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WHAT’S ALL THE COMMOTION ABOUT COMMODITIES THEN? I S S U E F O U R T E E N • J U LY / A U G U S T 2 0 0 6

Wachovia’s winning ways

A new era dawns for portfolio trading Picking up the pace of Dutch pension reform Indian M&A’s new international flavour GOODBYE GLOBAL CUSTODY, HELLO ASSET SERVICING!

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F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 6

HERE IS SMALL doubt that in the context of global investment, we live in interesting times. The global equity markets, for one, have taken something of a drubbing in the second quarter of this year, although this round of market volatility is not necessarily a bad news bear. Mark Mobius of the Templeton Investment Fund calls it “a healthy correction”, particularly in emerging markets, and should be measured against“almost three years of big gains”. Market fundamentals, he thinks suggest that any corrections“should be short-lived”. Highlighting a ‘don’t panic’ argument, he says that “price-to-earnings (P/Es) ratios in most stock markets are near to, if not below, their long-term averages (emerging markets P/Es are below the US and Germany), supporting the case that the readjustment served to let some of the air out of the tires of stock markets that had moved up substantially.” There are some concerns though, such as higher interest rates in the US coupled with a weaker dollar, as well as a pullback in commodity prices. Additionally,“Asian currencies have been undervalued”and “some sort of revaluation seems inevitable… [which] could help support the development of Asian countries’ domestic economies; and, finally, the inflated price of commodities. A lot of people have been saying that prices need to come down,”says Mobius. Dave Simons takes up this very issue in our commodities sector profile. While conceding that the market has been ripe for a pullback, other commentators have it that there is plenty of upside still to come. Commodity bulls believe that a prolonged and unprecedented cycle of undersupply and over-demand — a “supercycle” as some call it — coupled with a rolling global economy, particularly in countries such as China and India, make this advance far different from any we have experienced before. High touch customer service is another touchstone of this edition. In our cover story, Bill Stoneman scrutinises the focused and fastidious rise of the Wachovia Corporation. Revenue growth, employee engagement and customer service are the three pillars of Wachovia's growth strategy. “We know that employees who understand the company's vision and care about their work deliver the best service,” thinks G. Kennedy Thompson, Wachovia’s chief executive officer. “And being a leader in customer service is absolutely the best revenue strategy,”he adds. Elsewhere we look at the impact of customer centric service in both asset servicing and portfolio trading. As sure as eggs is eggs, the investment services industry is in flux. This can only be for the good of both asset managers and beneficial owners who are witnessing a ramping up of investment services provision on a galactic scale, offering buy side participants broader and more competitive choices. In portfolio trading the provision of direct market access tools is allowing greater participation in trading decisions by the buy-side. Algorithmic trading, according to ITG, is used by some 60% of US buy side firms, with the take up in Europe about half that level, though volumes are rising fast. What is new is the way in which broker/trading firms are devising new responses to that increase — especially as clients are asking for more customised algorithms. It all adds up to a much more exciting and challenging business environment.

Francesca Carnevale, Editorial Director June 2006

Contents COVER STORY COVER STORY: WACHOVIA’S WINNING WAYS ............Page 68 Revenue growth, employee engagement and customer service are three of Wachovia's top strategic priorities, and they are closely linked. Being a leader in customer service is absolutely the best revenue strategy, thinks G. Kennedy Thompson, chief executive officer (CEO) of Wachovia Corporation. Bill Stoneman finds out about the strength in depth of Wachovia’s commitment to customer care.

REGULARS MARKET LEADER

WILL INDEPENDENT RESEARCH REMAIN INDEPENDENT? ..........Page 6 Art Detman reports on an industry undergoing sweeping change.

IN THE MARKETS

THE COSTS AND IMPLICATIONS OF MIFID ..................................Page 10 Robin Seth, financial solutions manager at Vignette explains the impact of MiFID.

CME & REUTERS JOINT VENTURE IN FXMARKETSPACE ......Page 14 The Chicago Mercantile Exchange & Reuters create FXMarketSpace.

DUTCH PENSION FUND REFORM PICKS UP

................................Page 18 Lynn Strongin Dodds explains the twists and turns of market reform.

THE DEEPENING OF INDIA’S CORPORATE M&A MARKET

REGIONAL REVIEW

....Page 26

Mekha Renon discusses the internationalisation of the Indian M&A market.

BGI LAUNCHES INDIAN ETF ON SGX

........................................................Page 30 BGI and SGX play to the emerging patterns of intra-Asian investment flows.

THE GROWING APPEAL OF ASIAN ETFS

........................................Page 32 Dave Simons reports on the international appetite for Asia’s leading markets.

DOWNLOADING ASIA’S MUSIC INDUSTRY

................................Page 34 Dave Simons reports on new ways to listen to music in Asia and its financial impact.

M&A IGNITES EUROPEAN CORPORATE ISSUES ......................Page 59

DEBT REPORT

Andrew Cavenagh looks at the leading deals of 2006.

LATIN AMERICA’S DOMESTIC BOND MARKETS LIGHT UP....Page 63 The domestic market is coming to the fore as an issue location of choice.

HEDGE OF HEDGE FUNDS: THE NEW DRUMBEAT

ALTERNATIVES

INDEX REVIEW 2

..............Page 79 Funds of funds ballooned based on investor expectations of returns in excess of 300 to 400 basis points over LIBOR. A funny thing happened. The returns fell short. Neil O’Hara analyses the fund of fund market in the aftermath.

THE DIVERSIFICATION BENEFITS OF HEDGE FUNDS

..........Page 82 An increase in allocation to hedge funds will increase the expected portfolio return, reduce volatility and increase the information ratio and Sharpe ratio of a portfolio. So says Simon Hookway of specialist hedge fund advisors, MSS. Market Reports by FTSE Research ................................................................................Page 86 Index Calendar ..................................................................................................................Page 96

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

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Contents FEATURES FIVE STAR UNIVERSAL CUSTODY

........................................................Page 37 Custodian banks that wish to maintain their competitive edge in the global marketplace have developed an ever-widening menu of value-added services. These include, for example, fund-accounting, fund-administration, transfer-agency and performance-evaluation services. Which providers are best suited to handle all of these tasks over the long haul?

CUSTODY IS DEAD. LONG LIVE ASSET SERVICING

................Page 45 Traditional definitions of that one-time catch-all term ‘global custody’ are, these days inadequate to encompass the new service levels provided by custodian banks. Asset servicing is coming to the fore as the global investment market takes on new forms and investment strategies.

PORTFOLIO TRADING AT THE CROSSROADS

............................Page 50 It is a great time to be in portfolio trading as the daedal world of portfolio trading continues in flux. Today’s portfolio trader is both buffed and buffeted by a cross current of trends that, some say, will redefine a new era of business. In an increasingly intricate and ingenious marketplace, inevitably there will be winners and losers. The question is who and when.

THE INELUCTABLE PACE OF ALGORITHMS ................................Page 54 While algorithms are well suited to equity trading, increasingly they are finding applications in other asset classes, such as equity index futures, bond futures and some commodity futures, as well as options and foreign exchange. For some portfolio trading providers, that means a greater not a lesser role for traders and their service desks, even as algorithms become more customised and useable by the buy side.

WINNERS & LOSERS IN COMMODITIES FUTURES ................Page 72 Commodities futures are a zero-sum game. For every dollar that managed funds add on the long side, someone else is short. However, the market has its own temptations. Commodity prices are booming. Hedge funds, institutional investors and mutual funds are pouring money into the commodity futures markets, driving open interest and trading volume in many contracts to record levels. The new liquidity is a godsend to commercial players, who can manage their risk more efficiently. Is it all just too good to be true?

THE GROWING COMMOTION OVER COMMODITIES

........Page 76 For nearly 50 years, commodities ranked among the world’s most stubborn investments, moving virtually sideways for decades save for a few volcanic bursts of activity. While technology stocks virtually imploded at the start of the current decade, sub-sectors such as gold, copper, silver, platinum and, of course, oil began a sustained rally that has resulted in across-the-board record highs and a massive infusion of investment capital. What lies ahead for the feast-or-famine commodity sector?

MARCH/APRIL 2006 • FTSE GLOBAL MARKETS

Market Leader INDEPENDENT RESEARCH

JM Dutton, founder of JM Dutton Associates

John Dutton believes economics will steadily erode research at securities firms. “If you’re the director of research of a brokerage house,” he says,“your biggest challenge is to try to figure out how you’re going to make money based on trading commissions — or even just break even. You can trade today in liquid stocks as less than a penny or even half a cent a share. At that rate, it’s hard to pay even for the trade. A lot of these firms are wondering if research is even a business they want to be in, and I think many will decide it is not.” Photograph kindly supplied by Dutton Associates, June 2006.

ICHAEL W. MAYHEW, chief executive officer (CEO) of Integrity Research Associates, a consulting firm based in Darien, Connecticut, believes the number of independent US research firms will plummet from the current 450 to around 150 within five years. “The crazy part is that demand for research is going to only increase during this time,” he says. “We are in an environment where institutional investors are looking for good ideas and we think this trend will continue.” The problem for many independents, according to Mayhew, is that small firms simply will not have the marketing muscle and economies of scale to compete. The survivors will be bigger, grossing a projected $3.1bn by 2009, double today’s $1.5bn, and accounting for 26.2% of all research expenditures, up from 15.8% in 2004. One driving force behind this sea change is the unbundling of research and trading fees. For example, Fidelity Investments, the huge mutual fund company, has wrung agreements from at least three investment banks, including Lehman Brothers, to separate the fees charged for research and for trading.“In other words,”says Mayhew, “investment banker research will no longer be free. That means institutional investors will have more of a choice. As

HOW INDEPENDENT IS INDEPENDENT? Independent research— security analysis performed by neither analysts at sell-side entities such as brokerage firms nor those employed by mutual funds and other buy-side institutional investors — may be headed for sweeping changes: far fewer but much larger firms, and more of them doing issuer-paid research. Art Detman reports.

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

Market Leader INDEPENDENT RESEARCH

a result, independent research providers will actually benefit because their product—and I won’t call it better or worse—is certainly cheaper.” Mayhew’s firm estimates that the typical Wall Street brokerage firm spends $135,000 a year to cover one stock. An independent can do it, he says, for $20,000 to $30,000. Little wonder that in just the past five years research budgets at Wall Street’s big investment banking firms are down an estimated 30%.“The sell-side firms have laid off [sic] analysts altogether, or have replaced the more experienced ones with cheaper guys,” Mayhew says. “So the reality is that the current level of experience on the Street is significantly lower than it was a decade ago.” Some of these experienced analysts have joined mutual funds, pension funds and hedge funds. Others have gone over to independent research firms, including those that do issuer-paid research, also called sponsored research. Among the firms that have benefited from this shift is JM Dutton Associates, based in suburban Sacramento, California. In terms of research performance, it was ranked third in 2005 by Investars, an independent consultancy based in New York. The two highest-ranking firms—Emerging Growth Equities and Advait Research—are both independents but do not offer sponsored research. In a near tie with Dutton for third place was Goldman Sachs. John Dutton, the firm’s founder, believes economics will steadily erode research at securities firms. “If you are the director of research of a brokerage house,”he says,“your biggest challenge is to try to figure out how you are going to make money based on trading commissions—or even just break even. You can trade today in liquid stocks at less than a penny or even half a cent a share. At that rate, it is hard to pay even

for the trade. A lot of these firms are wondering if research is even a business they want to be in and I think many will decide it is not.” Mayhew, who tracks these sorts of things, reckons that about three dozen firms are doing issuer-sponsored research today. “That number is going to increase,” he says. “Interestingly, some of that growth is going to come from firms that today do subscriptionbased research. They will take on sponsored research in addition to their subscription business.” John Eade, chief executive officer (CEO) of Argus Research, among America’s largest subscription-based firms, agrees. “I could see our moving in this direction, particularly if the exchanges get behind the initiative, but with a separate staff of analysts.” Hardly a ringing endorsement of sponsored research then. It does, however, acknowledge economic reality. The sponsored-research business dates back to at least 1996, when InvesTrend Communications—a New York firm that arranged analyst meetings for its client companies— began publishing reports paid for by those clients. Investrend CEO Gayle Essary says his firm is the field’s largest, with more than 70 analysts. Their performance is not measured though by a third party such as Investars or its San Francisco-based competitor, StarMine Monitor.“That is not to say we won’t someday,” says Essary.“But our research comes from a different direction. We are not performance-oriented. We believe our analysts should determine a fair value for a stock, and it’s sort of immaterial whether or not the marketplace accepts that figure.” This is a battle that Essary is not likely to win. Many money managers are skittish about paying attention to any sponsored research, and given the choice between research from a highly

Michael W. Mayhew, chief executive officer of Integrity Research Associates, a consulting firm based in Darien, Connecticut, believes the number of independent US research firms will plummet from the current 450 to around 150 within five years. “The crazy part is that demand for research is going to only increase during this time,” he says. Photograph kindly supplied by Integrity Research Associates, June 2006.

rated firm such as Dutton and one that is not rated at all; if they choose either, it will almost certainly be the former. “Research firms that refuse to have their performance measured make me a little nervous,” says Mayhew. “It is like a money management firm that refuses to have its performance measured.” Measured or not, does sponsored research have a positive impact on a company’s stock? Dutton insists it does.“The average company that signs up with us has an increase in trading volume of 500% and substantially outperforms the Russell 2000 in the first year of coverage.” This is a plausible claim. After all, these are selfselected companies that believe their stock is undervalued because their stories are not being told effectively.“If we are highly selective in our recruiting of analysts,” Dutton says, “we can replicate the results of the best and best brokerage firms 10 or 15 years ago, before Wall Street began cutting back. All issuer-paid research is an economic model to take the place of commission-paid research. Whether it is any good depends on the performance of the firm, not the way

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

the research is funded. If it doesn’t perform, people won’t use it.” The fact is, of course, that not all sponsored-research firms (make that very few) can meet the standards set even by today’s Wall Street investment bankers. Mayhew, for example, believes firms should meet at least four basic rules. One, there should be independent third party tracking of performance. Two, there must be clear and full disclosure of the financial arrangement between the covered company and the research firm. Three, payment should be in cash only, not in stock or warrants, and four, certification must be provided by the analyst that the report is truly his or her own view.

“Of course, individual analysts also need to be experienced and credible,” says Mayhew. Sadly, at some firms the “analysts” are investor relations consultants who are experts in their own specialty but without the training or experience to analyse a stock. Contrast this with, say, the analyst roster at Spelman Research Associates, a large New York-based sponsored research firm, which offers at least seven chartered financial analysts, one of whom is also a certified public accountant. Spelman provides one year of coverage for an up-front fee of $26,500—cash only. InvesTrend meantime offers six coverage plans; a year’s coverage, which includes four

reports, is about $35,000. Dutton also prices his yearlong coverage at $35,000. Typically, the firms follow the Wall Street practice of having the covered company review for accuracy the factual narrative but not the conclusion, rating or recommendation. As Wall Street firms cut back their coverage, especially of firms with market caps below $1bn, almost certainly more and more companies will bite the bullet and commission reports. Do not expect that this sponsored-research, now the industry’s ugly duckling, to become a beautiful swan. Nonetheless, it should become a handsome duck.

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Transforming Information Into

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 6

Intelligence

In the Markets MiFiD

In the vision of the future of the European investment market promoted by MiFID, all transactions will be transparent and standardised, regardless of where they take place. Firms will benefit from streamlined business processes that offer a higher level of business efficiency and enable organisations to have a greater understanding of their operations, highlighting areas where productivity can be increased. Photograph by Prawny and supplied by Dreamstime, June 2006.

The Day of the MiFID The European Union’s Markets in Financial Instruments Directive (MiFID) is placing yet more pressure on the already highly regulated investment market. With analysts predicting that complying with the directive will cost the market in excess of £1bn, the reaction of financial institutions has been for the most part highly cautious, if not actively negative. Robin Seth, Financial Solutions Manager, Vignette EMEA, the enterprise content management solutions group, investigates what the directive aims to achieve, and whether the market can reap benefits beyond its immediate implications. DOPTED BY THE European Union in April 2004, MiFID is expected to have a wider reach than both Basel II and Sarbanes-Oxley, yet is described as an evolution, rather than a revolution. MiFID is essentially an update of the Investment Services Directive (ISD), previously the most significant legislation in this market. MiFID extends the coverage of ISD. It introduces requirements that are more extensive but maintains the same basic function—setting core high-level requirements for the organisation and conduct of Europe’s investment market. Standardising conditions across the European investment markets, MiFID aims to create a single borderless European securities market for all financial instruments, allowing firms to provide services regardless of location, and establish branches in other European states. This open

market will contribute to the EU’s vision of making Europe “the most dynamic and competitive knowledgebased economy in the world”by 2010. In theory, then, the directive looks beneficial, and financial institutions are more than accustomed to complying with regulation by now. So why is MiFID causing such concern within the industry? The problem does not lie in the destination. Instead, the problem lies in the route required to get there. The Tower Group, the research and consulting firm, predicts the directive could cost investment houses as much as £13m each, a figure others claim may be somewhat conservative. Much of this will be spent on the technology needed to enable the processes involved in working in borderless markets, as well as that needed to respond to the burden of proof associated with complying with the legislation.

The directive requires all information relating to financial transactions to be saved for five years, including details of price, venue, cost and speed. Firms must be able to show that all transactions have been carried out in the best possible way, proving “best execution”. It means that firms will need to store a great deal more information than previously, and in many cases, it will lead to an overhaul of communications and information management infrastructure. Not only that. The overhaul and adoption of systems and processes could take as long as two years to complete, say analysts. The situation is not helped by delays in the formal adoption of the directive. Financial organisations were unable to begin serious preparations until the final version of the directive was announced. That announcement was due at the end of 2005, but was, in fact, delayed until February 2006, which has increased the pressure felt by the investment market—particularly as the deadline for compliance is set for November 1, 2007. The timescales involved are indisputably tight — a little over a year and a half for what amounts to a complete system overhaul for many institutions. However, the outlook need not be completely bleak. The directive is being introduced for the benefits it will bring over the long-term.

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

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In the Markets MiFiD

Last year was a very strong year for asset management, with a high level of mergers and acquisitions activity creating buoyancy in the market. In turn, it has meant that financial organisations have capital for investment. With the right strategy, they can implement technology to streamline business processes, improving employee efficiency and customer response times, and creating a more productive and profitable business. Invariably then, the way information is managed and shared is crucial. Centralised information management solutions, such as electronic records and documents management, automate the collation, storage and destruction of different types of information. Processes are streamlined and organisations are able to keep track of all interactions with customers, employees, partners, shareholders and regulatory bodies. Such measures are essential for the reporting and accountability required by MiFID, helping investment firms show 'best execution' on deals. An electronic records and documents management solution that integrates with all systems and automatically files related information together for ease of access is essential. This will need to be combined with web capture technology, ensuring that details of all transactions are stored, including those that take place online. The increasing importance of the internet as a source of information and communications tool will not only be reflected in the integration of webbased data with that created internally. Tools such as customer websites, dedicated partner extranets, and personalised employee intranets will also play a vital role in the evolving European investment market. Firms will need to use portal and content management tools to maximise the

effectiveness of their web presence, enabling the rapid and secure sharing of sensitive information. As the significance and limitations of traditional geographic borders is removed with adoption of the standards of the directive, online collaboration will become increasingly critical. Investment firms need to make decisions on very short timescales, and this presents a significant challenge in a European market where project stakeholders are likely to be in different geographies, and possibly time zones. Collaborating through virtual team rooms and other online workspaces is the most efficient and cost-effective solution for day-to-day interaction amongst these team members. The benefits of technological adoption can be seen both internally and externally. Implementing internal controls and automating certain processes, for example, increases accuracy that, in turn, reduces operational risk. It also promotes a greater level of confidence in the market, encouraging wider investment. The increased transparency provided by information management and the regulatory audit process is also likely to increase customer confidence. In the vision of the future of the European investment market promoted by MiFID, all transactions will be transparent and standardised, regardless of where they take place.

Firms will benefit from streamlined business processes that offer a higher level of business efficiency and enable organisations to have a greater understanding of their operations, highlighting areas where productivity can be increased. The directive does away with the view that all transactions must go through exchanges, legitimising “offbook” activity. This takes place when shares held by the investment house are moved directly between the customers that want to buy and those that want to sell. This is easier and more cost-effective than going through exchanges. Under the terms of MiFID, “offbook” transactions are completely valid, though as with any deal that takes place, the firm must be able to prove “best execution” through stored details of the sale and purchase. The need to prove best execution will lead to new standards of best practice in the European market. The quality of service offered and the reach of transactions will be improved, and there will be greater competition in the market as smaller or younger firms from less developed investment markets start to compete on a Europewide basis with large, established players and global enterprises. The directive will effectively create a level playing field where the number one investment house will no longer have all the advantages. As the European market becomes more dynamic and barriers to entry are removed, it is likely more businesses will be attracted to the investment space. Competition will drive down costs and offer consumers greater choice. Combined with a reduction in the risks associated with investment gained through the new automated systems and transparency of processes, more investors will be drawn to the market.

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

/X[VRWP ]QN /^]^[N XO 2W_N\]VNW] /^WM\ +TMIZ[\ZMIU 1V^M[\UMV\ .]VL[ ;MZ^QKM[ Q[ I LMLQKI\ML J][QVM[[ ]VQ\ _WZSQVO KTW[MTa _Q\P \PM -]ZWXMIV 1V^M[\UMV\ .]VL [MK\WZ \W LMTQ^MZ QVL][\Za [WT]\QWV[ *]QTLQVO ]XWV +TMIZ[\ZMIU [ XZW^MV UIZSM\ QVNZI[\Z]K\]ZM KIXIJQTQ\a IVL \PM >M[\QUI WZLMZ ZW]\QVO [MZ^QKM W]Z .]VL[ J][QVM[[ Q[ ZM[XWVLQVO \W UIZSM\ LMUIVL NWZ \PM LM^MTWXUMV\ WN KMV\ZITQ[ML [M\\TMUMV\ [MZ^QKM[ <W TMIZV UWZM IJW]\ _PI\ _M KIV LW NWZ aW] KITT WZ ^Q[Q\ ___ KTMIZ[\ZMIU KWU

Regional Review NORTH AMERICA: CME/REUTERS’ FXMARKETPLACE

CME & Reuters To Launch Global FXMarketplace Foreign exchange (FX) is the most actively traded asset class around the globe and until now trading has tended to operate as an overthe-counter (OTC) market, conducted directly between dealers and principals by telephone or via electronic trading networks. Now, the Chicago Mercantile Exchange (CME) and Reuters have deepened long standing ties and have established a 50/50 joint venture to create a centrally cleared global FX marketplace to leverage growing institutional and hedge fund activity. The new venture will facilitate more credit efficient access to OTC markets, reduce trading costs through market and operational efficiencies and broaden markets access with complete transparency of a central limit order book, say the partners.

CME chief executive Craig Donohue at a press conference following the announcement of FXMarketSpace said that,“the idea is that everybody can interact anonymously and multilaterally, without credit limits on trading activity.” Photograph kindly supplied by CME, June 2006.

that everybody can interact anonymously and multilaterally, without credit limits on trading activity,”explains CME chief executive Craig Donohue. In a wide-ranging agreement, CME will provide clearing, trade matching services while Reuters will provide trading access, trade notification services, and distribute market data from the joint venture over its network. The venture is a “major milestone for CME as it is the first time that we are applying our expertise in clearing, technology and global distribution beyond the futures market,” says Donohue. While there are numerous electronic platforms for OTC trades, FXMarketSpace will be the first one to offer central counterparty clearing, which eliminates the credit constraints that have hampered buy side participation in OTC FX markets. FXMarketSpace will provide an organised structure for clearing all transactions conducted on its platform and will guarantee the performance of contracts, thereby, claims the CME, reducing counterparty risk. CME Clearing will be the actual central

counterparty, explains Donohue with the new marketplace offering consistent pricing to all users, because after depositing performance bonds, all participants will essentially hold equal, anonymous status, he explained. A challenge for the platform, however, will be to demonstrate to liquidity providers that there is more value added in FXMarketSpace than simply addressing counterparty credit risk. Until now, most of the major financial institutions have used the Continuous Linked Settlement (CLS) System, which was launched back in 2002, and which helps eliminate settlement risks for foreign exchange transactions caused by delays arising from time zone differences. Some fifteen currencies are currently eligible for CLS settlement. While CME Clearing will be the counterparty for every trade, CLS will settle all trades. The CME will offer post-trade, presettlement netting through CLS, so market participants should see a drop in their CLS fees. FXMarketSpace also consolidates a long standing collaborative relationship between the CME and Reuters, which have worked together

ME AND REUTERS are further pooling their expertise in data dissemination, distribution, trade matching and central counterparty clearing services through FXMarketSpace, a 50/50 venture that will bring trading anonymity and price transparency to the global FX market. “CME and Reuters are addressing the needs of the current FX marketplace by establishing the first electronic trading platform that offers anonymous, cleared trades to the $2trn over the counter (OTC) FX market,” says CME chairman Terry Duffy. FXMarketSpace will offer market solutions to capitalise on key market trends, including the growing demand for broader access to the FX market, the growth of non-bank financial institutions in global FX markets as well as the growth of electronic and algorithmic trading. According to CME while there are numerous electronic platforms for OTC FX trades, FXMarketSpace will be the first one to offer central counterparty clearing, which eliminates the credit constraints that have hampered buyside participation in OTC FX markets. With FXMarketSpace, “the idea is

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

REGIONAL REVIEW 14

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Regional Review NORTH AMERICA: CME/REUTERS’ FXMARKETPLACE

since the late 1980s to pioneer electronic futures trading through the original CME Globex® system. It has been a profitable relationship. Last year over 84m FX contracts, with a notional value of over $10.2trn, were traded at the exchange. FXMarketSpace now takes things to another level and will offer market solutions to capitalise on the growing demand for broader access to the FX market, the emergence of FX as an asset class, the growth of non-bank financial institutions in global FX markets and the growth of electronic and algorithmic trading.“FX trading is experiencing strong growth and attracting new interest from both banks and the wider financial marketplace,” says Mark Robson, global head of treasury and fixed income at Reuters, at the press conference.“Reuters aims to capitalise on these trends and benefit its customers through this alliance with CME,”he adds. The parties anticipate a long-term joint venture relationship, with limited exit, buy/sell option and termination provisions. Some of these provisions will require the agreement to be approved by Reuter’s shareholders, “which will be sought at an extraordinary general meeting to be scheduled shortly,” states the official release at the time of the announcement. CME and Reuters have each agreed not to operate or have any significant interest in a competing, cleared platform for electronic trading of FX products (other than futures and futures options). The FXMarketSpace business plan, assumes the business will reach profitability by 2008, and requires each party to contribute capital of up to $45m to fund the venture through to profitability. The business plan anticipates two roughly equal amounts of capital

contribution, in 2006 and 2007. CME and Reuters expect their respective shares of start up losses to be between $20m and $25m, with around $5m expended this year. The venture will break even when it has revenues of $40m, said Reuter’s chief financial officer David Grigson, when the deal was announced. “We have calculated that if the venture only gets 2% of the market, which would be ridiculously low, we hit break-even,” Reuters chief executive Tom Glocer said at the press conference. “As you get up to more reasonable market shares, 10% and north, it gets very, very profitable.” At the press conference announcing the venture both Reuters and CME said they had been talking to existing partners, banks in the FX market and current CME customers, and "the reception we have gotten from the traditional sell side as well as the leveraged funds is positive,” said CME’s Donohue. The existing businesses of the two companies will not be included in the joint venture, and will continue to be operated separately by the respective companies. Details of the deal’s pricing structure were not announced. Profits generated by the joint venture’s operations, including under the service and other arrangements described below, will be shared in proportion 50/50. Donohue explains that the venture will be an extension of the CME’s existing FX products, which have grown quickly in recent years.“We think that our market model — an anonymous, multilateral system — is very attractive,” he says. CME’s FX futures and options contracts had compound annual growth of 37% between 2000 and 2005, while daily volume for 2006 to date is running about 38% higher. Trading is expected to start in early 2007 with the spot currency market and extend later to the forward, swap and options markets.

CME chairman Terry Duffy says that,“CME and Reuters are addressing the needs of the current FX marketplace by establishing the first electronic trading platform that offers anonymous, cleared trades to the $2trn over the counter (OTC) FX market.” Photograph kindly supplied by CME.

Interestingly the venture comes at a time of change, when many banks are withdrawing from the multi-bank systems that have dominated trading in the past, and while hedge fund activity is on the rise. The CME thinks this trend brings great opportunity. “This has the potential for very big returns,”said Duffy when the deal was announced. “CME’s FX markets are in the midst of one of their most robust growth periods ever. Much of this growth is being driven by electronic FX volume, which was up 53 percent in the first quarter of 2006 versus year ago levels. Meanwhile, total FX volume has averaged as much as $47.5bn per day in notional value in recent months,” said Donohue at a press conference following the announcement of the joint venture. In addition to providing deep liquidity, the key benefits of FXMarketSpace include credit efficient access to OTC FX markets, broad access with complete transparency of a central limit order book, a reduction in the cost of trading via both market and operational efficiencies and technological sophistication and scalability enabling low latency trading.

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

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Regional Review EUROPE: DUTCH PENSION FUND REFORM

FTK has rocked the relatively staid Dutch market by introducing mark to market reporting of liabilities. Starting next year, pension funds will have to calculate pension fund liabilities using variable interest rates depending on the duration of their liabilities, rather than the current fixed 4%. This means liabilities will become more volatile as they will be subjected to the prevailing winds of interest rates. Pension funds will also have to maintain a funding level equivalent to 105% at all times with buffers of up to 130% depending on the risk structure of the portfolio. Moreover, they will have a year to recover if it drops below 100%. Photograph by Sue Colvil; supplied by Dreamstime.com, June 2006.

LTHOUGH NOT EVERYONE has welcomed the new rules with open arms, everyone agrees that the Netherlands’ pension fund industry is in need of reform, given the country’s ageing population. Stefan Baecke, institutional adviser for the Dutch institutional market for AXA Investment in Belgium, explains, “I think there is acceptance in the Dutch pension fund industry that change is inevitable. First, there was the International Financial Reporting Standards (IFRS) in 2005 and the FTK is a follow on from that. The delay has given funds more time to get ready and in fact now is a better time to deal with the new rules changes as interest rates have risen and the equity markets have improved during the past year.” Harvinder Sian, a London based analyst at ABN Amro, adds,“Whatever happens with the pension law, it is not prudent to ignore the rules because the FTK is here for all intents and purposes. FTK is a fundamental shift in the way pension funds look at the assets and several of the major pension funds have started to put strategies in place during the second half of last year when they thought the rules were going to be introduced in 2006.”

The twists and turns that lead to reform It seems the road to pension fund reform in the Netherlands has more twists and turns than a strand of DNA. First, the Financial Assessment Framework (FTK) was delayed until 2007 and now there are murmurings that the new pension law might not be passed (as hoped) before Parliament’s summer recess. However, despite the potential setbacks, change is firmly in the air. Alternative assets, tighter risk management controls and liability driven investing are not just buzzwords but are fast becoming part and parcel of the Dutch pension fund vernacular. Lynn Strongin Dodds reports.

