FTSE Global Markets

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ASIAN SECURITIES LENDING ENTERS A NEW GROWTH PHASE ISSUE EIGHTEEN • MARCH/APRIL 2007

OUTSOURCING PRIVATE EQUITY BNY/MELLON SETS THE BENCHMARK CPDOs SQUEEZE CREDIT SPREADS

BGI’s KRANEFUSS:

ETFS & THE NEXT

GENERATION US CUSTODY: HOW MUCH CONSOLIDATION CAN ONE MARKET TAKE?

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

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FTSE GLOBAL MARKETS • MARCH/APRIL 2007

HREE WORDS SAY it all for this edition and those words are: consolidation, consolidation, consolidation. Wherever you look in this dynamic opening quarter of 2007, the compelling storyline is the dramatic pick up in merger activity across both the exchange world and the custody market; with equally dramatic and far reaching consequences for the global investment market.

Bank of New York shook custodians at year end 2006 by agreeing to purchase Mellon Financial Corporation for roughly $16.5bn, giving the combined company—to be called Bank of New York Mellon Corporation—some $17.5trn in assets under custody. “The deal is so compelling that it is likely to pressure some of the company’s competitors to think about acquisitions,” wrote analyst Richard Bove of Punk Ziegel shortly after the deal was announced. Sure enough, in early February State Street Corporation countered Bank of New York’s gambit with its own agreement to purchase Boston-based Investors Financial Services Corporation, the holding company for Investors Bank & Trust, for $4.5bn.

What now for JPMorgan? The bank had spent most of 2006 trumpeting itself as the world’s leading custodian with $13.9trn in custodial assets.

While it was revelling in its victory parade, Bank of New York and State Street were all the while planning to regain their one-two positions through accretion. As a consequence, the bank is now once again deposed to third place, behind State Street’s $14.1trn and BONY-Mellon’s megatrillion market share. If JPMorgan’s route to dominance is yet dependent on organic growth, it will be some while before it regains the top slot once more. Not only that, with the quest for scale continuing to drive the industry, analysts say that more mega deals are on the way, which may yet again change the geography of the global custody league tables. Dave Simons talks to the main players in the increasingly complex game-plan that is now the custody market. For more, please turn to page 48.

Equally, in the exchange market seismic shifts are underway as traditional exchanges seek to protect their own turf against both hostile and friendly acquisition moves by market hungry competitors. At the same time those very same exchanges are beginning to cast envious glances at the exponential success of established derivatives exchanges, which appear to be enjoying runaway growth in a market that even in today’s heady trading atmosphere is only a fraction of what it will be over the coming decade. A new geography of alliances, services and product innovation is underway, which promises to re-write the book of securities trading in the second decade of the 21st century. To find out what it might look like, turn to page 81.

In all cases the inevitable questions are: is big really better? If so, better for whom? The shareholders? The institutions involved? Or, more pertinently, the clients? Is consolidation the only response to an increasingly globalised market in which 24/7 access is a bare-minimum service level? An expert, any expert, is yet to write the empirical research report which categorically states that investment services and trading services provision will best benefit users if only a few providers remain on one or more continents. In diversity, there is choice. In choice can be found real competition and then, in turn, a propensity by service providers to provide quality and not just quantity in service provision. Is that not worth a basis point of two of cost to an end user? The debate begins here …

Francesca Carnevale, Editorial Director February 2007

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Contents COVER STORY BGI AND THE NEXT GENERATION OF EXCHANGE TRADED PRODUCTS ..................................................................................Page 44 Lee T Kranefuss, the architect of BGI’s ETF strategy and chief executive officer of the company’s Intermediary Products and Index & Markets Group, thinks that ETFs continue to be a growth market “and we expect to continue to be the leader in it.”

BGI is now marketing the next generation of exchange traded products and is showing how effective collaboration across the wider Barclays Group benefits both the asset management firm and its clients. Art Detman reports from San Francisco.

REGULARS MARKET LEADER

PUTTIN’ ON THE CREDIT SQUEEZE

........................................................................Page 6 Few innovations in the financial markets have created as big a stir as constant proportion debt obligations (CPDOs). Neil O’Hara explains why

INDEX REVIEW

TESTING THE LIMITS OF THE FTSE’S BULL RUN ............................Page 12

IN THE MARKETS

INVESTMENT APPROACHES THAT MIMIC HEDGE FUNDS..............Page 14

FACE TO FACE

........................Page 23 JPMorgan’s Sandie O’Connor explains the bank’s new securities lending solutions

Capital Spread’s Simon Denham asks how long can the good times last?

Neil O’Hara looks at how mainstream investing is encroaching on hedge fund strategies

CREATING A NEW SPIN IN SECURITIES LENDING SAUDI ARABIA BEATS THE ODDS

....................................................Page 26 Irrespective of its stock market performance the Saudi economic boom continues

MIDDLE EAST REITS COME OF AGE

REGIONAL REVIEW

................................................Page 34 Mark Faithfull reports on the impact of the region’s expanding real estate sector

TURKEY’S ELECTIONS CREATE A STIR

....................................................Page 39 Lynn Strongin Dodds on the economic impact of this year’s presidential elections

MICEX MAKES A PUSH FOR MARKET SHARE

................................Page 41 The Moscow exchange makes a push for growth in a banner year

US CUSTODY: THE IMPACT OF MARKET CONSOLIDATION Page 48

INVESTMENT SERVICES

Is bigger really better? Dave Simons reports on the market impact of the current round of mergers and acquisitions that is redrawing the custody league tables

ASIAN SECURITIES LENDING COMES OF AGE

..............................Page 60 Growing in confidence, a string of Asian countries are introducing or re-introducing securities lending. Rekha Menon reports on a market that is fighting fit

EXPORTING SPANISH COVERED BONDS

DEBT REPORT

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....................................Page 66 Runaway growth enjoyed by Spain’s covered-bond market must take a different turn in 2007. Andrew Cavenagh reports on moves to export Cedulas Hypothecarias to the US

PFANDBRIEF: THE CALM BEFORE THE STORM

......................Page 70 Pfandbrief issuance volumes have remained level this year. 2005’s regulatory changes should begin to impact positively on new issues in 2007

DEPOSITARY RECEIPTS IN THE SPOTLIGHT

CAPITAL MARKETS

................................Page 85 After a moribund period, issuers are returning to the American Depositary Receipt market. Is it a short term trend, or does it point to a wider use of the DR market?

INDEX REVIEW

Market Reports by FTSE Research ................................................................................Page 92 Index Calendar ................................................................................................................Page 104

MARCH/APRIL 2007 • FTSE GLOBAL MARKETS

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Contents FEATURES BANK OF NEW YORK/MELLON MERGER ....................................Page 55 On December 4th, 2006 Bank of New York Corp. (BNY) and Mellon Financial Corp. said they will merge, creating the world's largest securities servicing and asset management firm. The deal is expected to be complete in the third quarter of 2007. The new company will be called Bank of New York Mellon Corp., and be the world’s leading asset service provider, with $16.6trn in assets under custody and $8 trn in assets under trusteeship. It will also rank among the top 10 global asset managers with more than $1.1trn in assets under management. So, what can we expect now from this powerhouse? Bill Stoneman reports.

THE PEETZ EFFECT

..............................................................................................................Page 58 In the spring of 2006, Bank of New York [BNY] agreed to sell its middle market and retail business to JPMorgan Chase in return for JPMorgan’s corporate trust business. The transaction has resulted in the bank leading the corporate trust services market by well more than a country mile. BNY now boasts a trust business serving 90,000 clients, covering $8 trn in total debt, which involves some 3,700 employees in 54 offices in 18 countries.

Francesca Carnevale talks to Karen Peetz, BNY’s senior executive vice president, in charge of the bank’s global trust business, on the operation’s forward strategy.

PRIVATE EQUITY FUND ADMINISTRATION ....................................Page 74 Mainstream investors will recognise the drivers behind the rise of fund administration services to private equity firms: improved efficiency, a requirement to gain access to better technology without attendant investment costs, a heightened focus on corporate governance and reporting transparency. To this mix must be added breakneck growth and increased complexity in the private equity industry. In a dynamic and more complex world, it makes sense for private equity firm to outsource in-house administration services to skilled practitioners. Enter global custodians with multi-jurisdictional clout.

Can the traditional providers to the private equity community continue to compete?

Francesca Carnevale reports.

OUTSOURCING: THE RISE OF ALTERNATIVES ..........................Page 78 Outsourcing has benefited from a climate marked by intense regulatory pressure, rising operational costs and an increasingly complex menu of alternative investments. No surprise then that an efficient outsourcing platform has become a highly valued commodity for asset managers requiring a solid base of support that will allow them to focus on their core competencies.on transition managers, who are required to not only transit portfolios efficiently, but also to add value throughout all stages of the process. By Dave Simons.

THE EXPANDING WORLD OF DERIVATIVES EXCHANGES ..Page 81 In the arcane world of derivatives exchanges, the only problem (well, almost) is how to spend the rising tide of revenue flooding into the coffers of the major houses. Barely having scratched the surface of the potential for global growth, no one could fault the exchanges for resting on their laurels. But eager eyes in mainstream exchanges now look upon this Eden with undisguised envy and are slowly formulating their plans to grab at least some of the hallowed turf. Will they succeed?

TOBACCO: ASIA LIGHTS UP ....................................................................Page 88 Japan Tobacco’s impending $14.7bn takeover bid for the British giant Gallaher gives some insight into what is at stake in a market that is paradoxically contriving to become more regulated and more globalised at the same time. Up for grabs are the still growing markets of Asia, which are increasingly important to tobacco firms now that smoker numbers are shrinking in western markets. Who will win out in this new battle for market share?

Ian Williams reports

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MARCH/APRIL 2007 • FTSE GLOBAL MARKETS

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Market Leader CPDOS SQUEEZE CREDIT SPREADS

CPDOs Squeeze Credit Spreads Few innovations in the financial markets have cause as big a stir as constant proportion debt obligations (CPDOs), the latest twist in structured products ABN Amro introduced last August.

Although the new instrument offers leveraged exposure to investment grade credits comparable to the constant proportion portfolio insurance notes (CPPIs) ABN Amro developed in 2003, the similarity ends there. CPPIs have variable coupons and a guarantee of principal at maturity, whereas CPDOs look like conventional floating rate notes: they deliver interest payments at a fixed margin over LIBOR and a bullet payment of principal at maturity that is not guaranteed. Neil O’Hara reports on the rise of the leveraged asset class.

PDOs BECAME THE talk of the market overnight. Investors pining for yield could suddenly get 200 basis points (bps) over LIBOR on a 10-year note in a leveraged structure robust enough to earn a AAA rating on both interest and principal payments—an improvement over CPPIs, for which only principal is rated. While other players immediately copied the structure, ABN Amro still sponsored about half the $2bn of CPDOs issued during 2006.

Within weeks of the first issue, market participants blamed CPDOs for a sharp fall in investment grade credit default swaps index spreads; the Dow Jones iTraxx fell from 35bps in July 2006 to 26bps in late September.

The high initial leverage (typically 15:1) does give CPDOs a disproportionate influence on the market. Every $100m issued generates $1.5bn selling pressure on spreads.

Nevertheless, the $30bn initial leveraged principal of all the CPDOs

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issued in 2006 cannot account for such a dramatic tightening.

A heavy issue calendar in all leveraged credit products, including collateralised debt obligations (CDOs), CDO squared and leveraged super senior notes contributed to spread compression, too. Participants say the market over-reacted in anticipation of future issuance of CPDOs and other leveraged credit instruments.“The coupon you can get is very dependent on the starting spread on the credit default swaps index that you are referencing,” says Alexandre Linden, a senior director at Derivative Fitch, Fitch’s rating agency dedicated to derivatives.

Linden points out that if the index spread drops from 40bps to 30bps, the gross spread on a structure levered 15:1 shrinks 150bps, enough to push the coupon down from 200bps to around 125bps. CPDOs attract AAA ratings from the agencies despite the high initial leverage because the

Within weeks of the first issue, market participants blamed CPDOs for a sharp fall in investment grade credit default swaps index spreads; the Dow Jones iTraxx fell from 35bps in July 2006 to 26bps in late September. The high initial leverage (typically 15:1) does give CPDOs a disproportionate influence on the market. Every $100m issued generates $1.5bn selling pressure on spreads. Nevertheless, the $30bn initial leveraged principal of all the CPDOs issued in 2006 cannot account for such a dramatic tightening. Photograph by Alan Heartfield, supplied by Dreamstime.com, February 2007.

structure incorporates self-correcting mechanisms that reduce the probability of default, according to Linden. The cash-in protects a successful structure against any subsequent widening in spreads, the excess margin over LIBOR provides a buffer against credit losses and when the index components roll over to a longer maturity every six months the new portfolio delivers incremental income [Please refer to box on page 10: How a CPDO works].

Both CDX and iTraxx are based on the most liquid investment grade credits with an average maturity of five years. Every six months, the indices are reconstituted to eliminate any names that have dropped below investment grade rating and extend the maturity from 4.75 to 5.25 years.

“You expect to receive some spread pickup because you take a longer

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Market Leader CPDOS SQUEEZE CREDIT SPREADS

maturity exposure,” Linden says. The rollover also limits the credit risk in CPDOs to a migration from investment grade to default in a sixmonth period that matches the index re-composition dates. It can happen— witness Enron and WorldCom, however it is rare.

If credit spreads widen between index rollover dates, CPDOs will suffer a mark to market loss but higher income from the reconstituted credit default swaps index portfolio rebuilds the NAV over time. In back tests run at potential investors’ request, ABN Amro found that in one scenario spreads would have to tick up 700bps over a three-year period from first issuance and then stay at that level through maturity to jeopardise full repayment of CPDO principal. “It would have paid all the coupons but would not quite have enough cash to pay the entire principal at maturity,” says Andrew Feachem, a structured credit marketer in ABN Amro’s London office, “You really have to throw some pretty extreme situations at the transaction for it to fail.”

Feachem sees a bigger threat to the CPDO structure if defaults tick up but spreads do not, an unlikely outcome given the strong positive correlation between credit spreads and default rates in past credit cycles. In practice, credit spreads tend to revert to the mean; if spreads do blow out, history suggests they will not stay at that level and any shift back from wide spreads toward the mean will allow CPDOs to recoup earlier losses. The rating agencies will grant a AAA rating only if thousands of simulations based on different assumptions about credit spreads, mean reversion, liquidity and volatility allow the CPDO to make timely payments of interest and principal in almost every case.

Feachem says CPDOs placed so far

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Andrew Feachem, structured credit marketer in ABN Amro’s London office. ABN Amro found that in one scenario spreads would have to tick up 700bps over a three-year period from first issuance and then stay at that level through maturity to jeopardise full repayment of CPDO principal.“It would have paid all the coupons but would not quite have enough cash to pay the entire principal at maturity,” says Feachem,“You really have to throw some pretty extreme situations at the transaction for it to fail.” Photograph kindly supplied by ABN Amro, February 2007.

have tended to exceed that hurdle— 99.3% in the case of Standard & Poor’s—by a comfortable margin, which reduces rating and price volatility. The potential rating volatility of CPDOs (much higher than for conventional bonds) has sparked a discussion at Moody’s over whether the agency should develop a quantitative measure for rating risk to help clients distinguish among equally-rated securities, according to Olivier Toutain, vice president and senior credit officer at Moody’s.

Toutain believes CPDOs and other leveraged credit vehicles are putting intense downward pressure on credit spreads that will not let up until credit fundamentals deteriorate. To Dan

Ivascyn, an executive vice president and portfolio manager at PIMCO in Newport Beach, California, CPDOs combine the excess spread accumulation developed to build credit support in rated CDO equity tranches with the high leverage embedded in super senior CDO tranches. He notes that although the six-monthly index rollover purges weak credits, the portfolio may still suffer realised losses.

Credit default swaps prices of downgraded names usually drop because existing contracts do not reflect the higher spread implied by a lower rating. At the rollover date, the CPDO has to pay the difference to the swap counterparty when it replaces

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Market Leader CPDOS SQUEEZE CREDIT SPREADS

the positions with new investment grade credit default swaps trading at current market spreads. For example, the first index roll after the rating agencies downgraded auto-related credits in 2005 would have imposed a significant cost on a CPDO. “You do not actually need defaults,” Ivascyn says,“You just need negative migration where the cost to roll into the new index is high enough for long enough that you whittle away your capital.”

PIMCO is working to model how CPDOs would have performed in crisis periods before the credit default swaps indices were developed about four years ago. Ivascyn suspects index-related CPDOs would have suffered rating downgrades during the technology bust in 2001/2002; mark to market losses might even have approached the cash-out threshold for the most leveraged transactions.

CPDOs would have fared better through the Russian debt default in 1998 when spreads blew out only briefly. “If the structure does not get stopped out, it can withstand temporarily wider spreads as long as they snap back,” he says, “It will look ugly on a mark to market basis for a while before it recovers.”

Although increasing leverage to recoup from losses looks like throwing good money after bad, the mechanism does tend to reduce volatility. Losses occur when spreads widen or defaults tick up, so CPDOs increase leverage when spreads are high and cut it when spreads are low.

That is the exact opposite of CPPIs, in which leverage increases as spreads tighten and falls when they widen — a counterintuitive buy-high sell-low approach that encourages trendfollowing momentum trading.

The CPDO advantage disappears if it triggers a cash-out, however.

“Whether it’s a CPDO or CPPI, you have a tremendous amount of credit

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leverage that can get unwound very quickly in widening spread environments or panic scenarios,” Ivascyn says.

The CPDO structure may soon be applied to other credit classes, including high-yield, emerging markets and asset-backed securities, ABN Amro’s Feachem says. Bankers are already working on managed transactions, in which a bespoke collateral pool replaces the credit default swaps in the indices.

Managed collateral helps investors diversify their portfolios because it distinguishes one transaction from the next, whereas all index-related CPDOs have the same underlying credit exposure. Managed deals get away from slavish adherence to the index rollover date, too, which should reduce transaction costs. The enthusiastic investor reception of CPDOs and frenetic pace of innovation are sure to spur additional developments during 2007.

Dan Ivascyn, an executive vice president and portfolio manager at PIMCO in Newport Beach, California, says CPDOs combine the excess spread accumulation developed to build credit support in rated CDO equity tranches with the high leverage embedded in super senior CDO tranches. He notes that although the six-monthly index rollover purges weak credits, the portfolio may still suffer realised losses. Photograph kindly supplied by PIMCO, February 2007.

HOW A CPDO WORKS he financial alchemy behind a CPDO relies on a dynamic leverage mechanism. At the outset, the present value of future payments, including coupons at LIBOR plus a margin of up to 200 bps and a bullet payment at maturity, exceeds the proceeds of the CPDO note issue, or net asset value (NAV). To fund the shortfall, the sponsor uses the proceeds of the note issue as collateral to support short sales of the onthe-run 5-year CDX and iTraxx investment grade credit default swaps index components at an initial leverage ratio of 15:1. The collateral pays LIBOR, and if, for example, the initial index spread is 40 bps, the credit default swaps generate a 600bps spread over LIBOR, of which 200 bps are paid to note holders. The excess spread builds up the NAV over time to cover the shortfall and acts as a buffer against potential defaults. The leverage cap, which is a function of NAV and credit spreads, is designed to protect the sponsor against the possibility that the NAV could fall below zero if credit spreads blow out and/or the default rate ticks up dramatically, the so-called gap risk. If the NAV drops to 10% of par — the cash-out point — the structure is unwound and note holders receive whatever is left after the sponsor has bought back the credit default swaps that are still on the books.

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MARCH/APRIL 2007 • FTSE GLOBAL MARKETS

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Index Review SHORT TERM BENCHMARK INDEX PERFORMANCE

Can the FTSE 100’s bull run continue?

Many analysts are calling for a renewed surge in commodity prices after ‘me too’ investors have been finally pushed out of the sector. News of two major hedge fund disasters in the copper market is, in all probability, just the tip of the iceberg, hiding a good deal of other poor performances elsewhere. Even the renowned Goldman Sachs took a heavy hit on its commodity funds. With support holding in gold and silver and traders hoping for a floor in copper at around 23,000, there is confidence returning to the mining sector which may well give the FTSE 100 a sunnier outlook than in 2006. Simon Denham, managing director of spread betting firm Capital Spreads, looks at the short term outlook for benchmark indices.

ITH INTEREST RATES now at 5.25%, some commentators have begun to worry that the Monetary Policy Committee (MPC) is fighting the wrong battle. Most inflation in the pipeline has been caused by factors beyond the control of interest rates— things such as energy, food and taxation. The likelihood is that these will fall out of the consumer price index (CPI) as time decay works its magic. Unfortunately, in raising rates, the MPC has re-awakened underlying wage demand as workers with mortgages and loans to pay look at their increased outgoings and want more money.

If the rate increases actually ignite secondary inflationary pressures, then the Bank of England could be in for a longer, harder battle than if they had left rates quietly unchanged at 4.5%.

