FTSE Global Markets

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WHY COMPONENT OUTSOURCING IS THE LATEST TREND ISSUE SEVENTEEN • JANUARY/FEBRUARY 2007

Mastercard & Visa face up to the competition Finding value in fundamental indices Why everyone wants a piece of Greek banking

THE PRIME OF

NBK

Setting the standard in GCC banking

ROUNDTABLE: THE FUTURE OF GERMAN TRANSITION MANAGEMENT

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Outlook EDITORIAL DIRECTOR:

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Neil O’Hara, David Simons, Art Detman.

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Andrew Cavenagh, Rekha Menon, John Rumsey, Bill Stoneman, Lynn Strongin Dodds, Ian Williams.

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FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007

Y THE TIME you receive this edition, you may well have read the wire service stories about Amgen’s big selling drug Epogen, used to treat anaemia in patients undergoing dialysis. As our story notes, Amgen sells Epogen to companies that operate chains of dialysis centres that are, in turn, reimbursed by Medicare for the cost of Epogen plus 6%.

This cost-plus arrangement is under scrutiny by Congress. Some members want to set a flat fee for each dialysis treatment, that would include the cost of drugs such as Epogen. Meanwhile, a study published in the New England Journal of Medicine purports to show that dialysis patients who receive a higher dose of Epogen have worse outcomes than those who receive a lower dose.“This result is inferentially determined,” says Art Detman, who profiles Amgen on page 53. “The haemoglobin levels that cause the unfavourable outcomes are higher than the haemoglobin levels recommended by Amgen. Amgen recommends that Epogen be administered to achieve a target haemoglobin level of 10 to 12 grams per decilitre of blood. This is approved by the Food and Drug Administration (FDA). The National Kidney Foundation says that 11 to 13 grams is appropriate,” he says. The study that determined this level was sponsored by Amgen, although the Foundation says that Amgen did not influence this recommended level. Kevin Sharer, Amgen’s CEO says the study reported in the New England Journal of Medicine is flawed because it comprised only a few hundred patients. Amgen is undertaking a similar study that includes 4,000 patients. When the dust settles, Art thinks the FDA will have imposed limits on the target level of haemoglobin and Congress will require Medicare and other government agencies to pay a flat inclusive fee for dialysis, that includes all drugs, and investors will refocus on Vectibix and Denosumab once again. We will keep you informed on progress in subsequent editions.

Separately, market roundtables will be a regular feature in 2007 and we hope to galvanise your interest in a broad range of topics in upcoming editions, including global portfolio trading, securities services, GDRs, ETFs, covered bonds and transition management. An important battleground for transition management business in Europe is in Germany, where only a handful of players dominate the market. In our roundtable on German transition management, beginning on page 57, we look at some of the key characteristics and challenges facing investors, Kapitalanlagegesellschaften (KAGs) and transition managers in executing portfolio transfers and transitions. While the concerns of investors and consultants remain the same the world over — such as quality of service, accuracy in pre-and post-transition analysis, the protection of the value of portfolios and a requirement for best execution — some approaches and processes are unique to Germany. The roundtable participants explain why pre-hedging is sometimes the right thing to do and why soft factors can sometimes outweigh hard data analysis in determining whether or not a transition is a success.

Meanwhile our investment services coverage looks at the rise of component outsourcing: the latest rage in fund administration, according to Lynn Strongin Dodds, as fund managers contract out only selected products and services. Is it the end of back and middle office blanket lift-outs before the trend has even had time to establish itself? Find out on page 73.

B

Francesca Carnevale, Editorial Director December 2006

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Contents COVER STORY NBK: REDEFINES GCC BANKING

..................................................Page 45 NBK has much to celebrate. Operating income is up 27% on the year and now tops $1.3bn. It dominates a country market replete with young consumers with money to burn. The bank is now offering a growing raft of products and services to a regional audience with noted success. How long can the good times last and just how far can NBK go? Francesca Carnevale reports from Kuwait City.

REGULARS MARKET LEADER

EXPLAINING EASTERN EUROPE’S PROPERTY BOOM

..........................Page 6 Just how much longer can Eastern Europe’s property boom continue?

INTEREST RATES: ANATHEMAS AND INDICES ..........................Page 8

INDEX REVIEW

Capital Spread’s Simon Denham on the inevitability of rising interest rates.

THE BRIGHT POTENTIAL OF FUNDAMENTAL INDICES ......................Page 10 Dave Simons talks to Rob Arnott about the real value in fundamental indices

IN THE MARKETS

LDI: TIME FOR A CHANGE OF STRATEGY? ....................................................Page 16

FACE TO FACE

BURSA MALAYSIA RAISES ITS GAME ....................................................Page 20

Neil O’Hara explains why only buying long bonds is not an effective LDI strategy

CEO Yusli Mohammed Yusuf on the exchange’s new growth strategy

THE IMPACT OF REGULATION NMS

..................................................Page 24 Ian Williams explains the repercussions of the National Market System regulations

TAIWAN REDEFINES ITS REGIONAL ROLE

REGIONAL REVIEW

..................................Page 26 Does Taiwan really wants to be a regional capital markets centre?

NEW GROWTH TRENDS IN ASIAN HEDGE FUNDS ....................Page 32 Hong Kong and Singapore fight to become the Asia’s hedge fund capital

WHY EVERYONE WANTS A PIECE OF GREEK BANKING ......Page 35 Lynn Strongin Dodds reports on the acquisition opportunities in Greece’s banking sector

COVERED BONDS: LET THE GOOD TIMES ROLL ......................Page 40

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DEBT REPORT

Covered bond issuance grew by more than 15% in 2006, as investors were able to buy a wider range of products — in both geographical and structural terms — than ever before. Andrew Cavenagh reports.

INVESTMENT SERVICES

....................................Page 73 Component outsourcing is all the rage. Fund managers increasingly contract out only selected products and services. Lynn Strongin Dodds report on the implications.

PLUS: THE ARCHEUS CASE – BLAMING THE MESSENGER

ASSET MANAGEMENT

............Page 81 Yannick Daniel, head of quantitative research at Société Générale explains how ETFs can add value in a core-satellite portfolio construction

INDEX REVIEW

Market Reports by FTSE Research ................................................................................Page 84 Index Calendar ..................................................................................................................Page 96

THE RISE OF MODULAR OUTSOURCING

ETFS: MARKETING GIMMICK OR NEW PARADIGM

JANUARY/FEBRUARY 2007 • FTSE GLOBAL MARKETS

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“Predictability is what I bank on.”

DA NI E L O ’SULLI VA N Managing Director, Head of FX, Americas, HSBC Bank USA

For more consistent results in the face of global exchange rate fluctuations, Daniel O’Sullivan relies on CME, the world’s largest regulated marketplace for foreign exchange trading. CME offers futures and options contracts on all major currencies — including the euro, British pound, Swiss franc and Japanese yen. They provide a cost-effective and credit-efficient way for leading corporate and investment banks like HSBC to help customers manage foreign exchange exposure.

By improving the way markets work, CME is a vital force in the global economy, offering futures and options products on interest rates, equity indexes, foreign exchange, commodities and alternative investments. For more about how CME can change your world, visit www.cme.com.

CME®, the Globe logo and Chicago Mercantile Exchange® are trademarks of CME. Copyright © 2006 CME. All rights reserved.

I D E A S T H AT CHANGE T H E W O R L D™

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Contents FEATURES GAS TRADING ......................................................................................................Page 45 Hedge fund Amaranth Advisors famously lost $6bn in a week trading natural gas last September. That figure dwarfs the $3.5bn loss racked up by Long Term Capital Management when it went bust in 1998, but at least Amaranth was able to meet its obligations before it went out of business. The debacle highlights the extraordinary volatility of natural gas prices in North America, a market that has historically been self-sufficient and remains isolated from the global trade in liquefied natural gas (LNG). Finely balanced domestic supply and demand combined with shifts in consumption patterns could drive volatility even higher. Neil O’Hara reports.

AMGEN

........................................................................................................................................Page 53 Although approaching middle age, and facing a raft of potential problems ranging from patent infringement, and changes in the way that Medicare buys drugs, biotechnology giant Amgen is far from depressed. The firm’s revenues will probably rise by at least 50% in the next four years to around $21bn. Moreover, profits will follow suit. The corporate strategy: “remain hungry, nimble and focused on serving patients,” looks likely to outmanoeuvre all-comers. Art Detman reports from California.

ROUNDTABLE: GERMAN TRANSITION MANAGEMENT ......Page 57 In September 2006, Volkswagen, transited €1.4bn of its pension scheme’s assets in a move to a masterfund and a simultaneous multi-asset class restructuring of the portfolio, including an overlay mandate. It typifies key trends in the German market outlined and debated by the market specialists attending FTSE Global Markets’ transition management roundtable in Frankfurt. The resulting discussion highlights the growing sophistication of the beneficial owners, KAGs, consultants and the increasing demands on transition managers, who are required to add value throughout all stages of the process.

MASTERCARD/VISA ........................................................................................Page 69 A door was opened in 2004 by a US court decision holding that Visa and MasterCard’s exclusionary rules violated antitrust laws. The ruling appears to give American Express Co., a financial services powerhouse itself, and Discover, a unit of the Wall Street firm Morgan Stanley, a new niche and a market boost in the lucrative card business. What does it signify for credit card providers and users over the long term? Bill Stoneman goes in search of answers.

SOCIALLY RESPONSIBLE INVESTMENTS ........................................Page 78 The old notion that it is cheaper to run a business without worrying about the raw sewage running into the nearby water supply was not lost on Al Gore, presidential candidate turned environmental crusader. In his eye-opening documentary about the impact of global warming, An Inconvenient Truth, Gore, affirmed that “you can’t make somebody understand something if their salary depends upon them not understanding it. Growing concerns over issues ranging from global warming to corporate accountability have helped raise the profile of socially conscious investment platforms, Dave Simons reports.

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JANUARY/FEBRUARY 2007 • FTSE GLOBAL MARKETS

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All rights reserved.

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Market Leader REAL ESTATE: WILL THE BOOM END?

EASTERN EUROPE’S PROPERTY BOOM Real estate prices have at least doubled in Eastern Europe since 2004, when a raft of ex-communist states joined the European Union (EU). The region is the world’s fastest growing property market, after Asia. How far can it go—particularly as interest rates have been rising steadily throughout Eastern Europe in 2006? Is the bubble about to burst and could lender banks end up with a raft of bad loans?

ASTERN EUROPE’S PROPERTY boom was built on two pillars: the availability of floating-rate mortgages as low as 4.4%, and the influx of foreign investors anxious to leverage the inevitable property boom that followed membership of the EU. One of those pillars has taken something of a knock this year as central banks lifted rates across the region, and local buyers began to be priced out of the market or became over-leveraged.

Right now, markets to watch include Bulgaria and Romania, which joined the EU in early 2007.

Residential properties in Bulgaria went up by just under 36% in 2005, but signs are that 2006 marked a watershed for the country, and even perhaps the wider region. According to a recent Mortgage Federation Hypostat report, there is a downturn in demand for new mortgages.

In Bulgaria, mortgage applications were up 68.9% in 2006. Although that sounds still high, it is well below the increase of 97.4% recorded the previous year. The report also anticipates a fall in demand for eurodenominated mortgages in the

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country by at least 1% in 2007 to 5.5% of the total mortgage market.

While EU membership has spurred economic growth by attracting investment from Western companies, wages in the region still are a fraction of those in Western Europe. In Latvia, for example, the average gross monthly wage is $410, compared with more than $4,000 in Germany.

Although wages in the country rose by 17.9% last year, income rises still trailed the 50% surge in property prices. In central Riga, prices in some quarters have doubled.

Residential property increases have also been paralleled by rises in commercial property values.

Slovakia’s recent economic success has had a positive effect on employment, wage growth and, subsequently, purchasing power of local consumers.

Slovakia consequently has the second highest saturation of hypermarkets in Eastern Europe, after the Czech Republic.

However, the problem should not be over-stated. The residential mortgage market in Eastern Europe is still in its infancy. Banks in Eastern Europe now hold almost $50bn worth

of mortgages, equivalent to around 6% of the region's gross domestic product (GDP), compared a 40% average in the rest of the EU. So far, British and Irish investors have led the surge of homebuyers into the new EU countries, searching for bargains and investments after house prices boomed in their own countries.

Eastern markets are cheap for many West Europeans. In Denmark, for example, retail property prices are up 16.1%, while Ireland is reporting average increases over 10%. And while similar rates are being recorded in Budapest, it is from a much lower base, with like for like properties up to 50% cheaper.

From having virtually no investment activity in Prague five years ago, huge progress is being made towards making the city a wellestablished investment market.

However, in light of its initially low prices and high returns, nobody expected it to reach western yield levels so fast, with Class A office buildings now trading at sub-7% yield levels. The country’s debt market is also becoming increasingly competitive and yield decline is being matched by low interest rates, thus providing attractive leveraged margins. However, the compression of yields is caused by the sheer volume of capital pushing into the market, as much as by the market’s maturity and the overall lower-risk investment environment.

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The major challenge for those looking to invest in the in Eastern European property remains the sourcing of suitable products. The supply of Class A office and retail developments cannot keep pace with demand. Investors who are able to take advantage of market niches such as forward funding coinvestments, hotels, opportunistic investments, Class B properties or secondary locations outside of The

major cities in the region are taking the chance to do so. Those remaining within the main market segment are bidding smartly and aggressively, which is driving the market to its current position. Additionally, key investors in Eastern Europe are more diverse than in recent years. German and US money is highly significant but Dutch, Irish and UK buyers also have a strong a presence.

Large real estate investment

FTSE GLOBAL MARKETS â&#x20AC;˘ JANUARY/FEBRUARY 2007

projects, economic growth, new technologies and many other innovations combine to create the appeal of an area that forms more than half of Europe and is destined to become highly developed in the next decades. With the growth of business and the seemingly insatiable demand for travel fuelling the European property markets, the real estate boom looks set to continue for a long time to come, in spite of near term blips.

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Index Review THE IMPACT OF INTEREST RATES

STAYING ON THE RIDE Champagne corks are popping city-wide as markets and bonuses get ever higher. In truth though, the sustained rally is based not on speculation or take-over activity, but on solid corporate profitability.

Over the past few years, forecasters have tried to call the top of the expansion in net corporate revenues. Up to now, it has been a thankless task. This autumn they have been out again, warning of an imminent implosion of company growth. The analysts are not alone; politicians and central bankers are increasingly shrill as they warn about the expanding bubble of asset values, debt levels (from government institutions) and private equity risk. Are they right, or are we still only in the foothills of a new bull run? Simon Denham, managing director of spread betting firm, Capital Spreads, reports on index trends and expectations.

HE US MARKETS have now surmised that interest rates are either at, or just one hike away from their highs. The market has been re-rated, taking into account the likelihood of a soft landing economy, a more benign inflation outlook (due to falling oil and metals prices) and an amazingly resilient US consumer. If dealers are right then Fed rates will be down at 4.75% this time next year and this could fuel even greater gains in the Dow and S&P. The recent huge increase in retail sales over the thanksgiving period, reputedly 20% up on the rather miserable events of last year, could give rate watchers pause for thought. Such numbers are often double edged swords promising higher profits, but also warn of new Fed activity.

On-going dollar weakness will boost equity prices, as globally, a falling greenback will make US equities look even better value to foreign investors. Aside from oil, the US is insulated from commodity price inflation as it has its own vast resources and oil is seemingly plentiful just at the moment. With price/earnings (P/E) ratios still below 20 for the S&P 500, investors can take

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some heart from the fact that (aside from P/E comparisons with the inflationary 1970s and 1980s) shares do not appear to be expensive on any reasonable historical valuation.

Elsewhere, the headline UK index, the FTSE 100, seems to have been running through treacle this year.

Although the markets basks in recent highs with the index trading at 6100, in reality it is up only 8.5% on the year (against the DAX up 18%, the Dow up 14.7% and S&P up 12.5%). It’s good, but not exceptional by any means and this in a year when you seemingly only have to close your eyes for one minute before yet another corporate gets snapped up by foreign raiders.

In comparison to Europe, UK plc appears very cheap, especially when you look at the burdensome tax regime. Do not be surprised if the corporate tax take of the British government takes a bit of a dive as net revenue is diverted to a more favourable tax centre. Recent gains in the pound versus the dollar will not help. Much of the FTSE 100 index is also tied up in oil and mining stocks which have not had a great time of it over the past three or four months as oil, gold and copper have stalled or

Simon Denham, managing director, Capital Spreads. Photograph kindly provided by Capital Spreads, December 2006.

reversed but are also (crucially) all commodities that are sold in dollars.

It is, of course, difficult for western indices to move in different directions.

Even so, since June’s lows the FTSE has rallied 650 points against 1150 from the DAX. Should the balance of payments and public deficit deteriorate further and the dollar continue to weaken, there is a good chance that this phenomena will continue. We may well have seen the highs in the index (at 6250) for the near to medium term.

The fall in energy prices and the dollar have had an impact on costs (especially commodities) and bottom line performance for much of European industry. However, they are not so reliant on US buyers as is the UK and the fall in competitiveness in the Euro does not have much of an impact. The DAX has come off from its highs of the disturbingly symbolic looking 6500 level, but in reality the index is due a little profit taking and it would need a good deal more than this to upset the trendline support, let alone all the momentum indices.

Investors must also watch volatility indices. These have hit headlines as the various measures of volatility have hit recent historical lows. In an era where we are warned constantly about the fragility of the markets it appears strange that the major measure of actual investor worry is so low. Some commentators see this very complacency as a sign of troubled times ahead. They may be right, but just now the markets are saying stay in there for the ride.

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Intelligence. It’s what we’re all about. Our culture is defined by the diverse thinking and creativity we bring to bear on each and every one of our clients’ needs. And the more complex the problem, the more we relish the challenge.

Investments and services offered through Morgan Stanley & Co. Incorporated, member SIPC. Employee names have been changed to protect their privacy. Morgan Stanley and One Client At A Time are service marks of Morgan Stanley. © 2006 Morgan Stanley.

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Index Review FUNDAMENTAL INDICES

FUNDAMENTALLY DIFFERENT

Investors like an index because it lowers the cost of investing by giving broad-market participation a host of advantages. However, at the same time, there is something inherently counter-intuitive about an approach that says that if a company has just doubled, an investor will want to own twice as much of it as he did before, thinks Rob Arnott, chairman of Research Affiliates LLC (RA). While a company might actually deserve that higher market multiple, it does not necessarily mean that from that higher level it is going provide even higher returns. Therefore, thinks Arnott, investors can end up frustrated that indices are not what they could be. An index based on fundamentals, rather than capitalisation, has the potential to secure annual returns at least 200 basis points higher than its cap-weighted counterpart he maintains. Dave Simons reports from Boston.

EVERAL YEARS AGO, Arnott, a successful money manager in his own right, began conducting research on an index alternative with help from RA colleagues Jason Hsu and Philip Moore, among others. In a white paper published two years ago,Arnott indicated that an index based on fundamentals, rather than capitalisation, had the potential to secure annual returns at least 200 basis points higher than its capweighted counterpart. To minimise risk and maximise performance, Arnott

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Photograph kindly supplied by Istockphotos.com, December 2006.

proposed a four-pack of fundamentalsbased yardsticks: sales, book value, gross dividends and cash flow.

“For example, while dividends are the weakest of the fundamental indices, it also has the lowest risk and volatility, and therefore performs the best of any of the fundamental indices in a bear market, even if it’s the only fundamental index that underperforms in a bull market,” he says.

Similarly, using an earnings-based approach exclusively will “have you in cyclical stocks at their cyclical peaks, a sales-based approach will concentrate the portfolio in high-sales, lowmargin segments of the economy, a book-value approach will concentrate on companies that use aggressive accounting, and so forth. What we do is to take the view that any one of these single-metric approaches has its vulnerabilities. So while they’re all flawed, by using a composite you mitigate the damage any single flaw can make,”he continues.

While various non cap-weighted alternatives have surfaced in recent times—among them the EqualWeighted index, which rotates between small- and large-cap issues depending on the current investment climate— Arnott says his fundamental approach is far more effective, and supports his claim with 44 years’ worth of backtesting, using data derived from the CRSP-Compustat merged database, which Arnott acquired during the development stage. “We have tested using small companies, emerging markets—it adds value everywhere we have looked,” says Arnott. “It is even starting to rock the finance-theory world by calling into question the whole notion that price identically equals true fair value on all assets at all times. So it has had some pretty farreaching implications.”

Perhaps the most compelling argument in favour of fundamental indexing: performance peaks during weak and turbulent markets when value

JANUARY/FEBRUARY 2007 • FTSE GLOBAL MARKETS

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STATE STREET DELIVERS RESULTS TRANSITION MANAGER OF THE YEAR Global Pensions, January 2006

EUROPEAN TRANSITION MANAGEMENT PROVIDER OF THE YEAR ICFA European Custody and Fund Administration Awards, February 2006

RECIPIENT OF FIVE “BEST IN CLASS” AWARDS PLANSPONSOR’s 2006 Transition Management Survey, May 2006

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State Street is the world’s leading provider of financial services to institutional investors. Our broad and integrated range of services spans the entire investment spectrum, including research, investment management, trading services and investment servicing. With $11.3 trillion* in assets under custody and $1.6 trillion* in assets under management, State Street operates in 26 countries and more than 100 markets worldwide.

For more information, please contact State Street’s transition team at SSGM-sales@statestreet.com.

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Brokerage product and services offered in the US through State Street Global Markets, LLC, member SIPC. Transition Management offered by State Street Bank Europe Limited across Europe. ©2006 STATE STREET CORPORATION.

06-SGM009731106

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Index Review FUNDAMENTAL INDICES 12

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is needed the most, according to Arnott more than 14% while maintaining a (who has suggested as much as a 700 value-conscious price to earnings ratio basis-point advantage during such of 14 as well. In the wake of that cycles). A look at the charts comparing success, in September PowerShares growth indices with their fundamentally licensed from FTSE a new series of 10 weighted counterparts during the period fundamentally weighted sector ETFs 2000-2002 says it all—growth drops based on the FTSE RAFI index, including industry groups such as basic sharply while value continues to climb.

“It is very easy to design a defensive materials, consumer goods, energy, kind of strategy that will work for that healthcare and telecoms/technology.

Rob Arnott, chairman of Research Affiliates Unlike the Big Board-based PRF, the kind of an environment,” says Arnott. says “With cap-weighting, you’re going to “What is problematical is that it PowerShares sector ETFs made their double your exposure to a company just because usually takes it back from you during a debut on the NASDAQ, a decision it’s doubled in price, or because it’s trading at positive market—while it continues to aimed at achieving maximum twice the market multiple. Is that really what add value, it does so at a slower pace. exposure for RAFI going forward, you want? With fundamental indexing, that By comparison, to date the S&P is up explains Jerry Moskowitz, president problem goes away.” Photograph kindly supplied roughly 14%, while the fundamental and managing director of FTSE

by Research Affiliates, December 2006. index is ahead 17%—3 points higher Americas. Moskowitz is pleased with in a bull-market year. In other words, the initial response to FTSE RAFI $5.5bn still is not a lot of money in it doesn’t suffer the defensive-value products thus far. “We see growth today’s world,”says Arnott with a grin, investing Achilles heal of not being accelerating over the next few years, “but that kind of movement in only 10 particularly with regard to ETFs, months really is staggering.” able to keep pace in an up-market.”

All of this, of course, begs the question: The concept has been met with mutual funds and other investment cap-weighted investing is considerable interest. In November products,” he says, who also presided if 2005, FTSE Group joined forces with over the launch of the new Vanguard fundamentally flawed, as has been Research Affiliates to create the FTSE High Dividend Yield Index Fund, suggested, why has it taken so long for a RAFI Index Series, a multi-tiered menu based on a custom benchmark created value-oriented approach to catch on? For of non market-cap weighted indices by FTSE.“The FTSE RAFI series offers starters, the fear of breaking with that includes the FTSE RAFI 1000 many ways to look at fundamental tradition, says Moskowitz. “Sometimes, Index, FTSE RAFI Global ex US 1000 indexing—sectors, regions, etc.—so like anything that’s new, a concept that Index, and the FTSE RAFI US Mid the growth looks quite good globally.” challenges the status quo is slow to be Indeed, to date total global assets accepted,”says Moskowitz.“But these are Small 1500 Index, in addition to a list of individual country-based indices. The committed to fundamental indices times of change, and the market seems combination of research affiliates’ have reached nearly $5.5bn, from only ready and more receptive to alternative concept and FTSE’s indexing expertise $800m at the start of 2006. “Granted, ways to enhance returns.

In fact, there have been proved an immediate hit various attempts at with investors. A month FTSE RAFI Indicies: Upward Bound 240 creating a fundamentalslater, ETF-provider 220 based platform, including PowerShares Capital 200 several during the ‘90s at a Management joined the 180 time when value was fray with its PowerShares 160 clearly out of favor, and as FTSE RAFI US 1000 140 120 such those efforts failed to Portfolio (PRF), a first-ever 100 generate any appreciable exchange-traded fund 80 enthusiasm. But times based on fundamental 60 have clearly changed. criteria, which uses the “Early on it just shocked FTSE RAFI 1000 as its the heck out of us that this underlying index. In its first FTSE RAFI Developed ex US 1000 Index FTSE Developed ex US Index FTSE RAFI US 1000 Index FTSE US All Cap Index hadn’t been explored year on the charts, the decades ago,” admits index notched a gain of Source: FTSE Group

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Index Review FUNDAMENTAL INDICES

Arnott.“The more we thought about it, the more we realised that in a very real sense, people bought into finance theory as if it were fact. For instance, shortly after the S&P index was invented, the Capital Asset Pricing Model came along and said you can’t beat cap-weighting, it’s the efficient market’s answer, it’s the marketclearing portfolio and you can mathematically prove that it’s unbeatable except by taking the same assets and leveraging them. And that’s all well and good, but as with most proofs there are some simplifying assumptions—that there are no taxes, that all investors are rational and fully informed and have the same risk tolerance, that the markets are completely efficient and that price equals true fair value, and so forth. If all of those things are true, then you can’t beat the market. So in effect what happened was that finance theory came along and said,‘you know what?

You guys stumbled on the right answer by accident seven years ago, you’re now entitled to stop thinking!’ Which, in a sense, is what really happened— the industry concluded that capweighting was the right way to go, the market itself is cap-weighted, we need look no further.”

Where fundamental weighting has succeeded, says Arnott, is by giving people a viable and compelling alternative to traditional indexing. “If you weight the index by how big a company is—rather than how big the market thinks it will be in the future and is paying for it today—you wind up avoiding the risk of over-weighting the overvalued and under-weighting the under-valued.You don’t even have to know which ones are over-valued and which ones are under-valued because you’ve broken that link. The evidence on that is very compelling.”

As one might expect, the fundamental methodology has

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garnered its share of critics, including those who suggest that the index cannot truly function as an index if it ignores cap-weighting, the largest segment of the overall market. Others, like John C Bogle, founder of Vanguard, and Princeton professor Burton Malkiel, contend that fundamental indexing merely shifts the emphasis onto small-cap and value-based issues.

“The criticism that I think is more accurate is that a fund such as the FTSE RAFI US 1000 Portfolio has a value tilt, and it will always do so, relative to the cap-weighted index,” says Arnott.

“Why? Because the cap-weighted index doubles the weight on companies at twice the market multiple. Cap-weighting has a structural and profound growth bias, whereas fundamental indexing utterly ignores valuation multiples and therefore has no growth bias. As such, comparing RAFI with any index that has a cap-weighting, and hence a growth bias, is going to look valuetilted, because it is.”

Apparently,“One of the nice things is that it’s a dynamic value-tilt. When value is shunned as it was during the peak of the bubble, FTSE RAFI seems to have a profound value tilt— because the cap-weighted index has a profound growth tilt! When the market is a little hesitant about growth and doesn’t pay up in a big way for growth potential as is the case today, the value tilt of the fundamental index diminishes. So that it has a very slight value tilt right now. And this dynamic tilt means that when the market isn’t paying a large premium for growth, you don’t have a deep value tilt so you won’t get hurt badly if the market enters a growth cycle. When the market overpays for growth drastically, you have a big value tilt at a time when you’re most likely to get big rewards for it,” adds Arnott.

Jerry Moskowitz, president and managing director of FTSE Americas. Moskowitz is pleased with the initial response to FTSE RAFI linked products thus far.“We see growth accelerating over the next few years, particularly with regard to ETFs and mutual funds,” he says, who also presided over the launch of the new Vanguard High Dividend Yield Index Fund (VYM), based on a custom benchmark created by FTSE.“The FTSE RAFI series offers many ways to look at fundamental indexing—sectors, regions, etc.—so the growth looks quite good globally.” Photograph kindly supplied by FTSE Group, December 2006.

Like any emerging product, getting investors on board at both the institutional and retail segments of the market is one of the many challenges facing fundamental-index proponents in the coming years. “FTSE RAFI indices will be attractive to institutions that want to diversify and look at other options beyond market cap weighted benchmarks,” says FTSE’s Moskowitz.

“Some of the bigger US plans — CalPERS and South Dakota Investment Council — have shown interest in adopting a fundamental approach, so we can see other plans following suit once they have seen the performance of these indices.”

While the approach to selling the concept to the various segments of the market may vary, the overall message is the same, says Arnott. “With capweighting, you’re going to double your exposure to a company just because it’s doubled in price, or because it’s trading at twice the market multiple. Is that really what you want? With fundamental indexing, that problem goes away. It is as simple as that.”

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In the Markets LIABILITY DRIVEN INVESTING

LDI CHANGES TACK The precipitous decline in funding ratios ushered in liability driven investing (LDI), a risk management framework that attempts to match cash flow from fund assets to projected future liabilities.

Under LDI, sponsors strive for returns that exceed the accrual rate of liabilities, not a market benchmark. In effect, sponsors focus on net asset value rather than gross assets. When LDI first took root, it was thought that long bonds were the answer: now people are not so sure. Neil O’Hara reports on a change in strategy.

ENSION SPONSORS USED to assume the way to ensure a plan could meet its liabilities was to take good care of the assets. The 20002002 bear market demonstrated how wrong they were. Although equity markets dropped, they did not give up all the gains of the late 1990s. The rolling 10-year compound total return on the Standard & Poor’s 500 index was still 6.4% at the lowest point.

Meanwhile, bonds rallied as interest rates fell to levels not seen in half a century. If assets were all that mattered, pension plan funding ratios would have ticked down, but not disastrously.

What went wrong? The same falling interest rates that boosted bond prices wrought havoc on plans’ liabilities. A lower discount rate applied to future pension payments sent the present value of those commitments through the roof. Asset values fell while liabilities soared – and funding ratios plummeted.

In the traditional model, plan sponsors update their asset-liability studies every three years or so and tweak the asset allocation to reflect changes in projected funding requirements and then forget about the liabilities until the next actuarial review. Between studies, sponsors try to hire managers who can beat market benchmarks for each asset class. In a typical allocation of 70% equities and 30% bonds, the equities are supposed to deliver long term returns higher than inflation while the bonds

P

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generate income to meet current payment obligations and reduce portfolio volatility.

On closer examination, sponsors discovered their liabilities were far more sensitive to movements in interest rates than they had imagined. Stuart Jarvis, LDI strategist in the London office of Barclays Global Investors, points out that inflation determines how large the payments will be and participants’ longevity how long they will continue.

The best available match is a portfolio of bonds and swaps that have the same sensitivity to real and nominal interest rates. “Pension plans have borrowed bonds from their scheme members and invested the proceeds in the equity market,” Jarvis says, “They have a big equity versus bond bet.”

To remedy that mismatch, early LDI proponents advocated a massive shift into bonds. While that may be part of the strategy, a new interpretation insists that LDI has far broader implications.

To Alan Brown, head of investment at Schroders Investment Management Ltd, which has $229.4bn under management, a portfolio that merely mimics the liabilities is a “very poor proposition indeed.” Although it will match the liabilities from an accounting standpoint, it ignores other risks, including longevity; earnings increases that exceed the assumed inflation rate; regulatory and tax changes; and sponsor solvency.“The point estimates

Joseph Moody, LDI strategist in the London office of State Street Global Advisors says that LDI effectively breaks the portfolio in two: one part matches the liabilities, the rest generates excess returns. It is a bit like portable alpha, except that under LDI the matched portfolio replaces the market return, or beta.“The marriage of alpha and beta is on rocky ground,” says Moody,“They have been looking to separate from each other for a while.” Photograph kindly supplied by State Street Global Advisors, December 2006.

of your liabilities 40 years down the road are subject to huge uncertainty based on your assumptions,” Brown explains, “The notion that LDI can eliminate all risks is simply not true.”

Brown believes pension trustees should develop a risk budget based on the strength of the covenant with the plan sponsor and then attempt to optimise how the budget is spent. For example, when Schroders decided to allocate a portion of its £500m pension plan to low risk assets designed to match its liabilities, long-term real interest rates in the UK were near historic lows. Rather than taking a slice of fund liabilities all the way out to 50 years, Schroders focused on the shorter end.“We used part of the risk budget to take a chunk of the near term liabilities up front and defease those,” Brown says. The firm is betting it will be able to correct its duration mismatch when long-term real rates move higher.