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

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Regional Review EUROPE: DUTCH PENSION FUND REFORM

Not surprisingly, heavyweight pension fund players such as ABP and PGGM, which have ready resources and expertise, are already implementing the new framework into their investment strategies. Other funds that are now as well endowed, especially smaller funds, have inevitably been slower to come to terms with the proposed changes and accounting legislation. This is because the new rules are not just about a few minor changes but require a completely different mind and skill set, focusing more on liabilities instead of the assets in a portfolio. According to research published by KPMG in March, only about half of Dutch pension funds are at some stage of preparation for implementing the new framework. Just 10% are fully prepared; roughly 36% are reportedly close to the final hurdle while the rest are unprepared, despite the legislation being delayed for a year.“It is a mixed picture with some of pension funds such as ours being early adapters while others are just now getting ready,” notes Niels Kortleve, manager of actuarial projects and special accounts for PGGM, which has €74.4bn assets under management. “There are also smaller funds that are just starting to make their move now.” As Arthur van der Wal, director of institutional clients at ING Investment Management puts it, “In general, Dutch pension funds [have] lived in a world of stable returns and predictable obligations. That all changed in 2000 with the fall of the stock market. This caused a problem on the asset side but in the past two years, we have had issues surrounding the liabilities side with the introduction of the IFRS and FTK that has and will have a dramatic impact.“ The IFRS, which came into effect in 2005, introduced fair value accounting compared to historical cost accounting.

It also obliged EU listed companies to include assets and liabilities of their pension funds on their balance sheets. In the past, the pension fund was seen as a separate entity but the new rules will force chief financial officers to focus more on risk management and better matching of the liabilities and assets in the fund. The fear is that chief financial officers will become uncomfortable with the risk on their balance sheet and want to remove it by closing defined benefit (DB) pension plans. Although it unlikely — for cultural reasons — that Dutch companies will move over to the Anglo Saxon defined contribution (DC) pension plan type system, about 40% of firms want to change their pension arrangements to what is called a collective defined contribution (CDC) scheme within the next five years, according to a separate KPMG survey. A CDC is a hybrid between the DB and DC systems. It retains the structure of a DB plan in that employees’ accrual rates are based on an average-salary model. However, employers’ contributions are fixed (typically for the next five to ten years) and they cannot be forced to increase their level of contribution to make up any deficits in the plan. The employees (as a group) will be responsible. They can increase contributions or, more likely, take a hit on their pension benefits. The risk is spread across the plan rather than limited to an individual. The decision on what to do is made by a governing board, often composed of employee and employer representatives. DC plans accounted for 5.5% of all Dutch pension funds as of the end of September this year, according to the most recent data available from De Nederlandsche Bank, the central bank, based in Amsterdam. This may still be a drop in the ocean, but it is an increase from 3.8% in 2000. Over 90%

Bart Heenk, managing director of the Benelux and Nordic regions at SEI in Amsterdam, says that,“The focus on mark to market reporting and maintaining assets worth 105% of liabilities will force fund managers to think more in the short term and increase their use of fixed income instruments and derivatives to hedge their interest rate risk. However, fund managers will also have to look at the long term and increase focus on liability driven strategies and diversifying their assets because they will need to produce the returns.” Photograph kindly supplied by SEI, June 2006.

of the Dutch workforce participates in occupational or supplementary retirement plans and for the average employee, they can expect to pocket about 50% of their pre-retirement income when they leave work. According to Dick van den Oever, senior consultant at Hewitt Associates in the Netherlands, the IFRS has forced many companies to revaluate their pension plans due to the balance sheet volatility of their DB plans. However, he does not believe that the Netherlands is ready to make the switch to individual DCs.“There is too much solidarity in pension funds, which goes back generations. It is more likely that companies will adapt collective defined contribution plans because they share the risk.” The FTK, on the other hand, has also rocked the relatively staid Dutch market by introducing mark to market reporting of liabilities. Starting next

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Regional Review EUROPE: DUTCH PENSION FUND REFORM

longer term to cover the liabilities.” The consensus is that there will be a higher demand for long dated fixed income securities and inflation linked bonds to better align the duration of their assets with their liabilities. Rob Kamphuis, director of business development at F&C in the Netherlands, explains, “Pension funds will have to be much more aware of the risks in their portfolio which is a good thing. This means that pension funds will become much more active in using swaps and other derivatives to hedge their risks. Asset managers such as F&C Stefan Baecke, institutional adviser for the will have to create new instruments and Dutch institutional market for AXA Investment products to help pension funds tailor in Belgium, explains,“I think there is acceptance their portfolio to hedge the unwanted in the Dutch pension fund industry that change risks while other products will allow is inevitable. First, there was the International them to exploit more efficiently the Financial Reporting Standards (IFRS) in 2005 risks they do want to take.” and the FTK is a follow on from that. The delay The KPMG research notes that has given funds more time to get ready and in pension funds are likely to use a variety fact now is a better time to deal with the new of instruments to hedge the interest rate rules changes as interest rates have risen and risk including, in the order of preference the equity markets have improved during the – swaps, long term debt, swaptions and past year.” Photograph kindly supplied by AXA credit derivatives. Analysts believe that Investment, June 2006. €120bn of Dutch assets will flow into long-dated bonds before the end of next year, pension funds will have to year.There also seems to be no shortage calculate pension fund liabilities using of European governments who are variable interest rates depending on willing to feed their appetite. the duration of their liabilities, rather This past April, for example, The than the current fixed 4%. This means Dutch State Treasury Agency issued its that liabilities will become more first 30-year deal in more volatile as they will be than seven years while subjected to the prevailing FTSE Netherlands vs. FTSE Developed Europe Index the French Treasury came winds of interest rates. 125 to the market with a 50 Pension funds will also have year, €6bn bond. to maintain a funding level 100 However, as Maarten equivalent to 105% at all Roest, head of sales times with buffers of up to 75 support at ABN AMRO 130% depending on the risk Asset Management, puts structure of the portfolio. 50 it, “The FTK rules have Moreover, they will have a significantly changed year to recover if it drops 25 the risk framework for below 100%. According to Dutch pension funds analysts and industry trade but they are about much statistics, most pension funds FTSE Netherlands Index FTSE Developed Europe Index more than just interest are not below the 105% mark rate management. It but the challenge will be Source: FTSE Group / FactSet Limited Euro price returns. Data as at June 2006 5

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maintaining such high levels of solvency. In other words, managers will need to ensure that their funds are in a healthy state at all times and will need to walk the fine line between reducing their risk while generating the higher returns needed to ensure the money is in the retirement pot. Last year, industry pension funds turned in a good performance — ranging from 6.5% to 19.4%. However, the average cover ratios of their members had dropped by two percentage points to 121% when valued on the market interest rate, according to VB, the umbrella organisation for industry wide pension funds. Frits Bosch, director of Bureau Bosch, an investment consultancy in the Netherlands, explains,“In the past, Dutch pension funds ran a simple balanced mandate of equities and bonds and they worked on a 30 year time horizon. Now, they must ensure that their fund ratios are at 105% all the time. This makes fund management much more complex and sophisticated and managers need to have risk management tools to be able to fulfil the short term strategy of the plan while also looking at a broader range of solutions for the

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

EUROPE: DUTCH PENSION FUND REFORM

alternatives such as real allows pension funds to estate and private equity for find different ways to several years, and more improve other parts of recently commodities their portfolio as well. It because we were looking forces them to be more for higher and more stable structurally aware of what returns. However, smaller type of risks they want to pension funds may not bear, which ones will pay have the capacity to use off and those that are not many alternatives because worth having.” they will need advice and it Bart Heenk, managing is expensive to use many director of the Benelux and consultants and experts.” Nordic regions at SEI in Not surprisingly, there is Amsterdam, believes, “The no shortage of consultants focus on mark to market willing to give a helping reporting and maintaining hand or investment banks assets worth 105% of ready to offer their menu liabilities will force fund of products, particularly on managers to think more in the risk management the short term and front. Although foreign increase their use of fixed Maarten Roest, head of sales support at ABN AMRO Asset Management, players have been a income instruments and says that,“The FTK rules have significantly changed the risk framework feature of the Dutch derivatives to hedge their for Dutch pension funds but they are about much more than just interest pension fund landscape interest rate risk. However, rate management. It allows pension funds to find different ways to for many years, fund managers will also improve other parts of their portfolio as well. It forces them to be more competition is expected to have to look at the long structurally aware of what type of risks they want to bear, which ones will intensify as they jostle for term and increase focus on pay off and those that are not worth having.” Photograph kindly supplied position, particularly liability driven strategies by ABN AMRO Asset Management, June 2006. among the smaller to and diversifying their assets because they will need to ABP, Europe’s largest pension fund medium sized pension plans that may with €190.6bn of assets under need more of a helping hand. produce the returns.” One of the biggest challenges, Sian echoes these sentiments. “The management, says,“The FTK and IFRS FTK is producing a fundamental shift in rules will lead funds to look at the according to van der Wal of ING Management, “Is the way pension funds look at their broader portfolio context: that is, a Investment assets. If for example, interest rates drop, larger focus on liabilities and greater providing the right solutions. Pension their solvency will be hit. We are diversification. Moving into more funds have to reduce their risks and beginning to see pension funds extend illiquid asset classes, for instance, will improve their returns but there is a their duration and move into long term provide opportunities to reduce the broad range of asset solutions out in bonds as well as derivatives. They will overall risk of the portfolio whereas the market place. Our job is to find also have to diversify their asset base some of these asset classes may also tailor made answers but it all depends into alternatives such as commodities, act as a good inflation hedge. We have on the specific situation of the private equity, emerging market equities been investing in alternatives such as pension fund. For example, an and property in order to produce extra hedge funds and real estate for several “ageing”or more mature pension fund years, not just because of their returns will have a different dynamic and performance to offset the liabilities.” Again, the impact will be greater for but also because of their low requirement than a pension plan of an IT company. Of course, it is always the the smaller funds as larger funds such correlations with equities.” Kortleve adds, “The move to question if the sponsor may not be as ABP and PGGM have already moved down the alternative road alternatives started in the early 1980s able to help and contribute if the cover several years ago. Olaf Sleijpen, but we expect it to increase because of ratio falls. So there are a lot of factors director of financial and risk policy at FTK. We have been investing in to deal with in finding solutions”.

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

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Regional Review ASIA: TRENDS IN INDIAN M&A

CULTURAL SHIFTS CREATE M&A SURGE

These are exciting times for India’s corporate sector. Revenues and profits are consistently on the rise, valuations are high and mergers and acquisitions (M&A) by and among Indian corporates are at an all time high. According to estimates by accountancy firm Grant Thornton India, the total deal value for M&A in 2005 was $16.3bn (46% up on 2004), with the total deal value in the first four months of 2006 touching $8.2bn. Rekha Menon reports. HE SURGE IN M&A activity over the past couple of years reflects the coming of age of the Indian corporate thinks Harish HV, Grant Thornton India’s head of M&A. It is a cultural shift, he says, with company founders and owners now giving precedence to business considerations over sentimental attachments to their companies. They are no longer averse to give up control for a profit, to achieve scale or to exit from low growth areas, he adds, which is leading to significant consolidation in the Indian market. The telecommunications sector has seen the most M&A activity over the last year, with the Essar Group acquiring a controlling stake in leading cellular operator, BPL Communications in September 2005, to become the second largest GSM service provider in the country. In financial services, the highest profile deal has been the merger of two regional banks, Bank of Punjab from the north and Centurion Bank which has strong market share in the western and southern parts of the country. Meanwhile, in the biggest deal in India’s civil aviation history, Jet Airways acquired Air Sahara at the

The Tata Group has been one of the more successful Indian companies at post acquisition integration. The firm has also engineered a number of important strategic alliances this year, including this recent deal, back in January between Tata Group and Italy’s FIAT. This photograph shows Ratan Tata, left, chairman of Tata and Sergio Marchionne, chief executive officer (CEO) of FIAT S.p.A pose for a photograph at the 8th Auto Expo in New Delhi, India, Friday, January 13, 2006. FIAT and TATA had announced plans of an openended alliance whereby FIAT cars will be sold through Tata’s dealership network in India, to begin with. The two companies will also collaborate in technology, design and the distribution of Tata cars in Europe through FIAT dealerships. This photograph was taken by Saurabh Das and provided by Associate Press/EMPICS, June 2006.

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

beginning of this year for nearly $500m in an all cash deal. “The M&A market in India is growing as a function of strong economic and corporate performance,” says Raj Balakrishnan, senior vice president for global markets and investment banking at DSP Merrill Lynch. He notes a growing international element with cross-border transactions, now accounting for over half of all the volume and for around 60% of the value of all M&A deals. “International companies are looking at transactions in India since acquisitions represent the best and fastest way to participate in the Indian growth story. Domestic companies are also keen to grow their businesses internationally to take advantage of the India sourcing story, and hence are looking at acquisitions in overseas markets,” explains Balakrishnan. There have been several noteworthy inbound cross-border transactions, such as Europe’s leading mobile phone company, Vodafone’s acquisition of a 10% stake in Indian telecom leader Bharti Televentures for $1.5bn and IT global giant, Oracle’s purchase of a 41% stake in leading financial software company i-flex solutions. However, one of the most significant developments in recent months has been the sharp acceleration in the number of outbound deals, where Indian companies have bought overseas firms. Compared to 136 outbound deals, there were only 56 inbound transactions in 2005, estimates Harish of Grant Thornton. A recent Confederation of Indian Industry (CII) and Boston Consulting Group (BCG) study, revealed that during 2005 there was a three-fold rise in overseas buyouts by Indian companies, cumulatively valued at $4.5bn, well up on the $1.7bn worth of deals concluded in 2004.

The Hansen acquisition is the second-largest foreign corporate takeover by an Indian company in the past twelve months. Earlier this year, in a strategic move to expand its presence in the European market, Indian drug major Dr Reddy's Laboratories acquired German generic drug maker Betapharm for $570m to expand presence in the European market. This deal was preceded by a flurry of smaller acquisitions in the pharmaceutical segment. Wockhardt bought German drug maker Esparma, Matrix Laboratories bought Belgium’s Docpharma and Ranbaxy acquired three European generic drug companies in Belgium, Italy and Romania. This photograph of an old Indian painting was taken by Ryszard Laskowski and supplied by Dreamstime, June 2006.

In March this year, Indian wind turbine maker Suzlon Energy, bought Belgium-based Hansen Transmissions International, the world’s second largest maker of wind turbine gearboxes, for over $500m. "The acquisition of Hansen gives us technological leadership and will make Suzlon a leading integrated wind turbine manufacturer in the world,” says Tulsi R Tanti, chairman and managing director of Suzlon Energy. Over a period of time, he says, Suzlon will work with Hansen to develop supply chain synergies, expanding capacity in Belgium and development of additional capacity in new emerging markets in Asia. The Hansen acquisition is the second-largest foreign corporate takeover by an Indian company in the past twelve months. Earlier this year, in a strategic move to expand its presence in the European market, Indian drug major Dr Reddy's Laboratories acquired German generic drug maker Betapharm for $570m to expand presence in the European market. This deal was

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preceded by a flurry of smaller acquisitions in the pharmaceutical segment. Wockhardt bought German drug maker Esparma, Matrix Laboratories bought Belgium’s Docpharma and Ranbaxy acquired three European generic drug companies in Belgium, Italy and Romania.“In the last seven auctions of pharmaceutical companies in Europe in recent months, Indian firms have emerged as winners every time,”states Delhi based Jayesh Desai, national director of transition advisory services at Ernst & Young. What is remarkable about these deals is not the transaction itself, but the level of confidence it implies. “Indian companies are finally thinking global. They are now starting to see India as part of the global economy. The level of confidence has gone up which is driving these expansion plans overseas across all major sectors,” notes Desai. Further, he says, Indian companies are increasingly being accepted as potential buyers in the international M&A space. “Three to four years ago,

Regional Review ASIA: TRENDS IN INDIAN M&A Phiroz Vandrevala, executive vice president of TCS, which has a turnover of $2.9bn and a 60000 strong workforce, states that the company aims to be a $10bn company by 2010, among the top 10 IT consulting firms globally. To achieve this, Vandrevala says, an inorganic growth strategy is essential, but he emphasizes that IT services being a very people oriented business, acquisitions have to be very well thought out. Photograph kindly provided by TCS, June 2006.

for a sale process taking place internationally, an Indian company rarely got a call as a prospective buyer. Today, there is rarely a case where Indian companies are not considered,”adds Pramit Jhaveri, head of Citigroup’s investment banking business in India. Along with pharmaceuticals, the sectors that have witnessed the highest level of outbound M&A activity are oil, gas & energy, metal, automotives, information technology (IT) and business process outsourcing (BPO). Tata Steel recently acquired equity stake in Millennium Steel of Thailand, which, together with its earlier $486.4m acquisition of Singapore based NatSteel early last year, is expected to strengthen its position in South-East Asia. In the auto components space, Mahindra & Mahindra Limited

acquired a majority stake in Stokes Group, the largest automotive forgings company in the United Kingdom with customers such as Koyo Bearings, Land Rover, ZF, Bosch, Visteon, Ford and Jaguar. Experts state that the acquisitions in these sectors is driven primarily by Indian firm’s need to secure their supply chain, customer acquisition and gain ready access to high end technology, a ready-made distribution network, and brand recognition in a new market. International forays by Indian companies have also been spurred by a host of external factors, remarks Deepak Kapoor, executive director at PricewaterhouseCoopers. Aligning of interest rates with global rates, lowering of import barriers, and easy access to international funding namely, raising funds though foreign

convertible currency bonds (FCCB); American depository receipts (ADRs) and global depository receipts (GDRs) as well domestic funding through public issues in the booming domestic stock market, are the other drivers, he explains. Experts also point towards the positive impact of the growing presence of private equity players, such as Blackstone, 3i and Temasek, in global forays both inward and outward. Private equity investment, which has been growing steadily, touched $2.5bn in the first three months of 2006 alone, up from $2.3bn in calendar 2005. Interestingly M&A, in the telecommunications sector has been restricted more to inbound activity rather than outbound, and in the IT sector, inbound acquisitions are much larger than outbound. All leading Indian IT companies have made small-scale acquisitions targeted to gain expertise in niche areas. For instance, Wipro acquired Austrian semiconductor design services firm New Logic and Satyam acquired UK-based investment management consulting firm Citisoft. Tata Consultancy Services (TCS) on the other hand acquired a Chilean BPO firm, Comicrom and banking software vendor, Financial Network Services (FNS) of Australia. Phiroz Vandrevala, executive vice president of TCS, which has a turnover of $2.9bn and a 60000 strong workforce, states that the company aims to be a $10bn company by 2010, among the top 10 IT consulting firms globally. To achieve this, Vandrevala says, an inorganic growth strategy is essential, but he emphasizes that IT services being a very people oriented business, acquisitions have to be very well thought out.“We do not want to merely acquire a large company with

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through or want to a large workforce for the Expanding their presence globally discuss these integration sake of size. In other challenges.” sectors such as 2500 “If you look at corporate pharmaceuticals, steel 2000 India today, opportunity and and automotives, entering capital exist, but the biggest a new market requires an 1500 challenge is the people to aggressive acquisition 1000 execute it,”adds Jhaveri. strategy. This is not the Vandrevala of TCS, case in IT. We already 500 meanwhile, counters that have operations in 53 0 there is no dearth of countries worldwide.”The managerial skills and key consideration for TCS professional talent. while doing acquisitions, Tata Steel Mahindra & Mahindra FTSE India All Cap Index However, he agrees that he says, is to ensure that integration is a process of principles of synergy Source: FTSE Group / FactSet Limited Indian Rupee Price Returns. Data as at June 2006 learning. The Tata Group, apply with its identified which has been at the growth areas such as Vikram Utamsingh, executive forefront of acquisitions in India, has consulting, BPO and products. Jhaveri of Citigroup agrees that the director at KPMG India concurs. He been able to successfully integrate its dynamics of the IT sector differ from thinks that in the coming years earlier acquisitions such as Tetley Tea, others. “Indian IT companies are Indian M&A deal sizes will continue of the UK (acquired in 2000) and already enjoying an organic growth to grow. However, he cautions that Daewoo Commercial Vehicles of rate of 25% to 30%. So there is no need firms need to start focusing on post- Korea (acquired in 2004). However, for massive acquisitions,”he points out. acquisition issues. “It is widely Tata may be the exception that proves In other sectors, he says that sizes of acknowledged that the most difficult the rule. According to Vandrevala, acquisitions will continue to grow. part of an M&A deal is integration. looking further afield and further “What has not happened till date [sic] For a successful transaction, ahead, integration will be one of the is an acquisition of meaningful size integration needs to be done within biggest challenges for Indian firms as globally. But even as we speak, the the first six months. But not many they expand their businesses at home companies have really thought and abroad. needle is moving,”thinks Jhaveri.

Select Recent Overseas Acquisitions Company

Acquirer

Industry

Consideration

Stake

Valuation

Advanta Netherlands Holdings BV

United Phosphorus

Agri Products

€100 mln

100%

€100 mln

Campos Basin oil fields stake of Exxon-Mobil)

ONGC Videsh (OVL)

Oil & Gas

$1.5 bln

30%

$5 bln

96.7%

$335.05 mln

(estimated acc. To sources) Terapia, Romania

Ranbaxy

Pharma

$324mln

(stake from Advent International ) Hansen Transmissions International NV, Belgium

Suzlon Energy Ltd

Wind Energy

€465 mln

100.0%

€465 mln

Betapharm Arzneimittel GmbH, Germany

Dr Reddy’s Laboratories

Pharma

$570mln/ €480 mln

100%

$570mln/ €480 mln

Millennium Steel Public Company of Thailand

Tata Steel

Steel

67.11%

$253.31 mln

(stake of 3i pvt. Equity) $170 mln

(24.99 %-preferential, 42.12 -open offer) Brunner Mond Group UK

Tata Chemicals

Chemicals

$177 mln

63.50%

$278.7 mln

UK-based Azure Solutions

Subex Systems, India

Software

$140mln

100%

$140mln

Dunlop Tyres International (Dunlop South Africa)

Apollo Tyres

Auto ancillary

$64 mln

cMango Inc

Wipro Ltd

IT consulting

$20 mln

100.0%

$20 mln

(Telecom Products)

(93% stock + 3% cash)

(technology infrastructure) Source: PricewaterhouseCoopers, June 2006

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Regional Review ASIA: BGI’S INDIA ETF LISTS ON SGX

India ETF lists on SINGAPORE exchange

Photograph provided by Empics, June 2006.

Barclays Global Investors’ launch of the first India-focused exchange-traded fund (ETF) will not be listed in India. Instead, the iShares MSCI India ETF will be listed in Singapore, to help broaden the exposure to international investors and tap the new geography of cross-border investment patterns in the Asian marketplace. Additionally, the listing is also a tactic in the Singapore Exchange’s (SGX’s) strategy to position itself as an Asian gateway for international investors that want to gain from the region’s burgeoning growth story. Tapping the very same investment dynamic as BGI, SGX is offering Asian-based customers exposure to other markets in the region. ARCLAYS GLOBAL INVESTORS’ (BGI’S) listing of the iShares MSCI India ETF, an open-ended fund, on SGX in mid June will tap new investment patterns in the Asian markets. BGI Southeast Asia Ltd, a subsidiary of BGI in Singapore, will manage the index, which is tracked against the MSCI India Index that includes some 65 companies offering coverage of around 85% of the free float-adjusted market capitalisation of each industry group in the Indian market. The ETF listing was sponsored by Citigroup’s Global Markets division, which will act as the chief market maker for the ETF. According to Chris Sutton, chief executive officer for iShares in Europe, “There is a lot of growth in the Indian

economy, which is difficult to access efficiently without actually being in India. This ETF goes some way to solve this problem.” The ETF is not aimed solely at the institutional market; the minimum investment in the fund is reportedly expected to cost $428 at launch, which also makes it affordable for small investors. As a bellwether, BGI’s iShares FTSE/Xinhua A50 China Tracker ETF, which is listed in Hong Kong, raised $800m over a year and a half of trading, even taking into account the local QFII quota restraint. Sutton acknowledges that it has not been easy to set up the Indian ETF, “which had to overcome several regulatory and operational hurdles.” Sutton explains that there are already six ETFs listed in India, five on

the National Stock Exchange and one on the Mumbai exchange. Asset sizes have remained comparatively low, with the largest fund, the S&P CNX Nifty, featuring assets of just under $80m. However, according to local newspaper reports, more sector-specific ETFs are in the planning stage, with 10 of them being launched by domestic player Benchmark Asset Management. BGI is not the only institution hoping to leverage investment patterns in Asia. Linus Koh, executive vice president and group head of products and services of SGX explained when the ETF was announced that the, "initiative forms an integral part of SGX's efforts to broaden our product suite to include regional ETFs … [and] will further strengthen our position as a gateway to Asian markets for both institutional and retail participants." Since 2000, SGX has gained momentum in attracting foreign growth companies seeking capital funding on an international platform. Foreign companies now account for more than 40% of companies listed on SGX, while current corrections aside, aggregate performance of foreign stocks, particularly China stocks, have outpaced the broader market over the last 12 months. SGX plans to expand the current suite of Asian equity products to include regional index futures and new ETFs. The forthcoming launch of FTSE/Xinhua China A50 Index Futures in September 2006 will give local and foreign investors convenient access and the ability to manage their exposure to the China A-share market. A more diversified suite of ETFs to give local investors exposure outside Singapore is also in the pipeline. New investment instruments such as business trust and infrastructure funds are also part of the SGX product plans.

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

Take global exploration beyond complimentary peanuts and a reclining seat. Go further. Broaden your reach. Discover new asset classes and regions. Drop in on emerging markets. Enjoy liquidity, transparency and costeffectiveness, wherever your investments take you. Choose iShares, the world’s leading ETF provider. Now available on your local exchange.

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Trade the world with This advertisement is intended for institutional investors who subscribe to FTSE Global Markets magazine. It is directed at persons having professional experience in matters relating to investments, and it relates to investments which are only available to, and will only be engaged in with, such investment professionals. Persons who do not have professional experience in matters relating to investments should not rely on this advertisement. This advertisement has been issued by Barclays Global Investors Limited (“BGI”), which is 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 in Ireland. The iShares funds are authorised by the Financial Regulator in Ireland. Any application for shares in any fund is on the terms of the relevant prospectus. The iShares funds may not be registered in your 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. 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. 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. Copies of the relevant prospectus can be obtained from www.iShares.net or by calling +44 (0)20 7668 8007. “iShares” is a trademark owned by Barclays Global Investors N.A. © 2006 Barclays Global Investors Limited. All rights reserved.

Regional Review ASIA: EMERGING ETFS

Why emerging market ETFs are still emerging Two years ago, Lee Kranefuss, chief executive of Barclays Global Investors’ (BGI’s) exchange-traded fund division iShares, sized up the positive trend in exchange traded funds (ETFs) with an air of cautious optimism. “The growth pattern has been great, but we are still in the early days of these funds,” says Kranefuss. Even so, the diversification, low cost and tax efficiency of ETFs suddenly mean a whole lot more when the big returns aren’t there. David Simons reports. ITH BIG RETURNS in equities harder to come by in these volatile days, investors in mature markets are looking elsewhere. Recent market volatility aside, ETFs continued to make great strides, with increased investor awareness and a rapidly expanding menu of ETF products resulting in a year-end ETF asset tally of $312bn. In a perpetually stingy market, investors continue to be drawn to the costefficiency of ETFs, which offer an expense ratio typically well below the average mainstream mutual fund. The outlook for ETFs—baskets of equities linked to a specific index that feels like a mutual fund but trades like a stock—is particularly rosy in Asian markets, and in 2005, numerous ETFs were able to capitalise on the superior growth of emerging regions such as China, Taiwan, India and South Korea. Despite the ongoing threat of random price fluctuations, most observers agree that these strongest of Asia’s emerging markets are still in the early stages of a prolonged growth spurt. Where the US will likely see annual economic growth in the 2% to 4% range at best, the outlook for regions such as China and India is far greater, says Paul Tracy, editor of Street Authority Market Advisor. For ETF investors looking long

term, that’s good news. Chris Sutton, chief executive officer of BGI iShares in Europe expands. “ETFs improve the ability of international investors to get into China, which is hard to do through direct investment from overseas. So what is happening is everyone is moving to get an ETF market up and running in Asia.” Sutton also points to a growing trend. “it is very different from Europe and the US in that we increasing see Asian investors pushing demand for non-domestic Asian equity. This phenomenon will be more apparent as local investors that have benefited from wealth creation seek to find ways to gain access to growth elsewhere in the region.” The concept of Asia itself is problematic, concedes Sutton. “It is rather a clutch of individual markets.” It is the appeal however of individual markets to investors outside the region that determine in large part the opportunity to create ETFs, “we now have 10 iShares based on the Japanese market, but where the primary listing is either in New York or Europe.” Although the market is replete with opportunities for new ETFs, time is on the side of the region’s leading economies. “China's economy is worth about $1.4trn,” says Tracy. “For China to grow by more than 10%, the

nation would need to add just $140bn to its annual GDP.” Bottom line: the US economy, while still the largest in the world, will not be able to match the growth of smaller, rapidly modernising economies such as India and China over the next few decades. When going foreign, why go ETF? For starters, there’s liquidity. In a market known for its hair-raising twists and turns, share prices can drop fast and without warning, leaving mutual-fund investors precious little time to head for the sidelines. Case in point: in January, Japan's main stock market gave up a whopping 6% over a two-day period, the result of massive selling sparked by alleged securities violations on the part of an Internet service provider. Under hellacious circumstances such as these, the perpetual re-pricing of ETF shares gives investors a fighting chance. At the start of 2006, the trailing priceto-earnings ratio of many emergingmarket equities was nearly half that of the S&P 500. In China, where price/earnings (P/E) multiples currently hover around 11, one could easily make a case for jumping into ETFs on the basis of valuation alone. Additionally, dividend yields for emerging markets were, on average, a good 75 basis points higher than the S&P's current 2% rate, according to data from Bloomberg. “Traditionally, many developing Asian markets have been prone to large fluctuations in share prices and FX movements. ETFs allow retail as well as institutional investors to gain access to these volatile markets in a cost effective way and in a way that reduces volatility for the investor,” says Paul Heffernan, business development manager at Bank of Ireland.“ETFs are also an ideal investment tool, particularly for those risk conscious investors who want exposure to these markets but are wary of the risk of direct equity investment,” he adds.

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more efficient, cost effective Perhaps the most FTSE/Xinhua China A50 Index vs. FTSE SGX Asia Shariah way to invest in China—in compelling argument is the 100 Index one trade, investors can growing perception that 180 gain exposure to 25 Asia’s emerging market 160 Chinese companies." equities are no longer the 140 A word of caution, tempestuous investments 120 however. While further they once were. “While gains are possible, individual foreign markets 100 emerging ETF mavens can see volatility from year to 80 have not been surprised to year,” says, “studies have 60 see some of the froth shown that these markets blown off over recent offer significant return months. As well not every advantages in the long run FTSE/Xinhua China A50 Index FTSE SGX Asia Shariah 100 Index market is suitable for ETF when taken as part of a creation. “There are some diversified portfolio.”Indeed, Source: FTSE Group US Dollar Price Returns. Data as at June 2006 markets where we would Jeremy Grantham, chairman of Grantham, Mayo,Van Otterloo & Co. hedge for otherwise conservative certainly question whether the market infrastructure is sufficiently robust for considers emerging ETFs a key investors like us,”argues Grantham. China-based ETFs such as iShares a transparent and fungible product component of a well-balanced portfolio. “I increasingly like emerging equities, FTSE/Xinhua China 25 Index Fund such as an ETF. Indonesia, for despite their good performance, represent a major opportunity, says example, might struggle for a high because they have become a wonderful BGI’s Kranefuss. "There's never been a quality ETF,”says Sutton.