Add to this mix a government not famed for its strength in reining in public sector spending. Consequently, the central bank will unlikely get help from this quarter. Money supply remains at historically high levels.

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Furthermore, Chancellor and premierin-waiting Gordon Brown will not want his first act in office to be the unpopular one of tightening the public purse. The budget deficit is forecast at something in the region of £20bn this year. Something tells me that this may get much bigger before the brakes are applied.

Like other benchmark indices, the FTSE 100 has had an almost unbroken bull run since early 2003—even the market correction back in May of last year failed to break the major weekly upward trend line. We are now pushing the Bollinger band envelope at 6375. In the past, unless the bands have been on a steep upward trend, this has been something of a sell indication. However, over the last six weeks or so we have noted a lack of enthusiasm in taking the market higher. At the start of 2006, the DAX was 200 points or so below the FTSE 100. It now stands over 500 points higher and, since the peaks of May last year, for all of the merger mania, the FTSE has rallied just 3.4% against 7.7% for the Dow and 8.3% for the

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

S&P. The question is: will the UK index start to recoup some of this deficit or are there other factors at work?

One pointer to note is the base rate, which has gone up by 0.75% since the last US squeeze and the corresponding rise in Sterling. The fact is that to a US or Far Eastern investor, buying in dollars or Yen, Britain looks decidedly pricey. Another major influence has been the commodities markets. For all of the headline grabbing comment, gold, oil, copper, and heating oil for example, are actually substantially below levels seen mid-way through 2006. In turn, this has seriously impacted on some of the real heavyweights in the FTSE 100—including Billiton, Rio Tinto and Shell. But the big sheet anchor has been BP which has, all on its own, kept the FTSE 100 lower by some 190 points since April 2006.

In all of this there is also the anomaly that is the US Volatility Index (VIX). Overall volatility has been drifting downhill for the last few years and VIX is flirting with the 10% level.

This is a historically low level just as the markets are all rallying to, if not all time highs (certainly 5 or 6 year highs). In times past a low VIX has preceded a period of extreme price action (generally to the down side) as option strategies have tightened to strike prices that are increasingly close to the current levels in an attempt to maintain sale revenues. It is this potential for a rolling attack on cheaply sold PUTs that has some commentators worried.

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In the Markets NEW INVESTMENT APPROACHES THAT MIMIC HEDGE FUNDS

A MOVEABLE FEAST In the classic science fiction movie Invasion of the Body Snatchers pod people replicate the human hosts they destroy in every respect but one: the substitutes are devoid of emotion. Today, the hedge fund industry faces a similar invasion of synthetic products that purport to mimic the performance of hedge funds by investing in liquid indexrelated derivatives that owe nothing to human judgement.

It is a sign that the line between traditional investment managers and hedge funds is beginning to blur. Neil O’Hara reports.

All three products use factor models that solve for the closest correlation between the performance of the average hedge fund and a basket of investable market benchmarks. The developers built on academic studies that analysed hedge fund returns from a performance attribution perspective.“We turned that on its head,” says Michael Dellapa, director of investment research at Rydex,“If it’s useful for explaining performance, then it’s useful for building products as well.” Photograph supplied by Dreamstime.com, February 2007.

S MAINSTREAM PRODUCT developers deconstruct hedge fund returns into idiosyncratic (alpha) and market-related (beta) components, they are finding cheaper ways to capture hedge funds’ performance attributes. At the same time, traditional managers are offering modestly leveraged long-short portfolios that encroach directly on turf that was once the exclusive preserve of hedge funds.

New investment approaches typically take root among institutions before they reach retail investors, but synthetic hedge funds are an exception. The first products offered in the US came from Rydex Investments, a Rockville, Maryland-based quantitative money manager that distributes mutual funds to retail

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investors primarily through independent financial advisors.

Rydex launched its Absolute Return Strategies Fund and Hedged Equity Fund in September 2005, almost a year before the Merrill Lynch Factor Index (MLFI) came to market aimed at institutional investors. A similar product, the Goldman Sachs Absolute Return Tracker (ART) fund, debuted in Europe last autumn and will be offered it to institutions in Asia and North America as soon as it complies with local regulatory requirements.

All three products use factor models that solve for the closest correlation between the performance of the average hedge fund and a basket of investable market benchmarks. The developers built on academic studies that analysed hedge fund returns from

a performance attribution perspective.

“We turned that on its head,” says Michael Dellapa, director of investment research at Rydex, “If it is useful for explaining performance, then it is useful for building products as well.”

In addition to equity, fixed income and commodity indices, Rydex incorporates skill-based factors including market neutral; value, growth and size exposure; stock- and industry-level momentum; merger arbitrage; and credit default swaps.

Even though Rydex limited its universe to investable vehicles, it was able to generate return streams that closely match those derived from the increasingly utilised Fama-French performance attribution model, which contains non-investable elements. For

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In the Markets NEW INVESTMENT APPROACHES THAT MIMIC HEDGE FUNDS

example, to generate an investable value factor, Rydex ranks the components of the Standard & Poor’s 900 Index by conventional value measures including price to book, price to earnings and price to cash flow. It buys the top ranked names and sells short lower ranked names in the same industries to create a valuebiased basket. Rydex uses OTC derivatives to capture other skillbased factors not susceptible to the basket approach.

At 1.4%, the Rydex funds charge fees comparable to long-only mutual funds but far lower than funds of hedge funds, which typically levy a 1% management fee and 10% performance fee on top of the 1% to 2% management fees and 20% performance fees for the underlying

Michael Dellapa, director of investment research at Rydex says that developers built on academic studies that analysed hedge fund returns from a performance attribution perspective.“We turned that on its head [at Rydex],” he says “If it is useful for explaining performance, then it’s useful for building products as well.” Photograph kindly provided

by Rydex, February 2007.

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hedge funds. It even undercuts investable hedge fund indices, the cheapest funds of hedge funds, which still have to pass through fees on the constituent hedge funds.

The low fees will help offset any tracking error between returns on the funds and the Dow Jones Hedge Fund indices against which they are benchmarked. Rydex does not pretend to match the performance exactly, but since inception it has achieved a better than expected 85% correlation.“We are trying to deliver at the retail level the essential franchise of hedge funds: that is, over time, some level of absolute return using strategies that don’t have high degrees of correlation with equity strategies,” says David Reilly, Rydex’s director of portfolio strategy. The firm is just beginning to attack the institutional market and sees its first mover advantage in synthetic hedge funds as an important part of that push.

The Merrill Lynch and Goldman Sachs products use different factors but are otherwise similar in concept.

As befits products aimed at institutional investors, fees are lower: total expenses for the MLFI come in a little less than 1%, while the Goldman Sachs ART charges a 1% management fee plus administrative expenses.

Merrill Lynch’s model tracks its benchmarks better than Rydex does, too; in back tests, the MLFI achieved 90%+ correlation to a composite of hedge fund indices over 10 years and 95%+ in the most recent periods.

According to Jeffrey Gabrione, head of Americas manager research at Mercer Investment Consulting in Chicago, synthetic hedge funds compete most directly with investable hedge fund indices, which parcel investors’ money out to the constituent hedge funds in proportion to their weighting in the index. Both products aim to deliver hedge fund

William Crerend, chief executive officer of EACM Advisors, a fund of hedge funds manager based in Norwalk, Connecticut. He believes synthetics and 130/30 portfolios compete mainly against long-only or long biased hedge fund strategies. In effect, traditional products that most closely resemble hedge funds are nipping at the heels of hedge funds that are the least different from traditional investments.“The more truly hedged and skill-based a product is the more difficult it is to track reliably through some basket,” Crerend says. Photograph kindly supplied by EACM Advisors, February 2007.

beta, the performance of the average hedge fund; neither can substitute for the excess return, or alpha, generated by top hedge fund managers. With lower fees, the synthetics need only come close to matching the performance of investable indices to gain market share based on price.

“Clients are willing to pay for alpha, but they are less and less willing to pay for beta,”Gabrione says.

Although Gabrione foresees increasing acceptance of synthetics, he expects traditional money managers will make greater inroads on hedge fund turf with another product, the leveraged long-short portfolio. In most cases, these portfolios—typically 130% long and 30% short—generate additional alpha from the underlying long-only strategy for the same level of risk.

Although 130/30 managers do sell short individual stocks, Gabrione believes they are more interested in leveraging returns on the long side, rather than looking for alpha on both sides the way a long-short equity hedge fund manager does.

The 130/30 portfolios don’t have the same flexibility as hedge funds, either.

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Institutions expect them to deliver a leveraged return relative to a benchmark, not an absolute return.

It’s a strategy for which the leverage can be tailored to meet specific objectives, too. Fees are higher than for long only portfolios but lower than true hedge funds, Gabrione says; around 0.75% management fee plus a 10% performance fee, for example, although some managers forgo the performance fee in exchange for a higher management fee.

Todd Trubey, a mutual fund analyst at Morningstar in Chicago, believes the 130/30 strategy appeals primarily to institutions, which often favour diversified portfolios with a precise risk reward profile. Although it has proved popular among retail investors in Europe, he knows of only one retail mutual fund in the United States, the ING 130/30 Fundamental Research Fund, which has attracted just $10m

Jeffrey Gabrione, head of Americas manager research at Mercer Investment Consulting in Chicago, thinks that synthetic hedge funds compete most directly with investable hedge fund indices, which parcel investors’ money out to the constituent hedge funds in proportion to their weighting in the index. Both products aim to deliver hedge fund beta, the performance of the average hedge fund; neither can substitute for the excess return, or alpha, generated by top hedge fund managers. Photograph kindly supplied by Mercer Investment Consulting, February 2007.

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since its launch in April 2006.

The 130/30 concept is a natural evolution for traditional asset managers and their easiest entry into alternative assets classes, according to William Crerend, chief executive officer of EACM Advisors, a fund of hedge funds manager based in Norwalk, Connecticut. He believes synthetics and 130/30 portfolios compete mainly against long-only or long biased hedge fund strategies. In effect, traditional products that most closely resemble hedge funds are nipping at the heels of hedge funds that are the least different from traditional investments. “The more truly hedged and skill-based a product is the more difficult it is to track reliably through some basket,” Crerend says.

Factor models like synthetic hedge funds rely on historical data to determine the weighting for each factor. It is like driving by the rearview mirror. It works well enough on a straight road but it is hard to navigate around corners, let alone a hairpin bend. EACM finds that algorithmic investment strategies—used for years by commodity trading advisors and others—do not readily adapt to change, whether it is a new environment not reflected in past data or a market inflection. “It is the Achilles heel of these strategies,” Crerend says, “The ability of skilled active managers to run dynamic portfolios has proven very challenging to replicate.”

Algorithm-based managers must clear a higher hurdle than others to win a place in EACM’s portfolios as a result.

To Charles Gradante, managing principal at Hennessee Group, a hedge fund consultant based in New York, synthetic hedge funds have as much — and as little — to offer as other algorithms he has watched come and go on Wall Street over the

David Reilly, Rydex’s director of portfolio strategy says,“We are trying to deliver at the retail level the essential franchise of hedge funds: that is, over time, some level of absolute return using strategies that don’t have high degrees of correlation with equity strategies.”

The firm is just beginning to attack the institutional market and sees its first mover advantage in synthetic hedge funds as an important part of that push. Photograph kindly provided by Rydex, February 2007.

past 20 years. The successful ones make a splash for a year or two until market conditions change and the models no longer deliver consistent performance. Even if synthetic hedge funds prove an exception, which Gradante doubts, they will only deliver returns comparable to hedge fund indices. “I do not see where the alpha is coming from in using algorithms, especially because they are based on historical data,”he says.

Gradante bristles at the idea that hedge funds—real or synthetic— deliver absolute returns, too. “I am very surprised that Goldman is using that term. There is no such thing as an absolute return strategy, one that always delivers positive returns,” Gradante says. He believes absolute return is a misnomer for the low correlation between the performance of hedge funds and traditional asset classes. Still, he recognises that for investors seeking hedge fund beta synthetics will be a winner based on price — provided their performance does match investable hedge fund indices. The acid test for the body snatchers will come when the markets encounter a systemic problem—the financial equivalent of a hairpin bend.

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In the Markets SECURITIES LENDING

ERISA exemption creates new SecLending opportunities for pension plans 2007 ushered in a new era for US pension plans and custodians, thanks to regulatory changes that are opening the door to lending portfolio securities in select foreign jurisdictions. By Michael P McAuley, senior managing director and chief product officer for State Street’s Securities Finance business.

Global custodians have significant experience in processing securities lending transactions with foreign borrowers and holding foreign collateral on behalf of other US and non-US clients. With the DOL exemption, they can now leverage this infrastructure and experience to assist US pension plans in conducting securities lending transactions in foreign markets and accepting foreign collateral. Photograph supplied by Dreamstime.com, February 2007.

N LATE 2006, the United States’ Department of Labor (DOL) issued prohibited transaction exemption (PTE) 2006-16 under the Employee Retirement Income Security Act of 1974 (ERISA). The new PTE, which allows pension plans to both lend securities outside the US as well as accept certain foreign collateral, took effect on January 2nd 2007.

Plan sponsors and fiduciaries are already exploring ways to take advantage of potential opportunities created by the new class exemption.

By enabling pension plans to better utilise their securities inventory, the foreign lending exemption should increase lending activity.

For custodians, the new exemption should result in an increase in securities lending activity in pension plan portfolios. US pension plans can take comfort in the fact that global custodians have been supporting this type of non-US securities lending activity for many years. Global

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income securities—such as sovereign bonds—had little or no opportunity to lend those securities, due to a lack of demand from US borrowers. This asset class should now generate additional lending opportunities due to increased demand as pension plans add foreign borrowers to their list of approved borrowers. Moreover, plans will in many cases now be permitted to accept collateral denominated in the same currency as the foreign securities they are lending. This will eliminate the foreign exchange component of the collateral process.

It may also provide new cash collateral investment opportunities.

New PTE levels the playing field

Michael P McAuley, senior managing director and chief product officer for State Street’s Securities Finance business. McAuley writes: “For market participants, the DOL class exemption represents the culmination of years of effort to bring US securities lending rules in line with the reality of today’s global financial markets.” Photograph kindly supplied by State Street, February 2007.

custodians have significant experience in processing securities lending transactions with foreign borrowers and holding foreign collateral on behalf of other US and non-US clients. With the DOL exemption, they can now leverage this infrastructure and experience to assist US pension plans in conducting securities lending transactions in foreign markets and accepting foreign collateral.

Prior to the new PTE, pension plans that had portfolios of foreign fixed-

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For market participants, the DOL class exemption represents the culmination of years of effort to bring US securities lending rules in line with the reality of today’s global financial markets. Following the initial 1981 ERISA class exemption (PTE 81-6) that set out the requirements for securities lending by US pension plans, lending activity has steadily grown along with the evolution of financial markets. With this growth, custodians built securities lending programmes and infrastructure for their clients that were not regulated by ERISA. Since the initial exemption in 1981, the US gradually fell behind other countries in the regulation of securities lending by pension plans.

Plan sponsors in the US have long faced more restrictive securities lending requirements than foreign plans, which in many cases are limited only by potential cross-border tax concerns. Therefore, along with new opportunities for greater utilisation, the new exemption also affords another welcome benefit for US plan sponsors—a more level playing field versus foreign plans.

In addition, global custodians can now lend securities for US pension plans utilising the experience and infrastructure developed over the intervening years.

An additional safety net Interestingly, the DOL’s new PTE 200616 is not the only recent change that provides new opportunities for pension plans to expand securities lending. In 2006, Congress re-wrote parts of ERISA itself, adding a new service provider exemption.

Practitioners are still debating the scope of this new provision. However, once some of the issues surrounding its requirements are clarified, many believe that it will provide plans with a statutory exemption that will be easier to comply with and allow all types of securities lending transactions, including transactions not currently permitted under the new class exemption.

In the interim (because the DOL’s class exemption is more detailed in its language and requirements) pension plans are more likely to use it as their regulatory map—even with its narrower provisions, until the requirements of the service provider exemption are clarified.

That is not to say that pension plans will not immediately benefit from the ERISA revisions. Even with the DOL exemption as their regulatory map, pension plans will still have the new statutory exemption as a reassuring “safety net” of authority for their broader lending practices. Provisions offer plans direct access to international lending.

The DOL’s new class exemption includes two key provisions. US pension plans can now lend directly to certain broker-dealers and banks outside the United States, specifically in the United Kingdom, Canada, Japan, Germany, the Netherlands, Sweden, Switzerland, France and

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In the Markets SECURITIES LENDING

Australia. Qualifying foreign banks must have equity capital of at least $200m and be subject to regulation by the relevant banking agencies in their home country. Similar qualifications are required of foreign broker-dealers, including equity capital of at least $200m. Plans can now accept certain foreign collateral, as well as an expanded list of US collateral linked to SEC Rule 15c3-3.

Prior to the DOL exemption, pension plans could only lend to US borrowers, except in a few instances where the DOL granted individual exemptions. In selecting countries eligible for direct foreign lending, the DOL looked at countries for which it had previously granted individual securities lending exemptions.

For pension plans to lend to borrowers in permissible jurisdictions other than the United Kingdom and Canada, the exemption requires plans to have a borrower default indemnification (indemnity) from a US bank or broker-dealer lending fiduciary. For the United Kingdom and Canada, borrowers must agree to submit to US jurisdiction, appoint an agent for service of process in the US and agree to settle disputes exclusively in US courts. Otherwise, an indemnity from a US bank or broker-dealer fiduciary is also required. The new exemption also applies to security loans that are structured as repurchase agreements, provided all conditions and requirements are met.

Expanded collateral requirements Beyond opening the doors to securities lending in these foreign jurisdictions, the DOL also broadened collateral rules to allow pensions plans to participate in more loans. First, the DOL linked the new collateral requirements to SEC Rule 15c3-3, expanding ERISA’s original collateral

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limits — US Treasury securities, US dollar cash or letters of credit—to include, in part, certain debt securities issued by US governmental agencies (e.g. Fannie Mae), CMOs, assetbacked securities and corporate debt.

Moreover, plans will in many cases now be permitted to accept collateral denominated in the same currency as the foreign securities they are lending. This will eliminate the foreign exchange component of the collateral process. It may also provide new cash collateral investment opportunities.

Second, four types of foreign collateral are permitted under the new class exemption: • Debt securities backed by a multilateral development bank (e.g. the European Bank for Reconstruction and Development, the Asian Development Bank) • Highly rated foreign sovereign debt securities • Cash in Euros, Sterling, Canadian Dollars, Swiss Francs, or Japanese Yen • Letters of credit issued by a foreign bank meeting specified criteria.

These broadened collateral rules not only allow pension plans to participate in more loans, but, in many cases, plans can also realise marginally more lending income.

This income will be a result of borrowers no longer needing to go beyond their inventory as frequently when obtaining and financing the necessary collateral for a securities

loan as well as reducing the cost of any such financing.

Under the DOL exemption, the following minimum collateral levels are now required. US collateral must be 100% of the market value of the loaned securities. Foreign collateral, if denominated in the same currency as the loaned securities, must equal at least 102% of the market value of the loaned securities — unless the lending fiduciary is a US bank or US broker-dealer providing the plan with an indemnity. With an indemnity from a US bank or broker-dealer, the minimum foreign collateral is reduced to 100%.

Foreign collateral denominated in a currency different than the loaned securities must equal at least 105% of the market value of the loaned securities. However, with an indemnity from a US bank or brokerdealer, the minimum foreign collateral is reduced to 101%, provided that the collateral is in Euros, Sterling, Japanese Yen, Swiss Francs or Canadian Dollars.

For collateral in all other currencies, the minimum remains 105%, even with indemnification. Experienced agents can best support lending growth The new opportunities presented by the DOL class exemption have spurred plan sponsors and fiduciaries into action.

Plans are reviewing their portfolios for foreign lending opportunities, and, to smoothly effect the expanded lending, will be seeking out global service providers with the most extensive experience working with foreign broker-dealers and dealing with cross-border legal and tax concerns.

Sorting through their options may add a layer of complexity for pension plans. However, one thing is certain.

The new opportunities for greater securities utilisation and provides worthwhile motivation.

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Face to Face JPMORGAN’S NEW TAKE ON SEC LENDING

JPMORGAN TAKES A NEW TURN IN SECURITIES LENDING The convergence of mainstream investment strategies with hedge fund strategies is a pivotal element in the growth outlook for securities lending and all growth projections for the industry are upward. However, regulatory and competitive challenges in the industry at large, now call for new approaches to the service mix. Sandie O’Connor, JPMorgan’s global head of securities lending, for one, wants the bank to focus on client delivery and break out of its traditional custodian mould and offer securities lending services to those clients who do not have a custodial relationship with the firm. The focus is on elevated levels of client service to a broader customer base, giving its non-custody securities lending clients access to its distributional strength and risk management expertise.

