next few years and are the numbers of transition managers in the market sustainable?

EMILY: Invariably as pension funds with big deficits are looking for solutions to plug the deficit there will be an increasing number trying out new tools and new investments. As well, I think that portfolios will become more complex. Combined these factors will continue to propel demand for effective transition management.

FRANCESCA: Do you see volumes sustaining the current numbers of

transition managers in the market?

TIM: It doesn’t already.

EMILY: From what you say about the apparent 27 providers, I don’t think that can continue.

GRAHAM: Breaking news! There aren’t 27 transition management teams out there. Some are virtual transition management teams. And if I am a consultant and meet the transition team unannounced, I think I would be shocked.

RICK: Three years ago the average cost of a transition was about 130 basis points. Now the average cost of a transition is about 40. We know there has been a 90 basis point improvement, which is of phenomenal value to clients. I don’t think we should forget that. Now the profitability, the commission, the number of entrants, at the end of the day, they are all important factors and some of which have been important in getting these costs down, but ultimately transition managers across the piece have become extremely effective at execution. But let’s not forget that volatility across the market has also fallen significantly and we have to ask: what happens on the next downturn? What happens when volatility rises? For some people – these virtual shops that Graham referred to – are not going to be able to deal with those conditions, because they’ve not seen them …

JIM: It’s a bit like if the price of washing machines collapses, it is great for value at that time, but if it means that all washing machine producers except one go out of business, and next year anyone who buys a washing machine has to pay three times more than what they pay today then that is not such great value for ongoing purchasers. Therefore if I were in Matthew’s position I’d actually be quite worried as to whether this was a sustainable drop in transition costs, because he is having to undertake transitions several times a year.

MATTHEW: Commission is a small part of the cost and I would rather pay a bit more and get a better service. It is a two way thing. It has got to be a partnership.You can’t cut the fees to the

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

RICK DI MASCIO, chief executive and founder of Inalytics “We clearly see trades go through the market and have a clear sense of where the costs are at any point in time and we also know who is doing a good job and who isn’t. We are fortunate in that we are part of the post-mortem, and we know what clients think of the manager and how well they have done. By and large I think most people are actually quite satisfied.”

BEN GUNNEE Mercer Consulting “Research shows that somewhere between a half and two-thirds of pension schemes say that they do not rely on a consultant. They go out direct. It is quite an interesting statistic and something that we have to work on to lower …most pension funds in reality are only really carrying out a restructure or a serious manager change once every three to five years. And on that basis, you cannot rely on who you dealt with previously.”

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TRANSITION MANAGEMENT ROUNDTABLE 66

bone because you will get a substandard service. So, if it has got to go up, it has got to go up …

JIM: While I have sympathy with transition managers and their various models and the fact that profitability is very tight, I actually ask the question: why doesn’t BMW worry about Ladas, even though they are charging six times the price for their cars? And the answer is that BMW have properly explained what the advantages of BMW are relative to Ladas. I think that there is a big onus on transition managers who are at the quality end of the business to fully explain what they are doing.

TIM: But we do Jim and the difference is that it is very easy to see the difference between the BMW and the Lada, you just get in and drive it.You just take one look at it. Unfortunately in the transition management industry, as Matthew has articulated, we all sound the same even though we are categorically not, and unless someone takes the onus to expose the flawed models and inappropriate practices they will continue to thrive and some clients will get charged for a BMW but, in fact, are delivered a Lada.

JIM: I remember in my old guise, we did a presentation very late one night to a London borough, to get some new business, to manage their pension fund. And the next morning, I phoned up the treasurer and asked how the decision had gone. We were told we hadn’t won it. I asked her: “How did you make that decision?”She said,“You are not going to like this Jim, but it was very late at night and we sat through five presentations, you all sounded the same to me.”Does this sound familiar?

“And at the end of it we couldn’t choose between you and as it was getting late at night we decided that we would just choose the cheapest one.”

Actually, history shows that they didn’t make a bad choice. The point is I found it quite difficult to agree with her decision making process, but you can’t stop it happening and frankly it was our fault for not differentiating ourselves. If we had differentiated ourselves enough we would have won the business. Similarly I think that the transition management industry needs

to ask: how do we differentiate ourselves from each other?

RICK: Jim is absolutely right. One of the biggest issues for the client is the lack of differentiation between one shop, one model, and another. It is all blurring at the edges, whether for good reasons or for bad reasons, but at the end of day, clients are not able to differentiate.

TEETH AND THE T-CHARTER FRANCESCA: Can we talk a little bit about the T-Charter because it does bring together many of the elements we have discussed. Obviously Graham and Tim have been strong proponents of the T-Charter. Graham, could you kindly tell us latest status of the T-Charter.

GRAHAM: We’re on our fourth draft. The sub-group is working on minor amendments, will distribute it to all interested parties, and a review meeting will take place in December. A key change is that people can now see clearly what the cost estimate template will look like, so that clients can more easily make direct comparisons of cost estimates. But the big innovation is on disclosure. Transition managers will have to present a disclosure document that outlines their conflicts of interest, the steps taken to manage those conflicts, what the business model is, and whether the transition manager is acting as a custodian, broker or fund manager. They will also have to state whether they are acting as agent or principal and how remuneration is earned. The general principles remain the same in the current draft but the dos and the don’ts have been expanded markedly. There are still elements inciting debate, but the market does appear to agree on many issues and, hopefully, will agree on the code of practice by the end of the year. We will then pass it to firms’ legal and compliance departments to finalise a charter that is unambiguous and robust.

MATTHEW: It is going to straightaway tell me the people who I shouldn’t go and see. So in that respect, yes it is very valuable.

FRANCESCA: How much consultation did you undertake with

the fund management community?

GRAHAM: It would have been a very bad initiative if we had conducted it behind closed doors. It hasn’t gone out to everybody, because that’s impossible to manage, but discussions have involved representatives from each community: clients, fund managers and consultants.

BEN: Mercer endorses the idea of a T-Charter and we wouldn’t be backing it if we didn’t think that it was a good idea and a useful document to have within the industry.

EMILY: I think that disclosure is good and certainly having information on a level playing field. But it is not there to say who is a good and who is not. As consultants we have to say who we believe are competent transition managers, but we welcome more information.

FRANCESCA: What problems do you think that the T-Charter might throw up?

JIM: If someone signs up to the TCharter and writes in there the seven bases of his remuneration and accidentally forgets another one that might be a little bit woolly what’s to stop them doing that? What’s to stop them accidentally forgetting to note that there is a conflict of interest in some of the blurb? I think those are the question marks that have to be addressed. The tighter the document is, the better it will be.

RICK: Does it have teeth? Or is it going to be anodyne enough so that everyone can sign up. This issue came out of the very first meeting of the T-Charter discussion group on the 1st of December last year. I am still not sure where it will end up, as each firm will have its own view based on how it will operate in practice. It is about disclosure. It is about profitability. It is Jim’s point isn’t it? It’s about conflicts of interest.

It’s about spelling it out. The principle is absolutely right.

JIM: The problem is that investment banks are extremely complicated places and one compliance officer’s view of what a conflict of interest might be may be well very different from another

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

compliance officer’s view. The structure of the investment bank itself might lead to a difference of view in terms of conflicts of interest.

So it is not a simple document and even if it is written extremely tightly, it will be subject to interpretation and it will depend on the scope of that interpretation.

GRAHAM: It was suggested that we have another template for the disclosure document – but I don’t think we should. It should be an area where we fight on competitive advantage. If I indicate that I have certain potential conflicts of interest and a competing provider chooses not to declare any conflicts, then the client can decide if the transparency I offer makes me a more attractive partner.

TIM: When the T-Charter was originally tabled it was full of teeth and quite prescriptive. You shall not prehedge, you shall not price adjust, you must do live time reporting, and so on.

Inevitably, everyone came in with their different vested interests and it has since been pulled back to a more principlesbased charter. Now the notes therein and the ability to check the box or not check the box is where the teeth come back into it. So apart from putting down your own perceptions of conflicts of interest and how you deal with them – which is insightful in its own right – these notes are actually serving as the teeth. Can you do live-time reporting?

Are you a separate unit? How are you regulated? Do you have a dedicated team? How do you get paid? All of these things are competitive issues upon which we will hopefully be able to differentiate ourselves versus the competition. I think it is still going very much in the right direction and I think that the people who don’t sign up it will simply find themselves marginalised.

FRANCESCA: Shouldn’t all these concerns have been articulated by the consultants?

BEN: Its part of the discussion we have already had about clients not always coming to consultants to ask about these issues. So if they’ve got a TCharter out there they’ve got something that they can rely on, it gives them a certain comfort factor. It also

helps the consultants. If we have got a certain level of information already we can devote more time to digging deeper and the deeper we dig the more we can find out about the differentiating factors of each transition manager and more about the organisations we are researching. So in my mind it is almost a win, win situation.

MATTHEW: Yes, but I am interested in who is going to take it forward and police it.

GRAHAM: I think people would like an industry body to take on the TCharter. The problem is – and this is why there is so much fundamental confusion in the marketplace – that we are not all members of the same clubs.

Let’s finish the document and then decide where it best sits. However, there is no doubt that the consultants are very powerful because they talk to each other and if, in any instance, there has been mis-selling or worse, such as a breach, the consultants wield enough power to punish the guilty by withholding business.

FRANCESCA: Have all the 27 transition managers participated?

TIM: Sixteen transition managers have participated, and they were those perceived to be the more established players GRAHAM: There are 16 that we can see, but if I hear of a 17th, they will be welcomed. A broad group of market professionals have all contributed to the current draft and soon the industry will be able judge whether we have taken it in the right direction and at the right speed.

TIM: Actually, I think it has done more by just being tabled than we could have realistically expected. I think we may be looking back in five years time and whether or not it ends up being the document that we want it to be, and whether or not it gets past all the legal and compliance departments, I suspect we’ll be acknowledging that the TCharter has done an awful lot to improve the transparency and integrity of the industry.

FRANCESCA: Thank you. I think we’ve had a very interesting, fast and fruitful discussion.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

JIM HORSBURGH, chief executive, Witan Investment Trust “In the transitions I have done I would have liked to have known the exact profit model for transition management, because you have no idea before, during or afterwards exactly how much profit anyone is making from transition management. The more explicit transition managers are about the profit model, the more I think clients might be comfortable with saying,“I would rather pay you explicitly than implicitly”.

FRANCESCA CARNEVALE, A key selling point of transition management is that it is a ring-fenced operation within a financial institution – which I have not actually been terribly convinced of when I’ve actually been to see some transition managers by the way. Sometimes, that ‘fence’ consists only of a door and it is not always closed …

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DEBT REPORT: COVERED BONDS

WELCOME

TO THE

NEW KINGDOM The covered bond market has become the darling of European investors. Demand for the bonds is outstripping supply, leaving order books oversubscribed, pricing tight and investors clamoring for more issuance- despite the likely arrival of Italy on the scene, 2006 looks like offering little relief. Paul Whitfield reports from Paris T IS NOT often that Italians can be accused of being late to adopt new fashion. Yet – if fashion can be credibly stretched to include debt – Italy’s continued absence from the covered bond market has left them trailing the pack with regards one of Europe’s hottest debt markets.

That absence is due to end next year when Italy will introduce a second round of legislation that should clear the way for a raft of Italian covered bond launches.

The arrival of the Italian banks will be the biggest single development in the covered bond market next year–baring an unlikely decision by the European Union to introduce Europe-wide regulation of the market. With a large domestic mortgage pool Italy has a hefty loan base on which to build a substantial covered bond market and is expected to become one of Europe’s biggest issuers. The arrival can not come soon enough for covered bond investors, many of whom

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68

have struggled to satiate their hunger for the instruments – leading spreads to tighten (in an already tight spreads environment) and many new issues two or three times oversubscribed.