Regional Review ASIA: MUSIC INDUSTRY REVIEW

MOBILE MELODIES

WITH A ROCKET The Asia Pacific region accounts for around one quarter of all mobile-phone sales worldwide — the result of the rapid deployment of wireless transmission towers and the proliferation of low-cost handsets. In cities such as Hong Kong and Beijing however, mobile phones are not simply for walking and talking. They are also about downloading and listening. Dave Simons reports on one of Asia’s fastest growing industries. IGITAL MUSIC BECAME a worldwide phenomenon in 2005. Portable MP3 players flooded the market and subscription download services experienced unprecedented demand. The International Federation of the Phonographic Industry (IFPI) estimates that digital-music revenues increased by 190% to $1.1bn during 2005, accounting for 6% of all music sales. Some 40% of digital downloads went to users with mobile phones—and these numbers are on the rise. Nowhere is this more evident than in handsetobsessed Asia, where the

mobile phone has quickly become the product of choice for accessing digital music. More than half of Hong Kong’s mobile-service subscribers use their phones for over-the-air (OTA) music downloads on a regular basis, compared to just 6% of mobile users in the United States. Research firm Synovate reports that nearly three quarters of all young adults residing in China’s metropolitan regions (such as Beijing, Shanghai and Wuhan) own a mobile phone. Most of them are using the phones for entertainment purposes. Combined with pocket-sized digital-music players, Internet-capable mobile phones have helped fuel sales of digital music in China, to the tune of $500m in 2005. The story is much the same in Japan. There 96% of all digital-music sales during the first

Combined with pocket-sized digital-music players, Internetcapable mobile phones have helped fuel sales of digital music in China, to the tune of $500m in 2005. The story is much the same in Japan. There 96% of all digital-music sales during the first three quarters of 2005 were based around mobile phones. In Korea meanwhile, analysts estimate that some 10m handsets capable of downloading and storing digital music will be sold by the end of this year. Photograph supplied by Istockphotos.com, June 2006.

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three quarters of 2005 were based around mobile phones. In Korea meanwhile, analysts estimate that some 10m handsets capable of downloading and storing digital music will be sold by the end of this year. All told, Asia is expected to lead the market for mobile music over the coming decade. Sales are expected to rise by at least 15% a year, according to data from PricewaterhouseCoopers, as revenue from mobile music exceeds sales of compact disc and other physical music products over the next several years. Phones equipped with multiple gigabyte storage capacity and other technological enhancements will help propel the mobile market even faster, say observers. “China has experienced enormous growth in mobile phone uptake over the past five years,”says Anna-Lucille Montgomery, a researcher at Queensland University of Technology's Creative Industries Research and Applications Centre. “Each month about 5m people sign up for mobile services for the first time. Saturation of the handset market is prompting the industry to focus on handset upgrades and value-added services. Mobile technology companies predict that overall growth in the market will continue, and expect to see sharp increases in demand for mobile content as third generation (3G) networks expand and the content becomes more affordable.” For the Chinese, owning music is not nearly as important as having access to it, says Ruuben van den Heuvel, vice president of digital business Asia at Sony BMG. "In China 100m people access the Web through internet cafes,” says van den Heuvel. “For them it is not about downloading, it is about the experience. In the US it is still all about ownership."

In India, purported to be the fastest growing mobile population in all of Asia, some 5m mobile subscribers are being added monthly, according to the Cellular Operators' Association of India (COAI), with industry revenues expected to reach $170m by the end of 2006. "Mobile music downloads are growing at a scorching pace—over 50% annually,” says TV Ramachandran, secretary general of COAI, "whereas growth of legal conventional music is stagnating." By 2008, Ramachandran believes there will be 250m mobile subscribers in India,“almost all of whom would buy handsets capable of playing polyphonic music or actual music," adds Ranchandran. "Clearly, the growth of devices capable of playing conventional music would be nowhere near the growth mobile music devises promises, so this segment of digital music is set to explode.” By far one of the most in-demand products on Asia’s digital market is the ringback tone—a personalised musical excerpt that a caller hears prior to completing a connection. Wireless operator China Mobile recently estimated that ringback tones and related novelties account for nearly 20% of the company’s revenue last year. China Unicom Ltd’s ringback business blasted off with a rocket, growing 8000% in a single year, from just 280,000 users in 2004 to nearly 22m by the end of 2005. “Ringback tones are more popular in China than in Western countries because, to a certain extent, they provide a chance for people to express their personality freely,” explains Alina Zhang, analyst with UOB-Kay Hian in Shanghai.

Fighting piracy The mobile phenomenon has been great news for subscription services such as Soundbuzz, the Singaporebased mobile music retailer. Last

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 6

summer, the company began offering a downloadable music library consisting of some 300,000 songs, including the works of both native and international artists, at around $1 per track. “In Asia, music is being licensed for people's online avatars, as backgrounds to messengers and for gaming platforms,” notes Soundbuzz CEO Sudhanshu Sarronwala. “This is not present in the US, and new business models are emerging.” Still, the pay-for-play model is not exactly catching fire in China, where piracy levels continue to be among the highest in the world. Some 85% of all digital music accessed in the country is unlicensed, according to data from the IFPI. “Chinese Internet search engines provide music that is fast, free and easy to download, giving consumers little incentive to pay for MP3s,”remarks Montgomery. Despite the recent high profile lawsuit by several music labels against search engine Baidu.com, to date no individual Chinese citizen has ever been prosecuted for downloading music illegally, he adds. China’s inability to contain its piracy problem has, until very recently, been a deterrent to foreign music-industry investors. However, as the volume of legal downloads to mobile phones becomes more pronounced, experts believe the trend will be reversed. China’s mobile service industry includes a billing system that automatically adds the cost of mobile content to a customer's monthly bill and passes along payments and royalties to copyright holders. This is vital to the success of China’s mobile music market, says Montgomery. “Mobile phones are already providing an important revenue stream for Chinese record labels,”says Montgomery. “Consumers are paying for mobile ring tones and ringback tones, and copyright owners have had

Regional Review ASIA: MUSIC INDUSTRY REVIEW

some success in ensuring that they receive a portion of the money being spent on these services. Many record industry players see mobile content as key to the future of China's music industry. Chinese consumers are spending a high proportion of their income on mobile telephones, accessories, and the content required to personalise them.”

Secure mobile-music solutions such as Melodeo’s Digital Rights Management (DRM) technology for protecting against the threat of piracy will finally break the cycle of illegal downloads that have plagued China and neighboring markets, says Valenti. “The major music labels, in fact, see mobile as the only secure, legitimate way to distribute music in China. Online and physical markets are virtually 100% piracy. By contrast, it is much more difficult to steal content from mobile networks/handsets, and consumers are quite used to paying for what they use on mobile phones.” Because mobile has been a much more broadly deployed computing platform in Asia, OTA services are ramping up at a significantly faster pace than in predominantly PCdriven markets, says Valenti.“The Web is more mobile-centric than in other markets,” says Valenti. “For example, China has nearly 500m mobile subscribers, versus roughly 200 million PC users. For many Chinese, their first experience of the Web is from a mobile phone, and the payment mechanism in mobile networks is well-suited to distribution of digital content via mobile phones.”

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At the annual five-day MIDEM music trade fair held in Cannes earlier this year, industry executives repeatedly underscored the longterm significance of mobile technology. “Mobile is the saviour of the music industry in China," proclaims Richard Robinson, cofounder of Shanghai ISP and mobile content provider Linktone, one of China's leading service Mobile alliance providers. "For the Chinese, the Though piracy remains a concern phone is the window to the world, throughout Asia, foreign companies and mobile is the key revenue have begun casting their nets in an generating service emerging in effort to gain a piece of the action. In China,” he adds. April, Monstermob, the UK-based ring While internet downloading tones provider, paid $81.5m for enjoys tremendous volume, it is an W-Infinity Communications of Beijing, almost entirely pirated medium, a mobile content group that serves 27 of whereas money is being made in the China’s 31 provinces. It was the mobile sector, adds Robinson. Sales company’s latest purchase in a series of of handsets in countries like China, acquisitions that included Atop Century India and Brazil continue to grow at in 2005, a ring tone and mobile-content an astonishing rate, making piracyprovider, for a price tag of $100m. free mobile technology a powerful Meantime, in the US, Seattle-based investment proposition. "The global Melodeo, a developer of mobile music music market is fast becoming a delivery technology, recently mixed economy in the way fans and announced a joint venture with consumers are buying their music,” wireless data supplier Access China to remarks IFPI chairman and chief begin offering OTA music downloads executive officer John Kennedy.“It is to Chinese mobile users. With an encouraging that the markets with estimated mobile subscriber base of the strongest digital 350m Melodeo’s sales are also generally executives are Mixed Fortunes in the Mobile Telecommunications Industry the best performing understandably upbeat 350 markets overall. In about their prospects.“Our 300 Japan, digital has already goal is to be the first to made up for the decline deploy a legitimate— 250 in physical sales, and meaning, major music 200 other markets develop in label-approved—mobile 150 this manner as well. Asia music service via the has in many ways leading wireless operators 100 become the ‘coal face’ of in China,” says Bill Valenti, 50 the digital environment, executive vice-president and many of the amazing for Melodeo. “In addition advances in the digital to our mobile music FTSE USA Mobile Telecoms Index FTSE Hong Kong Mobile Telecoms Index and mobile business are solution, we expect to FTSE Japan Mobile Telecoms Index FTSE Global All Cap Index being fuelled by the deploy mobile pod-casting Source: FTSE Group US Dollar Price Returns. Data as at June 2006 Asian region.” in the future as well.”

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

GLOBAL CUSTODY Perhaps the greatest opportunity for custody providers in the coming years is helping clients formulate strategies for dealing with under-funded pension plans. Says Keaney,“You see this taking shape in the form of these emerging businesses, where investment banks are going out and raising equity and then approaching under-funded defined benefit plans and saying,‘Guys, let us take this stuff off your balance sheet — we will buy your liabilities from you.’ Image provided by Dreamstime, June 2006.

FIVE STAR SERVICES: THE RISE OF THE UNIVERSAL CUSTODIAN Custodian banks that wish to maintain their competitive edge in the global marketplace have developed an ever-widening menu of value-added services. These include fundaccounting, fund-administration, transferagency and performance-evaluation services. Securities lending, enhanced performance evaluation and analytics and full-service trading capabilities are also areas of growing importance for clients. Which providers are best suited to handle all of these tasks over the long haul? Dave Simons goes in search of answers. ICHARD WARNE, HEAD of relationship management for Europe, the Middle East and Africa at JP Morgan’s Worldwide Securities Services (WSS) division is sitting pretty right now. In 2006, JP Morgan assumed the number one position among global providers with $11.7trn in assets under custody. Warne cites three factors for JP Morgan’s

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 6

current dominance by volume. “We have been successful in acquiring some new business, including some larger transactions, and that helps. Secondly, a number of our clients have been quite successful in their own right. We have a very strong franchise in some of the offshore markets such as Luxembourg, for instance, which has grown strongly,”he says. “Finally, the markets themselves have picked up considerably, which I think everyone has benefited from. Still, we feel we have outperformed the market, which is largely attributable to the first two factors,”he concludes. That strong and diverse franchise was one reason for Henderson Global Investors, the global asset manager with $124.8bn in assets under management, to outsource its middle and back office operations, which service some 14 hedge funds representing some $2bn in assets, to JP Morgan’s Hedge Fund Services’ (HFS) operations in London at the end of May. The mandate cuts to the heart of the matter in the current round of custody related mandates, which are playing to the strengths of the global

GLOBAL CUSTODY 38

giants. According to Bhagesh Malde, global business head of JP Morgan HFS, the agreement with Henderson allows the fund manager “to focus on what asset managers do best – make investment decisions.” The competition is moving just as fast these days. In an effort to pool its collective talent in the custody arena, the number two-ranked Bank of New York, currently with $11.3trn in worldwide assets under custody, announced in May the formation of a Global Investor Services division, combining custody, fund services, risk services, accounting and outsourcing business units, along with product development and operational support teams. The new division comes on the heels of an agreement with JP Morgan Chase that saw Bank of New York swap its retail banking business for JP Morgan’s corporate trust unit plus $150m cash. “We were very impressed with how quickly the client constituencies are becoming Photograph of Richard Warne, head of relationship management for Europe, the Middle global,” remarks Bank of New York East and Africa at JP Morgan’s Worldwide Securities Services (WSS) division. Warne senior executive vice president Tim says,” Over the past year in particular we have begun to see increasing demand across the Keaney, who will head the newly board for a range of alternative investments, some of which has been driven by market launched division. “Obviously it is forces, some by a relaxation of regulations, which has made it possible for a broader range of really hard to serve a global client if investors to consider such alternatives. So our thinking around that was to establish a you look at the world through a separate unit where we could concentrate our expertise in order to focus in on the growing narrow geographic lens. There are range of alternatives.” Photograph kindly provided by JP Morgan, June 2006. also a number of common issues weaving across those client constituencies, geography to includes services for hedge funds, private equity funds, geography. So we thought, now would be the best time to global derivatives and leveraged loans. The new daily do two things: set up a dedicated client-executive operational service has the capability to interface with over organisation that is global in its scope and that sits above 15 prime brokers and provide daily valuation for trading the individual product silos. We see this as a trend that is groups in the Americas, Europe and Asia. “Paloma’s experienced personnel and innovative technical in hyper-growth, especially with the custody world consolidating at its current rate. Therefore it is imperative platform are very attractive to JP Morgan,” said Liz Nolan, global head of alternative investment services for JP Morgan that we stay ahead of that curve.” With both institutional investors and asset managers WSS, when the deal was finalised. “We aim to lead the moving toward hedge funds and hedge fund-like products industry in servicing clients with complex alternative in greater numbers, it becomes increasingly important to investment strategies, and the next step in the growth of our be able to provide support in that area, adds Warne, integrated Alternative Investment Services unit is the particularly as the boundaries between traditional and acquisition of Paloma’s middle and back office operations.” “Over the past year in particular we have begun to see non-traditional investing continue to blur. In mid February this year, JP Morgan’s WSS division finalised the increasing demand across the board for a range of acquisition of the middle and back-office operations of alternative investments,” says Warne, “some of which has Greenwich, Connecticut-based Paloma Partners been driven by market forces, some by a relaxation of Management Company, an investment fund manager. regulations, which has made it possible for a broader range Aimed at helping the company sharpen its hedge-fund of investors to consider such alternatives. So our thinking focus, the new venture, dubbed JP Morgan Hedge Fund around that was to establish a separate unit where we Services, is a key component of the company’s Alternative could concentrate our expertise in order to focus in on the Investment Services business unit, a suite of products that growing range of alternatives.”

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

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Paul d'Ouville, senior vice president for corporate and institutional Services at Northern Trust, considers the alternativeinvestments trend a significant opportunity.“The flow of capital into alternative assets isn’t slowing,”says d'Ouville, whose company was recently named global custodian for Prince Street Capital Management, an investment management firm specialising in emerging markets. “As a custodian and asset-service provider, we are adding to our suite of capabilities to ensure that we’re giving our clients all the capabilities that they need to manage the risk and to understand the impact of their overall portfolio.” Andrew Tucker, partner and head of investor services, Europe for Brown Brothers Harriman, sees half of all alternative asset inflows that BBH services going into real estate, with most of the remainder being directed through fund-of-funds (FoFs) and funds-of-hedge-funds (FoHFs), “both areas where BBH has chosen to concentrate our specialty, building up expertise and technology in this space,” says Tucker.“We are also seeing growth in the creation of exchange-traded funds (ETFs), both international and commodity products, as well as funds-of-ETF (FoETF) structures.“ Perhaps the greatest opportunity for custody providers in the coming years is helping clients formulate strategies for dealing with under-funded pension plans. Says Keaney, “You see this taking shape in the form of these emerging businesses, where investment banks are going out and raising equity and then approaching under-funded defined benefit plans and saying, ‘Guys, let us take this stuff off your balance sheet—we will buy your liabilities from you.’ That did not exist two years ago, not even a year ago.” In turn, plan administrators seeking higher-earning asset classes are seeing the benefits of alternative investments including real estate, private placements, and

Raymond Carney, who heads the Custody and Investment Services (C&IS) Innovation Center at Northern Trust.“They might want a product or an outsourcing service whereby the provider can take control of the plan for the client. However, before clients even get to that point, they may need to decide whether to freeze the plan, immunize part of it, and so forth. It is our job as well to help the clients look at the situation from many different angles, in order to help them make the right decision.” Photograph kindly provided by Northern Trust, June 2006.

Paul d'Ouville: Senior Vice President Corporate and Institutional Services for Northern Trust considers the alternative-investments trend a significant opportunity.“The flow of capital into alternative assets isn’t slowing,” says d'Ouville, whose company was recently named global custodian for Prince Street Capital Management, an investment management firm specializing in emerging markets.“And as custodian and asset service provider, we are adding to our suite of capabilities to ensure that we’re giving our clients all the capabilities that they need to manage the risk and to understand the impact of their overall portfolio.” Photograph kindly provided by Northern Trust, June 2006.

commodities. “It is all completely driven by under-funded pension plans,” says Keaney, “companies that are being forced to put the under-funded amounts on their balance sheets and find ways to accelerate payments. It’s really what’s behind the changing forces in our industry for the time being.” Government regulation has increased the responsibility of pension fund administrators, says Nigel Taylorson, head of relationship management UK & Ireland at ABN Amro Mellon, and a failure to meet these regulatory requirements could have serious consequences for clients. As such, custodians are in an ideal position to provide crucial information for trustees by implementing new and innovative solutions on their behalf, says Taylorson.“This is not just a case of increased investment in technology, essential though this may be—of vital importance is the range of products and services offered by the custodian, combined with a flexible, tailored and client-friendly delivery system. One without the other is of little help to clients.” “You take a company that has a $190m liability stream, and they need help fixing the situation,”says Raymond Carney, who heads the Custody and Investment Services (C&IS) Innovation Center at Northern Trust.“They might want a product or an outsourcing service whereby the provider can take control of the plan for the client. However, before clients even get to that point, they may need to decide whether to freeze the plan, immunise part of it, and so forth. It is our job as well to help the clients look at the situation from many different angles, in order to help them make the right decision. “The thing is, not everyone has reached the point where they are ready to buy a really sophisticated investment product—many clients just need to see the big picture,” adds Carney. He points out the importance of having a provider with “really good consulting skills

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

the effect of financial relationships on

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all of which is particularly important for our institutional investors. For our asset managers, the whole goal is around straight through processing (STP), making sure the system works efficiently with as little manual intervention as possible.” In June, State Street Corp., currently with $10.7trn in assets under custody, debuted a suite of enhanced web products, including an Online Documents Manager, Securities Lending Performance Analyser and a TaxEfficient Lot Selector, with the goal of providing global clients increased access to pertinent data. “The evolving regulatory environment, along with the heightened complexity of the overall investment process, has meant that our customers need greater accessibility to their investment information along with better monitoring and control over the activities of their managers,” says Joseph Antonellis, executive vice president and chief information officer for State Street. “These new developments also highlight State Street's ongoing investment in the diverse technology needs of our global Bank of New York senior executive vice president Tim Keaney, who says that,“We were very customer base.” impressed with how quickly the client constituencies are becoming global … Obviously it is At BBH, clients may tap into really hard to serve a global client if you look at the world through a narrow geographic Infomediary, a hosted messaging solution, lens. There are also a number of common issues weaving across those client constituencies, to streamline a wealth of operational geography to geography. Photograph kindly provided by Bank of New York, June 2006. processes, including trade instructions, who can really put that asset-liability picture together more payments, reconciliation, corporate actions, foreign often than just once every three years when the asset-liability exchange and fund-order messaging. “It is really the study is done. And using some of these front-end modeling backbone of our approach to modular and open tools, you can do a bit of scenario-creating for the client, in architecture outsourcing,” says Tucker. Additionally, BBH has devoted significant investment capital to support core order to help them understand where they are,”he says. At State Street Global Advisors (SSgA), the investment- global-custody and investment-administration offerings, management arm of State Street Corporation, helping plan including enhanced global investment accounting sponsors manage interest-rate and duration risk within a capabilities and institutional transfer agency, adds Tucker. Technology is the lifeblood of Bank of New York’s custody liability-driven investment framework is the goal of SSgA’s Pooled Asset Liability Matching Solution (PALMS). Using regime, says Keaney.“It is absolutely huge. Everything from liabilities to measure pension-fund risk is a viable tax regimes changing, to SWIFT technology, connectivity alternative to traditional approaches to risk and return, with your clients—these are technology businesses we are observes SSgA’s Alistair Lowe, director of global asset talking about, and if you are not investing in the technology, allocation. “By addressing un-rewarded liability risks, and you are doing anything in a manual way, you are a including interest-rate and duration risk, through a ticking time bomb.That is all there is to it! It is just a problem restructuring of the fixed-income portion of their portfolios, waiting to happen, and believe me; problems in our business plan sponsors can better manage future liabilities and work are broadcast, just like on CNN. We are zapping everything to increase funding levels by allocating that ‘risk budget’ to real-time to clients on our online systems, and if you make a mistake, your clients know about it in roughly three seconds. return-generating strategies,”says Lowe. Tech spending is of vital importance to custody leader JP In other words, it is a zero-defect environment out there Morgan, which devotes a significant portion of its right now.You have to embrace that way of thinking and run investment capital to Internet-enabled proprietary at it, which means devising a technology system that’s reporting technology.“There is a lot more to it than just a industrial strength and bulletproof.” As clients increasingly see the value of concentrating on user-interface,” says Warne, “it is the ability to access an enormous amount of data in a meaningful way, analyse it core competencies, global custodians have in turn continued and then use it in a manner that is critical for our clients. to benefit from outsourcing opportunities. A recent There is a lot of work involved in rolling that out properly, outsourcing deal with F&C Netherlands BV gave ABN Amro

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

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imperative that universal custodians Mellon custody over client and use their scale in the most efficient fund administration activities for way possible. “Firms often fail to 181 institutional clients in that leverage their large numbers of country. Meanwhile, Bank of New client relationships and extensive York is collaborating with UKdistribution networks for either based Capita Financial Group to improved cross-selling or product provide trustee, depositary and innovation,”says Dence,“and those custody services for Capita clients. firms that do successfully achieve Increasingly, clients are issuing efficiency through scale—aiming challenges to providers, says for other important scale benefits Keaney, including asking such as greater scope, depth and custodians to undertake more of breadth—will prove vital to seizing the work they no longer want to opportunities and combating do. “And if you are not willing to margin pressures.” take that on, they [will] talk to Andrew Tucker, partner and head of investor services, “It is such a tight market right some of the other folks, and if they Europe for Brown Brothers Harriman, sees half of all now,” affirms Keaney. “We have can help them with their problems, alternative asset inflows that BBH services going into great competition, there are a lot then guess what—your custody real estate, with most of the remainder being directed of people nipping at our heels, business might go right out the through fund-of-funds (FoFs) and funds-of-hedge-funds and it’s a reminder every day that door with them.” To meet that (FoHFs). Photograph kindly supplied by BBH, June 2006. if we don’t do a great job for our challenge, says Keaney, custodians must develop an understanding as to how their clients’needs clients, they are not going to wait for us to get our act are changing, and seize that as an opportunity to drive their together—they’re going to go out and find a partner that is product agendas—and, in the case of Bank of New York, well-positioned to support their needs.” Above all, a strong custody division serves as a gateway “build what I call ‘sticky client relationships’ that none of my to a whole range of client services and investment major competitors can unglue. And that is a holy grail.” “The whole cost-reduction outsourcing mega-trend is opportunities, argues Keaney. “I like to use the analogy something we have really been focused on,”says Carney at that custody is really the equivalent of our stomach Northern Trust.“There are clients who have been doing this muscles—it’s the means by which we deliver the firm to sort of thing in-house on spreadsheets,”he says that really our clients. It gives us access to opportunities supporting can not afford to maintain the level of staffing that is alternative investments, to provide securities lending, to required to run a back and middle office operation. Those do transition management, to do execution. In short, it’s are the very clients that “need to know that they can really a major platform for cross-selling our firm into outsource the job to someone who is going to committed virtually every client constituency.” Looking ahead, clients will continue to demand globalto this business,” and also has a culture that is innovative and is going to want to keep developing and making things custody and asset-administration services that are flexible enough to help them achieve improved investment better in the long run, he maintains. Being the biggest does not necessarily mean you can rest on performance and increased distribution, says BBH’s Tucker. your laurels. In May, HSBC Securities Services dethroned JP “Efficiencies gained through, for example, pooled Morgan from a $40bn securities services brief at structures or increased use of derivatives, require robust operational capabilities Royal London Asset and expertise in the Management. It marked the Facing the challenges of greater competition in the middle and back offices.” third straight multi-billion custody business 200 Products like BBH’s dollar contract loss for the 180 Infomediary and other global-custody giant; earlier, 160 streamlined methods of the Railways Pension 140 reporting complex Trustee Company, which 120 100 information back to the runs the $32bn industry80 client are also at a wide pension scheme for 60 premium, adds Tucker. the UK rail system, named 40 “These types of solutions, ABN Amro Mellon to 20 0 delivered on a global replace JP Morgan as its platform and supported global custodian, while locally by knowledgeable retaining the Bank of New JPMorgan Chase & Co. Bank of New York Co. client service in the client's York as co-custodian. Northern Trust Corp. FTSE USA Banks Index preferred language, will be As IBM report consultant the near-term winners.” Suzanne Dence notes, it is Source: FTSE Group / FactSet Limited US Dollar price returns. Data as at June 2006

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

THE COMPLEX FACE OF INVESTMENT SERVICES

NEW ASSET SERVICING

Are traditional definitions of the global custody business now seriously outdated? Many practitioners seem to think so. In an increasingly sophisticated investment world, the pressure on global custodians to step up to the plate and extend the scope of the services provided under the latest umbrella term “asset servicing” is immense. So what does it all mean? Is global custody dead? Should the rallying cry be “Long live asset servicing”? Francesca Carnevale talks to some of the principal custodian houses to determine the timbre of the emerging investment servicing landscape.

Ann Doherty, senior relationship manager at JP Morgan WSS in London prefers the description that,“custody has become more complex.”This complexity has grown in part from divergence, both of customer requirements (particularly in reporting frequency and content) and investment approaches. Doherty sees clear distinctions in the emerging geography and customer segments of today’s custody markets and the growing variations in service requirements of each. Photograph kindly supplied by JP Morgan, June 2006.

HE ACQUISITION OF UniCredit’s Italian securities services business, with €455bn in assets under custody, by Société Générale Securities Services (SGSS) for a reported price tag of €548m in February this year elevated the bank to the third biggest custody player in France and Italy. The deal marked out SGSS as a committed player in the consolidating European custody market. The acquisition should be finalised in September, “so it is perhaps a little early to gauge the true impact of the acquisition,” says Sebastien Danloy, global head of sales for investors’services, “but it is a critical, strategic acquisition: giving us credibility and it also demonstrates the bank’s strong commitment to securities services business,”he says. Etienne Deniau, deputy head of investor services at SGSS, meanwhile acknowledges that,” it positions us as a consolidator in the European theatre.” It was a necessary thing to do as market consolidation, such as that between RBC and Dexia, continues to be a strong theme in Europe and will likely continue to be for some time (there are obvious buying opportunities in Spain, Germany and Scandinavia, for instance) and the deal brings in clear benefits—not least the custody, clearing and settlement, depositary bank, fund administration and transfer agency business that UniCredit

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provided for clients in Italy. A critical advantage, thinks Deniau “This acquisition has made us an established local player in the Italian market, a position that will be enhanced by our existing European network. In addition, we think that outsourcing will be the next trend in the Italian market.” There are other attendant advantages of the deal. For the hefty price tag that SGSS paid for Unicredit’s investor services business it now has operations in Germany, Luxembourg and Dublin that, says Deniau, are vital accessories for an institution with pretensions to become the dominant custodian in the European theatre. As well, there is the transfer agency business attached to Pioneer, Unicredit’s specialist subsidiary that came along with the sale as well as sub transfer agency services (banca correspondente), which adds Deniau “is a value added, highly complex and specialist offering.” Deniau is open about the intention of SGSS to build market share through organic growth and further acquisitions,“The turnaround was back in 2004,”he explains, when SGSS was created. “It articulated a degree of commitment,”he adds, with Danloy adding: “we are willing to write a cheque.” SGSS’s latest move is signal intent then for the bank to step up to the plate and manoeuvre in the same playground as leading lights such as BNP Paribas, JP Morgan, Citigroup, State Street and

NEW ASSET SERVICING

Penny Biggs, head of customer relations, EMEA at Northern Trust in London describes an emerging landscape that is around 40% that is traditional business and rooted in the large pension funds,“largely public funds and corporate pension schemes that want hand holding and support and education and jurisdictional expertise. Then there is another 40% or so that are more traditional fund managers working in newer asset classes,” she says. Then she says there are another 20% that are more “radical organisations, such as private equity firms.” Photograph kindly provided by Northern Trust, June 2006.

Northern Trust, in an increasingly complex market space where a number of concurrent trends are at play. Consolidation and restructuring have been consistent themes over the last three years in the global custody business and not just in Europe. In May, the Pittsburgh-based Mellon Financial Corporation reported that following a review of its asset servicing businesses, the firm will be restructuring “to operate even more effectively”according to the accompanying press blurb. The move follows a similar review late last year of Mellon’s asset management businesses, which led to the combination of the Institutional Asset Management and Mutual Funds businesses into Mellon Asset Management. Mellon’s actions come at a time of extensive change in what has historically been called the global custody market. In part, this is driven by growing numbers of custody mandates in a year long spurt of business that has resulted in record years for assets under custody for many firms. Within this umbrella trend, a number of sub-trends are apparent. Martin Kunz, head of global custody product management at BNP Paribas acknowledges that the business environment has been “rather torrid up to the last 12 to 18 months: with industry professionals being subsumed by the amount of energy required to comply with mandatory and SWIFT changes since 2000 , including changes MiFiD, compliance requirements, and corporate governance.”After a rather quiet period, he continues,“we have now seen a significant increase in larger mandates.” In February, for example, JP Morgan went live with a global custody, fund administration and fiduciary solution for

Cazenove Capital Management (CCM) £4bn worth of UK and Irish funds, with a further custody transition covering £6bn in private and institutional client assets, which will be gradually transferred to JP Morgan during the remainder of 2006. Mellon Global Securities Services (MGSS) meantime won the mandate to provide custody and associated services (such as securities lending and performance measurement and analytics) to Carleton College, College of the Holy Cross, The George Washington University, and Trinity College endowments with a combined value of more than $2bn in total assets. Mellon already services 11 out of the 20 largest university endowments in the United States and accounts for more than two-thirds of the Top 50, representing more than $130bn in assets under custody. Second, in some instances, beneficial owners are consolidating their assets into one or fewer custody providers. In early June, for example, the Royal Mail Pension Plan, which manages £22bn of assets, consolidated £2.2bn worth with JP Morgan’s WSS business bringing all its segregated assets under one global custodian; although in the context of the European business sourcing market, it is unlikely that this presages a larger trend. Ann Doherty, senior relationship manager at JP Morgan WSS in London prefers the description that,“custody has become more complex.”This complexity has grown in part from divergence, both of customer requirements (particularly in reporting frequency and content) and investment approaches. Doherty sees clear distinctions in the emerging geography and customer segments of today’s custody markets and the growing variations in service requirements of each. The market divides, for example, into the larger traditional institutions and emerging specialist asset managers. “The larger pension funds have leveragability and better resources to manage vendors and most of these institutions will review their custodian relationships every three to five years,” she explains. “All clients receive a quarterly scorecard. However, as fund managers have a market facing product, they undergo more change and that’s where the partnership or relationship element is becoming critical to help them develop their business and our relationship evolves with our clients.” A point raised in a different way by Penny Biggs, head of global business development at Northern Trust in London. Biggs describes an emerging landscape where around 40% of what they deal with is traditional business rooted in large pension funds employing global managers to invest their assets, “largely public funds and corporate pension schemes that want support and education combined with risk management and revenue enhancement. Then there is another 40% or so that are your more traditional fund managers, but who are increasingly working in newer asset classes,” she says. Then she says there are the final 20% who are the more “radical organisations, such as private equity firms, emerging market managers and multistrategy hedge funds.” She highlights the variety of the European market: “In the UK we note the increasing interest of UK pension

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funds into alternatives, involving between 2% and 3% of their portfolio. In mature European markets, such as the Netherlands and the Nordic region you are often looking at between 5% and 10% being allocated into these newer and more aggressive asset classes.” Biggs also highlights the sea change both in customer make up and business definitions that result from a market in flux.”The definition of the business is changing. It is no longer about traditional custody and simply putting documents in vaults or recording on an electronic system. The more our clients look to invest in new asset classes, the more the definitions of our business are broadening. We have to handle an increasing array of instruments and asset classes from commodities to weather derivatives these days with the same alacrity that we handle equities and bonds. It is exciting, but also challenging.” The growing biodiversity in the market is also changing the nature of the relationship between client and custodian. Connectivity is fundamental here, says Doherty. “A custodian does not stand on its own. Systems are nowadays integrated with fund managers because they rely on us for downstream processing, a trend that we have encouraged.”Additionally she provides the example of a client who wanted the bank to provide an over the counter (OTC) derivatives capability that would cost £4m.“They wanted an outsourced solution because

that £4m accounted for the majority of their development spend for the year and they preferred to spend it on the front rather than the back office. Again, we have encouraged this.” JP Morgan is open about working hard for this relationship. Doherty points out that the scope of today’s custody business involving “corporate actions, international taxation and linkages around accounting and reporting,” is naturally concentrating business into the hands of the major player. “The barriers to entry in this business are now immense; not least the magnitude of technology spending that is required.” JP Morgan reportedly spends around 20% of its revenue (reckoned in the billions from its investment services businesses) annually. Most recently, JP Morgan launched its VIEWS Portfolio Reporting technology, for institutional investors to report custody, accounting and securities lending activities. VIEWS enables clients to integrate and access data across multiple disciplines including custody, accounting, securities lending, and compliance and provides a link to performance measurement. Users can search and access a database with information across all of their holdings, trades, transactions activity, corporate actions and loans and make long range cash forecasts. Clients can also develop their own “chart of accounts”and investment ledger, so they can create on-demand interfaces to a local general ledger.“We think it gives us an additional edge,”says Doherty.