N EARLY FEBRUARY, the New York State Teachers’ Retirement System (NYSTRS), the second largest public retirement system in New York State and one of the top ten by size in the US, selected JPMorgan Worldwide Securities Services as its first noncustody lending agent for fixed income securities totalling $12bn. While something to celebrate in itself, the agreement signals a sea-change in JPMorgan’s approach to the provision of securities lending services.

Until a few years ago the securities lending market was straightforward.

Asset managers and beneficial owners bundled their custody and securities lending mandates.

Custodian providers, such as JPMorgan, State Street, Citigroup and Northern Trust,

I

competed with each other on price, knowing they could pick up additional fee revenue for lending securities in their portfolio on a ‘best efforts’ basis.

Even today, custodian lenders benefit from the tendency of asset managers to outsource all or part of their back office operations, with securities lending mandates often attached to the overall package. It was and remains a degree of ‘stickiness’ in the business that allows custodian lenders to retain a substantial, even dominant, role in the overall securities lending marketplace.

Like State Street, JPMorgan now wants to play in an increasingly diverse and complex marketplace as an agent lender to both custody and noncustody clients. In part, the move recognises that third party lending

FTSE GLOBAL MARKETS • MARCH/APRIL 2007

operations, such as Dresdner Kleinwort Wasserstein (DKW), that do not provide custody services, have been steadily picking up market share over the last few years. Some of that business has come from new clients bringing in new liquidity. Some has come at the expense of custodian lenders. The market is further complicated by the rise of specialist securities lending auction houses, such as eSecLending and direct market access (DMA) by pension giants, such as Holland’s Robeco, which have both in-house expertise and regulatory approval to participate in the market.

Distribution capability, operational strength and innovative technology are key buzz words in the vocabulary of Sandie O’Connor, managing director and global head of the securities lending and execution products business of JPMorgan Worldwide Securities Services. O’Connor is responsible for domestic and international securities lending, foreign exchange, futures and options clearing and transition management and is focused on positioning the Securities Lending and Execution Products business for growth.

O’Connor’s latest initiative in delivering market facing product is to break JPMorgan to out of its traditional

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custodian lender mould — a move the globe client service dedication is driven largely by market forces. “We increasingly important, she thinks, think that securities lending clearly particularly as the main area of focus provides value independent of custody. around the global securities lending Securities lending is not processing, it is business during the last year and a half Sandie O’Connor, JPMorgan’s global head of about risk management and are regulatory and tax issues. MiFid securities lending. Photograph kindly supplied distribution capability,” maintains and Basel II have focused everyone on

by JPMorgan February 2007 and infrastructure O’Connor. It is that thinking that transparency The issue for lenders then is flexibility delivers JPMorgan a ‘win-win’equation, capacity. Additionally the debate on adding, “We continue to value our corporate governance is continuing to and an-all encompassing service custody clients who are part of our impact the industry. The biggest issue offering.“We leverage auctions, such as securities lending programme, and arguably is the Agent Lender Equilend, and we do auctions from our these relationships enable us to be key Disclosure Initiative (ADLI), an SEC own desks.” She believes that the most suppliers in the marketplace. But why ruling that came into effect last important developments lie around the not offer services in securities lending October, which ensures that the significant increase in competition derivatives, and she to those institutions that have their identity of beneficial owners is known around to the securities borrowers. ADLI has acknowledges that the bank’s eye, “is assets under custody elsewhere?”

Increasing levels of demand for placed more complex (and costly) keenly focused on that competition, securities from prime brokers and requirements on agent lenders – with particularly in the area of credit default attendant requirement on swaps which have replaced demand for hedge funds crystallises the need for an beneficial owners and asset managers infrastructure and IT development; corporate bonds and there’s more to to better leverage their investments by which some market watchers think will come.” Equally, she says, “foreign providing access to their assets and play into the strengths of the global exchange is becoming an increasingly generating incremental returns. Today’s players. O’Connor agrees and views important consideration for clients who increased transparency demands high JPMorgan’s move as the latest are hedging future flows. We regularly levels of performance from agent evolution in the business.“Everything is ask ourselves, are we cutting edge in lenders and more balanced splits about creating the biggest pools of derivatives and can we help beneficial between lenders and beneficial owners. liquidity — something that is also being owners do more and achieve alpha? We The advantages of working with the demanded by our client community.” forcefully answer in the affirmative.”

Additionally, the emerging markets bank, says O’Connor, include, “A That community says O’Connor is customised lending programme increasingly sophisticated and as a are an area of greater interest, most tailoring risks and returns for each consequence is now focusing less on notably in Taiwan, though markets such beneficial owner, access to an efficient “how they get to market and more on as India, China, Russia and Brazil have all shown signs of developing an operating infrastructure (even if they do what they get from the market.” offshore securities lending not have assets under Securities lending shifts up a gear framework. As securities custody with us) and the 3-Year Price Performance (USD Terms) lending grows at a dramatic benefit of scale, including 160 pace, our clients can enjoy our global distribution and increased yield from their depth of firmwide 140 investments. According to resources. However, that 120 O’Connor, today’s securities expertise and product lending trends point to an offering is not enough. We 100 eventual flight to quality and need to make it easy for 80 global strength. Yet, says broker dealer and O’Connor, even with scale beneficial owner clients to 60 and global reach on offer, the deal with us. We are overarching requirement is raising the bar with all the quality of service. “We don’t clients that we serve.” take clients for granted,” This 360 degree or Source: FTSE Group and Datastream, data as at 31 January 2007. notes O’Connor. around the clock/around

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Regional Review MIDDLE EAST: NEW ISSUES ADD TO SAUDI GROWTH STORY

The Saudi Stock Exchange (Tadawul) all-share index (TASI) has tumbled from a high of 20,634 on the 25th February 2006 to a low of 6,916 by the end of January this year, a fall of 66%. For most economies a stock market fall of this magnitude would precipitate an equally severe downturn in retail and industrial activity, with a recession the most likely outcome. In Saudi Arabia the very reverse has occurred. Even the naturally cautious International Monetary Fund (IMF) predicts an increase in real GDP growth in Saudi Arabia to reach 6.5% this year, up from 5.8% last year.

NEW ISSUES CALENDAR BUOYS SAUDI GROWTH

Real estate is Saudi Arabia’s boom industry. An artist rendering released by Emaar Development in Riyadh, Saudi Arabian shows the Financial Island perspective of the planned King Abdullah Economic City in Jiddah. A consortium of three Saudi and Emirates companies plans to build a $26.7bn ($22.4bn) city on the Saudi Arabian seaside that is being called the largest-ever private development in the kingdom's history. Since the photograph was released, the project has been increased in size and the first foundations are now being laid. Photograph provided by Emaar, via Associated Press/EMPICs, February 2007.

Y

OU NEED TO distinguish between the real economy and the stock market,” explains Talal Al-Qudaibi, chief executive officer (CEO) of Riyad Bank.

“While the stock market may have suffered significant falls to date we have witnessed very little spill-over effect on the wider Saudi economy.

Retail spending appears to have held up well, the bank’s commercial lending “

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to domestic firms has actually increased over this period and direct foreign investment by overseas firms into the Kingdom is at record highs.”

Even so, the TASI remains stubbornly in the doldrums despite the efforts of the Capital Markets Authority (CMA), the local market regulator, to boost investor confidence. In January, Abdulrahman Al-Tuwaijri, chairman of the CMA

announced the suspension of trading in two firms listed on the Tadawul as a result of financial losses, and stated that the CMA would apply similar actions against all listed firms with losses that exceed 75% of their capital.

The CMA hopes this measure combined with others such as improved transparency of the market, and the re-introduction of IPO activity will have the desired effect.

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Regional Review MIDDLE EAST: NEW ISSUES ADD TO SAUDI GROWTH STORY

The repercussions of these reforms have yet not been felt. All three firms that joined the Tadawul in January, Advanced Polypropylene Company (APPC), Al-Babtain Power and Telecommunication Co., and Fawaz Abdulaziz Alhokair Company suffered sharp falls from their offer prices, albeit in a market continuing to suffer falls across the board. Market watchers are nonetheless alive to the debut, and subsequent performance, of Malath Insurance, one of the 13 newly licensed insurance companies scheduled to list in February. Will Malath follow suit? Or will it buck the trend and show an uptick in the aftermarket?

One issue under consideration to help stimulate the market is for the CMA to open the market to international investors. While GCC nationals and foreigners resident in the

John Coverdale, CEO of Saudi British Bank (SABB) which directly (and now indirectly through its HSBC investment banking joint venture) has been responsible for seven of the 17 initial public offerings (IPOs) on the Tadawul since the beginning of 2005 believes that allowing direct access by international institutional investors would have a number of benefits .Photograph kindly supplied by SABB, February 2007.

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Kingdom are able to invest directly in the Tadawul, international investors from outside the region are restricted to investing indirectly through Saudi country funds.

John Coverdale, CEO of Saudi British Bank (SABB) which directly (and now indirectly through its HSBC investment banking joint venture) has been responsible for seven of the 17 initial public offerings (IPOs) on the Tadawul since the beginning of 2005 believes that allowing direct access by international institutional investors would have a number of benefits .“As the largest stock market in the region institutional investors would most likely to always require at least some exposure to the market. As long-term value investors rather than short term speculators this should mean that some of the volatility we see today would be greatly reduced,”he says.

Another knock-on effect of allowing international investors’ access to the Tadawul, thinks Coverdale, will be an improvement in the quality of research available to investors. “Currently the market is underserved in terms of the availability of company specific rather than broader macro and sector research.” Eisa Al-Eisa, managing director (MD) and CEO at Samba Financial Group agrees there is not enough public research available on the Tadawul—particularly on individual companies. However, he thinks, “there will be a natural evolution of the market, and I expect to see more quality research emerge with the growing competition among asset managers and investment companies.

We fully plan to maintain our market leading position in research.”

International investors would be keen for exposure to planned IPOs such as the Saudi Arabian Mining Company (Maaden) which is looking to raise between $1.9bn and $2.5bn in the third quarter to fund corporate

Eisa Al-Eisa, managing director (MD) and CEO at Samba Financial Group agrees there is not enough public research available on the Tadawul— particularly on individual companies. However, he thinks,“there will be a natural evolution of the market, and I expect to see more quality research emerge with the growing competition among asset managers and investment companies. We fully plan to maintain our market leading position in research.”

expansion. According to Maaden’s CEO, Abdallah E. Dabbagh, the money will be used to help to finance a phosphate production plant for fertiliser, and an aluminium project which have a predicted combined cost of $10bn. However the IPO in which Maaden will sell at least 40% of its stock to the public and possibly 10% to two government institutions will only be open to Saudi investors.

As a result of the delay in the number of IPOs, there has been a significant increase in the number of private transactions. “Over the last 12 months we have managed several private transactions of varying sizes with strategic investors. Of these, three would have been likely IPO candidates on the Tadawul”, explains Salman AlDeghaither, head of investment banking, Gulf International Bank (GIB). He believes that there are a number of benefits to a private placement with a select number of high-net worth individuals prior to a future listing.“Just as with an IPO the company must have a strong future strategy but with a private placement the costs are much lower and it provides capital for the company to invest whilst allowing it time to bring its corporate governance and reporting

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Regional Review MIDDLE EAST: NEW ISSUES ADD TO SAUDI GROWTH STORY

up to the exacting standards now required by the CMA. The result is a more profitable company with a more compelling ‘investment story’ for investors when the company does eventually come to market.”

Saudi Arabia’s growing debt market also promises to be a draw for investors. A rush of corporate debt was expected in the second half of 2006, following Saudi Basic Industries Corp’s (SABIC’s) SR3bn issue in July last year.

The introduction of the Sukuk law in the Kingdom has not led to a massive upsurge in new issues. However, both SABIC, the world’s largest chemical company by market value, and Saudi Aramco have publicly announced their commitment to issue more domestic debt in the future. Mutlaq al-Morished, SABIC’s chief financial officer, announced in early February that affiliates of SABIC could borrow as much as $9bn this year. SABIC meantime estimates it will invest as much as $30bn to boost output by 60% to 80m tonnes per year by 2012—up from 50m in 2006. SABIC has already appointed BNP Paribas, Arab Banking Corporation and Samba as financial advisers and lead arrangers for a $4.8bn loan for the Saudi Kayan project. It may be that, like the SABIC financing, it too is converted to a Sukuk. Aramco meanwhile has earmarked an even greater investment expenditure of $137bn for the period 2006-2010.

Project finance will again dominate the market in 2007. HSBC is heavily involved in project finance for the Saudi power and water sectors, advising on the Shuaiba 3, Shuqaiq 2 and Ras Azzour. The SR9bn Shuaiba 3 water and electricity production project, 110 km south of Jeddah and due to be operational in 2008, was awarded to a Saudi-Malaysian consortium, the Saudi-Malaysian Water and Electricity Company, on a

30

build-operate-transfer (BOT) basis.

The plant however will be owned and run by the recently established Shuaiba Water and Electricity Company (SWEC), the first private Saudi company for the production of water and electricity. It is 60% owned by the consortium, 32% by the Public Investment Fund and 8% by SEC. Initially, credit support is being provided by the Ministry of Finance but an IPO is planned to help finance the project.

Although investor interest in issuances from quasi-utilities such as Aramco, SABIC and the Saudi Electric Company (SEC)—which is rumoured to be arranging an issuance for later in the year—remains buoyant, more keenly they expect the Kingdom's first sovereign issue to establish the ultimate benchmark for the Saudi market. The Saudi Arabian Monetary Agency (SAMA) is coy about its intentions, but local bankers believe it is preparing to launch its first sovereign issue sometime in 2007.

The opportunity to arrange international financing for the Kingdom is one that is attracting attention from both within and outside the region. Estimates for the value of announced projects vary between $400bn and $1trn over the next 15 years, figures well in excess of what can be funded by government and private sector resources alone.

More pertinently for the banks, it adds up to a whole lot of fee income. The wholesale entry of bulge bracket banks into Saudi Arabia on the back of that potential business is well documented.

Now, regional banks are also seeking a piece of that pie.“We have applied for an investment banking license to the CMA and are expecting to hear back shortly,” relates Douglas Dowie, CEO at National Bank of Dubai (NBD) which has recently invested heavily in its investment banking capabilities.

Robert Eid, CEO, at Arab National Bank (ANB). The residential real-estate sector is expected to experience significant growth in the Kingdom over the next decade, providing “a significant new income stream for Saudi banks,” thinks Eid.“We believe that the next significant boost to banking growth in the Kingdom will be the financing of the residential real-estate market on which ANB is well placed to capitalise,” he adds. Photograph kindly supplied

by ANB, February 2007.

“With our presence in the Dubai International Financial Centre (DIFC) NBD is well placed to assist Saudi institutions seeking external financing through some form of listing on the Dubai International Financial Exchange (DIFX).

In February one of Saudi Arabia’s leading residential real estate developers, the Riyadh-based Dar AlArkan Real Estate Company (DAAR) issued the first international Sukuk by a Saudi corporate. The three year $425m Sukuk Al-Ijara was listed on the DIFX and was lead-arranged by ABC Islamic Bank, Saudi-based Arab National Bank (ANB), Standard Bank, Unicorn Investment Bank and Germany’s WestLB all of whom also acted as book-runners and underwriters of the deal. DAAR is not new to accessing Islamic financing. In May 2006, Samba arranged an SR810m Murabaha facility for the company to finance its Al-Qasser residential project in Riyadh. The company is currently involved in or planning over 20 residential developments throughout Saudi Arabia and targets approximately 65,000 residential units by 2009. Overall DAAR estimates that the housing market in the Kingdom is expected to increase by 25% in 5 years, from 4.34m units in 2004 to 5.4m units in 2010.

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Regional Review MIDDLE EAST: NEW ISSUES ADD TO SAUDI GROWTH STORY

Additionally, the residential realestate sector is expected to experience significant growth in the Kingdom over the next decade, providing “a significant new income stream for Saudi banks,” thinks ANB’s CEO, Robert Eid.“In recent years the banks’ have benefited from the development of the consumer credit market and following that the development of the capital markets. We believe that the next significant boost to banking growth in the Kingdom will be the financing of the residential real-estate market for which ANB is well placed to capitalise,” he adds. Recent data backs up Eid’s thinking. Borrowing levels in Saudi are relatively low with mortgage housing finance representing only 2% of GPD—opposed to 17% in Malaysia, 50% in the USA, and 72% in UK. SABB’s Coverdale however maintains that the size of the existing loan market has been underestimated.

“People did borrow money from the banks to finance land purchases and building costs but these were categorised as personal loans rather than as mortgage finance,” he says.

Since SAMA issued new guidelines about the size and multiples allowed on personal loans this is no longer an option for potential home buyers.

What is not in doubt, however, is the size of the potential market. “166,000 new homes will have to be added to the housing stock every year just to keep pace with the growing Saudi population and this is before you take into the account any replacement of existing homes,” explains John Sfakianakis, chief economist, SABB. A further boost to the housing finance market should come from the new mortgage law which is expected before the end of year. While complete details are not yet known it is hoped the law will clarify some grey areas of property ownership and provide a legal framework which allow for the

32

development of new mortgage products. However it is not for the lack of mortgage products which has held back the domestic housing market.

Many banks already offer some form of mortgage products with both conventional and Islamic options available.“Riyad Bank already offer a 20 year Murahaba Home Finance product which will is totally Shariah compliant and requires only a 5% deposit,” says Al-Qudaibi. “The problem is not the lack of finance available but a lack of housing stock.”

Currently there is virtually no secondary housing market in Saudi Arabia. Traditionally houses are passed down from generation to generation without ever being placed on the open market. As there have been few large scale residential developments or secondary market, in order to buy a property a family has to purchase a plot of land, organise a contractor to construct the home and then attempt to arrange the provision of utilities. The fact that extended families have tended to live together in the property is reflected in an average property size of 400 square metres. Add to this the fact that until recently, apartment buildings were managed and individual apartments were not for sale has meant that there have been significant barriers to young Saudi families wishing to purchase homes.

To overcome the shortfall ANB is establishing a housing finance company in association with DAAR subsidiary Kingdom Installment Company (KIC), the International Finance Corporation (IFC) and the Housing Development Finance Corporation of India. ANB’s Eid believes that this “best of breed” approach has a number of benefits.

“Firstly by teaming up with the most accomplished developer in the Kingdom we can ensure a steady supply of high quality homes. Secondly

Talal Al-Qudaibi, chief executive officer (CEO) of Riyad Bank explains that,“While the stock market may have suffered significant falls to date we have witnessed very little spill-over effect on the wider Saudi economy.” Photograph kindly supplied by Riyad Bank, February 2007.

the long-tenure involved in mortgages is not naturally suited to the traditional commercial banking model. HDFC has significant experience of the housing market and by separating this business out from the bank it allows the company to apply more suitable risk modelling and financing techniques whilst still leveraging our customer base. The result is that for the first time Saudi consumers will be able to look to the collective skills and expertise of a leading retail bank and a specialist real estate finance company to structure and make affordable Shariah compliant funding solutions for residential properties constructed by DAAR or any other reputable developer.”

For investors seeking exposure to the Saudi real-estate market without actually buying bricks-and-mortar, Samba has launched a new Shariah Compliant Real Estate Fund, the first of its kind in the Kingdom under the umbrella of the Real Estate Investment funds bylaws and regulations issued recently by the CMA. “The fund’s activities cover several investment areas, such as acquiring and developing residential, commercial and investment lands for sale or lease; financing residential, commercial and industrial real estate projects and selling them in instalments, as well as other real estate financing need. The Fund will be eligible also to invest in equities of real estate companies” says Samba’s Al- Eisa.

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Samba … Saudi Arabia’s leading corporate bank and IPO manager Our proven expertise in raising capital and our strength as Saudi Arabia’s leading corporate bank have made us an unrivalled partner in success for companies with big visions for the future. In fact, in the last 4 years, we managed the Kingdom’s largest and most successful IPOs, M&As and corporate finance deals.

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Regional Review MIDDLE EAST: REITS BEGIN TO ENTER THE MARKET

REITs on the STARTING BLOCK

With no taxation in many Middle Eastern markets and restricted investment rules for foreign ownership of property in a number of nations, the incentives to develop regional real estate investment trusts (REITs) have remained limited. However, as analysts call for international investment standards in the Gulf to widen its global appeal and with Far Eastern exchanges trying to cash in on Shariah-compliant institutional products, REITs may yet have their place.

Mark Faithfull reports.

Khalifa Stadium in Qatar has put infrastructure to the fore in the development of its own property strategy and many of the projects were assigned to coincide with the Asian Games, which took place late last year. Photograph independently sourced by Mark Faithfull, February 2007.

HERE HAS BEEN an awful lot of talk about real estate investment trusts (REITs) in the Middle East.