An expanding pool of banks issuing covered bonds means total new issuance is likely to end 2005 at about €130bn; higher than the total €116bn of new issuance in 2004. Yet the increase in supply has been more than matched by rising demand for the bonds from banks, central banks, managed funds and insurance companies.

Fevered buying The first Dutch covered bond was a €2bn AAA-rated structured bond issued by ABN Amro in September 2005.

Within hours of opening its order book was two times oversubscribed and eventually received more than €5bn of orders. Another September issue of the first Finnish covered bond, a €1bn 5-year issue from Sampo Housing Loan Bank was more than five times oversubscribed.

The problem of strong demand – not that issuers would necessarily describe it as such – is symptomatic of a number of factors. The most significant of is the undoubted attractiveness of covered bonds. The bonds are debt instruments backed (or covered) by the expected cash flows from a pool of mortgages or public sector loans. In the event

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

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DEBT REPORT: COVERED BONDS 70

at BNP Paribas. of default by the bond An example of this is in issuer the bond holder can the Spanish market where theoretically (as it has never spreads on covered bonds, been tested) claim against called cédulas hipotecarias, the asset pool. This have tightened over the structure, which is past year despite some guaranteed by formidable €50bn of new issues – a legislation in some more than 10% increase countries and by exhaustive on the previous year’s contractual guarantees issuance. “The market has of the issuing banks been particularly strong in in countries without the last couple of years as legislation, has assured the bank buyers have put bonds an AAA rating. This liquidity to work in the means that covered bonds market since the bonds fill a niche just to the riskier have offered a good side of government bonds, spread over swaps,” says whose returns they Derry Hubbard, product typically outperform by 10 Ralf Preusser, senior European rates strategist at Deutsche Bank. head of covered bonds at to 15 basis points (bp) “We are currently in a sweet spot for covered bonds,” says Preusser.“If BNP Paribas. depending on their European economic growth accelerates, government deficits improve On top of high levels structure. and sovereign swap spreads widen, then structural demand for AAA of demand from “If an investor is being rated collateral will switch from government bonds into covered established investors the asked to beat the bonds.” Photo: Deutsche Bank, November 2005. market has recently government yield, as they witnessed demand for often are on cash portfolios, “We are beginning to place bonds in covered bonds from new then the simplest and sources, notably central safest way to do that is by Asia, often with central banks or agencies banks and government using covered bonds, linked to the government,” says Alain linked investment agencies. which trade at a positive Marcel head of investor relations at CIF “Central banks are yield to government bonds Euromortgage, which issues covered bonds becoming increasingly [govies], with little volatility on behalf of Crédit Immobilier de France. familiar with the market and lots of liquidity,” says and the newer market Ralf Preusser, senior segments, and as that European rates strategist at familiarity breeds confidence, I expect we will see them Deutsche Bank.

With a continued lack of confidence in the equity market, shift more assets into the market,”says Hubbard.

This newer class of investor typically uses covered bonds low government bond rates and little faith in the fortitude of corporate debt – not the least following the plunge in GM as a proxy for government bonds. Covered bonds’ AAA benchmark long bonds – demand for covered bonds has rating and the liquidity of the bonds’ secondary market, been strong and seems unlikely to dry up in the near future. which is guaranteed by market-makers, mean they share “We are currently in a sweet spot for covered bonds,” says both the safety and liquidity of the government market and Preusser. “If European economic growth accelerates, make them a good substitute. On top of providing the government deficits improve and sovereign swap spreads central banks with a pick-up on government bond returns widen, then structural demand for AAA rated collateral will covered bonds have also been used, particularly by switch from government bonds into covered bonds. On the European and Asian central banks, as a means to reduce flip side if credit spreads start to widen then I would expect traditional exposure to US government debt and US credit investors to bail out of riskier instruments into dollars. A trend toward selling down these US assets in covered bonds to maintain returns without exposure to favour of euro-denominated holdings has added yet further weight to the amount of central bank buying. The downgrade or spread widening risks,”he adds.

The same factors that have positioned covered bonds in new investors have been embraced by covered bond issuers this“sweet spot”have also conspired to make sure investors some of which have extended their road shows to take in have a preponderance of cash to spend on them. “New the Asian market.“We are beginning to place bonds in Asia, issues have been digested very well and while spreads on often with central banks or agencies linked to the existing issues used to widen with new issues that has been government,” says Alain Marcel head of investor relations less evident recently, so clearly there is new money coming at CIF Euromortgage, which issues covered bonds on into the market,”says Heiko Langer, covered bond analyst behalf of Crédit Immobilier de France.

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

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Department and the Bank of Italy, the central bank, which Central banks tend to be interested in bonds with three are responsible for producing secondary legislation needed to seven year durations. This has meant that supply at the to open the market, move to put the measures in place and short-end of the market has been particularly tight – all the how quickly banks are prepared to move after that. “I do more so as issuers have recently focused on long-dated not think we will see a first issue under the new legislation bonds of 10-years or more. Given the reasonably assured in the first half and perhaps not until late in the second half assumption that demand for covered bonds will continue of the year,” says Langer. In the event that Langer’s more to be strong over the coming year any easing of the current pessimistic prediction eventuates, Italian issuance could be supply/demand imbalance will by necessity arrive via an far lower than many are predicting.

Even if Italy proves ‘fashionably’ late, there remains hope increase in new issuance. The good news on that front is that most commentators agree that total issuance is likely that other new and debuting markets will step in to pick up to increase over 2006. The bad news is that the increase is some of the slack. New issuance is expected next year from once again unlikely to satiate rising demand “Over 2006 I The Netherlands – where ABN Amro has said it will seek think we will see at least €140bn to €150bn,” says BNP to build a range covered bonds with different maturities; Paribas’Hubbard. Much of the increase is expected to come Portugal – which is waiting on its own covered bond from relatively new markets and from the re-emergence of legislation expected in 2006; and Nordic and Central European countries.

UK bank issuance.

Not that any of these should be relied on to significantly Banks in the United Kingdom will issue some €18bn to €22bn of covered bonds over the coming year, according to buoy supply. The size of the mortgage pool in smaller BNP Paribas estimates. That is more than double the €9bn countries ensures that issuance tends to be sporadic and that is expected to be issued this year, and should add rare, offering opportunities for investors to grab some considerable bulk to the €21.3bn of UK covered bonds diversification rather than having a tangible effect on overall supply. In terms of tipping the balance of supply already in circulation.

New issues from UK lenders dried up after August 2004 and demand in favour or investors even the new issuance after the UK financial regulator issued a letter suggesting from Italy and the UK could yet prove to be a smaller no more than 4% of bank assets should be used to blessing than they first seem.

History suggests that new national entrants to the underwrite covered bonds – a limit many smaller banks were already pushing against. New life was breathed into covered bond market tend to bring demand that is at least the market in August this year when the regulator clarified equal to their new issuance, as local banks, pension funds its position – saying it was comfortable to let banks use as and insurance companies enter their newly created much as 20% of their assets to construct covered bonds domestic market.

If covered bonds continue in their “sweet spot” there before they risk a revision of their capital requirements.

Demand for the UK covered bonds promises to be seems little reason to think that this should be any different strong. Despite having no covered bond laws the UK is next year. In fact, if Italy’s new issuance disappoints, considered to be one of the more attractive markets as a demand from Italian investors could spill over into the result of both the size and quality of its mortgage pool, the covered bonds of other nations putting further pressure on size and quality of its issuing banks, and the quality of the supply in established markets.

If supply is to gain an edge over demand it will likely fall contracts underpinning its covered bond issuance.

Of the markets expected to debut in 2006 it is the arrival to the mature markets of Germany, France and Spain to of the Italians that is most keenly anticipated. Italian banks make a difference. The prospects of that are mixed. could issue anywhere up to €10bn of covered bonds in the Commentators agree that Spanish cédulas are set for a bumper year of new coming year. That will both issuance, repeating the significantly top up to the Capturing the demand for covered bonds – performance of the past new issuance flow and The FTSE Pfandbrief Index vs. FTSE Developed Europe Index year. opens a welcome new 200 In 2005 gross issuance of front in the covered bond 180 cédulas will almost market that promises a 160 140 certainly outstrip German number of years of new 120 jumbo covered bond issuance growth – all the 100 issuance, the first time any more important given the 80 country has wrested the recent decline in new 60 pole position from issuance from more 40 Germany.

Some €45bn of mature markets. The final 20 cédulas had been issued volume of Italian issuance over the calendar year to over the coming year will FTSE Pfandbrief 10+ Index FTSE Developed Europe Index mid-October 2005, largely depend on how compared to €40bn from quickly the Italian Treasury Euro Return Index. Data as at 30 November 2005. Source: FTSE Group.

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DEBT REPORT: COVERED BONDS 72

augmented by the maturing of significant tranches of Pfandbriefe in 2006.

One way or another 2006 looks likely to be a good year for covered bond issuers and another lean one for investors.

A BRIEF HISTORY OF COVERED BONDS

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Derry Hubbard, product head of covered bonds at BNP Paribas.

“The market has been particularly strong in the last couple of years as bank buyers have put liquidity to work in the market since the bonds have offered a good spread over swaps,” says Hubbard. Photo: BNP Paribas, November 2005

Germany, according to figures provided by BNP Paribas.

The coming year should see the Spanish banks repeat the trick. “There will be fewer new issuers [in Spain] but the amount of mortgages means current issuers have scope for another active year,” says Langer. In contrast to the burgeoning Spanish market, issuance of French obligations foncières (the name given to French covered bonds) is tipped to fall over the coming year, continuing a trend that has seen new issuance fall from about €12m in 2003 to €10m last year, to under the €10m mark this year.

The rate at which the French market appears to be shrinking may not be as drastic as first appears. A significant amount of new issuance is being placed via private sales that do not appear on the radars of the market surveys. Such issuance is expected to increase in the coming year and could, at least superficially, lead to further falls in the size of French new issuance.

Meanwhile, the arrival of new legislation in the German market looks likely to give the old man of the covered bonds market a new spring to its step. After years of falling issuance in jumbo Pfandbriefe Germany could see an increase in new issuance over 2006 – albeit a modest one.

The reason for this is a change in regulation. Over the coming year Germany’s Landesbanks will lose government support that has until now enabled them to tap financing at rates typically reserved for states. The loss of this backing should make the idea of issuing covered bonds more attractive. “The cost of Landesbank funding has already risen in anticipation of the change to the law but I expect that it will really start to bite next year and they could become more active users of the Pfandbriefe,” says Preusser.

The increase will likely be digested by the German market, which will see the usual demand for covered bonds

he covered bond market traces its origins back more than 230 years to the birth of Germany’s Pfandbriefe. For most of their history the bonds remained a curious niche instrument, mired in the backwaters of Germany’s financial markets. That changed in 1995 when German lenders launched the first jumbo Pfandbriefe. Jumbo’s introduced liquidity and size to the covered bond market, making them attractive to a wider range of investors. They are popular because they enjoy a water-tight guarantee backing the bond—although that has never been put to the test, as the instrument boasts the remarkable achievement of having no defaults over its long history.

During the last five years, however, the European covered bond business has grown increasingly competitive, and the Pfandbrief's position as the dominant asset class has weakened somewhat. In 2000, for example, German issuance accounted for about 80% of overall covered bond volumes in Europe.

By the end of 2004, this ration had fallen to 50%.

In July 2005 the German parliament passed a major reform of the Pfandbrief law, to coincide with the withdrawal of state guarantees for German public sector banks (Landesbanks). The law amalgamated the Mortgage Bank Act, the Public Pfandbrief Act and the Ship Banking Law into a single law and abolished the principle which only allowed specialist mortgage banks and Landesbanks to issue Pfandbriefe. Now any credit institution holding a licence from the German financial regulator can issue Pfandbriefe, as long as they meet the specific requirements contained in the new law.