An overlay of interest rate and inflation swaps allows sponsors to adopt LDI without incurring the transaction costs of switching cash positions from equities to bonds. The riskless collateral to support those swaps is cash earning LIBOR (the rate the fund pays on the swaps), but sponsors can pursue

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alternative collateral management strategies that deliver a higher return â&#x20AC;&#x201C; as Schroders did.â&#x20AC;&#x153;We think many people will use a bit of their risk budget there,â&#x20AC;?

Brown observes.

For the rest of the portfolio, Brown argues the historic preference for home market equities was never justified but international equities no longer offer much diversification because market returns have become more correlated.

He believes sponsors should direct their risk budget to a broad range of asset classes, including private equity; real estate; high yield and emerging market bonds; hedge funds; and infrastructure.

The optimum portfolio would look more like the Yale Endowment, a

famously successful early proponent of alternative investments, than a traditional pension fund.

Plan sponsors are not the only ones to recognise flaws in conventional pension fund management. Fearful that under-funded pension plans might create a future claim on the public purse, governments have begun to adopt regulations that put the liability back on the plan sponsorâ&#x20AC;&#x2122;s balance sheet. They demand a shift in pension accounting toward a mark to market approach for both assets and liabilities, run the dollar change in funding status through the earnings statement and impose timetables for eliminating funding deficits.

Stuart Jarvis, LDI strategist in the London office of Barclays Global Investors, points out that inflation determines how large the payments will be and participantsâ&#x20AC;&#x2122; longevity how long they will continue. The best available match is a portfolio of bonds and swaps that have the same sensitivity to real and nominal interest rates.â&#x20AC;&#x153;Pension plans have borrowed bonds from their scheme members and invested the proceeds in the equity market,â&#x20AC;?

Jarvis says,â&#x20AC;&#x153;They have a big equity versus bond bet.â&#x20AC;? Photograph kindly supplied by Barclays Global Investors, December 2006.

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FTSE GLOBAL MARKETS â&#x20AC;˘ JANUARY/FEBRUARY 2007

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In the Markets LIABILITY DRIVEN INVESTING

The new rules took effect in the UK, Ireland and the Netherlands first, which is why LDI is spreading fast in these countries.

In jurisdictions where older regulations prevail, plan sponsors may accept the premise but have little incentive to implement LDI. Under current US accounting rules, for example, discount rates used for pension liabilities in financial statements reflect long-term averages rather than market rates. The Pension Protection Act of 2006 will provide added impetus to LDI in the US by shifting pension accounting to a mark to market standard from 2008. A pension plan following LDI has a better economic match between assets and liabilities, but today the accounts will show extraordinary volatility in the funding ratio because the liabilities are not marked to market.

Plan sponsors don not want to put the company at a competitive disadvantage, according to Richard Nuzum, Americas business leader at Mercer Investment Consulting. If interest rates rise, a pension plan pursuing LDI will experience lower returns relative to others in its industry. Although the funding ratio of its pension plan may not change, competitors that do not pursue LDI will experience less adverse returns and an improvement in funded status.

“Companies do not take peer risk in that way,” says Nuzum,“They want to beat the competition in their core business. They won’t take bets on the pension side.”

Nuzum explains that LDI alters the minimum risk portfolio for a pension fund from cash in the traditional model to long-term bonds, both nominal and inflation-linked. A new efficient frontier of possible investment portfolios runs from 100% bonds up to 100% in risky assets. Sponsors who adopt LDI often start by extending the duration of their fixed income portfolios to match their

18

liabilities. “That reduces risk,” Nuzum says, “They can either redeploy that exposure in risky assets and raise their expected rate of return, or they can just take that risk off the table.”

Critics of LDI claim it works best for plans that are fully funded and closed to new members. For those who equate LDI to a bond portfolio, that may be true.

In the broader definition, LDI can improve risk management for any plan, whether open or closed and however well funded. Nuzum points out that a fund holding 70% equities and 30% bonds could implement LDI, boost the risky asset portion to 85%, pick up an extra 1% in expected return and improve the funding status over time – as long as the return on risky assets exceeds LIBOR. LDI effectively breaks the portfolio in two: one part matches the liabilities; the rest generates excess returns, according to Joseph Moody, LDI strategist in the London office of State Street Global Advisors. It is a bit like portable alpha, except that under LDI the matched portfolio replaces the market return, or beta.“The marriage of alpha and beta is on rocky ground,” says Moody, “They have been looking to separate from each other for a while.”

Although a plan that is 85% funded would introduce leverage if it defeased 100% of its liabilities, Moody notes it is leveraged already: it has only $85 of assets for every $100 it owes. A 15% shortfall is not an insuperable obstacle, either. Changes in the discount rate have a big impact on liabilities, after all: an average pension life of 20 years means $100 discounted at 5% soars to $120 if the rate falls to 4% but drops to $80 if the rate goes up to 6%.“If the liabilities fall to a point where the plan was fully funded, the sponsor would probably want to do something about that,”Moody says.

Plan sponsors missed a chance to hedge their exposure in 1999, when many plans had surplus assets and bonds were relatively cheap. Most did

Richard Nuzum, Americas business leader at Mercer Investment Consulting. If interest rates rise, a pension plan pursuing LDI will experience lower returns relative to others in its industry. Although the funding ratio of its pension plan may not change, competitors that do not pursue LDI will experience less adverse returns and an improvement in funded status.“Companies don’t take peer risk in that way,” says Nuzum,“They want to beat the competition in their core business.

They won’t take bets on the pension side.”

Photograph kindly supplied by Mercer Investment Consulting, December 2006.

not do so; traditional risk management did not require or even suggest it.

Dimitry Mindlin, a managing director at Wilshire Associates, believes the opportunity will recur at some point and sponsors will not want to make the same mistake. “The time of investing against asset-only benchmarks is over,” he says,“I believe pension plans should adopt better ways of managing their pension commitments.”

As a risk management framework, LDI allows plan sponsors to separate risks they choose to accept from those they want to neutralise. Mindlin believes sponsors have been rightly sceptical of narrow-based LDI because it is a “quintessential single-period optimisation of accounting statements.”

It tries to minimise the volatility of a measure of the funding surplus or deficit that may not reflect economic reality. In its broader form, which Mindlin calls commitment driven investing, LDI improves the odds that pension funds will meet their future financial obligations – a better mousetrap many plan sponsors may find hard to resist.

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Face to Face BURSA MALAYSIA

FACE TO FACE WITH BURSA MALAYSIA

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Following demutualisation two years ago, Bursa Malaysia has undergone radical and rapid changes to help it compete more effectively in the global market. That process also involved a successful debut on the Bursa Main Board, involving a public offering of 166m shares, that raised RM521m, of which just under a quarter was taken up by foreign institutional investors. The institutional portion was over-subscribed 38 times. FTSE Global Markets talks to Bursa Malaysia chief executive officer Yusli Mohamed Yusoff about the exchange’s latest initiatives.

Yusli Mohamed Yusoff, chief executive officer, Bursa Malaysia. With the growing global focus on commodities, does it make sense for Bursa Malaysia to help promote the creation of a pan-ASEAN exchange? “I think it is too early for that to happen. But if it makes sense to do so, it will.”

Photograph kindly supplied by Bursa Malaysia, December 2006.

sized Malaysian companies. “It was an important step, signals Yusli.

“Research coverage of the market was limited, with only the top 10% of our leading 100 companies attracting the attention of analysts. Then only another 10% had official investor relations programmes.

Bursa Malaysia now has closer trading links with the Singapore Exchange (SGX) to help boost liquidity.

The link facilitates the trading of securities listed on the Singapore Exchange by investors in Malaysia and similarly for securities listed on Bursa Malaysia by investors in Singapore. It will provide brokers with access to market and trading information, and allow them to transmit orders through their local trading terminals directly into the electronic trading systems of the other exchange. Bursa Malaysia is also exploring opportunities to collaborate with other exchanges “some of the things we are looking at include the development of new benchmarks, such as the expansion of our crude palm oil benchmark and encouraging the trading of the contracts on other exchanges, such as the MultiCommodity Exchange in India and the Dalian Commodity Exchange in China.

Then we want to explore whether we

can do the same in the Eurozone where we see an growing interest in biofuels,”he adds.

With the growing global focus on commodities, does it make sense for Bursa Malaysia to help promote the creation of a pan-ASEAN exchange? “I think it is too early for that to happen.

But if it makes sense to do so, it will. I can see some sense in it. It provides a strong economic base: a market of 550m people and there are obvious advantages to marketing ASEAN as an economic destination. But in the short term, I see only formal cooperation taking place, no mergers,” thinks Yusli.

However, he concedes that if the region’s other exchanges want to take a stake in the Bursa,“we will consider the offer seriously, depending on the offer that is made and the potential value they can bring into play.”

The second area of focus for Bursa Malaysia was to enhance revenue growth through new products and services. This includes introducing new products and services for both derivatives and equities markets, and strengthening its information business. April 2006, Bursa Malaysia introduced Single Stock Futures (SSFs). The addition of single stock futures to Bursa Malaysia’s product range“facilitates price discovery, provides

HROUGH OUR LISTING, we wanted to heighten the profile of not just the exchange, but also its market participants and Malaysia as an investment destination,” says Yusli. “It also signalled the coming of age of the bourse itself as an exchange.”Since the IPO Bursa Malaysia has focused on growing three business areas.“The first challenge was to increase turnover velocity by encouraging greater participation from existing market participants, mainly listed companies and companies seeking listing, intermediaries, as well as institutional and retail investors,” adds Yusli. The velocity and liquidity of the shares traded on the exchange is becoming more important concedes Yusli. “The free float of some companies is too low and we have encouraged them to reduce their stakes. While they hold on to a smaller portion of the company’s shares, the value of those shares rises. It is a balancing act. You want to avoid a speculative bubble, but also you need to increase liquidity.”

Another solution was to raise the profile of companies listed on the exchange and the upshot was a research tie-in with Standard and Poor’s, which now provides quarterly research on 300 small and medium

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FTSE® is a trade mark jointly owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE under licence. “Research Affiliates” and “Fundamental Index” are trademarks of Research Affiliates LLC (“RA”). The FTSE Research Affiliates Fundamental Indices (“Indices”) are calculated by FTSE. All rights in the Indices vest in FTSE and RAFI. The trade names Fundamental Index, Fundamental Indexing, RAFI, the RAFI logo and the RA corporate name and logo are the exclusive intellectual property of RA. Any use of these trade names and logos without the prior written permission of FTSE or Research Affiliates, LLC is expressly prohibited. FTSE and RA reserves the right to take any and all necessary action to preserve all of their rights, title and interest in and to these trade names and logos.

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Face to Face BURSA MALAYSIA

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an additional risk management tool for investment products such as exchange Malaysia aims to improve turnaround investors, and gives investors a lower cost traded funds (ETFs), derivatives and time of operational and regulatory and easier means for entering the over the counter (OTC) products. The functions, improve business efficiency and market,” says Yusli. The underlying indices in the FTSE Bursa Malaysia enhance customer satisfaction. It also company must have showed an average Index Series include the benchmark seeks to focus on proactive capital daily market capitalisation of at least FTSE Bursa Malaysia EMAS Index, that management, seeking ways to optimise RM1bn in the previous three months comprises the constituents of the FTSE its capital structure and maximising to shareholders. “Since ending on the last business day of the Bursa Malaysia 100 Index and FTSE returns calendar month immediately preceding Bursa Malaysia Small Cap Index, and demutualisation we have reduced the date of issue.To encourage the launch the FTSE Bursa Malaysia Small Cap headcount from 1000+ people down to of the new products, Bursa Malaysia Index comprising the 101st company to around 600 and at the same time we have waived exchange and clearing fees for the 200th company on the Bursa improved productivity and the framework for all the exchanges processes,”explains the initial three months and fees Malaysia Main Board.

Bursa Malaysia has also implemented Yusli. This involved a special Renewal covering data feeds were also waived for Bursa Trade, a common trading platform Work Out Initiative (RWO) which information vendors.

Bursa Malaysia Securities Clearing, a (CTP) to promote the local securities involved analysing in depth every process subsidiary of Bursa Malaysia, also market abroad. The derivatives platform or activity undertaken by the exchange established a Clearing Guarantee Fund is now live in the second quarter and and then trying to improve the process.

(CGF) to provide guarantee support for the equities component is expected to We are continuously reviewing the work.

One example of the effect of RWO is a settlement of trades when there is a kick off in the last quarter of 2007.

Bursa Trade will facilitate the trading reduction in the time it takes to review payment or delivery default by its of all products of the exchange on one documents for approval of corporate Trading Clearing Participants (TCPs). actions. We have now committed to a The Fund came into play in early July integrated platform.

Bursa Malaysia hopes that improved timetable of 15 working days as a and consists of a pool of assets such as cash, bank guarantees and other access and new businesses will translate maximum for the most complex financial resources, enables the Clearing into higher trading volumes and documents.” Yusli also says that Bursa trading of multiple Malaysia continues to concentrate on House to deal with potentially large enhance credit and/or liquidity risks that may arise instruments. The enhanced range of ways to improve the quality of the 1,000when a trading participant defaults on its products and service offerings facilitated odd companies listed on the exchange. payment or delivery obligation on any by the CTP will encourage participation While focusing on enhancing commercial settlement day.The CGF is used to cover of intermediaries and investors on the value, Bursa Malaysia will continue to discharge its duties as a regulator in liabilities of the Clearing House arising exchange, thus improving liquidity. out of market contracts, typically when The third area of focus is to enhance maintaining a fair and orderly market the trading participant defaults. With the operational scale and efficiency. Through with its intention to set corporate Clearing Guarantee Fund, the Clearing business process re-engineering, Bursa governance and disclosure standards for the industry.

House will be still able to continue its functions to FTSE Bursa Malaysia Index Series “Listing on the other participants exchange will enhance the 180 without disruption. profile of not just Bursa 160 Additionally, Bursa Malaysia as a competitive 140 Malaysia, in collaboration global exchange, but it will with FTSE Group (FTSE), also profile the 120 launched the first phase of competitiveness of the 100 the new FTSE Bursa Malaysian capital market.

80 Malaysia Index Series in The listing is also geared 60 June. The series comprises towards instilling greater six indices, covering all of discipline in enhancing the Malaysian market transparency and FTSE Bursa Malaysia Top 30 Index FTSE Bursa Malaysia Mid Cap 70 Index which are to be used as the efficiency at the FTSE Bursa Malaysia 100 Index FTSE Bursa Malaysia EMAS Index basis for the creation of exchange,”he concludes.

FTSE Bursa Malaysia Small Cap Index FTSE Bursa Malaysia Fledgling Index Source: FTSE Group

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JANUARY/FEBRUARY 2007 • FTSE GLOBAL MARKETS

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Regional Review NORTH AMERICA: REG NMS

Reg NMS consolidates shift to electronic trading

Even in its infancy, Reg NMS has already had some effects; above all, in consolidating the shift towards electronic trading. Exchanges with the right technology platforms are clear winners in the new system. Professor Maureen O’Hara of Cornell University claims,“It has really changed the securities markets. Everybody has started an ECN. Many of them are private networks that are used to internalise order flow.” Photograph by Sylvia Bukovac and supplied by Dreamstime.com, December 2006.

In October 2006, the long discussed and delayed SEC Regulation National Market System (Reg NMS) began implementation, with a timetable of a year to completion. In an interestingly candid prediction, NASDAQ’s Edward Knight wrote to the SEC about the proposals two years ago claiming, “All that can be said with certainty is that the securities industry, with its infinite capacity to mine the intricacies of government regulation for competitive advantage, will create a new set of issues that will require further Commission action.” Ian Williams reports from New York.

HE NEW NATIONAL Market System regulations go into some minute detail – over 371 pages of them in fact. The regulations are designed to speed up trading in the markets and make it cheaper. Their precise prescriptions and proscriptions will try to curtail, for the time being at least, “the infinite capacity,” of the industry to evade the spirit of US regulator, the Securities and Exchange Commission (SEC).

Institutional investors pay about $11bn a year in trading commissions.

So there is a lot at stake.

The main focus of Reg NMS is to ensure that orders go to the best price available anywhere in the markets,

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and the fine print is intended to close off the various ways in which some parts of the industry have handled orders in order to maximise trading revenue. For example, Reg NMS will ban price increments of less than one cent (sub-penny) so that companies cannot juggle microscopic price advantages to attract trades.

Robert Monks, the corporate governance activist, suggests Reg NMS has something of the appearance of a lot of little boys poking little fingers in a leaking dyke.

“Ultimately, it may prove to benefit investors but there will be a period of workout in which there may be some immediate discomfort. At least there

will be clarity about jurisdiction, but there is long time underlying problem here with self-regulation. The case for self-regulation has not been made.”

Even in its infancy, Reg NMS has already had some effects; above all, in consolidating the shift towards electronic trading. Exchanges with the right technology platforms are clear winners in the new system.

Professor Maureen O’Hara of Cornell University claims, “It has really changed the securities markets.

Everybody has started an ECN. Many of them are private networks that are used to internalise order flow.”

Indeed, the recent demutualisation of many exchanges, in the US and elsewhere in the world, throws into clear relief the contradiction between their duty to their shareholders and to their customers. The big brokerage firms that used to sit on the New York Stock Exchange (NYSE) Board are now in effect rivals for the trading volumes and revenue who are setting up their own ECN’s and buying regional US exchanges to

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chip at the NYSE/NASDAQ duopoly.

Already, Philadelphia, Chicago, Boston and the like have begun merging and consolidating to meet the new era along with investing in the electronic platforms.

Most of the big brokers will try to meet a bid from internal liquidity without going into the markets at all.

Since last month’s price increase that saves them 2.75 cents per share on NYSE trading costs. Consequently, as a recent report from Aite consultants in Boston suggested that the algorithms used for trading which search out the best prices often send the orders to internal networks. Already major brokers are directing 12% of their trades to them, and that will reach 18% by the end of the decade.

That has eroded the position of the NYSE even further, since, O’Hara suggests, “sending an order to an exchange is now almost an afterthought.You’ll find whatever you want in the way of liquidity out there, so going to the floor of the exchanges is not particularly necessary. This is not a good time to be a specialist firm.

They are close to running up the white flag.”

Interestingly, she suggests that “One of the interesting things happening is dark trading, in which the transaction is never shown to the market,” which removes one of the few competitive advantages of the trading floor, in which stocks could be unloaded discreetly without too many identifying fingerprints.

NYSE is reticent about its spokespeople going on the record, but they are happy to point out that they have two separate NMS compliant systems, ARCA, which is fully electronic and can execute in 3 milliseconds and their new Hybrid system, currently trading 262 stocks which takes 300 milliseconds, but where the Specialist services are still

At the end of November NYSE announced the abolition of Specialists’ commission on the stocks that they specialise in they are fighting back. The move, even with a 10% increase in trading commissions, at 17.5 basis points gives NYSE the world’s lowest trading costs – compared with London at 23.5 according to a recent Elkins/McSherry report – which is widely mentioned by NYSE spokespeople. They also point the actual large increase in trading volumes, which have so far generated more revenue than has been lost to the internal networks. available. By February all 2,700 NYSE listed stocks will be available on the Hybrid system as well.

At the end of November NYSE announced the abolition of Specialists’ commission on the stocks that they specialise in they are fighting back. The move, even with a 10% increase in trading commissions, at 17.5 basis points gives NYSE the world’s lowest trading costs – compared with London at 23.5 according to a recent Elkins/McSherry report – which is widely mentioned by NYSE spokespeople. They also point the actual large increase in trading volumes, which have so far generated more revenue than has been lost to the internal networks.

While it is very early days the Reg NMS pressure towards ECN’s does raise longer term issues for NYSE and NASDAQ. NYSE’s problems are

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007

somewhat more apparent because it was had such a dominant position before. NASDAQ meantime has had similar problems for a long time, as Professor O’Hara points out, “A lot of people are clearing NYSE stocks – but not using NYSE’s trading system and that has also been true of NASDAQ for a long time. Trades may appear on NASDAQ, but only because many of the ECN’s report to it. But they are not actually trading on Super Montage or any of the NASDAQ trading platforms.”

It does raise the question of what the percentage is in paying heavy NYSE listing fees for companies whose stocks are mostly trading on ECN’s. “A lot of firms are grappling with that at the moment,” reports O’Hara.“Around the world listing fees were dropping rapidly, except here in the US where they were kept remarkably high. If where you list is not where you trade then it becomes somewhat less important.”

Set against that, of course, NYSE points to its lower trading costs – and certainly the effect of Reg NMS will be drive those downward even further. Beyond the domestic US implications, securities markets are globalising, and while the US financial securities industry has been agonizing about the dire effects of Sarbanes Oxley on its international position, one can foresee some competitive advantage from the ease and economy of transactions and added liquidity in the newly unified markets. It will certainly put pressure on London to lower costs.

However, while the future is, as always, murky, there is no doubt that for US financial securities industry, it will be electronic – and that, as NASDAQ predicted, in a year the SEC will notice all the holes leaking through the dyke of NMS and begin plugging them all over again. A regulator’s job is not a happy one!

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Regional Review ASIA: TAIWAN SEARCHES FOR A NEW ROLE

The country has long held ambitions of becoming a regional financial hub and successive governments have been consistent in working to improve the banking and financial sector achieve this status over the past decade. The Kuomintang (Nationalist Party or KMT) government introduced plans to transform Taiwan into a regional financial centre were initiated in the in the 1990s. In recent years, the efforts have been carried forward by the Democratic Progressive Partyled administration, along with Taiwan’s newly created financial regulator, the Financial Supervisory Commission (FSC). Photograph of a temple lion in Taiwan by Mary Lane, supplied by Dreamstime.com, December 2006.

N SEPTEMBER THIS year, the United Kingdom headquartered Standard Chartered Bank announced its plans to acquire Hsinchu International Bank, a mid-sized bank in Taiwan. This particular deal is the latest in a long line of strategic acquisitions by Standard Chartered in Asia. Over the last two years Standard Chartered has acquired Korea First Bank, a 44.5% stake in Indonesia’s PT Bank Permata, in joint venture with PT Astra, bought control of Union Bank, Pakistan’s sixth largest bank, and took a 19.99% interest in China Bohai Bank.

Standard Chartered has offered to pay $1.2bn for Hsinchu, some 2.3 times the bank’s book value. Bryan Sanderson, chairman of Standard Chartered, explains, “Taiwan is an important element of our Asia strategy. It is the fourth largest banking market in Asia and is integral to the rapidly increasing economic activity and trade flows in the region.

We believe that the acquisition of Hsinchu is an excellent opportunity to create further value for our shareholders.”

For one, Standard Chartered plans to offer its international network and global product capabilities to Hsinchu’s 2.5m

I

IN THE DRAGON’S MOUTH What now for Taiwan? A recent Financial Times country report quoted incoming FSC chairman Shih Chun-Chi as saying, “We are no longer talking about becoming any sort of ‘centre’ now because we have become more realistic.” Strong-arm tactics by China and an acknowledgement that Taiwan’s capital markets infrastructure still lacks sufficient depth has discouraged Taiwan’s ambitions. Its government has backed away from its strategy to develop the country as a regional financial powerhouse and is now positioning Taiwan more as a fund raising centre. What does that really mean for Taiwan and for investors in the country? Rekha Menon reports.

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It is not as if Taiwan has neglected its fail, trading can be resumed if the fail is customers. Equally important, says Kai Nargolwala, Standard Chartered’s financial sector. The country has long remedied and reported. However the group executive director, “by held ambitions of becoming a regional failed account has to be closed and the hub and successive resumption of trading, in a new leveraging our international network financial and cross-border capability we will governments have been consistent in account,” says Chang. “A positive for capture a greater share of Taiwan’s working to improve the banking and foreign investors, Taiwan plans to adopt rapidly growing trade and investment financial sector achieve this status over a T+2 delivery versus payment flows. In 2005, Taiwan’s exports to the past decade. The Kuomintang settlement cycle, which will ensure that mainland China, Hong Kong and (Nationalist Party or KMT) government cash and securities are settled Korea accounted for approximately introduced plans to transform Taiwan synchronously,” she adds further.

However, despite ongoing reforms of 39% of its total exports. “This into a regional financial centre were opportunity is all about growth,” says initiated in the in the 1990s. In recent the financial system, where Taiwan has Mervyn Davies, group chief executive years the efforts have been carried often been much more proactive than forward by the Democratic Progressive other emerging economies in the of Standard Chartered.

The Hsinchu takeover is a Party-led administration, along with region, the fact remains that the landmark. It is the first acquisition of a Taiwan’s newly created financial financial industry has still not achieve local bank by an international regulator, the Financial Supervisory dits goal of the country becoming a regional financial centre. Experts financial institution and has received Commission (FSC). suggest that Taiwan’s capital widespread support both market needs to grow much from other market The country has long held ambitions of further if it is to compete participants and regulatory becoming a regional financial hub and successfully against existing authorities that have being regional financial centres pushing for consolidation successive governments have been such as Hong Kong and and internationalisation in consistent in working to improve the Singapore in attracting the highly fragmented banking and financial sector achieve this international capital. The banking marketplace. status over the past decade. island also needs to watch There are close to 50 banks its record in certain areas, catering to Taiwan’s 23m Datong Chang, securities country such as insider trading. population but none of the players has Commenting on Taiwan’s gained regional eminence. Last year manager at Citigroup in Taiwan says that the banking industry also faced a crisis after making several regulatory changes longstanding efforts to become a caused by spiralling bad debts among over the past 18 months, which have regional financial centre, Jerry Guo, helped make the market more attractive executive director and head of credit card customers.

Indeed, the Geneva-based World to foreign institutional investors, such as investment banking at UBS in Taiwan, Economic Forum (WEF) in its last two the introduction of securities lending in says the country’s financial industry further deregulation. reports on World Competitiveness has Taiwan.The government is now focusing requires highlighted financial competitiveness on improving the infrastructure around “Although Taiwan is in the process of liberalising, there are still several and banking soundness as a key area securities settlement.

Taiwan currently follows a T+1 regulatory limitations that (along with of concern for Taiwan. The World Competitiveness Report measures settlement cycle for securities, with cash the ongoing pressure from China) global competitiveness across 125 exchanging hands the next day. For restrict the flow of capital and countries around the world. In its investors in Europe and the US, with manpower.”In recent months however, 2006-2007 Report, released earlier this the difference in time zones, this means he notes, the government has of-late year, Taiwan achieved 13th in global it can be more difficult to ensure pre- de-emphasised its efforts to transform competitiveness, above many matching is done and adequate into a regional financial centre.

A Financial Times report on Taiwan neighbouring countries such as Korea, funding is available in the time allowed.

India and China. However, it was “Till last year, failed trades meant corroborates Guo’s statement. The ranked 100th in financial suspension from trading for 3 years for report quotes the new FSC chairman competitiveness, 13 places below its the concerned counterparties. Taiwan Shih Chun-Chi who began his 4-year has changed this and now if there is a term in July, saying,“We are no longer previous year’s ranking.

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Regional Review ASIA: TAIWAN SEARCHES FOR A NEW ROLE Taiwan’s President Chen Shui-bian (centre) and premier Su Tseng-chang (left) are shown electronic chips by Advanced Semiconductor Engineering (ASE) chairman Jason Chang during Chen’s visit at the plant, Tuesday, December 5th 2006, in Kaohsiung 350km (217m) south of Taipei, Taiwan. Chen called on ASE to have confidence in the island’s future, underscoring his determination to limit Taiwan’s economic ties with rival China, two weeks after a high profile American investment firm announced it was offering to buy 100% of ASE shares for NT$179bn ($5.46bn). Photograph by Dean Kao, supplied by Associated Press/EMPICs, December 2006.

talking about becoming any sort of ‘centre’ now because we have become more realistic.”

Guo says that the government has altered its strategy and is now positioning Taiwan more as a fund raising centre, “In recent years, the market has seen excess liquidity which combined with lowered interest rates is good for fund raising.” In line with this strategy, the market saw Deutsche Bank successfully issuing $230m dollar-denominated corporate bonds in October. This marks the first time a foreign bank floated bonds in Taiwan.

Local media reports state that encouraged by the response to Deutsche Bank’s bond issue, several

28

leading foreign banks including HSBC, BNP Paribas, and Société Générale have now approached the FSC expressing their wish to issue bonds in the domestic market as well.

Notably, Taiwan is continuing with its financial reform agenda. In September this year, the government unveiled a new financial reform package. Referred to as a three-year ‘stimulation plan’ for the period 2007-2009, the package consists of eight reform goals aimed at building a diversified, internationalised and strong financial market in Taiwan.

These include issues priority such as priority privatisation of state-owned financial institutions, developing the fixed-income markets and creation of a

vibrant insurance and pension fund market. The FSC is also pushing for increasing the ratio of institutional investors share in trading from the current 27% to 30%, with foreign investors share of trading pushed up two percentage points to 20%. Separately, the regulator aims to encourage up to 250 initial public offerings (IPOs) during the next three years.

While the spirit behind this plan cannot be questioned, there are doubts around its feasibility and industry observers are concerned that the targets will not be met in the stated period.

Allen Wu, senior vice president of International Development at Taiwan’s leading brokerage, Yuanta Securities

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We like to think we’re the world’s leading index provider. And it seems we’re not alone. In both its last two awards, Global Pensions made us its Index Provider of the Year. And in 2005 FTSE was crowned Index Provider of the Year at the Structured Products Magazine Awards, as well as being named Most Innovative Benchmark at the William F Sharpe Indexing Achievement Awards. For more details on our innovative range of indices, global benchmarks and custom calculations please visit www.ftse.com BEIJING +86 10 6515 9265 BOSTON +(1) 888 747 FTSE (3873) FRANKFURT +49 (0) 69 156 85 143 HONG KONG +852 2230 5800 LONDON +44 (0) 20 7866 1810 MADRID +34 91 411 3787 NEW YORK +(1) 888 747 FTSE (3873) PARIS +33(0) 1 53 76 82 88 SAN FRANCISCO +(1) 888 747 FTSE (3873) TOKYO +81 3 3581 2840 FTSE® is a trade mark of the London Stock Exchange Plc and The Financial Times Limited and is used by FTSE International Limited under licence. All rights reserved.

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Regional Review ASIA: TAIWAN SEARCHES FOR A NEW ROLE

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estimated that exports to labels the financial Taiwan Faces up to Hong Kong and Singapore mainland China increased blueprint as highly 3 Year Performance in USD terms 200 by 750% from 2001 to 2005 ambitious, “Although the with direct investments FSC has stated their targets, 175 from Taiwan to China they have not outlined how 150 currently worth $150bn. to reach these targets. That 125 However, adopting a is one of the biggest 100 nationalist agenda, the challenges.”

The Taiwan government government’s track-record 75 continues to maintain in this arena too fails to 50 several restrictions to engender much confidence investment in China such as in its ability to achieve the the 40% investment cap. targets. In 2004, the FTSE Taiwan Index FTSE Hong Kong Index FTSE Singapore Index FTSE Asia Pacific Index Other examples of artificial government had pledged to Source: FTSE Group barriers include Taiwan halve the number of government controlled financial might still prove problematic. The banks not being allowed to have institutions within a year and to cut the main obstacle, suggest industry branches in China and foreign funds number of financial holding companies experts, lies with Taiwan’s relationship marketed in Taiwan not allowed to have by half within two years. Both these with China and the mainland ‘China-holdings’ weighting of more investment cap that has been placed than 10%. targets were missed.

The restrictions have effectively Wu says that most of the present by the government. Because Taipei targets set are tough. The target of listed companies can only invest up to prevented Taiwan from exploiting its getting 250 IPOs in three years, he 40% of their net worth in mainland close proximity to China and truly notes, is going to be extremely China, Taiwanese companies have becoming a gateway to China for and international difficult, if not entirely impossible, to increasingly been opting to list in domestic investors. However, as market achieve. This scepticism is shared by Hong Kong instead.

Guo of UBS says, “Since the 40% participants and industry experts others in the industry. After all, to reach the 250 target by 2009, there ceiling limits the expansion of unanimously agree, given the needs to be over 80 IPOs a year, which business in China, many Taiwan political implications involved, there is nearly double this year’s rate. companies want to list in Hong Kong is no immediate solution to the Moreover, while the FSC plans to take because unlike in Taiwan there are no cross-strait relations issue. In the short term, the only way Taiwan can steps such as simplifying application restrictions for investing in China.”

Given the close cultural and historical ensure a thriving financial industry procedures, lowering the profitability thresholds for listing, streamlining ties between the two countries, is through continued deregulation trading and more aggressive Taiwanese enterprises have strong along with a focus on improving the marketing, achieving the numbers business links with China. It is financial infrastructure.

FOREIGN DIRECT INVESTMENT IN TAIWAN UP BY ALMOST 300%

B

ETWEEN JANUARY AND October 2006, foreign direct investment (FDI) inflows into Taiwan amounted to $11.23bn, up by 290.97% year-on-year, according to the Ministry of Economic Affairs. The ministry also agreed some 1,410 investment projects presented by potential foreign direct investors, coming from China and other countries, up by more than 55% on the same period in 2005. The figures keenly illustrate the success of the government’s efforts to improve Taiwan’s investment regime.

In comparison, outward direct investment did not fare as well. The Investment Commission approved 397 investment projects over the period, worth $2.86bn, down by almost 42% on the same period in 2005. Locally listed companies meanwhile applied to issue securities overseas worth a total of $3.8bn, while the total value of net inbound remittances of foreign capital investments in the Taipei stock exchange reached $14.64bn.