However, despite a huge property boom in the region, there has been very little action. The Middle East is rife with enormous building projects, from the Las Vegas-style sprint to create a major leisure and shopping destination in Dubai, to the infrastructure and Asian Games led development of Qatar and the property-focused catchup being played in Abu Dhabi. Add to this a slew of schemes in Bahrain, the

T

34

emergence of Egypt and particularly Turkey as investment attractive nations and the pending housing shortage in the Kingdom of Saudi Arabia (KSA) and any investment vehicle with a property bent would seem an enticing proposition.

Even so, the fundamental appeal of REITs in the Western and Far Eastern markets in which they currently prosper is their charitable, tax free status. In a region where many energyrich nations charge no business or personal tax, and where foreign

property ownership and investment opportunities are at best restricted and often not permitted at all, the wait for a suitable trust-based investment vehicle is still on. However, tentative first steps have been made into the MENA property market, where Gulf investors are the most active players.

Financial liquidity is estimated at $2.3trn, of which $1.5trn is concentrated in the Gulf Co-operation Countries (GCC) alone. But tapping into this market without taking the risky step of direct property investment

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Regional Review MIDDLE EAST: REITS BEGIN TO ENTER THE MARKET

to allow customers to invest in has been difficult and so, in a property assets globally. The bid to help create more two banks also formed a internationally acceptable venture to manage a $272m investment opportunities, the infrastructure fund for Abu Dubai Financial Services Dhabi’s government. “REITs Authority (DFSA) introduced have been successful in other rules permitting the operation markets and we feel the of REITs within the Dubai timing is right for the rollout International Finance Centre of such vehicles in the region,” (DIFC) last August.

Barry Barakat, a director of The new rules enable the Macquarie, explains. flotation of REITs in the Nevertheless, to attract region for the first time, using investors REITs need a selling the Dubai International point and if it is not tax Financial Exchange (DIFX) in efficiency inducements then a bid to attract international what is it? Transparency, the banks, asset managers and introduction of international insurers to a 110-acre cluster standards for investment, a of buildings in central Dubai, way of spreading risk across a operating under a Westernproperty market that has style regulator. Since opening suffered some setbacks— in 2004, it has given licences despite its full-speed-ahead to firms including Citigroup, strategy—and an opportunity Morgan Stanley and Credit to create funds suitable for Suisse Group. However, there has hardly been a rush of new Central Market is an upcoming scheme by Aldar Properties, Islamic investors seem to be REITs to pick from. Arabian which combines A-office space with traditional retail and a hotel the most obvious drivers.

Indeed, the relatively small Real Estate Investment Trust as Abu Dhabi invests heavily in real estate projects, fuelled by (AREIT)—a joint venture energy riches and a desire to offer an alternative work, leisure and number of Shariah-compliant to religious company majority-owned by holiday destination to Dubai. Photograph independently sourced (adhering HSBC Bank Middle East and

by Mark Faithfull, February 2007. strictures including prohibited business activities such as Daman—has confirmed but not fulfilled plans to list on a regional combine cash flows with potentially alcohol, pork, casinos or ammunition) stock exchange such as Dubai Financial strong capital gains over a five to seven investment opportunities in the Gulf Market (DFM) and DIFX, some time in year time horizon. The fund will target region is a concern says Sameer Abdi, the “near future”. The $200m fund is returns in the region of 15% IRR to head of Islamic financial services, real estate with Ernst & Young. The Middle currently registered in the Cayman investors,”declared Atkinson.

Another potential fund emerged in East could see Islamic capital shift to Islands. “The GCC market is evolving fast and as laws regarding ownership December when Macquarie Bank, exchanges such as Malaysia and become clearer we hope to launch Australia’s largest securities firm, Singapore, which are busy pitching funds which will be open to wider confirmed plans to start a $2bn UAE themselves as hubs, evidenced by investor base that will be listed on REIT with local partners. Macquarie’s FTSE and Bursa Malaysia establishing regional stock exchanges,” says AREIT real estate unit is in talks with Abu the FTSE Bursa Malaysia EMAS Dhabi Commercial Bank and the DIFC Shariah Index in January this year. managing director Stephen Atkinson.

“Converting some of the ShariahAREIT plans to invest primarily in to form a trust which will acquire developed commercial and specialised assets now owned by state-run DIFC compliant funds into REITs could be properties in the GCC region in order as well as other UAE properties. Earlier problematic,”reflects Abdi,“as there are to maximise stable cash flow.“The fund last year Abu Dhabi Commercial Bank, issues based around transparency and will focus on acquiring developed the UAE’s fourth-biggest lender, procedures. The market is also quite properties in the GCC region that entered in to a venture with Macquarie young and has been fairly volatile but

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Regional Review MIDDLE EAST: REITS BEGIN TO ENTER THE MARKET

there would be some merit in these schemes converting to at least a more REIT-like, equity based investment.

“We need to encourage the capital markets and in some ways this would be a natural progression to more transparency and better risk diversification. But that also requires more choice – one or two REITs is not enough, investors need a good selection of vehicles,”he adds.

A year ago the Jeddah, KSA based Siraj Capital and Johor Corp of Malaysia agreed to develop and launch $500m of Shariah-compliant investment funds. Two open ended investment funds are planned; a REIT and a regional private equity investment fund (RUIF), each with an investment size of $250m. The REIT fund will focus on real estate investments related to tourism, education, property, industrial and technology parks, and will seek a listing on the Bursa (Malaysian) stock exchange. The RUIF will be focused on investments in strategic private equity sectors like palm oil, biodiesel, oil and gas industry and other related sectors that have technologybased components.

Ultimately the real drivers for REITs if they are to thrive in the Middle East are that they can act as a mechanism for investors to get the advantages of professional management, a higher level of liquidity and a diversified portfolio, which reduces risk.

Individuals therefore can then make small investments with some stability in income stream.“We would certainly welcome anything that brings in international money, which we feel is lacking for the market to really mature,” says Nicholas Maclean, managing director of CBRE Richard Ellis, Middle East.“But at the moment this is a tricky market for REITs. There is a culture of owner occupiers rather than companies selling 10 or 20 year

38

leases to foreign companies, which is what is really being cried out for. But it will come.”

In spite of a generally good news property story across the Middle East, the regional real estate sector has not been without its blips. The reawakening Lebanese economy was devastated by Israel’s attacks on Beirut, while in Dubai residential yields fell on buy-to-let residential properties last year, precipitating small capital falls in some areas.

Bank, Australia’s largest securities firm, confirmed plans to start a $2bn UAE REIT with local partners.

Macquarie’s real estate unit is in talks with Abu Dhabi Commercial Bank and the DIFC to form a trust which will acquire assets now owned by state-run DIFC as well as other UAE properties.

Investment in a REIT could iron out some of those fluctuations. Stuart Gissing, regional director for Dubaibased Colliers International, cites Emirate Abu Dhabi as an example.

“Abu Dhabi is at the onset of a real estate boom, with demand currently outstripping supply. As such, we feel that in the short to medium-term, healthy competition will exist between it and Dubai,” he reflects.“In the long-run, where we expect supply extensions to outstrip demand, the scenario may change with both Emirates targeting similar segments.”

The office sector in Abu Dhabi is currently characterised by undersupply, adds fellow regional director Ian Albert. “Landlords are negotiating out of market norms and in the short-term, in consideration of

anticipated increasing rentals in light of undersupply until 2009 at least, we expect capital appreciation in the office sector. In the medium-term with initial delivery of quality office space in the market, rental levels could stabilise, with stable capital values. In the long-term, however, with supply extensions of an unprecedented scale, we would expect rentals to soften and this could subsequently have a negative impact on capital values.”

With such unpredictability Simon Thomson, managing director of UKbased Middle East retail specialist Retail International adds that with no taxation advantages REITs might prove more attractive for small and medium-sized investors. “At the moment there’s not much discussion about REITs in the Middle East but what they might provide is, for example, a way of creating a diversified structure for investing in a number of properties owned by a really go-ahead developer like Emaar,”he reflects.

However, for local investors, more attuned to short-term speculative capital gain, it may be a bit of a challenge to present something which is by its nature a very stable, long-term bond-like structure and some of the region’s more risk-friendly investors may not find it particularly appealing.

“The returns on property investments are going down and consequently REITs may become sexier,” reflects Maclean. ”New instruments are always welcome in the market and if they could, for example, be used to invest in companies which have acquired land for residential development in Saudi then that would be a very useful tool. If you are talking about REITs in the Gulf right now then there is not much to say. Come back in a couple of years’ time and that might be a completely different matter.”

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Regional Review EUROPE: THE IMPACT OF TURKEY’S ELECTIONS

TURKEY’S ELECTION FEVER

Wide-ranging structural reforms have meant cuts in state spending, a gradual move to liberalise the labour force and a revival of the privatisation programme. The government has generated over $10bn by selling off stakes in Tupras Refinery, an oil refinery, Telsim Mobile and Turk Telecom as well as Erdemir Steel. Moreover, the Central Bank became independent and succeeded in reducing inflation and stabilising the exchange rate. As a result, nominal and real interest rates declined significantly. Photograph by Tamer Yazici, supplied by Dreamstime.com, January 2007.

Last May when emerging markets unexpectedly tumbled and the Turkish lira slid, the currency crisis of 2001 flashed before the investment community’s collective eyes. Much to the country’s relief, its economy and all important banking sector weathered the mini-storm thanks mainly to strong structural reforms and central bank support. This year investors know they are in for a bumpy ride as the country faces two potentially contentious elections. Lynn Strongin Dodds reports.

URKEY’S PRESIDENTIAL ELECTION — set for May — followed by general elections in November have eclipsed, albeit temporarily, the European Union (EU) accession talks which ran into trouble in late 2006. The EU suspended membership talks in eight policy areas because of Turkey’s refusal to open its ports to the Greek controlled half of the island of Cyprus — an EU member since 2004. Turkey said it would not do this until the EU took steps to end the Turkish Cypriot community’s isolation.

For now, market participants are not unduly worried about Turkey gaining entry into the EU. The general consensus is that the country will eventually become part of the fold although it could be a long and tortuous affair, taking at least another

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ten years of negotiations. As Magar Kouyoumdjian, a credit analyst with Standard & Poor’s puts it, “The prospects for full EU membership is not the key issue. The more important question is whether the government will continue to implement the reforms to gain entry into the EU, continue to cooperate with the International Monetary Fund (IMF) and remain secular. The focus this year is on the elections.”

Election jitters have already prompted the government to temporarily pull the plug on the privatisation programme of parts of the electricity distribution network.

There are concerns that the potentially higher prices that might result from a state sell-off could hurt its chances in an election year. The Turkish public are

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already weighed down by some of the highest energy prices in the world.

In the meantime, the country is holding its breath to see whether prime minister Tayyip Erdogan, head of the pro Islamic Justice and Development Party (AKP), will throw his hat in the presidential ring. Alternately, whether a compromise candidate will be found that will be more acceptable to the secular establishment, which includes the all-powerful Turkish military and the judiciary.

Erdogan is keeping the pundits guessing, although an announcement is expected in mid-April. Industry observers are split as to which path Erdogan will follow.

At first glance, there seems little to be worried about. The prime minister wields more power and the

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presidency in Turkey is considered an important symbolic position as the seat of Mustafa Kemal Ataturk, the founder of modern Turkey.

However, a closer look reveals that the position also carries great influence. For example, the president, who is elected by Parliament for a seven year term, is the head of the National Security Council (MGK) which consists of generals and government officials. Moreover, he is able to veto bills passed in Parliament or send them to the Constitutional Court for review. For example, outgoing President Ahmet Necdet Sezer, a staunch secularist, used the veto to block many AKP laws.

Responsibilities also include making influential appointments and confirmations of high-ranking officials and university rectors.

Scenarios are being played out at every level. For example, if Erdogan is elected as president and AKP retains its majority in the general election, then there are fears that too much power will be concentrated in the hands of the pro-Islamist party, blurring the lines of the separation of religion and state.

Despite Erdogan’s economic reforms and pro-business stance, rumours are once again rife in some quarters that he has a hidden agenda to turn Turkey into a religious state.This is partly due to the fact that AKP, founded in 2001, grew out of the Islamist Welfare Party, which had been banned in 2000 by the military for allegedly threatening the country’s secular nature.

Eli Koen, senior portfolio manager European Small Caps Equities — Emerging Europe for Fortis Investments, observes,“The Presidency is seen as the last stronghold of secularism and if Erdogan runs then this will give power to that political spectrum. The people who are most concerned are the secularists such as

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the army, parts of the media, judiciary and business. However, more people will care if there is a strong reaction from the international markets. If that happens, it could trigger economic volatility. At the moment, the markets have factored in the uncertainty and multiples in the stock markets are trading at a reasonable 10 to 11 times 2007 earnings.”

The other picture being painted, which perhaps would tarnish Turkey’s image even more is if Erdogan wins the presidency, but the AKP fail to secure a majority in the general elections. This could result in the clock being turned back to the turbulent years of coalition governments which hampered the growth and development of the economy. During the 1980s and 1990s, inflation and interest rates never climbed down from their lofty double digit heights while fiscal deficits only grew wider.

Moreover, these alliances never lasted long enough to make a difference. According to Tevfik Aksoy, chief economist, Turkey with Deutsche Bank in Istanbul, between 1990-2000, Turkey witnessed over 12 governments whereas the AKP will go down in history as one of the few parties that stayed the distance of the five year term.

As Koen puts it, “In the 1980s and 1990s, Turkey’s government was characterised by boom and bust. Debt to GDP was more than 100% while inflation was between 70% to 100%. In the past four years, there has been a significant change accompanied by the government following EU reforms.

The country is growing consistently by 5% over the last four to five years, inflation is below 10% and debt is under 60% of GDP which is in line with other European countries.”

Elif Tokman, Istanbul-based head of financial institutions and public

sector, Turkey at ABN AMRO, also believes that“businesses have factored in a certain amount of volatility due to the elections. I think we might see some slowdown in corporate and consumer spending but we do not believe there will be a major event that will block the progress of the economy. The regulatory bodies and Central Bank have expressed their intension to continue to focus on maintaining strong fiscal and monetary policies and no election scenario will change that.”

Although there are mixed views about what the election outcomes will be, all agree, including critics, that the AKP has done an impressive job of navigating the country onto a path of strong, solid economic growth. When Erdogan came to power in 2002,Turkey could not have been in much worse shape. The country was in the throes of one of its worst recessions, triggered by a political crisis which caused the devaluation of the lira and a wave of banking and corporate bankruptcies.

Despite scepticism about his alliances and credentials, Erdogan has not only doggedly stuck to the conditions embedded in the $10bn loan agreement with the IMF but also assiduously followed the EU blueprint for accession. He continues to remain on track despite the stalled EU talks.

The government is currently drafting detailed legislative plans to continue aligning the country’s laws with EU standards. Edward Parker, a senior director of Fitch Ratings says,“Although there were concerns about the Islamic roots of the ATP, the government has implemented sound economic reforms.

The country has been enjoying its best and most sustained growth since the 1960s. Foreign direct investment is expected to rise to $18bn, which equals the FDI amount for the past ten years put together.”

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Regional Review EUROPE: MICEX RIDES A RISING TIDE OF BUSINESS

MICEX COMES OF AGE Diagram demonstrating the growth of Gazprom shares during trading at Russia’s Stock Exchange in Moscow, Friday, Jan. 13, 2006. Russia's main stock exchange reported heavy trading volumes in shares of OAO Gazprom, the largest gas producer in the world, on the first day that the state company was directly listed on its main, dollar-denominated index..

Photograph by Sergey Ponomarev, supplied by Associated Press/EMPICs, February 2007.

AST YEAR MARKED watershed for MICEX. By total turnover of trading, the MICEX is the largest exchange in Russia, the CIS, Central and Eastern Europe, though the growth of the volume of exchangebased transactions, primarily in corporate securities, now means that MICEX ranks among the world’s top 20 exchanges by volume. According to the MICEX’s president Alexander Potemkin, record-high levels of exchange-based turnover are a direct result of new exchange products and services and the growing attractiveness of the stock market as a means for investors to leverage the Russian growth story. “Our main achievement over the last 15 years,” says Potemkin, “is building an efficient infrastructure supporting the national capital market, based on advanced exchange and information technologies.”

That infrastructure is now extensive.

The MICEX Group comprises the MICEX stock exchange, the National Mercantile Exchange, MICEX Settlement House, the National Depositary Center, the National Clearing Center, and a host of regional exchanges. The Group has several key markets: foreign exchange, equities, corporate and regional bonds, government securities, the money market and derivatives. In 2006, the

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It has been a banner twelvemonth for the Moscow Interbank Currency Exchange (MICEX) and 2007 promises more of the same.

According to Alexei Rybnikov, the MICEX Stock Exchange’s chief executive officer (CEO), “last year was marked by an explosive growth of liquidity of the exchange-based market for corporate securities.” total volume of trading in all markets of the MICEX Group amounted to R52.04trn (just over $1.9trn), doubling volume year on year and equal in value to about twice Russia’s annual GDP. The Group has ridden an upward market, and the MICEX Index has grown by 68% over the year. Potemkin explains that MICEX has spent time improving the exchange’s system of index management and increased the number of securities in the index by adding common shares in Gazprom, Mobile Telesystems, Uralsvyazinform, RBK Information System, Rosneft, Polus Gold and preference shares in Transneft, thereby increasing its appeal.

Since the beginning of 2006, the number of securities traded on MICEX has increased 44%, while the number of issuers admitted to the main board has grown by 40%.

The MICEX Index, which is the price-weighted index of Russia’s most liquid stocks, has been calculated since 22 September 1997. Right now the index comprises 21 securities and is calculate in real time A number of significant

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developments underpinned MICEX’s explosive growth over the last few years. Among these are the tripling of the exchange’s corporate securities market, in large part supported by a raft of new market issuers. Corporate bonds now account for 8% of the Group’s revenue. Last year 225 companies offered their securities on MICEX, with a combined issuance value of just over $17bn, almost the volume of the previous year, and the exchange also reports a significant uptick in secondary market trading of corporate bonds (a market now worth just under $68bn). Interest in shares of mutual funds is also growing. The volume of exchange-based trading of the funds tripled last year and amounted to around $186m. Growth in the trading of mutual funds was provided an important fillip with the launch of specialists on the exchange, with three trading institutions granted specialist status. Additionally the first mortgage securities were launched on the exchange last year.

But perhaps the most important event that took place on the stock

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Regional Review EUROPE: MICEX RIDES A RISING TIDE OF BUSINESS

segment for all resulted in increased business volumes market in 2006 was the liberalisation dollar/rouble of the market for Gazprom shares.“We instruments and in the Euro/Rouble across the range of Group services. The managed to partially reverse the segment for swaps. The effectiveness value of securities in depositors’ depot outflow of liquidity generated by of the move is apparent: the volume of accounts with the National Depository trading in Russian assets” says Euro-Rouble swaps business grew by Centre, Group’s clearing and Potemkin. The share of trading in a factor of 20. At the same time, the settlement arm, grew 86% to around shares on the MICEX in the total exchange also launched interest R3.3trn, with shares accounting for (global) volume of trading in Russian bearing futures on the exchange’s around one third of that amount. In shares, including GDRs and ADRs, derivatives market. MICEX also takes August last year, the National Clearing grew from 59% to 71% between credit for the development of collective Center was founded by the MICEX January and November 2006, he adds. investments and the doubling of and the NDC and received a central The top five most actively traded individual investors on the exchange bank licence to perform banking stocks on the exchange include as the exchange introduced online operations. The move was significant Gazprom (accounting for 32%), RAO trading. Individual investors now for the further development and UES (25%), LUKoil (14.6%), Norilsk account for around 30% of trading on diversification of the MICEX Group, the exchange. Additionally, it launched maintains Potemkin. The National Nickel (6.3%) and Sberbank (6.1%).

The MICEX Stock Exchange has government savings bonds, while Clearing Center now provides clearing played an important role in domestic organising Bank of Russia’s lending in exchange-based and OTC markets.

“An important area of our work was (through collateral initial public offerings (IPOs). In the operations corporate bonds market, the exchange crediting). Russian banks can now use the promotion of cooperation with has long been a democratic leader by the MICEX System of Electronic foreign exchanges and financial the number and the total volume of Trading to effect deposit transactions institutions,” confirms Potemkin, who placed securities. In 2006, the with the Bank of Russia to place funds stresses that the exchange “takes an exchange has also tried to attract more on the Bank of Russia’s deposit on active part in the work of the Association of IPOs in the share market. Last year, “demand” terms as well as credit International seven companies used MICEX to transactions (collateral crediting). Exchanges of the CIS countries, launch their IPOs, including Rosneft, Besides, the MICEX has introduced which coordinates the development Severstal, OGK-5 and others, which the second (evening) trading session, of orderly capital markets in the countries”. raised about R350bn (around $13bn). in the course of which participants can Commonwealth “In the early days, we regarded effect deposit and credit transactions Cooperation memoranda were signed exchanges such as the London Stock with the Bank of Russia on fixed terms. with both the London Stock The Group has also done extensive Exchange (LSE) and Deutsche Börse, Exchange as competition. Then we understood that global depositary work in upgrading the capital markets which “confirms MICEX’s status as receipts gave us more advantages than servicing infrastructure, which has Russia’s leading exchange,” notes Potemkin, who is keen to losses,”says Potemkin.