Importantly the Act ensured that Landesbanks could continue issuing Pfandbriefe even though they would no longer have recourse to highly rated stateguaranteed paper that in the past had enabled them to achieve more attractive funding costs.

The success of jumbo Pfandbriefe meanwhile caught the attention of non-German lenders and in 1999 Spain and France launched their own covered bonds, called respectively cédulas hipotecarias and obligations foncières. More recently they have been joined by Austria, the United Kingdom (which in 2003 became the first country to issue a covered bond without specific legislative backing), Ireland, The Netherlands and Finland. In 2006 Italy, Portugal are expected to join the market while both Nordic and central European countries are also expected to move toward passing legislation that will facilitate covered bond issuance there.

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

comeback Chairman and chief executive officer (CEO) John Mack, nicknamed ‘Mack t he Knife’ after an aggressive job cutting spree in the 1990s, returned to Morgan Stanley in June replacing Philip Purcell, who was forced out after a bitter public battle. Since then Mack has tried hard to stem departures of the bank’s most productive bankers and traders, address legal setbacks and restore investor confidence.

In mid-November 2005 Mack told investors that he wants to double profits within five years by expanding a number of capital markets and investment banking businesses. Morgan Stanley also expects to rebuild its private equityinvesting business and revive its retail brokerage. Bill Stoneman assesses Mack’s chances of success.

trail

BANK PROFILE: MORGAN STANLEY

On the

The world headquarters of Morgan Stanley in New York. The photo was taken on Friday, Sept. 2, 2005. Photo sourced from: Associated Press/EMPICS. Photographer: Mark Lennihan.

ORGAN STANLEY HAD a hand in quite a share of the biggest business deals around the globe last year, proving that it still remains a financial powerhouse. It was a lead underwriter in the biggest initial public offering through the first 10 months of 2005, an $8bn offering by China Construction Bank Corp. The bank advised Unocal Corp alone last April in its $18bn sale to the Chevron Texaco Corp. And it won at least a share of financial advisory fees awarded in connection with a raft of last year’s biggest mergers and acquisitions, such as Mitsubishi Tokyo Financial Group’s $41bn acquisition of UFJ Holdings Inc as well as SBC Communications Inc’s $22bn takeover of AT&T Corp. The storied Wall Street firm managed to be ranked fifth in global debt and equity underwriting through the first three quarters

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FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

of last year, according to information services provider Thomson Financial, and second in global mergers and acquisition fees. Not bad for a firm that found itself in a certain amount of turmoil over the last year and a bit.

Still, months after harsh critics of the firm were quieted by the appointment of a popular former president as chairman and chief executive officer, it still is nowhere near clear whether Morgan Stanley is better off or worse for wear than it was a year or two ago. The firm’s stock price, which has moved little since John J. Mack made his triumphant return in June, seems to be saying, “Wait and see.” And that may not be a bad idea. As Merrill Lynch analyst Guy Moszkowski put it in the stilted language of a research note to investors in early November: “Under new

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BANK PROFILE: MORGAN STANLEY 74

Indeed, there are plenty of observers who say that Morgan Stanley’s earnings and stock price will pick up soon enough.

“I’m confident that they still have one of the premier franchises on the institutional securities side of the business,” says Michael Hecht, an analyst with Banc of America Securities. Morgan Stanley’s stock has lagged behind Goldman Sachs, Bear Stearns and Lehman Brothers in the last couple of years, he explains, primarily because it does not have as large a share of its business (as they do) in fixedincome trading, which has performed especially well lately.

leadership, progress likely in improving institutional trading, retail revenue. But pace likely to be slow and . . . comparisons with key peers will likely remain unfavorable for a time.”

For while John Mack has calmed broiled waters and the firm’s investment banking prowess appears undiminished, many questions invariably remain for investors seeking betterthan average growth. Among them: Can Morgan Stanley attract more affluent investors to its retail stock brokerage business? Does the Discover credit card business belong under the same roof as bankers who provide sophisticated financial advice to the world’s biggest corporations? What are the prospects for sustaining earnings growth in the firm’s trading business? Perhaps the question still looming largest is: what does Mack himself bring to the table?

Such questions are asked particularly often these days in light of a rather tumultuous period for the firm in the first half of 2005. Frustrated by what they said were years of poor performance, a group of former executives called on Morgan Stanley’s board, beginning in March, to either dismiss then-chief executive officer Philip J. Purcell or spin off the investment banking and trading businesses.

The group castigated Purcell in a letter to Morgan Stanley’s board that it published in The Wall Street Journal, citing problems with the firm’s share price, earnings growth, return on equity, pre-tax margins in the retail brokerage business and growth in assets under management. Then Purcell and the firm’s board did about everything they could to make the situation look worse over the next couple of months. Purcell relieved executives who seemed like they might be sympathetic to the Group of Eight, as the former executives called themselves, of their responsibilities. He promoted others seemingly for their loyalty to him and made no comment as five members of the firm’s 14-person executive committee walked out the door.

Eventually, a drumbeat of news – about a board that seemed beholden to Purcell, about the evident weak performance of the firm’s retail brokerage business and about the departure of people like Vice Chairman Joseph F. Perella, who supposedly reeled in business like no one else – became too loud to ignore. Purcell said in June that he would step aside when a successor was picked.

But the missteps continued. The board member who headed the search for a new chief initially specifically ruled out Mack, who left Morgan Stanley three years earlier. Then, within two weeks the board did turn to Mack, amid a crescendo of news accounts suggesting that

he was the overwhelming favorite of investment bankers and traders who had not jumped ship.

“This was about the most unusual Wall Street coup d’etat there ever has been,” says Roy C. Smith, a professor of finance at New York University’s Stern School of Business and a former Goldman Sachs & Co. partner.

Arguably, Morgan Stanley was never in the dire straights that the retired executives depicted.

“All these cranky old Morgan Stanley types,” Smith says,“got together and decided that although they had done very well with their stock throughout the time that they owned it, in the last year or so the stock had done poorly relative to the firms these old guys thought were Morgan Stanley’s principal competitors.”

Indeed, there are plenty of observers who say that Morgan Stanley’s earnings and stock price will pick up soon enough. “I’m confident that they still have one of the premier franchises on the institutional securities side of the business,” says Michael Hecht, an analyst with Bank of America Securities. Morgan Stanley’s stock has lagged behind Goldman Sachs, Bear Stearns and Lehman Brothers in the last couple of years, he explains, primarily because it does not have as large a share of its business (as they do) in fixed-income trading, which has performed especially well lately. The environment for equities will improve again, however, he said, giving an advantage to Morgan Stanley.

And by all accounts, Morgan Stanley remains a marquee name to large corporations and bright young people looking for a place to make a career.

Still, there is widespread sentiment on Wall Street that the 1997 merger of Dean Witter Discover & Co and Morgan Stanley Group Inc that created what was initially called Morgan Stanley, Dean Witter, Discover & Co. has done little that the two firms could not have done on their own. And while Mack moved quickly to put new managers in charge of several units and has attracted new directors to the firm’s board, those are just early steps. Reflecting the view that the Dean Witter-Morgan Stanley combination was a bust, the Group of Eight said last March that Morgan Stanley’s stock had declined 28% over a five year period while an index of seven key competitors rose 4.2%.

The group said that earnings-per-share growth lagged behind competitors over several time periods. It added that a significant reason for the weak stock price and earnings was poor performance of the retail brokerage business and a failure to integrate it effectively with the investment banking business. To a large extent, the brokerage business is the former Dean Witter business, which Purcell had

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

headed. The investment banking business mostly reflects the historic Morgan Stanley franchise, where Mack had been the second in command.

More recently, Morgan Stanley’s results through the first three quarters of 2005 were decent, but lagging some of its competitors’ numbers. Earnings per share from continuing operations were up 4% in the first nine months of 2005.

Earnings per share were down 23%, however, after including one-time payouts to Purcell other executives who left and other charges. The stock price has climbed from a low of $48 in May to the low $50s, where it has remained since June.

And so although the mergers and acquisitions and debt and equity league table rankings are impressive and maybe even show that even the highest-profile bankers are replaceable, pumping up earnings and getting the stock price moving again does not look that easy. For one thing, as the Group of Eight argued, three consumer-oriented businesses – the retail stock brokerage, the Discover credit card and asset management – are relatively weak performers.

Significantly, although Mack has signaled his intent to hold onto the consumer businesses, which together accounted for 42% of revenue and 38% of income before taxes in the first nine months of 2005, some analysts and investors say they’d like to see Morgan Stanley sell them.

Merrill Lynch’s Moszkowski downgraded Morgan Stanley from buy to neutral in October in part because Mack decided not to sell the credit card business, which Moszkowski previously figured was worth more to a buyer than it was to

Morgan Stanley. The firm said in Purcell’s waning days that it would explore selling the credit card business.

Fixing the brokerage business, where traditional stock and bond sales commissions have been squeezed hard industrywide by online discounters, may be Mack’s most acute challenge. As difficult as the business is for everyone, Morgan Stanley brokers appear to be less productive than many of their peers. Morgan Stanley brokers generated an average of $431,000 in revenue in 2004, according to a Group of Eight presentation. (The Group of Eight are retired and former executives of Morgan Stanley, who organised themselves to muster for change.) By comparison, average revenue was $533,000 at Citigroup’s Smith Barney, $697,000 at Merrill Lynch and $680,000 at Wachovia Securities.

By most accounts, the old Dean Witter brokers do too much low-margin stock and bond business with people of relatively modest means. Observers say they need to capture more affluent clientele and then offer a wider range of financial services to them, including mortgages, insurance and banking services. Shifting up-market, however, is bound to be really difficult and could easily touch off a bidding war for top talent.“It is very difficult to bring in high-producing brokers,” said Rick Peterson, president of Rick Peterson & Associates, a brokerage industry headhunter in Houston. “It’ll probably set off another round of recruiting frenzy.”

In one of his early moves, Mack hired James Gorman, who had led Merrill Lynch’s retail brokerage business, to fill

In a historic file photo John J. Mack, left, then president of Morgan Stanley, and Philip J. Purcell, then chairman and chief executive officer of Dean Witter, Discover & Co., discuss the $9.9bn merger of Morgan Stanley and Dean Witter, Discover & Co., way back on Wednesday, Feb. 5, 1997, in a news conference in New York. Morgan Stanley named former president John Mack as its new chairman and chief executive officer on Thursday, June 30, 2005, replacing Philip Purcell at the head of one of Wall Street’s most storied investment banks.

Photo: Associated Press /EMPICS. Photographer: Kathy Willens

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

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BANK PROFILE: MORGAN STANLEY 76

whether its earnings should the same role at Morgan grow and at what pace.

Stanley. Under Gorman, In one of his early moves, Mack hired Unlike investment banking Merrill’s Global Private James Gorman, who had led Merrill or the retail brokerage Client Group’s pre-tax Lynch’s retail brokerage business, to fill business, it depends little on margin rose to 19% in 2004 the same role at Morgan Stanley. Under attracting and retaining from 9% in 2001, Morgan Gorman, Merrill’s Global Private Client customers, making it tough Stanley said in an to guess about a firm’s announcement.

Gorman, Group’s pre-tax margin rose to 19% in prospects. “How sustainable however, does not actually 2004 from 9% in 2001, Morgan Stanley it is difficult to say,” says join Morgan Stanley until said in an announcement. Gorman, Svilan Ivanof, a vice February, due to constraints however, does not actually join Morgan president and director with in his contract with Merrill.