A fresh perspective on investor services RBC Dexia Investor Services combines the strengths of RBC Global Services and Dexia Fund Services — two recognised leaders in global custody, fund and pension administration and shareholder services. See how our fresh perspective can support your strategic objectives and enhance your business performance. Visit us at www.rbcdexia–is.com. RBC Dexia Investor Services Limited and its affiliates are licensed users of the RBC and Dexia trademarks, which are registered in the name of their respective owners. RBC is a registered trademark of Royal Bank of Canada. RBC Dexia Investor Services is the brand name under which RBC Dexia Investor Services Limited and its affiliates conduct their global custody and investment administration business. RBC Dexia Investor Services Limited is a holding company that provides strategic direction and management oversight to its affiliates, including RBC Dexia Investor Services Trust which is authorised and regulated in the U.K. by the Financial Services Authority.

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NEW ASSET SERVICING 48

Size and technological clout are not supporting commoditisation of the industry however. Instead, the reverse is happening.“One size no longer fits all, particularly in Europe,” says BNP Paribas’ Kunz. He takes the point further and explains that the reliance on consultants by many of the larger beneficial owners has meant that in many instances, customers are looking for best of breed expertise, particularly in areas such as transfer agency business and distribution support. “In practice it has promoted a preference for clients to unbundle the services they receive from custodian banks; a process that, on the supply side, has made it tougher to develop a consistent process,”he adds. Doherty thinks that unbundling is driven by “a desire to receive the lowest price for every component.”It is an issue she has some sympathy with and acknowledges that with JP Morgan at least,“in terms of running a healthy business everything has to stand on its own two feet. We work with a cost based model, but we are realists and know where the market is and the demands of competition.” A point that BNP Paribas’Kunz clearly acknowledges,“there is still pressure in pricing.” Nonetheless, he points out the attendant dangers of such an approach “Ask yourself, given the increased risk and potential inefficiencies that flow from the unbundling of services; is the pricing more significant than the sum of the risks involved in separating the parts of the business?”says Kunz. Everyone agrees unbundling brings its particular limitations. “When you had products bundled you had cross-subsidisation, where the loss of margin on one business could be recovered either via custody or through, say, stock lending. But if the components now have to stand on their own legs, it can be tough,” concedes Kunz. JP Morgan’s Doherty, highlights a possible countertrend emerging.“This is the area where there is the potential for a proliferation of small, specialist service providers.” While business is flowing to the majors, an increasing component is their ability to develop local expertise and, further, put people on the ground, either in “centres of excellence,” as JP Morgan calls them, or as with Northern Trust, local ‘hubs’. Northern Trust’s Biggs explains the logic. “While multiple asset classes are stretching the boundaries of custody in mature markets, in others a personalised and local touch is required. That is because Europe is still not a uniform market and local regulations as well as culture and tradition may limit what investors can and cannot do. Offering a bewildering array of products to these clients is of no value at all. They want their own circumstances attended to and that means local representation, or at least ‘local understanding’ and constant communication to understand what they want to get out of their investments and provide them with the appropriate service.” That willingness to think globally and act locally has paid off in spades for Northern Trust. Following the establishment of a Netherlands base, it was most recently selected by the Stichting Federatief Pensioenfonds (SFP) – the collective pension fund for small and medium-sized privatised public bodies in The Netherlands – to provide custody, securities

Etienne Deniau, deputy head of investor services at SGss, meanwhile acknowledges that,” it positions us as a consolidator in the European theatre.” It was a necessary thing to do as market consolidation, such as that between RBC and Dexia, continues to be a strong theme in Europe and will likely continue to be for some time (there are obvious buying opportunities in Spain, Germany and Scandinavia, for instance) and the deal brings in clear benefits — not least the custody, clearing and settlement, depositary bank, fund administration and transfer agency business that UniCredit provided for clients in Italy.” Photograph kindly supplied by SGss, June 2006.

According to Sebastien Danloy, global head of sales for investors’ services, it is perhaps a little early to gauge the true impact of the acquisition of UniCredit’s investment services operations, “but it is a critical, strategic acquisition: giving us credibility and it also demonstrates the bank’s strong commitment to securities services business,” he says. Photograph kindly supplied by SGss, June 2006.

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lending and performance measurement services to the spot the winners of tomorrow.” For Denaiu and Danloy, the €330m fund. The mandate follows a similar deal originating consolidating European market, both in terms of custody from Stichting Bedrijfstakpensioenfonds voor het provision and asset management offers opportunity: “Look Beroepsvervoer over de weg (Pensioenfonds Vervoer), the at the impact of the Merrill Lynch Investment travel and transport industry pension scheme, in the Management/Blackrock and the recent Aberdeen Asset Netherlands in March this year, worth a whopping €7.5bn for Management/DWS deals,” says Deniau, in a throw of a global custody, compliance monitoring, performance gauntlet. “One custodian’s gain is invariably a loss for another. Knowing who will remain in tomorrow’s market is measurement, commission recapture and securities lending. For BNP Paribas, localisation of expertise has been a the key in this business. In France for example, only seven to cornerstone of it current service offering.“We have booking ten large pension funds will remain, the question is which of centres in multiple locations and clients can hold accounts the global custodians will win and retain this resultant in five or six or more locations. We find an increasing business. We aim to make sure it is us,”he smiles. demand for local service provision over having the business, say booked centrally in a centre such as London, although the platform is standard,” says Kunz. What it means he says is that the bank can offer “consistency of service with a strong local flavour.” SGSS’s Deniau thinks that with the market in flux, there is everything to play for, “in Eastern Europe for example, regulations are changing the way people save money, which is a very different scenario from that of even four years ago. We expect to see growth, especially in countries where they do not yet have second or third pillar pension plans.” “The investment management marketplace is looking for fresh ideas for their increasingly complex challenges,” says JP Morgan’s Doherty.“The ability to meet this challenge head on will be the key to new business,”she adds. Doherty has two acronyms and one piece of legislation that she uses as lodestones for future business: KYC, AML and Sarbanes Oxley. “Know your client and anti-money laundering involve no small job Uif!DJTY!qspwjeft!tdsffo.cbtfe!usbejoh!boe!uif!mjtujoh!pg!jowftunfou!gvoet-! of work, given the number and tqfdjbmjtu!efcu!jotusvnfout!boe!tibsft!jo!dpnqbojft/ diversity of funds and assets in Pvs!bqqspbdi!jt!ijhimz!qfstpobmjtfe-!pggfsjoh!gbtu.usbdl!qspdfttjoh! the market, keeping that straight pg!bqqmjdbujpot!xjuijo!b!ijhimz!sfhvmbufe!boe!joopwbujwf!nbslfuqmbdf/ and in good order will be vital for Wjtju!pvs!xfctjuf!ps!dpoubdu!vt!gps!efubjmt/ custodians going forward. Add Q/P/!Cpy!734-!Pof!Mfgfcwsf!Tusffu-!Tu!Qfufs!Qpsu-!Hvfsotfz!HZ2!5QK to that the rigorous reporting Hvfsotfz!Ufm;!,55!)1*!2592!824942!Kfstfz!Ufm;!,55!)1*!2645!848262 Gby;!,55!)1*!2592!825967 requirements of Sarbanes Oxley.” xxx/djty/dpn What is important says SGSS’s competitive Deniau is“to

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GM EDITORIAL 14

12/6/06

20:51

Page 50

PORTFOLIO TRADING

HIGH TOUCH DEMANDS AT LOW TOUCH PRICES

With increased connectivity and more market feeds between clients and brokers, portfolio trading is becoming a complex market making business. More and more is expected of broking firms by buy side clients, which are themselves looking for greater control over the trading of their shares; either through direct market access (DMA) or direct to model (DMO) trades. In an increasingly intricate and ingenious marketplace, inevitably there will be winners and losers. The question is who and when. Francesca Carnevale reports on the concomitant trends that are changing the face of portfolio trading, perhaps forever.

HE DAEDAL WORLD of portfolio trading continues in flux. Today’s portfolio trader is both buffed and buffeted by a cross current of trends that, some say, will redefine a new era of business. Portfolio or programme is the simultaneous trading of a portfolio or ‘basket’of stocks, defined by the New York Stock Exchange (NYSE) as involving at least 15 stocks with a total value in excess of $1m in a wide range of trading strategies. According to Adam Toms, executive director and head of portfolio trading at Lehman Brothers in London; “that is outdated now, given the variations of execution channels.”

Toms’ ebullience is based on the acknowledgement that portfolio trading continues in transition and the growing volume of trades moving through Lehman’s pipes, as elsewhere, has grown exponentially. At the same time, the relationship between trader and client is morphing into a complex web of connectivity and interdependence even as more buy side firms show a willingness to participate in trading either through DMA or DMO routes. Toms points to the sheer volume of business that is breaking one record after another. Lehman Brothers reckons to have around 12.7% of the UK market by volume traded, with a lead in quantitative based trading approaches; with volume boosted by a massive rise in both cash programme and DMA trading through its pipes.“As a key indicator of the volume coming just from us, we were the first firm to break the million transactions a month record on the London Stock Exchange (LSE). We have

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important as the since broken this record “tendency has been for several times in succession the frequency to increase this year,” says Toms. It is but for the size of the an indicator of the wider trading baskets to get trend. “The numbers of smaller as customers trades are eye-popping; in become more specific in the recent market volatility their portfolio strategies,” we hit a new LSE record. explains François Lehman accounted for Banneville, deputy head 25% of all transactions in of global portfolio trading one day,”he says. at Société Générale. He points to unbundling “Of course, hedge funds these days are a fixed part of the landscape,” Trades are initiated either and regulatory issues such says Zachary Tuckwell, global head of portfolio trading at Dresdner by an algorithms' as Regulation NMS in the Kleinwort Wasserstein (DrKW),“though traditional funds also have suggestion to exploit US and MiFid in Europe high touch strategies in play. They are conscious of long/short sector small price differentials as important influences biases, for example, and so you have to have systems in place that can between securities or by a on today’s market, handle this demand.” Photograph kindly supplied by DrKW, June 2006. portfolio manager “particularly unbundling, which has been a major theme,”he stresses, explaining that anxious to arbitrage stock price movements. There are three principal tiers of providers: around six or it has driven“volume in terms of execution channels. It has been groundbreaking.” The unbundling “stipulates how seven banks with truly global capability such as Merrill much they pay for trades and research” adds Toms, Lynch, a growing number (around 40) of mid-tier houses, explaining that in consequence, “clients are placing a such as ABN AMRO, and thirdly, a host of specialist greater emphasis on trading and more efficient execution.” providers, that leverage particular expertise. It is the It has also encouraged clients to put a spotlight on value middle space that is in flux, explains Tony Nash, managing for brokerage fees says François Banneville, deputy head of director, head of portfolio and electronic trading sales at global portfolio trading at Société Générale concurs. Lehman Brothers in London.“There is a focused group of “Unbundling has led to a tail off at the lower end of the houses which are on the cusp of becoming global players market, generally among local brokers that lack the ability and so there is a migration coming at the top end as they move up the value chain. At the bottom end, we think there to provide flow.” According to Richard Balarkas, managing director and could be a fallout as the investment in technology required head of advanced execution strategy sales at Credit Suisse to stay in the business will simply be too much for some of in London, “Clients as a whole are becoming more the houses: even if they partner with a third party discerning, about who they trade with. They have a duty to technology vendor.” The growing complexity of the market is exemplified by ensure that when they choose a broker for execution they have made the decision on the broker’s proven ability to the various strategies that the world’s leading broking execute the trade, not because of a desire to pay the broker houses have deployed to offer the portfolio trading product. Last December, Lehman Brothers bolstered its for other non-trading services that may be provided.” While unbundling is really all about the desire for electronic trading offering with the acquisition of transparency and clarity, particularly in Europe and is being Townsend Analytics (TA), the Chicago-based software and pushed by both the Financial Services Authority (FSA) and service provider. The deal includes Townsend's clients, its buy side clients, the result is that these days “trading flagship RealTick execution management software and the commission is more closely related to client business,”says developer’s various other trading technologies and Zachary Tuckwell, global head of portfolio trading at services. Financial terms were not disclosed. RealTick delivers a wide range of North American and Dresdner Kleinwort Wasserstein (DrKW). “Most portfolio trading desks are paid on a relationship/unbundled service European market data and trading capability across equity, basis in any case. What is significant now is what it is futures, options, fixed income, and foreign exchange costing us to service clients and how much time and effort markets, research, analytical tools and risk and account is spent on getting a defined benefit from each account,”he management tools, as well as direct trading connectivity to adds. Programme trading it seems is a high-volume, low major pools of liquidity such as listed exchanges in the US margin business placing heavy demands on both hardware and Europe, ECNs and broker-specific destinations. The relationship between the businesses is not exclusive and software. Return on portfolio trading and the various approaches however and in fact,TA sold its direct access platform to UBS and market strengths offered by the leading houses is and specialist trading house Cheuvreux. There are no then a key dynamic. Particularly as the business today immediate plans for Townsend Analytics to begin in-house demands low transaction costs coupled with increasingly or dedicated development for Lehman Brothers, although sophisticated trading information. This is particularly the firm may take advantage of Towsend’s resources in the

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PORTFOLIO TRADING According to Adam Toms, executive director and head of portfolio and electronic sales trading at Lehman Brothers in London, average trade size has plummeted and the number of trades has soared. TABB Group, a research and advisory firm headquartered in Westborough, Mass., estimates that algorithmic trading captures 13% of US equity order flow today and projects this share will grow 34% compound over the next two years to 23%. Photograph kindly supplied by Lehman Brothers, June 2006.

future. “We absolutely are looking at extracting as much leverage for our in-house systems as is practical,”says Toms. Vendor acquisition is quickly becoming a popular strategy in the financial services industry as firms look to add value, separate themselves from the competition, and seek to establish high technology services without going to the expense of the larger houses, such as Credit Suisse and Merrill Lynch, that prefer proprietary solutions. “We feel that the customisation and flexibility needed to meet global client trading needs is best addressed with our proprietary trading and analytical systems, underscores Mike Stewart, head of global cash equities at Merrill Lynch in New York. Lehman’s acquisition followed Citigroup’s acquisition of Lava Trading; Bank of New York’s acquisition of Sonic Financial Technologies (back in March 2004) while JP Morgan acquired DMA technical specialists Neovest in June of last year. Competition is obviously a key driver, even in a burgeoning market, particularly at the top end. Banneville explains why.“While some houses deal with as many as 50 brokers,” he says “there are only around 10 houses with a serious array of algorithms on offer.” He tells that the bulk of global portfolio trading is concentrated in the hands of around 20 houses globally, “with a tail of 30 or so and on average a client will work with 10 brokers. But there is big difference between third and fourth place and an even bigger difference between fourth and eight place,”he smiles. “The thing is,” says Balarkas at Credit Suisse, “no single vendor has a dominant market share so it is essential for us

to work with all vendors to distribute our product effectively.”As for vendors moving into the brokers’space by building their own algorithms into their front ends, Balarkas says, “by definition, vendors are behind the curve when it comes to developing new and complex algorithms to face directly into the markets. The demands of the business force us to innovate like crazy.You cannot buy off the shelf the complexity involved in some of our algorithms.” Not all mid tier houses feel the threat. According to DrKW’s Tuckwell, “In a global house you can become something of a traffic copy directing flow on the desk. I wonder how personalised some of the business they handle can be? We take the niche approach. In Europe, for instance, we concentrate on our strong cash franchise and expertise in the German market. As with leading players, the focus on tailored and efficient execution service is very high.” According to Banneville, “service on index arbitration margins has been reduced. Therefore, proprietary traders have had to find ways to process more flows to keep up overall return. That problem is something that the buy side is facing as well. Therefore, business has to rotate more and so you cannot change allocations on a daily or weekly basis if costs are high and so you need powerful tools to execute the business effectively. That fact dictates the structure of the market as it is today, with continued reliance on broker expertise.” That plays into the hands of the leading players thinks Merrill’s Stewart. He explains why. “The key drivers for future growth in portfolio trading are a full global platform with high market share in most developed and emerging markets,”he says.“Second, is the provision of a quantitative analytical infrastructure to assist clients in both pre-trade execution modeling and an actionable post-trade transaction cost analysis and lastly, a robust, high performing algorithmic product that is driven off this quantitative infrastructure.” Stewart notes an increasing concentration of business into the leading houses,“we see it clearly on the NYSE and although we all know that markets move in cycles, there are consistent dynamics at play.” He notes that in a market of rising trading volumes and increased complexity that the ability to receive and process both market and client-based data involves “a serious investment in information technology and brainpower.” “We have spent considerable resources in both our quantitative infrastructure (which has fueled both our client facing pre and post trade tools) and X-ACT, our leading algorithmic offering,” says Stewart, who thinks that few houses around the globe can match that level of commitment. Much is made these days of the quality of the broker interfaces with their clients, which invariably offer complex computer algorithms that can trigger trades in response to defined strategic market signals, such as price changes in a given stock. Toms explains that in general there are two types of algorithms: portfolio management algorithms that are designed to generate alpha signals and then execution algorithms that implement investment decisions. Often the

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choice of strategies available through the interface, defines the brokers exact place in the lexicon of portfolio and electronic trading. Improved execution is the primary benefit of the use of algorithms as brokers search for better ways to execute orders. Nash at Lehman emphases that it is not just about size. “Access to liquidity is paramount, combined with the ability to execute efficiently and service a growing and increasingly sophisticated customer base. The availability of useable front-end technology which is being deployed on customers’ desks is changing the nature in which buy side traders interact with their brokers. It is the quality of this technology which helps drive execution.” It is a particular challenge, says Ken Kane, managing director and head of European program trading at Credit Suisse noting that,“Competition and market regulation are increasing the number of possible liquidity pools. We are utilising our technology to look at all possible destination and not necessarily only the primary exchange. The ultimate goal is to find price nad volume points. It is a fundamental shift.” Most brokers agree that the provision of liquidity creates customer stickiness as much as the quality and range of the trading strategies employed. Steve Vandermark, managing director, equity quantitative analytics at Lehman Brothers International (Europe), in London explains why. “The simple fact is that different algorithms suit different stocks. Blue chips are a natural. It is very difficult to find a mid cap stock that trades in clumps, so other approaches come into play and clients will gravitate towards those firms that can trade them out of positions quickly when necessary.” Nonetheless, both Nash and Vandermark give a nod to the fact that technology has also encouraged DMA, which explains Vandermark is “really happening this year and longer term that is going to be a real market change.” Obviously, that cannot take place, says Nash without “smart order routing technology allows a greater efficiency, particularly in terms of cost,” says Nash. It becomes a particular issue, agrees Tuckwell as the range of assets that are being introduced into the mix has broadened.“We are seeing futures, ETFs, equity swaps, contract for differences (CFDs) as well as the growing requirement for DMA.” It is a fundamental shift from the traditional source of portfolio trading business, namely index rebalancing. “Index Fund clients are still a very important part of Merrill Lynch's portfolio trading desk, but they are a lower percentage of our portfolio client trading base, than they were three years ago. Index fund client volume has not gone down, it is that other client bases are adapting to using portfolio trading as an efficient method for executing multiple orders,”says Stewart.“Both fundamental long only and hedge fund accounts are a larger part of our client base, and we are providing these clients with a consultative approach as well as pre-trade optimization tools to illustrate optimal portfolio trading execution schedules” The figures, at least on the NYSE, speak for themselves. In addition to a broader asset mix, there is a wider range of

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trading strategies being used by the buy side either through DMA, or through broking firms. Taking one week in February this year as a working example, some 9.5% of programme volume executed by NYSE member firms related to index arbitrage, (though more commonly this level bounces around the 7% mark, compared with around 3% three or four years ago). Index arbitrage is defined as the purchase or sale of a basket of stocks in conjunction with the sale or purchase of a derivative product such as stock-index futures, to profit from the price difference between the basket and the derivative product. The NYSE reports also highlight the biodiversity of approaches of broking houses themselves to portfolio trading. Of the five member firms reporting the most program trading activity on the NYSE in February this year, for instance, UBS Securities regularly executed most of its program trading as principal for its own account. Goldman Sachs, Morgan Stanley, Lehman Brothers and Merrill Lynch and specialist house Pierce, Fenner, & Smith, Inc. on the other hand appear to have executed most of their program trading activity on behalf of their customers, as agent. Even so, while there is still a dependence on the broking houses to execute efficient trades, the advance in capabilities that the buy side is developing in terms of DMA, will likely have every more important reverberations on the market. For one, at the top end of the scale, a recent TABB Group report found a growing propensity for the buy side to rationalise the number of client relationships at the top end of its providers— namely, tier one houses and the upper echelons of the mid tier brokers. Smaller specialist houses however tended to be retained as they offer specific market liquidity. There is an effect in reverse as well.Vandermark notes that buy side preferences have tended to put limits on the range of trading algorithms used: “effectively many investment managers are often forcing providers to do similar things.” Société Générale’s Banneville gives a nod to this duality. “What is means is that we have to be more flexible, offering both tailor made solutions to clients and highly managed algorithms.” Banneville believes that the managed element will increase in importance over the long term.“It depends on customer need and an understanding of where we can add value,” he says. The crux, he thinks is that after a bull market than has enjoyed a five year run, clients increasingly are looking “for ownership of their order. And they want to do that at low cost. The firms that will survive in this changing environment will offer this low cost ownership, together with the proper monitoring tools and managed algorithms. In other words, clients demand high touch service for the price of low touch service.” Stewart at Merrill Lynch proffers some final degree of caution over the DMA mix. It is still a specialist game, he maintains, and even while offering the DMA option to clients, for Merrill Lynch it is a carefully managed process. “We spend a lot of time training people on our system, but we ensure that there is a sanity check on the movement through our pipes.”

TRADING ALGORITHMS

INELUCT ABLE, ASSURE Algorithmic tradingâ&#x20AC;&#x201D; an algorithm that is applied to the programme to break up trades and submit it gradually to maximise profitsâ&#x20AC;&#x201D;brings portfolio trading to a whole new level of efficiency and, these days, complexity. While algorithms are well suited to equity trading, increasingly they are finding applications in other asset classes, such as equity index futures, bond futures and some commodity futures, as well as options and foreign exchange. For some portfolio trading providers, that means a greater not a lesser role for traders and their service desks, even as algorithms become more customised and useable by the buy side. ANKS HAVE BEEN using computer programmes to execute trades and exploit arbitrage opportunities for years. Algorithmic trading grew out of electronic execution and smart order routing techniques in the equity markets, according to William Sterling, a managing director at UBS Investment Bank. Early versions used relatively simple logic, such as pegged orders, which moved with the market but set a target percentage of volume participation until filled, or smart orders that would automatically decide where to execute a trade. Algorithms quickly developed to fill orders at the volume weighted average price (VWAP) over a specified time

period. VWAP algorithms analyse past trading patterns to determine the best way to minimise the market impact, disguising large orders as a sequence of trades that resemble undisturbed activity in a stock. Instead of a single 300,000-share trade, for example, a VWAP algorithm may execute six 50,000-share trades spread out over two hours, for example, giving a price that (all being well) is available through FIX, a special protocol that standardises transaction messages between clients and brokers. People generally undertake a black box strategy to algorithmic trading. In practice, this is an algorithm wrapped up and presented through an interface provided by

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further: “The buy side itself a broker, or third party is evolving. A year ago vendor. Historically, most of perhaps, brokers would these algorithms have been enter into beauty contests VWAP strategies. However, over algorithms, showing as investor strategies have off how ‘technical’ they become more refined and could be and business was diversified—and though driven by the offer not by some institutions remain demand. With the rise of happy with vanilla VWAP— exchange-traded funds a growing number of asset (ETFs), and maybe the managers want either markets in financial slightly modified versions, instruments directive or complete customisation (MiFiD), the buy side is of available algorithms. “As becoming increasingly portfolio managers have aware of good execution”. become more systematic in It is not just a propensity managing alpha, banks towards expert execution, have become more John Bates, vice president of the Apama products division of Progress explains Banneville. “The systematic about trading Software, which develops algorithms for both buy side and sell side impact of a trade can and thereby extending clients. A money manager who asks a broker to run an order through represent up to 50% of algorithms to suit changing the VWAP algorithm will receive a confirmation when the trade is trading costs, and the buy demand,” explains Steve filled — and that is all.“The buy side has no idea how the algorithms side is well aware of the Vandermark, managing work,” says Bates,“They don’t feel they are in control.” Photograph need to reduce that cost. director, equity quantitative kindly supplied by Progress Software, June 2006. That is why today, the analytics at Lehman Brothers, in London. The attraction being he explains that, algorithm product is going towards adding value and “if you have three or four dealers at a customer’s desk, you reducing the market impact of trades.” To illustrate the can address maybe 70% of client flow, freeing them up to point Banneville explains that seven or eight years ago, index arbitrage business based on the Eurostoxx 50 was 20 focus on alpha.” Interestingly, it is a phenomena pushed not only by basis points (bp).“Three years ago, it was 5bp and today it newer and more esoteric investment houses, but also by is below 0.5bp. To keep up profitability, index arbitrageurs traditional clients.“Of course, hedge funds these days are a have to assume more sophisticated techniques, such as fixed part of the landscape,” says Zachary Tuckwell, global statistical arbitrage to eke out alpha.” Backing this activity are increasingly well-used and proven head of portfolio trading at Dresdner Kleinwort Wasserstein (DrKW), “though traditional funds also have pre-trade strategies—signals that tell the trader when to trade. high touch strategies in play. They are conscious of This may involve pair trading, index arbitration, basket trades long/short sector biases, for example, and so you have to or spread trading. Added to that is an order management component. This can involve either wave trading (or icehave systems in place that can handle this demand.” Single-stock algorithms have become far more berging), out of market limits, active re-pricing and timeouts if sophisticated in the past two years as the buy side has sales are not filled. Alternately, traders may use smart order moved away from measuring execution against VWAP, routing, where they route orders to a different liquidity pool explains Sterling at UBS.“Institutional clients are focusing depending on what the best price is at any one time. “The on algorithms that try to automate the entire life cycle of a ability to match effectively pre trade analytics to order large order,”he says.“It’s no longer tenable for single stock management strategies,” is significant in this regard and is trades to execute without the use of algorithms,” posits becoming a cornerstone of the individual expertise of broking Vandermark.“You can do it at the margin and retail buyers houses,”says Tony Nash, managing director, head of portfolio and electronic trading sales at Lehman Brothers in London. can, but for institutional orders – it is a different story.” Nash points to a number of touchstone trends that are Popular single-stock algorithms seek to minimise either the difference between the execution price and the arrival changing both the tempo and introducing more complexity price (the price that prompted the decision to trade), or into the algorithmic trading business; giving users more implementation shortfall, a smarter version of the same choice, speed to market and flexibility. For one, equity concept that takes into account the size of the order relative market liquidity has fragmented with the emergence of electronic communications networks (ECNs), crossing to normal trading volume. These algorithms analyse real-time market information networks and, in the US, the move to penny pricing (via as well as historical patterns to determine the best execution Regulation NMS). In the US, Europe and Japan, equity profile for a particular order. Francois Bonneville, deputy exchanges are competing as trading venues which head of global portfolio trading at Société Générale, goes emphasises the fragmentation of liquidity as a single stock

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is traded in more than one exchange. “The next step is to extend into the newer markets of Eastern Europe and Southeast Asia,”thinks Vandermark. Everywhere, average trade size has plummeted, continues Adam Toms, executive director and head of portfolio and electronic sales trading at Lehman Brothers in London, and the number of trades has soared. TABB Group, a research and advisory firm headquartered in Westborough, Mass., estimates that algorithmic trading captures 13% of US equity order flow today and projects this share will grow 34% compound over the next two years to 23%. Robert Kissell, vice president, global execution services, at JP Morgan Chase, believes algorithms have already grabbed a 20% market share at some firms and could reach 50% by the end of 2008 – provided sell side firms are willing to offer more transparency about cost and risk estimates as well as how the algorithms adapt to changing market conditions. Added to these rising trade volumes are efforts by traders to introduce more efficiency into the trading process. This bio-diversity means three things. First, there is a growing desire by tier one institutions to show off their competitive differentiation through strategy customisation. Mike Stewart, head of global cash equities, at Merrill Lynch in New York, cautions that algorithms are great tools, but at times are limited by the liquidity o the marketplace. Liquidity, or lack thereof, costs money; clients have to be aware that they are trading off between risks and costs.” “At Merrill, we have been putting considerable resources into algorithmic customisation to meet client specific trading risk and cost preferences,” explains Stewart. For investment institutions to build their own proprietary, customised trading strategy (their own algorithms) is simply not economical. Factors such as time, technology and the cost of maintenance and upgrading means that it is traditionally the large tier one banks that have dominated the development of algorithms explains Stewart—either working on a proprietary basis; or in concert or joint venture with a specialist third party vendor. Transparency – or the lack of it – is a major concern on the buy side today, according to John Bates, vice president of the Apama products division of Progress Software, which develops algorithms for both buy side and sell side clients. “The buy side has no idea how the algorithms work,” says Bates, “They don't feel they are in control.”“That is why client education is so important,” says Toms at Lehman Brothers. A desire to customise and control algorithms is fuelling demand in the US for third-party providers, such as Apama which is not affiliated with the bulge-bracket securities houses that dominate the business; although this does not appear to be the case outside the US. The lack of transparency makes it hard for the buy side to compare performance among algorithms for the same purpose offered by different brokers, too. The bulge-bracket firms all have a suite of algorithms that cover the same ground, but Sterling believes it will take a period of high volatility to reveal the differences in performance. UBS tries to build in routines to cope with extraordinary market

conditions, the events that happen once in a blue moon. The firm also provides tools that allow its traders to monitor the performance of algorithms in real time and adjust the parameters if necessary. Additionally, houses such as Credit Suisse have now moved to convert their advanced execution services (AES) into a modular format, allowing AES users to request customised strategies and compound strategies than can be rolled out in a few days, if not a few hours. With markets and investment strategies changing at a rapid pace, the market for algorithmic trading is often about first mover advantage. Lost opportunity cost can be huge. Not just in terms of development time, but developing the strategy over time. “These days it is all about speed to market and build versus buy,” concedes Toms at Lehman Brothers, which develops all its algorithms internally. On a more prosaic level, Sterling finds that buy side players who cannot see how an algorithm routes orders do not like to show their hand to a single broker for fear word of the trades will leak. Clients will split up an order; they may execute a 500,000-share trade as four 125,000-share orders through four different brokers.“It's hard to optimise the execution if you only know part of the picture,”Sterling says,“An algorithm trading 500,000 shares should be able to figure out a smarter way to trade that than four algorithms competing with each other to trade 125,000 shares each without any knowledge of the full order size.” In an attempt to overcome buy side misgivings, UBS has a team dedicated to electronic order flow that does not handle other business. Sterling acknowledges it is an uphill battle to win over clients afraid that the proprietary trading desk or other customers may front run their orders, however. Fear of proprietary trading desks is not the only factor impeding efficient algorithmic execution. There are other market and client factors that should be involved in the decision to choose a particular algorithm or order trading venue. Clearly more of the execution of a portfolio is via an algorithmic route as algorithmic performance increases and does a better job of searching different liquidity venues, notes Stewart at Merrill Lynch. “However, superior execution of a portfolio is done by using our quantitative resources to create an optimal trading schedule, one that can only be had by truly understanding the clients' alpha and timing needs as well as our portfolio traders’ market knowledge. We also have quantitative criteria checks to identify when algorithmic trading is not the proper solution and if sales trader intervention or capital is needed. Again, the algorithms are very powerful tools, but the data needed to decide when not to use them is of equal importance.” Some houses have made a virtue of intervention, particularly in a direct market access (DMA) environment, says Bonneville, who believes that the future is about managed algorithms. “It is all about asking what does the customer need and how can we add value. This involves not only a trader behind every client, but also a service desk behind the trader who monitors trades and can intervene if necessary to meet VWAP over the day. It also means that overrides are much easier. Just call the service desk who will implement the change in trading strategy