MICEX leverages Russia’s Economic Boom note also that the exchange The exchange’s foreign 3-Year Price-Performance (USD) has moved far to exchange related business 400 international standards of also grew, with trading 350 listing and disclosure of volumes almost reaching 300 information on securities $1bn in value. The 250 and issuers.

“The exchange has also 200 implementation of these encouraged liquidity in 150 agreements will help to the exchange based 100 improve the reliability of currency market. To cut the exchange system of risk participants’ costs, while 50 management and the maintaining the reliability transparency of the Russian of exchange-based stock market for trading in foreign *based on backcast data. international investors,” currency, MICEX lowered Source: FTSE Group and Datastream, data as at 31 January 2007. he says. its commission in the

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COVER STORY: BGI

Lee T Kranefuss, the architect of BGI’s ETF strategy and chief executive officer of the company’s Intermediary Products and Index & Markets Group, ETFs continue to be a growth market “and we expect to continue to be the leader in it,” he says. Photograph kindly supplied by Barclays Global Investors, February 2007.

BGI:

THE DOMINATOR FACTOR

Exchange-traded funds (ETFs) are hot. In the US alone, ETFs top $450bn in assets, a figure that could reach $2trn in 2010. San Francisco-based Barclays Global Investors (BGI), a majority-owned subsidiary of Barclays Bank PLC, holds a 60%-plus market share in America and aims to dominate the world market for ETFs for time to come. Its first-place rank appears secure for the time being.

However, the profusion and complexity of ETF offerings is multiplying almost exponentially and competition for market share is increasing. Keeping up with BGI though might be hard. Working in concert with other elements of the Barclays Group, BGI is now marketing exchange-traded notes (ETNs), which BGI says is the next evolution of exchange-traded products. Art Detman reports from San Francisco on how and why BGI’s dominance will be hard to break.

ORE THAN 130 exchange-traded funds were launched in 2006, to push the year-end total over 335, comprising $418bn in assets, up 39% from 2005. Some 225 more ETFs are expected this year, making them the fastest-growing asset class in the American financial market. The rush to market these days is so fast that during a single week in January some 22 funds were filed with the US Securities and Exchange Commission (SEC) by one investment advisor alone.

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ETFs are open-ended mutual funds or unit trusts that trade like individual stocks, and are multiplying like rabbits. While early ETFs tracked traditional stock market indices, the sector has now broadened to include fixed income, commodities and narrowly focused sector stock portfolios. ETFs can be sold short making them a valuable tool for hedge funds and investors using active managers can use ETFs with core-satellite investment strategies.

Investors can purchase ETFs to generate a market return

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relatively cheaply in US large caps for example, and look to active managers who they believe will outperform their benchmark in other markets.

ETFs are also the fastest growing segment of BGI, the largest money manager in the US, with $1.7trn total assets under management. Of this, $300bn is in some 190 ETFs, called iShares, a net cash increase of $60bn from a year earlier. Out of the US mutual fund families, only Capital Group’s American Funds pulled in more net new money than BGI’s US iShares. “It’s a growth market,” acknowledges Lee T Kranefuss, architect of BGI’s ETF strategy and chief executive officer (CEO) of its Intermediary Products and Index & Markets Group, “and we expect to continue to be the leader in it.”

Although markets in Europe, Latin America and Asia are far less developed in terms of ETFs, Kranefuss is optimistic about their potential.“The US had its first ETF in 1993,”he says. “If you plotted growth of the US ETF market from 1993 to today, and then started at zero in Europe in 2000, you would find that Europe’s Year One and Year Two were faster growing than Year One and Year Two in the US. That is because there is a much higher level of comfort and knowledge about ETFs today than back in 1993.”

At the end of 2006 BGI took a big step in Europe with the acquisition of Munich-based INDEXCHANGE Investment AG, the ETF advisor/provider owned by Bayerische Hypound Vereinsbank AG (HVB), Germany’s second-largest bank for €240m. [HVB was taken over by Italian banking giant UniCredit in 2005.] “The combined business will create a powerful force to accelerate the development of ETFs in Europe,”said Barclay’s president Bob Diamond in a statement at the time of the transaction. BGI’s purchase was a strong statement of intent, widely interpreted as the first in a series of possible acquisitions across Europe and Asia to drive innovation and accelerate the uptake of ETFs. INDEXCHANGE’s €15.2bn of assets under management was rolled into iShares. With the stroke of a pen, BGI doubled its European market share to nearly 47%, well ahead of the 24% of Société Générale’s Lyxor, BGI’s closest European competitor. iShares already had a presence in the UK, France, Italy, Switzerland, the Netherlands and Germany and BGI sees expansion opportunities in France and Italy in particular.

In Asia, where ETFs are still relatively new, iShares has an operation in Hong Kong. Even so, the actual numbers were small—about $44bn (about €30bn) for the newly enlarged BGI iShares Europe versus $22.4bn for Lyxor—but inflows have since risen rapidly. “The ETF market is the fastest growing market within all asset management classes in Europe,” says Chris Sutton, CEO of iShares Europe. “We think there is more growth in the future than in the past – and in the last years, iShares Europe has had growth of 80% yearly,” adding,“The acquisition of INDEXCHANGE supports a key element of our strategy which is to be in each local market and serve their specific needs.”“The story is pretty much the same around the globe,”Kranefuss says.

“Asia and Latin America are just a little behind Europe but

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are growing quickly. Two years ago we listed iShares on the Mexican exchange. Since then we’ve had very good success in Mexico. Same thing in Asia. They [see] ETFs as a core investment.”

The story of BGI’s dominance of the ETFs market is a classic. It is the one where the prime mover did not leverage its innovation, and much later a rival firm came along that understood its potential and capitalised on it in a wider marketplace. The first ETF, the Standard & Poor’s Depositary Receipt, known as SPDR, was in fact created in 1993 by State Street Global Advisors (SSgA) together with the American Stock Exchange (Amex). At the time, Amex was seeking a new security to boost volume and even today lists more ETFs than any other exchange. The SPDR was followed by an S&P mid-cap index and a fund indexed to the Dow Jones 30 Industrials. However, it wasn’t until the NASDAQ 100 tracking stock—the famous QQQQ—was introduced that ETFs became a big hit. “It was the right product for the moment,” says J Parsons, head of BGI’s intermediary sales. “It was a highly volatile, tech-heavy basket of stocks, exactly what was in favour.”

In March 1996 BGI introduced a family of ETFs for institutional investors, though they remained obscure and grew slowly. In 1997 Kranefuss — an electrical engineer with an MBA in finance — joined BGI after six years with The Boston Consulting Group. “The first year and a half I spent doing a corporate strategy study across all the company’s lines of business, looking for opportunities and trying to figure out where we should focus our efforts. One of the holes we saw was in BGI’s offerings for non-pension institutions and individual investors.”

The US ETF market was then worth around $20bn in total assets—most of which were in the SPDR and QQQQ. By then, BGI had 17 ETFs, all country funds and all complicated to manage. In 2000, Kranefuss simplified and re-branded these World Equity Benchmark Shares (WEBS) as iShares, expanded the concept across a much larger universe of indices and offered them not only to institutions but also, as exchanged listed securities, to individual investors. The rest, as they say, is history. The “i” Global ETF Market – Split by Geographical Region

Over the last quarter, the global ETF market has increased by 12.9%. EMEA saw the largest regional increase of 14.3%, while North/South America increased by 13.1%.

However, the Asia Pacific region has increased by 8.2%.

Source: FTSE Group and Datastream, data as at 31 January 2007.

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in iShares doesn’t stand for anything in particular.

Kranefuss says it could represent any of several words: innovative, index, integrated, intelligent. Whatever, iShares is a better brand name than WEBS. “With iShares, institutional quality index funds were made available to the average retail investor,” says Amy Schioldager, head of US indexing at BGI.“That was the biggest change, the quality of product available to the retail investor.”

In May 2000, Kranefuss rebranded 17 WEBS as iShares funds—they accounted for less than $2bn in assets and no more than 3% of the ETF market—and in the year’s second half introduced 37 more iShares ETFs. Meanwhile, Parsons had sales people visiting registered representatives at broker-dealers and financial advisors of all kinds. They worked on salary, not commission, and their role was largely educational. “By offering a broad set of products,” says Parsons,“we actually made this an acceptable universe of investments. People could say,‘I have an asset allocation style that I want to execute,’ and we could offer them a complete suite of funds to invest in that style. Never before was that true.You could not cover the universe.”

The largest of the ETFs is the iShares MSCI EAFE Index Fund, with $39bn in assets and as 2006 ended, BGI’s smallest was the iShares Dow Jones US Insurance Index Fund with $19m in assets. Expense ratios range from 0.09% for the iShares S&P 500 Index Fund to 0.74% for its emerging market funds: including Taiwan, South Korea, South Africa, Brazil and China. Kranefuss and Parsons concede that in 2000 there were few believers in ETFs outside of BGI.“Industry analysts were saying that this is a niche market that will never grow,” says Parsons, “Today, most analysts say that ETFs will be the fastest growing financial services product for the next five to ten years. And that the total market will be $1trn to $2trn. Those are pretty nice numbers.”

At day’s end, the credit must go to Kranefuss, the first to recognise that ETFs can replicate more than just a handful of broad market indices and therefore be used for more than just beta ballast in a portfolio. Granted, even today the SPDR remains the largest ETF, comprising $64bn of ETF assets under management and accounting for nearly 15% of the entire ETF market. Additionally, most of the other top ten ETFs are broad-based funds widely used as the beta portion of accounts whose managers seek aboveaverage returns in the alpha portion by investing in other types of securities. The Tarbox Group, an investment advisor based in the monied environs of Newport Beach, California explains that, “ETFs are the core of our client portfolios,” says vice president Mark Wilson. “We use the standard indices to build about 40% or 50% of each client’s portfolio. Then we use other types of investment vehicles around that.”Tarbox favours Three iShares funds: the EAFE Index Fund, S&P Mid-Cap 400 Index Fund, and the Russell 2000 Index Fund. However, Wilson uses other index funds as well, such as the Charles Schwab institutional S&P 500 index.“It is actually a little cheaper,”he explains.“We do not have to pay a transaction fee to buy it. When we started

Chris Sutton, CEO of iShares Europe, says,“We think there is more growth in the future than in the past – and in the last years, iShares Europe has had growth of 80% yearly.” He adds,“The acquisition of INDEXCHANGE supports a key element of our strategy which is to be in each local market and serve their specific needs.” Photograph kindly supplied by BGI, February 2007.

At day’s end, the credit must go to Kranefuss, the first to recognise that ETFs can replicate more than just a handful of broad market indices and therefore be used for more than just beta ballast in a portfolio. using [ETFs], our clients did not know an ETF from a hole in the ground. But the ETF indices have been very difficult to beat during the past five years. … I am sure our clients are happy that they have them in their portfolios.”

For all that, the fastest growth for ETFs is among more specialised funds, many of which are becoming increasingly used as substitutes for single stock positions. A partisan for this approach is Michael Jones, managing director and chief investment officer of Wachovia Securities of Richmond, Virginia, which extensively uses ETFs in managing $5bn of separate accounts.“A lot of people view ETFs as simply index management. That is not what we

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believe at all. It is not about passive management. It is them, “the majority of ETFs that we use are iShares about active investment management with lower risk than [though] we use a little bit of WisdomTree and traditional investment tools would make possible. With PowerShares, too,”notes Arthur who explains that iShares ETFs, you can implement an asset-allocation strategy and funds are based on indices weighted by market make continual adjustments in that strategy — increasing capitalisation, while WisdomTree funds are based on cash or decreasing small caps, shifting from value to growth or dividends and PowerShares funds reflect fundamentals vice versa, whatever appears necessary to optimize return,” and technical analysis.

It is here in fact that BGI really stakes its claim, providing says Jones, “You can set up sector strategies, sub-sector products based on meaningful and established indices. strategies, even sub-sub-sector strategies.”

It is a flexibility that XACT Fonder and Lyxor have Early in the year BGI introduced eight iShares fixedleveraged, as have others through the launch of a raft of income ETFs, all based on Lehman Brothers indices. Unlike FTSE RAFI ETFs in February. Their move clearly shows that some other advisors, it has resisted the temptation of ETFs are indeed moving away from pure passive creating trendy indices simply for the sake of additional revenue. Instead, it has focused on recognised indices management to more active strategies.

Then, too, there is the advantage of minimising wrong created by third parties and the firm believes that its links with index providers, such individual stock selection. “If as FTSE Group, will be an you had wanted to be in area of significant growth in integrated petroleum Both Kranefuss and Parsons the future. The diversity of companies for the past concede that back in 2000 there were ETFs in this space is couple years, you could have few believers in ETFs outside of BGI exemplified by the iShares bought Exxon Mobil or FTSE/Macquarie Global British Petroleum,” Jones (and maybe not many even inside Infrastructure 100 ETF and says. “But if you bought BP, BGI). “Industry analysts were saying the iShares FTSE you would have missed the that this is a niche market that will EPRA/NAREIT Asia boat. You would have had the never grow,” says Parsons. “Today, Property Yield Fund ETF right concept, but because of most analysts say that ETFs will be the (FTSE Group now has a the specific security with diverse range of ETFs, which you implemented the fastest growing asset class for the next including the Claymore strategy, you wouldn’t have five to ten years. And that the total FTSE RAFI Canadian Index performed. With an ETF, you market will be $1trn to $2trn. Those Fund and the Powershares do not have to make that are pretty nice numbers,” he adds.

RAFI ETF Series). Then, too, one-stock decision. You can competition is growing buy a fund that has from other quality advisors, everybody in integrated oil, and if that strategy is correct, your portfolio wins and your such as Vanguard. Money managers pay more attention to how well an ETF tracks its benchmark than to its brand investor wins.”

Wachovia also uses ETFs to reduce turnover in actively name, so just by the draw of the straw BGI will eventually managed portfolios of individual stocks. If an asset lose market share, even as BGI’s ETF’s asset increase.

For both BGI and investors this is a good thing, not least allocation model calls for 20% of a portfolio to be in small caps, 15% will be in individual stocks and 5% in ETFs.“If because the firm will not rest on its laurels. The next we want to underweight small caps,” explains Jones, “we generation of exchange-traded products has already come don’t tell the asset manager to sell three shares of each of to market. In fact, there is a proliferation of “iProducts”. The his stocks. Instead, we liquidate the ETF and, boom; we are latest being exchange-traded notes (ETNs), issued under 5% underweight in small caps.” Jones points to hedge the iPath brand. iPath ETNs are 30-year unsecured, funds to clinch his argument. “Hedge funds are the subordinated senior debt securities listed on the New York pioneers in the ETF market. We are right on their heels. Stock Exchange and issued by Barclays Bank PLC that The rest of the industry is going to follow along because essentially promise to pay investors the return of a ETFs create the ability to do things for a client that simply commodity index, minus annual fees of 0.75%. However, was not possible before this technology became available.” no principal protection exists. ETNs are similar to ETFs, but San Francisco based advisory firm Main Management, they differ in structure. “iPath ETNs are complimentary to with $200m under management, has taken Jones’s views iShares,” explains Philippe El-Asmar, head of investor to their logical conclusion. “We use only ETFs here,” says solutions, Americas, at Barclays Capital, which is the president Kim Arthur. “We did not want to use mutual issuer’s agent. “iPath ETNs are innovative investment funds because of the higher imbedded fees, lack of products that were introduced in June 2006 to provide transparency, and lack of tax efficiency, so our whole access to difficult-to-reach markets with the trading business model has been built on 100% ETFs.”Typically, flexibility of an equity.” BGI assists in the promotion of its portfolios have anywhere from ten to fifteen ETFs in iPath ETNs to intermediaries.

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COVER STORY: BGI

Four ETNs are currently available: two representing commodities indices (Goldman Sachs Commodities Index (GSCI) and the Dow Jones-AIG Commodity Index), the third covering oil and the most recent represents the MSCI India Index. [Please refer to the Chart: Comparing ETFs with ETNs.] ETNs like ETFs are designed to provide low-cost exposure to commodities and other investments, usually by tracking an index, and since they both trade like stocks, provide a chance to hedge against a market downturn.

However, there are several key differences and the biggest are the treatment of tax and credit risk.

Observers say ETNs could end up being more tax efficient than commodity ETFs, which continually “roll” futures, meaning they move into longer-dated contracts to maintain exposure rather than taking physical possession of the commodities. Any capital gains are passed along to investors and are taxed as 60% long-term gains and 40% short-term gains. Conversely, Barclays says ETNs should be taxed as prepaid contracts tracking an index. Therefore, investors should only pay taxes if they recognise a gain when they sell the ETN or when the note comes due, if they chose to hold it that long. Even so, the tax advantage remains theoretical at this point. Barclays acknowledges the US Internal Revenue Service (IRS) has not made a definitive ruling on the tax treatment of ETNs, so there is some uncertainty, particularly for investors in markets outside the US, who are subject to domestic tax rulings.

Although Barclays has only four ETNs right now, their structure means they can be applied to any tradable index, opening the door to many more in the future. Opportunity lies close to home as asset classes such as timber; foreign currency bonds, foreign commercial real estate and equity volatility in the US still lack an index security. BGI however, is looking to cast the net even farther afield, seeing opportunity wherever investors want particular market exposure. As El-Asmar says, “The ETF mutual fund structure can be difficult in some asset classes, so we have created [these alternative] structures to help our clients gain exposure to specific markets or securities. The China iShare, for instance, gives investors real exposure to the market. But what of places such as India, Russia and specific commodities? That is where the ETN concept offers

Philippe El-Asmar, head of investor solutions, Americas, at Barclays Capital explains that: “iPath ETNs are complimentary to iShares. iPath ETNs were introduced in June 2006 to provide access to difficult-to-reach markets with the trading flexibility of an equity.”

Photograph kindly supplied by Barclays Capital, February 2007.

real value to clients looking for low cost, tax efficiency and trading flexibility.”

The concept of increasing liquidity by accessing an entire class of assets as if it were an individual stock is in its infancy, but will continue to grow fast and while that trend continues, BGI will try to expand its product offerings and set a benchmark of a kind for rival firms to beat. What is significant is BGI’s willingness to leverage expertise elsewhere in the Barclays Group to develop and bring product to market. It is an ability that might continue to give it an edge, compared to other large asset management firms attached to wholesale and investment banks that perhaps have been unwilling to blur the edges of marketing and product innovation among different parts of the same institution.

COMPARING ETNS AND ETFS Features Issuer Liquidity Registration Recourse Principal Risk Institutional Size Redemption Short Sales Tracking Error Expense Ratio

ETN* Barclay’s Bank Daily, On Exchange Securities Act of 1933 Issuer Credit Market and Issuer Risk Weekly, To the Issuer Yes, On an Uptick or Downtick No 75 bps

ETF Barclay’s Global Investor Daily, On Exchange Investment Company Act of 1940 Portfolio of Securities Market Risk Daily Via Custodian Yes, On an Uptick or Downtick Yes 75 bps Source: BGI iShares, February 2007 * Please note that this table compares the GSCI ETN & ETF.