Stanley until February, due to constraints Boston Consulting Group, In the mean time, Mack speaking of the trading fired about 1,000, or 10%, of in his contract with Merrill. business in general, not Morgan Stanley’s lowest Morgan Stanley’s in producing brokers in a bid to cut costs. Problem is, getting rid of unproductive brokers will particular. Brad Hintz, a securities industry analyst with not do much to reduce overhead unless the firm closes offices, Sanford C. Berstein & Co Inc, a unit of Alliance Capital too, says Danny Sarch, president of Leitner Sarch Consultants, Management LP, echoes that sentiment, also referring to the industry rather than just Morgan Stanley he says, “An a brokerage recruitment firm based near New York.

Investors have plenty of doubts about the asset analyst who is truthful to you is going to say, ‘I really have management and credit card units as well. Morgan Stanley a difficult time forecasting the trading business.’”

In some respects the biggest question mark of all hangs has $428bn under management, including assets managed through its Van Kampen mutual fund family. It is very difficult, over Mack’s head. He’s generally well regarded. But unlike however, for brokers to sell in-house asset management today Purcell, who nurtured development of the Discover credit without exposing themselves to accusation of putting the card at the old Dean Witter, Mack isn’t associated with any firm’s interest ahead of its client’s, said Anton Schutz, whose particular project or accomplishment. Mack joined Morgan Mendon Capital Advisors owns 137,000 shares of Morgan Stanley in 1972 as a trader in the bond department. He rose Stanley, virtually eliminating the one-time rationale for the to head of fixed income sales in 1984 and then the head of asset management business. Of the Discover business, Schutz all fixed income business in 1987. He was named chief said,“There are no synergies.”Meantime, Argus Research Co operating officer in 1992 and then president a year later.

Mack left Morgan Stanley in early 2001. And though he analyst David Ritter called Discover a “lower-return, lowernever said why publicly, it has been widely reported that he growth”unit in a research report.

Investors and analysts are far more bullish about Morgan did not believe that Purcell would fulfill an agreement Stanley’s institutional securities business, as it calls its apparently made in the course of sealing the deal to investment banking and trading units, which accounted for combine Dean Witter and Morgan Stanley. Purcell agreed, 58% of revenue and 62% of earnings before taxes in the according to published accounts, to give Mack the top job first three quarters of 2005. Additionally Morgan Stanley is at the combined firm after holding it a few years himself.

Months later, Mack was named president of Credit Suisse perennially a leader in underwriting as well and advising on mergers and acquisitions. Perella, the former vice First Boston (CSFB), the American investment banking arm chairman and investment banking star, reportedly earned a of Credit Suisse Group, where trouble was brewing. Costs $40m fee on his own in the weeks after he left Morgan were soaring out of control and regulators were beginning Stanley by advising MBNA Corp on its $30bn sale to Bank to ask questions about how the firm’s technology group, led of America Corp., giving investors reason to worry about by Frank Quattrone, allocated shares of initial public the damage done by the executive suite struggle. Overall, offerings. Mack cut CSFB’s staff by 6,000, including however, the firm seems to be doing fine without people Quattrone, who was charged with and eventually convicted of obstructing investigators looking at his business. With who left when leadership looked shaky.

But just what even that is worth is not clear. Within the improving fortunes at the firm, Mack was named in 2003 institutional securities business, underwriting and financial co-CEO of the parent Credit Suisse Group. A year and half advisory are dwarfed by sales and trading, about which later, however, Mack was out of work again. With little Morgan Stanley doesn’t even report earnings. Sales and fanfare and just a hint that differences swirled over whether trading generated 76% of institutional securities revenue in the firm should remain independent or find a merger 2004, compared to just 24% for the traditional underwriting partner, Credit Suisse declined to renew Mack’s contract.

Unlike Purcell’s departure from Morgan Stanley, which and advisory businesses, according to a Boston Consulting Group analysis of Morgan Stanley financial reports. Trading was chronicled in excruciating detail, Mack’s separation appears to be hugely profitable up and down Wall Street, from Credit Suisse garnered little attention after the first few but it is difficult for analysts to even form a judgment on days and provoked little speculation about what happened.

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

AUTOMOTIVES: HYBRIDS

HYBRIDS TAKE THEIR TURN

It used to be that ‘going green’ was a concept reserved mainly for activists and the environmentally enlightened. But as Americans face the growing reality of unstable gas prices and continued foreign-fuel reliance, exploring alternative modes of transportation is fast becoming a very mainstream pursuit and – for some savvy investors at least – a potentially profitable one at that. Dave Simons reports.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

URING THE FIRST part of 2005, the push for fossil-fuel substitutes gained further ground in the United States (US) as gas prices reached new heights and tensions over the war in Iraq continued to mount. Then, back-to-back hurricanes named Katrina and Rita arrived, with strong winds that damaged and then crippled Gulf Coast refineries and proved that America’s vulnerability was not limited to external forces. While service stations were advertising $4-a-gallon gas, auto dealers such as Toyota, Honda and Ford began to struggle to keep up with orders for its fleet of hybrids – vehicles that utilise both conventional fuel and battery power for energy. At a conference in early September, James Press, president of Toyota Motor Sales in the US indicated that demand was such that its leading hybrid model, the Prius, was at “zero inventory”.

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AUTOMOTIVES: HYBRIDS Daimler/Chrysler Motor show: Dr. Dieter Zetsche, Member of the Board of Management of DaimlerChrysler AG, responsible for the Mercedes Car Group presents the new Mercedes-Benz S-Class at the 61st International Motor Show in Frankfurt: Photo courtesy of Daimler/Chrysler, November 2005.

Nor has alternative fuel (nowadays jauntily referred to as alt-fuel) fever been limited to the new-car showrooms.

Shares of companies that manufacture micro-turbines, or develop fuel-cell technologies and/or provide other forms of alternative-energy products for the auto industry have been snapped up by profit-seeking traders eager to get in on the ground floor. Since hybrids cannot function without their electric power source, many energy-sector specialists (or mavens) have taken up positions in firms that produce the batteries for the vehicles. Once such company is Energy Conversion Devices, which is the country’s leading supplier of nickel metal hydride batteries used by hybrids. Energy Conversion Devices has seen its stock price nearly triple over the past 12 months.

A quick trip through the history books reminds us that niche markets do not always have the longest life span. In 2001, for example, a sudden price spike at the petrol pumps gave a similar boost to companies in charge of developing alternative automobile power technologies. By the end of that year however gas prices had once again drifted downward and, along with them, the stock of many of those green companies. Similarly, this past summer investors have piled high into micro-turbine maker Capstone Turbine sending its stock price rocketing from less than a dollar per share to a year-to-date high of nearly $6 by mid-September. But as the panic over extreme fuel prices leveled off, Capstone’s shares took a plunge, and as of November traded around $2.50.

But many believe that long-term alternative energy investors may very well be on the right track this time around. Even though domestic fuel prices have fallen considerably since their post-Katrina highs, Americans –

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who readily responded to the lure of cost-effective Japanese automobiles during the gas-crunch days of the late 1970s and early 1980s – now appear ready again to enter a new era of fuel efficiency and environmental enlightenment after years of gas gluttony. At least for the time being, the hybrid appears to be the solution.

Driving Force First developed in Japan during the early 1990s, the hybrid propulsion system employs a combination of gasoline and electricity, which work in tandem during periods of acceleration and other operations requiring added power.

During normal driving activity, power from the engine fuels a generator that keeps the battery recharged; kinetic energy released during braking is also converted and stored for later use. Because of its dual power source, the engines of hybrid vehicles are subject to less wear than conventional gas-powered engines and, best of all, have higher fuel-efficiency and improved emissions ratings. First on the market was Toyota, which introduced its popular Prius model in 1997. Two years later Honda made its debut with the Insight, which was the first hybrid car to be sold in the US. Today, Honda offers hybrid versions of its flagship Accord and Civic models, while Toyota entered the sports utility vehicle (SUV) market with its combo-powered Lexus and Highlander models. The company has also indicated significant demand for a hybrid Camry, slated to become available next year.

Like any new technology, hybrids are more expensive than conventional vehicles. However, to help offset the extra cost and give incentive to prospective drivers, the US Energy Policy Act of 2005 offers hybrid-vehicle owners a tax

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

credit of up to $3,400. According to marketing-information services firm JD Power and Associates, sales of hybrids will top the 400,000 mark by next year, a six-fold increase since 2004. Analysts predict that in the future hybrids could potentially account for 10% to 15% of all auto sales.

While other global automakers have jumped into the hybrid ring – including, belatedly, Detroit’s Big 3 (Daimler/Chrysler, Ford and General Motors) – Toyota remains well ahead of the pack. Toyota is so convinced that hybrids are the industry’s next big thing that it remains, in fact, the only automaker to produce power-trains for nearly every kind of vehicle – including front and rear-drive, cars and trucks, and 4-cylinder to 8-cylinder engines. Toyota has devoted huge chunks of its substantial operating capital to hybrid research and development (R&D), resulting in the creation of hundreds of patents, some of which have been licensed by the company’s competitors, including Ford.

As one might expect, the push for alternative-energy products has the investment community seeing green. In a precedent-setting move, Merrill Lynch recently partnered with environmental non-profit organisation World Resources Institute (WRI) for a report entitled SocialFunds.com that links the demand for eco-friendly resources with compatible investment opportunities.

Policies aimed at reducing greenhouse gas (GHG) emissions will continue to expand worldwide, according to the report, and companies that can provide the means to reduce carbon dioxide and other tailpipe emissions by offering fossil-fuel alternatives may benefit greatly over the long term.

For the auto industry, the main challenge over the nearterm will be responding to consumers who demand environmentally compatible vehicles with the same performance and features found in conventional automobiles. Speaking on behalf of the report’s authors, John Casesa, Merrill Lynch global auto team coordinator, says,“This is what we mean by the Clean Car Revolution: in a world of finite resources, higher consumer expectations are stimulating a technology race to meet them. For investors, solutions to these challenges present a compelling investment opportunity.” Companies that appear to be well positioned to meet this challenge include BorgWarner, Toyota, Hyundai and Magna International, according to the report.

Detroit Delay With the hybrid market heating up, US auto manufacturers find themselves in a familiar position: far behind. Recent research found that Japanese automakers accounted for more than 96% of all hybrid vehicles currently registered in the U S. When a shortage in battery packs threatened hybrid production, Toyota moved quickly by increasing its ownership stake in battery supplier Panasonic EV Energy, giving the company parts dominance as well.

Unlike its Detroit competitors General Motors and DaimlerChrysler, Ford has come around to the idea of a hybrid future, and in late 2004 the company unveiled its Escape Hybrid, which became the first hybrid SUV on the market. The Escape will be joined by the 2006 Mercury

Hybrid Taxis In San Francisco: Feb 2005 San Francisco Mayor Gavin Newsom welcomes ten 2005 Ford Escape Hybrid taxis to his city’s Yellow Cab fleet, the first hybrid SUV taxi fleet in use in the United States.

Gasoline-electric hybrid SUVs deliver an EPA-certified 36 mpg in city driving, and 31 mpg in highway use and will save San Francisco’s Yellow Cab Cooperative thousands of dollars over the life of the vehicles.

Photographer: Kim Kulis; Photo courtesy of the Ford Motor Company, November 2005

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

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AUTOMOTIVES: HYBRIDS

Mariner Hybrid SUV, which will offer fuel economy nearly twice that of the standard model. Ford’s gains in the hybrid arena, however, have been somewhat tempered by the fact that it opted to pay Toyota a licensing royalty due to similarities that existed between its hybrid system and that of Toyota’s.