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Presentations From Regulators, Le nders, Agents, Borrowers, & Business Leaders Discussing: N Regulatory Issues N Hedge Fund Development & Opportunities in Asia N Regional Market Developments & Updates The conference will feature many regional pr actioners, specialists and regulators in the securities finance field. If you want to know about securities lending and finance in Asia this is the conference to attend DONâ&#x20AC;&#x2122;T MISS IT!!!

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Regional Review ASIA: THE RISE OF ASIAN HEDGE FUNDS

OTEWORTHY Hong Kong skyline by night.

GROWTH IN Asian Competition between Hong Kong hedge fund activity and Singapore is the most intense, over the last three years is though for the time being, Hong assisted, in part, by the Kong is still winning the race. A slowdown in the US and recent survey undertaken on behalf European hedge fund markets. of the Securities and Futures High growth levels in China, Commission (SFC) in Hong Kong India and Southeast Asia, shows the number of hedge fund together with the resurgence managers rising from 58 to 118 of the Japanese economy after during the last two years, with the a long period of gloom, now number of hedge funds managed in provide consistent Hong Kong rising from 112 to 296, opportunities to secure higher with hedge fund assets under returns in the region. A survey management (AUM) up by 268% by research firm, Greenwich to $33.5bn. Photograph by Marc Associates, finds that Asian Johnson, kindly supplied by markets have outperformed Dreamstime.com, December 2006. the rest of the world in recent head of fund services at years. Moreover, the outlook Citigroup. He thinks that for returns in Asia in 2007 countries where the range from 7.5% in India to personal and corporate tax 11% for Taiwan, with Hong rates are high will continue Kong, China, Singapore and to attract more investments South Korea potentially from hedge funds. Australia, returning anywhere between The Asian hedge funds space has been growing “where the tax rates are over 9% and 10%. at a phenomenal pace. From close to 150 hedge 40%, and Japan, where the According to Eurekahedge, funds at the turn of the century, the number of tax rates are over 30%, are the Singapore-based hedge Asia focused hedge funds increased to around two markets that will see fund research firm, total 800 in 2005, and assets under management high inflow of capital inflow assets in Asia’s hedge fund grew from $14bn in 2002 to around $130bn in in the hedge fund space,”he industry will have grown by 2006. Rekha Menon highlights where the smart says. Established emerging at least 40% in 2006. The money is heading in 2007. markets such as Vietnam, number of Asia-focused hedge funds which grew by 35% in nearly $130bn in 2006. But Asia still China and India will also be of 2004 and 30% in 2005 will have grown represents only a small percentage of particular interest, he adds, although in by at least 25% by the end of 2006. the global $1.3trn hedge fund market. Vietnam, pure country funds and Although the level of growth is down, Therefore there continues to be private equity funds still outstrip hedge Eurekahedge says capital inflows in significant interest in Asia from the US, funds by a wide margin.

One of the drivers of the hedge fund absolute terms remains substantial, Europe and the Middle East.”

“Increasingly, pension funds, business is regulation; or rather the lack with more than $30bn in net assets estimated to have flown into Asian government institutions, insurance of it. According to Brown,“Part of what firms and private banks are investing in makes a hedge fund appealing is that hedge funds during the year. funds.

This increased they are not regulated. Regulation by Colin Lunn, head of business hedge development, Asia-Pacific for HSBC’s institutional investor interest only goes itself does not stop a hedge fund from Alternative Fund Services in Hong to prove that hedge fund growth will having exotic mandates. It only means Kong expects Asia’s hedge fund market continue in Asia, although it remains to that reporting guidelines need to be set to continue growth at a brisk pace.“The be seen if the same pace of growth can in place and followed. Increasingly, in market has doubled over the past two be maintained,” says Matthew Brown, coming months regulation will become years, from $60bn at the end of 2004, to managing director, Asia Pacific and very important.”.

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VYING FOR MARKET LEADERSHIP

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Regional Review ASIA: THE RISE OF ASIAN HEDGE FUNDS

One critical challenge is the dearth of experienced staff. The meteoric growth of the hedge fund market has already created a severe shortage of quality personnel. Moreover, as the hedge fund industry in Asia currently represents only around 10% of the global hedge fund market, to meet its future potential, market participants need to increase capacity. “People with good experience in the hedge fund space are scarce. Shortage of good quality staff can not only impact service levels but growth prospects too and is probably the foremost challenge facing the industry today,”says Brown.

It is also a key consideration behind a move by well-established European and US houses to import expertise while they expand their regional presence. US hedge funds such as Citadel Investment Group, Stark Investments and Elliott Advisors are among the many that have already set up local offices. Industry experts suggest that after years of managing Asian strategies from the US and Europe, hedge funds are finding a local presence operationally much more effective. Nonetheless, while there is a progressive increase in the number of managers working out of Asia, the UK still remains the most preferred location for managers allocating funds to the region, with 25% of the Asia-focused funds managed based there. Eventually though, that dominance will fade.

Eurekahedge estimates that the combined share of US and UK managers has shrunk from 55% two years ago to under 45% now. Singapore and Japan have been the main beneficiaries of the shuffle. As a result, they are beginning to catch up with Hong Kong and Australia, which have so far dominated the region’s hedge fund business, with a combined market share of between 10% to 15% of the total.

Competition between Hong Kong and Singapore is the most intense, though for the time being, Hong Kong is still winning the race. A recent survey undertaken on behalf of the Securities

34

Singapore’s Esplanade. Lifestyle is a major criterion in Singapore’s marketing plan, explains Lunn. A recent Financial Times report noted Hong Kong’s worsening air pollution.

Photograph by Johnny Lye, kindly supplied by Dreamstime.com, December 2006.

and Futures Commission (SFC) in Hong Kong shows the number of hedge fund managers rising from 58 to 118 during the last two years, with the number of hedge funds managed in Hong Kong rising from 112 to 296, with hedge fund assets under management (AUM) up by 268% to $33.5bn during the same period. The survey suggests this trend will continue unabated. It also has official blessing. Martin Wheatley, SFC’s chief executive officer maintains that hedge funds,“aid market efficiency and add liquidity”.

Additionally,“The SFC maintains a close dialogue with both local practitioners and regulators of other major financial markets and has been participating actively in the setting of international hedge fund regulation standards.”

Lunn of HSBC thinks Hong Kong’s proximity to China is a main attraction; particularly as Chinese firms use the market for an overseas listing. In May, Hong Kong staged the world’s biggest initial public offering of recent years with the $9.7bn flotation of Bank of China, the second-biggest lender in the republic.“Hong Kong has good links to China and rest of Asia especially the northern region. The size of the market too plays a key role. Larger players tend to prefer Hong Kong since that is where most other institutions are headquartered,” says Lunn. These benefits he adds will continue to make Hong Kong an attractive location for hedge funds to set up their decision making centres. Singapore on the other hand, he explains is more attractive for start-ups and boutique outfits.

Singapore’s response has been to introduce tax incentives, supporting legislation and a marketing campaign highlighting the city-state’s quality of life. “The regulatory environment can be very accommodating in Singapore.

For instance many hedge funds are domiciled in offshore locations such as the The Cayman Islands to benefit from tax exemptions, though a recent directive allows hedge funds domiciled in Singapore to enjoy [similar] tax exemptions”, says Allard De Jong, Singapore head of HSBC Alternative Fund Services.

Lifestyle is a major criterion in Singapore’s marketing plan, explains Lunn. A recent Financial Times report noted Hong Kong’s worsening air pollution. The extent of the problem is highlighted by Anthony Hedley, an environmental and public health expert at the University of Hong Kong, who claims the city’s air pollution claims at least 1,600 lives every year in a recent study. It is beginning to have an effect. Reportedly, US hedge funds such as Stark Investments and Concordia Advisors are moving their Asian operations to Singapore, largely because of lifestyle factors.

Brown of Citigroup, who is based out of Hong Kong, is sanguine. He says that with the enormous growth potential in Asia, both Singapore and Hong Kong will continue to see growth in the coming years. “Both have their own geographical advantages and offer tax benefits. Plus there is sufficient scale across both regions to grow.”

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Regional Review WESTERN EUROPE: THE APPEAL OF GREEK BANKING

The minute that Crédit Agricole bought Emporiki Bank in a government sell-off, talk of other foreign suitors reverberated in the hallowed halls of Greece’s banks. Although consolidation will not happen overnight, analysts think it is only a matter of time, as the market is looking increasingly overcrowded.

But in a counterpoint, Greek banks are seemingly adept at finding good expansion and acquisition opportunities overseas. Which trend will win out? Lynn Strongin Dodds reports from Athens.

Greek banks face the sweep of history The Acropolis by night. Views remain mixed though to the possible reaction if an outsider makes a play for National Bank of Greece (NBG), the country’s largest financial institution. Sophia Skourti, analyst at HSBC in Athens, thinks NBG’s wide geographical reach may spur interest from a foreign buyer. However, there are no major shareholders and about 20% of NBG’s share capital is held by state owned funds, which includes employee unions who may be reluctant to sell their stake. Even so, Papadakis believes,“There has been … a sea change … In the 1970s, it would have been unthinkable for a foreign company to come into Greece and take over one of the country’s main banks [and] in the last few years, the country has been much more open to outside companies coming in.” Photograph

by Alfio Ferito and supplied by Dreamstime.com, December 2006.

oannis Papadakis, senior economic adviser at Emporiki Bank, Greece’s fifth largest bank thinks: “Consolidation is on the cards, but I am not sure what shape it will take, nor when it will take place. It could be in the form of a friendly takeover, an exchange of shares between two banks or a foreigner coming in and making a bid. I would not be surprised to see a combination of all three scenarios [sic].” Meantime, Fokion Karavias, general manager- global markets at Eurobank EFG, the third largest bank, does not believe that Greek banks will emerge unscathed from the wider cross-order movements sweeping across the

I

region. “Consolidation is a European phenomenon and we cannot expect to be excluded from this trend.

However, I cannot predict how things will develop. [We may] see mergers between Greek banks, or foreigners coming into the market either as buyers or joining the management team of a bank,”he says.

Mergers are nothing new in the Greek banking sector. In the past couple of months, Cyprus’s Laiki Group cemented its foothold in the country with the acquisition of two smaller banks, Marfin and Egnatia, for about €2.4bn. In 2004, French bank, Société Générale acquired Geniki Bank in a privatisation related sell off. Moreover,

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007

Portugal’s Millennium BCP now owns Novabank, and ING has ING Hellas, an insurance subsidiary. Consolidation too is a feature. Six years ago the Piraeus Group, the fourth largest bank, emerged from the combination of three commercial banks – Piraeus Bank, Xiosbank and Macedonia-Thrace Bank, while in 1990 Eurobank joined forces with Crete Bank, Interbank and Ergobank. The bank is part of EFG Group, a Geneva-based banking group controlled by the Latsis family.

Crédit Agricole’s €3.3bn purchase of Emporiki set tongues wagging because of its size. It is the largest foreign takeover of a Greek company and the French bank’s largest purchase since it

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Regional Review WESTERN EUROPE: THE APPEAL OF GREEK BANKING

6

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bought rival Credit Lyonnais in 2002. Phaedon Tamvakakis, managing make redundancies difficult). The Even so, observers were surprised that director of Alpha Trust, an Athens based political environment was also Crédit Agricole was the only real investment advisory services group, accommodating. Paul Mylonas, chief contender. Emporiki may have needed agrees, “The days of the national economist and chief of strategy at a major face lift, but analysts expected champion are over. Now, though, all the NBG notes, “Since the entry into the more of a contest, particularly from banks are doing well and I am not sure Euro, Greece is at a level of peace and domestic banks. Actually, the only which one will break first. The market prosperity not experienced since the significant rival was Bank of Cyprus will dictate [events] and then I think we end of the dictatorship in 1974.”

In 2005, banks’ earnings per share which suddenly withdrew its offer will start to see some activity.”

Greece’s banking boom was (EPS) rose 30% on the back of an 18% reportedly over concerns about Emporiki’s unfunded pension liabilities triggered when the country joined the rise in 2004. While earnings growth is in 2001.

Michael set to slow this year, EPS is still set to (estimated at €1.2bn), even though the Eurozone Greek government provided Massourakis, senior manager of Alpha increase by about 20%. The question is: explains, “The system how long can the credit party last, assurances that the pensions issue Bank, experienced rapid credit expansion of especially as activity is beginning to would be resolved by new legislation.

Some say the government favoured over 30% to 40% since we entered the abate and spreads tighten? In the past Crédit Agricole’s bid because of its Euro five years ago. Almost overnight five years, household credit has jumped international clout and experience. interest rates fell from double digit to to an average of 38% of GDP from 18% Others say the French bank was a single digit rates. This coincided with in 2001 (still below the Euro zone’s 56% known entity in the country, having strong economic improvement, average). Analysts think that credit to cut its teeth in the market five years followed by full liberalisation of the Greek households will slow to 20% in ago when it took a 9% chunk of consumer credit market in 2003. These 2006 and slip to 15% in 2007. As Emporiki and set up joint ventures forces together were a real impetus to Tamvakakis notes,“We are beginning to see shrinking spreads and more with the domestic bank in insurance the retail banking market.”

The banks were in prime position to competition in both the consumer and and consumer finance.

Views remain mixed though to the capture the public’s new found mortgage lending arena. I think the true possible reaction if an outsider makes a enthusiasm for mortgages and cost cutting is mostly done and what we play for National Bank of Greece consumer credit. They had already are now seeing is banks moving into their operations. new product areas, higher margin (NBG), the country’s largest financial reorganised institution. Sophia Skourti, analyst at Overhead costs were cut, liquidity consumer lending and strengthening HSBC in Athens, thinks NBG’s wide positions improved plus much needed their positions in South-East Europe.” geographical reach may spur interest investment was injected into both IT Between March 2005 and March 2006 from a foreign buyer. However, there are and risk management systems. All the spreads between deposit rates and no major shareholders and about 20% banks stress however that layoffs were mortgages narrowed by 15 to 48 basis of NBG’s share capital is held by state voluntary (Greece’s rigid labour laws points to between 1.80% and 2.35%, according to research owned funds, which calculated based on data includes employee unions Why everyone loves Greek banks from Eurobank EFG, Alpha who may be reluctant to sell 300 and Piraeus. their stake.

Even so, 250 Although the major Papadakis believes, “There 200 players – NBG, Alpha, has been … a sea change …

Eurobank EFG, Piraeus In the 1970s, it would have 150 and Emporiki – have a been unthinkable for a 100 seeming lock on the foreign company to come 50 market with a 75% to 80% into Greece and take over 0 share – they are not one of the country’s main complacent and have banks [and] in the last few already set the wheels in years, the country has been National Bank of Greece Alpha Bank EFG Eurobank motion to counteract the much more open to outside Bank of Piraeus Emporiki Bank of Greece slowdown in consumer companies coming in.”

Source: FTSE Group

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lending. Moreover, while each player is forging its own path, they all seem to be heading down the same road.

For example, asset management, brokerage and insurance are on the priority list as is increasing lending to small and medium sized enterprises (SMEs). Last, but certainly not least is the expansion of their already burgeoning south-eastern European networks.

The region has become an increasingly important part in the Greek banks’ growth proposition.

Banks initially gained a foothold to service their corporate clients but they quickly realised that there were retail banking opportunities to unearth.

These countries have both low levels of consumer banking penetration and household indebtedness below 10% of GDP. Moreover, Bulgaria and Romania are slated to join the EU and their neighbours hope to follow in their footsteps over the next ten to 15 years. According to Skourti, “NBG is the strongest regional force following its recent acquisitions but the bank also has the highest risk profile.

Eurobank has the second largest network in the region and an evenly spread presence between the countries, while Alpha in general is more conservative than the others in its expansion policy. Overall, Greek banks are estimated to have a sizeable 17.5% market share in lending in the combined region encompassing Romania, Serbia, Bulgaria, Albania, Macedonia and Cyprus. The goal has been to reproduce their business models and develop products and services as the markets mature. They are also hoping to cross sell products once the markets develop and mature.

Massourakis says, “We believe that in 30 years time, it will have the same per capita growth that Greece has while Greece will catch up to the rest of Western Europe in 10 to 15 years

time.” Alpha Bank has steadily expanded in the Balkans – Bulgaria, Romania, Macedonia, Serbia and Albania -- buying banks and setting up branches to secure new areas of growth before expansion at home peaks. The aim is to quintuple the number of branches to 260 by 2008 and achieve an average of 10% market share in the region. International operations should rise to 20% from about 9% of overall pre-tax earnings.

“We are following an organic growth strategy although we are looking to buy small banks in Turkey and the Ukraine. These markets aren’t core to our operations right now but if an opportunity arose then we would look at it” he adds. “We are a conservative institution. We like to start with a small presence and then build from there. We do not want to bet the capital of the bank.”

At home, Alpha is bolstering its asset management and private wealth operations to capture funds of the escalating upper middle income classes. It is also hoping to cross sell products through its recently forged partnership with AXA on the insurance side. “We have signed a long-term exclusive partnership agreement with AXA and I believe, that once it is fully functional, we will be able to cross sell a lot more products through our network,” says Massourakis. Eurobank EFG, on the other hand, is moving at a more aggressive pace in the South-East European region. Earlier this year it added Turkey’s Tekfenbank, Bulgaria’s DZI Bank and Ukraine’s Universal Bank to its stable. The bank already has a presence in Romania and has recently moved into Poland, although it is also on the lookout for an acquisition. Karavias explains, “It is natural for Greeks to export experience to these countries which are still under banked.” The one

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007

Birds flock to the main building, Athens University. Papadakis of Emporiki points out, “I would not be surprised if foreign banks wait for the Greek banks to build their networks and consolidate their positions in the region.

At the moment, the banks in these countries are looking expensive to buy individually but it may be more affordable in the future for an overseas bank to gain access by buying a Greek bank which has a sizeable presence.”

Photograph by Michael Pates and supplied by Dreamstime.com, December 2006.

country it has decided to step back from for now is Egypt. Perhaps for geopolitical reasons, Eurobank EFG recently pulled out of the bidding process for the Bank of Alexandria, which was recently sold to Italy’s Sanpaolo IMI. Karavias explains, “It does not mean that we will not look at the market in the future.”

In Greece, Eurobank EFG is also targeting asset management and the SME market, which it defines as companies with turnover between €2.5m and €25m, where it sees “significant growth opportunities,” according to Karavias. “Asset management, for example, is underdeveloped in the country on both the retail and institutional side.

We have the products in place to service the market. We are stepping up our marketing and sales efforts to educate the customer base about our products,”he notes.

NBG has a domestic market share of between 25% and 35% and has been busy building its international operations. Mylonas notes, “We now have young, dynamic democracies on our doorstep plus relations with Turkey have improved. We have a strong footprint in the region in five countries – Romania, Bulgaria, Serbia,

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Regional Review WESTERN EUROPE: THE APPEAL OF GREEK BANKING

Macedonia and Albania. Also we plan to open 60 branches in the region to reach 300 by end year.”

In April, it completed a $2.8bn acquisition of a 45% chunk of Finansbank, Turkey’s eighth largest bank. It intends to by the rest at the same price in the future. It was NBG’s largest foray abroad and is the biggest foreign takeover by a Greek company.

At the time, it was also seen as a boon to Greek and Turkish relations and analysts believed it might unleash a long-awaited wave of Greek investment in Turkey. Praise for the deal, however, quickly turned to criticism when the stock markets crashed unexpectedly in May. Emerging markets were particularly hard hit and all of a sudden, Finansbank’s price tag, at 3.6 times book value, looked expensive. NBG’s share price plummeted and the rights issue to finance the deal, had to be priced at a 31% discount to NBG’s market price on June 2nd, due to market sentiment.

Mylonas defends the price, saying, “Finansbank … is in good financial shape. We liked Finansbank because it was the first or second overall best run bank in its product areas. It also has a return on equity of 30% and from a valuation model standpoint, was worth more than we paid. Our target is to expand the network to 300 by the end of 2006 from its current 275 and hopefully go to 500 to 550 by the end of 2009.” Skourti of HSBC adds, “The timing was not favourable and the deal was definitely expensive but we are quite comfortable with the quality of the assets.”

As for Emporiki, one of its main attractions to Crédit Agricole is its strong regional network in South-East Europe, according to Frederic de Leusse, acting chairman of Emporiki and director of international operations at Crédit Agricole SA. “We decided at

38

Paul Mylonas, chief economist and chief of strategy at National Bank of Greece notes, “Since the entry into the Euro, Greece is at a level of peace and prosperity not experienced since the end of the dictatorship in 1974.”

Photograph kindly supplied by National Bank of Greece, December 2006.

Fokion Karavias, general manager- global markets at Eurobank EFG, the third largest bank, does not believe that Greek banks will emerge unscathed from the wider cross-order movements sweeping across the region.

“Consolidation is a European phenomenon and we cannot expect to be excluded from this trend.

However, I cannot predict how things will develop. [We may] see mergers between Greek banks, or foreigners coming into the market either as buyers or joining the management team of a bank,”he says. Photograph kindly supplied by Eurobank EFG, December 2006.

the end of last year to develop our international retail banking in the Euro zone in order to cross sell our products in different countries. We had a strategic partnership with Emporiki and at the time of privatisation, we decided to make an offer to be the main shareholder.”

Emporiki recently appointed Anthony Crontiras as its new chief executive, while Christian Jacques, acting chief executive since August became deputy CEO. The French bank is expected to make provisions of around €400m to cover nonperforming loans, possible unfunded pension liabilities, and accumulated losses at Emporiki’s insurance subsidiary. A restructuring is set to involve a voluntary redundancy programme for about 500 people. An official game plan is due next year but the first priority will be to transform the state owned bank with its public sector culture into a more dynamic, service oriented operation. To this end, the bank is set to hire 250 people to hone its customer services edge.

“There is a huge potential in [Greece] and we can generate more business if we become more customer focused.

The goal is to sell products through Emporiki’s branch network in Greece and South-East Europe … [and] further develop the business in Romania, Bulgaria, Albania and Cyprus,”says de Leusse.

Other banks may take heed. As Papadakis of Emporiki points out, “I would not be surprised if foreign banks wait for the Greek banks to build their networks and consolidate their positions in the region. At the moment, the banks in these countries are looking expensive to buy individually but it may be more affordable in the future for an overseas bank to gain access by buying a Greek bank which has a sizeable presence.”

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The market for European covered bonds goes from strength to strength. The overall level of issuance in 2006 was up by almost 15% on the previous year’s total of €150bn before the end of November, as investors were able to buy a wider range of products — in both geographical and structural terms — than ever before. Andrew Cavenagh reports.

HE PAST 12 months saw the emergence of significant new issuers in Europe’s covered bond market, including HSBC in the UK, BNP Paribas in France, Caixa Geral de Depositos in Spain and – perhaps most importantly – the third largest US mortgage lender, Washington Mutual. Nordea Hypotek also issued a ground-breaking bond under the recently enacted Swedish legislation for these instruments.

These first-time entrants brought innovative structures to the market, and the investor base for European covered bonds continued to enlarge with the regional scope of the issuers.This trend seems certain to continue this year [2007], as the governments of Portugal, Italy and the Netherlands either passed — or prepared to pass — further legislation in 2006 to boost the issue of covered bonds. The European Commission’s focus on funding as part of its exercise to integrate the European Union’s mortgage markets should also help to attract more countries to the covered bond market in 2007. “I think most of Europe will end up there,” says Dominic Swan, managing director at HSBC in London, who heads the bank’s covered bond programme.“The logic of the product is very strong.”

The most spectacular rates of growth in Europe’s covered bond markets 2006 were, predictably, in the more recent jurisdictions, such as the UK and Ireland. The €2bn third issue out of the Nationwide Building Society’s €14bn

T

LET THE GOOD TIMES ROLL programme in December, for example, took total UK issuance for the year to over €17bn — a 70% hike on the previous year’s figure — and virtually half this total came in the final quarter of the year.“I think that acceptance of the UK covered bond has increased significantly over recent months,” observes Derry Hubbard, head of covered bond execution and marketing at BNP Paribas in London.

Meanwhile, the burgeoning Spanish market, whose issuance levels exceeded those of the much longerestablished German jumbo pfandbrief market for the first time in 2005, continued to crack on at a brisk pace. By the end of November, the €66bn total was well past the €59bn recorded in 2005. A further €1.2bn issue is expected before the year end from the largest issuer in the country (and

The most spectacular rates of growth in Europe’s covered bond markets 2006 were, predictably, in the more recent jurisdictions, such as the UK and Ireland.The €2bn third issue out of the Nationwide Building Society’s €14bn programme in December, for example, took total UK issuance for the year to over €17bn—a 70% hike on the previous year’s figure — and virtually half this total came in the final quarter of the year.“I think that acceptance of the UK covered bond has increased significantly over recent months,”observes Derry Hubbard, head of covered bond execution and marketing at BNP Paribas in London.

Photograph kindly supplied by Istockphotos.com, December 2006.

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Europe), the AyT Cedulas vehicle that pools the mortgages of a wide range of smaller Spanish savings banks.

Despite the general upsurge in activity, however, the European Covered Bond Council (ECBC) reports that the total volume of outstanding issuance was marginally down in mid-2006, the latest period for which it has provisional figures. Outstanding issuance totalled €1.77bn, against the €1.807bn issued in the same period of the year before.

Cristina Costa, senior adviser to the ECBC, says that in part this might be down to a higher rate of covered-bond redemptions in 2006. It also certainly reflects that by far the jumbo pfandbriefe market — the largest market for covered bonds in terms of overall outstanding issues by far — was the only one to see levels of issuance decline over the year.

The latest available statistics from the Association of German Pfandbrief Banks (VDP), covering the period from January to August, recorded a 5.5% drop in overall pfandbrief issuance on the comparable period of 2005.

However, more recent figures from leading banks suggest there has been a steeper decline in the jumbo market.

Torsten Elling, the head of covered bond syndication at Barclays Capital in Frankfurt, says the bank’s running total shows that by the end of November jumbo pfandbrief issues in 2006 had had only reached €39.1bn against a total of €48bn for the whole of the previous year.

This probably reflects a trend towards more private placements in Germany, as a growing number of domestic insurance companies and fund managers are looking for smaller, often tailor-made, issues that offer them more flexibility in managing their balance sheets under German accounting rules. “They often have special interests concerning maturities and structures,” explains Holger Dohra, head of business/relations management on the treasury side of DG Hypothekenbank. He says these types of investor frequently seek foreign-currency bonds in smaller denominations and shorter maturities than a public issue could readily accommodate.

The dip in the jumbo pfandbrief market should reverse, however, once the full impact of the Pfandbrief Law and other changes to banking legislation in 2005 comes through.

The law, which unified the previous separate legislation covering the three types of pfandbrief – backed by publicsector loans, residential mortgages and shipping loans respectively – broadened the franchise of banks that could issue the hypotheken instruments beyond the specialist mortgage banks, with the clear intent of expanding the market. “Based on a higher degree of transparency and diversification of the asset pool, the Pfandbrief was to be made even more widely available,” says Jochen ArtzingerBolter, partner at law firm White & Case in Frankfurt.

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Aareal Bank · AHBR · Bayerische Landesbank · Berlin Hyp · Deutsche Hypo · Deutsche Schiffsbank · Dexia Kommunalbank · DG HYP · Düsseldorfer Hypothekenbank · Essen Hyp · Eurohypo · Hamburger Sparkasse · HSH Nordbank · Hypo Real Estate Bank · Hypo Real Estate Bank International · Hypo Real Estate Holding · HypoVereinsbank · Karstadt Hypothekenbank · Kreissparkasse Köln · Landesbank Baden-Württemberg · Landesbank Hessen-Thüringen · Münchener Hyp · SEB · Sparkasse KölnBonn · U n i C r e d i t o · Wa r b u r g H y p · We s t d e u t s c h e I m m o b i l i e n B a n k · We s t L B · W L - B A N K · W ü s t e n r o t B a n k

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interest-rate “optionality” – such While it has taken time for as annual and monthly caps on prospective new issuers to set interest-rate increases – meant up the necessary compliance they were not so “friendly” for and monitoring systems, a net covered bonds. “The impact of increase in their numbers that makes structuring the should start to filter through covered bond harder,” he over the next 12-18 months. continues.“The whole process is There should also be a surge in just that much more difficult and issuance from the state painful. I don’t see the US issuers landesbanks. Pfandbriefe are financing anything like as much likely to offer the most through covered bonds as the economic source of funding UK issuers do.” now that their straightforward Another rather intriguing balance-sheet borrowing no development in November saw longer benefits from state BNP Paribas announce the first guarantees — but only once Holger Dohra, head of business/relations management on the issue out of a new €25bn they have exhausted the funds treasury side of DG Hypothekenbank explains that investors, programme. The programme they secured on that “often have special interests concerning maturities and is based on contractual guaranteed basis. structures,”explains. He says these types of investor frequently undertakings rather than the Elsewhere, there were some seek foreign-currency bonds in smaller denominations and well-established obligations remarkable innovations. The shorter maturities than a public issue could readily foncieres legal framework for one that grabbed most of the accommodate. Photograph kindly supplied by DG covered bonds in France. headlines was undoubtedly the Hypothekenbank, December 2006.

The reason BNP Paribas opted €4bn of structured bonds that Washington Mutual launched — out of a planned €20bn for a structured programme was down to the composition of programme — at the end of September. The two €2bn issues its mortgage book. About half the bank’s residential loans in were the first euro-denominated covered bonds to be issued France are credit lodgement home loans, where repayments by a US institution and as such were arguably the clearest are secured by a guarantee from a financial institution rather evidence yet that this type of European debt security has than a mortgage over the property. The obligation fonciere now achieved truly global appeal. “Nobody had thought law allows such loans to account for no more than 20% of the about the possible interest of US issuers in the covered bond bonds’ collateral. “We want to include about 50% of these product,” says Elling at Barclays Capital, the deal’s sole credit lodgement home loans in our covered bond pool — arranger and co-distributor along with ABN AMRO and that is why we went down this kind of semi-structured route,” explains Hubbard. The programme will give BNP Deutsche Bank.

These two inaugural issues were massively Paribas a more flexible means of refinancing its French oversubscribed. Within hours the lead managers had built mortgage and residential loan portfolio - and also in future up an order book for €16bn, which persuaded Washington the residential mortgage loans that it originates overseas.

Hubbard adds that while the French legal framework for Mutual to increase the size of each issue by 25% from the €1.5bn originally envisaged, and the extent of investor covered bonds set a small limit on the number of such loans, interest clearly re-affirmed the originator’s commitment to they represented a solid security - the guarantees committed further issues. “The demand we saw in this issuance was the insuring party to pay off all interest and principal owing outstanding,” says Robert Williams, senior vice-president if three monthly repayments were missed. Loan-to-value and treasurer of Washington Mutual. “The covered bond (LTV) ratios in the BNP Paribas mortgage book are also market represents a key diversification tool for us in the conservative. The preliminary cover pool analysed by the rating agencies – which was chosen to be representative of context of our overall funding strategy.”

The issue’s success seems certain to persuade other US the overall book – had a weighted average LTV ratio of mortgage companies to follow Washington Mutual’s example 78.9% and a current one of just 56.7%. (The lower the LTV, over the next 12 months.”There are going to be a few, for the greater the equity that the borrower has a stake and so is sure,” says Hubbard at BNP Paribas. “I would expect to see less likely to default.)

Hubbard makes the further point that while the between two and four more issuers in 2007 – and fairly significant issuance volumes.” Some bankers nevertheless programme offers BNP Paribas more flexibility on the advise a measure of caution about the degree of such US underlying collateral than the obligation fonciere regime, it involvement in the market. They believe the underlying remains subject to greater legal and regulatory control than product is not so well suited as a typical European mortgage typical structured bond programmes, such as those in the to the key requirements of the instruments. Swan at HSBC UK.“It is a structure that in a way uses many legal features says that the large number of US mortgages where borrowers and is still regulated by the Bank of France.”

While some issuers and investors think that the obligation had the ability to repay fixed-rate loans at par and other

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© Keima – Photo credit: X

fonciere regime has not perhaps been as responsive as it excess spread to each individual subsidiary. So the subsidiaries could be to the rapid expansion of the overall European sell their loans to a securitisation vehicle (Fonds Commun de market for covered bonds, it nevertheless grew significantly Créances), which on-sells the triple-A RMBS notes to CIF in 2006. The market returned an outturn issuance volume Euromortgage to use as the collateral for its covered bonds. worth €16bn, against €10bn in 2005 according to the The subsidiaries then repurchase their subordinated notes from the FCC.“They keep the risk of their customers, and we Barclays’ figures.

Obligation fonciere issuers meanwhile finalised a return the excess spreads – less the cost of funding and the national market-making agreement with 23 big cost of the risk,”Marcel explains.“It is very clear that we save international banks — the last one signed up in June — at least 10 to 15 basis points (bps) compared with corporate making France the first country in Europe to boast such an funding.”Other noteworthy innovations across the European accord. The market is also looking to expand its investor market in 2006 included the HSBC €15bn covered bond base by targeting Asian buyers. The two largest issuers, programme, which will share a single pool of more than Compagnie de Financement Fonciere (CFF) and Dexia, 286,000 residential mortgage loans with the bank’s RMBS have already denominated small parts of recent issues in US and Australian dollars to this end, and the third-ranking CIF Euromortgage may soon Acknowledgement follow suit.“It is not impossible of excellence... that next year we will study issuing in dollars, but presently our priority is to remain loyal to issuing euro benchmark regularly – our issues are largely oversubscribed and our secondary market is performing,” confirms Alain Marcel, head of investor relations at CIF. The demand for new housing in France market should boost the market further over the next five years – with a projected requirement of 400,000 new homes a year – as covered bonds are likely to offer lenders the most economic cost of funding. Credit Immobilier de France, CIF Euromortgage’s OBLIGATIONS FONCIÈRES parent, is using a combination Covered bonds of covered bonds and the group’s internal residential CIF Euromortgage obligations foncières offer investors a mortgage-backed securitisation highly AAA rated investment.