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FTSE GWA Indices (Total Return) Index Name

Consts

Value

3 M (%)

2036 1339 1552 513 694

4147.14 4493.60 4132.68 4253.14 3932.19

6.1 6.8 6.3 5.4 2.7

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 (%)

14.5 15.1 15.6 15.5 8.6

19.5 22.6 21.5 20.4 13.5

YTD (%)

Actual Div Yld (%)

1.0 0.6 1.0 1.9 -0.5

2.19 2.43 2.32 2.79 3.00

FTSE RAFI Index Series FTSE RAFI Index Series – 5-Year Performance (Total Return Basis) 300

FTSE RAFI US 1000 Index (USD)

250

FTSE RAFI Global ex US 1000 Index (USD)

200

FTSE RAFI Kaigai 1000 Index (USD) FTSE RAFI Europe Index (EUR)

150

FTSE RAFI Eurozone Index (GBP) 100

-0 7 Ja n

6 Ju

l-0

-0 6

l-0 Ju

Ja n

5

5 -0

l-0 Ju

Ja n

4

4 -0 Ja n

Ju

l-0

3

3 -0 Ja n

2 l-0 Ju

Ja n

-0

2

50

FTSE RAFI Indices (Total Return) Index Name

FTSE RAFI US 1000 Index (USD) FTSE RAFI Global 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 (%)

977 997 1009 451 263

6201.42 6736.89 5944.86 6307.98 6431.49

5.8 7.5 6.6 6.1 6.7

6 M (%) 12 M (%)

14.8 15.5 16.1 16.2 18.0

18.5 22.6 22.8 21.5 23.3

YTD (%)

Actual Div Yld (%)

2.1 0.9 1.3 2.2 2.2

2.02 2.40 2.41 2.72 2.69

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

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

Kamila Lewandowski Research Analyst 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 • MARCH/APRIL 2007

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CALENDAR

Index Reviews March – June 2007 Date

Index Series

Review Type

Effective Data Cut-off (Close of business)

Early Mar Early Mar Early Mar 2-Mar 2-Mar 3-Mar 7-Mar 7-Mar 7-Mar 7-Mar 7-Mar 7-Mar 7-Mar 7-Mar

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

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

28-Feb 28-Feb 28-Feb 12 Mar 28-Feb 28-Feb 28 Feb 6-Mar 29-Dec 28-Feb 28-Feb 28-Feb 2-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 4-Jun 5-Jun 6-Jun 6-Jun

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 FTSE/JSE Africa Index Series FTSE EPRA/NAREIT Global Real Estate Index Series 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 S&P BRIC 40 S&P / ASX Indices DJ Global Titans 50 OMX S30 DAX FTSE UK FTSE All-World

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 30-Apr 31-May 1-Jun 31-May 29-Jun 8-Jun 2-Jul 15-Jun 22-Jun 15-Jun 15-Jun 15-Jun 15-Jun 30-Jun 15-Jun 15-Jun

2-Mar 28-Feb 28-Feb 12-Mar 20-Feb 1-Mar

6-Jun 6-Jun 6-Jun

FTSE techMARK 100 FTSEurofirst 300 FTSE eTX

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 - shares in issue Semi-annual review Quarterly review Annual review Quarterly review Annual review Semi-annual review Quarterly review Semi-annual review Quarterly review Semi-annual review - constituents Quarterly Review Annual review of index composition Semi-annual review Quarterly review Quarterly review Annual review - Emgng Eur, ME, Africa, Latin America Quarterly review Quarterly review Quarterly review

15-Jun 15-Jun 15-Jun 15-Jun

28-Feb 30-Mar 30-Apr 30-Mar 30-Mar 30-Apr 31-May 31-May 31-May 31-May 31-May 31-May 31-May 30-Apr 31-May 31-May 5-Jun 30-Mar 31-May 31-May 31-May

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

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THE FTSE GLOBAL EQUITY INDEX SERIES. AHEAD OF THE CROWD. FTSE adds emerging markets to the global universe with the inception of the FTSE All-World FTSE introduces free float adjusted indexes

2000

2001

The FTSE Multinational Index Series is launched

FTSE extends the global universe to 98% with the launch of the FTSE Global Equity Index Series

The FTSE4Good Index Series is launched

FTSE introduces Non-market Cap Weighted Indexes

2002

2003

2004

2005

FTSE was the first index provider to pioneer the move to a seamless global index series covering Large, Mid and Small Cap stocks in 2003. The FTSE Global Equity Index Series offers unparalleled coverage of the global investable opportunity set.

FTSE has continued to stride ahead with new innovations. We make it easier to manage the entirety of an asset owner’s investments, no matter what the mandate. Whether it is fixed income, alternative asset classes, socially responsible investment or new perspectives on equity investing, FTSE measures up with the index solution.

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 International Limited (“FTSE”) 2007. FTSE is a trademark of the London Stock Exchange Plc and the Financial Times Limited and is used under license by FTSE International Limited. All rights in and to the FTSE Global Equity Index Series are vested in FTSE.

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TODAY ’S

PRICE

FOR

US CUSTODY

Continued pressure for fund managers to sustain a level of independence and transparency with regard to securities pricing and valuation provides h challenges and opportunities for wellequipped custodians in equal measure. Meanwhile, mega mergers continued to thin the ranks of the leading providers, fueling speculation as to who will be the next to join forces in order to achieve scale and global dominance. From Boston, Dave Simons reports.

GLOBAL MARKET SHARE

Photograph supplied by Dreamstime.com, February 2007.

YEAR AGO, the nation’s leading custody players were enjoying a significant boost in asset-management based revenue. It was the result of a powerful comeback in equities and the rise of alternative-investment and pension-plan servicing. The joy would continue throughout 2006, as a combination of stock-market gains and a rising stream of outsourced business from investment managers helped make the decidedly un-sexy but seriously solvent business of custody more buoyant than ever.

The roll call of Q4 earnings statements, issued in late January, spoke volumes: JPMorgan saw investment-banking

A

FTSE GLOBAL MARKETS • MARCH/APRIL 2007

revenue jump 48% to $4.72bn; Northern Trust reported $170.8m in overall net income, up from $147.6m a year earlier; while State Street Corp., whose assets under custody grew 17% during the final quarter, reported earnings per share (EPS) growth of 86 cents, a 16% rise from the year-ago period. Also surging was Bank of New York, which reported net income of $1.79bn for the quarter, powered by higher feebased revenue and asset-management income.

The most compelling story perhaps was the unprecedented level of merger activity that shuffled the custodial deck numerous times within the space of a few

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US CUSTODY Rajen Shah, global custody product executive for JPMorgan Worldwide Securities Services thinks that expansion is not the end-all.“We are very selective about our methods of expansion, because while there are longterm benefits, in the short run it can impact client services. If you consider the market’s move towards the alternative space and a greater emphasis on the outsourcing space, there are many areas that we as providers need to address. If not planned carefully, consolidating can act as a deterrent.”

Photograph kindly supplied by JP Morgan, February 2007.

months. In early December, Bank of New York (BNY) rocked the custody world by agreeing to purchase Mellon Financial Corp. for roughly $16.5bn, giving the combined company (to be called Bank of New York Mellon Corp) some $16.6trn in assets under custody. “The deal is so compelling that it is likely to pressure some of the company’s competitors to think about acquisitions,” wrote analyst Richard Bove of Punk Ziegel shortly after the deal was announced. Sure enough, in early February State Street Corp. countered with its own agreement, the purchase of Boston-based Investors Financial Services Corp (the holding company for Investors Bank & Trust) for $4.5bn, the largest expenditure by the company since it forked over $1.5bn for Deutsche Bank AG’s recordkeeping and securities-lending business five years earlier.

When all is said and done, JPMorgan, which spent most of 2006 as the world’s leading custodian with $13.9trin in custodial assets, will be deposed to third place, behind BNYMellon and State Street’s $14.1trn respectively. With the quest for scale continuing to drive the industry, analysts say that more mega deals are on the way.

Echoing the sentiments of the general market, Patrick Curtin, executive vice president of Investor Services at the Bank of New York, calls the BNY-Mellon alliance a “marriage made in heaven,” one that creates a “powerhouse franchise

50

with both product and relationship capabilities across all kinds of financial intermediaries and institutions, from pension schemes to mutual funds, offshore funds, hedge funds, insurance companies, central banks, and so on.”

Mellon’s leadership role in the pension-fund space is very important, says Curtin, particularly as pension-plan sponsors continue to separate their beta or market-driven strategies from their alpha strategies for the ability to add value either through the use of alternative or liability driven investments.

“Pension funds are looking for greater transparency, risk management and analysis, as well as insight into their investment managers who can accomplish these tasks for them on the alpha side. At the same time, those same managers who are generating the returns look to provide efficiency in areas such as clearance and settlement processes and asset servicing. Given all these factors, the role of the custodian has become more prominent than ever.”

Given the rapidly evolving state of custody, consolidation allows providers to grow in scale and at the same time become more efficient, says Rajen Shah, global custody product executive for JPMorgan Worldwide Securities Services.“The BNY-Mellon deal didn’t surprise us, and I think this kind of consolidation is something that will continue to happen within the industry,”says Shah.

In 2006, JPMorgan bolstered its position by striking an outsourcing deal with UK-based investment-funds group Threadneedle Investments. This followed the acquisition of the middle- and back-office operations of US-based investment-fund manager Paloma Partners Management Company.“The alternative space is clearly a continued area of growth,”says Shah,“our clients want to find better margins, and the regulations are helping them to invest in alternatives in a much bigger way. Obviously it’s where the market will continue to head indefinitely, and as such we are always looking to see how we can deliver solutions for our clients in the best way possible and with the best level of quality.”

And yet expansion is not the end-all, Shah adds.“We are very selective about our methods of expansion, because while there are long-term benefits, in the short run it can impact client services. If you consider the market’s move towards the alternative space and a greater emphasis on the outsourcing space, there are many areas that we as providers need to address. If not planned carefully, consolidating can act as a deterrent.”

Key acquisitions are also at the heart of State Street’s custody-based business model. Prior to the Investors Financial agreement, State Street paid $564m in cash for Currenex, the London-based online foreign exchange trading platform, in an effort to raise its profile in the burgeoning electronic foreign-exchange marketplace. “That was a great opportunity for us to not only pick up a synergistic competitor, but to obtain some real technology that we would have otherwise had to build out on our own,”remarks Joseph Antonellis, vice chairman, chief information officer and head of investor services in North America for State Street. “We are still seeing high growth across our entire business, both here in the US and around the world, and a

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Northern Trust Banks are members FDIC. ©2007 Northern Trust Corporation.

business decisions and their impact on

JOB-RELATED STRESS

Quality of Life

high

low You pick the right financial partner

You pick the wrong financial partner

You pick the right Tai Chi Master

The people you work with can either be a source of comfort, or frustration. Which is why so many choose to work with Northern Trust. We’re known for exceptional client service. We also have some of the most sophisticated technology in the business, and an array of innovative products. All delivered in a way that’s convenient for you.

Because it’s our job to provide solutions that decrease your anxiety. Not add to it. If you’d like to know how we can help you, call +44 (0) 20 7982 2000 or visit northerntrust.com.

Asset Management | Asset Servicing | Wealth Management

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US CUSTODY Patrick Curtin, executive vice president of Investor Services at the Bank of New York, calls the BNY-Mellon alliance a “marriage made in heaven,” one that creates a “powerhouse franchise with both product and relationship capabilities across all kinds of financial intermediaries and institutions, from pension schemes to mutual funds, offshore funds, hedge funds, insurance companies, central banks, and so on.” Photograph kindly supplied by Bank of New York, February 2007.

hallmark of our strategy is to continue to provide growth across the breadth of our services and to cross-sell into our client base.To that end we will innovate around new products as necessary according to client need, and we intend to be more aggressive on the acquisition side, as evidenced by the Currenex deal.”

Rob Mancuso, senior vice president of Boston-based Investors Bank & Trust, currently the believes the timing of the State Street acquisition is good for clients of both firms.

“The acquisition will give our clients access to a broader range of services. At the same time, State Street will strengthen its position in meeting the mutual fund, hedge fund and offshore fund servicing needs of its clients. In addition, Investors Bank & Trust and State Street already share a similar focus, service model and customer type which we believe will make for a seamless and swift consolidation.”

Chicago-based Northern Trust saw its stock rise following the BNY and State Street merger announcements as investors speculated on the prospects for additional acquisitions among the remaining players.“Not that we feel pressured to make that kind of move at this time,”counters Jeffrey Conover, senior vice president of corporate and institutional services and head of North American institutional asset servicing sales for Northern Trust.“We have a very positive growth trend, with good staff, technology and clients. Of course, we do need to continue to execute—if you stumble in this kind of environment, the consequences can be severe.”

Processing Power The alternative space remains one of the single-biggest drivers of custody services, requiring support systems that are

52

increasingly streamlined and straight-through. “The place where most of the custody providers are focusing their efforts and resources is in developing their capabilities in accounting and administration, and specifically within the area of alternative investments,”says Mancuso. For instance, because clients want to be able to work with vendors who have the technology to provide support around the clock, providers must be able to process some of their daily book of business in different geographic locations in order to be in a consistent time zone with the portfolio managers.

Additionally, clients demand strong expertise in supporting the growing volume of complex instruments such as OTC derivatives, remarks Brian Coughlin, Investors Bank & Trust’s managing director for US and European operations.

“Virtually all market participants agree that it is imperative to streamline the derivatives trading process and provide accurate, independent and timely pricing of these complex instruments, which are inherently difficult to value,”he adds.

While technology continues to play a key role in all custodial functions, technology in and of itself cannot create a sustainable competitive advantage for any one player, says BNY’s Curtin.“If not invested in sufficiently or executed upon properly, technology can create a disadvantage, in fact,” asserts Curtin. “That said, the product developments that have taken root over the course of the past year as well as over the near-term all have technology at their core. The ability to offer a pension fund a monthly universe comparison of its investment managers, or a read-out on their managers’ daily compliance with investment guidelines—all of these things have at their core a strong technological capability. But at the same time there also has to be a thorough understanding of potential business problems, how to solve them, and so forth. So while technology is prominently featured in everything we do, without the existence of this kind of know-how, the technology simply cannot have any kind of meaningful impact.”

Going Global At State Street, approximately 43% of total revenue is currently non-US based and rising, and as clients continue to avail themselves of global investment opportunities,“the increased complexity will in turn spur demand for more sophisticated solutions and integrated global platforms that custodians can offer,”says Antonellis.“Providing those kinds of skills and having them fully incorporated into accounting and custody makes for a very compelling argument—it has the potential to eliminate a lot of the decision making on the manager’s part. And we see that driving the business dramatically.”

Northern Trust’s recent alliance with China’s National Council for Social Security Fund, which enlisted both Northern Trust and Citigroup to serve as custodian for the $30bn fund’s overseas investments, is indicative of NTRS’s global evolution, says Conover. “What initially began as a consulting relationship has grown into this potentially major custody pact—and in China, of all places,” says Conover.

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Joseph Antonellis, vice chairman, chief information officer and head of investor services in North America for State Street says, “We are still seeing high growth across our entire business, both here in the US and around the world, and a hallmark of our strategy is to continue to provide growth across the breadth of our services and to cross-sell into our client base.” Photograph kindly supplied by State Street, February 2007.

Jeffrey Conover, senior vice president of Corporate & Institutional Services and head of North American institutional asset servicing sales for Northern Trust says,“We have a very positive growth trend, with good staff, technology and clients. Of course, we do need to continue to execute—if you stumble in this kind of environment, the consequences can be severe.” Photograph kindly supplied by Northern Trust, February 2007.

Additionally, in January Northern Trust was named custodian for the $8bn New Zealand Superannuation Fund, with a projected ten-fold growth rate over the next several decades.

“Particularly when you compare the relatively mature US and UK markets, the kind of opportunity that is emerging from other parts of the world is just staggering,”says Conover.

The rapid globalisation of custody has also resulted in an increasingly larger number of services becoming comingled, adds IBT’s Coughlin. “With derivatives, for instance, a lot of the associated cash flows and processing require insight into the accounting of the instruments for future cash flows, interest and expense, making it necessary to have the right processing efficiencies in place.”

reducing their costs through a carefully developed outsourcing programme,” claims Tucker. In the rapidly growing fund-of-fund (FoF) space, for instance, BBH has developed an integrated solution that fits the particular needs of this special group of clients. “In addition to providing expert advice on legal structures and distribution channels, the BBH FoF solution is a customised configuration of administration alternatives, asset allocation models, fund trade execution and settlement automation with transfer agents, comprehensive custody, and automated share class foreign exchange hedging for cross-border shareholders. Much of this is enabled in the background by our Infomediary connectivity programme, but it also capitalises on sophisticated ‘modules’ of BBH expertise. In this way we can help a client avoid building infrastructure at the outset and accelerate their time to market and the competitive edge of their product.”

As consolidation within the asset-servicing business continues to expand, “The way to create a sustainable competitive advantage will be to offer excellent client service, to really differentiate yourself around quality of product functionality, and, most of all, have a core group of people with a passion for excellence,” says Curtin. “It sounds so self-evident—but the fact of the matter is doing it is not nearly as easy as saying it. Even if it’s someone who is not necessarily paying you to service the assets—such as a third-party fund manager who’s been hired by a pension fund—treating them as if they are customers and creating an environment that fosters that kind of attitude, quarter after quarter and year after year, will keep you in a leadership role in the long run. And that’s how we intend to keep our standing in the business.”

Looking Ahead Fees continue to propel the custody business, and while the outlook remains positive, one cannot afford to rest on one’s laurels, maintains Antonellis.“There are players who can’t always offer the same level of sophistication or the same capabilities, and therefore try to compete on fees alone, but that eventually catches up with them. You need to be able to do things on your own to improve margins, such as increased productivity and internal automation. But of equal importance is providing greater value to the client through new products and services.”

Nor can one underestimate the significance of establishing client relationships with a focus on individualised business strategies, contends Andrew Tucker, partner and head of investor services Europe for Brown Brothers Harriman (BBH). “We strive to help our clients maintain the differentiated services that contribute to their competitive advantage, while simultaneously

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BANK OF NEW YORK/MELLON MERGER

On December 4th, 2006 Bank of New York Corp. (BNY) and Mellon Financial Corp. said they will merge, creating the world’s largest securities servicing and asset management firm. The deal is expected to be complete in the third quarter of 2007. The new company will be called Bank of New York Mellon Corp., and be the world’s leading asset service provider, with $16.6trn in assets under custody and $8 trn in assets under trusteeship. It will also rank among the top 10 global asset managers with more than $1.1trn in assets under management. So, what can we expect now from this powerhouse? Bill Stoneman reports.

The Bank of New York President, Gerald L. Hassellin, left, and Mellon Chairman, President and CEO Robert P. Kelly, right, speak at a news conference in Pittsburgh, Monday, December 4th 2006. Bank of New York Corporation. has agreed to take over Pittsburgh-based Mellon Financial Corp. in a $16.5bn all-stock deal that will create the world's largest securities servicing company and one of the biggest asset managers. Photograph by Andrew Rush, supplied by Associated Press/EMPICs, February 2007.

BNY MELLON MERGER RAISES THE BAR S INVESTMENT MANAGER of a $3bn cash fund fof Idaho state treasurer’s office in the United States, Lisa Carberry cannot possibly rank as one of Bank of New York’s important custody customers. Her BNY account representative called, however, just after the New York company announced in December its plan to merge with Mellon Financial Corp. to allay any concerns that she might have.“I was assured that the merger will not impact us in any way,” Carberry says. It may take a year or two or even longer to know whether that’s true or not. But in calling as small a client as the Idaho treasurer’s office as quickly as it did, BNY signaled a key strategy in combining its business with Mellon’s—its continued customer focus and determination to hang onto existing customers.

Indeed, executives with both companies said when the transaction was announced that “lose no customers”would be their rallying cry over the months ahead.

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Customer retention has proven in myriad financial services conglomerations to be the crucial determinant of success or failure. Thus, observers say, retaining business, and of course winning new business, will depend on how well the new Bank of New York Mellon Corp., as the successor company will be named, articulates how the transaction benefits customers and then how well it executes on its promises. Most of all, the message that BNY and Mellon executives are delivering is that combining the companies will create even greater ability to invest in service delivery than either company had alone.

“It means a committed parent that’s going to continue to invest in the technology, the people and the incentives and rewards that we need to make this a successful business,” says Timothy F. Keaney, a designated co-chief executive officer of the asset servicing business and executive vice president and head of asset servicing for

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BNY until the deal is completed. That thinking and the idea that size alone should make Bank of New York Mellon a tougher competitor than either predecessor was individually. Added to that, the mergers has drawn consistent support among financial services analysts and investors. “Both companies are in extremely scalable businesses—asset management and asset servicing— which means that in this case, bigger really is better,” writes Thomas K. Brown, who runs Second Curve Capital, a hedge fund concentrating in financial services stocks in New York, in a blog about financial services investing. To others, however, especially people who focus on the custody and asset servicing businesses, it is not quite that simple.

Even so, there are some detracting opinions at large.“Yes, there are some advantages to scale,” says James Economides, a principal with Amaces, a London-based consulting firm that assists investment managers in the selection of custody banks. “I’m not at all convinced that they are that significant to warrant the breakage that is potentially going to be involved in mashing together two fairly sizeable organizations.”

The head of a business that surveys asset managers Robert P Kelly succeeded Martin G McGuinn early last year as about their satisfaction with custody banks goes a step chairman, chief executive officer (CEO) and president at Mellon Corp., further.“One has to question whether this is for the benefit nearly two years before McGuinn had been expected to retire. Kelly came of shareholders or the benefit of clients,” says Richard to Mellon from Wachovia Corp., where he had been chief financial officer Hogsflesh, managing director of R&M Surveys Ltd. in and a key player in a long series of mergers and acquisitions.

Surrey, England. Actually, the two are not mutually Photograph kindly supplied by Mellon Corp., February 2006. exclusive. According to BNY’s Keaney, “We have an opportunity to create a world class asset servicing company from State Street with close to $300bn in custody assets. by bringing clients the best in class offering from two However, it should be noted that the State Street/Deutsche Bank deal was different in substance to the BNY/Mellon industry leaders. That is what this means to clients.”

Even so, the 2003 acquisition by State Street Corp. of merger. Prior to the sale of its custody business, Deutsche had Deutsche Bank AG’s $1.9trn-asset global custody portfolio, strongly signalled its intent to exit the business and some of which briefly gave State Street the largest custody business its clients had already moved to other firms. “Our deal is worldwide, provides a cautionary note. Growth in State between two fully committed firms with clients that remain Street’s global assets under custody has badly lagged most of pleased with both firms,”says a BNY spokesman.