Not surprisingly, General Motor’s vice chairman Bob Lutz was only more than happy to take a jab at his crosstown adversaries.“If hybrids are going to be a factor,”Lutz said recently,“Do we really want to place ourselves in the hands of our largest and most aggressive competitor, and be technology dependent?”For his part, Lutz, who in 2002 proclaimed that hybrids would never find mass acceptance in the US, was forced to eat his words in the face of overwhelming demand. But while GM plans a 2006 rollout of Dodge Ram and Saturn VUE hybrids, Lutz maintains that hybrids will not rule the road forever, and, along with Big 3 counterpart DaimlerChrysler has piloted a course towards the development of hydrogen fuel cells. However, such technology may take upwards of 20 years to be fully DEARBORN, MICHIGAN: Nancy Gioia, Ford’s newly appointed implemented, during which time hybrid makers could director of Sustainable Mobility Technologies and Hybrid Systems achieve a significant leg up on the competition. (right center), reviewing the Ford Hybrid Escape engine with other Still, some critics charge that the modest efficiency gains leaders of Ford’s Hybrid team, including (from left to right) Mark don’t always justify the extra expense of certain hybrid Jessup, engineer technician, Sustainable Mobility Technologies; Tom models, which can run anywhere from $2,000 to $5,000 Watson, manager, Propulsion System Implementation, Sustainable more than their standard counterparts.“In the view of the Mobility Technologies; Gill Portalatin, chief engineer, Hybrid Drive major car companies, hybrid technology can only be an Systems; John Sullivan, director, Hybrid Vehicle Program; and James interim technology, as it involves adding substantial weight Holland, chief engineer, Gen II Hybrid Programs. to each car, not to mention the added cost of the electric Photo courtesy of Ford Media, November 2005. systems and power-train,” offers Harald Hendrikse, equity research analyst for Credit Suisse First Boston.“The actual and the car companies seem confident that they can meet fuel efficiencies achieved on the combined cycle – that is, the most stringent emission standards, and still achieve not just in urban situations – is also not as impressive as better fuel efficiency and costs than for hybrids.”

Even if hybrid technology isn’t the absolute best generally believed, and struggles to compete with the best technology, that does not mean it will not succeed on the diesel-engine technology in terms of fuel efficiency.”

Indeed, diesel-powered vehicles have been an sales front, adds Hendrikse.“Toyota is doing a great job of overwhelming favorite in Europe, where they account for associating the technology with fuel efficiency and as much as 50% of all new car sales. While diesel cars, like environmental credentials in the US and this can only help hybrids, cost at least several thousand dollars more than their long-term franchise,”he says.

At the very least, many consumers view the hybrid as an traditional vehicles, because diesel is cheaper to refine and opportunity to make a is somewhat cleaner than personal statement about gas-burning engines, many Hybrids the product of the future? the direction of the Europeans consider these 175 economy, world politics cars a viable alternative.

150 and, most importantly, the BMW and DaimlerChrysler environment. “What is the are among the companies 125 cost of fuel?” observed that have stated their 100 Toyota’s James Press preference for diesel75 recently. “It is not just [the powered vehicles over price of] a gallon of gas. It hybrids.

“Diesel can 50 is the cost of a war in Iraq. achieve the same fuel 25 Or it is the cost of efficiency as hybrids under pollution. Or the fact that most driving conditions, Toyota Motor Honda Motor Co Ford Motor you've only got 75 years of especially on longer General Motors Corp FTSE Developed Automobiles & Parts All Cap Index this stuff left on the planet. journeys,” says Hendrikse.

At some point, the industry “Diesel-engine technology has to recognise this.” is continuing to improve, Price Returns (USD). Data as at 30 November 2005. Source: FTSE Group/FactSet Ltd.

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

From the series Renato the Tiger.

Photographer: ALiJA, Agency: Istockphotos.com, November 2005.

Taming India’s Mutual Funds LTHOUGH ESTABLISHED WAY back in 1964, it is best said that India’s mutual fund industry has only come into its own over the last ten years.The catalyst for change came in 1993 when, for the first time, private sector players were allowed in the market. Until then, under a protectionist regime, only state-backed entities ruled the roost. In the same year, formal regulations were laid out that govern all mutual funds. All excepting UTI – the investment vehicle of choice for millions of middle class Indians – which accounted for well over 80% of the mutual fund market at that time. Ironically however, the special status accorded to UTI by the Indian government proved to be its undoing and to a large extent contributed to its much-

A

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

FUND PROFILE: INDIAN MUTUAL FUNDS

The domestic Indian mutual fund industry has come a long way since its origins four decades ago when the country saw the launch of its maiden mutual fund; the government sponsored Unit Trust of India (UTI). The industry has grown from an initial asset size of $5.5m to over $45bn in 2005 and compared to the lone UTI which launched with a single scheme back in 1964. There are now well over 400 products and 29 players in the market. Rekha Menon reports.

publicised financial crisis in the late 1990s. UTI’s flagship US64 scheme (which has over 20m investors and a 37 year unblemished track-record as a dividend-paying secure and liquid fund) ran into trouble when it became clear after a stock market fall that the price at which investors could redeem from the scheme was higher than the value of the assets available to meet such redemptions.

This exposed a saga of alleged financial mismanagement and political interference. The situation was brought under control only through government intervention. UTI Mutual Fund, the main entity that emerged from the restructuring of the erstwhile UTI, now operates like all other mutual funds in the country under the ambit of the capital market watchdog,

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FUND PROFILE: INDIAN MUTUAL FUNDS 82

protection, an essential Securities and Exchange ingredient to enhance the Board of India (SEBI).

The trend towards more flexible ability of the mutual fund Industry experts often exchange rates reduces the risk of the industry to mobilise regard the UTI experience mis-matches that caused the late-1990s savings on a wider scale. as a coming-of-age of the Asia crisis; holding assets in local Unlike in many other fledgling Indian mutual countries, retail fund industry. Ravikanth currency, but borrowing in US dollars. participation in the Indian Konteti, vice president, Flexible foreign exchange rates also cut mutual fund industry is India Operations manager, the risk of a run on foreign reserves that very low. According to at JPMorgan Treasury and often trigger more serious problems.

SEBI records, at the end of Securities Services, says, March 2003, corporates “The UTI crisis has in a way controlled 57.12% of total provided an opportunity for funds under management, the government and SEBI INDIA’S MUTUAL FUND INDUSTRY even though they to drive much needed THE GROWTH IN ASSETS UNDER MANAGEMENT represented only 2.04% of positive changes in the FROM 1964 TO 2004 the number of unit holder local market. First of all it 180000 accounts.

Mrugank established the fact that 155845 160000 153108 Paranjape, who looks after state could not provide 140000 121805 150537 139616 product and client guaranteed schemes and 120000 management at Deutsche that there could not be 87190 100000 79464 Bank’s domestic custody different regulations for 80000 services in India states that UTI and rest of mutual fund 60000 47000 at present only a small industry. Finally, the public 40000 percentage of the started understanding the 4564 20000 25 population is involved in concept of net asset value 0 mutual funds and with (NAV) based returns.”

Phase IV since Feb 03 investor education, there is Most importantly, the UTI Years a huge potential for the crisis underscored the mutual funds market to importance of a robust PHASE I: 1964-87 grow. Not only is there regulatory framework that PHASE II: 1987-1993 Entry of Public Sector (state-backed) Funds much more investment in governed all players in the PHASE III: 1993-2003 Entry of Private Sector Funds the stock market as industry and PHASE IV: 2003 onwards compared to mutual funds, comprehensively addressed Note: Erstwhile UTI was bifurcated into UTI Mutual Fund and the Specified Undertaking the overall retail savings issues such as accountability, of the Unit Trust of India effective from February 2003. The Assets under management pool in commercial banks risk management and of the Specified Undertaking of the Unit Trust of India has therefore been excluded is comparatively much investor protection. from the total assets of the industry as a whole from February 2003 onwards. higher than that invested Currently, the Indian Source: Association of Mutual Funds in India (AMFI) November 2005. in the mutual fund market. mutual fund industry But to increase levels of retail participation in mutual functions under the SEBI (Mutual Fund) Regulations 1996 that substituted an earlier set of regulations introduced in funds, along with investor education, it is imperative to 1993. Working in concert with Association of Mutual Funds improve regulation and corporate governance standards. in India (AMFI), the mutual funds trade association, SEBI is Especially since the track record is not very encouraging on widely credited with providing a patient ear to the the latter aspect. In recent years mutual funds have received a lot of flak from the local press about questionable practices industry’s grievances and responding accordingly.

Nilesh Shah, chief investment officer at Prudential ICICI such as late trading, dividend stripping and running of Mutual Fund – one of the top funds operating in the certain schemes with a single investor. It is suggested that in country – commends the role played by Indian regulators. their rush to increase assets under management, mutual They “have evolved over time and there are now robust funds have indulged in unethical practices and launched guidelines in place for industry players. In terms of schemes that benefit their main customer base, institutional disclosures and best practices, we are equal or way ahead investors, at the cost of retail investors.

In 2004 SEBI took corrective action to curb late trading of other much more mature markets,”he says.

Despite such upbeat sentiments, critics complain that by introducing uniform cut-off timings for equity and SEBI has followed a trial-and-error approach to plug debt funds and asking Asset Management Companies loopholes in the system and that it does not always work (AMCs) to set up time-stamping machines that would proactively. Industry experts also believe that regulation keep track of the date and time when applications and needs further strengthening with respect to retail investor cheques were received.

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

One idea mooted to improve governance standards and rein in unethical practices was the introduction of a professional trustee company in the mutual fund equation. This subject has been under discussion for a long time and was brought up again in a 2003 study titled Reform of Mutual Funds in India that looked at ways to encourage retail investments in mutual funds. Commissioned by the Indian Ministry of Finance, the study was carried out by the United Kingdom-based investment fund consultancy, Cadogan Financial. Among other things, the Cadogan report has recommended a model based on the one prevailing in markets such as the UK, where the functioning of more than one mutual fund is overseen by professional corporate trustees that are, “…wholly independent of Laurence Bailey, senior vice president, Asia Pacific Business Executive, at JPMorgan Worldwide Securities the AMC and its promoter Services, says,“The trustee function is very limited in the Indian funds industry. Most mutual fund trustees and which would have the have immense industry experience, but they don’t have the infrastructure to do independent reviews. necessary infrastructure Photo: JP Morgan, November 2005 and expertise to supervise mutual funds and their AMCs on a continuous basis and in a of the monitoring process undertaken by the trustees. more professional way.” Proponents of this model suggest Currently, individuals act as trustees on their own accord and that such a structure will ensure the interests of investors by we do not believe that this model is the optimal way forward.”

In recent years SEBI has taken several steps to improve keeping expenses down, offset the overarching power of AMCs and by extension make mutual funds more popular the working and independence of the trustee board and several industry participants believe that the existing norms with the public Laurence Bailey, senior vice president, Asia Pacific with regards to independence of directors of trustees were Business Executive, at JPMorgan Worldwide Securities stringent enough. While the new model would increase the Services, says, “The trustee function is very limited in the degree of independence, they suggest that the costs Indian funds industry. Most mutual fund trustees have involved would far negate the benefits. And with the immense industry experience, but they don’t have the Indian markets being very price sensitive, a professional infrastructure to do independent reviews. Most of them trustee model would not come to fruition in India. As Shah depend on the compliance officer at mutual funds to make of Prudential ICICI remarks,“the key criterion for any new certifications. Given the industry size, this works fine. But model is that it should provide value and reduce costs. I feel keeping the current growth rate in view, in the next four to that the current model works well. Our board of trustees five years, there will definitely be a need to have an comprises professional, respected and very eminent people from the industry. They really act as a watch dog.” institutional type of professional trustee framework.”