(RMBS) to provide the lowest Governed by the French legal framework,“obligations possible cost of funding for the foncières“ are almost certainly one of the safest investment choices group’s 18 specialised combining quality and liquidity. mortgage-lending subsidiaries.

The subsidiaries vary in size Liquidity Market making and benchmark issues but none are large enough to Quality AAA rated pool of top class assets access the capital markets Security Maximum transparency and low risk individually, and the direct sale of their loans to the obligation fonciere issuing vehicle was not ® a realistic option because it Groupe CIF® would have been be too difficult to re-allocate the defaults and w w w. c i f e u r o m o r t g a g e . c o m

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Torsten Elling, the head of covered bond syndication at Barclays Capital in Frankfurt, says the bank’s running total shows that by the end of November jumbo pfandbrief issues in 2006 had had only reached €39.1bn against a total of €48bn for the whole of the previous year.

Photograph kindly supplied by Barclays Capital, December 2006.

programme, and the multi-cedulas progamme that AyT set up in Spain with two levels of guarantee.

As the diversity of covered bonds continues to grow, however, some bankers are starting to ask questions about what the differences in the structure and collateral of the respective instruments really means in terms of risk.

Spanish mortgage bonds, cedulas hipotecarias, which are backed by the entire portfolios of the issuing institutions rather than cherry-picked assets that meet conservative criteria on LTVs, have historically attracted a small premium for this reason. They continue to do so as supply of the bonds remains abundant and fears grow that the Spanish property market is in danger of overheating.

So while DG Hypothekenbank’s latest 10-year pfandbrief issue in November came in at two basis points under mid-swaps, the most recent equivalent cedulas priced at 5bps over, while a comparable Portuguese issue — which might have been expected to pay a relative premium for a new jurisdiction — achieved a 4bp margin over the swap benchmark “You tend to have this discussion about the collateral in Spanish cedulas hipotecarias,” commented one banker familiar with the market.

Others argue that the concerns are overblown, given the massive over-collateralisation that this characteristic of Spanish mortgage bonds affords investors. A level of 200% or more is common and for an institution’s initial issue it has exceeded 2,000%. However, this source of security will inevitably diminish over time as the big Spanish banks and AyT increase their volumes of outstanding bonds. There is certainly no evidence from the level of spreads on new issues – which continue to compress across most jurisdictions in the current low-yield environment – that investors are

starting to discriminate more between bonds on the basis of their structure or collateral.

Fitch Ratings recently drew attention to the different characteristics of covered bonds in eight European countries and compared the way in which the different types of bond were able to achieve the same high (mostly triple-A) credit ratings. The agency’s report compared the covered bonds of 38 financial institutions, backed by 51 cover pools with a total value of €1.19bn.

One issue that Fitch has highlighted, for instance, was the way in which different jurisdictions addressed the problem of interest rate and currency mismatches between the underlying cover pools and the bonds. The bond in all the “structured” jurisdictions hedge this risk fully through swap agreements, as do the French and Irish issuers, but the others rely primarily on over-collateralisation to absorb this risk. Jan Seeman, the Fitch analyst who co-authored the report, says there were also differences of note in the underlying assets, but he maintained these should not be that significant a concern for investors in bonds that had secured the highest possible rating.“At the end of the day, if covered bonds are triple-A rated that means the identified risk has been sufficiently mitigated - for instance through overcollateralisation,” says Seeman. “Furthermore, triple-A rated covered bonds have to withstand very stressful scenarios.”

When the Basel II capital accords reduce the current differential in risk weighting between the UK structured bonds (20%) and those covered by legislative frameworks (10%), the bank investors that account for 30-40% of the market will probably become even less discriminating on this basis. The Financial Service Authority’s recent announcement that it would re-consider the riskweighting of UK covered bonds in 2007 produced an almost instant compression in their spreads.

One issue that might become more relevant, however, is the difference in how isolated the ratings of bonds are from those of their issuers in the various jurisdictions. Swan at HSBC says there was already a clear distinction on this score between UK and German bonds. “A lot of issuers in the UK could be downgraded between three and six notches without there being any rating impact on their covered bonds,”he insisted.

That this would not be the case with most pfandbrief issuers was evident last year, when for the first time one of them Allgemeine Hypothekenbank Rheinboden – was facing the real threat of insolvency.The relief when Lone Star stepped in to acquire AHBR was palpable, as many pfandbrief issuers and their advisers clearly feared there would be a negative impact on both AHBR’s bonds and the wider market.

“For the first time in history the ring-fencing was going to be tested,”said Artzinger-Bolten at White & Case.“While I wasn’t worried about it, I think it was nevertheless good for the covered bond market generally that it did not have to be tested.” Hubbard at BNP Paribas agrees that the degree of insulation between the risk of covered bonds and risk of their issuers would become a more important consideration for investors in future.“That is something that the market is going to be more and more sensitised to going forward.”

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up the

heat

Hedge fund Amaranth Advisors famously lost $6bn in a week trading natural gas last September. That figure dwarfs the $3.5bn loss racked up by Long Term Capital Management when it went bust in 1998, but at least Amaranth was able to meet its obligations before it went out of business. The debacle highlights the extraordinary volatility of natural gas prices in North America, a market that has historically been self-sufficient and remains isolated from the global trade in liquefied natural gas (LNG). Neil O’Hara reports.

INELY BALANCED DOMESTIC supply and demand combined with shifts in consumption patterns could drive volatility in the trading of natural gas even higher.

Amaranth’s trades might have worked out if it had been able to hold on. In mid-November 2006, gas prices were $1 higher than in late August when a sudden drop triggered the hedge fund’s demise. However, a market as volatile as natural gas gives no quarter to overextended traders.

Throughout the late 1980s and 1990s, North America had excess natural gas supplies that kept a lid on prices and volatility. When consumers turned up the heat in winter, the industry drew gas from storage, of course, but output from the wellhead also rose to meet incremental demand, according to Britt Dearman, manager of special projects at Apache Corporation, a leading independent producer. The gas bubble vanished in 2000, however, and the industry has been running flat out ever since. As a result, the market now depends primarily on natural gas storage to meet seasonal swings. “We have not seen much increase in storage capacity so it is putting more stress on that network to satisfy demand,”says Dearman.

Meanwhile, production from traditional high flow rate wells in shallow Gulf of Mexico water is declining by about 10% per year. New drilling activity in the Gulf has migrated to deep water wells that often produce more oil than gas.

F

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007

Although these wells deliver good flows, it can take five years or more to bring them on stream.“You have to build the infrastructure,” Dearman says, “The pipelines are not there. It costs a lot more to install the platforms and the wells are riskier.” In shallow Gulf water, by contrast, producers can easily hook up new wells to an extensive pipeline system built up over the past fifty years.

The industry has offset declines from traditional wells by tapping unconventional sources – tight sands, gas shale and coal bed methane – which by some estimates now account for 40% of supply in the 48 contiguous states.

Tight sands formations have low porosity and permeability; wells must be close together and require expensive fracturing techniques to release the gas. Shale requires similar treatment. Tight sands and shale gas wells also suffer from hyperbolic decline curves: a sharp drop from the initial production rate in the first year or two followed by a long lived tail of slowly falling production that may last for decades.

Coal bed methane wells have a different production profile. Water pressure in the coal seam keeps the gas in place, so producers drill a pattern of wells close enough to have an interconnected pressure gradient. At first, the wells deliver plenty of water and a little gas. As the pressure falls, more gas escapes from the coal; production rises to a peak about two years after it starts and then tails off over many years. All three unconventional gas sources require more wells – and therefore higher costs – per million cubic feet (mcf) produced. Even though average production has declined, US drilling activity has almost doubled since 2002.

Imports supply about 15.4% of US natural gas, mostly via pipeline from Canada, according to the Energy Information Association (EIA), while LNG shipments account for just 2.4%. Plans to build additional LNG terminals around the country have encountered fierce opposition from local residents worried about the possibility of a catastrophic explosion in a populated area.

VOLATILITY IN NATURAL GAS TRADING

Turning

A mild winter could put the industry in a bind. Dove estimates that unconventional gas sources become uneconomic below about $6/mcf. If slack demand leaves too much gas in storage the price will drop below that level and drilling will stop.“Unconventional gas is being exploited because prices have been relatively high over the last few years,”Dove says,“You need a relatively high price for companies to invest.”Photograph by Alfredo Ferlito, supplied by Dreamstime.com, December 2006.

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summer months while utilities draw Offshore terminals draw fire from gas out through the winter peak. fishermen who will lose access to Last summer, though, a heat wave fertile fishing grounds, too. As a result, caused a spike in electricity demand although LNG imports will eventually that curtailed injections. “We had play a more significant role in US gas record low injections at a time when supplies, that day is still some way off. you are normally injecting a lot of On the demand side, stable gas into storage because demand is consumption overall in recent years not there,” says Timothy Dove, disguises significant changes among president and chief operating officer the principal users. In residential and of Pioneer Natural Resources, an commercial heating, demand is flat Roger Cooper, executive vice president for policy and independent producer. because improvements in building planning at the American Gas Association, notes Despite the injection blip, and appliance efficiency have offset that residential and commercial customers have storage facilities are bursting at the growth in the number of customers. used 1% less gas each year for the last 25 years – a seams going into the 2006/2007 Roger Cooper, executive vice remarkable success for energy conservation that has heating season. Dove attributes president for policy and planning at driven per capita consumption down 25%. the anomaly to an increase in the American Gas Association, Photograph kindly supplied by the American Gas supply, particularly from the notes that residential and Association, December 2006.

Barnett Shale near Fort Worth, commercial customers have used Texas. The industry desperately 1% less gas each year for the last 25 needs a cold winter to bring years — a remarkable success for inventories back in line – and it energy conservation that has driven caught a break in late October per capita consumption down 25%. when a cold snap prompted Industrial demand for natural gas withdrawals from storage at the reached a peak in 1998/99 but has earliest date ever. With so much declined since then. Electricity riding on the weather, price generation has taken up the slack — forecasts are all over the map, from most plants built since the midas low as $6/mcf up to $10/mcf.

1990s are gas-fired — but the switch A mild winter could put the is contributing to price volatility.“An industry in a bind. Dove estimates industrial customer can switch to oil that unconventional gas sources or shut down a facility,” Cooper become uneconomic below about says,“You are substituting an electric $6/mcf. If slack demand leaves too generator that may not be inclined much gas in storage the price will or able to do so.” drop below that level and drilling Meanwhile, today’s industrial Donald Santa, president of the Interstate Natural will stop. “Unconventional gas is customers have become more Gas Association of America,“With storage being being exploited because prices have dependent on gas. A 2003 National very full some of the Rockies prices are significantly been relatively high over the last Petroleum Council study found that below Henry Hub.” Pipeline constraints can affect few years,” Dove says, “You need a only 10% of industrial boilers could the price at point of delivery, too. For example, when relatively high price for companies switch fuels, down from an estimated temperatures plummet in New York City, the spread to invest.” A low gas price won’t 26% in 1998, and boiler fuel accounts over the Henry Hub price soars.“The cost of buying open the door to LNG imports even for 25% to 30% of industrial gas that last gas molecule in New York City tends to go if the capacity existed to bring them consumption. Historically, industrial through the roof,” Santa says. Photograph kindly in. The global market prices LNG demand fell off when gas prices supplied by the Interstate Natural Gas Association off its thermal equivalent in crude ticked up for the winter heating of America, December 2006. oil: about 5.6 mcf/bbl. At $60/bbl, season, and most customers bought interruptible supplies that allow utilities to cut off service in the crude price implies $10-11/mcf for LNG, compared to a peak demand periods. Lower and less flexible demand from North American spot gas price around $7-$8/mcf. At $6/mcf, industrial customers leaves a smaller buffer for local gas LNG is even less competitive.“If we are in a situation where oil is still very strong, LNG will go to other markets that are distributors and accentuates price swings.

The growth in gas-fired electricity generation has altered buying the gas based on world oil prices,”Dove says.

The benchmark for US natural gas is the price delivered at seasonal usage patterns, too. Peak demand still falls in the winter heating season but, in some regions, a secondary peak Henry Hub, an interconnection at which nine interstate now occurs in summer when consumers turn on the air pipelines and four intrastate pipelines converge. The New York conditioning. Gas flows from the wellhead throughout the Mercantile Exchange (NYMEX) bases its natural gas futures year, so producers inject gas into storage facilities during the contracts on the Henry Hub price. It is also the principal

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deregulated markets no longer have reference for over the counter (OTC) cost recovery embedded in their transactions at other delivery points rates nor do any guarantee that their traded on the Intercontinental plants will be used. The fastest Exchange (ICE), where prices are growing customers in the gas quoted as Henry Hub plus or minus a market therefore have the least basis difference that reflects incentive to commit to pipeline transportation costs to the contracted capacity or even long term gas delivery point rather than Henry Hub. supply contracts – and the more ICE provides a centralised they rely on the spot market, the electronic platform for trading that more volatile prices will be. used to take place over the phone.

Timothy Dove, president and chief operating officer of Although industry fundamentals Trading volume has grown rapidly in Pioneer Natural Resources, an independent producer. are pushing up volatility, Eric recent years, spurred in part by ICE’s Last summer, though, a heat wave caused a spike in Bolling, an independent trader at move into clearing OTC electricity demand that curtailed injections.“We had the NYMEX, finds that volatility also transactions.

That eliminates record low injections at a time when you are normally increased after the futures market counterparty credit risk and allows injecting a lot of gas into storage because demand is introduced electronic trading as a financial institutions to trade with not there,”he says. Photograph kindly supplied by complement to open outcry. He has energy majors even if they do not Pioneer Natural Resources, December 2006. pared back his positions and trading have a bilateral line of credit in place, from the days when he was one of according to Kelly Loeffler, vice the most active players in natural president for investor and public gas. “I want to make sure I am relations at ICE. Commercial players, comfortable with the new volatility who once dominated trading, now parameters,” Bolling says,“I have to account for about 50% of the market; figure out how markets have banks, financial institutions and changed and adjust before I make other speculators make up the rest. big trades again.”

Transportation costs make a big Gas prices shot up after difference to gas producers’ take at Hurricanes Katrina and Rita tore the wellhead in areas where through the oil patch last year. The pipeline capacity is tight, as in the nearby settlement month rose Rocky Mountains. If the pipes from $7/mcf in late June 2005 to a cannot move the gas it has nowhere peak at $15.37/mcf in midto go and the price will collapse.

December 2005 but then fell back.

“We have seen that recently,” says It touched a low of $4.20/mcf in Donald Santa, president of the late September2006 on the Interstate Natural Gas Association Britt Dearman, manager of special projects at absence of hurricanes and the of America, “With storage being Apache Corporation, a leading independent producer. unwinding of Amaranth’s book. By very full some of the Rockies prices The gas bubble vanished in 2000, however, and the mid-November, the price had are significantly below Henry Hub.” industry has been running flat out ever since. As a bounced back over $8/mcf thanks Pipeline constraints can affect the result, the market now depends primarily on natural to the early cold snap.“Natural gas price at point of delivery, too. For gas storage to meet seasonal swings.“We have not is really sensitive to weather,” example, when temperatures seen much increase in storage capacity so it is Bolling says,“Much more than any plummet in New York City, the putting more stress on that network to satisfy other energy contract.” spread over the Henry Hub price demand,” says Dearman. Photograph kindly supplied The market absorbed soars. “The cost of buying that last by the Apache Corporation, December 2006.

Amaranth’s collapse without major gas molecule in New York City tends to go through the roof,” Santa says. Pipeline operators will disruption in part because the crippled hedge fund’s losses add capacity only when they have secured long term were somebody else’s gains: derivatives markets merely commitments from customers to pay for access they may reallocate the spoils among market participants but the net not need for most of the year. The Federal Energy profit is always zero. Bolling believes OTC derivatives Regulatory Commission regulates pipeline pricing, which is exacerbated Amaranth’s losses because higher leverage based on cost of service plus a return on capital. If capacity allowed the fund to take on more exposure than it could gets tight, the pipeline cannot charge more to capture the support in exchange traded futures.“The position got so big scarcity value so operators never build pipes on speculation. and unmanageable they could not get out,”he says,“I do not “It is not a build-and-they-will-come industry,”Santa says, think they could have gotten that big without posting a lot “You have to have the customers willing to sign up for more margin to the futures exchanges had they done it that capacity.” In an ironic twist, electricity generators in way. It could never have happened on NYMEX.”

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COVER STORY: NBK

With operating income that now tops $1.3bn, up 27% on 2005, National Bank of Kuwait (NBK) is easily the country’s largest bank and boasts the highest rating of any bank in the Middle East. While NBK has an extensive international network, its strategic imperative over the immediate term is driven more by regional considerations. The regional investment climate remains buoyant, in spite of no small degree of volatility in the region’s equity markets and local consumer credit growth remains strong. These factors have so far played to the bank’s strengths. How long can the good times last though and just how far can NBK go? Francesca Carnevale reports from Kuwait City.

UNLOCKING

NBK’s LONG TERM

GROWTH T HE CRISP AUTUMN night in Kuwait City is illuminated by a stream of limousines heading to the Arab Fund for Economic and Social Development building, an architectural marvel that showcases the growing artistic and financial sophistication of the Gulf Cooperation Council (GCC) countries in general and of Kuwait in particular. The limo occupants are invitees to a special seminar, arranged by NBK on “Leveraging the GCC Boom: A View Towards Asia,” and where the headline speaker is no less than the ex-premier and now Minister Mentor of Singapore, Lee Kwan Yew. The seminar is significant for a number of reasons. The GCC is awash with investment money looking for a profitable home. Two, more of that money is heading eastwards rather than its traditional route to the western economies of North America and Europe — as much (it has to be said) for political

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Ibrahim Dabdoub, NBK’s chief executive officer.

Photograph kindly supplied by NBK, December 2006.

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reasons as financial ones. Three, the Singapore growth model back in 1961. He worked up the corporate ladder, heading carries resonance in a region (or even a country) that sits bang the bank’s credit operations in 1969 and then being at the crossroads between the ‘new’economies of the east and promoted to deputy CEO soon after. Although naturally the ‘old’ economies of the west. Individually all the GCC reticent, Dabdoub has the easy frankness of a man with a countries have aspirations to be an entrepôt for trade and successful track record. It’s a natural consequence of a period of uninterrupted growth, concedes Isam Al-Sager, financial flows between the old world and the new.

Kuwait, like all other GCC countries is swept up in a NBK’s deputy chief executive officer. Even so, “The good cultural, religious, and political maelstrom, with all the thing about NBK is that it is a well-diversified operation, contradictions that might suggest. Each country is rapidly with most departments in the bank contributing directly to having to absorb a heady cocktail of new technology, the bottom line,”he says.

Dabdoub’s latter-day management style is collegiate, in line changing consumer tastes, new financing and investment products (both Islamic and non-Islamic), a population with his avowed aim to decentralise decision-making. profile that is skewed towards the under 25s, a rising and Dabdoub has a three line strategy to ensure that it works to increasingly affluent middle class, and a rapidly expanding best advantage. The first is“to encourage communication and range of opportunities in which to invest the region’s the free flow of ideas between management. Our focus is on abundant petro-dollars. Naturally, that is also counter- our people. We have a first class team and we actively foster a balanced by a (some say transient) resurgence of traditional collegiate approach, that encourages the discussion of politico-religious values and practices that sometimes sit strategy. The flow of information at NBK is first class. Given askance with the modern push and tug of change. NBK’s our size, it is probably much easier than it is, at a larger operation. On Sundays, story lies firmly in its Tuesdays and Thursdays we apparent ability to look have informal management above the parapet and make session, which are sense of the interweaving supplemented by other streams in the broader “We do a lot of market meetings and the senior region, leveraging them to management team is in best effect. segmentation analysis and product constant touch throughout At the seminar, Lee Kwan testing, which has helped us develop a the day.”

Yew, outlined what he saw as range of products that have a high The second is careful some of the pre-requisites take up,” says Dabdoub.” market analysis, “We do a that underpin sustainable lot of market segmentation economic growth. In the analysis and product dinner table talk that testing, which has helped followed the seminar, it was us develop a range of clear that attendees had clearly understood the significance of the event. What was products that have a high take up,”says Dabdoub. Third, is discussed was not so much Lee Kwan Yew’s paean to a heavy investment programme in staff training and the western economic and political values, but the fact that bank’s technology infrastructure. In October, LogicaCMG NBK was presenting such a seminar and such a topic. The secured a $27m contract to modernise NBK’s core banking bank was clearly laying out its credentials as a regional applications. LogicaCMG will manage the replacement of thought leader and positioning itself as a natural partner NBK’s current bank branch teller and core banking systems for key GCC businessmen looking to leverage Asia’s and build a service orientated architecture (SOA) platform. growth story. Most importantly, NBK was clearly displaying Phase one of the contract has already been completed with LogicaCMG undertaking a business study which led to the its growing confidence.

While established international players might take that sort production of a transformation roadmap for the bank. “It of thing for granted, for a bank in the Middle East, it is a thing involved the full technical and business architecture plans of moment. Two days later, in a private interview, Ibrahim that will help us to position ourselves to leverage our Dabdoub, NBK’s chief executive officer hints at the extent of expansion strategy. It is a major transformation program the wholesale change in thinking and approach this has that will provide us with a platform to operate on a larger required. “I once asked Jamie Dimon, JP Morgan’s chief scale, in a more open and competitive environment, and executive, whether size inevitably results in bureaucracy. He keep in step with the evolution of banking practices and said he is sure it does. It is something we took to heart and converging technologies,”explains Dabdoub.

“Once the implementation of the plans is complete, therefore have given our people leeway to make decisions. We have people in place now whose job is just to manage change. NBK will benefit from streamlined processes, new branch Frankly, it has not been easy because we have always lived in functionality, enhancements to other bank functions a command/control environment. But we are doing it — including banking operations, retail and corporate banking even if sometimes we do it more slowly than we might like.” and the ability to offer more flexible products, pricing and Dabdoub has run NBK since 1983, having joined the services which can be delivered more quickly to market,”

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Adel Abdul Wahab Al-Majed, group general manager, consumer banking. Photograph kindly supplied by NBK, December 2006.

Shaikha Khaled Al-Bahar, group general manager, corporate banking. Photograph kindly supplied by NBK, December 2006.

explains Adel Abdul Wahab Al-Majed, group general manager, consumer banking. “The bank will also achieve greater efficiency and scalability through the introduction of straight through processing and improved management control and compliance,” adds Salah Al Fulaij, group general manager, investment services and treasury group.

“It adds up to a significant change in the corporate culture, so that we can handle the booming markets in which we work and make the best of it. Things are changing so rapidly here and the old command and control systems cannot accommodate the requirements of today’s markets.

I am pleased with what we are achieving,”adds Dabdoub.

Dabdoub has much to be pleased about. NBK’s bottom line is on a rising trajectory. Recently issued performance figures for the first nine months of 2006 show the bank enjoyed a record net profit of $657m, up 22% on comparable year on year figures. NBK’s total assets stood at $24.2bn at the end of September, with shareholders’ equity of $2.8bn. Return on assets and return on equity also rose to 3.85% and 38.7% respectively, demonstrating the bank’s robust earnings power. NBK’s earnings power has earned it the highest credit ratings in the Middle East from Moody’s, Standard & Poor’s and Fitch Ratings. The rating agencies have praised the depth and stability of NBK’s management and the clarity of the bank’s near term growth strategy. But there are also other considerations.

The ratio of non-performing loans to total loans at NBK dropped to 1.4% in 2005, which rank among the lowest worldwide, with provisions against bad loans at 224% of their value, confirming the bank’s prudent credit culture.

Most recently, NBK embarked on a capital increase programme, at the end of October that will see the bank’s capital increase by 10%. The subscription was sold down to shareholders through NBK’s branches across Kuwait, with a reportedly high demand for shares.

NBK now has the largest domestic network in Kuwait with 59 branches and one of the largest international networks among Arab banks. It is clear that NBK is breaking out of a confined national and GCC banking model. Although the bank’s international growth strategy was conceived in the

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Randa Azzar, chief economist, NBK. Photograph kindly supplied by NBK, December 2006.

mid-1990s and it has most notably gathered pace over the last three to four five years. During this time the bank has made a concerted play in the GCC countries and begun to work out into the wider Middle East and North Africa (MENA) region and beyond that into Turkey and selected markets in East, such as Vietnam and China (specifically Shanghai).“Our expansion is not worldwide,”concedes Isam Al-Sager, deputy chief executive officer,“because we have a high level of customer focus, we are in some markets not on a competitive basis, to win market share, but on a supporting basis, to help our customers. Our major expansion is in the Middle East,”he adds.

In 2004, NBK bought 20% of International Bank of Qatar (formerly Grindlays Qatar Bank) together with full management control. The same year, NBK opened a new branch in Amman, Jordan, and a tenth branch in Lebanon.

The following year, NBK extended its branch network in Kuwait and opened a representative office in China, also kicking off operations in Iraq through the newly acquired Credit Bank of Iraq. In May 2006, the bank opened its first branch in Saudi Arabia.“NBK’S focus was and is to expand in markets with strong prospects and where we can leverage our fundamental strengths,” explains Dabdoub.

NBK is now looking to buy an Egyptian bank next year and also has its eyes on pushing into the UAE as well.

The turn of the century revitalised NBK. Since then, NBK has shown it has effectively learned to leverage the dynamics between the old and the new. Shaikha Khaled Al-Bahar, group general manager, corporate banking explains the synergy between the bank’s strategy and its customer focus: “Our business is defined by our clients. Our relationship with some of the strongest international players in the region, which make up the bulk of our corporate banking clients, nowadays want us to provide more creative and complex services. Part of that is helping them list overseas, in New York or buy real estate in the growing markets of India and China. I’ve told our clients again and again, because we have a comprehensive product range, we have the strength to underwrite their transactions. It puts us on a different plane to other banks in the region.”

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COVER STORY: NBK

group’s ongoing expansion across That depth in service the Gulf and the Middle East,” provision, according to Alexplains Nasra. The new Turkish Majed, group general manager operation builds on a year in of consumer banking, has been which NBK has opened developed through NBK’s operations in Kuwait, Beirut in ability and determination to May, and in the Dubai respond positively to a number International Financial Centre of tipping points. For one, in February. competition spurred the bank’s A third tipping point, push for growth, explains Alaccording to Al Fulaij, was the Majed. “Up to five years ago, reorientation of the bank’s we were working in a protected regional focus. “We had held market. Over those same five back,”admits Falajj,“intentionally years competition has begun to avoiding the regional markets accelerate under the until we felt they offered assumption that the market is appropriate depth.” NBK’s opening up. So, NBK began to George Nasra, ceo NBK Capital. It’s latest fund, which caution was perhaps well improve its service offering,”he has garnered commitments worth $200m to date will grounded: memories of market explains. Expectations of the focus on private equity investments in the GCC, Levant, shakedowns in 1982 and 1997 bank are high, he concedes, Egypt and Turkey. Photograph kindly supplied by NBK, were still strong.

Dabdoub particularly in Kuwait itself, December 2006. maintains the bank is pleased which provides a benchmark for its regional service offering. “A high proportion of with the strong results coming from the new markets in Kuwaitis travel and deal with international banks and Qatar and Jordan “alongside our established network in therefore have ample opportunity to benchmark service major financial centres. Our international network has long quality. I would say we are innovative and have a head played an important role in supporting NBK’s businesses start on most offerings in our regional market. However, from treasury, trade finance and corporate banking to many of these services can be duplicated within a three to private banking and wealth management.”

Dabdoub agrees that the bank has enjoyed prevailing six month timeframe. So we are kept on our toes.

Sustaining good service and innovative service on a winds that support its growth strategy to date. “The consistent basis is difficult, but I would reasonably claim operating environment has, on the whole, remained very positive for banking services, as all indicators pointed to it for the bank.”

Al Fulaij explains that another tipping point was the creation a continuation of momentum built in 2005, boosting and separation of NBK Capital from the main bank. Like many NBK’s business at all levels. Kuwait and the region regional institutions NBK had investment banking, asset continued to enjoy solid economic growth, high business management and treasury services firmly embedded in its confidence, and strong consumer spending and operations. It now operates as a commercial bank and has a investment, fuelling demand for credit. NBK’s interest defined investment bank, NBK Capital. While NBK Capital margins benefited from the rise in interest rates, and its sources and manages specialist private equity funds of its own, sound management of liabilities.”

“We leveraged our solid franchise and fundamental the bulk of the group’s asset management business is still retained within the main bank. NBK Capital is managed as a strengths to capitalise on the favourable business separate business by CEO George Nasra, who has adopted a environment by expanding our client base in all of our markets,” agrees NBK’s parallel growth strategy to chief economist, Randa that of the main bank. It’s NBK Successfully Builds on a Booming Local Market Azzar. As a result, we latest fund, which has were able to generate garnered commitments 200 balanced growth across worth $200m to date will 180 business lines and focus on private equity 160 regions,” she adds. investments in the GCC, 140 Dabdoub believes the Levant, Egypt and Turkey. In 120 success of the bank over September 2006, the 100 the medium term will investment bank opened a 80 depend on whether NBK new office in Turkey, 60 continues to leverage the appointing Ahmet opportunities on its own Tartaroglu as country doorstep and among its manager. “The move is very nearest neighbourhood. much in line with the Source: FTSE Group

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AMGEN’S MOLECULAR STRATEGY

CORPORATE PROFILE: AMGEN

Having dashed the hopes of baldheaded men, Sharer continues to differentiate Amgen from big pharma companies.“We are a science-based company, not a marketing-based company. Marketing is very important, but fundamentally we are a science-based company. It is a little bit involved to make the difference between biotech and big pharma, but for those of us who live it, It is quite apparent.” Photograph kindly supplied by Istockphotos.com, December 2006.

Approaching middle age, biotechnology giant Amgen faces a raft of potential problems ranging from patent infringement, and changes in the way that Medicare buys drugs, to complacency. Save your sympathy. The firm’s revenues will rise probably 50% in only the next four years, and are expected to rise to $21bn. Moreover, profits will follow suit. The corporate strategy: “remain hungry, nimble and focused on serving patients,” looks likely to outmaneouvre all-comers. Art Detman reports from California.

T IS AFTER nine o’clock on a glorious fall morning — warm and cloudless — at the headquarters of Amgen Inc. in Thousand Oaks, a distant suburb northwest of Los Angeles. A steady stream of cars pours into the company parking lot. Employees, contractors, vendors and visitors — they continue to arrive even though all of the thousands of spaces in the vast lot are taken. Not to worry. A young man directs traffic to aisles where his colleagues hand out claim tickets. The vehicles will remain parked in the aisles until their drivers return. At the world’s largest biotechnology company, nestled in the coastal hills of Southern California, valet parking has prevented a systemic collapse.

Already at his desk in one of 43 buildings in the complex is Kevin W Sharer, an aeronautical engineer and former US Navy officer who became chief executive officer (CEO) in January of 2001. Since then the company has added well over $10bn in revenues, to an expected $14.1bn or so for 2006 — an average annual compounded growth rate of

I

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more than 25%. Net profits have kept pace, rising from $1.1bn in 2000 to a projected $4.5bn last year. Some analysts forecast revenues of $21bn and earnings of $7bn by 2010.“It is kind of interesting for me to be the CEO of the largest company of its kind in the world in a technology that did not exist when I graduated from college,” says Sharer, who graduated from the US Naval Academy in 1970.

Amgen will be only 27 years old in April, having been founded in 1980 as Applied Molecular Genetics by professors from the University of California at Los Angeles.

In company lore, the founders “just drove out here where the houses were cheap and land was cheap and said,‘Okay, this is it,’ The story may be apocryphal,” says Sharer, “although I am pretty sure it is true.”

One thing for certain is that the remote Thousand Oaks location is entirely a historical accident. Amgen’s 194 acres there are virtually built out, and for some years the company has been expanding elsewhere and now has operations in

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nine US states and 30 countries. Like the big pharmaceutical companies, such as Pfizer, Merck and so forth, Amgen is in the business of creating medicines to cure or ameliorate human illness. But Sharer is quick to point out the differences in product, strategy and culture. “A pharmaceutical company’s technology is basically carbohydrate pills,” he says. “These pills are just chemical compounds made through normal chemical processes, and they can be swallowed and digested and have their effect.

Our products are completely structurally different. They are large molecules and mostly they are proteins and antibodies.

Take, for example, our earliest product, for the treatment of anemia, Epogen. This molecule comprises 165 amino acids, which are natural substances, that are in a chain in a specific sequence. On this chain hang some big sugar molecules.”

Because the body’s digestive system would break down this elaborate construction, Epogen and most other biotech medicines must be injected. What’s more, Sharer says,“the molecule is so exquisitely matched to the biology of the body that a change in one amino acid will almost always render the molecule not workable and perhaps even dangerous.” In contrast, substitution in the world of traditional drugs is common. “You can get around the patent by changing one of the compounds in the small molecule,”Sharer says. “That’s why there are seven or eight statins on the market now. Everybody’s got a statin.”