Though producing just 28% of revenue and 24% of preits biggest competitors over the past five years, including BNY, Mellon and JPMorgan Chase, according to research by tax earnings when the two companies’ balance sheets and GlobalCustody.net, a London firm that follows the asset income statements are combined, custody and other asset custody business. While Bank of New York enjoyed 77% servicing – virtually unknown services outside the world of asset management — are growth in assets under Global custody on the up and up widely viewed as key to custody from late 2001 until 3-Year Price Performance (USD) the proposed merger. late 2006, based on With $16.6trn under computations with 160 custody, the combined GlobalCustody.net figures, 140 company would be the Mellon turned in 61% largest custody bank in growth and JPMorgan 120 the world. Executives with chalked up 89% growth, 100 the two companies and State Street’s growth was many financial services about 33%, after adjusting 80 industry securities for the Deutsche acquisition.

60 analysts see big In fact, BNY executives opportunities to sell boasted 10 months after the custody and other State Street-Deutsche deal servicing, such as was completed that they reporting, accounting and had attracted 50 customers Source: FTSE Group and Datastream, data as at 31 January 2007.

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securities lending, to asset management clients. In addition, analysts say that the biggest custody banks with the lowest cost bases and the broadest capabilities are best positioned to survive industry consolidation that they expect to continue occurring.

It wasn’t too long ago that Bank of New York and Pittsburgh-based Mellon both were fairly traditional banks, albeit with big specialty businesses related to asset management and asset servicing. Both, however, headed down narrower paths in recent years.

Mellon sold its retail banking business in 2001 to Citizens Financial Group Inc., the US arm of the Royal Bank of Scotland PLC. While it retained its corporate and private banking businesses, net interest income (typically a banking company’s mainstay) produced just 7% of total revenue last year. Instead, Mellon has been focusing on asset management, creating through acquisitions what it has called a multi-boutique business, in which managers continue to do business fairly independently. With $918bn under management when the BNY deal was announced, the company said it was the 13th largest manager worldwide. It also claimed fifth place among global custodians, with $4.4trn under custody. And it has a sizeable business providing payments and shareholder services to corporate clients.

BNY, the oldest bank in the US, founded in 1784, jettisoned most of its legacy banking business just prior to reaching its deal with Mellon. It swapped business units with JPMorgan Chase & Co. in October, exchanging 338 branch offices, where it had relationships with 700,000 consumers and small businesses, for Chase’s corporate trust business [Please refer to Page 58: The Peetz Effect], which performs chores such as making interest payments on behalf of corporate securities issuers.

But even before that, securities servicing fees— including its global custody business—was the biggest revenue line on BNY’s income statement. With $12.2trn under custody, BNY ranked second to JPMorgan Chase among global custodians when the Mellon deal was announced. Other large BNY businesses are clearing and executing trades for independent brokerage firms and treasury and issuer services.

Both companies finished 2006 with very strong earnings.

But both also have performed unevenly in the past few years. At Mellon, that led to Robert P Kelly succeeding Martin G McGuinn early last year as chairman, chief executive officer (CEO) and president, nearly two years before McGuinn had been expected to retire. Kelly came to Mellon from Wachovia Corp., where he had been chief financial officer and a key player in a long series of mergers and acquisitions. At BNY, earnings per share topped the 1999 level for the first time just last year. The company’s stock price is about where it was five years ago.

Combining the companies appears to move both in the direction they were already headed, but faster, says Thomas C. McCrohan, a stock analyst with Janney Montgomery Scott LLC in Philadelphia. “Bank of New York was

Jon Little, chief executive officer of Mellon Global Investments. Little thinks that a good relationship based on asset servicing can open doors at plan sponsors. In addition, clients that use both asset management and asset servicing also stick around longer, he adds.

“We tend to find that when we’ve got a client and we are both their asset servicer [sic] and their asset manager, that the client relationships are really long-standing,” Little says. Photograph kindly supplied by Mellon Corp., February 2006.

strategically looking to become more like Mellon,” McCrohan says, at the same time: “Mellon was looking to become more like the Bank of New York.” In addition to Mellon’s heft in asset management and BNY’s size in the custody business, Mellon has traditionally done more business with plan sponsors, such as pensions, endowments and foundations, while BNY has focused more on financial institution fund managers.

Businesses in the combined company mostly fall into four general groupings, none of which would account for more than about 30% of revenue or pre-tax earnings: asset management and wealth management; asset servicing, which includes custody; issuer services; and treasury services and clearing services. In addition to owning the largest custody business, Bank of New York Mellon will rank in the top 10 globally and the top five in the US in asset management, company executives said. And it will rank No. 1 in corporate trust services, depositary receipts services and stock transfer services.

Executives said when the deal was announced that they would cut expenses by about 8.5%, in part by reducing the two companies’combined headcount, now at about 40,000, by some 3,900. But the bid to retain existing customers is reflected in the deal structure and integration plans. BNY shareholders appear likely to receive just a small premium over the pre-announcement price, 4.4% based on recent trading in Mellon stock. With such a small premium and consequently only modest dilution in earnings per share, there is little pressure to make the kind of drastic cost cuts that sometimes undermine customer service. On top of

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that, executives hope to avoid customer disruption by spreading integration of the two businesses over three years. The transaction is expected to be completed early in the third quarter. Thomas A. Renyi, currently chairman and CEO of Bank of New York, will serve as chairman of the combined company for 18 months. Kelly will serve as CEO at the outset and succeed Renyi as chairman. Gerald L Hassell, currently president of Bank of New York, will hold the same position in the new company. The board of directors will have 10 members designated by Bank of New York and eight members designated by Mellon.

BNY executives say they did not build merger-related revenue gains into their financial projections, but made clear that that’s where the real potential lies. With as much as $100trn in worldwide assets up for grabs by custodians today and growth in cross-border investing steadily raising that figure, they suggested that the custody and asset servicing businesses are particularly poised to grow. They also say that they saw opportunities to sell Mellon’s asset management to BNY’s securities servicing clients, that Mellon’s asset and wealth management products could be distributed through Pershing, a BNY unit that provides back office services to independent brokers and advisers, and that BNY’s banking customers would be interested in Mellon’s cash management and stock transfer services.

Indeed, to the extent that custody and other asset servicing might be viewed as commodities, it could make sense to get them from a bank that’s also providing asset management services, says Walter Knox, assistant director of the Ohio Public Employees Retirement System, a $77bn fund. Selling in the other direction could be tougher, he says, explaining that performance, not price or efficiency, distinguishes one asset manager from another. True enough, in theory, says Jon Little, chief executive officer of Mellon Global Investments. But in practice, he thinks that a good relationship based on asset servicing can open doors at plan sponsors. In addition, clients that use both asset management and asset servicing also stick around longer, he adds. “We tend to find that when we’ve got a client and we’re both their asset servicer [sic] and their asset manager, that the client relationships are really longstanding,”Little says.

The risk in combining BNY and Mellon is the possibility that the deal could lead significant numbers of asset managers to put servicing contracts up for review or that fund managers already considering a change in custodian would shy away from a company that’s tied up with internal organization issues. Fund managers, Says R&M Surveys’ Hogsflesh, will want to know which predecessor company is going to dominate the business, who will determine which systems are used and generally how the business will be managed. Mellon, he says, consistently scores higher than BNY in asset manager surveys about their custody service.“If I were a Mellon client, I would be distinctly concerned about the merger,”he says.

It is not clear yet whether companies such as State

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Gerald L Hassell, currently president of Bank of New York, will hold the same position in the new company. The board of directors will have 10 members designated by Bank of New York and eight members designated by Mellon. Photograph kindly supplied by Bank of New York, February 2007.

Street, Northern Trust and BNP Paribas will face tougher foes than ever, or whether they’ll soon have a chance to pick up new business. The biggest questions, however, probably are whether scale does produce meaningful economies and how asset managers, which pay banks anywhere from hundreds of thousands to millions of dollars annually, depending on their size and the scope of services they use, will feel about working with an even bigger asset service provider.

Securities analysts tend to see opportunities in size for cost cutting. Economides, the consultant who helps asset managers evaluate and select custodians, isn’t so sure.

Scale is important in large domestic markets, like the US, he said, but far less elsewhere. Among other jobs, custodians often provide accounting and reporting services to asset managers.“You can’t have one mother of all accounting systems for US GAAP, UK and Luxemburg reporting requirements,” he said, referring to generally accepted auditing practices in the US and statements of standard accounting practices in Europe and the UK. Similarly, it may be too early for asset managers, which hire banks to hold securities and provide other behindthe-scenes processing for them, to get a firm grasp on if or how they’ll be affected.“Clients have talked to us about a concern over what is going to happen with service quality going forward,”Economides said.

Other asset managers, however, are receptive to the basic message, that the deal will fund new investments in the asset servicing business.“The merger is good,”says the Ohio Public Employees Retirement System’Knox,“because it will set a standard for technology that other custodians will need to reach. As long as we don’t get down to just one custodian, I think it will be fine.”

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BNY CORPORATE TRUST

THE PEETZ EFFECT In the spring of 2006, Bank of New York [BNY] agreed to sell its middle market and retail business to JPMorgan Chase in return for JP Morgan’s corporate trust business. The transaction resulted in the bank leading the corporate trust services market by well more than a country mile.

BNY now boasts a trust business serving 90,000 clients, covering $8 trn in total debt, which involves some 3,700 employees in 54 offices in 18 countries.

Francesca Carnevale talks to Karen Peetz, BNY’s senior executive vice president, in charge of the bank’s global trust business on the operation’s forward strategy.

ARLY IN 2006, Bank of New York (BNY) was appointed by Blue City Investments 1 Ltd to provide multiple corporate trust services for its tourist development project on the northern coast of Oman. The $925m issue of securitised notes—the largest of its kind— will fund the first construction phase of Blue City, the residential and tourist project. BNY acted as trustee, registrar, agent in various on-shore and offshore capacities, cash manager, account bank, lookback calculation agent and Irish paying agent. Nicolas Geoghegan, managing director at Bear Stearns, which arranged and lead managed the deal, noted that BNY was chosen for its expertise in the Middle East and its “global and technological capabilities”.

That double headed capability has been won through a mix of organic growth and an accretive expansion policy, acknowledges Karen B Peetz, who heads up BNY’s global corporate trust business. Corporate trust services are used by any issuer of debt, be it a corporate or municipal issuer.

Service providers perform a variety of duties, including

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Karen B Peetz, head of BNY’s global corporate trust business. Peetz is renowned for her strong focus on customer satisfaction. To back up that client focus, Peetz says the bank regularly conducts client surveys.

“If you have established a business around a value proposition, then you have to be organised and check that it is working and we tell our customers, call us if it is not working for you.” Photograph kindly supplied

by Bank of New York, February 2007.

servicing and maintaining the debt issue, processing principal and interest payments for investors, representing investors in defaults, and providing value-added services for complex debt structures. Corporate trust services cover the gamut of debt financing and enjoy a global reach.

Two recent transactions typify the range. In February last year, BNY provided indenture trustee, registrar and paying agent services for Kazakhstan’s JSC Kazkommertsbank’s $300m debut diversified payment rights (DPR) transaction.

Later the same year, it was appointed by Viacom Inc. to perform indenture trustee, registrar and paying agent services for a $4.75bn three-tranche plain vanilla note offering. “It’s comprehensive,” acknowledges Peetz, who points to the bank’s number one ranking in almost every debt security globally, “all excepting the mortgage backed business and even then we are number two.”

Peetz took over the running of the combined global corporate trust business in May last year, following the announcement of the agreement with JPMorgan. She was

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an obvious candidate for the post having established a strong imprint during her tenure heading up BNY’s corporate trust business. BNY chairman and chief executive Thomas A Renyi noted that Peetz had delivered “consistent revenue growth and creating significant business momentum globally. She has done so by creating a model for client service that now sets the standard for the industry.”

Peetz joined BNY back in 1998 to head its domestic corporate trust business, also managing the global payments services group before being named head of corporate trust in 2003. Fortuitously perhaps, Peetz had worked at JPMorgan Chase, formerly Chase Manhattan Bank and Chemical Bank, for 16 years, where she was responsible for client management and sales for its global trust services group as well as business management for domestic corporate trust. She also headed the bank’s EMEA business and worked for a time in London.

Single-minded customer focus is key, thinks Peetz.“I’m paid to be myopic,” she says. Okay, many senior executives say that. Peetz however, definitely walks the talk. Her focus is entirely on who is in the room with her: are they comfortable? Her offers of hospitality are genuine and repeated. Most significantly, her dialogue is peppered with words such as “we” rather than “I”, and “valued clients”,“fabulous team”, as in: “We expend a lot of time and energy on relationship management and we believe in a one-stop concept which is vital as debt markets become more sophisticated. We provide each client with a dedicated relationship manager as a single point of contact. Relationship managers will have specific experience and expertise across financial instruments.”

She also talks about specific staffers who have made particular contributions to the business, a rarity in these kinds of interviews. To back up that client focus, Peetz says the bank regularly conducts client surveys. “If you have established a business around a value proposition, then you have to be organised and check that it is working and we tell our customers, call us if it is not working for you.”

The scale of that commitment is surely tested by the convergence with JPMorgan Chase’s corporate trust business; after all, the deal was only finalised in October 2006. Under the terms of the agreement, The Bank of New York sold its retail and regional middle-market businesses to JPMorgan Chase for $3.1bn with a premium of $2.3bn and JPMorgan Chase sold its corporate trust for $2.8bn with a premium of $2.15bn. The difference in premiums resulted in a net cash payment of $150m to BNY, with a further contingency payment of up to $50m tied to customer retention performance. Through the acquisition, BNY took on the servicing of $5trn in total debt outstanding and some 2,400 employees in more than 40 locations globally.

Since the deal was finalised, BNY has been transitioning accounts, assets, systems and staff across all parts of its global corporate trust business. It was a challenge of some

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magnitude, acknowledges Peetz. BNY’s corporate trust business represented $3 trn in total debt outstanding and the business employed 1,300 employees in 25 locations globally.“JPMorgan was probably five years ahead of where we wanted to be. It’s CDO business, for example, was 20 times our size,”says Peetz. As far as convergence of the two businesses was concerned, two issues were immediately tackled.“We told all client-facing staff that they had a job.

The second was to assure clients that we would adapt to the best technology. In EMEA, JPMorgan dwarfed us, so it was a simple matter of putting our clients on their system. In the US, we were using the same back office system and so integration was straightforward. Clients were immediately reassured,” explains Peetz. Most recently, the bank completed the conversion of the corporate, municipal and global Americas business segments. The conversion has involved more than 40,000 client accounts with 90,000 securities and cash positions and the successful processing of more than $47bn in principal and interest payments. The bank has also utilised its expertise in custody.“We use the bank’s custody reporting system, Inform,” she explains.

“Our clients have connections viewing the underlying assets.” The next phases of the conversion, which will involve the structured finance, CDO, international and loan agency business segments, are expected to be completed by the end of the second quarter of 2007. “These will be our fastest growing segments through the year,” acknowledges Peetz, “particularly CDOs, both domestic and global and primarily out of Europe. EMEA will provide strong growth, as will Asia and we expect the asset backed, mortgage backed and conduits business to grow globally.”

In February this year, BNY claimed is number one ranking for its overall global corporate trust business for 2006, according to data from data providers Thomson Financial, Dealogic and Asset-Backed Alert. The bank has held pole position in Thomson Financial’s rankings since 2004. BNY’s trustee ranking includes lead positions across almost all US and international debt segments, including long-term municipal, straight debt, high yield, investment grade, convertible, asset-backed, collateralised debt, structured finance, investment grade bonds and high-yield bonds. BNY ranks number two in the US mortgage-backed category. In all, the Bank served as trustee for 3,035 issues valued at more than $1.3trn in proceeds, a 15.4% market share. The next closest competitor was US Bancorp with 1,889 issues valued at $471bn, a 9.6% market share.

How the competition, including Deutsche Bank and Citigroup globally, US Bancorp, and Wells Fargo in the domestic US market will respond to the impact of BNY’s current corporate trust business reach has yet to surface. If Peetz has anything to do with it, BNY’s dominance will continue over the coming decade. “We are in this for the very long term and although we might still have some work to do on customisation of some parts of the business, the different strengths that the JPMorgan and BNY elements have brought to the combined business will help see us through,”she says”

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ASIAN SECURITIES LENDING

Bursa Malaysia chief executive officer (CEO),Yusli Mohamed Yusoff.“[We adopted] a CLA model whereby borrowers are limited to Malaysian securities brokers and lenders lend as principal to the CLA either through Malaysian securities brokers or local custodian banks,” says Yusoff.“Securities borrowing and lending (SBL) is normally conducted on an over the counter (OTC) basis.

In the Malaysian model, borrowers must go through the Malaysian securities broker to borrow whereas for lending, the lender will lend as principal to the CLA by going through either a Malaysian securities broker or a local custodian bank.” Photograph from Berlinguer Ltd’s own photo archives, supplied February 2007.

COMING OF AGE Despite all fragmented market and cautious approach to market growth, the prognosis for Asia’s securities lending industry is positive these days. The benefits of securities lending are well known, regulators are regularly engaging with market players, and the market is experiencing double digit growth rate.

“The market has tremendous potential,” thinks Sunil Daswani, regional manager for securities lending at Northern Trust in Asia, particularly with the increasing presence of hedge funds and corporate events in the region. Rehka Menon reports the opportunities opening up in the continent.

FTER AN EIGHT-year suspension, the Malaysian stock exchange has reintroduced securities lending.

Bursa Malaysia now allows controlled securities lending in order to facilitate short selling and increase market liquidity. Unusually perhaps, the exchange will have an active role in the programme, becoming the main intermediary for all transactions. The new scheme, called Bursa Securities Borrowing and Lending (SBL), was due to be introduced in October last year, but the launch was rescheduled to January 2007 after the market participants requested more time to prepare their systems.

SBL features Bursa Clearing, an exchange’s subsidiary, in the role of the central lending agency (CLA). Under this

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framework, the CLA will be the single point of contact between borrowers and lenders and a single site where transactions are matched. Any entity or person with shares deposited in the Bursa Malaysia Depository can lend shares to the CLA. The CLA in turn will lend the shares to clearing participants who will then on-lend to the ultimate borrowers.

According to Bursa Malaysia chief executive officer (CEO), Yusli Mohamed Yusoff; the model will allow to better manage risks associated with borrowing of securities and guarantee that all transactions are successfully closed.“[We adopted] a CLA model whereby borrowers are limited to Malaysian securities brokers and lenders lend as principal to the CLA either through Malaysian securities brokers or local custodian

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banks,”says Yusoff.“Securities borrowing and lending (SBL) is continues to be a strong demand for borrowing stocks across normally conducted on an over the counter (OTC) basis. In the Far East particularly in Hong Kong, Japan and Australia,” the Malaysian model, borrows must go through the remarks Reeve Serman, Director of Securities Lending at Malaysian securities broker to borrowers whereas for RBC Dexia.“The Hang Seng Index is up 30% from last year lending, the lender will lend as principal to the CLA by going as investors look for exposure to China through listings in through either a Malaysian securities broker or a local Hong Kong. Japan, as a mature and liquid market, continues custodian bank. The role and purpose of the CLA is part of a to be in heavily in demand and there is a very active lending phased-implementation approach to develop local SBL market in Australia as supply has grown exponentially over expertise, monitor and control loans and provide retail the last 12 years,”he continued.

Despite the impressive growth of the securities lending in investors with an avenue to lend their securities without risk as the CLA guarantees return of securities loaned to the the Asia, electronic platforms such as Equilend and eSecLending, that have enjoyed growing popularity in recent CLA,”he adds.

The annual borrowing fee is set at 2.2% of the average years in US and Western Europe, have not yet carved out a value of shares. Lenders will receive 2%, after the CLA takes significant presence in Asia, though that is said to grow. a 0.2% transaction fee. So far, Bursa has admitted 50 stocks to Global custodians are typically the major source of lendable the scheme. Borrowers will deposit collateral in cash that is assets while borrower demand is being driven to a large equivalent to 105% of the value of the shares borrowed. extent by hedge funds in the region. The market is also Borrowers can also collateralise with other shares they own, witnessing growing participation from the large Asia-based which are then valued at 30% of their most recent market fund managers states Robert Winmill, vice president, price. Bursa Clearing as the CLA will guarantee the return of securities finance and investment products at HSBC. “Increasingly, we are seeing an acceptance by Asia-based securities to lenders.

The Bursa SBL service will be offered by brokers that have fund managers that securities lending provides a critical a Malaysian licence and are cleared for cooperation with the means of improving portfolio performance.” states Winmill.