There might be divergent views on the feasibility of a Vikramaaditya, head of securities services at HSBC in India, agrees,“A professional trustee model will definitely bring in a professional trustee model, but industry participants almost greater degree of transparency and enhance the effectiveness unanimously agree the timeline for any change on this front

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

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FUND PROFILE: INDIAN MUTUAL FUNDS 84

is nowhere near. Bailey of JP Morgan, which is the largest norms and the regulatory responsibility lays with the fund trustee in the United Kingdom and hopes to extend the management companies themselves.

Paranjape explains,“The Indian mutual fund industry is well service in India, says that the firm has been having ongoing discussions with SEBI for the past three years, but no regulated to protect the interest of the investor in general. For instance, there are guidelines on the offer document, concrete steps have yet been taken.

Another major development that Bailey foresees in the investment rationale, valuation and mandatory certification. coming years is regarding growth in offshore investment by The regulation also mandates that custody can be domestic investors. “There is currently very limited independent from the fund house. But while custody activity investment by domestic mutual fund players in offshore is regulated by SEBI, third party service providers of fund markets. The next big step for the mutual fund industry will administration services are generally custodian banks who are be how to enable domestic investors to invest in the regulated by the Reserve Bank of India. The fund manager is overseas market.” When that happens, adds Bailey, responsible for the corporate governance and regulatory customers that have outsourced their fund administration compliance as well as the appointment of trustees.”

The lack of regulation is not, in fact, detrimental to the activities to JP Morgan will have a head-start over other industry, says Prudential firms. “Outsourcing their ICICI’s Shah. Being one of fund administration Building the foundations for growth – FTSE India Financials the older mutual fund activities to a global All Cap Index vs. FTSE Global Equity Index Series 450 houses in the country, custodian gives them the 400 Prudential ICICI has its assurance that when the 350 own in-house fund time comes, they will be 300 accounting team. “There is able to service multi250 no need for regulation of country, multi-asset 200 fund administrators. The classes,”he explains.

150 outsourcing can happen Third party fund 100 from a cost point of view, administration has taken off 50 but not from a in India only in the last responsibility point of couple of years with all the view.

The ultimate fund houses that have set FTSE India Financials All Cap Index FTSE India All Cap Index responsibility lies with shop during that time having FTSE Global Equity Index Series fund itself. We cannot shun adopted the outsourcing Total Returns (Indian Rupee). Data as at 30 November 2005. Source: FTSE Group. responsibility,”he adds. model. Even some of the However, Rakesh older players such as Shah of Prudential ICICI remarks, “The key Vengayil, head of asset Reliance Capital and Birla criterion for any new model is that it should management operations at Sun Life that had their own ABN AMRO Asset fund administration teams provide value and reduce costs. I feel that Management (India) Ltd. have gone for outsourcing. the current model works well. Our board of suggests that despite the “We are seeing a lot of trustees comprises professional, respected current levels of service interest from fund houses. and very eminent people from the industry. being provided by Till around a year back, some They really act as a watch dog.” custodians meeting the weren’t even willing to fund manager’s discuss outsourcing. Now requirements, regulation they have started considering it as a potential strategy,” says Paranjape of will certainly be useful for it will help in standardizing the Deutsche Bank, which has been offering the service since 1999. levels of service, “Regulators play a constructive role in the According to guidelines by the Reserve Bank of India (RBI), market and have helped the mutual fund industry in fund administration can only be offered as an adjunct to improving performance norms and matching up to custodial services. So fund houses can either do fund international standards,” he says. Regulation will also help administration activity in-house or outsource it to their satisfy concerns of fund houses that might be wary of custodian if they offer the service. Up to now third party fund outsourcing due to lack of regulation he says, noting that administration services in India have been offered by only four with more than 75% of domestic funds doing administration global banks, JP Morgan, Deutsche Bank, HSBC and Citigroup, in-house, the outsourcing business has still not achieved a which recently acquired ABN AMRO’s domestic custody and critical mass.

And therein lays the crux. Despite significant growth in fund administration business. Industry sources suggest that other domestic custodian banks, such as HDFC are now in the the past decade, at $45bn, the Indian mutual fund industry process of building up the relevant market expertise. is still a nascent entity. While existing regulations have Interestingly, SEBI does not have any specific regulations for been sufficient thus far, they might fall short as the industry third party fund administration. Compliance with investment moves into the next phase of growth.

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

Company Name

Page

ABN AMRO ABN AMRO Bank ABN AMRO Capital Alpha Bank AlpInvest Partners AltAssets America Movil America Online American Safety Razor APT Archipelago Argus Research Athens Stock Exchange Axioma Bahrain Monetary Authority Banco Itaú Banco Pactual Bank Austria Creditanstalt Bank Millennium Bank of America Bank of Bermuda Bank of Boston Brazil Bank of Communications Bank of Greece Bank of New York Bank of Shanghai Bank Pekao Barclays Capital Bayerische Hypo- und Vereinsbank Aktiengesellschaft Benson Oak Capital Berkshire Hathaway BNP Paribas BNP Paribas Securities Services Boston Beer BRE Bank Bulgaria’s Bulbank CalPERS Campbell Soup Capital Intelligence Capital Market Commission Carling Cemex Central and Eastern European Securities and Clearing Houses Association Ceskoslovenska Obchodni Banka China Asset Management Company Ltd Citibank Citigroup

27 32 32 20 70 33 36 68 47 58 75 48 8 59 43 39 39 27 27 39 53 39 53 22 52 53 27 36 27 32 75 43 28 48 27 27 1 46 43 22 47 36

26 27 8 32 27

Company Name

Page

Clark Chewing Gum 47 Clearstream 26 Cohen and Steers 14 Coors Brewing 46 Copernicus Capital Partners 33 Council of Mortgage Lenders 73 Credit Suisse Asset Management 39 Crescent Petroleum 42 CVC 32 Cyprus S.E. 8 Dana Gas 42 Delphi 68 Delta Lloyd 72 Deutsche Bank 39 Deutsche Börse 26 Disney 46 Dow Jones Index 8 Dresdner Bank 29 Dresdner Kleinwort Wasserstein 37 Dutch Mortgage Portfolio Loans 72 EFG Eurobank 20 EIRIS 8 Enterprise Investors 32 EPRA 8 Euroclear 53 Euroclear Bank 65 Euronext 8 European Central Bank 65 European Central Securities Depositories Association 26 European Union 59 Federal Reserve Bank of New York 64 Fitch Ratings 72 Foundation for Fiduciary Studies 18 FTSE Group 6 Gamet 32 General Motors Acceptance Corporation 72 GMAC-RFC 72 Goldman Sachs Asset Management 59 Grisoft 32 Gulf International Bank 42 Hang Seng 8 Hedging Griffo 39 Heineken 48 Home Depot Inc. 75 Honeywell 80 Hong Kong Housing Authority 10 Hoyt Advisory Services 14

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

Company Name

Page

HSBC HSBC Brazil HSBC Middle East HVB IMF ING Bank ING Bulgaria ING Wholesale Banking INOGATE Instinet Group Inc. Intel Capital International Capital Markets Association International Monetary Fund International Swaps and Derivatives Association Intesa Jarislowsky Fraser Johannesburg Stock Exchange JPMorgan JPMorgan Chase KBC KBC Investco KBC Private Equity Kereskedelmi es Hitelbank Kerr McGee Latibex Latsis Group Legal & General Lehman Brothers Lloyds Bank Merrill Lynch MFS Financial Investment Miller MobilTel Morgan Stanley Mylan Nabisco NAREIT NASDAQ National Bank of Abu Dhabi National Bank of Dubai National Bank of Greece New York Stock Exchange NIB Capital Nike Nordic Exchanges Nortel Networks Northern Rock Northfield Nova Ljublijanaska Banka Ohio Public Employees Retirement System

53 39 42 27 37 27 32 28 22 74 32 62 23 64 27 46 8 39 64 27 33 33 27 49 8 22 80 53 39 34 19 46 32 36 49 49 8 10 43 43 20 74 70 46 8 68 72 60 27 69

Company Name

OMX Ortelius Papst PGGM Pharma Futures Philip Morris Ping An Piraeus Bank Privredna Banka Quest RiskMetrics Group Russell RZB Santander Schlitz Securities and Exchange Commission Shell/Royal Dutch Petroleum Siveco Romania SKB Banka Smith Barney Societe Generale Standard & Poor’s Standard Chartered Bank Star-Kist Foods State Street Bank Stichting Pensioenfonds ABP Stratosphere SunGard Adaptiv Supervisory Committee of Private Insurance Taageer Finance Taiwan Stock Exchange Tel Aviv Stock Exchange Texaco The Bank of New York The Leuthold Group Time Warner TWA UBS Unibanco UNICEF Unicredito Italiano Universities Superannuation Scheme US Congress USX Wal-Mart Wilshire Analytics Xinhua Financial News XO

Page

26 33 47 70 69 46 53 20 27 68 58 8 27 39 47 18 68 33 27 48 27 43 43 46 52 67 1 61

COMPANIES IN THIS ISSUE

FTSE Global Markets Company Directory

22 42 8 10 49 62 14 49 49 43 39 8 27 69 18 49 36 59 8 49

85

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MARKET REPORTS BY FTSE RESEARCH

FT SE

MARKET REPORTS 11.qxd

Page 86

FTSE Global Equity Index Series – Global, Year to Date

31st December 2004 - 30th November 2005

FTSE Regional Indices Performance (USD) 150

FTSE Global AC

140

FTSE Developed Europe AC

130

FTSE Japan AC

120

FTSE Asia Pacific AC ex Japan

110

FTSE Middle East & Africa AC

100

FTSE Emerging Europe AC

90

FTSE Latin America AC

10

0

FTSE North America AC

FTSE Regional Indices Capital Returns (USD)

45

40

35

30

25

20

15

10

5

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FTSE Developed Country Indices Capital Returns

40

30

20

Dollar Value

Local Currency Value

-10

-20

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

MARKET REPORTS 11.qxd

7/12/05

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FTSE All-Emerging Country Indices Capital Returns 120 100 80

%

60

Dollar Value 40

Local Currency Value

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Ar ge FT ntin SE a B AC FT raz SE i l A F T Ch C ile S FT FTS E C A hi C SE E na Cz Col A o ec C m h b Re ia A p FT ub C li S FT E E c A SE gy C Hu pt A n F T ga C FT SE ry SE In AC In dia do A FT nes C SE ia A C FT Isr S a FT E K el A SE or C M ea FT alay AC SE si FT M a A C SE ex ico FT Mor A SE oc C Pa co AC ki s FT FT tan SE SE AC Ph Per u ili F T p p i n AC SE es AC Po F FT TS lan SE E R d A So us C sia ut AC FT h A SE fric FT Ta a A S E iw C Th an F T a i l AC SE an Tu d A rk C ey AC

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-20

Stock Performance Best Performing FTSE All-World Index Stocks (USD/%) Lotte Midopa 283.2 High Tech Computer 269.3 Korea Investment Hol 260.8 Perusahaan Gas Negara 248.3 Muslim Commercial Bank 216.6

Overall Index Return FTSE Global AC Index FTSE Global LC Index FTSE Global MC Index FTSE Global SC Index FTSE All-World Index FTSE Asia Pacific AC ex Japan Index FTSE Latin America AC Index FTSE All Emerging Europe AC Index FTSE Developed Europe AC Index FTSE Middle East & Africa AC Index FTSE North Americas AC Index FTSE Japan AC Index

Worst Performing FTSE All-World Index Stocks (USD/%) Doral Financial -79.5 Nakornthai Strip Mill -76.1 Prodisc Technology -68.6 Sahaviriya Steel Industries -63.4 Elan Corporation -61.5

No. of Consts

Value

3 M (%)

7,875 1,160 1,855 4,860 3,015 1,850 198 103 1,590 200 2,567 1,367

326.98 316.70 439.88 391.04 195.34 383.43 669.22 612.38 338.06 494.84 302.91 364.32