As Sharer notes with some satisfaction, in the world of large-molecule biotech drugs, there is much less flexibility in the ingredients and their arrangement. In terms of patent protection,“This makes biotech a more defensible business.”

The intangible differences appear every bit as important.

What Sharers — and apparently all of Amgen’s 16,500 employees — want to avoid is becoming a “big pharma”, which by their definition is a large, slow-moving, traditionbound drug company focused more on marketing than innovation.“The fact that we are 26 years old and based in Southern California instead of being a 100-year-old-plus company based in New Jersey means there are vast cultural differences,” says Sharer. “I hope that we are more nimble, that we can recognise an opportunity quicker and make a decision faster. We certainly are not perfect by any stretch of the imagination, but I have been told by people who came from those companies that there is just more energy, more enthusiasm, more speed, and more ambition here.”

Another difference, Sharer says, is Amgen’s product focus.“We have a much different research and development strategy. Our strategy is to develop innovative medicine for grievous illnesses. That means we’re not going to have a product to treat male pattern baldness; there’s a need there, and I am sure somebody can make a lot of money from that.

However, we are going to focus on serious illnesses. I am not saying that the pharmaceutical companies are all chasing non-serious illnesses; they are not. They are certainly in the cardiovascular space, the cancer space, trying to do that too. But we are there exclusively.”

Having dashed the hopes of baldheaded men, Sharer continues to differentiate Amgen from big pharma

companies. “We are a science-based company, not a marketing-based company. Marketing is very important, but fundamentally we are a science-based company. It is a little bit involved to make the difference between biotech and big pharma, but for those of us who live it, It is quite apparent.”

Amgen has only ten products that are both governmentapproved and sold commercially, and five of these account for 90% or more of its sales. Amgen’s first product was Epogen, created in 1983 when an Amgen scientist cloned the gene for human erythropoietin — EPO, for short — and produced recombinant EPO, later patented and named Epogen. This became the first of Amgen’s family of billion-dollar drugs.

Later a similar protein, Aranesp, was introduced. Both are used to support people undergoing chemotherapy for cancer or dialysis because of chronic kidney disease. Often in these instances the patients aren’t just a little tired, they are virtually bedridden with exhaustion. “These drugs restore the red blood cells,” says Sharer. “They make a dramatic difference in the lives of dialysis patients. And they make it possible for people with cancer to actually live with the disease; they can get chemotherapy and still have a quality of life.”

Together, Epogen and Aranesp sales grew about 18% in 2006, to more than $6.7bn. Neulasta and Neupogen are both proteins that reduce the risk of chemotherapy-related infections in cancer patients. Annual sales are about $3.5bn. Amgen’s fifth principal product is Enbrel, a protein used to treat rheumatoid arthritis and psoriasis. It generates about $2.6bn annually. “Enbrel has not done as well this year as we hoped,”Sharer admits. “This is due to the fact that one of its markets, moderate to severe psoriasis, has not grown much at all.”

Sharer finds this puzzling — after all, the overall population is growing — and suspects that many psoriasis sufferers simply don’t know about the drug. A direct-toconsumer advertising campaign had to be pulled because of objections from the Food and Drug Administration. The company is now negotiating with the FDA regarding a new series of advertisements. “It is possible that many psoriasis patients need to be communicated to so they will go to a doctor’s office,” says Sharer.“The kind of psoriasis we’re talking about is not just a little something on your elbow. It is nearly full-body coverage. Essentially, you cannot go outside. You don’t have a life. But about threefourths of the psoriasis patients who take Enbrel find it just makes it disappear.”

Two new products are Sensipar, a small molecule developed in conjunction with NPS Pharmaceuticals that is used to treat a thyroid condition caused by chronic kidney disease, and Vectibix, an antibody designed to shrink or eliminate colorectal cancer tumors. While Sensipar’s potential is relatively modest — Eric Schmidt of Cowen and Company believes it will take more than four years before sales reach $1bn — Vectibix holds the promise of being a blockbuster (as drugs with multibillion annual sales are known in the industry). Schmidt believes Vectibix will capture 60-70% of the anti-EGFR market in colorectal cancer in three or four years

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Kevin W Sharer, chief executive officer of Amgen. Amgen will be only 27 years old in April, having been founded in 1980 as Applied Molecular Genetics by professors from the University of California at Los Angeles. In company lore, the founders “just drove out here where the houses were cheap and land was cheap and said,‘Okay, this is it,’ The story may be apocryphal,”says Sharer,“although I am pretty sure it is true.”Photograph kindly supplied by Amgen December 2006.

and over time gain acceptance in all of the same markets as the current dominant therapy, Erbitux, a product of ImClone Systems and Bristol-Myers Squibb.Vectibix received approval in September and since then, says Sharer,“There was a very substantial uptake. We are doing well against Erbitux, and we hope and expect that this will continue.”

Amgen’s next potential blockbuster is Denosumab, which Sharer says has the potential to score big in two different markets: postmenopausal osteoporosis and bone cancer caused by the metastasising of other cancers. “When a cancer metastasises,” he explains, “it often migrates to the bone. That causes enormous pain and weakens the bone. It is a horrendous side effect, if you will. Our early and midstage tests give us a great deal of hope that Denosumab will greatly reduce the tendency of cancer to migrate to the bone, which would be a huge benefit to patients. We will know the results of the current clinical trials in 2008. We are investing on the order of $500m a year on this product alone.”

It is likely, then, that Amgen could have invested $1bn in Denosumab by the time its final clinical trials are complete — but before it is approved for general use. Just how risky this is for drug companies was dramatically illustrated in December, when the world’s largest pharmaceutical company, Pfizer, abruptly halted a clinical trial of an experimental drug intended to treat heart disease after it was discovered that it apparently caused an increase in deaths and heart problems. What had promised to become the world’s largest-selling drug suddenly became a write-off of almost $1bn. On the next trading day, investors frantically sold Pfizer shares, driving down the price 11%. In a day, more than $21bn in market value vanished.

Meanwhile, Amgen has about a dozen drugs in phase one

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of development. Most are intended to treat cancer or cancerrelated illness. Two are to treat pain, one is for asthma, another for obesity, and a third for Type 2 diabetes. In addition, five new drugs — including Denosumab — are in phase two or phase three of development, and several approved drugs are being tested for new applications. For example, Aranesp, the anemia therapy, is being investigated to treat cardiovascular disease in patients with chronic kidney disease and Type 2 diabetes.

Last year Amgen’s research and development budget was about $3bn, an attention-getting 22% of revenues and perhaps the highest ratio among all large biotech and pharma companies. Sharer expects R&D spending will increase this year by double digits. “Our basic policy is to spend as much as we can possibly afford,” he says. “Our products will eventually go off patent; we have to be ready for that. So now is the time to invest and do our best.”

Of course, even drugs with patent protection can be challenged. Right now Amgen is battling Roche, the huge Swiss-based company, over its CERA drug, which Sharer says violates the patent on Epogen, which treats anemia in patients who are on dialysis. Amgen has 100% of this market, which it serves by selling to companies that operate chains of dialysis treatment centers. They in turn are allowed by Medicare a 6% markup on the average selling price of Epogen.

Amgen won the right to sue Roche, and the trial is expected to begin late this year.“Our plan is to beat Roche,” Sharer says.“We are very confident in our patent position.”

Among analysts who follow Amgen — they all are MDs or PhDs in molecular biology — opinions range widely. Michael

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all, all House seats and a Aberman, a physician and third of Senate seats will analyst at Credit Suisse, gives Because the body’s digestive system face voters in 2008 — the Roche an 80% chance of would break down this elaborate outcome might be winning. Another physician, construction, Epogen and most other immaterial for Amgen.

Mark Schoenebaum of Bear, biotech medicines must be injected.

“The company’s products Stearns, takes the opposite are almost all unique,” says view. “I am increasingly What is more, Sharer says, “the Schmidt of Cowen. “And if comfortable with the idea that molecule is so exquisitely matched to any legislation were passed, Roche’s CERA probably the biology of the body that a change we’d have to see if it even infringes Amgen’s patents,” in one amino acid will almost always pertains to biologics. All the he says. render the molecule not workable and discussions I have seen Cowen and Company’s Eric focus on small-molecule Schmidt, a Ph.D., isn’t sure perhaps even dangerous.” pills, and that would have either way. “This is a tough not impact on Amgen.” call,” he says. “We’ve gotten Ironically, then, the two concerns that seem to affect [sic] advice from a lot of legal experts, and everything indicates this is going to be a close one. But I am not sure that Amgen’s stock price right now (Roche’s CERA and changes the impact of CERA coming to the US market, should Roche in Medicare) could well be non-issues. While some analysts get around Amgen’s patents, is of that much consequence. It are neutral on the stock, others — among them Schmidt, would still have to compete in the marketplace, and that is Albert Rauch of AG Edwards and Elise Wang of Citigroup going to be a significant hurdle for CERA. It doesn’t have any among them — have issued buy ratings. Amgen stock has advantages over the Amgen products, which are entrenched moved up nicely since dipping below 31 in 2002, and now and have been on the market anywhere from five to fifteen trades at around 70, which gives the company a market years. That’s where CERA is going to fall short, and that is capitalisation of $85bn. (Like electronic high-techs, biotechs why I think it really does not matter much to Amgen whether were caught up in the bubble of 2000; Amgen’s stock topped 80, fueled by a price/earnings ratio that approached 70.) or not CERA is marketed here.”

Sharer is confident in the capacity of biotech to eventually Indeed, Amgen has already locked up some major dialysis chains with exclusive long-term contracts. And Roche can’t conquer human illnesses. “There is no disease that is tempt the others with a lower price because the government’s theoretically beyond the reach of biotechnology,” he says. reimbursement is based on a percentage of the cost. Dialysis But he cautions against excessive optimism.”We know less centers have no incentive to buy a lower-cost product. If about biology than the man in the street thinks. People read Schmidt’s analysis is correct, then the CERA problem is about sequencing the human genome and think that we mostly an illusion, despite the very real concerns of many on must know all about human biology. The human genome Wall Street. Another illusionary problem may have to do with is a wonderful advance, but it is just a parts list for the body.

Medicare and the new Congress, both houses of which will be The secret is how those parts interact and how they go controlled by Democrats. Right now Medicare — unlike the wrong. The goal of biotechnology is to understand the Department of Veterans Affairs — cannot negotiate with drug fundamental biology and then develop products that can companies over prices. Many Democrats have favored interact with the biology in safe and effective ways.”

In conquering diseases such as cancer, ALS, diabetes and changing this, something virtually all drug company CEOs (at Alzheimer’s disease, patience is a required virtue. “Fifty biotechs and pharmas alike) oppose.

Sharer, who is chairman of the board of the Pharmaceutical years is only two and one-half product development Research and Manufacturers of America, a trade association, cycles,”Sharer notes.“That’s frustrating, but that is the way is among them. “The government today gets very good science is. I think we will get there, but it is going to take prices,”he says. “The government has essentially outsourced a while.”

Sharer expects that, on this long road to overcoming the negotiation of prices to many, many private plans, and these private plans have real bargaining leverage. When you human disease, Amgen will remain at the forefront read the newspapers, you get the idea that under the current provided it remains true to its basic principles. “We’re system the government just pays list price and is, if you will, proud of our success and enthusiastic about the future,”he a dumb buyer. That’s not remotely true. The government says.“But any successful enterprise contains, at the time of its success, the seeds of its potential future troubles. pays negotiated prices that are quite aggressive.”

Since the election in November, talk about empowering Nobody is immune from that, and there’s no silver bullet Medicare to negotiate prices has quieted down. Bear, answer to avoid it. But the first thing to do is recognise that Stearns’Schoenebaum believes there“will be a drumbeat of the possibility exists, and be alert to that potential.”As he negative headlines, but the probability of any real policy told shareholders in last year’s annual report: “We are changes ahead of the 2008 presidential election is small. absolutely determined to avoid the pitfalls of growth and success and remain hungry, nimble and focused on serving Besides, Bush would veto it.”

And even if a presidential veto were overridden — after patients. Our best is yet to come.”

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TRANSITION MANAGEMENT

Roundtable THE FUTURE OF GERMAN TRANSITION MANAGEMENT

ATTENDING

Supported by:

Left to right back row: ED PENNINGS, managing director, head of sales and client relations, State Street Transition Management HOLGER KNAUER, manager, Universal Investment PETER DOMBECK, director, manager selection, Feri Institutional Advisors GARY SPREADBURY, vice president, transition management, Morgan Stanley Left to right front row: CHRISTOPH KESY, portfolio management, E.ON Energie AG ALEXANDRA THIELE, senior manager, master kags, ACTIVEST [Now PIONEER INVESTMENTS] KARIN RUSSELL-WIEDERKEHR, director, transition management, germany, Credit Suisse FRANCESCA CARNEVALE, editor, FTSE Global Markets

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NEW BUSINESS, NEW CHALLENGES FRANCESCA CARNEVALE, EDITOR, FTSE GLOBAL MARKETS: Ed, can you start please and describe the key

and different levels of technology. Other complexities unique to Germany include the handling of withholding tax claims, capital gains and book value transfers, which can be challenging but are extremely important.

opportunities and drivers for growth in transition management in Germany?

CHRISTOPH KESY, PORTFOLIO MANAGEMENT, E.ON ENERGIE AG: The typical German relationship banking

ED PENNINGS, MANAGING DIRECTOR, HEAD OF SALES AND CLIENT RELATIONS, STATE STREET TRANSITION MANAGEMENT: There have been a number of

model broke apart—at least this is the case for many companies. Investors are more knowledgeable these days and performance more transparent, particularly as the market has moved from balanced portfolios to core-satellite structures and from a multiple KAG structure to the centralised Master-KAG. Now we have liability driven or alternative investment approaches, and a much higher rate of portfolio turnover than in the past. Investors nowadays also accept transactions costs as an important performance factor of the overall portfolio. Following on from that, they want assistance from a decent transition manager.

KARIN: Transition services and its benefits are well understood in Germany. Wherever we go consultants have already primed clients about when or when not to use a transition manager. Not every restructure requires the support of a specialist transition manager. Do you agree Peter?

PETER: I agree with Karin that it is not always the case that a transition is suitable—particularly when there are only small changes in a portfolio that can be easily moved out. However, in complex asset restructurings, you get a much better result if you have a suitable transition manager. Consultants are an important influence in this regard, definitely.

HOLGER: There is another important consideration. While investors and KAGs are happy to work together with a range of transition managers, if we have a big restructuring, involving various asset managers, we are now happy to have just one transition manager who is in control of the entire project. It means somebody is taking care that the whole process is carefully controlled, and we are reassured that the wishes of the investor are met. In these instances, we are also assured that execution is in the precise format we need and therefore we can take care that any new managers are able to start their mandate by a due date.

Moreover, we know precisely when we can begin to measure the performance of a new manager and there are no excuses about late starting periods and costs associated with the starting period.

PETER: Yes, investors are very keen on this. It has also been an educative process for consultants, if you like, as well.

There shouldn’t be any black holes or any reasons at the outset for missing performance targets.

developments: companies are funding their pension funds, funding their liabilities and this trend continues. The Kapitalanlagegesellschaften (KAG) investment law has changed which has been an incredible business driver and made things a lot simpler. It has been good for transition management and good for investors as well. Also, there is a greater awareness of transition management and that is helping all of us.

HOLGER KNAUER, DEPUTY HEAD OF INSTITUTIONAL SALES AND RELATIONSHIP MANAGEMENT, UNIVERSAL INVESTMENT: I would add that beneficial owners are likely

to change their asset manager faster these days. They no longer have the patience to accept poor investment results and therefore they change managers more frequently. In turn, that is providing more transition opportunities.

GARY SPREADBURY, VICE PRESIDENT, TRANSITION MANAGEMENT, MORGAN STANLEY: A lot of that growth

has come from increased awareness and a greater understanding of how the transition manager can help.

There are definitely instances where a transition manager does not necessarily add value and it is being able to work out whether he can pick value out of the process or not.

What you highlighted Holger, is right. There is absolutely no reason today why a fund should have any exposure to underperforming managers any longer than is necessary.

You should use the transition process to make that change quickly and in a structured and efficient fashion.

PETER DOMBECK, DIRECTOR, MANAGER SELECTION, FERI INSTITUTIONAL ADVISORS: Nowadays you find

yourself dealing with more complex and complicated asset classes and more core-satellite fund structures. People are aware that you need more transition specialists, particularly if you are moving from one or two managers to three, four, or five different managers with very specialised investment approaches. Beneficial owners recognise that you need someone who can handle complex transitions, is experienced and who will make the shortfall of your performance as small as possible.

KARIN RUSSELL-WIEDERKEHR, DIRECTOR, TRANSITION MANAGEMENT, GERMANY, CREDIT SUISSE: I agree. Transitions have become more complex

and it is vital to have someone specialised for the job. In the German market some of the peculiarities are regulatory in nature; others are operationally driven due to the existence of KAGs. It starts with the regulatory counterpart for a transition being the KAG and not the beneficial owner, which is very different from other markets.

Additionally, each KAG has its own operational models

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CHOOSING TRANSITION MANAGERS FRANCESCA: Looking around this table, none of the transition managers is German. How do you know that these transition managers can deliver for you? Do they know your market well enough? Does it matter that none are German?

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CHRISTOPH: We feel comfortable to have someone in a transition management team that has a good knowledge of the German markets, of the master KAGs and local custody structure. We think it is very important. Project management competences are also key.

GARY: The KAG question is interesting. With the consolidation of the market, and the master-KAGs coming into play, people are reducing the number of KAGs they are using. Subsequently, we have found that the transition manager has had to deliver an awful lot of value coordinating KAGs. It is all very well the legal entity being one KAG here and one KAG over there, but if they are not talking to each other, then you will encounter serious issues. Unquestionably, the possibility and potential for the transition manager to project manage that whole space, is significant and you cannot really undervalue the importance of it. Even though a fund may know that there will not be a complete restructuring, or a series of fund manager changes, changing the KAG structure can be a risky process if it is not handled properly.

ED: The trend towards outsourcing, rather than advisory agreements, which used to be more prevalent in the past, also gives a lot more freedom and responsibility to the transition manager. It is a role that is, in fact, complimentary to what the KAG does. It acts as a sort of fiduciary role for the underlying investor and the work that the transition manager does fits very well into that space. I want to build on Christoph’s point. I would not want to say that relationship banking is falling apart, but it certainly is crumbling and you see a trend towards a model of best of breed service providers. For transition managers to be successful in this environment they have to have experience of the German model.

GARY: It’s interesting that you talk about experience within transition managers. There is a core skill set within perhaps three or four houses, that have a unique understanding of the German investment industry and that are not necessarily working for domestic providers. The global provision of transition management in Germany does give you a very good illustration of why and who has the inhouse expertise.

FRANCESCA: Alexandra, does that give you comfort?

ALEXANDRA THIELE, SENIOR MANAGER, MASTER KAGs, ACTIVEST [NOW PIONEER INVESTMENTS]:

Obviously, it is important that a transition manager has the right experience, but I also think it is important that the KAGs are good at their work. It is vital for the KAG to ask the right questions, thereby avoiding problems in the later stages of a transition. Although we all speak English, it is easier sometimes if you can explain your concerns in your own language. So, a knowledge of the German language, direct experience of the market; someone who knows what kind of issues or problems they will face in transition in the German market and who you can speak to directly is vital.

KARIN: Language skills are particularly important when you are transitioning for local authorities and domestic Vorsorgeeinrichtungen. I speak from experience. When I

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ED PENNINGS, managing director, head of sales and client relations, State Street Transition Management

have to deal in unfamiliar territory, I prefer to speak in my mother tongue and that has proven to be important for German clients too. It does not matter where a transition manager is located, where the person sits, or whether the person works for an American international financial conglomerate or a German institution. It is really down to the individual’s skills.

CHRISTOPH: As an investor, we look for operational excellence when we undertake our transition manager selection. It is not important where the effective trading is done, if it is done in London or Frankfurt or elsewhere. It is absolutely crucial to the process to have one relationship person as a link, who knows everyone’s roles in detail.

More often than not, it turns out to be the key factor in a transition. Fluent German is absolutely crucial to exploit the German market opportunities for a transition manager.

BUYSIDE/SELLSIDE/AGENCY/PRINCIPAL? FRANCESCA: It cannot be that I turn up, speak German,

communicate well and know the German market and that means I win business. There has to be more. Is a transition manager’s project management ability, trading ability, or capability in fixed income, for instance, a factor as well?

CHRISTOPH: It is a mixture of many factors. As I mentioned before we look for operational excellence. Each large transition has its moments where afterwards you say, we were really lucky to complete the transition successfully, due to technical restrictions, the breakdown of SWIFT

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communication, or other operational events. To avoid bad Certainly you have to be able to identify the parts of the surprises you need a clear definition of responsibilities – a portfolio that are going to take longer to trade and transition manager must be willing to take full responsibility whether you are going to treat them differently, and for the process and define up front its responsibilities vis à vie whether you need to look at alternative strategies for the KAG, the custodian, and of course, the customer. I also exiting them. You also have to find out whether the think that transition management is moving from being pure customer is prepared to pay a premium or a discount to execution business, doing a series of trades over a minimised complete that portion of the portfolio. A fund has to be period of days, to more of an advisory business. This involves aware of the options available and the transition the terms of risk management, exposure risk management, manager must offer all the options that make sense when managing the trade-off between potential opportunity cost dealing with a broad mix of assets: be it fixed income, and market impact; coming up with hedging proposals, equity, or even how you interact with the FX part of the process and provide options showing the cost of a hedge, so perhaps to ensure that the that you can weigh the trade off client’s assets are moving between risk taking and the cost across in a systematic and of the hedge.Then of course, the structured fashion and avoid basis of the service has to be unnecessary cost. excellent execution capabilities and access to sufficient liquidity KARIN: Most transition sources in the markets. Last but managers have tools that not least, two final points: enable them to identify quality people and transparency, potential problems, not only on transparency, transparency. the trading side, but operationally as well. Before HOLGER: What is important the implementation of a for the KAG is proper transition we conduct detailed execution. If you have a good pre-transition analysis. We have broker who is failing one, two sophisticated systems that help or three trades or they were not us identify liquidity constraints communicated in the approved or any difficult securities to format, you can do it manually. trade, which could affect the However, think, if you get 500 cost of the restructure. This or 1000 trades and they do not technology enables us to define fit in your system, you will not the right trading strategy for be able to get the transition each of the asset classes. They finished by the agreed date.You also help us in working out any also have to think of the potential hedging requirements additional risk of failed trades HOLGER KNAUER, manager, Universal Investment to reduce costs. Our tools and and claims. This really could hurt you. Operational strengths are important. Operational our analysis form part of our transition management strengths must also encompass the ability to create a agreement. Furthermore, during the implementation of a process that brings together all parties in an effective way, transition we now have smart trading systems that help us control and minimise costs and risks. We work with even with the various custodians that are also involved. algorithms, such as Portfolio Hedging Device (PHD), that FRANCESCA: Have you ever had a failed transition, or where help us trade in a smart way. your transition manager hasn’t delivered to your satisfaction?

HOLGER: In the past, we have had to expand a transition ED: You should be aware of illiquid tails in the planning period as some of the trades were not executed or not all stage. It can take a little bit longer, but at least, you can the trades had been settled in time. The investor was make appropriate arrangements. If you do start making exposed to the risk that their portfolios were not really undertakings, it is a very slippery slope. As soon as you managed for that period by the target manager. start giving undertakings, guaranteeing any sort of benchmark or timeframe the conflicts of interest grow FRANCESCA: At the tail end of a transition, you can be left with some very difficult assets that you somehow you have significantly. As long as there is communication and you to trade away. Do you give undertakings to your clients that plan it properly, everyone should be able to trade these stocks and everyone should be able to access multiple you will complete a transition, whatever it takes? liquidity sources. It could be through crossing, agency GARY: It can be an unnecessary conversation to have right at the start of a process. To say that by day three, for trading, arranged principal bids, or alternative trading example, we will be able to complete on this whole strategies, using hedging strategies to get you exposure to portfolio without consideration being given during the the desired asset class, which allows you to take a little bit actual implementation is rather cavalier in approach. longer to get out of the underlying position.

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EXPLICIT VERSUS IMPLICIT COSTS

noted. That is absolutely key for us.

GARY: You have to be able to understand what that explicit

FRANCESCA: When you choose a transition manager, how much is cost on your mind?

GARY: Just so that we are clear, explicit costs?

FRANCESCA: Explicit costs PETER: Cost is a factor, for sure, because explicit costs are easier to compare. Definitely it should not be the sole factor in deciding on a transition manager. If you then talk to the client and explain the significance of the implicit costs, such as the costs of worst execution or perhaps the cost of failed project management, then everybody will agree that explicit costs are significant, but not the only decisive factor.

KARIN: We encourage potential users of transition management services to look at the people and the experience that they have in project management and the types of assets they are looking to restructure. Furthermore, it is important to look at global market access, technology and language skills. Most of all, when you are selecting a transition manager, it is important to go and visit the operation, meet the people that are dealing with your project and experience the systems they will employ.

PETER: It is not important whether you are number one in the league tables, number five can probably be as good as number one in most cases if you don’t have a really large major transition. I agree with Karin, that soft skills are as important as hard skills. Moreover, transparency as we first

GARY SPREADBURY, vice president, transition management, Morgan Stanley

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cost represents. Providers who offer their services for zero or even enhancing exits are not necessarily being transparent and clear on how they are being paid for the process. Our approach is to be transparent from the start: i.e. this is how much it is going to cost you; this is what you are paying for.

The fund can then begin to start looking at other parts of the equation: the implicit costs, then very clear comparisons between one provider and another can start to be formulated.

CHRISTOPH: When you do a portfolio trade, say €200m of a European large cap equity portfolio, brokers offer you zero commission for a bloc trade, with a guaranteed market close.

That is zero explicit cost, but is it a bad benchmark? Yes, a terribly bad benchmark, because first the broker can influence the benchmark and secondly, the impact of what is going to happen in the market in a closed auction is going to outweigh your explicit costs by a multiple. Therefore implementation shortfall is a good benchmark, because it is the only one which the manager, or the broker, cannot influence. Even so, implementation shortfall is not sufficient, because there is a component that is not covered: risk. Implementation shortfall is only a target. At the end of a transition we all hope for a good total result. But is it the consequence of high risk taking and luck? Or, is it the desired result of a proper shaping of the implementation shortfall distribution up front? That is what you want to see in the process.

ED: Christoph mentioned luck. This is where it comes down to looking at the experience and track record of the manager.

What did the transition manager say to the client in terms of estimating implementation shortfall cost and what did he actually deliver? Clients are more sophisticated and now ask for correlation numbers between pre-trade estimates and actual post-trade results.This is actually a very useful measure to include when analysing transition managers. Furthermore, any sort of guarantee of a benchmark implies a principal trading strategy. I am not saying that there is anything wrong with principal trading, because I don’t think there is. However, when it combines with a transition management mandate, it does present serious problems. Christoph is right to ask, how do we measure the right benchmark? It is all about how you use the benchmark. Do you trade before it is set, do you trade into it, or do you actually use it as a clean, un-conflicted reference point to measure yourself, after the benchmark is set? Nevertheless, there are explicit costs, implicit costs and hidden costs, and clients should ask more questions about them. Any benchmark guarantee implies a hidden cost, because after all nobody does this as a charity.

HOLGER: You are right. However, in practice in the past, if investors were choosing a transition manager for the first time, the focus was entirely on costs. Once the transition manager provides a full breakdown of the costs in a transition, then the investor begins to understand (sometimes for the first time) the various factors that combined to make up the costs and the benefit and/or the losses of the transition. It is a process of education and to be fair, transition managers have also spent time educating clients. Of course we also take up

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PETER DOMBECK, director, manager selection, Feri Institutional Advisors

these points and warn clients of potential pitfalls. However, not all transition managers are equally transparent. We are not always in a position to say this will be cheapest and/or best transition manager, because everyone’s offers look quite different and it is difficult to compare them.

GARY: Any providers’ pre-transition analytics should be powerful enough to highlight risks before you go into the trade. Just as an example, we worked on a portfolio which had an extremely high weighting in commodity related stocks. The commodity sector weighting was way beyond the benchmark.

This was in April/May time as commodity stocks were reaching a peak. Volatility kicked in and the client made an active decision, based on our analytics, not to transition during that month. We could actually have just implemented and gone back to them and said to them, look we said it would be bad, it was bad. However, our process allowed them to make an informed decision and deal with the risks accordingly.

HOLGER: We have a good benchmark for the trading period: implementation shortfall and volatility implementation shortfall. What worries an institutional investor though is what happens from the moment where you dismantle your portfolio and the first trade takes place.

That is the most interesting question and it is up to the transition manager to come up with a reliable solution.

TO PRE-HEDGE OR NOT? KARIN: I know we are going to talk about the T-Charter

later, but I think this is the right time to touch on the subject.

The T-Charter is a set of 10 principles that guide and protect clients when transitioning and provides protection again poor and questionable practices. One of the principles is to disclose pre-hedging transactions and the performance impact of pre-hedging activity in the implementation report.

When you have a transition manager, you choose him

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because you trust him implicitly. You will have confidence that he will not pre-hedge for his own gain. In fact, nothing should happen before trading starts that could adversely influence the ultimate result of the transition.

FRANCESCA: Alexandra, does it matter if your transition manager pre-hedges as long as the portfolio that arrives with your destination manager has the value that you wanted?

ALEXANDRA: It depends on who has selected the transition manager. We always talk to our clients and ensure that if they have chosen a transition manager that they provide us with the model on which they made their decision and we then analyse where any costs might be. I am not very happy if a transition manager is involved in pre-hedging, because they have acted for their own book. I don’t think it is the right way to go about things. If the client says,“I’m okay with this,”it is his decision and we have to accept it. However, if we had chosen a transition manager, and he pre-hedged, it would be the first and last transition that he did for us. It comes back to costs.

There has actually been very little constructive discussion and debate about the true costs of transitions in recent years. I think that is because at one time the market really did not understand the difference between implicit and explicit costs.

That is no longer the case and the market is learning fast.

PETER: In the first place we would probably ask why a manager would like to opt out of best execution. Moreover, we would like to hear a very, very, good explanation for that. Usually, we would say that I wouldn’t advise any client to opt out of best execution and to say that prehedging is OK. I can’t imagine a case where we would be comfortable with it.

HOLGER: As a KAG, we have a contract with the transition manager. We undertake all means to ensure best execution.

We have that explicitly stated in the contract, that we require best execution for the portfolio. If we see something that contradicts this clause that would be a breach of this contract ED: What is pre-hedging? It sounds pretty warm and fuzzy. However, really it is front-running. So let us just call it what it is. I do not see any reason for anyone ever to prehedge. Pre-hedging pretty much guarantees a nondisclosed profit for the transition manager and renders any benchmark irrelevant.

GARY: The key thing to understand is that pre-hedging and front running are often referred to as one and the same thing; but in certain circumstances they are different. Morgan Stanley does not pre-hedge — FSA rules prohibit it. But, as an example, one could argue that if you were looking to build a portfolio of highly illiquid stocks that you are going to benchmark at the end of the month and start performance at precisely that point, one could rationally work with a house to provide capital to help you passively build that portfolio beforehand and then, at the benchmark point, you gain the immediacy of entry into the portfolio. The house has executed a wholly transparent basis with you beforehand and you can understand what the real cost is. Transparency is the key message here.

CHRISTOPH: Don’t misunderstand me, I am not promoting front-running, but I see this topic less dogmatically. It is a question of transparency up front. If a transition manager

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comes up with the exclusive pre-hedging proposal to cover the illiquid parts of the portfolio, or the high-alpha part, because best execution as the KAG and the market understands it, asking three different brokers to trade out your portfolio, will produce serious market impact, then I would say, let’s discuss the point. It is not front-running anymore, if the customer agrees to it. So let’s discuss it and compare it to the ideas of the other candidates who are pitching for the mandate and let’s find out what is best for our portfolio. So, it is probably an exotic view …

KARIN: It doesn’t really matter what the client and the transition manager decide as the right way of trading, as long as it reflects the interests of the client and it is a transparent solution. This ensures that there is not going to be an accusation of mis-selling, or the client misunderstanding that he contracted into, or opted out of best execution. If a client wants to opt out of and waive his right to best execution and this is defined in the trading strategy then I am in agreement with Christoph. However, at Credit Suisse we do not pre-hedge.

CHRISTOPH: In most of the small cap portfolios which have become attractive in a satellite-core environment and also are still attractive for alpha generation, you will find stocks where market impact neutral trading, based on the average daily volume, takes you 20/40/60 trading days. And it must be allowed that for these very illiquid parts of your portfolio, maybe 2% or 3%, you have to think of more creative ways to trade it. Asking the company to do a share buyback programme for example, or it might be pre-hedging, but in accordance with the investor, or other creative solutions.

MEASURING A SUCCESSFUL TRANSITION? ALEXANDRA: As a KAG it is always important that the

operative things work really well and that we don’t have failed trades. If I understand the model of the transition manager and I see what has happened and I can understand the whole process, I am satisfied.

PETER: It involves a timetable that is suitable for the transition and that the whole transition starts and ends at the time horizons within the schedule discussed and agreed on beforehand. That’s one important factor. Another, surely, is implementation shortfall. Although it can always happen that you are off by about one or two basis points. OK, that is natural, but it should be in the normal range and the third point is probably the project management capabilities of the manager. There is always something going wrong in a very large transition and if you have someone you can call up or you can have a daily conference call including the KAG and the custodians, it is fine.You must always have someone you can talk to if something is going wrong and you see that after an hour, or sometimes after a day, the problem is solved. That is perfect.