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for you. Intervention then becomes part of the strategy itself.” Matt Simon, an analyst at TABB Group, points out that algorithms still offer the buy side better protection than conventional trading. After all, he says, buy side traders have long observed that “brokers have big mouths and computers don't”. Simon believes algorithms do have some drawbacks, however. They are slow to react to changing market conditions and they miss some block trades, except those put up by the broker who is running the algorithm. Simon thinks algorithms can be gamed, too.“What if traders and firms continue figuring out how to reverse engineer some of these algorithms?” he asks,“That could be very powerful.” Bates at Progress Software believes the market is moving toward smarter algorithms that monitor and respond to real time market data feeds. For instance, a statistical arbitrage trader could set the parameters that trigger execution and leave an algorithm to seize any opportunities that arise among multiple sources of Matt Simon, an analyst at TABB Group, points out that algorithms still offer the buy side liquidity. The algorithm would decide not better protection than conventional trading. After all, he says, buy side traders have long only how to trade – which is all a VWAP observed that “brokers have big mouths and computers don’t”. Simon believes algorithms do routine does – but also when to trade. have some drawbacks, however. They are slow to react to changing market conditions and In effect, algorithms let traders leverage they miss some block trades, except those put up by the broker who is running the algorithm. their skills to handle more order flow more Simon thinks algorithms can be gamed, too.“What if traders and firms continue figuring out efficiently. “The trader is changing into how to reverse engineer some of these algorithms?” he asks,“That could be very powerful.” someone who is more a coordinator of Photograph kindly supplied by TABB Group, June 2006. algorithms and much less of a barrow boy,” says Bates. He thinks algorithmic trading will cause a portfolio,”says Huck,“There is not a lot of product out there.” Richard Balarkas, managing director and head of shakeout, much as Liffe's conversion from open outcry to electronic trading did. “Half the Liffe traders evolved to advanced execution services (AES) sales at Credit Suisse in operate in an electronic environment and the other half went London, posits that the bank’s proprietary PHD algorithm, a portfolio hedging device, is the pellucid answer to Huck’s on to drive London cabs,”he says. Tony Huck, managing director and co-head of sales and concerns (please refer to box entitled PHD: The Holy Grail of trading at Investment Technology Group (ITG), expects Transition Management? for a more detailed explanation). talented traders to embrace a technology that makes their PHD is the next step on from Credit Suisse’s Guerrilla executions look better. He sees potential for improving basket strategy that has stormed the market and accounts for an trade execution by separating liquid names, for which estimated 18% of all US algorithmic trading. Also available algorithms work well, from illiquid names better suited to an in Europe and Asia, the Guerrilla tactic is unique in its aim experienced human trader.“Illiquid stocks are generally not a of minimising market impact through reduction of high percentage in dollar terms or numbers of shares but they signalling risk, even in conditions of low liquidity. PHD sure have a large percentage impact on the profit and loss,” meantime is aimed precisely at whole portfolio transitions. JP Morgan's Kissell expands on the point. Algorithmic Huck says,“You can add value where it needs to be added.” ITG, the independent broker, is now focusing on list-based trading, he explains, requires a big investment in data algorithms that can handle an entire portfolio trade, not just processing capacity even for single stock routines, but the the individuals stocks within it. Basket algorithms are in their computing power needed increases exponentially with the infancy, but Huck sees huge growth potential, especially number of stocks in a basket.“You need to manage market among transition managers. “Transition trades tend to last impact, risk and correlation across all names in the basket,” several days so managers are very concerned about managing Kissell explains, “As that list increases the time to solve their industry and sector exposures, managing the risk to the dramatically increases.” Traders presented with a basket

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during market hours cannot afford to wait even five minutes while an optimiser finds the best solution – and the calculation can take 20 minutes or more. Balarkas explains that traditional pre-trade analysis of portfolio trades might assess the internal risk inherent in the portfolio; however, the trading process is a far more basic affair, which means the end results bear little resemblance to the original forecasts. PHD actually uses the AES algorithms but is constantly reassessing the internal risk of the portfolio and adapting the trading frontier accordingly. Balarkas says that all expectations based on pre-trade analysis “can go out of the window when trades begin; unless you can analyse and react real time.” Kissell admits that despite all their advantages algorithms are mixed blessings. “Algorithms are great because they will do exactly what you tell them to do,” he says,“They are also horrible for the same reason. If you do not consider every possible condition they are going to fall apart.”JP Morgan filters basket trades through a suitability test to ferret out stocks better handled by human traders:

those that trade unevenly in blocks or with higher volatility and variance, for instance. Sterling sees the line between human and algorithmic trading becoming blurred as algorithms become more complex.“I can put an order into an algorithm, watch that order in real time and end up making 10 adjustments to the way that algorithm is trading. Is that an automated order or a managed order?” he asks. Talk in the early days that algorithmic trading could supplant human traders was never realistic. Algorithms help traders manage bigger volume, but someone who understands trading still has to keep an eye on how the algorithms perform. “You cannot take the trader off completely,” Sterling says, “An unmanaged algorithm can be very dangerous.” While it might be overstated that banks are in an “algorithmic war”, there is small doubt that the market is becoming more competitive. It seems that as an asset class increases in popularity, an algorithm develops to capitalise on it.

BOX: IS PHD THE HOLY GRAIL OF TRANSITION MANAGEMENT?

N TRANSITION MANAGEMENT the move from a legacy to a target portfolio, the problem facing transition managers is not just maintaining the value of a portfolio as it morphs from one structure into another, but also the integrity of the portfolio's risk profile as laid down by its beneficial owners. According to Graham Dixon, managing director of transition management at Credit Suisse, this is one of the great quests for transition managers and one that Credit Suisse algorithm creators think they have cracked. Their specialist portfolio algorithm PHD, which is aimed at the transition management market, is an execution tool that allows transition managers and target asset managers to match, as far as possible, the risk profile of the legacy portfolio still to be sold with the target portfolio not yet acquired. “Tools in pre trade are far more advanced than ever before, and the tools in PHD are unique says Credit Suisse’s Balarkas, “analysis and quant in pre trade cost estimates are now accurately embodied in the product.” PHD was launched in the United States some 18 months ago and was rolled out in Europe and Asia at the beginning of this year. “It has involved a constant conveyor belt of refinements, although the underlying principles have been around (the evolution of data and execution tools) for some time. It is a very mathematical product, very quant,” says Balarkas, who points out that it adds value by “optimizing the risk profile of a transition not just by delivering processing efficiency.” Portfolio algorithms, such as PHD, says Balarkas, sit “on top of the entire trade and seeks opportunities to unwind to reduce the overall risk of the portfolio.” PHD arose from extended discussions with diverse clients and consultants that had expressed concerns over the problem, explains Ken Kane, head of European programme trading at the bank. In essence, the problem that Credit Suisse had to solve was that the risk profile of legacy and target baskets only took into account a theoretical cost of trade, “but took no account at all of what people were doing in the real world. In a five stock portfolio for example, one of the names in the legacy portfolio could be a natural hedge for two or maybe even three names in the target portfolio. That fact would simply not have been recognised.” However, notes Balarkas, when trading begins it is important that the transition manager and the portfolio trader can react to any real time events and adjust accordingly, “otherwise everything goes out the window.” In the sometimes-opaque world of transition management, asset owners are faced with three types of costs: explicit costs (involving taxes, fees, commissions); market impact (price movement from being a persistent buyer or seller of an asset) and, finally, opportunity costs (price movements due to delayed acquisition or disposal of assets in the transition). The implementation shortfall of a transition is the sum of these three sources of cost. The opportunity costs “have been the hardest to manage,” acknowledges Dixon, “but PHD continually computes the riskiest positions in the transition and prioritises the dealing accordingly.” “PHD tactics allow traders to execute baskets of stocks using the advanced execution trading tactics while maintaining other goals such as dollar neutrality, sector neutrality, index tracking and risk optimisation,” explains Kane. In other words, it will keep the characteristics of the target portfolio as similar as possible to the legacy portfolio. If, for example, a beneficial owner is transfering a portfolio to European small cap stocks to another manager specialising in the mid-cap market, then “the starting point will be the smallest stock in the mid cap portfolio and the largest stock in the small cap portfolio.”

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The issuance of corporate bonds is rising sharply across Europe this year — fuelled by an unprecedented takeover boom and a cyclical upswing in the investment cycle. The surge in demand for new capital market debt however, particularly that related to acquisitions, could carry some danger for investors. Andrew Cavenagh reports. HE SCALE OF the mergers and acquisition (M&A) activity in Europe is staggering. According to Dealogic, the value of deals in the region over the first four months of the year was the equivalent of $454bn — a 114% increase on the same period of 2005. By contrast, the North American market was up just 9%. With interest rates still low, debt rather than equity remains the preferred means to effect even the largest acquisitions — witness the €29.1bn all-cash offer that German utility E.ON made for its Spanish counterpart Endesa in February — and predators have gone to the bond markets for much of their requirements.“The funding need is not generally going to be equity,”says Chris Legge, head of European corporate ratings at Standard & Poor’s (S&P). The impact of the bond market is evident. Up to the middle of May, corporate issuance across Europe toted up to just under €46.4bn. This compares with €102.6bn for the whole of last year and means 2006 will be the first year in three that the market has grown (please refer to Europe: Monthly new issuance volumes of corporate bonds table). Leading investors expect a big increase — at least 15% — on 2005. “Issuance is going to be significantly higher this

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Photography by Rossen Littof and supplied by Dreamstime.com, June 2006

year,”maintains Richard Hodges, manager of the Gartmore Société d’Investissement À Capital Variable (SICAV) European Bond Fund, an open-ended Euro-denominated Luxembourg based fund that invests in investment grade corporate transferable debt obligations, with over 41% of its portfolio invested in the financial sector. The explosion in the M&A market has created a pitfall for bond investors, however. Increased M&A action has brought in private-equity firms and other high-leverage buyout specialists into Europe’s capital markets to an extent not seen before. The typical strategy of these financial buyers (to load more debt on to the balance sheets of their acquisitions to beef up their equity returns and often to extract cash immediately) has not historically had much impact on the senior unsecured bond markets. This is because few of their targets up to now have been significant issuers. That has all changed now though, particularly over the past 18 months as unprecedented amounts of money have poured into privateequity funds. The size of the buyouts or acquisitions — or even attempted acquisitions — has grown commensurately, and many more buyout firms are now likely to have established unsecured bond programmes. Permira, for instance, announced in February that it was aiming to raise between €10bn and €11bn for its latest buyout fund. Permira would not comment on it latest round of fundraising, though off the record reports have it that the fund was oversubscribed in the middle of May by more than 50% (to around €16bn). The new fund will, in any case, be one of the largest buyout funds raised to date in Europe. Permira, it seems, has raised the stakes all round. It may fire off another round of fund raising by private equity firms.

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protection in this instance is structured More significantly, in the short term as a put option that is exercisable on a though, capital inflows of this change of control (as defined in the magnitude mean that very few bond documentation) or if the singlecompanies are now beyond the reach of A minus rating on the bonds drops to the private-equity investors. Permira below investment grade. and Cinven, for example, are said to “There is a lot of call now for contemplating a €11bn offer for change-of-control clauses,” agrees Portugal Telecom to trump the hostile Legge at S&P. He cites the instance of €10.7bn bid from its rival Sonae. the recent issue from BAA, the UK Private-equity groups and other buyout “Issuance is going to be significantly airports operator, where the company specialists are also expected bid up to higher this year,” maintains Richard was obliged to include such a provision £8bn for Thames Water later in the year. Hodges, manager of the Gartmore Société in the documentation as a result of These are companies that rely heavily d’Investissement À Capital Variable pressure from investors while it was on the bond markets for their financing (SICAV) European Bond Fund, an openroad-showing the deal. “Frankly, I will needs, and the gearing them up with ended Euro-denominated Luxembourg be surprised if you see any more issues large amount of additional debt that based fund that invests in investment from now on that don't have such ranks pari passu with their existing grade corporate transferable debt clauses in them,” concludes Urquhart obligations will significantly dilute the obligations, with over 41% of its portfolio Stewart at SIM. “Companies are now value of the latter. “You are effectively invested in the financial sector. trying to make more of an effort to issuing debt that will condemn existing Photograph kindly supplied by Gartmore. protect their existing bondholders.” bondholders to a permanent discount,” Of course, such protection comes at a explains Justin Urquhart Stewart, price. Hodges says that on a marketing director at the broad assetsubordinated (sub-investment grade) allocation firm Seven Investment issue, investors should probably expect Management. “They can find, almost to see the coupon drop from 8.5% to overnight, that the value of their bonds between 8.25% and 8% for the has been seriously reduced.” inclusion of a change-of-control clause. Urquhart Stewart adds that this The difference on an investment-grade development had come as a issue would be smaller, as the need for particularly damaging blow to the UK it would be less. Not all investors find pension funds, as it could further this an acceptable trade-off, and some eroding the value of their savings as prefer to take the change-of-control they attempted to make up the wellrisk. “There are plenty of cases where publicised shortfalls in their assets there are enough investors prepared to against their liabilities. Over the past buy the bonds without protection — year, corporate bond investors have and earn themselves a few extra basis consequently begun to demand the points,”confirms Legge at S&P. same sort of structural protection from Photograph of Chris Legge, head of The recent adoption of protective issuers — and the investment banks European corporate ratings at Standard & measures will not, of course, do much to who advise them — that have always Poor’s. "There is a lot of call now for help those holding senior long-dated featured in asset-backed securities, change-of-control clauses," he says. Legge unsecured bonds that were issued such as negative pledges and changecites the instance of the recent issue from before investors woke up to the recent of-control clauses that oblige any new BAA, the UK airports operator, where the threat. However, there is some evidence owner to redeem the issue. company was obliged to include such a that — in the European market at least “Clearly the strongest protection provision in the documentation as a result — that acquirers may still be more from our point of view is a change-ofof pressure from investors while it was inclined to “do the decent thing” and control clause that allows us to put the road-showing the deal. Photograph kindly redeem existing bonds before they issue debt back to the company at par supplied by Standard & Poor’s, June 2006. a lot of new debt. Their motivation for value,”explains Hodges at Gartmore. Hodges says there has been a 50-100% increase in the doing so is probably not entirely altruistic. They may need to use of such protection in senior unsecured issues over the tap the same investor base at some point in the future, but it last six to nine months, and that the last five or six deals may offer investors some respite in the short term. A recent example was the takeover bid that a group of that came to the market all had some form of change-ofcontrol condition attached.“They are becoming a lot more five leading private-equity firms (including Kohlberg common.” One of these was the €1.8bn two-tranche issue Kravis Roberts, Apax Partners, Blackstone Group, Permira that Compagnie de St-Gobain, the French building and Providence Equity) made for Denmark’s top materials company, issued in May. The bondholder telecommunications company TDC. In the offer document,

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defaults at the the sponsors offered to buy FTSE Sterling Corporate Bond Index vs. FTSE All-Share Index investment-grade level back the company's 160 but among single-B/triple existing bonds. Now that 150 C rated bonds. “We are is something those same 140 expecting 2007 to be the firms would apparently not 130 start of the reversal of that have done in the US. “In [low level of defaults over the US market that would 120 the past years],” he says. not have happened,” 110 “Some of these very highly claimed a source close to 100 leveraged transactions will the deal. 90 be tested.” The growing threat of “The outlook for the value dilution from asset class is not as private-equity led FTSE Sterling Corporate Bond All Maturities Index FTSE All-Share Index promising as it was a year takeovers comes as the ago,” concurs Hodges at performance of the Source: FTSE Group UK Sterling total returns. Data as at June 2006 Gartmore. He says the European senior unsecured market is likely to deteriorate, as corporate earnings come combination of the projected downturn in earnings, the increase in net debt issuance, and the prospect of more under pressure from higher fuel prices and interest rates. The seems to be a broad consensus that corporate shareholder-friendly activity such as share buybacks and profitability will decline over the next six months and payment of special dividends, meant he “had to be beyond, as economic growth slows across the euro zone. sceptical” about the performance of European corporate S&P has raised its interest-rate projections and now bonds between now and the end of the year. He stresses that he is not expecting a severe downturn. expects the European Central Bank raise its benchmark refinancing rate to 3.25% rather than 3% by the end of the The returns on corporates should not be “materially less” than the returns on sovereign debt. He also points out that year, and to 3.75% by mid-2007. The rating agency’s equity research analysts report the asset class would continue to receive support from the meanwhile that company feedback consistently indicates structured credit markets, where the appetite for that pricing power remains “very limited”due to high levels collateralized debt obligations (CDOs) remains strong. He of competition and fragile domestic demand. They adds though that there were additional risks surrounding consequently expect the earnings of publicly traded the subordinated corporate hybrid debt securities that had European companies to grow by less than 10% this year — emerged recently, with six or seven issues over the past year. against the 25% average increase in 2005 — and warn that These instruments offer investor a quantum leap in coupon there is likely to be a progressive deterioration in credit over senior unsecured bonds: some 280 basis points (bp) in the case of pharmaceutical company Bayer against 25bp to quality by next year. Legge at S&P says this would inevitably lead to higher 30bp for the company’s senior debt. Nonetheless, they still rates of defaults in the senior unsecured markets — represent a cheap source of funding for the issuer (relative although probably not until next year — and at the lower to equity). They also help keep a company’s gearing down, end of the credit spectrum. He does not expect to see as the rating agencies apply a 50% discount to such debt — crediting the other half as equity. While the bonds carry much the same risks as equities — payment of coupons stops with that of dividends — Monthly New Issuance Volumes of Corporate Bonds (€m) they do not have the same potential for capital growth. 2006 2005 2004 2003 “Obviously you’re upside is capped,” says Hodges. The January 9,012 9,259 11,512 24,705 performance of these securities is clearly more vulnerable February 11,366 6,305 4,410 19,405 March 11,446 11,245 12,852 3,860 to any general downturn in the corporate climate, and April 5,905 6,755 5,676 15,750 Hodges said he expected to see a marked deterioration in May 8,665 7,525 14,163 15,766 the quality of the asset class by this time next year. June 20,582 11,017 22,716 What he says has changed (to the benefit of fund July 4,718 10,703 12,990 managers who have adopted the Undertakings for the August 1,800 955 850 Collective Investment of Transferable Securities (UCITS) September 7,443 12,240 18,368 III directives and which allow funds to trade in derivatives) October 7,572 7,263 10,615 is the ability to use credit default swaps to give fund November 15,655 7,845 9,637 managers the opportunity for a (potentially) more stable December 3,730 4,055 4,539 return profile on bond investments. This is because the Total 46,393 102,590 102,690 159,201 derivatives enable them to gain from credit-market movements in either direction through short positions, Includes all domestic and global issues that are rated investment-grade unlike traditional long-only bond funds. Source: Bondware, June 2006

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Domestic The leading Latin American countries look set at last to develop domestic bond markets with real depth and liquidity, on the back of the budget surpluses they have enjoyed over the past year — primarily due to high commodity prices — and tighter fiscal policies. Andrew Cavenagh reports.

OWER RATES OF inflation together with stronger and stable exchange rates have enabled Brazil, Mexico, Argentina and Chile, to raise much more of their financing requirements from their domestic markets. The region’s net external obligations have fallen by 29% to about $460m over the past two years, and the trend looks set to continue throughout 2006 and 2007.“There is a strong commitment in these countries to stable macro-economic policies and containment of fiscal deficits, and as a consequence to develop local markets,” explains Pietro Masci, head of the infrastructure and financial markets division at the Inter-American Development Bank (IADB). Brazil, for example, aims to reduce its dollardenominated liabilities further, although just a quarter of its overall debt is in foreign currency. Meanwhile, Argentina placed $500m of 2011 dollar-denominated bonds through its domestic market rather than issuing overseas at the end of March at a reported yield of 8.36%. The deal was interesting for a number of reasons.The bond was the first public issue since Argentina cancelled a global issue in September 2005 due to high yield demands — various reports say that investors had demanded a yield between 8.8% and 9.5%. It was also only the second time that Argentina sold dollar denominated bonds to international banks since the country went into debt default in 2001 and undertook a contentious $100bn debt workout in February last year. Interestingly too, Venezuela has been a

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“In Mexico, some of the issues at the long end of the curve, at times, have been taken up almost entirely by foreign investors,” observes Anoop Singh, director in the Western Hemisphere Department at the International Monetary Fund.“The international investors are starting to buy in local currencies — they pick up the yield and the bonds also offer diversification,” adds Masci at the IADB. Photograph supplied by iStockPhoto.com, June 2006.

regular buyer of Argentine debt — an obvious power play in the sub-continent. Venezuela has bought some $1.7bn worth of Argentine bonds this year and around $1.3bn last year. In mid-May, Argentina sold a further $200m in Boden 2012 bonds to Venezuela, with the paper carrying a yield of 7.59%. That $200m bond was part of a bigger issuance programme as the government began issuing a further $1.5bn in Bonar bonds during May, which are being sold under Argentine law. The bonds are usually considered riskier than securities issued under either European or US laws. After Argentina completes the sale, it will be about $1bn short of meeting its financing needs for the year. Argentina reduced its financing needs last December when it used a third of its central bank reserves to pay off its entire $9.1bn debt to the International Monetary Fund (IMF). However, the country still is scheduled to make about $4bn in principal payments this year to creditors. Not only has this switch to more local market funding reduced the vulnerability of the Latin American countries to currency devaluations, but it has also boosted the liquidity of the local markets. The higher interest rates they offer — coupled with low and seemingly stable rates of inflation — have thereby proved attractive to yield-chasing foreign investors disillusioned with 3-4% returns on US Treasuries. Recent 5-year Bonar bonds versus Argentinian bonds, for example, are paying a coupon of 7%.“In Mexico, some of the issues at the long end of the curve, at times,

LATIN AMERICAN BOND ISSUES

Corporate issuance in the local markets however is have been taken up almost entirely by foreign investors,” observes Anoop Singh, director in the Western Hemisphere also increasing — in 2004, it accounted for just 7% of the Department at the International Monetary Fund. total, whereas in some countries companies may now be “International investors are starting to buy in local accessing their local market for almost half their currencies - they pick up the yield and the bonds also offer requirements. Larger corporate issuers in region for the most part have established programmes in the diversification,”adds Masci at the IADB. There is little doubt that the economic status of the region international markets and these are likely to remain is improving. Latin America experienced no significant their predominant source of funding in the near-to“negative credit events” last year, with Mexico, Argentina, medium term. US investment bank Bear Stearns reported that Chile, Uruguay, Venezuela and the Dominican Republic all enjoying upgrades to their sovereign ratings. This all adds up international corporate issuance out of Latin America was to mean that the region’s governments can issue global also on the rise, reaching $28.7bn in 2005 — up from bonds in their local currencies. The Bank of International $16.3bn the previous year. That figure is expected to grow Settlements (BIS) reported last month that Latin America again this year as the overall credit quality of the sector had been the driving force behind the growth of such local- continues to improve and demand for the bonds continues to rise. The sharp increase currency issues in the last year in part reflected international debt securities Local and Cross-Border Issuance in Latin America the desire of some of the markets last year to $6.3bn (Insurance Volume) largest borrowers to pre— its highest level since fund most of their 2006 1995. Latin American requirements — given the countries accounted for the impact that this year’s dollar-equivalent of $4.2bn calendar of elections in Latin of the total, with the AsiaAmerica might have. Even Pacific a long way second so, there are clear signs that with $1.4bn. the market is continuing to While the Brazilian expand and mature. government and financial A few of the region’s top institutions across the companies – such as region were chiefly Mexico’s state oil company responsible for this Pemex and Brazilian resurgence, Colombia steelmaker Companhia brought the largest *Pre– 1998 cross-border issuance not to scale; actual amount was $16.5 billion. Sideurgica Nacional — are transaction to market in now issuing perpetual bonds the final quarter of the year (with no maturity), while the with a 10-year bond worth 2005 Latin American Local Market — Breakdown by Asset Chilean copper exporter Pesos569bn ($250m). (Based on $11.3 Billion Insurance Amount) Codelco has achieved better financing terms with 30-year Sovereign issues instruments. dominate Larger corporations are Sovereign issuance also issuing in their own continues to dominate the currencies. One of the local capital markets — more notable of these accounting for a recent issues involved substantial share of debt America Movil, the securities. Masci says the Mexican telecoms increasing sophistication company, which placed a this surge of issuance has 10-year, Peso5bn bond with brought to the markets is US and European investors creating a platform for in September last year. private-sector issuance as Credit Suisse meanwhile well. He points out that, launched a Latin American for example, that virtually Auto Loans 1% Federal Tax Securitizations 11% Corporate Index in March, all the markets have Trade Receivables 6% Credit Cards 4% purely for dollarcreated yield curves for Real Estate Related 17% Consumer/Personal Loans 17% denominated issues. It government bonds off Future Flow 23% *Includes existing assets, toll roads, launched with an initial which other types of Partial Guarantee 2% construction bridge loans, tuition fees, nonperformiing loans, collateralized debt composition of 98 issuers security can price. Other* 19% obligations collateralized loan obligations and leasing. Source: Dealogic, June 2006

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LATIN AMERICAN BOND ISSUES

Greg Kabance, managing director for Latin American structured finance at Fitch Ratings in Chicago.“Lower-rated companies can now access the pension funds through the securitisation market,” explains Kabance. He points to the non-bank mortgage lenders — or sofoles — in Mexico as an example. In the last 18 months or so, these companies have issued 10 residential mortgage-backed securitisation (RMBS) deals worth nearly $1bn. Photograph kindly supplied by Fitch Ratings, June 2006 .

and a market value of $67bn.“Over the past five years the Latin American corporate bond market has grown significantly and credit quality has improved substantially,” explains Jamie Nicholson-Leener, head of Latin American corporate credit research at Credit Suisse.“We are seeing a continuation of these trends in 2006.” Nicholson-Leener says that during the past two years the number of companies in the index classified as highyield has dropped from 60% to 45% and that spreads on Latam corporate bonds are near historical lows on the back of rating upgrades, successful restructurings and strong market fundamentals. If some of the biggest names have largely pre-funded themselves this year, there will be no shortage of other issuers. Alex Monroy, managing director and Latin American corporate bond analyst at Bear Stearns in New York, says for example that Argentine utilities could be keen to refinance recently structured debt. The 2001/2002 Argentine crisis hit Argentine utilities hard, as the devaluation of the currency increased the cost of their dollar-denominated obligations, while a government-imposed freeze on their tariffs severely restricted revenues. Following defaults in many cases, they restructured their debts under — at times — onerous conditions and highly restrictive covenants and now have obvious incentives to refinance these restructured loans on terms that are more favourable.“I would not be surprised if we saw some issuance out of Argentine utilities over the next 18 months,” said Monroy. “Many of them have

recovered substantially since the crisis and might want to come back to the capital markets to refinance recently restructured debt under less restrictive covenants.” Masci at the IADB says such companies will continue to borrow from the international markets for the near future. “The cost of issuing is still high in Latin America,” he explains.“The challenge for these domestic markets is how to attract those corporate issuers,” he continues.“My view is their strategy should be to develop products that can get financing in the local markets, then — when you have the right conditions — these big corporates will come in.” Apart from the sovereign issuers, the one other sector of the bond market that has seen a rapid increase in the use of local markets is structured finance. Last year saw nearly 300 transactions worth the equivalent of $11.5bn come to the market — almost a 30% increase on the previous year, when there were about 200 deals worth $8.9bn and more than double the $4.2bn aggregate record in 2003. Issuance of international — or cross-border — asset-backed bonds out of South America, by contrast, has remained flat at around the $3bn mark for the past two years and seems likely to remain at this level in 2006, still below the $5.4bn it achieved in 2003. Mexico was the largest individual market in 2005 with $4.3bn, followed by Brazil ($3.5bn), Argentina ($1.7bn) and Chile ($867m), and asset-backed analysts expect to see an even bigger rise in the volume of issuance in 2006.“I would expect to see the same amount of growth this year — maybe to $15bn or $15.5bn,” says Greg Kabance, managing director for Latin American structured finance at Fitch Ratings in Chicago. There are a number of factors behind this rapid rate of growth. The improving credit climate across the region and growing confidence in legal frameworks — allied with the increasing sophistication among issuers, banks, and investors — has enabled domestic structured issues to achieve (local) ratings up to the double-A and triple-A levels, at which low-risk investors such as pension funds can buy them. “Lower-rated companies can now access the pension funds through the securitisation market,”explains Kabance. He pointed to the non-bank mortgage lenders - or sofoles — in Mexico as an example. In the last 18 months or so, these companies have issued 10 residential mortgagebacked securitisation (RMBS) deals worth nearly $1bn. Such deals offer pension funds and other local investment vehicles in Latin America — which are becoming increasingly flush with cash — a welcome diversification from sovereign bonds, and these localmarket structured issues are also starting to draw in international investors. Foreign buyers now account for probably 10-20% of the issues.“The local-market deals are less susceptible to any kind of economic issue,” explains Kabance. “And there are a lot of international buyers for these bonds that there never were before.” There was a broad diversification of asset classes throughout the sub-continent. Mexico, for instance, sold $160m of catastrophe (CAT) bonds in May to protect itself

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against the future cost of damage in the event of a major earthquake. It is the first time Mexico, or in fact any developing market, has tapped the financial markets in this way. The bonds have three-year maturities and are paying 2.35 percentage points over Libor. They were offered to Mexico by insurance giant Swiss Re as an alternative to reinsurance. Swiss Re also managed the sale of the bonds, alongside Deutsche Bank. CAT bonds are considered attractive by investors as they have almost zero correlation to other financial market risk. Additionally, new property-related deals; securitised mortgages, commercial space or construction bridge loans accounted for 17% of the Latin American market while typical ABS collateral, including consumer loans, credit card receivables and auto loans, supported another 50%. Future-flow deals accounted for most of the remainder (22%). There was wider spread of collateral in the crossborder asset-backed transactions — which were once the almost exclusive preserve of big, commodity-backed (usually oil) future-flow transactions. Meanwhile, oil companies such as Pemex and Venezuela’s Petróleos de Venezuela SA (PDVSA) are actually redeeming their securitised debt because they can achieve cheaper and less restrictive finance in the senior unsecured market. Banks and credit card companies too have begun to refinance pools of consumer debt with international issues. “We are definitely seeing a diversification in terms of companies,”says Kabance. Two Mexican banks — Su Casita and Metrofinaceria — issued bonds in 2005 that were backed by construction bridge loans, while Fumisa successfully securitised leasing revenue and other income streams from Mexico City Airport. The Dominican Republic also launched a $162m bond backed by toll-road revenues earlier this year, which Fitch rated single-B and the agency is anticipating more similar deals before the end of 2006. “I would expect to see a lot more of that this year - there are others in the pipeline of about that size or $200m,” said Kabance. “We’ll probably also see RMBS transactions in cross-border deals in the not-too-distant future.” Last year also saw significant geographical diversification in the cross-border market, with asset-backed issues out of Brazil, El Salvador, Guatemala, Panama, Peru and Costa Rica as well as Mexico, and investment bankers are looking to push the envelope out further as there appears to be plenty of appetite for whatever they bring to the market. “They are chasing it, because they think they can sell it,” comments one bank analyst.