3.3 3.3 3.7 2.3 3.5 4.5 18.5 11.2 0.6 9.9 2.6 12.4

6 M (%) 12 M (%) Actual DIv Yld (%)

9.1 7.8 11.9 10.9 8.9 11.1 37.5 42.5 7.1 25.9 6.9 21.1

11.0 9.0 16.1 13.6 10.7 15.6 54.2 51.7 8.3 24.2 8.9 21.0

2.01 2.16 1.65 1.61 2.06 3.02 3.32 1.84 2.68 2.61 1.67 0.87

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

FTSE GLOBAL MARKETS â&#x20AC;˘ JANUARY/FEBRUARY 2006

87

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FT SE

ed

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FT SE

FT SE

FT SE

FT SE

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MARKET REPORTS BY FTSE RESEARCH

Co

MARKET REPORTS 11.qxd

Page 88

FTSE Global Equity Index Series – Developed ex US, Year to Date

31st December 2004 - 30th November 2005

FTSE Developed Regional Indices Performance (USD) 125

FTSE Developed (LC/MC)

120

115

FTSE Developed Europe (LC/MC)

110

FTSE Developed Asia Pacific (LC/MC)

105

FTSE All-Emerging (LC/MC)

100

FTSE Developed ex US (LC/MC)

95

FTSE US (LC/MC)

90

%10

0

FTSE Developed Asia Pacific ex Japan (LC/MC)

FTSE Developed Regional Indices Capital Returns (USD) 25

20

% 15

10

5

0

FTSE Developed ex US Indices Sector Capital Returns (USD)

40

30

20

Capital

-10

Total Return

-20

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

MARKET REPORTS 11.qxd

7/12/05

10:11 pm

Page 89

Stock Performance Best Performing FTSE Developed ex US Index Stocks (USD/%) Ibiden 177.6 Chiyoda Corp 166.4 Sumitomo Metal 156.3 Daido Steel Co 156.0 Shinko Elec Ind 150.1

Overall Index Return FTSE Developed ex US Index (LC/MC) FTSE USA Index (LC/MC) FTSE Developed Index (LC/MC) FTSE All-Emerging Index (LC/MC) FTSE Developed Europe Index (LC/MC) FTSE Developed Asia Pacific Index (LC/MC) FTSE Developed Asia Pacific ex Japan Index (LC/MC) FTSE Developed ex US AC Index FTSE Developed ex US LC Index FTSE Developed ex US MC Index FTSE Developed ex US SC Index

Worst Performing FTSE Developed ex US Index Stocks (USD/%) Elan Corporation -61.5 Domtar -56.2 Arisawa Mfg -54.9 Privee Zurich Turnaround Group -52.5 Invoice Inc -52.4

No. of Consts

Value

3 M (%)

1,371 728 2,099 916 517 783 295 3,805 561 1,855 4,860

210.29 517.86 190.37 323.59 203.45 206.56 318.70 353.55 330.19 412.34 443.31

3.3 2.7 3.0 10.7 0.6 9.2 1.8 3.2 3.1 4.1 2.5

6 M (%) 12 M (%) Actual Div Yld (%)

10.9 5.6 8.0 22.1 6.8 17.6 9.9 11.0 10.4 13.0 12.3

11.4 7.9 9.5 29.6 7.5 17.8 12.7 12.1 10.3 16.3 17.8

2.34 1.72 2.01 2.69 2.75 1.62 3.52 2.28 2.43 1.65 1.61

FTSE Global Equity Index Series – Asia Pacific, Year to Date 31st December 2004 - 30th November 2005

FTSE Asia Pacific Regional Indices Performance (USD) 120

FTSE Global AC

115

FTSE Developed Asia Pacific (LC/MC)

110

FTSE Developed Asia Pacific ex Japan (LC/MC)

105

FTSE Asia Pacific (LC/MC) FTSE All-Emerging Asia Pacific AC

100 95

FTSE Japan (LC/MC)

05

05

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90

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

89

MARKET REPORTS 11.qxd

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10:11 pm

Page 90

20

15

% 10 5

ob al AC F ia TS E Pa D ci e fic ve De (L lop ve C/ e lo M d ex ped C) Ja A pa sia n P (L ac FT C/ i f i M c SE C) A As llia Em Pa er ci gin fic g FT AC SE As D FT i a ev SE e P Ja ac lop pa ifi e c d n AC In de x FT (L SE C/ M As C) ia Pa ci fic (L C/ FT M SE C) As ia Pa ci fic FT M SE C As ia Pa ci fic FT SC SE As ia Pa ci fic LC

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M O inin il & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap e c e & rsi e & Me r En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n b Fo Go ile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca s ev ile ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al ho s H rs l & d ea Bi Pr lth ot od ec uc hn ts Ge o ne To log M r b y ed Lei al R acc ia su et o & re ai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s ica g R po tio et rt n aile Se rs r U t E l vice ilit e c s ie t r i c s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw Te & Re pan e ar ch Ot al ies e no he Es & lo r ta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

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MARKET REPORTS BY FTSE RESEARCH

FTSE Asia Pacific Regional Indices Capital Returns (USD)

Stock Performance Best Performing FTSE Asia Pacific Index Stocks (USD/%) Lotte Midopa 283.2 High Tech Computer 269.3 Korea Investment Hol 260.8 Perusahaan Gas Negara 248.3 Muslim Commercial Bank 216.6

Worst Performing FTSE Asia Pacific Index Stocks (USD/%) Nakornthai Strip Mill -76.1 Prodisc Technology -68.6 Sahaviriya Steel Industries -63.4 Aromatics -57.8 Natural Park Ltd -57.7

Overall Index Return FTSE Global AC Index FTSE Asia Pacific AC Index FTSE Asia Pacific Index (LC/MC) FTSE Asia Pacific LC Index FTSE Asia Pacific MC Index FTSE Asia Pacific SC Index FTSE Developed Asia Pacific ex Japan Index (LC/MC) FTSE Developed Asia Pacific Index (LC/MC) FTSE All-Emerging Asia-Pacific Index (LC/MC) FTSE Japan Index (LC/MC)

No. of Consts

Value

3 M (%)

7875 3217 1345 515 830 1872 295 783 562 488

326.98 371.88 210.61 354.91 417.01 431.33 318.70 206.56 228.89 135.01

3.3 8.8 8.8 8.4 10.6 8.7 1.8 9.2 7.5 12.5

6 M (%) 12 M (%) Actual DIv Yld (%)

9.1 16.4 16.4 16.0 18.3 16.7 9.9 17.6 12.1 21.1

11.0 18.6 18.0 17.1 21.9 24.1 12.7 17.8 19.0 19.9

2.01 1.82 1.83 1.88 1.63 1.73 3.52 1.62 2.60 0.87

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

90

JANUARY/FEBRUARY 2006 â&#x20AC;˘ FTSE GLOBAL MARKETS

&

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n

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FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

5

5

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ep

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5

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31

MARKET REPORTS 11.qxd

Page 91

FTSE Global Equity Index Series – Europe, Year to Date

31st December 2004 - 30th November 2005

FTSE European Regional Indices Performance (EUR) 125

FTSE Global AC (EUR)

120

FTSE Developed Europe ex UK LC/MC (EUR)

115

FTSEurofirst 300 (EUR)

110

FTSE Developed Europe AC (EUR)

105

FTSEurofirst 100 (EUR)

100

FTSE Eurozone LC/MC (EUR)

95

FTSEurofirst 80 (EUR)

FTSE European Regional Indices Capital Return (EUR)

70

60

50

40

30

20

10

0

FTSE Developed Europe Sector Indices Capital Returns (EUR)

60

50

40

30

20

Capital

10

Total Return

0

-10

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

91

MARKET REPORTS 11.qxd

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Best Performing FTSE Developed Europe Index Stocks (EUR/%) OMV 111.4 Metso Corporation 90.3 Deutsche Boerse 88.6 Lonmin 83.9 Sacyr-Vallehermoso 83.2

Overall Index Return (EUR)

Worst Performing FTSE Developed Europe Index Stocks (EUR/%) Elan Corporation -55.6 AGFA-Gevaert -33.0 Kingfisher -24.5 Travis Perkins -23.9 Telecom Italia Ord -21.0

No. of Consts

Value

3 M (%)

7875 1693 237 344 1112 1590 103 804 1114 300 80 100

326.98 333.40 367.57 407.90 427.92 330.19 598.12 341.10 346.84 1236.06 4295.96 4054.16

3.3 5.1 4.9 5.5 4.4 4.9 16.0 4.7 5.7 5.0 5.3 3.8

FTSE Global AC Index FTSE Europe AC Index FTSE Europe LC Index FTSE Europe MC Index FTSE Europe SC Index FTSE Developed Europe AC Index FTSE All-Emerging Europe AC Index FTSE Eurobloc AC Index FTSE Developed Europe ex UK AC Index FTSEurofirst 300 Index FTSEurofirst 80 Index FTSEurofirst 100 Index

6 M (%) 12 M (%) Actual Div Yld (%)

9.1 12.8 11.4 13.9 14.9 12.2 49.2 12.3 13.5 11.8 11.8 10.2

11.0 22.8 19.8 26.9 31.0 22.1 71.0 22.0 23.6 20.8 19.2 18.4

2.01 2.66 2.82 2.32 2.08 2.68 1.84 2.64 2.46 2.73 2.96 3.00

FTSE UK Index Series – Year to Date 31st December 2004 - 30th November 2005

FTSE UK Index Series Performance (GBP) 125

FTSE 100

120

FTSE 250

115

FTSE 350

110

FTSE SmallCap

105

90

FTSE AIM All-Share

v-N o 30

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5

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FTSE Fledgling 5

95

5

FTSE All-Share

5

100

04

MARKET REPORTS BY FTSE RESEARCH

Stock Performance

FTSE techMARK

FTSE All-Share Sector Indices Capital Returns (GBP) 60 50 40 30

% 20

Capital

10

Total Return

0 -10

Co

ns

tr

uc

tio

n

M

O inin & il Bu & g i l d Ch G a in em s Fo g ic El S M r ec te es a als t e tr on Ae l & try eria ic ro O & ls & sp th Pa p En Ele ace er M er gi ctr & e ne ic D ta er al ef ls Ho in E e us Au g & qui nce pm eh to ol mo Ma en d c Fo Go bile hin t od od s & ery Pe Pr s rs & Par od on Te ts uc al e Ph Ca rs Be xtile ar re & ve s m & Pr rag ac H oc e eu ou es s tic se so al ho H rs s & ld ea Bi Pro lth ot d ec uc hn ts Ge o ne To log M L ral ba y ed ei R cc ia su et o & re ail En & ers Su ter Ho pp tai tel or nm s Te F tS e le oo co d er nt & v m m D Tra ice un ru ns s ic g R po at e rt io ta n ile S e rs r Ut El vice i l i ec s t i e tr s icit -O y th e B r In ve L In ank st ife sur s In m A a n e fo Sp nt ssu ce rm e Co ra at cia m nce So ion lity p ftw Te & Re an O c ar h t al E ies e no he s & lo r ta Co gy Fin te m H an pu ar ce te dw rS a er re vi ce s

-20

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

92

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

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Page 93

FTSE UK Index Series - Capital Return YTD (GBP) 25

20

15

10

5

g

AR F K TS 10 E 0

ed

te

ch

M

gl in

FT Al SE l-S A ha IM re

FT SE

FT SE

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35

ha re

p

0

0 25 FT SE

FT SE

10

0

0

Stock Performance Best Performing FTSE All-Share Index Stocks (GBP/%) BTG Elementis Autonomy Corporation Aquarius Platinum Ashtead Group