ALEXANDRA: If we have a problem or we need to change to some process or something it is important that the consultant, or the transition manager can say either that it is not a serious problem, or that they can fix the problem.

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There are always problems in transitions. It is vital that you communicate often and directly about the problem and show how it will be solved. That makes everyone feel a lot better about the transition.

HOLGER: I know the day when the new managers should start their business. That is the first time when I get hard feedback. Is everything settled, for example? Moreover, can he start managing the full portfolio on that day or not? If he can, then it is good, it worked, we are on schedule. Then we get information from the transition manager via the transition report. In addition we and the client have the opportunity to look at the details of the transition very closely and look into the explicit and implicit costs, and compare the execution with the original proposal. That’s when we have a full view of the transition and can decide whether it was really a perfect transition, or if there were some surprises he/we did not think of.

CHRISTOPH: After every completed transition we don’t always know what we feel. If the post-trade analysis looks brilliant, obviously it was a good transition. But of course, in evaluating the quality of a transition, the most important quantitative fact is: what does the pre-trade analysis show?

And is the realisation, the result, compared to the ex-ante analysis within a reasonable low amount of standard deviations? You can’t tell me that unfortunately there is a six standard deviation outcome and then that the ex-ante was not wrong. Then I would like to add some soft factors that give an investor a good feeling afterwards, that’s communication, information updates at every stage and of course a positive feedback from all three parties involved, the KAG, the custodian and the transition manager. If this matches then a lot speaks for a good transition, at least from an operational point of view. Another soft factor is, whether the transition manager created an extra value in the process.

For example, a target portfolio manager’s wish list of an index tracking portfolio may show some very illiquid government bonds. Then it is the time for the transition manager to alternatively suggest more liquid government bonds with comparable risk return characteristics. We must realise the target portfolio manager is in a very convenient situation. He gets the portfolio of his preferred choice delivered by the transition manager and therefore he doesn’t have to care about transaction costs. This is obviously a conflict of interest as well and I see it as one of the tasks of the transition manager, to point this out.

GARY: Christoph’s point is absolutely right. We have instances where we have had bond portfolios, modelled portfolios given to us, because the manager knows that we are going to go away and do all of the work, trying to find an issue that is 90% held and locked up. It may take two weeks to do it. The bond manager gets the bond, he is happy, but in reality he has delayed the portfolio coming across to him for a period while we are out there looking for the bond. Some managers do need to be policed a little bit. We have to make sure that manager knows that is not just a free rein to get a perfect portfolio and without all the attendant costs of achieving that portfolio.

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THE T-CHARTER AND ITS EFFECTS FRANCESCA: The T-Charter has been a strong talking

point, particularly in the UK market, and all the transition managers around this table have been active participants in the discussions to determine a workable code of practice for transition managers. What are your expectations of it?

ALEXANDRA: It is a great idea. It will bring clarity and more transparency as transition managers have to provide more detail about the way they plan and execute transitions. You are no longer looking at a black box when they speak to you about how they want to do it. I also look to it to make it easier for us to compare the different offers, as Holger said.

I hope that the T-Charter will become better known and that the big transition managers will sign up to it.

PETER: Self regulation is always very welcome. The T-Charter should not be the bible of transition management, but rather it should provide minimum standards. We feel any transition manager should explain why he didn’t sign up and give us the reasons what made him opt out. If these explanations aren’t clear we would definitely say that this is a definite key disadvantage in the competition for new business. If a transition manager doesn’t have very good reasons and doesn’t explain which specific points encouraged him to opt out I would say, if we can’t understand it, we would say that we would feel more comfortable with a transition manager who agrees with the T-Charter. However, as I pointed out before, it is probably a minimum standard. There are questions beyond the T-Charter that you have to ask, but I would say that it is the benchmark for the future.

GARY: It is absolutely the right way to view it. If someone is not really prepared to sign up to a standard that is there to provide a level of integrity, to provide the client with a degree of comfort that their transition manager is operating with best practice, then you have to absolutely understand why they are not signing. There is no question about that. However, one risk of the T-Charter is that you get a polarisation of providers and then you go almost full circle. I am not necessarily convinced this will happen, but it is a risk. Understanding a transition management team and their strengths and what the business model is, is part of the asset owner’s obligation to the fund. They must visit the team and see how they ring fence their transition business. Therefore, on the one hand you can understand why some people will and some people won’t sign up to it.

You have to use that knowledge in conjunction with other things. You cannot just rely on it alone. It becomes part of the investor’s tool box, if you like.

CHRISTOPH: To me it is a sign of a maturing industry. It seems to get to a high volume, low margin business now and it is in line with the spirit of MIFID. Asking your active managers for composite performance numbers is a comparable issue. The managers need good reasons for not doing that. I also see this completely in line with selfregulation or external regulation in the field of brokerage performance measurement over the last few years and of course, we appreciate greater transparency very much.

ED: It is a good initiative and it could not go fast enough in our opinion. As a firm we are very supportive of the highest possible minimum standards and that for any sort of best practice code to be meaningful and successful. You know you can’t please everyone and the success of the T-Charter depends where the debate is going hereon out. If you accommodate everyone’s business model you may as well not do it. If you do come up with a best practice, an industry best practice, it has to be of a level that you can go out with and that you are comfortable with so that it does not just give credibility to anyone that is only willing to sign up to a watered down version. We have seen people disappearing from the panel. They have their reasons and I am sure that you will be looking to find out what those reasons are. I can only guess. It is important that there are minimum standards that make us proud of being in a business with unquestionable integrity.

KARIN: I believe the T-Charter helps clients differentiate between transition managers. Christoph is echoing the views of the market and his comments reflect the feedback we are getting that self-regulation is a good thing. The BVI, DVFA and the German CFA are associations in Germany that are supportive of the T-Charter. You are right though Ed, it has not been implemented as fast as we had hoped.

Linklaters, the law firm hired to transform the T-Charter from a practitioners draft into a legal format, have now delivered a legally revised draft of the code. It will now be distributed to all transition managers, investors and interested parties. True, some institutions will not be part of the T-Charter. Surely though, the good thing is that everyone has the chance to be part of it.

FRANCESCA: Given that there is a flight to quality these days do you need the T-Charter?

GARY: We have talked to clients who have used other transition managers and it’s almost as if they don’t like talking about transition management because it has been such a painful experience for them. This is why the TCharter will be a worthwhile standard. It will actually provide benchmarks for providers. If they cannot show a minimum competency then straightaway you can move on.

Even people who sign up to it will very quickly go out of business if they cannot deliver that quality.

KARIN: The T-Charter reinforces transparency and disclosure. Providers are all still different, even though they are becoming more alike. They still apply different business models. The T-Charter does not favour one institution over another. It doesn’t matter how you do your business, or what your model is, as long as you disclose what you do and how you do it. In that way, the T-Charter will rule out poor practices and it gives clients and consultants a clearer insight into how we do our business.

ED: Signing off on the T-Charter is a good thing and we all here support it, as long as the standards are at a level that are sufficient. What I am not convinced of is that once you sign up, that everyone is similar. Every one is not similar. At the end of the day it comes down to experience and track record, the access to liquidity, project management skills

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CHRISTOPH KESY, portfolio management, E.ON Energie AG

KARIN RUSSELL-WIEDERKEHR, director, transition management, Germany, Credit Suisse

and transparency. Anyone who puts an extra desk in his or her trading room and says we are now a transition manager may not necessarily be equipped for the task. There are different business models and that will probably always be the case and it is healthy, as it helps define choice.

FRANCESCA: Are you aware of the differences in offerings between transition managers, subtle or otherwise? Or, at the least, the differences between the three houses around this table?

CHRISTOPH: We know which competitors are strong in fixed income or equity, and those which are more agency or principal focused. Then we start talking to other investors and get references and share experiences, which I think is a very important thing to do. Of course, we all know a bit about agency theory and we can make up our minds how the business model relates to these strengths and weaknesses. Personally, I am a fan of letting consultants, but also direct service providers like transition managers, do some homework and give them a case study. Let’s get away from the marketing slides. They are of no interest. I say, give transition managers some homework and let them show their experience in detail. This sort of thing will help sort out the differences between them.

FRANCESCA: Are you typical, or are you particularly demanding?

CHRISTOPH: In the field of transition management we are, I think, particularly demanding. That derives from our individual background of academic transition management research of course. I don’t think it represents the standard of the average investor.

FRANCESCA: Holger, are you equally as demanding?

HOLGER: We are, but our role is different. We interface with

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the customer and we have to inform if he is not familiar with transition management. Therefore, we have to be in a position to give the client advice on which he can choose the right transition manager for his project. We are required to provide an overview and detail and understanding about all our transition managers and their operational strengths.

That ability to provide an accurate picture is as important to us as the transition itself.

KARIN: Some 80% of a transition manager’s time is spent in the planning stage and finding out about each firm’s processes and nuances, such as the reconciliation process of a KAG and the custodian. Different firms have different processes. The majority of my time is spent speaking with all parties involved, defining processes and adding discipline to the reorganisation initiative. Implementation makes up the other 20% and can be the easier part of a transition.

THE KAG STRUCTURE GARY: You have to have a lot more structure in the German

market because you have to work within the investment guidelines particular to the German investment law, not just with this point here or this point there from start to finish when you take control of those assets you have to be fully compliant and the only way you can do that is by spending the time with the involved parties. So I think that in ensuring that the portfolio is ready for transition, you are definitely doing more work in the German market than you are doing

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in any other markets. From our point of view, we like the KAG structure, we think it makes a lot of sense, because we know that there is somebody that is looking after the client’s assets and we can have objective discussions with them. The KAG is there to act in the client’s best interests and help the client select the most appropriate person for the job.

KARIN: I would like to add one point Gary. In my experience, the biggest concern of a German client is the possibility of having an asset management gap.

GARY: I agree KARIN: The beautiful thing in Germany is that you have three parties that ensure there is no gap: the KAG, the consultant and the transition manager.

PETER: I agree. At any time during the whole process there has to be someone responsible for the portfolio. That is absolutely important for any client and for us as consultants as well.

ED: It’s key. Actually, any transition manager should take full responsibility for the portfolio and this goes back to the outsourcing agreements that we are signing now with KAGs for having that accountability. If something does go wrong and again I come back to this fiduciary care term, it is important for the transition manager to take that opportunity and take responsibility and provide that accountability.

PETER: Increasingly project management capabilities are important and that the transition manager adheres to an agreed timescale.

GARY: We have a very strong view of minimising the time we are in control of portfolios. If you have active portfolios within the transition environment and you don’t have robust operational procedures and you can’t settle all those positions on T+3 every day after the point at which the portfolio should have been handed over increases risk. That is because your active portfolio is potentially changing from an investment managers point of view. If you have an investment manager that is highly active, with a 7% or 8% tracking error and he is turning over a significant portion of the portfolio, by the time you give it to him a week later, he is going to have to revamp it all in any case. And in that inbetween period, does anybody account for the cost? The target manager is now over there and you are sitting here.

So again, you have got another transition to do or the manager has and no one really accounts for that performance measurement.

KARIN: If a significant proportion of a wish list is unsettled, a target manager may not be able to carry out his duties.

Of course, most custodians have access to borrowing and lending facilities. This means that the matter could be resolved through a lending/borrowing programme to make the portfolio fully available on the handover date.

HOLGER: Looking back, having done the first transitions in Germany with Universal Investments eight years ago, at that time there were only very few participants in the market. Then the main focus was on how to get a complex transition project done. It also involved foreign asset managers. This was a big change in the KAG world. Of

course the approach has changed somewhat over those eight years. Now our main focus is achieving best performance for the investor. That change has involved a much closer relationship with transition managers. We sit through their presentations and every time we meet them, we asked more pertinent questions and we learnt more about their business. Our side of the business has also changed. Now many more people within the company are involved in the process, although we centralise communication through specific people in our relationship team. It all means we are better placed to act as advisor, intermediary and communicator with the client and the transition manager and it is done more effectively.

ED: Those are good points. We find that KAGs are not so much gatekeepers, but facilitators. Actually, it is often more difficult in the UK where you have consultants that are much more powerful in deciding for the clients. KAGs are particularly concerned that all goes well from an operational perspective, in addition to the cost aspect, and rightly so. This is what the transition manager is responsible for: operational risk and portfolio risk. There has to be a balance between the two to make sure that you have the right party that you deal with. You can’t just look at things in isolation.

AVOIDING EXECUTION DRIFT FRANCESCA: It would be useful to highlight your thoughts on what are the most important risks that you think should be mitigated in transitions and from the client side, what particular assurances you look for from your transition manager. So Ed, if you don’t mind starting this process …

ED: Managing execution drift goes back to defining your execution strategy. For us, execution strategy is driven by a risk management strategy for which a framework is set in the planning stage. Obviously things can somewhat drift away from you. Things can take a bit longer and a transition manager needs to have ways to manage those risks. One could think of alternative trading strategies, such as hedging with derivatives and forwards, ETFs, EFPs etc, can be useful in mitigating these risks. Obviously you need to take account of investment guidelines and make sure that the client understands what you are trying to do and that goes back to communications. Having the tools to implement the trading strategy is absolutely key, however, the risk management framework sets that trading strategy.

GARY: Taking advantage of crossing opportunities is what you have to do, you have to make sure that the cross benefits the transition portfolio and you are not just crossing purely because you can cross. There are many instances where you can cross too much of a portfolio presenting liquidity problems: that is, you cross the liquid part of the portfolio, you can’t neutralise that cash exposure, so you have to be able to do it in the context of trading less liquid positions quickly. Ed talked about developing an execution strategy, and if you do that and

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you go into a blind cross you can completely destroy that strategy — as soon as you come out of it, you have to react, you have to change the strategy. It is about being able to use those opportunities intelligently.

ED: But of course, there are various definitions of crosses and crossing is one of the sources of liquidity that a transition manager has or doesn’t have. Some do not have that opportunity. At State Street, we operate a regulated crossing pool. We have done a lot of research on the benefits of crossing and basically what came out of it is that average execution costs are about 80% cheaper, so clearly there is a benefit in it. I totally agree with not postponing a transition just because of a crossing opportunity. If it is there, then you should take advantage of it. And there are very effective ways to manage the risks that come with it.

Do you want to wait two weeks for a crossing opportunity?

Probably not. Although in certain instances where you know you have one client that is selling out of a particularly difficult portfolio, a small cap or emerging market portfolio for example, and another client is buying into that structure, you may well want to wait two weeks.

FRANCESCA: Peter, from the gist of this, it seems that there is pressure on transition managers to come up to the bar, greater communication, greater preparation, pre-transition management, adding value wherever possible, demanding KAGs, and demanding consultants …

PETER: It’s been pointed out that we also have to do our homework. Five or six years ago transition management was not an important issue for us, but that is not the case now, and consultants are now giving advice on selecting transition managers. Not only that, we also help bring together all the different elements in a transition (the KAG, the client and the transition manager) and add value. While there are some people out there that are well enough educated about transition management; there are also people out there who are not educated well enough or sophisticated enough to deal with these three different organisations, taking part in a transition.

FRANCESCA: As a key client, you have increasingly sophisticated transition managers, you have increasingly sophisticated consultants, and do you feel that your portfolios and portfolio transitions reflect this?

CHRISTOPH: Developments in the market and responses or steps taken by large investors over the few last years, including greater use of advisors and transition managers, foreign asset managers, and adopting core-satellite strategies, etc., have had a remarkably positive effect on the overall return of the portfolio. Although active returns are not always what you wish in every single asset class. But the trend is going in the right direction. You are also getting away from using one single consultant for every piece of the business: for manager selection, ALM, transition manager selection, and the like. I would definitely recommend that you use a consultant. It is not that consultants know for sure who is the best transition manager, the topic is too young and the best academic brains are already working for the brokers or the buy-side. Consultants are excellent sparring

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ALEXANDRA THIELE, senior manager, master KAGs, ACTIVEST [Now PIONEER INVESTMENTS]

partners — all these guys are smart — but they should not prevent you from thinking yourself.

PETER: We highly recommend that the clients do not only rely on our recommendations but also ask their own questions and to be critical about the responses. We would really appreciate the opportunity to be a kind of sparring partner for a client, definitely.

RESPONSIBILITY & TRANSPARENCY ALEXANDRA: Communication is paramount.

It is also very, important that the transition manager has people who speak German, and know German laws. From our side, the KAG is someone who sits on top of the process is a key contact point for the client, the consultant, and the transition manager. So it is imperative that all these elements are brought together and work well together and that everyone sees and reacts to problems before they become too serious, and really, that is where experience counts in the market. And if something happens, that’s life.

It is important that you can talk openly and honestly with all parties and understand what was good, what worked well in a transition and what did not work, so that next time we can avoid potential problems. Or, we can all agree, that is was a beautiful transition, nothing went wrong and we are all happy. That, of course, is the best outcome.

GARY: I agree, you have got to take that standpoint and what is important is that the transition manager has to take responsibility. If something has gone wrong, they have got

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The German transition management roundtable, held in Frankfurt, November 2006.

to be the first person to highlight that to the client, to the KAG straightaway. The next step from there is the resolution of that problem and ensures that ultimately the client is not impacted by that. If there was a problem, work out why it occurred and make sure that the fund, which is not responsible, is made good. There’s nothing contentious there and everybody should really agree with that.

CHRISTOPH: Basically all of the big houses seem to have a strong product. It is an art to find the right one for a specific transition profile. You must ask incisive questions, get an impression of the capabilities and the sophistication of the risk analysis process, and also of the risk management and trading processes involved, and then decide on your transition manager. However, the time is now past, where the an investor can make a really, really bad choice.

KARIN: We have spoken about increased sophistication, which is apparent at every level in the German market.

Furthermore, there is internal political pressure on the funds, as well as performance pressure, which have resulted in greater emphasis on transparency. I am not referring to transparency on how performance is calculated and measured, but instead real time execution transparency. Clients look to play a part in the implementation process. I experienced this recently with a transition involving a regional fund in Germany, where the client logged on to our internet site to watch trading taking place real-time. They followed the event so intently that they contacted us on completion to comment that we had only traded 99.8% of their transition and were searching for an explanation for what had happened with the remaining 0.2%. The residual represented odd lots, which had been dealt with off-exchange. However, this is a clear example of the increased sophistication, political and performance pressure which is compelling clients towards greater transparency. I think it is something to watch.

HOLGER: With the benefit of experience of many, many transitions over the years and having a kind of standardised communication platform, being the SWIFT format, we find

we have a good working platform nowadays with many transition managers. So really I think we now have the chance to look forward at some recent developments, meaning derivatives, foreign exchange forwards, which are not always dealt with via these platforms and look at the significance of these changes, particularly their influence on the planning stages of a transition. I think things are constantly changes and these are some of the newer considerations for KAGs to focus on.

ED: Communication. Alexandra made that point quite clearly and rightly so. A transition manager should have at least the technical capability, at least quite clearly, both on the trading side and operational side. If you don’t have that then you probably should not be in the business.

Experience, track record also counts. Every transition is different, but at the end of the day, whether you have a fixed income, equity transition or a balanced transition, the process, the steps are similar. Moreover, if you have done enough of them, you know potentially what can go wrong.

Again, you need to know before a problem actually happens that it can happen, so that you can do something to pre-empt it. Finally, but certainly not least, transparency and accountability are vital. If something does not go the way it should, you need to be able to stick your hand up and say,“Let us try to resolve this quickly.”

FRANCESCA: Can I get a consultant’s perspective as a final sign off?

PETER: As Christoph mentioned earlier, transition management will become a mature industry. With the TCharter, which will be a minimum standard, but at least a benchmark, people can at least orient themselves on.

Additionally, Germany is obviously not a mature market; it is a growth market for transition management, because more consultants and practitioners are developing a deeper awareness of the value created by a successful transition.

This consciousness paired with understanding the key capabilities a transition manager must have can help them decide on a transition manager if they need one.

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A

A door was opened in 2004 by a US court decision holding that Visa and MasterCard’s exclusionary rules violated antitrust laws. The ruling appears to give American Express Co., a financial services powerhouse itself, and Discover, a unit of the Wall Street firm Morgan Stanley, a nice boost in the lucrative card business. What does it signify for the credit card market over the long term? Bill Stoneman goes in search of answers.

The most interesting development to watch, observers say, will be the response to public ownership at MasterCard, and at Visa when it takes the plunge. Until now, both organisations have been managed for the convenience of the banks that owned them, industry consultants and stock analysts say, rather than as truly competitive entities.That is likely to change.“There’s something about a free enterprise, being on your own, that’s going to force these guys to think about satisfying public owners,”says Duncan MacDonald, former general counsel of Citigroup Inc.’s Europe and North America card businesses. Photograph by Scott Rothstein, kindly supplied by Dreamstime.com, December 2006.

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Only time will tell if Hochschild is right. Discover and American Express both gained US market share in the first half of 2006, according to the Nilson Report, a card industry newsletter. Only however, by fairly small increments.

Nonetheless, the move by American Express and Discover onto turf they had been excluded from does reflect big changes rolling across the card business landscape, which has long been led by two look-alike bank-owned clubs.

Most importantly, perhaps, those same banks sold a controlling stake in one organisation, MasterCard Worldwide, which is based outside of New York, in May 2006. In addition, the very same institutions are now preparing to repeat the process with San Francisco-based Visa. Neither bank issuance of American Express and Discover cards, nor public stock offerings by MasterCard and Visa necessarily change the overall balance in the payments world. It remains greatly profitable for credit issuers, funded primarily by companies selling everything from pet supplies to neckties. Both, however, introduce a host of new variables to businesses that provide payment services and other businesses that depend on those services. Moreover, they hold implications for investors and consumers as well.

Among those variables is the possible impact on a wideranging dispute over the “interchange fee”. These are fees that merchants pay to banks in order to accept card payments. Others are the level of interest among mobile phone carriers in playing a role in payments, how well American Express and Discover capitalise on their new ability to make deals with banks and the extent to which working for public shareholders lights a fire under MasterCard and Visa managers.

SECTOR PROFILE: MASTERCARD / VISA

BANK OF AMERICA American Express card would not have been possible or conceivable a little more than two years ago. Visa and MasterCard association rules flatly prohibited Bank of America (BofA) and the rest of their members from issuing cards bearing the logo of an interloper to the bank world, such as American Express. Today, however, BofA and Citigroup, the two largest banks in the United States, are both issuing American Express cards. In addition, HSBC Group, a like-sized bank based in the United Kingdom, has similarly teamed up with Discover Financial Services, another outsider to the Visa-MasterCard circle, to issue Discover credit and debit cards in the US.“It radically changed the industry and opened up huge opportunities for us,” says Roger Hochschild, Discover’s president and chief operating officer.

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MasterCard President & chief executive officer Robert Selander, center left, and New York Stock Exchange CEO John Thain, center right, applaud as MasterCard’s stock begins trading in its initial public offering, Thursday May 25th, 2006. In one of the biggest IPOs of the year in the US, MasterCard Inc. shares surged in their stock market debut even though the world’s No. 2 credit-card brand originally priced below expectations.

Photograph by Richard Drew, supplied by EMPICs/Associated Press, December 2006.

At about 50 years old, the card payment industry is the most reliably profitable segment of the banking business.

Its great success is due largely to the willingness of large US banks to invest heavily in the two associations, rather than build networks on their own, explains David Robertson, publisher of the Nilson Report. That enabled the creation of an efficient system with near ubiquitous acceptance and name recognition in the US by the end of the 1970s and widespread acceptance and name recognition around the world by the end of the 1980s.

MasterCard and Visa do not issue cards or take credit risk themselves. Rather, they created the brands that consumers recognise and they set rules that enable financial transactions to occur. Banks that issue cards get three separate streams of revenue — annual fees paid by cardholders; interchange fees (which have raised the ire of merchants over the past decade) and most importantly, interest paid on outstanding balances. In the US, growth has shifted from credit cards to debit cards.

Merchants alleged in a series of lawsuits in the US that banks and the two big card associations illegally conspired to set unreasonably high interchange fees. Those fees amount to a weighted average of 2.19% of purchase price to accept Visa and MasterCard credit card payments and 1.75% for Visa and MasterCard debit payments, according to the Nilson Report. Credit card payments reflect an extension of credit by a card issuer, while debit payments

draw directly from a consumer’s checking account.

Though neither MasterCard nor Visa says so explicitly, market observers generally believe that the completed public share offering and plans for Visa’s pending offering were driven at least in part by desire to cap any liability resulting from any lawsuits brought by merchants against them and their shareholders. The thinking is that even if merchants convince a court that the banks and the card networks conspired to set unreasonably high fees, it would be tougher to make the case that the conspiracy continued after the banks had sold their controlling positions in the organisations and left their management boards.

American Express and Discover, at least until they started making deals with banks, were closed-loop systems, in which they issued cards and credit at the same time that they created the brands that consumers see when the shop.

MasterCard, perhaps unsurprisingly, has taken steps to build warmer relations with merchants.“At the suggestion of the merchants, MasterCard Worldwide has posted comprehensive information about its US interchange rates on its Web site,” says Chris McWilton, MasterCard’s chief financial officer in an e-mail exchange. “We were the first company in the payments industry to make a commitment to this important step.”

Industry observers say MasterCard will probably seek out marketing agreements with big merchants, such as one announced last summer with Home Depot, in which

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consumers are entered Industry observers say MasterCard will into a drawing for a probably seek out marketing agreements $100,000 kitchen with big merchants, such as one announced makeover when they last summer with Home Depot, in which make payments for a consumers are entered into a drawing for a purchase at the home supply store with a $100,000 kitchen makeover when they MasterCard card. make payments for a purchase at the home None of that, however, supply store with a MasterCard card. necessarily changes the interchange dynamics.

Even without controlling ownership and seats on MasterCard and Visa boards, banks possibly a contact-less device, card industry analysts say. may still call the shots on interchange fees. That is because “We go out with our mobile phones more frequently than they can promote either brand to consumers and could we go out with our wallets,”Robertson says.

Phone companies ought be interested as well, adds Bruce easily shift transaction volume to the card network that produces the most revenue for them. The networks, by Cundiff, an analyst with Javelin Strategy & Research, a contrast, do not really need to compete for the favour of financial technology research firm in Pleasanton, Calif. merchants. Merchants meantime are loathe to tell “Mobile phone carriers are always looking at ways to get customers that they accept one of the main global card stickiness in their subscribers,” he says. Bank-owned MasterCard and Visa would never would have allowed brands, but not the other.

While the outcome of complex antitrust litigation is Verizon Wireless or any of its counterparts to issue credit and probably impossible to know, Nilson Report data shows use their brands, just as they did not allow American Express that a great deal is at stake. US merchants paid $25.13bn to and Discover into the game until they were told that they accept MasterCard and Visa credit card payments in 2005 had to. However, as public companies, they ought to have and $9.76bn to accept debit card payments with cards bigger interest in new revenue sources, observers note.“They bearing the two big brand names. Most of those payments are no longer constrained to viewing their world strictly as a find their way to the card issuers; the networks take a small bank world,”says Eric Grover, principal of Intrepid Ventures, a payments consulting firm in Menlo Park, California. share of the total.

Issuing credit and accepting attendant risk, of course, Even if merchants are unsuccessful in their litigation, political pressure could well force down fees on debit card would be a huge leap for phone companies and so perhaps payments, says Nilson Report’s Robertson. Credit card they would choose only to enable transactions in acceptance probably helps merchants sell more than they partnership with a bank issuer. That would not divert as otherwise would, Robertson adds, as consumers spend more much revenue from the incumbent bankcard issuers.

One likely result of the changing landscape is increased than the money they have on hand. Debit card payments, however, simply substitute for cash, since the consumer has market share for American Express and Discover. To be sure, to have the funds available in order to use the card, he they are far behind the big networks that banks created.Visa explains. As a result, merchants are not as enamoured of had 42.2% of the credit card purchase volume in the first six debit card payments. However, since consumer usage of months of 2006 in the US, the largest card market in the debit cards is growing rapidly, any cut in fees could be costly world, according to the Nilson Report. It was followed by to banks. “It is a staggering amount of money,” Robertson MasterCard, which had 29% of the market, American Express, with 23.2%, and Discover, with 5.6%. American says.“If it were cut in half that would hurt.”

Predicting a political solution to the dispute is risky Express’s share rose from 22.5% a year earlier and Discover’s business. However, Craig Wildfang, the lead attorney for the share rose from 5.3%. The share gains, the newsletter says, merchants and a partner with Robins, Kaplan, Miller & Ciresi could be attributed to banks that also issue MasterCard and LLP in Minneapolis says that lawmakers and regulators Visa cards beginning to issue theirs as well.

Compared with the global scope of the three larger should note that the Reserve Bank of Australia ordered Visa and MasterCard to roll back interchange fees from about brands, Discover is mainly a US card. It is moving, however, 0.95% of a purchase transaction to 0.55% in 2003. When it to build acceptance in other parts of the world. It began was implemented, he adds, card issuers were not suggesting implementation in November of a reciprocal agreement with China Union Pay, under which its cards will be accepted they had second thoughts about the business.

“The networks said disaster would happen,” Wildfang in China and certain China Union Pay cards may be used in explains, but it has not. After the possibility that banks will the US. In August this year, it also announced a similar lose interchange fee income, another threat to the status agreement with JCB, the largest card issuer in Japan but has quo comes from mobile phone operators, though observers not said when the necessary supporting systems will be up say this may be a couple of years away. Logic suggests and running. In addition, it has struck deals with marketing enabling mobile phones to serve as payments devices, companies to sign up merchants in Latin America.

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It is not clear yet that merchants have a big stake in the likely gains by American Express and Discover. Their cost to accept American Express payments is a bit higher than to accept MasterCard and Visa cards. Their cost to accept Discover payments is a bit lower. Banks, however, presumably share some of their card revenue with American Express and Discover when they issue cards carrying those brands.

The most interesting development to watch, observers say, will be the response to public ownership at MasterCard and at Visa when it takes the plunge. Until now, both organisations have been managed for the convenience of the banks that owned them, industry consultants and stock analysts say, rather than as truly competitive entities. That is likely to change.“There’s something about a free enterprise, being on your own, that is going to force these guys to think about satisfying public owners,” says Duncan MacDonald, former general counsel of Citigroup Inc.’s Europe and North America card businesses.

MasterCard and Visa likely will face pressure to do more to differentiate themselves in the eyes of banks that issue their cards, even if differentiation among consumers and merchants is nearly impossible. “You have got to wonder why some financial institutions would go with Visa, MasterCard and American Express,” says Nilson Report’s Robertson. He explains that a bank might seek a better deal from either Visa or MasterCard by delivering all of its mainstream consumer volume to one network and then issue American Express cards to its high-end customer base.

The organisations might compete on the basis of the cost and efficiency of their networks and the effectiveness of anti-fraud tools they each offer. If American Express and Discover pick up significant market share or if they are forced to cut interchange fees, MasterCard and Visa could be forced to come up with new sources of revenue. In addition to working with mobile phone carriers, the card groups could move more aggressively into related businesses, such as transaction processing, observers says.

MasterCard intends to do exactly that, says McWilton, the chief financial officer, as well as continue to work to expand acceptance into new merchant categories.

“MasterCard is expanding acceptance in electronic commerce environments, fast food restaurants, convenience stores, and in public sector payments, including taxes, fees, fines and tolls,” McWilton says. If there is an alternative to the basic model, however, that merchants fork over to card issuers a slice of the payments that customers make to them, McWilton offers no suggestion of what it would be.

A number of observers say they see little sign of a more aggressive management at MasterCard since it sold shares worth $2.4bn last May. Maybe it is not an urgent or pressing issue. MasterCard stock more than doubled its initial public offering price of $37 by November to about $94. Without tinkering with its business model at all, MasterCard will see handsome growth in card payments outside of the US for many years to come, says Anurag Rana, a stock analyst with Key Bank Capital Markets.

Don’t work in the dark, who knows what you might find Emerging Markets Report provides a comprehensive overview of the principal deals, trends, opportunities and challenges in fast-developing markets. For more information on how to order your individual copy of Emerging Markets Report please contact:

Paul Spendiff Tel:44 [0] 20 7680 5153 Fax:44 [0] 20 7680 5155 Email:paul.spendiff@berlinguer.com

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THE RISE OF

COMPONENT OUTSOURCING

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AMES HOCKLEY, A principal in the operations practice at Investit, a UK-based investment management consultancy, notes,“There is a recognition that the days of the big end to end lift-out are coming to an end. One of the reasons is that in some of the deals, there have been problems with the migration from the client’s legacy platform to the provider’s dedicated outsourcing core platform. What we are now seeing is that clients are looking more to outsource components of their fund administration operations. This is not to say that they will use 57 different providers, but will use a core group of no more than three or four for most of their needs and then a handful of specialists for their alternative assets.”

The theory behind the lift-out operation was for an administrator to garner a significant number of deals from household name asset managers and run them on its global platform in order to churn out economies of scale for all concerned.The reality was that out of the 30 or so outsourcing deals struck over the past four years, only a handful actually transferred over, according to Hockley. In other words, it was not proving cost effective for anyone and the custodians baulked at having to run and maintain multiple systems.

These issues were the main reasons behind the unravelling of three major high profile deals in 2005.