Vulnerable to political change The Latin American bond markets are still, of course, considerably more vulnerable to political change than those in the US, Europe, and the Far East. The 2.5% drop in the value of Brazil’s stock market on March 28 following the resignation of Antonio Palocci, the finance minister, and his replacement by the less monetary-minded Guido Mantega, was a recent reminder of this volatility. The

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Alex Monroy, managing director and Latin American corporate bond analyst at Bear Stearns in New York, says that Argentine utilities could be keen to refinance recently structured debt. Photograph kindly supplied by Bear Stearns in New York, June 2006.

prospect of left-wing governments attaining power in Mexico, Peru and Ecuador has different implications for the financial markets in each case. A victory for Humula Ollanta’s nationalist party in Peru, for instance, would have been seen as potentially damaging to the country’s economic revival as his policies are heavily influenced by populist considerations. Any administration of his would have almost certainly established close links with the Chavez government in Venezuela, with all the implications that might have for further US investment. In Mexico, by contrast, the markets are unlikely to panic if Andres Manuel Lopez Obrador claims power. The greater institutional maturity of the country and the slim chances of Lopez achieving a congressional majority even if he wins should limit any fall-out. Masci at the IADB feels that concerns about changes in political leadership can be overdone. He points out that nothing changed in the management of Brazil’s economy when left wing President Luiz Inacio Lula da Silva came to power in 2005 and says all governments of whatever hue are fully aware of what is required to maintain access to international finance.“They know that if they want to be part of the world markets, they need to behave,”he says. In the fast-growing domestic market for structured finance, changes of government should have even less of an impact. “There is obviously some risk associated with political change,” concedes Kabance at Fitch. “But these deals have been structured to the point where they can survive a certain amount of political stress.”

PROFILE: WACHOVIA CORPORATION

Wachovia staffers believe that the economics of retaining customers are better than the economics of acquiring new ones. They should know. The product of scores of acquisitions over more than 20 years, and a strong customer focus, Wachovia Corporation. is now the fourth largest banking company in the US, with $542bn in assets and 3,159 branch offices in 15 states. Has Wachovia developed a sustainable model? Will it ever take on the bulge bracket giants in investment and corporate banking? Bill Stoneman goes in search of some answers.

“Revenue growth, employee engagement and customer service are three of Wachovia's top strategic priorities, and they are closely linked. We know that employees who understand the company's vision and care about their work deliver the best service,” thinks G. Kennedy Thompson, chief executive officer (CEO) of Wachovia Corporation.“And, being a leader in customer service is absolutely the best revenue strategy,” he adds. This photograph was supplied by Empics/Associated Press, June 2006.

Wachovia’s winning ways HEN AMERICAN BANKERS and the legions of people who follow their business talk about the potential for careening out of control with ambitious acquisitions, the handiest reference point often is First Union Corp. in the late 1990s. What comes to mind in particular is a pair of deals concluded in 1998: for CoreStates Financial Corp. and The Money Store. The North Carolinabased First Union first paid $17bn, or five times book value, for CoreStates, a mid-sized Philadelphia bank, in what briefly was the most expensive bank deal ever in the United

States. It then went on to pay $2.1bn for The Money Store, a non-bank lender. First Union cut costs at both companies so aggressively that it quickly exhausted the goodwill of their respective customers. It closed The Money Store two years later. A $3bn restructuring charge in 2000 crushed earnings; and then it cut its dividend in half the following year. But if it takes a couple of searing experiences to get a company to reform its ways, then the CoreStates and Money Store debacles seemed to work for First Union. Most of all, perhaps, G. Kennedy Thompson, who became chief

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executive officer (CEO) in April 2000, and re-focused his troops’ attention. While the company has continued to make acquisitions, Thompson made a more disciplined execution of day-to-day business top priority. Instead of selling relentlessly to new customers, as just about every bank expert urged a few years ago, the CEO urged, of all things, that his staff work on satisfying customers that bank already had. First Union’s big deal, in 2001, was for a North Carolina neighbour Wachovia Corp., whose name First Union took as its own. This acquisition was handled very differently than the earlier ones. Although First Union clearly was the buyer, the two companies pitched the transaction as a merger of equals, with very little premium paid to Wachovia shareholders. Systems were integrated slowly and carefully — and plenty of Wachovia executives landed senior positions. Results have been good since Thompson took over. In fact, the new Wachovia Corp. is today possibly the handiest example for anyone who would argue that US bank earnings growth depends more on customer relationships than great salesmanship. Earnings per share rose 10% in 2005 over 2004, after rising 20% in 2004, 22% in 2003 and 79% in 2002. The company’s stock performance was best among the 20 largest US banks from the time of Thompson’s appointment to the end of 2005, returning 92% to shareholders.“As the financial services industry has continued to consolidate, Wachovia has participated in the mergers and acquisitions activity,” explains Thompson, “but we have been very disciplined and loyal to the financial criteria we laid out for ourselves. We are 99% focused on organic growth, and at the end of the day that means focusing on our customers and executing better than the competition. It is no coincidence, say banking industry analysts, that Wachovia performs well in one independent customer survey after another and that its same-branch deposit growth appears to have led most of the other large banks in the US in the last few years. Moreover, with good deposit growth, it is not surprising that earnings and share price growth have been well ahead of the industry average during the Thompson era. “There clearly is a relationship between financial performance and shareholder performance and Wachovia’s [rise] to the top of the customer satisfaction tables,” says Alan McIntyre, managing director for North American banking for Mercer Oliver Wyman, a consulting firm. That is because the economics of retaining customers are better than the economics of acquiring new ones, he explains. Thompson agrees. “Revenue growth, employee engagement and customer service are three of Wachovia’s top strategic priorities, and they are closely linked. We know that employees who understand the company’s vision and care about their work deliver the best service. And, being a leader in customer service is absolutely the best revenue strategy,”he says. Whether Wachovia has built a sustainable model still is not clear and may not be for some time yet. For one thing,

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leaders of all the big banks have finally caught on to the idea that churning through customers is not nearly as productive as keeping existing ones happy. As a consequence, customer service is getting more than just a little lip service at Wachovia’s competitors these days and perhaps more. As well, say analysts, the temptation to pay dearly for an attractive expansion opportunity remains powerful.“There is always a nagging fear in the back of an investor’s mind that [to conclude] a deal a bank CEO will take three steps back, to hopefully go four steps forward,” says Gerard Cassidy, a bank stock analyst with Royal Bank of Canada's RBC Capital Markets. Indeed, Wachovia agreed in May to pay $26bn, or 2.8 times book value, for Golden West Financial Corp., a successful California-based mortgage lender that in some analysts’ view offers little opportunity for cost cutting. Wachovia’s price sank immediately after the Golden West deal was announced, suggesting investor worry that it is exactly the kind of dilutive transaction that Cassidy had in mind. The product of scores of acquisitions over more than 20 years, Wachovia is the fourth largest banking company in the US, with $542bn in assets and 3,159 branch offices in 15 states. With the addition of Golden West, which has $125bn in assets, it will have significant banking presence along the East Coast, in the South and in California. In addition to its mainstay deposit gathering and lending business, Wachovia owns the third largest network of stockbrokers and an investment bank that it believes it can become a major player on Wall Street. It gets high marks from analysts for its business management.“They are one of the better operators among the large cap banks in the US in terms of their retail, small business and commercial middle market franchises,” said Jon Balkind, a bank stock analyst with Fox-Pitt, Kelton Ltd. By most accounts, it is nearly impossible to differentiate one bank from another, especially very big banks, in the eyes of consumers. In particular, given the role of inertia in determining where bank customers do business, it is hard to make productive use of even a distinctive image. Wachovia, however, may be making the kind of impression that gradually attracts more of a customer’s business and then more customers, too. For example, Wachovia has topped a small group of large banks five years in a row in a University of Michigan Business School survey of consumer satisfaction. It was fourth in a group of 33 banks ranked on customer satisfaction earlier this year by JD Powers & Associates. Also it was the only large bank to rank anywhere near the top in a survey last year produced by Forrester Research measuring consumer perception about the loyalty of their financial institution to them. Respondents to Forrester’s survey mostly gave far smaller companies the highest marks for looking after customers’ interests, rather than the company’s interests. It may be just enough to keep customers with Wachovia slightly longer than with competitors, says Gordon J. Goetzmann, managing vice president of First Manhattan Consulting Group in New York. Even a small difference in

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customer retention and customer attribution makes a big difference organic growth over time, he says. It does not appear that the positive response to questions posed by research companies stems from any overarching clever idea. More likely, consistently courteous interactions between frontline bankers and retail customers, attention to small business customers, accurate handling of basic transactions and willingness to fix problems when they arise underlie slower customer attribution, Goeztmann adds. Lisa Purville, a customer service representative in a New York branch of Wachovia, says the account opening staff members try to glean information about customers that will lead to suggesting additional services that the bank might provide. For example, she asks about income and family status and whether a new customer has thought about financing his or her retirement. However, both she and her colleagues do not use a formal questionnaire, as some of the other large banks do, out of concern that that will make customers uncomfortable. Photograph of Quinten C. Stevens, managing director and head of the investment bank’s The process is strictly soft selling, she equities division. According to Stephens, the long-term tide, favours companies that offer said, making Wachovia a comfortable loans and capital markets under the same umbrella and that have brokerage arms to place to work. Moreover, there is no distribute securities.“I am a big believer in the universal banking model,” he adds. This point in nudging someone into an photograph was kindly supplied by the Wachovia Corporation, June 2006. account that does not serve any Reliable market share figures are difficult to come by in purpose; and she will lose the credit toward incentive pay banking. Deposit balances reported to the Federal Deposit if a customer closes the account, she adds. Purville, who has been with Wachovia for a year, appears Insurance Corp. for each of the 89,000 bank branches in to reflect what company executives say is the key to the US, do give some indication of how banks are doing customer service — an engaged workforce. The company compared to one another. They suggest that the positive uses a number of tools to ensure that employees are image that surveys describe may be translating into interested in their work, says James E. Fitzgerald Jr., growth completely apart from Wachovia’s many regional president for the bank’s North Atlantic area. It ties acquisitions. Wachovia turned in a 10% gain in samefinancial incentives to mystery shopping reports about each branch deposits for the year ended June 30, 2005, branch. Employees are given an hour of paid time each according to an analysis of FDIC data by Friedman, week to do community volunteer work and someone in Billings, Ramsey & Company, trailing only Commerce each region reports on what kind of volunteer work people Bank in New Jersey among the 19 large banks examined. are doing. In addition, a wide swath of the workforce is The average gain in same-branch deposits, which offered career development planning, in which executives attempts to measure only branches that have been in help junior staff members plot out what kind of course or business for at least two years, was 4.7%. Several of the responsibilities would help them move ahead.“People who biggest banks had especially sluggish same-branch feel some attachment to the company, who feel good about deposit growth, including Bank of America, at 3.0% and JP what they are doing, are going to be more productive,” Morgan Chase & Company, at 1.5%. Still, one of Wachovia’s big challenges is to make the Fitzgerald said. “They are going to stay longer.” It is all easier claimed than actually delivered any better than the same model work over a bigger and bigger network, one next bank, Fitzgerald readily acknowledges. Although the that results from opening branches in desired markets possibility that Wachovia is taking business from and buying banks in others. After acquiring banks in New York City’s suburbs, Wachovia entered Manhattan in 2003 competitors lends credence to the claims.

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says Quinten C. Stevens, with new offices. It now Taking on the bulge bracket giants in investment & managing director and has around 16 and has corporate banking head of the investment eight more on the 225 bank’s equities division. It drawing board. It entered 200 is grabbing bankers from Texas when it bought 175 bigger firms, including SouthTrust Corp., a 150 Stevens, who moved to $54bn-asset bank in 125 Wachovia in 2005 from JP Birmingham, Alabama, in 100 75 Morgan, and winning 2004. That triggered a 50 mid-sized jobs, such as a plan to build between 30 25 $162m initial public and 50 branches a year in offering (IPO) it led earlier the state through to the this year for Morton’s end of 2008. Wachovia Bank of America JP Morgan Chase & Co Restaurant Group Inc., a Wachovia also Citigroup FTSE Developed Banks Index high-end steakhouse completed an acquisition chain based in Chicago. for West Corp., an auto Source: FTSE Group / FactSet Limited US Dollar price returns. Data as at June 2006 Reaching the top rung of lender with $16bn in assets and a small branch network in California, earlier the ladder may seem like a stretch. Wachovia was ranked this year. Golden West, which had the 16th largest 12th among US mergers and acquisitions advisers mortgage origination business in the US last year, will add through the four three months of 2006, with deal value 285 branches to the total.“Wachovia is in the best growth about a fifth the size of Goldman Sachs’ leading deal markets in the country,” maintains Thompson, “and that value, according to Thomson Financial. It ranked 11th in will be even better with Golden West. With our four lines underwriting of US IPOs, with less than half the deal of business, we are able to offer individuals and value of UBS, which is the leader in the category. businesses in those markets a full menu of financial Wachovia also ranked seventh among underwriters of US products and services. As a universal bank that is strong corporate debt, with less than half the value of Citigroup, on execution, we can provide superior value to customers the deal value leader. The long-term tide, however, favours companies that and shareholders.” Traditional banking — taking deposits, making loans offer loans and capital markets under the same umbrella and generating fee income associated with deposits and and that have brokerage arms to distribute securities, loans — is easily the largest of Wachovia’s four lines of Stevens says.“I am a big believer in the universal banking business. The general bank, as the company calls it, model,” he adds, asserting that universal banks such as produced 59% of earnings last year. The Golden West Citigroup, JP Morgan, Bank of America, UBS and Deutsche acquisition, which is targeted for completion in the fourth Bank have taken market share over the last several years quarter, assuming it receives customary regulatory from the traditional Wall Street titans, Goldman Sachs, approval, would push the general bank’s share of total Morgan Stanley and Merrill Lynch.“Most companies would earnings to 67%. Other units are sizeable, too, however. like to be able to deal with a limited number of institutions With more than 10,000 stockbrokers at the end of last year for all of their financial needs,”he said. Moreover, Wachovia, which situated its equities business and an active recruitment program, the company’s capital management business runs the third largest securities and consolidated its trading floors in New York last year, brokerage in the US. In addition, Wachovia’s Evergreen has a secret weapon in recruiting from the big Wall Street Investments mutual fund business manages more than firms, Stevens says.“This is the most collegial atmosphere $250bn in assets. The unit accounted for 9% of Wachovia’s I have ever experienced in 20 years on Wall Street,” he earnings last year. The bank’s wealth management explains. Whether the investment bank nudges into the operation ranks as the fourth largest wealth manager in top tier or not, it is a solid contributor to the parent the US, according to Barron’s magazine. It earnings were company, analysts say, as actually are each of Wachovia’s major business units. The past several years’ worth of 4% of the company’s total last year. The corporate and investment banking unit, contributor strong performance throughout the company, however, of 26% of earnings last year, may be the operation to keep may not answer whether solid contributions from the an eye on. Although the general view among analysts who breadth of business units are the same as sustainable follow Wachovia is that it is a niche second-tier player.“I do contributions. The biggest test ahead will be to continue not believe, without an acquisition, they will ever make it organic growth in a world in which competitors have into the bulge bracket,”says RBC Capital Markets’ Cassidy, similar customer service ideas and then to stay disciplined referring to the handful of Wall Street firms that routinely in acquisitions. Time will tell whether the Golden West win the very biggest initial public offering and mergers and deal represents the kind of discipline that analysts say has been a hallmark of the Ken Thompson era or the worst acquisitions assignments. But that is exactly what the company is gunning for, fears of RBC’s Cassidy.

COMMODITIES FUTURES

Winners Losers

Commodity prices are booming. Hedge funds, institutional investors, exchange traded funds and mutual funds are pouring money into the commodity futures markets, driving open interest and trading volume in many contracts to record levels. It is a zero-sum game, however: for every dollar that managed funds add on the long side, someone else is short. The new liquidity is a godsend to commercial players, who can manage their risk more efficiently. Regulators are relaxed too. Is it too good to be true? Neil O’Hara reports.

HE NUMBERS TELL the tale. Open interest in wheat futures on the Chicago Board of Trade (CBOT) increased from 107,412 contracts in December 2003 to 385,116 in March 2006. Over the same period, open interest more than doubled in corn and rose more than

AND

50% in soybeans (please refer to Figure 1). The story is the same at the Chicago Mercantile Exchange (CME): live cattle and feeder cattle open interest has doubled, while lean hogs more than tripled (please refer to Figure 2). The supply of agricultural commodities varies from year to year with the harvest, of course, but the jump in open interest dwarfs any incremental production. It is not just agricultural products, either.The New York Mercantile Exchange (NYMEX) has seen dramatic increases in open interest in metals and energy. Trading volume is at record levels too — although proportionately volumes are not up as much as open interest.

Rudolf Hundstorfer, right, president of the Austrian trade union which is the owner of the BAWAG bank, listens to Austrian Chancellor Wolfgang Schuessel during a news conference in downtown Vienna, Tuesday, May 2, 2006. Austria's government and its banking and insurance sectors announced a rescue plan in early May to bail out the embattled BAWAG bank, which reportedly lost about €1bn ($1.26bn) in soured currency speculation deals in the Caribbean and is accused of playing a key role in the collapse of the US-based commodities brokerage Refco. Photograph by Ronald Zak and supplied by EMPICs/Associated Press, June 2006.

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believes his analysis of the Unlike other market detailed data “quashed participants, commodity Despite their reputation as some misconceptions about index funds tend to buy and aggressive traders, the CFTC found the role of speculators in hold until it is time to roll that on average hedge funds hold the markets”. out to a later contract. their commodity positions for longer Despite their reputation as Nevertheless, managed than do commercial players. Far from aggressive traders, the CFTC money — mostly index found that on average hedge trackers and hedge funds — driving prices, Haigh concludes that funds hold their commodity represents a huge new speculators trade in response to price positions for longer than do source of liquidity in the and position changes among bona commercial players. Far from physical commodity fide hedgers and other commercial driving prices, Haigh markets. Hedge funds are interests. “The commercial category concludes that speculators blamed for everything these changes position more frequently than trade in response to price days, including high and position changes among commodity prices. speculators,” he says, “Speculators bona fide hedgers and other Politicians (and even oil are fulfilling the textbook economic commercial interests. “The industry executives) decry role that they are supposed to have, commercial category changes speculators whom, they providing the liquidity that hedgers position more frequently claim, have pushed prices demand to manage their risk.” than speculators,” he says, to levels that are not “Speculators are fulfilling the justified by underlying textbook economic role that supply and demand. The hedge fund bogey plays well to constituents they are supposed to have, providing the liquidity that squealing about gasoline pump prices that are upside of $3 hedgers demand to manage their risk.” In the crude oil and natural gas markets, influxes of per gallon, but it is a straw man. Why? Because the futures markets do not drive the cash market, they only transfer managed money prompt an equal and opposite change in risk from one party to another in a closed loop. For every position among commercial players. As a result, the balance between speculative and commercial participation buyer there must be a willing seller. Statistics show that commercial interests – organisations has hardly shifted despite the explosion of open interest. that use or deal in physical commodities – still dominate Haigh points out that if managed money merely reacts to the markets, as they always have (please refer to Figure 3). A changes initiated by commercial interests it tends to lower 2005 study of natural gas and crude oil trading by the volatility, not increase it. NYMEX reached the same conclusion in a study Commodity Futures Trading Commission (CFTC) revealed no evidence that hedge funds or managed money have commissioned by James Newsome, president and chief disrupted the futures markets. Although the CFTC executive officer, soon after he joined NYMEX from the publishes only weekly data aggregated for commercial and CFTC (where he was chairman). “Funds actually decrease non-commercial interests, the agency collects volatility rather than increase it because they tend to hold unpublished daily information down to the position level on to their positions longer than other market for major market participants through its Large Trader participants,” says Newsome, “That was a surprise. It was Reporting System (LTRS). Michael Haigh, associate chief not what we expected.”It is a chicken and egg argument, of economist at the CFTC and one of the study’s authors, course, but Robert Ray, senior vice president for business Figure 1 CBOT Futures Open Interest

Figure 2 CME Futures Open Interest

1,200,000

250,000

1,000,000 200,000

800,000 150,000

600,000

100,000

400,000

50,000

200,000

0 Dec 2001

Dec 2002

Dec 2003

Soybeans

Dec 2004

Wheat

Dec 2005

Mar 2006

Corn

Source: Chicago Board of Trade

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Dec 2001

Dec 2002

Live Cattle

Dec 2003

Dec 2004

Feeder Cattle

Dec 2005

Mar 2006

Lean Hogs

Source: Chicago Board of Trade

COMMODITIES FUTURES 74

development at the CBOT believes that “real users” – in other words, food manufacturers and grain merchants who have to be in the market — take the lead. “It is the commercials; those that either need the grain or have the grain and need to hedge it,” he says,“They are constantly readjusting based on their inventories. They have a live dynamic underlying book.” Fears that the growth in index funds would boost volatility have proved unfounded, too. Joseph O'Neill, senior vice president of business development at the New York Board of Trade (NYBOT), estimates that indexed money in the futures markets now exceeds $80bn, up from $15bn three years ago. In the United States, these funds typically track the Goldman Sachs Commodity Index or the Dow Jones-AIG Commodity Index and have a predictable trading pattern: on certain days every month a large block of open interest will roll out to the next contract. Participants worried that such concentrated activity would overwhelm commercial demand for the other side of James Newsome, president and chief executive officer, pictured soon after he joined the trade, but the market has absorbed NYMEX from the CFTC. In a recent study commissioned by NYMEX, Newsome found ever-bigger rolls without a hitch.“We see that “Funds actually decrease volatility rather than increase it because they tend to hold a lot of trading activity associated with on to their positions longer than other market participants,” he says.“That was a surprise. that element but we do not see any It was not what we expected.” Photograph kindly supplied by NYMEX, June 2006. disruption,” Haigh says,“People will trade ahead of it. They know it is going to come some market participants are now talking about a so it flattens out that volatility.” Liquidity in the futures markets has traditionally permanent contango in energy. The move to contango has focused on the first two months beyond the delivery already affected users' behaviour: crude oil inventories are period, but the new money has spilled over to distant high in part because it pays to keep storage tanks full when contract months as well. John Harangody, director of future months are more expensive. Whether the new liquidity contributed to the switch in commodity products at the CME, explains that market makers who absorb commercial selling in nearby contracts energy is unclear, although O'Neill believes passive money lay off the risk they assume in contracts farther out on the does push the markets toward contango. “When all those curve. “There is a significant amount of spread activity in funds roll it is not really conducive to backwardation unless CME products,”he says,“You see that reflected in volumes there is a good market reason for it,” he says. Commercial interests prefer contango, too, O'Neill notes; it simplifies in the back contract months.” Those spread trades work best for markets in contango, their hedging. For regulators, the growth in open interest and trading where distant contract prices are higher than for nearby months. By selling longer-dated contracts they get a volume presents a dilemma. Whether or not to positive carry as long as the market is in contango. Spread authorise higher speculative position limits. “As the traders tend to avoid backwardated markets (in which the markets have grown and the number of players has distant contracts are cheaper) because negative carry turns grown, we think there is justification for an expansion in position limits,” says Newsome. He believes the CFTC, the hedge into a losing proposition. Unless failed harvests or other unpredictable events which has the final word, is sympathetic, but recognises upset the balance between supply and demand, the agency will face political pressure if it eases commodity markets tend to trade in contango. The restrictions on speculators while energy prices are high exception — until early 2005 — was energy, which traded and volatile. Regulators set speculative position limits to frustrate in backwardation for almost 15 years. CBOT’s Ray says

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potential market manipulation. For physically settled contracts, Haigh points out the greatest scope for short squeezes, cornering and other mischief arises in the final month when sellers can make delivery. The exchanges impose much lower limits for the last month that reflect the availability of deliverable supplies, forcing traders to cut back their positions during the prior month. The CFTC tracks any speculative traders who have not closed out their positions before the delivery period, too. In practice, no more than 1% of contracts go to delivery, even among commercial players. Ray observes that an active over the counter (OTC) market in commodity swaps means distant month position limits have less effect than they once did. OTC transactions,

often used by large speculative and commercial traders, take place outside the exchange environment and are not subject to regulatory position limits. The swap dealer will turn around and lay off the risk through the futures markets, but as a commercial interest, the dealer is not subject to speculative position limits. “It is a very tight relationship between the listed and OTC markets,” Ray says, “OTC, futures, options and ETFs feed off each other and grow as a result of each other's liquidity.” Notwithstanding illinformed sniping by politicians, the commodity futures markets today present a picture of robust health. Indeed, NYBOT’s O’Neill, who regularly talks to traders, says participants believe the markets are “working more efficiently than they have ever worked before.”

Figure 3 Percentage of Open Interest Held by Participant Categories for Crude Oil

As % of Total Open Interest Trader Category Futures Long Dealer Merchant 18.69 34.96 30.79 Manufacturer 7.21 7.75 6.84 Agricultural and Natural Resource End User 0.70 0.49 0.56 Producer 9.32 12.8 11.98 Commodity Swaps/Derivatives Dealer 12.00 12.62 12.85 Arbitrageur or Broker Dealer 0.20 0.18 0.19 Floor Broker or Floor Trader 2.33 6.73 5.45 Financial Swaps/Derivatives Dealer 0.11 0.49 0.40 Managed Money Trader 27.35 12.76 17.26 No registration 6.58 4.04 4.81

Short 24.04 21.72 22.21 21.46 8.89 12.77 0.28 0.21 0.23 11.84 12.39 11.87 4.46 28.75 22.79 0.06 0.09 0.08 6.78 9.26 8.73 0.00 0.13 0.10 7.34 6.16 6.57 7.11 5.80 6.07

Options Long 15.94 21.31 20.24 2.94 1.34 1.67 0.20 0.08 0.10 10.02 14.72 13.84 12.77 17.35 16.28 0.10 0.05 0.06 33.00 25.14 26.98 0.05 0.17 0.14 7.18 6.08 6.37 13.26 11.61 12.01

Short 22.98 28.92 27.85 7.09 2.43 3.19 0.34 0.15 0.19 14.33 15.89 15.70 16.01 21.39 20.32 0.15 0.03 0.06 18.07 16.61 16.94 0.16 0.4 0.36 5.42 4.12 4.40 10.7 7.93 8.50

Average Average Futures Options Daily Open Daily Open Interest Interest 148,237 56,107 477,637 211,693 625,874 267,801 148,237 56,107 477,637 211,693 625,874 267,801 148,237 56,107 477,637 211,693 625,874 267,801 148,237 56,107 477,637 211,693 625,874 267,801 148,237 56,107 477,637 211,693 625,874 267,801 148,237 56,107 477,637 211,693 625,874 267,801 148,237 56,107 477,637 211,693 625,874 267,801 148,237 56,107 477,637 211,693 625,874 267,801 148,237 56,107 477,637 211,693 625,874 267,801 148,237 56,107 477,637 211,693 625,874 267,801

Notes: (1) Upper figure represents shares based on the nearby contract (the month before delivery month), the middle figure (bold) based on all other contracts (except the nearby), and the lower (italic) figure includes all contracts combined. Options are delta adjusted option positions. (2) Arbitrageur or Broker Dealer and Financial Swaps/Derivatives Dealer categories have recently been combined into Commodity Swaps/Derivatives Dealer category Source: Data from “Price Dynamics, Price Discovery and Large Futures Trader Interactions in the Energy Complex,” a paper written by Michael S. Haigh, Jana Hranaiova and James A. Overdahl in the CFTC’s Office of the Chief Economist.

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COMMODITIES

While conceding that the market had been ripe for a pullback, others, however, say there is plenty of upside still to come. Commodity bulls believe that a prolonged and unprecedented cycle of undersupply and over-demand — a “super-cycle” as some have called it — coupled with a rolling global economy, particularly in countries such as China and India, make this advance far different from any we have experienced in the past. "It is not just about metals — almost every commodity asset class, whether it’s crude oil, precious metals, industrial metals, sugar — even bananas is going bananas,” cracks Nicholas Moore, global head of commodities for ABN-Amro. Photograph supplied by Dreamstime.com, June 2006.

The commotio For nearly 50 years, commodities ranked among the world’s most stubborn investments, moving virtually sideways for decades save for a few volcanic bursts of activity. While technology stocks virtually imploded at the start of the current decade, sub-sectors such as gold, copper, silver, platinum and, of course, oil began a sustained rally that has resulted in across-theboard record highs and a massive infusion of investment capital. What lies ahead for the feast-or-famine commodity sector? Dave Simons reports from Boston.