Overall Index Return

Worst Performing FTSE All-Share Index Stocks (GBP/%) Sanctuary Group -91.1 Goshawk Insurance Holdings -82.0 Phytopharm -72.7 Gresham Computing -71.9 Patientline -68.8

171.6 152.1 138.8 134.0 121.9

No. of Consts

Value

3 M (%)

6 M (%)

100 250 350 335 685 290 785 100

5423.17 8327.94 2788.37 3200.60 2741.05 3583.86 1012.03 1346.12

2.4 7.5 3.1 3.1 3.1 2.3 -7.9 5.6

9.3 17.1 10.3 13.2 10.4 11.1 5.7 16.1

FTSE 100 Index FTSE 250 Index FTSE 350 Index FTSE SmallCap Index FTSE All-Share Index FTSE Fledgling Index FTSE AIM Index FTSE techMARK 100 Index

12 M (%) Actual Div Yld (%)

15.3 26.6 16.8 19.2 16.9 17.9 2.0 13.9

3.21 2.42 3.10 2.06 3.07 1.89 0.63 1.48

Net Cover

P/E Ratio

2.31 2.09 2.28 1.21 2.26 -0.33 -0.19 –

13.5 19.79 14.14 40 14.43 0 0 –

FTSE Xinhua Index Series 31st December 2004 - 30th November 2005

FTSE Xinhua Index Series Performance (RMB/HKD) – H1 2005 140

FTSE/Xinhua China 25 (HK$)

130

FTSE Xinhua All-Share (RMB)

120

FTSE Xinhua Small Cap (RMB)

110

FTSE/Xinhua China A50 (RMB)

100

FTSE Xinhua 600 (RMB) FTSE Xinhua China Bond Total Return Index (RMB)

90

-0 5 ov -N 30

31

-S

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05

5

5

30

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05

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31

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5

05

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31

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4

80

FTSE Xinhua Index Series Index Name

FTSE/Xinhua 25 Index (HK$) FTSE/Xinhua China 50 Index (RMB) FTSE Xinhua All-Share Index (RMB) FTSE Xinhua 600 Index (RMB) FTSE Xinhua Small Cap Index (RMB) FTSE Xinhua China Bond Total Return Index (RMB)

Consts

Value

3 M (%)

6 M (%)

12 M (%)

Actual Div Yld (%)

25 50 999 600 399 33

8927.68 3682.02 2004.97 2153.94 1464.04 96.43

-1.6 -6.9 -5.4 -5.8 -3.2 -0.1

10.1 -0.3 -0.9 -1.4 1.6 4.1

6.2 -15.0 -23.6 -22.8 -27.9 12.5

2.81 3.34 2.38 2.59 1.20 3.12

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

93

MARKET REPORTS 11.qxd

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Page 94

FTSE Hedge Management Styles (USD) – 5-Year Performance 160

FTSE Hedge

140

FTSE All-World

120

Directional

100

Event Driven Non-Directional

80 60

05

5

vNo

M

No

v-

ay -0

04

4 M

No

v-

ay -0

03

3 M

No

v-

ay -0

02

2 ay -0

01 v-

M

M

No

v-

ay -0

00

1

40

No

MARKET REPORTS BY FTSE RESEARCH

FTSE Hedge Index Series

FTSE Hedge – Management Styles & Strategies (NAV Terms) Index Level*

3 M (%)

FTSE Hedge Index * 5113.33 Directional 3079.05 Equity Hedge 2122.41 Commodity Trading Association (CTA) / Managed Futures 2064.33 Global Macro 1898.38 Event Driven 3139.64 Merger Arbitrage 2014.76 Distressed & Opportunities 2163.33 Non-directional 2985.63 Convertible Arbitrage 1917.47 Equity Arbitrage 1975.72 Fixed Income Relative Value 2038.98 * Based upon indicative NAV index values as at 30 November 2005

5-Year Ann 3-Year 6 M (%) 12 M (%) Return (%) Volatility (%)

1.1 2.0 0.5 5.6 4.2 0.0 -0.8 0.6 0.5 -0.2 0.2 1.3

2.3 2.6 6.1 3.2 -5.1 4.7 0.7 8.2 -0.5 -4.1 -1.2 1.9

2.2 2.4 5.8 -1.8 -2.0 3.3 1.1 5.3 0.7 -4.0 0.9 3.4

5.7 8.0 7.5 11.5 6.1 3.3 0.4 5.8 3.9 7.4 4.0 2.1

3.1 5.3 4.1 14.6 6.3 3.1 1.7 4.8 1.6 4.4 2.0 1.5

FTSE EPRA/NAREIT Global Real Estate Index Series FTSE EPRA/NAREIT Global Real Estate Index Series Performance (Total Return) – Year to Date 135

FTSE EPRA/NAREIT Global Total Return Index ($)

130 125

FTSE EPRA/NAREIT North America Total Return Index ($)

120

FTSE EPRA/NAREIT Europe Total Return Index (€)

115 110

FTSE EPRA/NAREIT Eurozone Total Return Index (€)

105 100

FTSE EPRA/NAREIT Asia Total Return Index ($)

95

5 30 -N

ov

-0

05 ct-O 31

ep

-0 5

5

30 -S

5

-A ug -0 31

l-0 -Ju 31

30

-Ju

n-

05

5 31

-M

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5 -A pr -0 30

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28

-Fe

b-

ar -0

5

05

05 -Ja n31

31

-D

ec

-0

4

90

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

94

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

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10:11 pm

Page 95

FTSE EPRA/NAREIT Global Real Estate Indices (Total Return) Index Name

Consts

Value

3 M (%)

6 M (%)

12 M (%)

Actual Div Yld (%)

296 142 87 36 67

2420.47 3031.26 2484.53 2626.12 1740.08

2.6 2.7 2.9 -2.2 5.1

10.7 11.4 8.4 7.5 14.7

16.8 18.6 28.5 30.8 15.6

3.88 4.42 2.87 3.66 3.56

FTSE EPRA/NAREIT Global Index ($) FTSE EPRA/NAREIT North America Index Index ($) FTSE EPRA/NAREIT Europe Index (€) FTSE EPRA/NAREIT Euro Zone Index (€) FTSE EPRA/NAREIT Asia Index ($)

FTSE Bond Indices FTSE Bond Indices Performance (Total Return) – Year to Date FTSE Eurozone Government Bond Index (€) FTSE Euro Corporate Bond Index (€) FTSE US Goverment Bond Index ($) FTSE Pfandbriefe Index (€) FTSE Gilts Index Linked All Stocks (£) FTSE Japan Government Bond Index (¥)

108 106 104 102 100 98

5 -0 -N

ov

FTSE Euro Emerging Markets Bond Index (€) FTSE Gilts Fixed All-Stocks (£)

30

31

-S

-O

ep

ct-

-0

05

5

5 -0 -A 31

30

ug

l-0 -Ju

30

31

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n-

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5

05

5 -0

5 pr -0 30

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-A

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5

05 28

-Fe

b-

n-Ja 31

31

-D

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-0

05

4

96

FTSE Bond Indices (Total Return) Index Name

Consts

Value

3 M (%)

6 M (%)

12 M (%)

248 333 44 324 10 30 120 232 33

153.50 176.11 206.84 143.02 1973.89 1908.79 145.60 110.47 96.43

-1.3 -1.3 0.6 -1.3 1.6 1.0 -1.5 -0.3 -0.1

0.4 0.1 3.2 0.5 4.8 3.2 -0.7 -0.5 4.1

4.9 3.6 7.5 3.8 8.2 7.2 2.8 1.0 12.5

FTSE Eurozone Government Bond Index (€) FTSE Pfandbrief Index (€) FTSE Euro Emerging Markets Bond Index (€) FTSE Euro Corporate Bond Index (€) FTSE Gilts Index Linked All Stocks Index (£) FTSE Gilts Fixed All-Stocks Index (£) FTSE US Government Bond Index ($) FTSE Japan Government Bond Index (¥) FTSE China Government Bond Index (RMB)

Actual Div Yld (%)

3.51 3.36 4.36 3.80 1.47* 4.17 4.67 1.19 3.12

* Based on 0% inflation

FTSE Research Team contact details Carl Beckley Director, Research & Development carl.beckley@ftse.com +44 20 7866 1820

Andy Harvell Head of Research andy.harvell@ftse.com +44 20 7866 8986

Jamie Perrett Senior Index Design Executive jamie.perrett@ftse.com +44 20 7866 1817

Andreas Elia Research Analyst andreas.elia@ftse.com +44 20 7866 8013

Gareth Parker Head of Index Design gareth.parker@ftse.com +44 20 7866 1805

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2006

95

CALENDAR

Index Reviews January – May 2006 Date

Index Series

Review Type

Effective Data Cut-off (Close of business)

Mid Dec

PSI 20

Semi-annual review

31-Dec

30-Nov

Jan

AEX

Annual review

1 Mar

31 Dec

Mid Jan

OMX HEX 25

Quarterly review

31 Jan

31 Dec

10-Jan

TSEC Taiwan 50

Quarterly review

20-Jan

30-Dec

25 Jan

HEX 25

Quarterly review of number of shares

28 Jan

Jan/Feb

BEL 20

Annual review

1 Mar

31 Dec

10 Feb

Hang Seng

Quarterly review

10 Mar

30 Dec

14 Feb

MSCI

Quarterly review

28 Feb

31 Jan

21 Feb

DJ STOXX

Quarterly review (components)

17 Mar

27 Jan

Early Mar

ATX

Semi-annual review / number of shares

31 Mar

28 Feb

Early Mar

CAC 40

Quarterly review

17 Mar

28 Feb

Early Mar

S&P MIB

Semi-annual review

20 Mar

1-Mar

DJ STOXX

Quarterly review (style)

17-Mar

1-Mar

1 Mar

SMI

Semi-annual rebalance

31 Mar

28 Feb

6 Mar

DAX

Quarterly review

17 Mar

28 Feb

8 Mar

FTSE/ Hang Seng

Semi-annual review

17 Mar

28 Mar

8 Mar

FTSE UK

Quarterly review

17 Mar

7 Mar

8 Mar

FTSE All-World

Annual review Asia Pacific ex Japan

17 Mar

30 Dec

8 Mar

FTSEurofirst 300

Quarterly review

17 Mar

3 Mar

8 Mar

FTSE techMARK 100

Quarterly review

17 Mar

28 Feb

8 Mar

FTSE eTX

Quarterly review

17 Mar

3 Mar

10-Mar

NASDAQ 100

Quarterly review/ shares adjustment

17-Mar

28-Feb

13 Mar

NZSX 50

Quarterly review

31 Mar

28 Feb

14-Mar

S&P MIB

Quarterly review - shares & IWF

17-Mar

15-Mar

Russell US Indices

Quarterly review / Additions

31-Mar

15-Mar

S&P Europe 350/ S&P Euro

Quarterly review

17-Mar

15-Mar

S&P 500

Quarterly review

17-Mar

15-Mar

S&P/ TSX

Quarterly review

17-Mar

15-Mar

S&P MidCap 400

Quarterly review

17-Mar

16-Mar

DJ Global Titans 50

Quarterly review

17-Mar

15-Mar

15-Mar

S&P/ ASX 200

Annual /Quarterly review

17-Mar

28-Feb

Mid April

OMX HEX 25

Quarterly review

21 Apr

31 Mar

14-Apr

TSEC Taiwan 50

Quarterly review

15-Apr

31-Mar

Late April

FTSE / ATHEX

Semi-annual review

31-May

31-Mar

12-May

Hang Seng

Quarterly review

9-Jun

31-Mar

17-May

MSCI

Annual review

31-May

30-Apr

28-Mar

28-Feb

Sources: Berlinguer, FTSE, JP Morgan, Standard & Poors, STOXX

96

JANUARY/FEBRUARY 2006 • FTSE GLOBAL MARKETS

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