Although Bank of New York still caters to the custody and administration needs of Merrill Lynch Investment

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Trends come and go and even the relatively staid world of fund administration is not immune from the shifting winds of fashion. It was only a few years ago, that “lift-outs” of the back office function was the talk of the town. Today however, ‘component’ outsourcing looks to be all the rage. Instead of a blanket approach to outsourcing, fund managers are increasingly adopting a modular methodology, contracting out only selected products and services. Lynn Strongin Dodds reports.

Management’s, now rechristened BlackRock’s, assets, the fund manager decided against a full blown outsourcing deal, allegedly because the fund manager was reluctant to move to Bank of New York’s SmartSource platform.

Schroders Investment Management also surprised the markets with its decision to end its five-year back-office outsourcing contract with JP Morgan Worldwide Securities Services, while F&C Asset Management pulled the plug on the Mellon Financial deal; reportedly because the parties could not agree terms, particularly over the price.

The breakdown of these deals as well as changing market conditions has led asset management groups to re-evaluate their outsourcing intentions. They are opting for a much more granular approach and have broken down the different functions embedded within their middle and back office to see where costs can be saved and value added. As Sebastian Danloy, of Société Générale Securities Services, notes, “UK asset managers had looked at outsourcing because they thought it would make their lives easier. However, the providers were not able to leverage off the infrastructure that they had and some of the deals fell apart. Today, asset managers are looking at their offering on a product by product basis and opting for a more best of breed approach.”

Tom Abraham, managing director and global head of strategic solutions for the global transaction services

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Charlie Helmstetter, director, international head of product specialists at Mellon Financial Corporation, notes,“We are definitely seeing a blurring between the requirements of the pure alternative players such as hedge and private equity funds and the run of the mill equity fund investors.

Photograph kindly supplied by Mellon Financial Corporation, December 2006.

James Hockley, a principal in the operations practice at Investit, a UK-based investment management consultancy, notes,“There is a recognition that the days of the big end to end lift-out are coming to an end. One of the reasons is that in some of the deals, there have been problems with the migration from the client’s legacy platform to the provider’s dedicated outsourcing core platform. What we are now seeing is that clients are looking more to outsource components of their fund administration operations. Photograph kindly supplied by Investit, December 2006.

division at Citigroup, concurs, adding, “We are definitely seeing more component based arrangements. It is in a way, a much more sophisticated form of supply chain management where fund managers are focusing more on how, where and with whom to buy their services. The challenge for the providers is how to connect and integrate all the pieces together in order to be that best provider.”

This is not an easy task as the days of the plain vanilla funds are long gone. Equities and bonds are just one of many investment vehicles on the menu. Today, an asset manager is likely to have an ever increasing complex and intricate array of products that typically include a family of alternatives. Hedge funds and private equity are now almost mainstream; with commodities, currencies and emerging market bonds being increasingly added to the mix over the past year.

This is not even mentioning the explosion of the use of derivatives thanks to the introduction of UCITs III as well as the increasing popularity of liability driven investing strategies. They are now integral tools in a traditional manager’s investment box used for either hedging or as part of an absolute return strategy.

The goal for the fund administrator, of course, is to ensure that they are offering top of the range, state of the art services and products in as many of the functions as possible. Flexibility is the key word. The bread and butter core custody and fund accounting services are a must but players must today also offer price calculations, risk as well as transition management and performance measurement, just to name a few, for the thornier alternative asset classes.

Real time information is also on the agenda although all admit it will be some time before that becomes a reality.

In order to meet these more demanding requirements,

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Stephen Turner, head of BNP Paribas’ Securities Services’ global fund services products in the UK, says,“We try to use the organisation in its entirety and look to see how we can harness the skills of the investment bank and fund management group to enhance the performance of our fund administration capabilities, particularly in the area of structured products.

We were able to lift out the performance measurement and analytics group from asset management to create the Investment Reporting and Performance team, and now we are looking at opportunities around analysis of OTC and derivative pricing.” Photograph kindly supplied

by BNP Paribas, December 2006.

full service providers have taken a leaf out of their clients’ pages and are creating core and satellite packages. Susan Ebenston, senior vice president of JP Morgan Worldwide Securities Services, explains,“The need to create a portfolio with different instrument types is driving the complexity of the business and as a result, fund administrators need to reflect their client’s operations. We have created what we call a hub and spoke approach. There is the hub of our administration capabilities which we have been doing for many years – custody, fund accounting, transfer agency, etc – and around that we have created the spokes for derivatives, hedge funds, property, private equity, etc.”

Although custom made has become the buzzword in the industry, many players still have a set, albeit, expanding, range of products that are configured to meet a client’s specific needs. Fearghal Woods, director of business development, at Bank of Ireland Securities Services, says “Although a lot of the business is commoditised, it is rare, for example, to get two clients who want the same report or to distribute information to their customers in the same way. An insurance company, for example, has different requirements than a mainstream asset manager. In all cases, the boundaries are being pushed out even further and our job is not just to roll out solutions but to integrate the different individual requirements on one platform.”

Jeremy Hester, senior vice president in Global Fund Services business development at Northern Trust, notes,“It is essential that you have an efficient core processing architecture that provides clients with as much information as possible but also offers the flexibility to tailor services and deliver solutions such as, for example, in delivering analytics using a fund manager’s own liability driven investment benchmark. It is important to be able leverage the

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Susan Ebenston, senior vice president of JP Morgan Worldwide Securities Services, explains,“The need to create a portfolio with different instrument types is driving the complexity of the business and as a result, fund administrators need to reflect their client’s operations. We have created what we call a hub and spoke approach. There is the hub of our administration capabilities which we have been doing for many years – custody, fund accounting, transfer agency, etc - and around that we have created the spokes for derivatives, hedge funds, property, private equity, etc.”

Photograph kindly supplied by JP Morgan, December 2006.

Jeremy Hester, senior vice president in Global Fund Services business development at Northern Trust, notes,“It is essential that you have an efficient core processing architecture that provides clients with as much information as possible but also offers the flexibility to tailor services and deliver solutions such as, for example, in delivering analytics using a fund manager’s own liability driven investment benchmark. Photograph kindly supplied by Northern Trust, December 2006.

capabilities you have and be able to redefine them to support a client’s specific needs instead of having too many products on offer, that are delivered in an un-integrated fashion. The ability to do that is where you can add value for clients and provide the basis for cost efficiencies for both the client and yourselves. If you do not have that kind of service and system flexibility then the proposition becomes less attractive and the business will go elsewhere.”

Despite the cost and time, providers are more than willing to assist clients moving into new and unchartered territories if they believe there are benefits to be reaped and the service can be eventually rolled out for others. For example, Northern Trust was more than willing to lend Unilever, the multinational consumer goods company, a helping hand in launching a fully tax-transparent cross border pension pooling vehicle, at the beginning of 2006.The pooling vehicle, which is called Univest, was set up in the form of a Luxembourg-domiciled Fonds Commun de Placement (FCP) and the US-based house is providing the custody and fund administration services. Now that the prototype is in place, Northern Trust can leverage off its experience to other clients wanting to go down the pooling path.

Bank of Ireland Securities Services, on the other hand, developed a separate products development group in late 2005, which works with clients to design new solutions for their structured products.“Take a client who has a private equity structure. We do not just tick a box but will create additional capabilities that it can use,”notes Woods.

Meanwhile, BNP Paribas Securities Services taps into the expertise of its investment bank and asset management groups. Stephen Turner, head of the group’s global fund services products in the UK, says, “We try to use the organisation in its entirety and look to see how we can

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Brian Coughlin, IBT’s managing director for US and European operations,“First, providers need to be in an environment where they are doing automated reconciliation and exception identification on a daily basis. Particularly with these types of securities transactions and positions, you’re just not going to be fully aware of your potential risk exposure if you can’t reconcile in a timely fashion.”

Photograph kindly supplied by Investors Bank & Trust, December 2006.

harness the skills of the investment bank and fund management group to enhance the performance of our fund administration capabilities, particularly in the area of structured products. We were able to lift out the performance measurement and analytics group from asset management to create the Investment Reporting and Performance team, and now we are looking at opportunities around analysis of OTC and derivative pricing.”

If the fund administrator cannot create its own specialist offering, it will buy the expertise. This has certainly been the case in the hedge fund arena, which has seen an uptick in demand for services ranging from daily net asset valuations and pricing of over-the-counter derivatives to daily risk reporting and weekly subscriptions and redemptions.

The past two years has seen a swirl of activity with JP Morgan adding the middle and back office operations of US hedge fund group Paloma Partners to its 2004 purchase of Tranaut and State Street entering the fray with its International Fund Services purchase. Other notable mentions include HSBC buying Bank of Bermuda, Citigroup taking over Forum Financial, Northern Trust acquiring Baring Fund Services and Mellon Financial Corporation buying DPM, which was one of the few remaining independent hedge fund administration firms.

The irony, perhaps, is that these specialist services are no longer limited to the confines of the pure hedge fund players. The boundaries are converging and it is difficult to find a long only fund manager who has not already jumped on the hedge fund bandwagon or contemplating such a move. As Ebenston, points out, “We created JP Morgan Hedge Fund Services specifically to cater to hedge funds but now we are extending it to traditional fund managers as they are launching hedge funds.” The firm recently won

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a mandate from Henderson Global Investors, an asset manager with more than $126bn in assets under management, to tend to its middle- and back-office services for its hedge funds.

Charlie Helmstetter, director, international head of product specialists at Mellon Financial Corporation, notes, “We are definitely seeing a blurring between the requirements of the pure alternative players such as hedge and private equity funds and the run of the mill equity fund investors. There has been a significant increase in demand from long short players for the same types of services that the hedge funds require, such as collateral management and independent pricing of OTC derivatives. This not only requires a fund administrator to invest in the technology but also the intellectual capital.”

Offshore services are a further consideration in this regard.

Susan Clark, managing director of Fund Administration for RBS International in Jersey notes that: “Over the past few years we have noticed a definite shift in the requirements

offshore with regard to outsourcing arrangements, with “insourcing” often being the preferred route. For historic plain vanilla funds it was possible to operate on an outsourced basis where a “factory processing” model could prevail. In recent times, with increasingly innovative and, as a result, more complex structures being created, that model is no longer sustainable.

The emphasis and focus has changed with the administrator performing a more significant role in fund structuring from the outset of a project and transitioning from inception to launch, and ensuring a high level of customer service is attained and sustained.“We have found it to be more efficient and cost effective all-round to perform the functions offshore as a “one stop shop”and, to this end, we have worked to up-skill [sic] both resources and technology to meet client and market demands. This has resulted in a more flexible, tailored approach with customer service standards within our own control and the ability to create centres of excellence,”adds Clark.

THE ARCHEUS CASE: BLAMING THE MESSENGER Two years ago, Gary Kilberg and Peter Hirsch, operators of New York-based hedge fund Archeus Capital, presided over a mountain of assets totalling $3bn. Their focus on convertible-bond market arbitrage was seemingly unshakeable. That was then.

Within months, the strategy began to falter.

Redemptions soon piled up and before the year was out Archeus was in the midst of an irreversible freefall. By the autumn of 2006, the haemorrhage had reduced assets to less than $700m, forcing Archeus to finally throw in the towel. Dave Simons reports.

A

rcheus showed a year-to-date return of less than 2% at the time of closing. In a two-page farewell letter to investors, chief executive officers Kilberg and Hirsch chose not to focus on the fund’s poor performance, but instead cited “negative sentiment” that had resulted from their third-party administrator’s “failure to properly maintain the books and records of our funds.” That, coupled with an inability to properly re-reconcile the funds’ records in the months following the revelation, had “led to a series of investor withdrawals from which we have not been able to recover,” according to management.

The allegation that less than precise accounting was somehow to blame for the demise of the once-powerful Archeus—the second major hedge-fund death of 2006— has, understandably, received mixed reviews around the industry. For its part, Archeus’ administrator, GlobeOp Financial Services, has stayed out of the fray. In an interview with newsletter FINalternatives a GlobeOp spokeswoman said that the company “totally disagrees

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with the allegations.” She added, “While it is easy to point fingers at third parties, investors typically liquidate based on fund performance results.” While some commentators have suggested that Archeus might even take legal action, proving liability could be an uphill battle, note experts.

The Archeus hubbub comes at a time when the outsourcing of administrative functions has reached a fever pitch—particularly among hedge funds. Faced with an increasingly diverse investment climate and lacking sufficient in-house resources, fund managers find it advantageous to outsource rather than build infrastructure. At the same time, the evolving market for outsourcing compels providers to constantly sharpen their skill sets and include innovative services such as daily accounting and derivatives processing and reporting. The recent introduction of Moody’s Investors Service Operations Quality (OQ) hedge-fund rating system underscores the need for transparency with regard to such critical functions as valuation process, accounting controls and regulatory compliance.

“While we cannot offer an opinion as to who is at fault in this situation, it certainly does keep quality and riskmanagement front and center when folks are making this type of a decision,” says Rob Mancuso, senior vice president of Boston-based Investors Bank & Trust (IBT), which provides fund administration services. “The more incidences of big hedge funds collapsing, the more government may get involved, which adds yet another level of oversight and compliance.”

Adds Brian Coughlin, IBT’s managing director for US and European operations, “First, providers need to be in

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Against this background of increasing sophistication and customisation, one question looming overhead is the cost of supplying these niche products. There is no doubt that clients have become more demanding but are fund administrators confident enough to charge the appropriate price for their services, particularly on their higher value end range. The consensus seems to be yes.

One reason is that in today’s relatively buoyant markets, cost is not as big a factor. The dark, bleak days of 2000 and 2001 seem like a long time ago and memories are short, particularly when times are good and markets are on a relative roll.

As Hockley puts it,“Three to four years ago, economic and market conditions were much more of a factor. There was a big focus on cost reduction but now fund managers are more profitable and there is a realisation that the cost of administering an OTC derivative, say, is ten fold more than, for example, a straightforward equity trade, and the cost has to be passed through.”

Another factor is that fund administrators are no longer willing to give away services for a song. Developing top of the line products for alternative assets has a higher price tag than for example a mainstream equity fund, and they want to be reimbursed for their efforts. Investment managers, on the other hand, have also realised that the firms boasting the lowest prices may not have the best wares under their showcase.

Mark Kerns, executive vice president of fund manager services, Europe, at Bank of New York notes,“I think there has been a real change when it comes to price.There is much more emphasis on the relationship between the fund administrator and client, and the price today better reflects the level of overall activity and types of services that the fund administrator provides.”Woods echoes these sentiments, adding,“In terms of putting a deal together, it has become a much more consultative process between the fund administrator and the asset manager. The client needs to fully understand what is being provided and how much it will cost.”

an environment where they are doing automated reconciliation and exception identification on a daily basis. Particularly with these types of securities transactions and positions, you’re just not going to be fully aware of your potential risk exposure if you can’t reconcile in a timely fashion. The longer it’s out there, combined with the volatility of the markets, you’re just setting the fund and its potential investors up for a big fall.”

Of equal importance, says Coughlin, is a solid understanding of risk management and regulatory processes. “Firms like ours that have been heavily involved in the regulated 40Act world can leverage off of that knowledge, as opposed to the offshore type of administrator who has a more relaxed set of regulations, and therefore is not completely customer-tuned to this kind of scrutiny and pressure.” IBT has been a strong proponent of increasing independence in transparency, says Coughlin, “and to that end we’ve created a modelling solution for OTC instruments so that we are able to actually remove the hedge-fund manager from the pricing decisions associated with the instruments, which helps us maintain a proper level of independence.”

If in fact the independent body is at least partially to blame in the case of Archeus, how does one go about restoring investor confidence? For starters, by encouraging openness and ease of communications, says Coughlin. “Because it is not only about what the investment manager may be doing to achieve targeted results—investors also want to know who they’re hiring, what kind of quality control is in place behindthe-scenes, and so forth. It’s important that investors know that they’re welcome to come in and take a look at the process procedures and controls at a moment’s notice…they should be able to kick the tires when they feel like it.”

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Rob Mancuso, senior vice president of Boston-based Investors Bank & Trust (IBT), which provides fund administration services says,“The more incidences of big hedge funds collapsing, the more government may get involved, which adds yet another level of oversight and compliance.” Photograph kindly supplied by Investors Bank & Trust, December 2006.

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Green City. Underscoring the trend is a report from Merrill Lynch co-authored with the non-profit World Resources Institute (WRI), which links the demand for eco-friendly solutions with an increase in compatible investment opportunities. In a world of finite resources, higher consumer expectations are stimulating a technology race to meet them, according to the report, which will in turn “present a compelling investment opportunity for investors worldwide.”

Responsible

& Profitable

It used to be that investing with a conscience meant sacrificing returns for the sake of the planet. However, growing concerns over issues ranging from global warming to corporate accountability have helped raise the profile of socially conscious investment platforms, making responsible stock picking a potentially promising endeavor. From Boston, Dave Simons reports.

HE OLD NOTION that it is cheaper to run a business without worrying about the raw sewage running into the nearby water supply was not lost on Al Gore, presidential candidate turned environmental crusader. In his eye-opening documentary about the impact of global warming, An Inconvenient Truth, Gore, quoting Upton Sinclair, affirmed that “you can’t make somebody understand something if their salary depends upon them not understanding it.”

However, as Gore himself observes, that attitude is rapidly changing, as mainstream business begins to see the long-term profitability of adopting more environmentally sound operating practices. Last summer, California’s Republican governor Arnold Schwarzenegger announced that his state would launch a broad initiative aimed at trimming greenhouse-gas emissions by 25% over the next 15 years. Spearheaded by eco-minded chief executive officer (CEO) Jeff Immelt, General Electric has said it will increase research and development (R&D) investments in renewable technologies to $1.5bn by 2010, with the added goal of doubling revenues from clean technologies to nearly $20bn over the next three years. Even Wal-Mart, that favorite punching bag for the political left, has retrofitted its freight trucks with an alt-power converter that cuts fuel usage by 90% when idling.

Underscoring the trend is a report from Merrill Lynch coauthored with the non-profit World Resources Institute

T

(WRI), which links the demand for eco-friendly solutions with an increase in compatible investment opportunities.

In a world of finite resources, higher consumer expectations are stimulating a technology race to meet them, according to the report, which will in turn “present a compelling investment opportunity for investors worldwide.” Typical of such opportunities is a newly announced partnership between Fortis Investments and environmental research firm Trucost Plc, which identifies cost-saving environmental benefits generated by certain companies, allowing investors to capitalise through Fortissponsored sustainability funds.

Indeed, the push for green alternatives — from energy to whole foods to paper-conserving electronic communications — has helped raise the profile of so-called socially responsible investment (SRI) products. Unlike conventional fund managers, SRI stewards “screen” their stock selections using a variety of social and environmental factors, hold a company’s feet to the fire through active shareholder engagement, and ultimately drop a company altogether if standards fail to be met.

In addition to green or clean causes, SRI fund managers are continually on the lookout for companies that actively encourage workplace diversity or promote the equitable treatment of workers at overseas factories. However, they traditionally avoid “vice” or “sin” commodities, such as tobacco, alcohol and weaponry, SRIs have no qualms with technology and have championed industry giants such as Microsoft and Yahoo. Thanks to SRIs’ emphasis on corporate governance, socially conscious investors were largely shielded from the fallout surrounding Enron, WorldCom and other accounting-related scandals of the past several years.

“Responsible investment covers a range of issues and investment management approaches,” says Will Oulton, head of the responsible investment unit for London’s FTSE

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Group and an architect of the FTSE4Good Index Series.

“Our index selection criteria are based on a model of corporate best practice and cover environmental impact, human rights, countering bribery, supply chain labor standards and stakeholder relations,”he says.

The idea of influencing corporate policy through personal investment has been enormously enticing to a cross-section of investors, as evidenced by the sizeable increase in SRI fund flows. Since 1995, SRI-based assets have risen from $639bn to over $2trn, and currently represent more than 10% of all assets under management.

SRI fund choices have more than quadrupled during the same period.

Not that all of this social consciousness necessarily comes with a cost. With one-year returns in the 25% range, the industry’s preeminent SRIs, the New Alternatives Fund (NALFX) and Parnassus Fund (PARNX), have managed to achieve that perfect marriage of above-average profitability and investment responsibility. Others, such as the Aquinas Value Fund (AQEIX), Citizens Value Fund (CVALX) and Vanguard FTSE Social Index Fund (VFTSX) have posted solid gains while maintaining a stringent set of investment criteria.

Green and growing One of the more notable high-flyers of late is Bostonbased Winslow Green Growth Fund (WGGFX), which seeks capital appreciation through environmentally responsible investing in small-capitalisation companies.

Launched in 2001 by Jack Robinson, founder and president of Winslow Management Company, the fund currently totals $190m in assets and sports a five-year return of 15.10% (as of October 31st 2006), some six points ahead of the benchmark Russell 2000 through the same period. For his achievements, Robinson recently netted first place in the aggressive-growth category in Barron’s-Value Line 2006 Annual Fund Manager’s Survey.

Robinson disputes the notion that SRI managers are somehow limited by their selection of “correct” companies. “There are a number of factors that really allow us to be casting into a pond that has more fish and bigger fish,” says Robinson. “For instance, during the screening process you are addressing potential environmental problems that, in the long run, could wind up becoming real financial problems as well. So you are screening in companies that are incorporating the environment into their overall thinking and strategy, and by definition should be able to reduce their costs and enhance their revenues. At the same time, you are also including within your universe companies that should not have governance problems, with the idea that you are ending up with companies that are better managed than the ones you are screening out.”

Among Robinson’s rotating roster of holdings—which includes tech firms such as VA Software and Sonic Solutions, to green-energy producer Zoltek—a few heavy hitters have emerged, including Whole Foods, a leading retailer of natural-foods products that has reached nearly

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007

Will Oulton, head of the responsible investment unit for London’s FTSE Group and an architect of the FTSE4Good Index Series.“Our index selection criteria are based on a model of corporate best practice and cover environmental impact, human rights, countering bribery, supply chain labor standards and stakeholder relations,”he says. Photograph kindly supplied by FTSE Group, December 2006.

large-cap proportions. “It is sort of the Holy Grail of the green investment universe,” says Robinson.“The company has a very dynamic and decentralised management that is really driving it forward—it is not a top-down type of management. We continue to own it, recognizing that the returns of the next 10 years probably will not be quite as large as they were over the previous 10 years. But the story is still very compelling for a host of reasons, not only because it has worked so well for us, but to also remind us of what it is we need to be looking for in other companies.”

Challenging times Because their social screens prevent them from rotating into whichever sector happens to be heating up at the moment, SRI managers often have to work twice as hard once the going gets tough. Such has been the case for Amy Domini, founder and CEO of Boston-based Domini Social Investments and the acknowledged “first lady of social investing.” In 1990, Domini and partners Peter Kinder and Steve Lydenberg established the Domini 400 Social Index (the first index based on social-screening factors), a companion Domini Social Equity Fund (DSEFX) a year later, then rode the 1990s bull for all it was worth.“It was a perfect market for indexing, and social screens put us right in the sweet spot of the market for many of those years.

And then the inverse happened.”

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SOCIALLY RESPONSIBLE INVESTMENTS

should be distributed in unfettered Heavily invested in tech stocks capitalism without more restrictive when the downturn began in mechanisms involved. In the case of early 2000, Domini has spent the nuclear power, we ask, do you want past six years“facing a headwind” raw materials distributed as broadly while her non-SRI competitors and as cheaply as possible? As such, we exploited big gains in oil and think that our screens are important in weaponry. Though the fund order to make a statement about the currently maintains a respectable proper function of capitalism in this year to date return of 9.56% (as of world. So at the end of the day, I don’t November 22nd 2006), early last think you are going see these screens year Domini — who Time changing all that much.” magazine named one of the 100 Amy Domini, founder and CEO of Bostonmost influential people in the based Domini Social Investments and the world in 2005—decided to move acknowledged “first lady of social investing.” In Sticking with it away from indexing in favour of 1990, Domini and partners Peter Kinder and The notion of commitment has been an an actively managed strategy. integral part of the SRI story, with Steve Lydenberg established the Domini 400 Wellington Management, the investors showing a willingness to stick Social Index (the first index based on socialcompany that helped Domini’s with their funds, even during periods of screening factors); a companion Domini Social newly launched European Social pronounced volatility. “While some Equity Fund (DSEFX) a year later, then rode Equity Fund to a robust 1-year might climb into an SRI because it is hot the 1990s bull for all it was worth.“It was a gain of 42.64%, will serve as and dump it when it is not,” says perfect market for indexing, and social screens DSEFX’s steward.

Robinson, “for the most part, Winslow’s put us right in the sweet spot of the market for “For the first four years I was shareholders are individuals and many of those years. And then the inverse willing to ignore the trend,” says corporations who are committed to the happened,” she says. Photograph kindly supplied Domini,“because I have absolute environment, understand the philosophy

by Domini Social Investments, December 2006. confidence that over the march of and rationale and therefore won’t jump history the application of social ship just because we’ve had a down criteria, universe to universe, is an enhancement. quarter. This is exactly the kind of investor we want.”

Nevertheless, at a certain point you start to think, ‘Don’t I With baby boomers accounting for the lion’s share of owe it to the majesty of social investing to try and win in any pension investments today, managers such as FTSE’s kind of market that’s presented to me?’ With an index-to- Oulton view the SRI as a modern extension of the old index plan, you can always find a better stock, but because social consciousness of the past. “SRI investors have a you’re weighted by the market capitalization, it’s sometimes values set which is reflected in their investment choices,” hard to structurally adjust for the better companies.” says Oulton.“All things being equal, these values issues are By combining her company’s leadership with as important to SRI investors as the short term investment Wellington’s quantitative approach to delivering the active performance of their funds.” portfolio, Domini is confident that she is hit on the right “The way you use your investment capital is the formula for her geographically distinct brand of funds. perfect mandate to start living your life in a way that is “Even though the Wellington track record is brief, the ‘green,’” adds Robinson. “Rather than ignoring these work arrangement and information exchange has been issues or having negative feelings about them, more and excellent. It was obvious that the same model could work more people are looking for positive solutions, and one for the Social Equity Fund of those solutions is as well.” through your own 5 Year Performance of FTSE Korea Index vs. FTSE World While societal changes portfolio.” From Domini’s Index in USD terms have prompted some SRI vantage point, the 160 proponents to call for a underlying message from 140 review of certain social shareholders is still very 120 100 screens, Domini is not positive. “Through our 80 about to alter her core surveys, we keep hearing 60 beliefs just yet. “Alcohol, how people love the idea 40 tobacco and gambling that they can make a 20 are highly addictive, they difference in the world 0 destroy the addicted and at the same time be a person as well as that financial steward for their person’s family, and as family’s future. I think it is FTSE4Good Europe (EUR) FTSE4Good Global (USD) such, I’m not sure that a really elegant solution,” FTSE4Good UK (GBP) FTSE4Good US (USD) those kinds of products she maintains.

Source: FTSE Group

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Marketing gimmick

or a new paradigm?

Since the introduction of the first exchange-traded fund more than 15 years ago, the ETF market has recorded double-digit annual growth and now represents more than $400bn of assets under management on a global basis. Increasingly, institutional and individual investors realise that ETFs offer cheap and convenient access to a variety of investment styles, sectors, countries and asset classes, allowing the construction of both simple and more sophisticated investment strategies. Yannick Daniel, head of quantitative research at Société Générale explains how ETFs can add value in a core-satellite portfolio construction process by offering not only a pure beta return on the core side, but also an alternative for generating alpha in the satellites.

LPHA GENERATION IS what active managers get paid for. Before 1964, long-only investors who outperformed a market index in absolute terms would have imagined themselves to be successful. Stanford University professor William F. Sharpe amply demonstrated in various papers issued between 1962 to 1994, that the performance of an active manager should be measured on a risk-adjusted basis by differentiating policy return from active return. These days active asset managers know they are judged, not only on the quantity but also on the quality of alpha they are able to deliver. That is because investors will no longer allow managers use beta management to leverage the systematic risk exposure of their portfolios. This situation has led to the growth of coresatellite management, by which part of the portfolio is managed passively while the remaining is invested in satellite strategies.

Skill is what matters for generating positive alpha. Even so, empirical surveys suggest that, on average, active managers are not skilled at generating returns above their respective benchmarks. In fact, around two-thirds are unsuccessful in generating a positive alpha. As in all zerosum games, what is lost by some is gained by the others and therefore only talented active managers can durably add value in an inefficient market.

The Capital Asset Pricing Model (CAPM) framework implies that, at equilibrium, uncorrelated assets have no particular value in portfolio construction. Specific risk associated with individual assets can be diversified out and only systematic risk will be rewarded. Contrary to the Efficient Markets Hypothesis (EMH), empirical evidence

A

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007

shows that financial markets are not perfectly efficient, therefore generating alphas is possible. Market participants have different risk preferences, time horizons, skills and cognitive processing capabilities. Individuals also react to market information differently, for instance different individuals may buy or sell a security given the same piece of news hence creating market inefficiencies.

Because alpha is not homogeneously distributed among market participants, it can be thought of as the inefficient component of the market; whereas beta represents the efficient component. Skills of active managers differ, thereby creating opportunities for talented managers. Only luck and skill play a role in beating the index, but ultimately skill is the key to generating alpha over the long term.

GENERATING ALPHA WITH ETFs

ETFs:

Measuring the talent of an active manager To assess the real talent of a manager, one needs to differentiate skill from luck when looking at the manager’s past performance. One interesting metric for this is the Information Ratio (IR). IR measures the amount of active return generated per unit of active risk, making it possible to compare managers despite different active risk budgets. The ratio can be used to measure the statistical level of confidence that the alpha generated by the manager was due to skill and not simple luck. There is indeed a direct link between the level of information ratio and its level of confidence:

t – stat = IRx√n n= the number of years over which the alpha and the tracking error have been observed

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This relationship is represented graphically in the chart below for IRs between 0.2 and 1.2

3-Y rolling betas 1.6 1.4

The level of confidence in information ratios

1.2 1.0

120%

IR=0.2

IR=0.5

IR=0.7

IR=0.9

IR=1.2

0.8 0.6

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GENERATING ALPHA WITH ETFs 82

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Long strategy + short position in ETF DJ STOXX

Source: SG Equity Research

IR=1.2

The higher the information ratio, the higher the confidence the alpha generated is a consequence of talent and not simple luck and the shorter the time horizon required to evaluate the manager’s talent.

The synthetic position exhibits a low beta to the European market, thus making it a portable alpha vehicle that could be used with another beta exposure, for example a long position in an ETF on the FTSE 100 index.

Source : Société Générale Equity Research paper, Portfolio Engineering, Spring 2006.

Using ETFs in the alpha generation process Portable alpha strategies can be more than a marketing gimmick. Portable alpha strategies allow for the separation of market (or beta) returns from investment strategies that add value (or alpha) to a portfolio. They are known as portable alpha because they can be tranposed to any existing strategy irrespective of the underlying systematic risk exposure.

Removing the policy risk of a long-only strategy is called alpha purification. The main objective of such purification is to retain the added-value of the strategy and combine it with other pure alphas and/or another systematic risk layer. As a result, most portable alpha strategies are built on “purified alphas”derived from longonly strategies. The purification process requires separating alpha from beta using derivative instruments or a short position on ETFs. ETFs have become popular instruments for core-satellite management. ETFs are already widely used by institutional investors as perfect vehicles for managing the core. By making it possible to acquire beta exposure cheaply and quickly, ETFs allow investors to create efficient portfolios for managing policy risk. ETFs can also be used in the satellites to remove the systematic exposure from a long strategy and create a portable alpha component. To achieve this, portfolio managers need to know which beta exposure provides the best hedge against systematic risk, or in other words, versus which equity index the portfolio exhibits the lowest tracking error and the highest correlation.

To illustrate this point, we could take the example of the following long-only strategy that exhibit a non constant beta over a given observation period. Regressing the returns of the strategy against a set of European indices, its returns’ variance is mostly explained by the DJ Stoxx 600 index, having the highest coefficient of determination (rsquared). Once the best hedge is identified, we can neutralise the beta exposure by taking a short position in a DJ Stoxx ETF and get the following rolling beta.

Alpha can be extracted from many sources. The most common alpha bets undertaken by investment managers are stock selection, sector/style rotation and tactical asset allocation strategies. At the stock picking level, the use of ETFs is clear. Suppose for example that a portfolio manager wants to play the European telecom sector but thinks that Deutsche Telekom is not attractive at the moment and does not want to be exposed to the specific risk on this stock. The traditional – and expensive – way to play this strategy is to buy all the sector constituents but Deutsche Telekom. The alternative is to buy an ETF tracking the telecommunications sector and take a short position in Deutsche Telekom.

This simple example could be duplicated with more sophisticated strategies but the advantage of ETFs versus futures in this case is quite clear. When sectors are involved, ETFs represent a better alternative than futures for which the liquidity is very low. We observed a bid/ask spread of more than 30 basis points (bps) for future contracts on the DJ STOXX Telecom while the corresponding average bid/ask spread for the ETFs tracking the same index was around 10 bps.

Academic research has demonstrated that sectors benefit differently from the phases of the economic cycle and their prices do not follow the same patterns over time. A strategy based on dynamic sector allocation may therefore generate a positive alpha. We observe however, limited application of this insight in portfolio management. There are two main reasons for this: first the difficulty to identify ex-ante the rotation criteria to follow for switching amongst sectors, and second the fact that such a strategy can only be implemented with a pure exposure to the sector. Managing a sector allocation through direct positions in individual stocks is not optimal because of the presence of implied stock selection bets. Only a detailed performance attribution analysis allows separating allocation from selection alpha embedded in the total alpha of the portfolio.