N APRIL, THE financial papers were sounding the alarm.“If you are not already in commodities, get in — right now!” Well, it seemed like the right thing to do. Over the previous five months the price of zinc had doubled, copper had risen 80%, and silver and gold were ahead 60% and 50% respectively. The Commodity Research Bureau's (CRB’s) broad commodity price index soared into uncharted territory. What else could it take to spur a chorus of advisors who urged clients to increase their exposure to commodities, some suggesting as much as an allocation of 10%? Weeks later, the group sold off en masse, with copper pulling back 17% and gold falling to $640, $80 off its alltime high set in April. The sudden drop had many on the sidelines drawing parallels to the herd mentality that had beset the technology sector years earlier.“The time to own

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industry’s benchmark commodities … is when metal, gave back 15% the they are down, when Not everyone though is as easily following week, then everybody has lost money sold on the super-cycle theory. advanced 10% in a single in them, and when they Jephraim P. Gundzik, president of day following a report by trade below the cost of Condor Advisers, Inc., argues that the the Organization for production, and that time Economic Co-operation is not now,” warned Bill devaluation of the US dollar, and Development (OECD), Miller of Legg Mason responsible for a departure in foreign which estimated that Capital Management, just capital from the US, is the real Chinese growth would weeks before the sell-off. reason for surging commodity prices. remain close to 10 % over “Is it any surprise now the next two years. that oil is a six bagger, It is just that sort of news that copper has that has had metal mavens quadrupled in the past FTSE Gold Mines Index Series buying on the dips. China’s four years, and that after rapid industrial the biggest commodity 800 development has sparked a rally in 50 years…it is 700 600 mammoth boom in now that prices are ‘set to 500 housing. Copper wiring, soar’ and that pension 400 which is used in new funds are falling all over 300 homes in China, has in part themselves to allocate a 200 propelled the recent rise in portion of their assets to 100 copper pricing. These days commodities?” 0 around one-quarter of the While conceding that world’s entire copper the market had been ripe demand comes from the for a pullback, others, FTSE Gold Mines Americas Index FTSE Gold Mines Asia Pacific Index country. China's demand however, say there is FTSE Gold Mines Europe Middle East & Africa Index FTSE Gold Mines Index for commodities in general plenty of upside still to is unlikely to abate over the come. Commodity bulls Source: FTSE Group US Dollar price returns. Data as at June 2006 near term, say analysts, believe that a prolonged and unprecedented cycle of undersupply and over-demand particularly as urban populations continue to grow. While a — a “super-cycle”as some have called it — coupled with a step-up in production is possible, London-based rolling global economy, particularly in countries such as consultancy Bloomsbury Minerals Economics (BME) sees China and India, make this advance far different from any copper consumption holding steady at 3.5 % annually, we have experienced in the past.“It is not just about metals easily outpacing any new lines of supply. Other metals have made tremendous strides since the — almost every commodity asset class, whether it’s crude oil, precious metals, industrial metals, sugar — even start of the year. The price of zinc has more than doubled bananas is going bananas,” cracks Nicholas Moore, global since January, and Matthew Hope, analyst at Sydney-based AME Minerals, believes further gains are likely as zinc head of commodities for ABN-Amro. Analysts at Citigroup, while unwilling to forecast a inventories, which recently hit a five-year low, continue to continuation of this year’s commodities rally in spot prices, fall. Nickel, already ahead 75% since the start of the year, are nonetheless “more optimistic that underlying continues to hit new highs, and was among the few fundamentals will support metal prices in the medium commodities to emerge from the May pullback relatively term.” Citigroup raised its 2007 estimate for the price of unscathed. In addition, while gold has stayed around 15% copper by 50%, citing suppliers’ inability to meet off its 26-year high (set in April) most analysts are unfazed. Meanwhile, concerns over skyrocketing energy costs unprecedented worldwide demand which will in turn lead have helped pull oil off its April record high of $75.35. to higher prices over the long haul. However, like other commodities, the consensus among investors was that a prolonged retreat in the price of oil was Historic volatility Historically, commodities investing is one long boring ride, unlikely, given supply deficits, the possibility of disruptions albeit one with unexpected hair-raising peaks and troughs. and refinery outages as the hurricane season approaches, A notoriously low-volume business (on a particularly slow as well as the political fallout over Iran’s nuclear program. day, for example, only 4,000 to 5,000 cocoa contracts may A price target of $100 per barrel may be reached before change hands), commodities are unusually susceptible to long, experts suggested. “This is not a fundamental shift, and there has been no minor market shifts, leaving investors vulnerable to waves of speculative buying and selling. Here is a case in point. change in the big picture of supply and demand,”explains After rising 50% in just two weeks in early May, copper, the Larry Edelson commodities expert at safemoneyreport.com,

COMMODITIES 78

retracement is largely detached from conventional fundamental factors that typically underlie these markets,” remarks Peter Richardson, chief metals economist at Deutsche Bank, on copper’s recent volatility. “Rising demand in both OECD and industrializing countries coupled with persistent shortage of physical supply currently characterizes the base metals market and will continue to support strong prices regardless of the ebb and Metal meltdown? At the April meeting of his Berkshire Hathaway group, the flow of speculative investor money." “It takes seven to 10 years to bring on a new oil field and ever-prudent Warren Buffett told investors,“Like most trends, at the beginning it is driven by fundamentals…but at some five to seven years for a copper mine, so the new investments point speculation takes over.”Steve Roach, analyst at Morgan of today are in a production that we are not going to see until Stanley, agrees with the assumption that commodities have the next decade, during which time supplies of many become chips in financial markets for speculators to gamble. commodities will remain tight,” adds Jeffrey Currie, head of commodity research at “Speculation works if the Goldman Sachs. negative carry from the yield Commodity bulls believe that a Not even a series of prime curve and warehousing cost is lending-rate increases by the low; there are enough prolonged and unprecedented cycle US Federal Reserve Board speculators to keep prices of undersupply and over-demand — a has been able to quell high for an extended period; “super-cycle” as some have called it metal’s momentum. While and somebody will pay up — coupled with a rolling global economic weakness is not regardless of high prices,”says economy, particularly in countries out of the question, “for the Roach. The arrival of time being there is no commodity based funds such such as China and India, make this noticeable slowdown in as the United States Oil Fund advance far different from any we growth, allowing the (USO) and the iShares Silver have experienced in the past. “It is commodity bulls more or Trust (SLV), both of which not just about metals — almost every less free reign,”notes Edward debuted on the AMEX in commodity asset class, whether it’s Meir of Man Financial. April, have helped make crude oil, precious metals, industrial Not everyone though is as speculating in commodities easily sold on the super-cycle accessible to retail investors, metals, sugar — even bananas is theory. Jephraim P. Gundzik, says Roach. “ETFs, for going bananas,” cracks Nicholas president of Condor Advisers, example, hold copper more Moore, global head of commodities Inc., argues that the than half of the annual for ABN-Amro. devaluation of the US dollar, growth in global demand. responsible for a departure in Financial investment in the oil foreign capital from the US, is market could be twice as the real reason for surging commodity prices.“It is a dubious much as China’s annual imports.” So is the commodities sector topping, or just stopping notion that global economic growth has suddenly reached a for a breather? Jim Jubak, senior markets editor for MSN point where worldwide demand has overwhelmingly and Money, still sees a great deal of room to move,“as long as simultaneously outstripped worldwide supply of all these the economies of China and India keep devouring a commodities,” maintains Gundzik. “In 2005, real global bigger chunk of the world's raw materials and as long as economic growth slowed to about 3.2% from nearly 4% in the established economies of the United States, Japan and 2004. Slower global economic growth was led by slower real Europe keep chugging along at growth rates between 2% economic growth in the US, which decelerated to 3.5% in 2005 from 4.2% in 2004. Global demand for commodities and 4% annually,”reports Jubak. Nevertheless, analysts such as Tony Dolphin, director of was actually declining, as prices for these commodities economics and strategy for Henderson Global Investors, began to gallop higher in 2005.” Should commodity demand outpace supply indefinitely, believe that investors should proceed with caution. “The speed and scale of the rise in industrial metals prices seen and in turn lead to price increases that exceed nominal so far in 2006 is extremely hard to justify on fundamental GDP, it would be a precedent-setting event in the annals of grounds,” says Dolphin, “and it does appear that an economic history, notes Legg Mason’s Miller, since element of speculation, possibly a large one, has entered historically commodity prices usually level off as improvements in production technology cut into the the market for some commodities.” Insatiable demand and insufficient supply remains the demand-supply imbalance. “That does not mean it will not overriding mantra for commodity proponents. “Much like happen,” says Miller. “After all, lots of things happen that the rapid pace in which metals prices shot forward, the have never happened before.” the specialist internet-based market commentary. “The decline is still well within the parameters for a major bull market punctuated by healthy corrections. Ditto for oil and every other natural resource. All we're seeing here is hot speculative money pouring into these markets and then some of it pulling back out,”he adds.

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The promise of absolute returns drew institutions and high net worth individuals to hedge funds in droves during the 2000 to 2002 bear market. Neophyte investors typically chose funds of funds, a one-stop solution to asset allocation that outsources the selection of individual hedge fund managers. Funds of funds assets under management ballooned, based on marketing pitches that led investors to expect returns of 300 to 400 basis points (bps) over LIBOR. A funny thing happened on the way to the bank though. The returns fell short. Neil O’Hara analyses the fund of fund market in the aftermath. CCORDING TO ROBERT Schulman, chief executive officer of Tremont Capital Management, Inc., an investment management firm based in Rye in New York State, high net worth investors who dominate the funds of funds sector look for absolute returns in excess of 10% — a goal that eluded most funds in 2004 and 2005. Anything under 10% is "less exciting to someone who is going to pay taxes on it", he explains. Institutions will tolerate low absolute returns attributable to market conditions — LIBOR hit a 40-year low in 2004 — provided they get alpha, a margin over the risk free rate. Many funds of funds did not deliver that, either. Tom Whelan, CEO of Greenwich-Van Advisors in Greenwich, Connecticut, blames structural changes that crimped returns in some markets.“So much of the LIBOR-plus money was invested in market neutral hedge fund strategies,” he says, “Convertible arbitrage and things like that, which have historically very good records but did not do well in 2004 and 2005.” Investors will not pay fund of funds’ fees – 1% of assets and 10% of net gains on top of the underlying hedge funds’ fees — for a return that matches LIBOR.

DRUM Charles Gradante, managing principal at New Yorkbased hedge fund consultants Hennessee Group LLC, believes institutions often end up in funds of funds that are too diversified to beat the averages. If an institution wants to invest $50m to $60m and limit its exposure to 2% of fund assets, the fund it picks must have between $2.5bn and $3bn under management.“Fund of funds that large have so many managers in their belly [sic] they become like an index fund,” he says,“When you put the fees on top, they can have performance problems if they do not have good asset allocation.” Gradante says some institutional money has switched back to long only strategies as investors anticipate a strong equity market when the Federal Reserve stops raising interest rates. Other institutions maintained the same allocation to hedge funds but began investing in the underlying funds to save the fund of funds’ fee. Gradante believes that after a few years’experience investing in funds of funds investment committees accustomed to screening long only managers feel they know enough to select individual hedge fund managers, too. Direct investment does ratchet up the manager risk, however. Five percent positions in a hedge fund are not uncommon notes Gradante. Whereas a 2% investment in a fund of funds — a diversified pool where no one manager represents a significant percentage — virtually eliminates manager risk.

HEDGE FUND OF FUNDS

MARCHING TO THE BEAT OF A DIFFERENT

Mandatory registration is one more sign that the industry has matured. Whelan attributes hedge funds' focus on business operations in the past five years to the influx of institutional money. "The old days of two guys running a fund and attracting institutional dollars are over," he says. Today, a successful institutional hedge fund demands scale. Image supplied by iStockPhoto.com, June 2006.

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HEDGE FUND OF FUNDS 80

Funds of funds can provide a valuable service to investors. “For people that do not have the tools to make decisions about managers themselves, which is almost every individual, it is pretty addictive,” says Schulman. He sees more specialised funds of funds emerging too; including funds offering portable alpha, funds dedicated to specific strategies, guaranteed products and funds of funds that use leverage to boost returns. Schulman expects flows into funds of funds will strengthen once absolute returns pick up, as they started to do late last year. US hedge funds — including funds of funds — meantime face tough market conditions though. A flat yield curve, tight credit spreads and low volatility leave few opportunities among the relative value strategies on which so many hedge funds depend. That may tempt managers to ratchet up the risk through higher leverage or greater concentration, according to Jay Flaherty, an associate at Ennis Knupp & Associates, a consulting firm headquartered in Chicago, Illinois. “Those decisions will increase volatility and the chance of negative events,”he says.“After all, incentive fees are like an option and option values rise with volatility,” he adds. The market will adapt over time, of course. Greenwich-Van’s Whelan notes that in late 2003 convertible arbitrage funds ran into capacity constraints that hurt returns for two years. Investors lost patience and bailed out. Greenwich-Van estimates that convertible arbitrage funds lost a third of their assets in 2005, setting the stage for a recovery. “Spreads have widened back out again so there is opportunity,” Whelan says, “The same cannot be said for merger arbitrage, where spreads remain tight despite a big convertible space, and which is doing very well this year.” Indeed, compared with the FTSE Convertible Arbitrage Index, for instance, the FTSE Hedge Merger Arbitrage Index has gone nowhere for five years.“I do not want to say merger arbitrage is dead forever, but the returns are very low,” says Schulman, “Activism before a deal is announced is a more profitable strategy than trying to make money after the announcement.” Frustrated by poor returns in relative value plays, hedge funds have adopted the role played by corporate raiders in the 1980s. They acquire substantial stakes in underperforming companies, and then press management to boost returns to shareholders through dividend increases, stock buybacks, selling non-core assets — or the sale of the company outright. Gradante expects activism will grow because the corporate sector is flush with cash not earmarked for capital expenditures. He believes activists serve as a check on the board of directors even when the target does not implement their suggestions in full. “It is like a physical examination of corporate governance,”Gradante says,“You do not like to go through it but it is really a necessary evil.” He does harbour some reservations however. If hedge funds stoop to taking greenmail or throw their weight around at sound companies that are well-managed the activism would be counterproductive.“The interests of activists have to be in line with other shareholders,”he says. Activist hedge

Charles Gradante, managing principal at New York-based hedge fund consultants Hennessee Group LLC, believes institutions often end up in funds of funds that are too diversified to beat the averages. If an institution wants to invest $50m to $60m and limit its exposure to 2% of fund assets, the fund it picks must have between $2.5bn and $3bn under management. "Fund of funds that large have so many managers in their belly [sic] they become like an index fund," he says, "When you put the fees on top, they can have performance problems if they do not have good asset allocation." Photograph kindly supplied by the Hennessee Group, June 2006.

funds cannot rely on the unquestioning support of other funds, however. Carl Icahn’s assault on Time Warner failed in part because other hedge funds did not jump on the bandwagon, except for two that joined his campaign at the outset. Time Warner was also too big. Whelan believes activism works best among mid-cap stocks, at least for now. “Because of their focus on fundamental investment hedge funds are going to be activist shareholders,” says Gradante, “They are trying to unlock value, and they have been very successful.”Shareholder activism demands resources beyond research, trading and portfolio management. Public relations play an important part, so activist funds must adhere to legal restrictions on proxy solicitation and communications with other shareholders. It places an incremental burden on hedge funds' compliance function. Regulators have forced US hedge funds to beef up their compliance infrastructure, too. In February, a new US Securities and Exchange Commission (SEC) rule went into effect that requires hedge fund managers whose assets exceed $25m to register as investment advisors. That subjects the managers to random inspections by the SEC and obliges them every year to file Form ADV, which contains basic information about who they are, what they do and how much money they manage. Registered managers must also designate a chief compliance officer. It all costs money, of course — but there is a loophole. Bowing to pressure from private equity and venture capital funds, the SEC carved out an exemption for funds that lock up investors’ money for two years or more. Ennis Knupp's Flaherty points out that only 2,100 funds have registered out of a population typically estimated to lie somewhere between 8,000 and 10,000.

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

Of the rest, some are too small, while others have extended their lockups or are closed to new money. Hedge funds led by talented professionals with successful track records can duck registration, Flaherty says, at least for now. Other things being equal, he believes investors prefer registered managers, however, so hedge funds may find registration provides a competitive advantage. The new rule made little difference to managers that depend on institutional money. Most institutions insist the manager becomes a registered investment advisor before they will invest in a hedge fund. “A lot of money has been on the sidelines because hedge fund managers are not registered,” says Gradante,“It can only be good for the industry.” Mandatory registration is one more sign that the industry has matured. Whelan attributes hedge funds' focus on business operations in the past five years to the influx of institutional money.“The old days of two guys running a fund and attracting institutional dollars are over,”he says. Today, a successful institutional hedge fund demands scale. It needs a chief financial officer, a head of operations, cash management, marketing and investor relations as well as a top-notch investment management team, according to Whelan. The costs have increased barriers to entry, although star managers can still attract enough assets to build a complete infrastructure at once, as Jack Meyer just demonstrated. The former manager of Harvard's endowment, who presided over its growth from $4.7bn in 1990 to $22.6bn by the time he left in 2005, reportedly drew more than $5bn in subscriptions when he founded Convexity Capital earlier this year — the largest hedge fund launch ever.“People want to invest with a proven winner,”Whelan says,“Why does a football striker get multi-millions? It is track record.” As hedge fund managers accommodate institutional demands, they are beginning to resemble their long only counterparts. Investors may take comfort from offices where loose wires no longer hang from the walls, but Schulman points out there is a downside.“It is not a cottage industry any more.You can not start up with $10m of family money,” he says,“It is keeping a lot of entrepreneurs out.”

Hedge funds continue to attract bright people, however, even if they find it more difficult to set up their own shop. The industry may need all the talent it can get to stave off a looming threat to performance: the rising cost of short sales. When an institution allocates assets to a hedge fund it typically moves the money from a long only manager. The old manager sells securities to raise cash, which is then reinvested by the hedge fund. On the long side, it is a zero sum game. However, the hedge fund will hedge all or part of that exposure with a short sale, a trade that did not exist in the long only world, Gradante explains. The growth in hedge fund assets boosts demand for securities to short – which is driving up the cost.“The box on Wall Street to lend stock to shorts has not grown as fast as the hedge funds’ demand for shorts,”Gradante says. The cash proceeds of a short sale are held by the lender as collateral. When a stock is freely available, the lender retains a small portion of the interest earned as a fee and rebates the rest to the short seller. As the supply of stock dries up, lenders first retain a larger share of the interest, then start charging borrowers a fee — a negative short rebate. Gradante says that is happening more often in today's market. At some point, the cost of selling short approaches the economic benefit from the trade so demand tapers off. Hennessee's research indicates that hedge funds have started shorting more exchange traded funds (ETFs) instead of individual stocks to hedge their book. While that reduces the cost, Gradante points out that it also eliminates the potential for excess return on the short side. An ETF provides a market hedge tied to an index, whereas a skilled hedge fund manager can make money shorting individual stocks even if the market goes up. A Hennessee study found that when hedge funds exhibit their best performance relative to the equity market, at least half the alpha comes from the short side.“If the Street cannot come up with more sources of stock to borrow, returns will become a little more correlated to the market because market exposure will increase,”Gradante says,“The alpha potential is reduced. It is the Achilles heel of the hedge fund industry.”

FTSE Hedge Indices Relative Performance 2000–2005

Estimated Growth of Assets /Net Asset Flow Funds of Funds 1990–2005

1.80

$450,000 $400,000

1.60

$350,000

1.50 Convertible Arbitrage CTA/Managed Futures

1.40

Distressed & Opportunities Equity Arbitrage

1.30

Equity Hedge Fixed Income Relative Value

1.20

Global Macro Merger Arbitrage

1.10

Assets in $MM

1.70

$300,000 $250,000 $200,000 $150,000 $100.000 $50,000 $0

0.90

-$50,000 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05

1.00

D ec -9 M 9 ar -0 Ju 0 n0 Se 0 p0 D 0 ec -0 M 0 ar -0 Ju 1 n0 Se 1 p0 D 1 ec -0 M 1 ar -0 Ju 2 n0 Se 2 p0 D 2 ec -0 M 2 ar -0 Ju 3 n0 Se 3 p0 D 3 ec -0 M 3 ar -0 Ju 4 n0 Se 4 p0 D 4 ec -0 M 4 ar -0 Ju 5 n0 Se 5 p0 D 5 ec -0 5

0.80

Source: Hedge Fund Research, supplied June 2006.

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 6

Estimated Assets

Net Asset Flow

Source: Hedge Fund Research, supplied June 2006.

HEDGE FUND STRATEGIES

An overall increase in allocation to hedge funds, and away from the traditional equity and bond mix, will increase the expected portfolio return, reduce volatility, and increase the information ratio and Sharpe ratio of a portfolio. These benefits are achieved because hedge funds are exposed to global risk factors and new asset classes that effectively diversify the portfolio away from pure equity/bond exposure. Simon Hookway, CEO of MSS Capital provides insight into the dynamically diversified quality of hedge fund styles and strategies and the difficulty of replicating hedge fund exposure using static exposures to hedge fund global risk factors.

Diversification Benefits of Hedge Fund Investing HE GROWTH OF the hedge fund sector has coincided with an economic and financial market environment that is one of the most challenging in recent memory. The sector’s dynamic growth profile has attracted attention, some of it negative. Such negativity tends to focus on fee structures, performance, business risk and lack of regulation. The facts are as follows. Hedge funds do charge a higher fee structure than long-only funds. However, critics often fail to recognise that hedge funds have a more flexible investment mandate in their pursuit of absolute positive returns. The ability of hedge funds to take ‘short’ as well as ‘long’ positions allows them to deliver positive returns in falling markets and to position themselves more favourably in such climates relative to long-only funds. Due to the existence of high water marks, hedge fund managers have to deliver positive returns for their investors before they can take performance fees. In the five years to 31st December 2005, the hedge fund sector (as represented by the FTSE Hedge Index) has delivered a compound annual return of 5.6% in US dollar terms. This compares favourably with global equities (FTSE All-World Index), which delivered a compound annual return of 3.5%, and is credible relative to global bonds (JP Morgan Global Bond Index), which delivered a compound annual return of 7.3%. However, the return of hedge funds was delivered with significantly lower annualised volatility (just 2.9% pa), and therefore the risk-adjusted return of the hedge fund sector was superior.

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

correlation figures are Further, business risk at a bolded in the table. management company level The diversification potential offered One of the key reasons is substantially mitigated by by hedge funds, and funds of hedge that hedge funds are a thorough and rigorous funds especially, arises from the fact diversifying is that they have qualitative and operational that they are themselves diversified exposures to many global due diligence process into risk factors and new asset the management company, portfolios spanning different classes other than equities its balance sheet, structure, geographies, strategies and asset and bonds. Beta coefficients ownership and principals. classes. One of the main attractions can be thought of as the This forms part of the hedge of hedge fund investing is that tendency of the returns from fund selection process prior diversification can be achieved due to the Global Composite to to investments being made. their low correlation to traditional respond to swings in those In analysis presented at the factors. Table 2 shows the 8th Alternative Investment equity and bond markets. average global risk factor Roundup in Scottsdale, exposures of the FTSE USA, Taylor Hunt focused Hedge Global Composite on hedge fund frauds and actual investor losses between 2000 and 2005, over 8 years. Table 3 meanwhile shows that as assets are concluding that losses as a percentage of industry assets allocated away from an equity/bond mix towards hedge peaked at just 0.18% in 2002. His research stated that all funds, the portfolio exposure to global risk factors hedge fund blow-ups since 2000 would correspond to a becomes more varied and diversified. Table 4 shows that 1% down day in GE or -0.1% of the Dow Jones these global risk factors themselves have low correlations with each other. This means that hedge fund exposure Industrial Average. Additionally, the regulation of hedge funds is encompasses a range of global risk factors that are many progressing at a measured pace. As of the beginning of times wider and more significant than that of a traditional February this year, the SEC stepped up its regulation of the equity/bond portfolio. Allocating away from a traditional equity and bond mix sector by requiring all US domiciled hedge fund managers to register with the regulatory body. Those managers to hedge funds also improves Value at Risk (VaR).VaR is the choosing not to register suffered a new set of stringent worst expected loss under normal market conditions over a conditions imposed on the hedge funds they manage. In specific time interval at a given confidence level. A monthly the UK meanwhile, the Financial Services Authority has 5% VaR was used in Figure 1 (7). This means that there are signalled its intention to give individual investors access to only 5 chances in 100 that a monthly loss bigger than the hedge fund investments and focus on investor protection VaR will occur under normal market conditions. Therefore, under normal trading conditions, we would only expect to as a new area of supervision. The diversification potential offered by hedge funds, and see a loss greater than the indicated VaR once every twenty funds of hedge funds especially, arises from the fact that months on average. Figure 1 shows that as the percentage allocation to hedge they are themselves diversified portfolios spanning different geographies, strategies and asset classes. One of funds increases from 0 to 20, the specific monthly VaR loss the main attractions of hedge fund investing is that becomes smaller in magnitude, meaning that the downside risk to the portfolio reduces. diversification can be This can be explained by achieved due to their low Figure 1 — Improvement in Variance at Risk due to several qualities possessed correlation to traditional Hedge Fund Exposure by hedge funds, including equity and bond markets. having better risk-adjusted Table 1 presents strong returns, low or negative evidence in support of this correlation to equities and perception. In fact, bonds, and in the case of interestingly some CTA/Managed Futures strategies even have strategy, positive skewness. negative correlation to Figure 2 (8) draws equities and bonds, for attention to two interesting example, the nonstatistical concepts — directional style (due to skewness and kurtosis. equity arbitrage and fixed They are two important income relative value parameters when strategies) and measuring the downside CTA/managed futures risk of a portfolio. strategy. Negative Source: Bloomberg. Dec 97–05 USD Data Percentage Allocat ion to FTSE Hedge

-3.2%

10%

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

-3.4%

Monthly 5% Var iance at Ris k

-3.6%

-3.8%

-4.0%

-4.2%

-4.4%

-4.6%

-4.8%

Global Composite $

Directional

Non-Directional

Equity Hedge

CTA/Managed Futures

Global Macro

Equity Arbitrage

Fixed Income Relative Value

Convertible Arbitrage

Merger Arbitrage

Distressed and Opportunities

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 6

Event Driven

HEDGE FUND STRATEGIES

Table 1 – Correlation between Hedge Funds, Equities and Bonds FTSE All-World

JPM Global Govt Bond

0% Weight in FTSE Hedge; 60% Equities; 40% Bonds

0.48 0.41 0.56 -0.19 0.23 -0.08 -0.13 -0.18 0.20 0.67 0.46 0.66

-0.04 0.04 -0.10 0.28 -0.02 -0.16 -0.02 -0.17 -0.10 -0.11 -0.05 -0.12

0.45 0.40 0.51 -0.10 0.21 -0.12 -0.13 -0.22 0.16 0.61 0.42 0.60

FTSE Hedge Global Composite Directional Style Equity Hedge Strategy CTA/Managed Futures Strategy Global Macro Strategy Non-Directional Style Equity Arbitrage Strategy Fixed Income Relative Value Strategy Convertible Arbitrage Strategy Event Driven Style Merger Arbitrage Strategy Distressed & Opportunities Strategy

Negative Correlations bolded.Source: Bloomberg. Dec 97–05 USD data.

Skewness characterises the degree of asymmetry of a distribution around its mean. Positive skewness indicates a distribution with an asymmetric tail extending towards values that are more positive. By allocating to hedge funds, monthly skewness is significantly increased. This is good for expected geometric returns as good returns are strong while poor returns are moderate. In fact, positive skew is highly desirable because positive returns need to be larger than corresponding negative returns simply in order to preserve capital. For example, a 50% loss requires a 100% gain to follow in order to break even. Kurtosis characterises relative peaks or the flatness of a distribution compared with normal distribution. Positive kurtosis indicates a relatively peaked distribution. Negative kurtosis indicates a relatively flat distribution. By allocating to hedge funds, monthly kurtosis is significantly reduced, distribution is flattened, tails become thinner, and therefore the likelihood of extremely large losses is reduced.

Hedge Funds are individually diversified The performance of a fund of hedge funds varies depending on the number of underlying hedge funds. To examine this portfolio size effect in more detail, if we selected hedge funds randomly from the universe of FTSE Hedge constituent hedge funds to produce multiple equally-weighted portfolios of various sizes, it can be shown that the median risk-

adjusted returns (information ratio and Sharpe ratio) of these portfolios increased as the number of funds in the portfolio increased. Other benefits of diversification were an increase in average hit rate (percentage of positive months) and a reduction in the severity of maximum draw-downs. The diversification benefit of adding an extra fund was greatest for small portfolios. As the number of funds in a portfolio increased, the marginal improvement in risk-adjusted returns, hit rate and draw-downs from adding an extra fund decreased. For example, the improvement in Sharpe ratio from adding an extra fund to a portfolio of thirty-nine funds is much less than the improvement from adding an extra fund to a portfolio of only five funds. As the FTSE Hedge Global Composite currently has forty constituent funds, it captures most of the possible diversification benefit available to it from this portfolio size effect.

The Portfolio Effects of using Managed Accounts The vast majority of assets invested in the hedge fund sector have been allocated directly into co-mingled funds. This has long been accepted as the standard investment route into the sector. Figure 2 —Return distributions that raise a portfolio’s positive return momentum and reduce risk of large losses Monthly Kurtosis 0.05

20% Allocation to CTA/Managed Futures

Table 2 - FTSE Hedge Sensitivity to Global Risk Factors – Global Composite FTSE Hedge Global Composite FTSE All-World Return JPM Global Govt Bond Return S&P Small Cap minus S&P 500 Return GTX Commodity Index Return Change in US 1M Interbank Rates Change in Credit Spreads Change in Bond Volatility -1.88 Change in FX Volatility Change in Commodity Volatility

0.13 -0.09 0.08 0.02 -0.72 -2.71

-0.45

-0.35

-0.25

0.54 -0.04

-0.15

-0.05

0.05 -0.05

-0.10

-0.15

-0.20

-0.25

-0.30

-0.35

20% Allocation to Directional

Positive skewness: good returns are strong while poor returns are moderate. Low kurtosis: thin tails, less likelihood of large losses.

P-values of less than 5% boldedSource: Bloomberg. Dec 97–05 USD data.

0.00 -0.55

-0.40

-0.45

0% Allocation to FTSE Hedge Index 60% Equities 40% Bonds

-0.50 Monthly Skewness

Source: Bloomberg. Dec 97–05 USD Data

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

Table 3 - FTSE Hedge Sensitivity to Global Risk Factors – Allocating away from Equity/Bond Mix FTSE All-World Bond Return Returns FTSE All-World Return JPM Global Govt Bond Return S&P Small Cap minus S&P 500 Return GTX Commodity Index Return Change in US 1M Interbank Rates Change in Credit Spreads Change in Bond Volatility Change in FX Volatility Change in Commodity Volatility

1.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

0.000 1.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

Hedge Global Composite

Weight in FTSE Hedge 0%

10%

15%

20%

0.130 -0.090 0.075 0.017 -0.717 -2.708 -1.875 0.542 -0.037

0.600 0.400 0.000 0.000 0.000 0.000 0.000 0.000 0.000

0.595 0.395 0.001 0.000 -0.007 -0.027 -0.019 0.005 0.000

0.576 0.375 0.004 0.001 -0.036 -0.135 -0.094 0.027 -0.002

0.553 0.351 0.008 0.002 -0.072 -0.271 -0.188 0.054 -0.004

0.529 0.326 0.011 0.003 -0.108-0.406 -0.281 0.081 -0.006

0.506 0.302 0.015 0.003 0.143 -0.542 -0.375 0.108 -0.007

P-values of less than 5% boldedSource: Bloomberg. Dec 97–05 USD data.

However, hedge fund managers can offer preferential manager. This third party independent valuation of the investment terms to individual investors relative to others portfolio mitigates the possibility of fraudulent activity and/or via side letter agreements, even though they are all deliberate over-valuation of the assets. The managed account reporting framework between the hedge fund manager, the invested in the same fund. Indeed, the UK’s Financial Services Authority is now managed account prime broker and administrator safeguards turning its attention to such side letter agreements that the portfolio assets and mitigates against fraud and style drift. Another key feature of investing via the managed change the terms of an offering, on the basis that “the failure by hedge fund managers to disclose that side letters account route is that of enhanced liquidity. As the sole have been granted to certain clients may result in some owner of the assets, the investor has total control of the investors receiving more information and preferential portfolio and in the event of an emergency can instruct the treatment to other investors in the same share class”, prime broker to liquidate the portfolio in order to safeguard its value. This level of control is not available when leading to potential conflicts of interest. Investment into the hedge fund sector via managed investing in a co-mingled fund. Taken together, the greater level of risk management, accounts and/or a managed independent valuation of the account platform eliminates Another key feature of investing assets and the reporting such potential conflicts of via the managed account route is framework made possible by interest. This is largely due to the superior transparency of the fact that the investor is that of enhanced liquidity. As the the managed account the sole owner of the assets in sole owner of the assets, the delivers a much higher the managed account (whose investor has total control of the degree of safety to the portfolio is benchmarked to a portfolio and in the event of an investor relative to investing co-mingled fund) and emergency can instruct the prime in a co-mingled fund. The therefore receives a risk and return promise is significantly higher level of broker to liquidate the portfolio in therefore preserved. transparency and control over order to safeguard its value. Our analysis shows that the assets, all governed, an overall increase in together with liquidity and capacity terms, by means of legally binding documentation allocation to hedge funds and away from the traditional between the parties. The aim of the managed account is to equity and bond mix will increase expected portfolio replicate the portfolio of a co-mingled fund (and therefore its return, reduce volatility, increase the information ratio and Sharpe ratio of a portfolio. Other benefits include higher return and volatility characteristics). The full daily transparency of the managed account’s Hit Rate and less severe Drawdowns. These benefits are portfolio down to a position level allows total control of the achieved because hedge funds are exposed to global risk assets from a risk management, valuation and reporting factors and new asset classes that effectively diversify the standpoint (none of which is available from investment into portfolio away from pure equity/bond exposure. Individual hedge funds are also diversified in terms of co-mingled funds): Using such information, the investor is able to manage actively the risks associated with hedge fund strategy characteristics and therefore the risk factors to investing. The risk management system is also used for which they are exposed. By these means investors can monitoring style drift within the portfolio. Assets within the capture unique diversification benefits that are likely to managed account are valued by an administrator that is greatly improve the overall performance characteristics of employed by the investor and independent of the hedge fund their portfolio.