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Performance of sector allocation =

∑ [(Wpi - Wbi) x (Rbi -Rb)] Wpi = weight of the sector in the portfolio, Wbi = weight of the sector in the benchmark, Rbi = sector return, Rb = benchmark return Moreover, every stock exhibits sensitivity to several macro factors, including industry risk. Managing sector bets would imply constant monitoring of the active sector risk through direct positions in stocks, which is difficult and generates frequent rebalancing. The best means to create alpha from pure active sector exposure is to implement a strategy using ETFs, tracking the sector indexes as an overlay to an ETF tracking the whole market index.

Then, the most difficult task is finding a sector rotation alpha engine that exhibits a high IR ; that is, persistence in the alpha generation process. Suppose we can implement an active sector rotation model that generates an average quarterly alpha of 5% from a long short market neutral strategy. The optimal construction would be to overlay this alpha to a sector-neutral stock selection strategy. The two alphas will have close to orthogonal risk vectors, thus creating a high information ratio strategy.

At the global portfolio level, the investment sphere is typically divided into the strategic and tactical sides of asset allocation. In the longer term, strategic asset allocation provides the benchmark portfolio – typically with a horizon of at least one or two years. Investment managers try to create excess return by actively altering portfolio composition through over and underweighting particular asset classes at various points in time, usually with investment horizons of between three to 12 months.

The goal of Tactical Asset Allocation (TAA) is to improve the overall return per unit of risk of the portfolio through active management of asset allocation deviations. This is designed to facilitate portfolio’s long-term goals by seeking added value. As for stock selection or sector allocation alphas, tactical asset allocation alphas reflect successful asset classes bets versus the strategic asset allocation benchmark of the portfolio.

TAA looks to alpha generators to generate excess return over the passive benchmark, a simpler way to manage this being to divide it into beta and alpha drivers. Beta engines govern the overall risk profile of the fund as well as its expected return while alpha engines are used when markets are misaligned, producing a tactical bet. This can change the overall return pattern of the strategic asset allocation.

Dynamic core satellite strategies with an ETF portfolio The CPPI approach has largely been used in structured asset management. The technique offers investors the possibility of an asymmetric risk/reward profile by protecting downside performances. Most so-called

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007

‘protected funds’ use Constant Performance Portfolio Insurance (CPPI), Dynamic Portfolio Insurance (DPI) or Option Based Portfolio Insurance (OBPI) techniques to achieve their investment targets. We can apply these techniques to the active risk framework. In this case, the global risk budget is determined by the tracking error risk and the portfolio manager will dynamically manage his exposure between active and passive investments to achieve the targeted tracking error budget. The main advantage of this technique is the asymmetric active risk profile of the resulting portfolio. Most of the positive tracking error will be captured with a floor on the downside active risk.

What is important to keep in mind when applying the CPPI approach on active risk management is that the portfolio manager has a much greater control over the active return generated by the satellite portfolio than over the passive return of the core part. As risk is measured in the active sphere, the global strategy is thus exposed to a lesser extent to market shortfalls and early immunisation that can be a limitation in the traditional CPPI approach based on total risk.

Dynamic management of the beta using a two-ETF portfolio 175 165 155 145 135 125 115 105 95 0 Index

1

2

3

4

5

6

Portfolio

Source: SG Equity Research, Spring 2006.

Conclusion A recent survey conduced by EDHEC Risk and Asset Management Research concluded that following their rapid development, ETFs have established themselves as a widely used instrument among European institutional investors and their asset managers. More than half of the respondents are current or planned users of ETFs in equity investments and a majority of them think that the use of ETFs will increase in the near future. The results also reveal that the full potential of these instruments for asset allocation and portfolio construction is not fully explored by the majority of investment management professionals, suggesting that the use of ETFs and the organisation of portfolio management into a coresatellite approach are bound to increase. This leaves a significant growth margin for the future development of the ETF industry.

83

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MARKET REPORTS 17.qxd Page 84

FTSE Global Equity Index Series – Global

30 D ec e m b e r 2 00 5 to 3 0 N o v e m b e r 20 0 6

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

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FTSE All-Emer ging Country Indices – Capital Returns YTD 70 60 50 40

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S t o ck Pe r f o r m a n c e Best Performing FTSE All-World Index Stocks (USD/%) Minara Resources AU 235.1 Zijin Mining Group (H) CHN 209.7 Shanghai Zhenhua Port Machinery (B) CHN 207.7 HK 204.6 Shenzhen Investment (Red Chip) Great Wall Motor Company (H) CHN 201.0

Over all Index Return (USD) FTSE Global AC Index FTSE Global LC Index FTSE Global MC Index FTSE Global SC Index FTSE All-World Index 12% FTSE Asia Pacific AC ex Japan Index FTSE Latin America AC Index 10% FTSE All Emerging Europe AC Index FTSE Developed Europe AC Index 8% FTSE Middle East & Africa AC Index FTSE North 6% Americas AC Index FTSE Japan AC Index 4%

Worst Performing FTSE All-World Index Stocks (USD/%) ITV PCL THAI -76.3 Partygaming UK -76.1 Tokyu Construction JA -62.0 UFJ Nicos JA -66.9 Yukos RUS -72.6

No. of Consts

Value

3 M (%)

8,008 1,177 1,728 4,983 2,917 1,793 204 115 1,691 210 2,622 1,373

393.03 374.85 538.01 483.39 233.88 503.21 895.84 856.03 449.83 588.37 343.27 398.30

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6 M (%) 12 M (%)

10.8 10.6 10.3 10.0 10.9 15.9 23.9 17.3 14.0 6.8 9.9 -1.1

20.2 18.4 22.3 23.6 19.7 31.2 33.9 39.8 33.1 18.9 13.3 9.3

YTD (%) Actual DIv Yld (%)

17.3 16.0 18.2 20.1 16.9 24.9 31.9 32.8 28.4 8.1 13.1 0.6

2.03 2.27 1.83 1.69 2.10 2.62 2.94 1.55 2.66 2.76 1.68 1.07

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

2% 0% FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007 -2% -4% 8%

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MARKET REPORTS BY FTSE RESEARCH

O

MARKET REPORTS 17.qxd Page 86

FTSE Global Equity Index Series – Developed ex US

30 D ec e m b e r 2 00 5 to 3 0 N o v e m b e r 20 0 6

130 130

F T SE D e v e l op e d R e g i on al I n di c e s – L a r ge/ Mid C ap ( US D)

125 125

FTSE Developed (LC/MC)

120 120

FTSE Developed Europe (LC/MC)

115 115

FTSE Developed Asia Pacific (LC/MC)

110 110

FTSE All-Emerging (LC/MC)

105 105

100 100

FTSE Developed ex US (LC/MC)

95

FTSE US (LC/MC)

90

% 20

20

FTSE Developed Asia Pacific ex Japan (LC/MC)

F T S E D e v e l o p e d R e g i o n a l I n d i c e s – C a p i t a l R e t u r n s YTD (U S D) 30.0

22.5

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

50

40 40

30 30

Capital Capital

10

Total Return

Total Return

10

0

0

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

JANUARY/FEBRUARY 2007 • FTSE GLOBAL MARKETS

MARKET REPORTS 17.qxd

12/12/06

18:31

Page 87

S t o ck Pe r f o r m a n c e B est P e r f o r m i n g F T S E D e v e l o p e d e x U S I n d e x S t o c k s Minara Resources AU Shenzhen Investment (Red Chip) HK Boliden SWED SP Metrovacesa Zinifex AU

Over all Index Return (USD)

(USD/%) 235.1 204.6 195.3 189.0 166.4

Worst Performing FTSE Developed ex US Index Stocks (USD/%) Partygaming UK -76.1 UFJ Nicos JA -66.9 Tokyu Construction JA -62.0 Aiful JA -61.7 NIS Group JA -59.7

No. of Consts

Value

3 M (%)

FTSE Developed ex US Index (LC/MC) 1,346 FTSE US Index (LC/MC) 705 FTSE Developed Index (LC/MC) 2,051 FTSE All-Emerging Index (LC/MC) 866 515 FTSE Developed Europe Index (LC/MC) FTSE Developed Asia Pacific Index (LC/MC) 771 FTSE Developed Asia Pacific ex Japan Index (LC/MC) 285 FTSE Developed ex US AC Index 3,885 FTSE Developed ex US LC Index 555 FTSE Developed ex US MC Index 1,728 FTSE Developed ex US SC Index 4,983

264.93 581.25 226.00 428.06 267.41 239.00 407.59 447.98 412.06 542.97 586.29

6.7 7.6 7.2 12.7 8.5 3.1 10.9 7.2 6.2 9.2 10.5

6 M (%) 12 M (%)

10.4 10.3 10.4 16.4 13.5 4.5 16.4 10.5 10.1 12.1 10.9

26.0 12.2 18.7 32.3 31.4 15.7 27.9 26.7 24.8 31.7 32.3

YTD (%) Actual Div Yld (%)

20.6 12.3 16.3 24.1 27.0 8.6 25.5 21.1 19.8 24.6 25.0

2.41 1.74 2.08 2.29 2.78 1.75 3.28 2.33 2.58 1.83 1.69

FTSE Global Equity Index Series – Asia Pacific 30 D ec e m b e r 2 00 5 to 30 N o v e m b e r 2 00 6

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

FTSE Global AC

120

FTSE Developed Asia Pacific (LC/MC)

115 110

FTSE Developed Asia Pacific ex Japan (LC/MC)

105

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

100

FTSE Japan (LC/MC)

95

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

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007

87

MARKET REPORTS 17.qxd

12/12/06

18:31

Page 88

30 25 20

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MARKET REPORTS BY FTSE RESEARCH

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

S t oc k Pe r f o r m a n c e Best Performing FTSE Asia Pacific Index Stocks Minara Resources Zijin Mining Group (H) Shanghai Zhenhua Port Machinery (B) Shenzhen Investment (Red Chip) Great Wall Motor Company (H)

(US D /%) AU 235.1 CHN 209.7 CHN 207.7 HK 204.6 CHN 201.0

Worst Performing FTSE Asia Pacific Index Stocks (USD/%) ITV PCL THAI -76.3 UFJ Nicos JA -66.9 Tokyu Construction JA -62.0 Aiful JA -61.7 NIS Group JA -59.7

Over all Index Return (USD) 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)

8008 3166 1299 526 774 1851 285 771 528 486

Value

3 M (%)

393.03 442.75 252.22 427.86 483.75 490.33 407.59 239.00 306.71 149.73

8.0 6.0 5.8 5.7 6.1 7.2 10.9 3.1 14.7 0.0

6 M (%) 12 M (%)

10.8 6.5 7.1 7.7 4.1 2.4 16.4 4.5 15.5 -0.1

20.2 19.1 19.8 20.6 16.0 13.7 27.9 15.7 34.0 10.9

YTD (%) Actual DIv Yld (%)

17.3 11.2 12.1 13.2 7.0 4.6 25.5 8.6 23.9 2.4

2.03 1.83 1.83 1.91 1.79 1.91 3.28 1.75 2.08 1.05

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

88

JANUARY/FEBRUARY 2007 • FTSE GLOBAL MARKETS

8% 6%

il

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MARKET REPORTS 17.qxd Page 89

FTSE Global Equity Index Series – Eur ope

30 D e ce m b e r 2 00 5 to 30 N o v e m b e r 2 00 6

FTSE Eur opean Regional Indices Performance ( EUR ) 120

FTSE Global AC

115

FTSE Developed Europe ex UK LC/MC

110

FTSEurofirst 300

105

FTSE Developed Europe AC

100

FTSEurofirst 100

95

FTSE Eurobloc AC

90

FTSEurofirst 80

FTSE Eur ope All Cap Indices – Capital Returns YTD ( EUR ) 25

20

% 15

10

5

0

FTSE North America AC (US$)

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

70

60

50

40

30

Capital

20

Total Return

10

0

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

89

MARKET REPORTS 17.qxd

12/12/06

18:31

Page 90

MARKET REPORTS BY FTSE RESEARCH

S t oc k Pe r f o r m a n c e Best Pe r f o r m i n g F T S E D e v e l o p e d E u r o p e I n d e x S t o c k s ( E U R / % ) Boliden SWED 195.3 Metrovacesa SP 189.0 Sacyr-Vallehermoso SP 161.7 Vallourec FRA 145.0 Vestas Wind Systems DEN 136.0

Over all 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/%) Partygaming UK -76.1 EADS FRA -21.8 Tietoenator Oyj FIN -21.7 PagesJaunes FRA -21.6 Sogecable SP -16.6

No. of Consts

Value

3 M (%)

8008 1806 225 332 1073 1691 115 866 1203 300 80 100

393.03 395.36 422.11 519.13 556.96 390.77 743.63 411.26 416.81 1432.43 5032.79 4573.44

8.0 5.5 4.0 8.8 11.0 5.5 4.2 6.5 6.6 4.4 5.0 3.1

6 M (%) 12 M (%)

10.8 10.7 9.2 14.2 14.0 10.5 13.6 11.2 11.3 9.6 10.1 7.8

YTD (%) Actual Div Yld (%)

20.2 18.6 14.8 27.3 30.2 18.3 24.3 20.6 20.2 15.9 17.2 12.8

17.3 14.5 11.3 21.8 24.6 14.3 18.2 16.1 15.7 12.3 12.8 9.5

2.03 2.62 2.98 2.37 2.11 2.66 1.55 2.67 2.50 2.79 3.09 3.15

F TSE U K I n d e x S e r i e s 30 D ec e m b e r 2 00 5 to 3 0 N o v e m b e r 20 0 6

FTS E UK I nde x S er ie s (G BP) 125 125

FTSE FTSE100 100

120 120

FTSE FTSE250 250

115 115

FTSE350 350 FTSE

110 110

FTSESmallCap SmallCap FTSE

105 105 100

100

FTSEAll-Share All-Share FTSE

95

95

FTSE Fledgling

90

FTSE Fledgling

85

FTSE AIM All-Share

90

28 2 -Fe8b-Feb 06 -0 6 31 3 -M 1ar Ma -0 r6 06 30 3 -A 0pr Ap -0 r6 06 31 3 -M 1ayMa -0 y6 06 30 3 -Ju 0n-Jun 06 -0 6 31 3 -Ju 1l-0Jul 6 -06 31 3 -A 1ug Au -0 g6 06 30 3 -S 0ep Se -0 p6 06 31 3 -O 1ct-Oc 06t-0 6 30 3 -N 0ov No -0 v6 06

FTSE AIM All-Share

31 3 -Ja 1n-Jan 06 -0 6

31 3 -D 1ec De -0 c5 05

85

FTSE techMARK

FTSE techMARK

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

FTSE North America AC (US$)

90

JANUARY/FEBRUARY 2007 • FTSE GLOBAL MARKETS

FTSE North America AC (US$)

-6%

-6%

Steel & Other Metals

Aerospace & Defence

Diversified Industrials

Electronic & Electrical Equipment

& Other Metals

ace & Defence

ified Industrials

nic & Electrical uipment

Capital

Health

rmaceuticals & otechnology

Total Return

Leisure & Hotels

isure & Hotels

91

Telecommunication Services

12.88 19.28 13.56 38.24 13.85 0 0 -

ommunication Services

2.46 2.45 2.46 1.43 2.44 -0.91 -0.76 -

Food & Drug Retailers

3.15 2.12 3.00 1.83 2.96 1.69 0.53 1.43

Drug Retailers

7.7 21.4 9.6 10.5 9.6 11.8 -2.6 0.2

Transport

P/E Ratio

Transport

Net Cover

Support Services

Actual Div Yld (%)

pport Services

YTD (%)

Entertainment Media & Entertainment

General Retailers

neral Retailers

M AR F K TS 10 E 0

ch

20

Tobacco

te

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20

Tobacco

Pharmaceuticals & Biotechnology

re & Household Personal Care & Household ducts Products

Health

Food Producers & Processors

11.5 28.2 13.8 14.1 13.8 16.9 0.7 6.6

d Producers & Processors

5.7 14.8 7.0 6.6 7.0 9.8 -9.2 4.6

Beverages

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

Beverages

2.4 11.2 3.7 5.9 3.7 8.4 -2.6 4.0

Household Goods & Textiles

100 6048.85 250 10673.95 350 3173.54 328 3650.96 678 3119.85 246 4190.66 1156 1018.95 100 1434.49

ehold Goods & Textiles

No. of Consts

186.2 141.7 130.2 112.8 110.6

Automobiles & Parts

Bes t Pe r f o r m i n g F T S E A ll - S ha r e I n d e x S t o c k s ( G B P / % ) UK Coal Aquarius Platinum Aveva Group Chemring Group London Stock Exchange Group

obiles & Parts

Over all In8% de x Re tur n (GBP) FT SE

FT SE

Sm

0

35

18:31

ng & MachineryEngineering & Machinery

Forestry & Paper

restry & Paper

FT SE

FT SE

0

25

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12/12/06

ction & Building Construction & Building aterials Materials

Chemicals

Oil & Gas

FTSE 100 Index FTSE 250 Index8% 4% FTSE 350 Index FTSE SmallCap6% Index 2% FTSE All-Share Index 0% FTSE Fledgling 4% Index FTSE AIM Index -2% 2% FTSE techMARK 100 Index 6%

Chemicals

Oil & Gas

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007

-4%

Mining

-2%

Mining

0

10

O il

%

FT SE

FT SE

MARKET REPORTS 17.qxd Page 91

FT SE A l l - S h a r e S e c t o r I n d i c e s – C a p i t a l R e t u r n s Y T D ( G B P ) 80

60 60

40

40

Capital

Capital

Total Return

Total Return

0 0

-20 -20

25

F T S E U K I n d i c e s – C a p i t a l R e t u r n Y T D ( GB P )

20

15

10

5

0

-5

S t o ck Pe r f o r m a n c e

Worst Performing FTSE All-Share Index Stocks (GBP/%) Stanelco -91.3 iSOFT Group -89.92 Plasmon -86.13 Partygaming -79.1 Instore -67.36

-4%

0%

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

MARKET REPORTS 17.qxd

12/12/06

18:31

Page 92

F TSE X in hua I n de x S er i es (CN Y /H KD ) 200

FTSE/Xinhua China 25 (HKD)

180

FTSE Xinhua All-Share (CNY)

160

FTSE Xinhua Small Cap (CNY)

140

FTSE/Xinhua China A50 (CNY)

120

FTSE Xinhua 600 (CNY)

100

FTSE Xinhua China Government Bond Total Return Index (CNY) -0

6

06 -N

-O

ov

ct-

06

30

31

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30

31

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80

31

MARKET REPORTS BY FTSE RESEARCH

FTSE Xi nhua Index S eries 30 D ec e m b e r 2 00 5 to 3 0 N o v e m b e r 20 0 6

FTS E X inh ua I nd ex S er ie s Index Name

Consts

FTSE/Xinhua 25 Index (HKD) FTSE/Xinhua China 50 Index (CNY) FTSE Xinhua All-Share Index (CNY) FTSE Xinhua 600 Index (CNY) FTSE Xinhua Small Cap Index (CNY) FTSE Xinhua China Bond Total Return Index (CNY)

25 50 977 600 377 32

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

13977.39 7246.89 3950.56 4293.07 2626.38 97.25

18.6 41.2 22.1 24.4 6.1 1.5

27.8 37.2 22.7 23.7 13.9 1.3

56.6 96.8 97.0 99.3 79.4 4.1

Actual Div Yld (%)

51.9 85.6 87.4 88.4 76.3 2.5

1.86 1.37 1.33 1.42 0.67 2.94*

*Annual Redemption Yield

FTSE Hedge Index Series FTSE Hedge Management Styles (USD) – 5-Year Performance 140

FTSE Hedge

130

FTSE Hedge Directional

120

FTSE Hedge Event Driven

110

FTSE Hedge Non-Directional

100 90

06 vNo

6 ay -0 M

05 No v-

5 ay -0 M

04 No v-

4 ay -0 M

03 vNo

3 ay -0 M

02 vNo

2 ay -0 M

No

v-

01

80

Based upon indicative index values as at 30 November 2006

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

92

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FTSE Hedge – Management Styles & Str ategies (NAV Terms)

FTSE Hedge Index Directional Equity Hedge Commodity Trading Association (CTA) / Managed Futures Global Macro Event Driven Merger Arbitrage Distressed & Opportunities Non-directional Convertible Arbitrage Equity Arbitrage Fixed Income Relative Value

Index Level

3M (%)

6 M 12 M (%) (%)

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

5414.40 3300.74 2323.72 2007.04 1982.37 3401.44 2169.25 2353.49 3105.85 2058.82 2105.92 2056.32

1.9 3.8 4.4 -2.9 2.5 1.8 0.8 2.6 0.2 0.5 0.1 0.1

1.5 2.9 4.3 -4.6 1.1 2.6 3.0 2.1 0.6 2.1 0.2 0.2

4.9 5.7 6.8 -0.4 2.6 7.2 7.1 7.2 4.0 6.7 5.9 1.8

6.2 7.5 9.8 -3.0 4.9 8.5 8.0 8.8 4.5 7.1 6.6 2.2

27.1 39.2 42.5 35.8 26.7 21.7 9.8 32.8 15.3 34.9 17.4 5.5

4.9 6.8 7.3 6.3 4.8 4.0 1.9 5.8 2.9 6.2 3.3 1.1

6.3 8.6 9.8 11.5 8.3 7.7 6.9 8.8 3.7 5.7 6.1 1.9

Based upon indicative index values as at 30 November 2006

FTSE EP RA/NAREIT Global Real Estate Index Series FTSE EPRA/NAREIT Global Real Estate Indices (Total Return Basis) 150 140

EPRA/NAREIT Global Total Return Index (USD)

130

EPRA/NAREIT North America Total Return Index (USD)

120

EPRA/NAREIT Europe Total Return Index (EUR)

110

EPRA/NAREIT Eurozone Total Return Index (EUR) EPRA/NAREIT Asia Total Return Index (USD)

100

-N ov

-0

6

06 30

Oc t31 -

6

6

-S ep -0 6 30

31 -A ug -0

l-0 -Ju

-Ju 30

31

n06

6 -0 M ay 31 -

6

-A pr -0 6 30

ar -0

6

-M 31

-Fe b0 28

-Ja 31

31

-D

ec -0

5

n06

90

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

Consts

Value

3 M (%)

FTSE EPRA/NAREIT Global Index (USD) 326 FTSE EPRA/NAREIT North America Index Index (USD) 138 FTSE EPRA/NAREIT Europe Index (EUR) 99 FTSE EPRA/NAREIT Euro Zone Index (EUR) 42 FTSE EPRA/NAREIT Asia Index (USD) 89

3493.16 4217.06 3543.23 3707.53 2499.71

13.5 13.4 12.9 11.7 11.5

6 M (%) 12 M (%)

26.4 28.2 23.9 22.5 22.7

44.3 39.1 42.6 41.2 43.7

YTD (%)

Actual Div Yld (%)

38.6 38.5 37.3 38.4 29.3

3.07 3.53 2.17 2.60 2.99

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

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007

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FTSE Bond Indices (Total Return Basis) FTSE Eurozone Government Bond Index (EUR) FTSE Euro Corporate Bond Index (EUR) FTSE US Goverment Bond Index (USD) FTSE Pfandbriefe Index (EUR) FTSE Gilts Index Linked All Stocks (GBP) FTSE Japan Government Bond Index (JPY)

106

104

102

100

98

30

31 -O

ct-

06 30 -N ov -0 6

6 -S ep -0

31 -A ug -0 6

Ju l-0 6

6

31 -

31

-M

30 -Ju n0

ay -0

6

pr -0 6 30 -A

06

ar -0 6 31 -M

b28 -Fe

31 -Ja

c-0

n06

5

96

31 -D e

MARKET REPORTS BY FTSE RESEARCH

FTSE Bo nd Indices

FTSE Euro Emerging Markets Bond Index (EUR) FTSE Gilts Fixed All-Stocks (GBP)

FTSE Bond Indices (Total Return) Index Name

Consts

Value

3 M (%)

239 375 38 315 11 29 126 243 32

156.46 178.96 214.53 145.66 2104.05 1971.79 152.73 110.61 97.25

1.4 1.1 1.4 1.3 1.8 1.4 2.5 0.3 1.5

FTSE Eurozone Government Bond Index (EUR) FTSE Pfandbrief Index (EUR) FTSE Euro Emerging Markets Bond Index (EUR) FTSE Euro Corporate Bond Index (EUR) FTSE Gilts Index Linked All Stocks Index (GBP) FTSE Gilts Fixed All-Stocks Index (GBP) FTSE US Government Bond Index (USD) FTSE Japan Government Bond Index (JPY) FTSE China Government Bond Index (CNY)

6 M (%) 12 M (%)

3.4 2.6 3.9 2.9 5.8 3.1 5.3 1.7 1.3

1.9 1.6 3.7 1.8 6.6 3.3 4.9 0.1 4.1

Annual Redemption YTD (%) Yld (%)

0.8 1.0 2.8 1.2 4.6 1.9 3.6 0.2 2.5

3.83 3.90 4.69 4.31 1.29* 4.27 4.64 1.55 2.94

* Based on 0% inflation

F TSE G W A I n d e x S e r i e s FTSE GWA Index Series – 5-Year Performance (Total Return Basis) 250

FTSE GWA Developed Index (USD) FTSE GWA Developed ex US Index (USD) FTSE GWA Developed ex Japan Index (USD) FTSE GWA Developed Europe Index (EUR) FTSE GWA UK Index (GBP)

200

150

100

06 pSe

6 M ar -0

p05 Se

5 ar -0 M

04 pSe

4 ar -0 M

Se

p0

3

3 ar -0 M

Se

p0

2

2 ar -0 M

Se

p0

1

50

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

94

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FTSE GWA Indices (Total Return) Index Name

Consts

Value

3 M (%)

2051 1346 1567 517 684

4010.01 4333.39 4170.75 4015.31 3817.03

8.0 7.8 7.3 5.9 5.0

FTSE GWA Developed Index (USD) FTSE GWA Developed ex US Index (USD) FTSE GWA Developed ex Japan Index (USD) FTSE GWA Developed Europe Index (EUR) FTSE GWA UK Index (GBP)

6 M (%) 12 M (%)

12.2 12.4 18.6 12.1 9.2

23.9 31.1 30.6 21.8 17.5

YTD (%)

Actual Div Yld (%)

21.1 25.7 28.4 17.6 13.0

2.30 2.61 2.40 2.93 3.10

FTSE RAFI Index Series FTSE RAFI Index Series – 5-Year Performance (Total Return Basis) 250

FTSE RAFI US 1000 Index (USD) FTSE RAFI Developed ex US 1000 Index (USD)

200

FTSE RAFI Kaigai 1000 Index (USD) 150

FTSE RAFI Europe Index (EUR) FTSE RAFI Eurozone Index (GBP)

100

v06 No

-0 6 M ay

05 vNo

-0 5 ay M

v04 No

4 ay -0 M

v03 No

3 M ay -0

02 vNo

2 -0 M ay

No

v01

50

FTSE RAFI Indices (Total Return) Index Name

FTSE RAFI US 1000 Index (USD) FTSE RAFI Developed ex US 1000 Index (USD) FTSE RAFI Kaigai 1000 Index (USD) FTSE RAFI Europe Index (EUR) FTSE RAFI Eurozone Index (EUR)

Consts

Value

3 M (%)

985 1001 1013 454 264

5962.30 6468.59 5711.71 5941.63 6040.70

7.9 8.0 8.6 6.5 7.2

6 M (%) 12 M (%)

12.0 12.2 13.7 12.3 13.2

17.7 30.6 26.3 22.9 24.6

YTD (%)

Actual Div Yld (%)

17.5 25.2 24.0 18.8 20.8

2.06 2.54 2.48 2.84 2.86

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

Sandra Jim Research Manager, Asia Pacific sandra.jim@ftse.com +(852) 223 0-5814

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

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2007

95

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Page 96

CALENDAR

Index Reviews January – June 2007 Date

Index Series

Review Type

Effective Data Cut-off (Close of business)

11-Jan Mid Jan Mid Jan Feb Feb 9-Feb 12-Feb Early Mar Early Mar Early Mar 2-Mar 2-Mar 3-Mar 7-Mar 7-Mar 7-Mar 7-Mar 7-Mar 7-Mar 9-Mar 12-Mar 13-Mar 14 Mar 14-Mar 14-Mar 14-Mar 14-Mar 14-Mar 14-Mar 14-Mar 14-Mar 16-Mar 8-Apr 11-Apr Mid April Late April 11-May 16-May Early Jun Early Jun Early Jun Early Jun Early Jun Early Jun 1-Jun 1-Jun 1-Jun 1-Jun 4-Jun

TSEC Taiwan 50 PSI 20 OMX H25 BEL 20 AEX Hang Seng MSCI Standard Index Series ATX CAC 40 S&P / TSX S&P / MIB S&P / ASX Indices DAX FTSE Asiatop / Asian Sectors FTSE UK FTSE All-World FTSEurofirst 300 FTSE techMARK 100 FTSE eTX NASDAQ 100 NZSX 50 S&P MIB DJ STOXX DJ STOXX S&P US Indices S&P Europe 350 / S&P Euro S&P Topix 150 S&P Asia 50 S&P Global 1200 S&P Global 100 S&P Latin 40 Russell US Indices TSEC Taiwan 50 FTSE Nordic 30 OMX H25 FTSE / ATHEX Hang Seng MSCI Standard Index Series ATX KOSPI 200 IBEX 35 CAC 40 OBX S&P / TSX OMX C20 S&P BRIC 40 S&P / ASX Indices DJ Global Titans 50 OMX S30

Quarterly review Semi-annual review Quarterly review of number of shares Annual review Annual review Quarterly review Quarterly review Semi-annual review / number of shares Quarterly review Quarterly review Semi-annual review Annual / Quarterly review Quarterly review Semi-annual review Quarterly review Annual review Asia Pacific ex Japan Quarterly review Quarterly review Quarterly review Quarterly review / Shares adjustment Quarterly review Quarterly review - shares & IWF Quarterly review (components) Quarterly review (style) Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review - IPO additions only Quarterly review Semi-annual review Quarterly review Semi-annual review Quarterly review Annual review Quarterly review Annual review Semi-annual review Quarterly review Semi-annual review Quarterly review Semi-annual review Semi-annual review - constituents Quarterly Review Annual review of index composition Semi-annual review

19-Jan 30-Jan 20 Jan 1-Mar 1-Mar 1-Mar 28 Feb 30-Mar 16 Mar 16-Mar 19 Mar 16-Mar 16-Mar 16-Mar 16-Mar 16-Mar 16-Mar 16-Mar 16-Mar 16-Mar 30-Mar 19-Mar 16 Mar 16-Mar 16-Mar 16-Mar 16-Mar 16-Mar 16-Mar 16-Mar 16-Mar 31-Mar 20-Apr 20-Apr 20-Apr 31-May 1-Jun 31-May 29-Jun 8-Jun 2-Jul 15-Jun 15-Jun 15-Jun 15-Jun 15-Jun 15-Jun 15-Jun 30-Jun

29-Dec 31-Dec 31-Jan 31-Dec 31-Dec 29-Dec 31-Jan 28-Feb 28-Feb 28-Feb 12 Mar 28-Feb 28-Feb 28 Feb 6-Mar 29-Dec 28-Feb 28-Feb 28-Feb 28-Feb 28-Feb 12-Mar 20-Feb 1-Mar

28-Feb 30-Mar 30-Apr 31-Mar 30-Mar 30-Mar 30-Apr 31-May 31-May 31-May 31-May 31-May 31-May 31-May 31-May 30-Apr 31-May

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

96

JANUARY/FEBRUARY 2007 • FTSE GLOBAL MARKETS

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Page IBC1

MARHedge Presents: 12th Annual

European Conference on Alternative Investments 5-7 February 2007 • Hotel President Wilson • Geneva, Switzerland The MARHedge 12th Annual European Conference on Alternative Investments, 5-7 February in Geneva, Switzerland, will gather leading hedge fund and fund-of-funds managers, institutional and high-net-worth investors from all over the world to delve deeply into the next generation of alternative investments. Through keynote speeches, as well as general and targeted breakout sessions, investors and those who control the most lucrative distribution channels will reveal what they are looking for from managers. Managers will also detail the challenges of executing strategies in emerging markets and unique investment styles in more established arenas.

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Speakers Include: Albert Pinzón, Brown Rudnick Berlack Israels LLP Andrew Alford, Goldman Sachs & Co Charles Lemonides, ValueWorks LLC Gabriel Bousbib, Gottex Fund Management Alper Ince, Pacific Alternative Asset Management Co LLC Jeffrey Solomon, Ramius Capital Group Rubin Chen, ING Alternative Asset Management John Godden, IGS Group Limited Leila Kardouche, RAB Capital PLC Marcel Giacometti, Auda (UK) Ltd. Paul Ross, Arundel Iveagh Investment Management Ltd Sebastian Dovey, Scorpio Partnership Sebastian Stubbe, Landmark Investors LLC Tushar Patel, Hedge Funds Investment Management Ltd Barbara Rupf Bee, HSBC Republic Investment Ltd Hrishi Parandekar, Private Wealth Advisory

To Register Today!

Contact Jeannie Lee:

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GM EDITORIAL 17

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16:29

Page OBC1

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