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 6

Au st F FT TS rali E a SE Au AC Be s lg tria iu FT m/ AC SE Lu x C FT A SE ana C De da A n FT C m SE ar k F A FT inla C n S FT E F d A SE ran C Ge ce FT SE FT rma AC ny Ho SE AC Gr ng Ko eec e ng FT Ch AC SE in Ir a A e C FT land SE AC Ita FT FT ly SE SE A FT Ne Jap C a t SE he n Ne rla AC nd w s Z FT eala AC SE nd A FT No SE rw C Po ay FT rtu AC SE g Si ng al A a C FT por e S FT E S AC FT SE pai SE Sw n A Sw ede C n itz A er la C FT nd SE A C U FT K SE AC US AC

86 FT SE Gl

ob al Al AC l-W or ld In de FT x SE La rg e Ca p FT SE M id C FT ap SE Sm FT al lC SE ap De ve FT lo SE pe FT Ad d SE AC v Em Se er co gi nd ng ar AC y Em er FT gi SE ng Al AC l-E m FT er SE gi n La g AC tin FT Am SE er M ica id dl AC e Ea FT s t SE & No Af FT ric rth SE a As Am ia e ric Pa a cif AC ic ex Ja pa n FT AC SE J ap FT an SE AC De FT v SE Eu Em ro pe er gi AC ng Eu ro pe AC

FT SE

c-0 5

31 -M

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15:13

31 -M

-0 6

12/6/06

28 -Fe b

31 -Ja n06

31 -D e

MARKET REPORTS BY FTSE RESEARCH

FT SE

MARKET REPORTS 14 NEW.qxd

Page 86

FTSE Global Equity Index Series – Global

30 December 2005 to 31 May 2006

FTSE All Cap Regional Indices (USD) 140

FTSE Global AC

130

FTSE Developed Europe AC

120

FTSE Japan AC

110

FTSE Asia Pacific AC ex Japan

FTSE Middle East & Africa AC

100

FTSE Emerging Europe AC

FTSE Latin America AC

FTSE North America AC

FTSE All Cap (AC) Regional Indices Capital Returns YTD (USD) 15

% 10

FTSE All-Emerging Country All Cap Indices – Capital Returns YTD

Dollar Value

Local Currency Value

-5

-10

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

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

MARKET REPORTS 14 NEW.qxd

12/6/06

15:13

Page 87

FTSE All-Emerging Country Indices Capital Returns YTD 40 30 20

% Dollar Value

10 0

Local Currency Value

-10

FT SE

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 n FT e C SE sia AC I FT sr 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 SE iw C Th an F T a i l AC SE an Tu d A rk C ey AC

-20

FTSE Global All Cap Sector Indices – Capital Returns YTD (USD) 25 20 15

Capital

Total Return

5 0

Se il & rv G ice as s Pr & o Di du st ce r In C ibu rs d Co us hem tion ns tri i al ca tru M ls El Ae ctio et ec a ro n tro sp & Min ls ni a M in c c & Ge e & ate g El ne D ria e In ctr ral efe ls In du ica Ins nce du str l E ut st ial qu ria ria E ip ls l T ng me r in n S an e t Au up spo erin to po rt g m rt at ob Se ion ile rv s ice & s Fo Be Pa He Ho od ver rts al us Pro age th e d s Ph C Pe hol uce ar are rs d G rs m on o a c Eq al od e u uip G s tic m al en T ood Fo s & t ob s od B & ac & iot Ser co Dr ec vic h Ge uug no es Fi ne Re log xe ra ta y d l Li Re iler ta s M ne ile ob Te Tra v ile lec e M rs Te om l & ed le m Le ia c i u om n su Te So Gas m ica re ch ftw , W un tio no ar a ica ns lo e ter gy & & E tio Ha Co M lect ns rd mp ult ric w ut iu ity ar e til e r S iti & e es Eq rvi ui ce No pm s nl ife B ent Li In an Eq fe su ks ui In ra ty su nc In ve Ge Re rra e st ne al nc m ra E e en l st t I Fin ate ns an tru ci m al en ts

-5

Stock Performance Best Performing FTSE All-World Index Stocks (USD/%) Shanghai Zhenhua Port Machinery (B) CHN 156.0 Zijin Mining Group H CHN 145.1 CNPC Hong Kong (Red Chip) HK 128.0 Shenzhen Investment (Red Chip) HK 124.4 CSG Holding (B) CHN 121.6

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/%) CBS USA -60.3 Invoice Inc JA -61.4 ITV PCL THAI -62.9 Ladbrokes UK -57.9 Westwood One USA -50.8

No. of Consts

Value

3 M (%)

7,921 1,193 1,735 4,993 2,928 1,814 194 103 1,533 197 2,730 1,350

354.78 338.97 487.91 439.40 210.92 434.32 723.19 729.88 394.51 550.68 312.33 402.74

0.8 0.7 1.4 1.5 0.7 1.5 -9.5 -7.4 5.0 -6.4 -0.5 -1.6

6 M (%) 12 M (%)

8.5 7.0 10.9 12.4 8.0 13.3 8.1 19.2 16.7 11.3 3.1 10.5

18.4 15.4 24.2 24.6 17.6 25.8 48.6 69.8 25.0 40.1 10.2 33.8

YTD (%) Actual DIv Yld (%)

5.9 4.9 7.2 9.1 5.5 7.8 6.5 13.2 12.6 1.2 2.9 1.8

2.12 2.29 1.76 1.61 2.19 2.78 3.03 1.8 2.86 2.61 1.76 1.04

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

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 6

% FT SE

FT SE

ve l

De ve l De ve l

ve l

ifi

FT SE

Pa c Ja

ifi

Pa c

FT SE

Eu ro zo ne

Eu ro pe

er gi ng

c-0 5

29 -M

ay -0 6

rr06

ar -0 6

29 -A p 14 -M

-0 6

ar -0 6

14 -A p

30 -M

15 -M

28 -Fe b

13 -Fe b

29 -Ja n06

14 -Ja n06

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FT SE

ve l

De ve l

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ve l

12/6/06

De ve l

FT SE

-5

O Se il & rv G ic as es P & ro Di du s t ce r r In C ibu s du h tio Co st em n ns ria ic tr a l M ls u El Ae ctio et ec a ro n tr sp & Mi ls on ac M nin ic & Ge e & ate g El ne D ria e In ctr ral efe ls In du ica Ins nc du str l E ut e st ial qu ria ria E ip ls l T ng me r in n S an e t Au up spo erin to po rt g m rt at ob Se ion ile rv s ice & s Fo Be Pa o He Ho d ver rts al us Pro ag th e d es Ph C Pe hol uce ar are rs d G rs m E on o ac q al od e u uip G s tic m al en T ood Fo s & t ob s od B & ac & i o t Ser co Dr ec vic u h e Ge ug no s Fi ne R l o g xe ra eta y d l R ile Li et rs M ne T ai r ob Te a le ile lec ve M rs l o Te m & ed le m Le ia c i u s om n u Te So Gas m ica re ch ftw , W un tio no ar a ic ns lo e te a r gy & & Ele tion C Ha o M ct s m rd p ult ric w ut iu ity ar e til e r S iti & e es Eq rvi ui ce No pm s nl e ife B nt Li In an Eq fe su ks ui In ra ty su nc In ve Ge Re rra e st ne al nc m ra E e en l st t I Fin ate ns an tr ci um al en ts

MARKET REPORTS BY FTSE RESEARCH

MARKET REPORTS 14 NEW.qxd

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FTSE Global Equity Index Series – Developed ex US

30 December 2005 to 31 May 2006

125 125

FTSE Developed Regional Indices – Large/Mid Cap (USD) FTSE Developed (LC/MC)

119 119

FTSE Developed Europe (LC/MC)

113 113

FTSE Developed Asia Pacific (LC/MC)

107 107

FTSE All-Emerging (LC/MC)

FTSE Developed ex US (LC/MC)

101 101

FTSE US (LC/MC)

FTSE Developed Asia Pacific ex Japan (LC/MC)

FTSE Developed Regional Indices – Capital Returns YTD (USD) 14

FTSE Developed ex US Sector Indices (LC/MC) – Capital Returns YTD (USD)

Capital

Total Return

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

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

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Stock Performance Best Performing FTSE Developed ex US Index Stocks (USD/%) CNPC Hong Kong (Red Chip) HK 128.0 Shenzhen Investment (Red Chip) HK 124.4 Karstadtquelle GER 84.3 Lonmin UK 77.7 Oxiana AU 77.1

Overall Index Return

Worst Performing FTSE Developed ex US Index Stocks (USD/%) Invoice Inc JA -61.4 Ladbrokes UK -57.9 Privee Zurich Turnaround Group JA -46.8 GMO Internet JA -44.7 Novogen AU -44.5

No. of Consts

Value

3 M (%)

FTSE Developed ex US Index (LC/MC) 1,337 FTSE USA Index (LC/MC) 712 FTSE Developed Index (LC/MC) 2,049 FTSE All-Emerging Index (LC/MC) 879 FTSE Developed Europe Index (LC/MC) 500 FTSE Developed Asia Pacific Index (LC/MC) 772 FTSE Developed Asia Pacific ex Japan Index (LC/MC) 286 FTSE Developed ex US AC Index 3,738 FTSE Developed ex US LC Index 559 FTSE Developed ex US MC Index 1,735 FTSE Developed ex US SC Index 4,993

239.88 526.98 204.74 367.88 235.51 228.70 350.29 405.39 374.22 484.30 528.70

3.0 -0.7 1.1 -3.7 4.8 -0.5 2.1 3.2 2.9 3.6 4.3

6 M (%) 12 M (%)

14.1 1.8 7.5 13.7 15.8 10.7 9.9 14.7 13.3 17.5 19.3

26.5 7.5 16.2 38.8 23.7 30.3 20.8 27.3 25.1 32.8 34.0

YTD (%) Actual Div Yld (%)

9.2 1.8 5.4 6.7 11.9 3.9 7.9 9.6 8.8 11.2 12.8

2.49 1.84 2.17 2.48 2.96 1.68 3.33 2.42 2.60 1.76 1.61

FTSE Global Equity Index Series – Asia Pacific 30 December 2005 to 31 May 2006

FTSE Asia Pacific All-Cap (AC) Regional Indices (USD) 125

FTSE Global AC

120

FTSE Developed Asia Pacific (LC/MC)

115

FTSE Developed Asia Pacific ex Japan (LC/MC)

110

FTSE Asia Pacific (LC/MC)

105

FTSE All-Emerging Asia Pacific AC

100

FTSE Japan (LC/MC)

-M ay

-0

6 pr -0 -A 30

30 -M

ar -0 6

6 b0 28 -Fe

6 n0 -Ja 30

30 -D e

c-0 5

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

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 6

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% 4

FT SE

Pa c

ifi

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

FT SE

FTSE Asia Pacific All Cap Sector Indices – Capital Returns YTD (USD) 35 30 25 20 15

Capital

Total Return

0 -5 -10 O Se il & rv G ice as s Pr & o Di du st ce r In C ibu rs d Co us hem tion ns tri i al ca tru M ls El Ae ctio et ec a ro n tro sp & Min ls ni a M c ce a ing G & t El ene & D eria e In ctr ral efe ls In du ica Ins nce du str l E ut st ial qu ria ria E ip ls l T ng me r in n S an e t Au up spo erin to po rt g m rt at ob Se ion ile rv s ice & s Fo Be Pa He Ho od ver rts al us Pro age th e d s Ph C Pe hol uce ar are rs d G rs m on o a c Eq al od e u uip G s tic m al en T ood Fo s & t ob s od B & ac & iot Ser co Dr ec vic h Ge uug no es Fi ne Re log xe ra ta y d l Li Re iler ta s M ne ile ob Te Tra v ile lec e M rs Te om l & ed le m Le ia c i om un su Te So Gas m ica re ch ftw , W un tio no ar a ica ns lo e ter gy & & E tio Ha Co M lect ns rd mp ult ric w ut iu ity ar e til e r S iti & e es Eq rvi ui ce No pm s nl ife B ent Li In an Eq fe su ks ui In ra ty su nc In ve Ge Re rra e st ne al nc m ra E e en l st t I Fin ate ns an tru ci m al en ts

-15

MARKET REPORTS BY FTSE RESEARCH

FTSE Asia Pacific Regional Sector Indices – Capital Returns YTD (USD)

Stock Performance Best Performing FTSE Asia Pacific Index Stocks (USD/%) Shanghai Zhenhua Port Machinery (B) CHN 156.0 Zijin Mining Group H CHN 145.1 CNPC Hong Kong (Red Chip) HK 128.0 Shenzhen Investment (Red Chip) HK 124.4 CSG Holding (B) CHN 121.6

Worst Performing FTSE Asia Pacific Index Stocks (USD/%) ITV PCL THAI -62.9 Invoice Inc JA -61.4 Privee Zurich Turnaround Group JA -46.8 GMO Internet JA -44.7 Novogen AU -44.5

Overall Index Return No. of Consts

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)

7921 3164 1301 524 777 1863 286 772 529 486

Value

3 M (%)

354.78 415.61 235.58 397.27 464.87 478.97 350.29 228.70 265.45 149.89

0.8 -0.2 -0.3 -0.4 0.3 0.3 2.1 -0.5 0.4 -1.5

6 M (%) 12 M (%)

8.5 11.8 11.9 11.9 11.5 11.0 9.9 10.7 16.0 11.0

18.4 30.1 30.2 29.8 31.9 29.6 20.8 30.3 30.0 34.4

YTD (%) Actual DIv Yld (%)

5.9 4.4 4.7 5.1 2.8 2.2 7.9 3.9 7.3 2.5

2.12 1.82 1.84 1.86 1.72 1.73 3.33 1.68 2.35 1.03

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

J U LY / A U G U S T 2 0 0 6 2 0 0 6 • F T S E G L O B A L M A R K E T S

ui pm

O Se il & rv G ice as s Pr & o Di du s t ce r r In C ibu s d Co us he tion ns tri mi c a tru l M als El Ae ctio et ec a ro n tro sp & Mi ls ni ac M nin c a e G & te g e & r El ne D ia e In ctr ral efe ls In du ica Ins nce du str l E ut st ial qu ria ria E ip ls l T ng me r in n S an e t Au up spo erin to po rt g m rt at ob Se ion ile rv s ice & s Fo Be Pa He Ho od ver rts Pr ag al u t se od es Ph h C Pe hol uce ar are rs d G rs m E on o ac q al od e u uip Go s tic m o a e Fo ls & nt Tob ds od B & ac & iot Ser co Dr ec vic h e Ge uug no s Fi ne R log xe ra eta y d l R ile Li et rs M ne ai ob Te Tra le ile lec ve M rs l Te om & ed le m Le ia c om un isu Te So Gas m ica re ch ftw , W un tio no ar a ic ns lo e te gy & r & E atio Ha Co M lect ns rd mp ult ric w ut iu ity ar e til e r S iti & e es Eq rvi ui ce No pm s nl e ife Ba nt I L Eq ife ns nk ui In ura s ty su nc In ve Ge Re rra e st ne al nc m ra E e en l st t I Fin ate ns an tru ci m al en ts

% FT SE l-E

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 6 Eu ro pe

M C

ex Eu FT r SE UK ope Eu AC ro fir st 30 0 FT SE ur of irs t8 FT 0 SE ur of irs t1 00

De ve l

Eu ro zo ne

er gi ng

Eu ro pe

ay -0

-M

pr -0

-A

ar -0

-M

-Fe

-Ja

-0

-D

15:13

FT SE

De ve l

FT SE

Eu ro pe

12/6/06

FT SE

MARKET REPORTS 14 NEW.qxd

Page 91

FTSE Global Equity Index Series – Europe

30 December 2005 to 31 May 2006

FTSE European Regional Indices Performance (EUR) 114

112

FTSE Global AC (EUR)

110

FTSE Developed Europe ex UK LC/MC (EUR)

108

106

FTSEurofirst 300 (EUR)

104

FTSE Developed Europe AC (EUR)

102

100

FTSEurofirst 100 (EUR)

FTSE Eurobloc AC (EUR)

FTSEurofirst 80 (EUR)

FTSE Europe All Cap Indices – Capital Return YTD (EUR) 8

% 4

-2

-4

FTSE Developed Europe All Cap Sector Indices – Capital Returns YTD (EUR)

Capital

Total Return

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

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Best Performing FTSE Developed Europe Index Stocks (EUR/%) Karstadtquelle GER 69.2 Lonmin UK 63.2 Arcelor FRA 58.9 Xstrata UK 56.8 Euronext FRA 52.3

Overall Index Return (EUR) 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

Worst Performing FTSE Developed Europe Index Stocks (EUR/%) Ladbrokes UK -61.4 Carnival UK -34.1 Rank Group UK -32.2 Tietoenator Oyj FIN -28.1 A P Moller - Maersk B DEN -27.9

No. of Consts

Value

3 M (%)

7921 1636 234 331 1071 1533 103 776 1073 300 80 100

354.78 357.28 386.54 454.56 488.74 353.68 654.34 369.78 374.56 1306.63 4570.35 4243.31

0.8 -2.8 -2.8 -2.3 -1.5 -2.5 -14.1 -3.0 -2.7 -2.8 -3.1 -2.5

6 M (%) 12 M (%)

8.5 7.2 5.2 11.4 14.2 7.1 9.4 8.4 8.0 5.7 6.4 4.7

YTD (%) Actual Div Yld (%)

18.4 20.9 17.2 26.9 31.3 20.2 63.2 21.7 22.5 18.2 18.9 15.3

5.9 3.5 1.9 6.6 9.4 3.4 4.0 4.4 4.0 2.4 2.4 1.5

2.12 2.84 3.06 2.31 2.10 2.86 1.85 2.85 2.68 2.95 3.22 3.21

FTSE UK Index Series 30 December 2005 to 31 May 2006

FTSE UK Index Series (GBP) 125

FTSE 100

120

FTSE 250

115

FTSE 350

110

FTSE SmallCap

105

FTSE Fledgling

FTSE AIM All-Share

06 -M 30

-A 30

ay -

pr -0

6 ar -0 -M 30

-F eb 28

-Ja 30

-0

06 n-

-0 ec -D 30

FTSE All-Share

100

MARKET REPORTS BY FTSE RESEARCH

Stock Performance

FTSE techMARK

FTSE All-Share Sector Indices – Capital Returns YTD (GBP) 40 30 20

Capital

Total Return

-10

Se il & rv G ic a es s & Pro Di du st ce In C ribu rs du h tio Co st em n ns ria ic tr l M als u El Ae cti ec et ro on tr sp & Mi als on ac M ni ic & Ge e & ate ng El ne D ri a e In ctr ral efe ls In du ica Ins nc du str l E ut e st ial qu ria ria E ip ls l T ng me r in n S an e t Au up spo erin to po rt g m rt at ob Se ion ile rv s ice & Fo Be Pa s Ho od ve rts us Pro rag He eh d es u al Le old cer t is G s Ph h C Pe ure oo ar are m E rs G ds ac q on o eu uip al od tic m G s al en T oo s Fo & t & ob ds od B S ac c i e o & r o Dr tec vic uu hn es ol G g Fi en R og xe er et y d al ai Li Re ler M ne T ta s ob Te ra i ile lec ve M lers l Te om & ed le m Le ia c om un isu Te So Ga m ica re ch ftw s, un tio no a Wa ic ns lo re te a gy & r E ti & Ha Co M lec ons rd mp ul tric w u tiu ity ar te ti e r lit & Se ies Eq rv ui ice No pm s nl en ife Eq Li In Ban t fe s k ui ty In ura s In su nc ve Ge R rr e st n ea an m er l E ce en al s t I Fi tat ns na e tr nc um ia en l ts

-20

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

J U LY / A U G U S T 2 0 0 6 • F T S E G L O B A L M A R K E T S

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FTSE UK Indices – Capital Return YTD (GBP) 8 6 4 2 0 -2 -4

AR F K TS 10 E 0

FT Al SE l-S A h a IM re

g FT SE

gl in

Al l-S ha re FT SE

Sm FT SE

FT SE

lC ap

0 25 FT SE

FT SE

-6

Stock Performance Best Performing FTSE All-Share Index Stocks (GBP/%) Ashley (Laura) Holdings Cambridge Antibody Tech Group Robert Walters London Stock Exchange Group Lookers

Overall Index Return 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

No. of Consts

100 250 350 333 683 275 1040 100

Worst Performing FTSE All-Share Index Stocks (GBP/%) iSOFT Group -77.5 Telent -62.3 Ladbrokes -61.4 Plasmon -50.4 Instore -44.8

88.0 86.8 84.3 78.4 67.6

Value 3 M (%) 6 M (%) 12 M (%)

5723.81 9298.23 2966.63 3423.69 2916.85 3816.80 1121.62 1371.43

-1.2 -1.6 -1.2 -4.1 -1.3 -5.6 -4.7 -6.7

5.5 11.7 6.4 7.0 6.4 6.5 10.8 1.9

YTD (%)

15.3 30.7 17.3 21.1 17.5 18.3 17.1 18.2

1.9 5.7 2.4 3.6 2.5 1.8 7.2 -4.2

Actual Div Yld (%)

3.34 2.40 3.20 1.93 3.16 1.90 0.57 1.57

Net Cover

2.29 2.34 2.29 1.00 2.27 -0.96 -0.44 -

P/E Ratio

13.1 17.84 13.63 51.99 13.97 0 0 -

FTSE Xinhua Index Series 30 December 2005 to 30 May 2006

FTSE Xinhua Index Series (RMB/HKD) 140

FTSE/Xinhua China 25 (HK$)

135 130

FTSE Xinhua All-Share (RMB)

125

FTSE Xinhua Small Cap (RMB)

120

FTSE/Xinhua China A50 (RMB)

115

FTSE Xinhua 600 (RMB)

110 105

FTSE Xinhua China Bond Total Return Index (RMB)

100

-0 6 30 -M

r-0 6

30 -M

30 -A p

ar -0 6

b06 28 -Fe

n06 30 -Ja

30 -D ec -0 5

FTSE Xinhua Index Series Index Name

Consts

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)

Value

3 M (%)

25 10937.19 50 5282.33 989 3218.87 600 3470.85 389 2306.42 36 97.55

0.2 19.9 34.7 34.1 38.7 0.2

6 M (%) 12 M (%)

22.5 43.5 60.5 61.1 57.5 2.8

34.9 43.1 59.0 58.8 60.0 6.9

YTD (%)

Actual Div Yld (%)

18.8 35.3 52.7 52.3 54.8 1.1

2.61 3.15 1.78 1.96 0.71 2.88

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

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 6

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

FTSE Hedge*

140

FTSE All-World Directional*

120

Event Driven* 100

Non-Directional* 80

6 M

ay -0

5 ay -0

vNo

4 ay -0

vNo

3 ay -0 M

2 ay -0 M

ay -0

MARKET REPORTS BY FTSE RESEARCH

FTSE Hedge Index Series

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

3M (%)

6M (%)

12 M (%)

FTSE Hedge Index 5341.75 0.9 Directional 3215.48 -0.1 Equity Hedge 2231.88 -0.9 Commodity Trading Association (CTA) / Managed Futures 2093.62 4.5 Global Macro 1982.97 -1.8 Event Driven 3306.46 1.3 Merger Arbitrage 2102.14 0.9 Distressed & Opportunities 2297.37 1.6 Non-directional 3094.10 1.7 Convertible Arbitrage 2041.83 3.6 Equity Arbitrage 2100.91 2.7 Fixed Income Relative Value 2041.27 0.4 * Based upon indicative index values as at 28 April 2006 and 31 May 2006

4.8 4.7 5.4 1.2 5.0 5.5 4.7 6.2 4.1 6.2 6.3 1.5

7.3 8.3 9.3 5.4 8.6 7.8 4.6 10.7 4.9 7.6 6.6 2.4

YTD 5-Year Ann 3-Year (%) Return (%) Volatility (%)

3.5 3.0 2.6 3.9 2.6 4.2 3.7 4.6 3.6 5.8 5.7 1.1

5.2 7.1 7.2 7.9 5.9 3.6 0.8 6.0 3.3 6.8 3.9 1.2

3.2 5.3 5.0 11.8 6.5 3.0 2.1 4.5 1.6 3.4 2.4 1.5

FTSE EPRA/NAREIT Global Real Estate Index Series FTSE EPRA/NAREIT Global Real Estate Indices (Total Return Basis) 125 120

EPRA/NAREIT Global Total Return Index ($)

115

EPRA/NAREIT North America Total Return Index ($)

110

EPRA/NAREIT Europe Total Return Index (€)

105

EPRA/NAREIT Eurozone Total Return Index (€) EPRA/NAREIT Asia Total Return Index ($)

100

6 -0 ay -M 30

pr -0 -A 30

-M 30

6 ar -0

6 b0 28 -Fe

n-Ja 30

-D

-0

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

J U LY / A U G U S T 2 0 0 6 2 0 0 6 • F T S E G L O B A L M A R K E T S

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

Consts

Value

3 M (%)

311 140 92 38 79

2762.77 3289.38 2858.78 3027.57 2037.80

0.5 -0.7 -2.1 -1.3 -0.6

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 ($)

6 M (%) 12 M (%)

14.1 8.5 15.1 15.3 17.1

26.4 20.9 24.7 23.9 34.3

YTD (%)

Actual Div Yld (%)

9.6 8.1 10.8 13.0 5.4

3.63 4.27 2.62 3.17 3.32

FTSE Bond Indices FTSE Bond Indices (Total Return Basis)

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 (¥)

104 103 102 101 100 99 98 97

-0 30

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

-M

-A

-M

ar -0

pr -0

06 b-Fe 28

n-Ja 30

-D

-0

FTSE Bond Indices (Total Return) Index Name

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 (Y) FTSE China Government Bond Index (RMB)

Consts

Value

3 M (%)

247 350 41 289 12 29 121 236 36

151.30 174.41 206.54 141.50 1989.60 1911.90 145.09 108.78 97.55

-1.9 -1.2 -2.4 -1.0 -2.1 -2.0 -1.1 -0.8 0.2

6 M (%) 12 M (%)

-1.4 -1.0 -0.1 -1.1 0.8 0.2 -0.4 -1.5 2.8

-1.0 -0.8 3.0 -0.5 5.7 3.4 -1.0 -2.0 6.9

YTD (%)

Actual Div Yld (%)

-2.6 -1.6 -1.1 -1.7 -1.1 -1.2 -1.6 -1.4 1.1

4.05 4.01 5.02 4.45 1.57* 4.40 5.20 1.66 2.88

* Based on 0% inflation

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

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

Kamila Lewandowski Index Development Executive kamila.lewandowski@ftse.com +44 20 7866 1877

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

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 6

CALENDAR

Index Reviews July – November 2006 Date

Index Series

Review Type

Effective Data Cut-off (Close of business)

1-Jul

TOPIX New Index Series

Semi-annual review

27-Jul

14-Jul

TSEC Taiwan 50

Quarterly & annual review

21-Jul

16-Jun 30-Jun

Mid July

OMX H25

Quarterly review

31 Jul

30-Jun

11-Aug

Hang Seng

Quarterly review

8-Sep

30-Jun

17-Aug

MSCI

Quarterly review

31-Aug

31-Oct

30-Aug

FTSE All-World

Annual Review / Japan

15-Sep

30-Jun

30-Aug

FTSE Goldmines Index Series

Quarterly review

15-Sep

21-Aug

Early Sep

ATX

Semi-annual review / number of shares

15-Sep

31-Aug

Early Sep

CAC 40

Annual review of free float

22-Sep

31-Aug

Early Sep

S&P MIB

Semi-annual constiuent review

18-Sep

1-Sep

SMI Index Family

Semi-annual review

30-Sep

31-Jul

4-Sep

DAX

Quarterly review/ Ordinary adjustment

15-Sep

31-Aug

4-Sep

Nikkei 225

Annual review

Late Sept/Early Oct

6-Sep

FTSE/JSE Index Series

Quarterly review

15-Sep

6-Sep

FTSE Asiatop/Asian Sectors

Semi-annual review

15-Sep

31-Aug

6-Sep

FTSE UK Index Series

Quarterly review

15-Sep

5-Sep

6-Sep

FTSE Global Equity Index Series (incl. FTSE All-World)

Annual review / Developed Europe

15-Sep

30-Jun

6-Sep

FTSE techMARK 100

Quarterly review

15-Sep

31-Aug

6-Sep

FTSEurofirst 80 & 100

Annual Review

15-Sep

1-Sep

6-Sep

FTSEurofirst 300

Quarterly review

15-Sep

1-Sep

6-Sep

FTSE Euromid

Quarterly review

15-Sep

1-Sep

6-Sep

FTSE eTX

Quarterly review

15-Sep

1-Sep

6-Sep

FTSE Multinational

Annual review

15-Sep

30-Jun

6-Sep

FTSE4Good Index Series

Semi-annual review

15-Sep

31-Aug

6-Sep

FTSE Global Islamic

Semi-annual review

15-Sep

25-Aug

6-Sep

FTSE TMT

Annual review

15-Sep

5-Sep

6-Sep

FTSE Global 100

Quarterly review

15-Sep

31-Aug

8-Sep

NASDAQ 100

Quarterly review / Shares adjustment

15-Sep

31-Aug

11-Sep

NZSX 50

Quarterly review

29-Sep

31-Aug

12-Sep

S&P MIB

Quarterly review - shares & IWF

15-Sep

13-Sep

DJ STOXX

Quarterly review

15-Sep

15-Aug

13-Sep

DJ STOXX Blue Chips

Annual review

15-Sep

31-Aug

13-Sep

S&P US Indices

Quarterly review

15-Sep

13-Sep

S&P Europe 350/ S&P Euro

Quarterly review

15-Sep

13-Sep

S&P 500

Quarterly review

15-Sep

13-Sep

S&P Midcap 400

Quarterly review

15-Sep

13-Sep

S&P/ ASX 200

Quarterly review

15-Sep

13-Sep

S&P TSX

Quarterly review

15-Sep

31-Aug

15-Sep

Russell US Indices

Quarterly review

30-Sep

31-Aug

11-Oct

FTSE Xinhua Index Series

Quarterly review

20-Oct

15-Sep

12-Oct

TSEC Taiwan 50

Quarterly review

20-Oct

29-Sep

13-Oct

OMX H25

Quarterly review

8 Oct

29 Sep

Oct/Nov

FTSE/ ASE 20

Semi-annual review

30-Nov

29-Sep

10-Nov

Hang Seng

Quarterly review

8-Dec

29-Sep

16-Nov

MSCI

Quarterly review

30-Nov

31-Oct

1-Sep

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

MARCH/APRIL 2006 • FTSE GLOBAL MARKETS

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