CLA. The list of qualified brokers has 20 names, including In the more mature Asian lending markets, he says, there is eighteen local firms and Credit Suisse and JP Morgan. significant activity by both Western and Asian institutional Citibank, HSBC, Standard Chartered, Deutsche Bank and investors. Conversely, he points out that in the emerging several local brokers and custodians were approved as lending markets, such as Taiwan, the majority of lendable supply comes from local institutions that are comfortable lending agents.

Growing at a rapid pace, the over $200bn Asian securities participating via the local, onshore model.

Notably, navigating the emerging lending markets terrain lending industry is characterised by a uniquely dichotomous structure comprising both highly mature and extremely in Asia is not easy for foreign participants. “Unlike the US, nascent lending markets. The mature markets such as Japan securities lending in Asia, excluding markets like Japan, Hong and Australia function in a similar manner to that of the Kong and Australia, is immature. Many Asian markets do not lending markets in US and Western Europe, demonstrating allow securities lending,” remarks Stewart Cowan, vice large volumes, high liquidity and thin spreads. Emerging president and securities lending manager at JPMorgan Worldwide Securities lending markets such as Services in Australia and India and Philippines on Asian Securities Lending Market Statistics New Zealand. However, he the other hand, promise states that a hungry hedge high returns for early fund industry is driving movers, but are yet to truly lending associations and take off. The Philippine local regulators in these Stock Exchange has only countries to evaluate the recently announced benefits of securities securities lending lending. As a result, he guidelines, while India’s points out, Indian and securities industry Chinese regulators are regulator, SEBI (Securities assessing their markets for Exchange and Investment securities borrowing and Board of India), which has lending, while at the been consulting with the beginning of 2007, both industry over the past Source: Pasla, February 2006.

Malaysian and Philippines couple of years, still has to regulators announced securities lending guidelines for their come out with formal securities lending rules.

Japan is by far the largest lending market in the region. respective markets.

It is important to note that securities lending is not entirely Estimates by the Pan Asian Securities Lending Association (PASLA), suggest that it accounts for over 70% of the total a novel concept for some of these markets. In the late eighties market size, followed by Australia and Hong Kong. “There and early-to-mid-nineties, they had allowed the practice

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ASIAN SECURITIES LENDING Robert Winmill, vice president, Securities Finance and Investment Products, Corporate, Investment Banking and Markets at HSBC. “Increasingly, we are seeing an acceptance by Asia-based fund managers that securities lending provides a critical means of improving portfolio performance.” states Winmill. Photograph kindly supplied by HSBC, February 2007

before the Asian financial crisis forced the regulators in the respective countries to halt all ‘speculative’ activities.

Malaysia, for instance, had introduced regulated short selling and securities borrowing and lending back in 1996, but subsequently suspended these activities a year later at the height of Malaysia’s economic crisis.

A similar vein of caution and tight control permeates through the guidelines adopted by nearly all the countries in the region that have allowed securities lending in recent years. There are operational constraints around trading, restrictions around buy-ins, and stringent reporting requirements, to name a few. Each market that opens up for securities lending, has its own specificities. So while in Korea there is a limit of KRW10bn to the amount foreign borrowers can borrow onshore, in Taiwan there are double taxation issues that make lending unattractive for agent lenders. In the case of Indonesia, current regulations permit custodian banks to only act as lenders, with the effect that although the securities lending programme was formally launched in 2005 in Indonesia, no foreign custodian banks have yet joined the programme.

“The difference with emerging lending markets is that they tend to have bespoke regulations that can be out of kilter with international practices,” states Winmill. The creation of a central counterparty to lending transactions, he says, is an example of one such regulation. As in the case of

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Malaysia, in many markets that have recently introduced securities lending and short selling, there has been a tendency to position the stock exchange or CSD as a central counterparty to lending transactions instead of allowing bilateral transactions between borrowers and lenders, which is the norm in developed markets.“The presence of a central counterparty makes the market less attractive for international players since they lose control over risk management, collateral disposal and timing,” agrees Sunil Daswani, regional manager for securities lending at Northern Trust in Asia.“For a player like Northern Trust, it is important to have the right controls in place. We need to be comfortable that the risk can be controlled with the presence of a robust infrastructure for our clients,”states Daswani who is also the chairman of the Pan Asian Securities Lending Association (PASLA).

In an effort to help local markets become more orderly, efficient and operate along international norms, PASLA regularly liaises with regulators in Asia and conducts seminars and round-tables with regulatory authorities and market participants. Some of these initiatives have been quite successful. The Philippines Stock Exchange recently introduced regulations on securities borrowing and lending in close association with PASLA. Daswani is very positive about the rules announced in the Philippines since they are, he says, based on international standards which is not always the case. With respect to another emerging market, India, recent market reports suggest that the rules that might be announced later in 2007 will initially be more geared towards local onshore retail investors than foreign institutional investors.

Market participants unanimously agree that regulation remains by far the primary challenge facing the securities lending market in Asia today. “The biggest challenge in Asia is regulation. Over the last 10 years, a number of markets have appeared to have opened up, but then retreated. It takes some while for regulatory bodies to reach an equilibrium,”says Brian Traquair, President of Securities Finance at SunGard, which has over 30 clients for is securities lending products in Asia. “Regulators in some country might say that securities lending is allowed in that market, but they might also place certain rules that are counter effective,” adds Risa Muroi, head of securities lending in Asia at Barclays Global Investors.

Daswani sums up the challenges of operating in Asia, “There are seven or eight new markets. Overall there are 14 sets of regulators and sometimes more than one regulator in a market. Complying with all the rules and changes, languages and cultures is a big task. Add to it the logistical aspect of managing the wide geographical spread.”

Moreover, with rules changing rapidly, he says, due diligence is required before foreign institutional participants enters any market. Serman concurs,“Being the first player to participate in an emerging market can be very attractive, but there can be high costs associated with not doing one’s due diligence.” He elaborates further. “Understanding the operational nuances of operating in each market is a key

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challenge since the legal, regulatory and reporting requirements can be extremely onerous. For example, Taiwan follows a stringent T+1 settlement cycle and markets like Hong Kong have auto-buy in rules for failing trades that one needs to fully understand in order to mitigate against onerous fees or penalties. To successfully operate in the market, players need to adapt to these requirements.”

The cautious approach adopted by Asian regulators is expected, especially given the background of the financial crisis that the region suffered less than a decade ago.

Winmill of HSBC says that wanting tighter controls at an early stage is understandable. “As regulators become accustomed to the functioning of securities lending and the benefits it brings to a market, we have seen them adopt a policy of incremental liberalisation towards regulations.”

Winmill gives the example of Korea which was among the first emerging markets to create a securities borrowing and lending structure after the Asian crisis. Korea started off with a bespoke structure with many in-built controls, but the authorities have steadily relaxed key restrictions, such as permitting offshore collateral, and clarified tax regulations. These changes have encouraged foreign participation and over the past three years, volumes have increased to the extent that Korea is now a flow market.”

Taiwan on the other hand has been less successful in amending its initial structure and moving from a local model towards international standards. The country launched securities lending some 18 months after Korea, but volume growth in the market has not been as significant.“Taiwan also presents operational challenges. It has a short settlement cycle coupled with punitive failed trade regulations. These are among the reasons why the market has not grown like Korea,”says Winmill.

Muroi exhorts the authorities to maintain a balance between keeping control and providing a practical market place to increase liquidity. “Increased liquidity attracts more participants. It is a growing cycle,” she says. To continue having good growth in Asia, she adds, it is very important for all market participants to understand the benefits of securities lending and the need for an appropriate infrastructure. “The good news about Asia is that there is a good balance of countries that are open to securities lending and others that have not even embarked on the journey. This spells out huge opportunities for us. I am very positive about the Asian securities lending market,” adds, Francesco Squillacioti, senior managing director and regional director, Asia-Pacific Securities Finance at State Street.

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DEBT REPORT: CEDULAS HIPOTECARIAS

This year should see Spain’s covered bond market grow in a more dramatic direction, as domestic issuers look to launch dollar-denominated issues into the United States. Following the launch of two inaugural issues of structured covered bonds totalling €4bn from the third-ranking US mortgage lender Washington Mutual at the end of September, the big Spanish issuers clearly feel the time is right to offer their products abroad. Caja Madrid, which has historically taken the lead among cedulas issuers when it has come to breaking new ground, looks set to do so again with the launch of a $1.5bn to $2bn issue targeted primarily at US investors before the end of June.

Andrew Cavenagh reports.

EXPORTING SPANISH COVERED BONDS

Photograph by Scott Rothstein, supplied by Dreamstime.com, February 2007.

HE LIKELIHOOD IS that the runaway growth enjoyed by Spain’s covered-bond market over the past three years must take a different turn in 2007. A possible end to its seemingly unstoppable bull run must be somewhere in sight, as an inevitable consequence of the current slow-down in the Spanish real-estate borrowing.

That slowdown is beginning to reduce demand for domestic mortgages and is leading the country’s big lenders to advance more home loans that are not eligible as collateral for the cedulas hipotecarias. Something of a deceleration in issuance volumes does not mean stagnation however, and the market remains on course to consolidate its position as Europe’s leading issuer of covered bonds and to head off in at least one new direction this year.

Estimates for the volume of issuance in 2007 vary. Most analysts think however that a slight decline on the €65bn

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of large publicly sold issues that came to the market in 2006 is possible.“I doubt we will see more issuance than we saw last year,” maintains Carlos Stilianopoulos, head of capital markets at cedulas issuer Caja Madrid. “To be honest, the beginning of the year has been pretty quiet,” he adds. “I think it is the consensus that the market is likely to cool down somewhat in 2007,”confirms Alexandra Themistocli, director for primary rates syndication at Dresdner Kleinwort in Frankfurt. “And the market for jumbo issues could drop to €55bn.”

To some extent, the sheer volume of jumbo cedulas issues over the past three years is also beginning to have an inhibiting effect, for it has done little to tighten the spreads on new issues.“The high rate of cedulas issuance has not been beneficial to spreads at times,” acknowledges Themistocli, although she pointed out that the spread

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differentials with German pfandbriefe were not as pronounced as they had been two years ago. This progressive saturation of the jumbo market certainly persuaded the country’s largest issuer of cedulas, the multiissuer vehicle Ahorro y Titualizacion (AyT), to make more use of private placements and non-euro denominated issues in 2006, maintains Themistocli. “These securities were directly aimed at Asian and Scandinavian investors and other domestic issuers appear to be following its example,”she says.

“Private transactions, tailored to specific investor size and maturity needs, seem to be increasingly popular,” confirms Antonio Torío, head of funding at Grupo Santander.“We have seen a slower, more orderly access to the market by issuers this year, which is allowing the market to absorb supply without exerting pressure on spreads.” However and despite this trend, Spain looks set to retain its position as the European leading issuer of publicly-sold covered bonds for the third year running. A research report from Standard & Poor’s (S&P), issued in January concludes that the country will retain pole position this year in a European market that, in turn, is likely to grow between 10% and 20% as new issuers, structures and asset types come forward.

As the wider European market for covered bonds continues to expand on all these fronts, differences in legal frameworks are becoming more of an issue for the rating agencies and investors. Even though pressure has built up on the spreads of some cedulas from the scale of issuance over the past three years, Spanish mortgage bonds are likely to remain a popular choice for investors in the increasingly competitive environment. As well as providing market depth and liquidity (second only to the German pfandbriefe) Spanish mortgage bonds continue to offer investors an assuring combination of big asset overcollateralisation and highly rated issuers. This is reflected in recent rating actions. S&P raised its ratings on two issuers, Caja Madrid and La Caixa, a notch to double-A minus at the end of 2006, while Moody’s upgraded the cedulas hipotecarias programmes of Banco Pastor, Caixa Catalunya and Banca Sabadell to triple-A following a review of the legislative framework and the respective cover pools.

Amendments to the Spanish Market Mortgage Act scheduled for this year—including the option to use derivatives to hedge covered bond programmes—should strengthen the overall credit quality further.“Definitely the intent behind the changes is to improve credit quality – on issues such as liquidity and substitution of assets,”says Jose Tora, an S&P analyst in Madrid. Meanwhile, Torio at Santander has it that the strong liquidity of the Spanish market should ensure cedulas spreads remained tighter than those of other European covered bonds and says:“The cedulas market continues to enjoy good demand—it seems to be especially strong in the long end at the moment due to the slight increase in long-term yields.”

This view would certainly seem to be borne out by the broadening of the investor base for mortgage-backed

Carlos Stilianopoulos, head of capital markets at cedulas issuer Caja Madrid.“To be honest, the beginning of the year has been pretty quiet.” Photograph kindly supplied by Caja Madrid, February 2007.

cedulas over the past year, which, as Themistocli at Dresdner Kleinwort notes, had seen some significant trends. Not least of these is an increased take-up from domestic investors.“There has definitely been more buying out of Spain,” she says. “But it’s still nowhere as big as it could be at around 10%. German investors account for up to 50% to 70% of the big pfandbrief issues.”

She added that there had also been an increase in the number of Nordic buyers of Spanish bonds, more participation from central banks (particularly in some of the emerging European countries) and some new institutional investors. “We have seen some more Belgian pension funds as well.”Insurance companies were the one class of investor to be conspicuously less active in the market in 2006—largely a reflection of the greater number of issues during the year that had shorter (10-year) maturities. Themistocli observes that Asian buyers had also been noticeably “less active”than they were in 2005.

She thinks that German investors were still the biggest buyers of cedulas, accounting for about 20% to 30% of the total issuance, followed by the Netherlands (15%), the Scandinavian countries (between 8% and 15%), and France (between 5% and 12%), depending on the maturity of the bond.“European investors continue to be the most significant players, yet Asia and the Middle East are growing,”adds Torio at Santander to the mix.“The investor base is constantly growing.”

This year should see it grow in a more dramatic fashion, as Spanish issuers look to launch dollar-denominated issues into the United States. Following the launch of two inaugural issues of structured covered bonds totalling €4bn from the third-ranking US mortgage lender Washington Mutual at the end of September, the big Spanish issuers clearly feel the time is right to offer their products to American investors. Caja Madrid, which has historically taken the lead among cedulas issuers when it has come to breaking new ground, looks set to do so again with the launch of a $1.5bn to $2bn issue targeted primarily at US investors before the end of June.“We would like to do this in the first six months of the year,”confirms Stilianopoulous.

He says the bank is looking to place 70% of the bonds

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with American buyers, and the issue will likely be listed on the 144a market. The remaining 30% will probably be sold down to a mix of Asian and Scandinavian investors.

Stilianopoulous thinks that this first issue will probably have a maturity of 10 years—in line with the current preference of American and Asian investors for shorter maturities than their European counterparts. Caja Madrid has already had encouraging feedback from a road show in the US where it was promoting the generic product rather than a specific deal, and Stilianpoulos says the bank will conduct more investor briefings at conferences across the Atlantic in the coming weeks.

He is convinced that other leading cedulas issuers will Antonio Torío, head of funding at Grupo Santander notes,“We have seen a not be far behind Caja Madrid in launching issues on the slower, more orderly access to the market by issuers this year, which is 144a market.“For 2007 we are all looking very keenly at the allowing the market to absorb supply without exerting pressure on spreads.”

US market,” he explains. “I think this market is finally Photograph kindly supplied by Grupo Santander, February 2007. opening up four European issuers.”“The US is an important potential market for European covered bonds, and we may covered bonds and residential mortgage-backed securities see some interesting developments there during 2007,” is changing at the big Spanish mortgage banks. The trend adds Torio at Santander. Issuance of cedulas over the next for them to advance increasing numbers of loans with loan18-24 months will also receive a further boost from the to-values (LTVs) of more than 80%—which are ineligible as refinancing of existing issues that reach maturity. Some of collateral for covered bonds although they remain part of the initial deals will pay down this year, with many more to the covering asset pool—is predictably boosting retail follow in 2008. “Next year you’re going to see a lot of mortgage backed securities (RMBS) issuance in the country. redemptions, between 10% and 15% of outstanding In 2006, the volume of RMBS deals was close to that cedulas issuance,” maintains Stilianopoulos. “This market is going hipotecarias at around €60bn. Stilianopoulos said Caja Madrid had launched its first two RMBS deals last year for to go on for quite a while yet.”

By contrast, the emerging market for cedulas this reason, and others discern a trend in this direction. “I territoriales, which are backed by public sector loans rather think in general the ABS business is definitely increasing than mortgages, will not make much of an impact on the with the Spanish banks,”comments Themistocli.“There is a bigger picture for the near future. The three such issues in shift going on, but I am not able to quantify how significant 2006 from La Caixa, BBVA, and Caixa Galicia accounted for it will be.”

At the same time, the regulatory capital benefits that just €4bn, and while the planned changes to the cedulas legislation may encourage further deals this year, the much derive from off-balance sheet treatment for which RMBS slower rate at which the banks originate such assets qualifies will largely disappear under the Basel II capital compared with mortgages is likely to limit annual issuance accords. It will also become prohibitively expensive in to around this level.“Those loan books do not grow as fast regulatory terms to hold on to the first-loss pieces in such by any means, so the collateral for that business is much securitisation. Stilianopoulos thinks this will remove the smaller,” explains Tora at S&P. He holds that the pace of incentives for some institutions to go down that route.“It origination of such loans will be unlikely to sustain more is no longer attractive to do RMBS deals unless you are than one issue a year from each of the big banks. doing so purely for funding purposes.” However, not all the Spanish banks expect Themistocli at Dresdner Covered Bonds retain their appeal to see a significant switch Kleinwort meanwhile says 3-Year All-Maturities Total Performance Graph (EUR Terms) between the use of that mortgage-backed 116 covered bonds and offbonds will consequently 114 balance sheet remain the focus of the 112 instruments.

“Large cedulas market in the short 110 Spanish banks have been term, and Santander’s 108 106 issuing RMBS for many Torio further endorses this 104 years — since the early view from an issuer’s 102 1990s,” observes Torio at perspective. “I do not 100 Santander. “We regard foresee significant growth 98 both instruments as in the cedulas territoriales complementary and will market for the time being.” continue to use them as Opinion is more divided needed in our funding on how – if at all – the strategy.” dynamic between issuing Source: FTSE Group and Datastream, data as at 31 January 2007.

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PFANDBRIEFE

NEW ENTRANTS ADD MUSCLE TO PFANDBRIEF ISSUES

Photograph by Kutay Tanir, supplied by Dreamstime.com, February 2007.

Overall issuance levels of pfandbriefe may have fallen slightly last year – in contrast with the fastgrowing volumes of covered bonds issued elsewhere in Europe – but this did not mean the oldest and largest segment in the covered bond market was inactive. Not only did new issuers emerge in 2006, but the investor base for international German issues also widened dramatically. Andrew Cavenagh reports.

HE ASSOCIATION OF German Pfandbrief Banks (VDP) says new issues in the jumbo, traditional and registered markets last year reached €170bn and that it expects issuance to remain at the same level in 2007.

During the last twelve months, the market saw two banks – Aareal and DKB – issue pfandbriefe for the first time and WestLB return to market after an absence of several years.

There was also a notably bigger increase in the number of new pfandbrief. Four out of the eight that Moody’s rated for the first time in 2006 were newly established and the rating agency expects to see more come forward this year. In its 2006 review/2007 outlook, Moody’s forecasts that both existing and first-time issuers will additional pfandbrief.

That was good news, as earlier in the year, VDP had registered a 5.5% drop in overall issuance volumes between January and August of last year. The jumbo pfandbrief

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market was less active than in previous years. “German issuers these days predominantly fund themselves with private placements that are more cost efficient and only tap the jumbo market to maintain a market presence,”maintains Karen Naylor, head of covered bonds at Standard & Poor’s in London. Most likely this was a direct result of a growing trend towards more private placements in the German market, as a growing number of insurance companies and fund managers sought smaller, more tailor-made issues that provided them with greater flexibility in managing their balance sheets under German accounting rules.

Small to medium-sized covered bonds are usually in the range of €50m up to €500m but floating rate notes can be as much as €1bn to €1.5bn. Jumbo bonds are at least €750m at launch. Market-making occurs only in the jumbo market, with a minimum of five market makers, quoting two way

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prices with a fixed bid/offer spread up to 2.5 basis points, in a 20 to 25 year maturity range, for lots up to €15m.

Most market watchers agree that last year’s dip in the jumbo pfandbrief market is temporary, albeit the trend will show scant change in the first half of 2007. Once the full impact of the Pfandbrief law and other legislative changes (largely introduced in 2005) take effect, that will likely change. The regulatory changes were designed to make the instrument more widely available and introduce greater transparency and diversification of the supporting asset pool. The VDP meantime—whose membership has grown from 21 to 30 since it was formed in July 2005 and now accounts for 80% of outstanding issues—also believes the number of issuers will grow further this year.“We see room for some additional entrants into the pfandbrief market and even the jumbo segment,” says a VDP spokesman. “From our point of view, there may be a slight shift towards the private placement market,” agrees Holger Dohra, head of investor relations at DG Hypothekenbank. He holds that the change had been largely investor driven, as increasing numbers of German fund managers and insurers sought more tailor-made instruments (denominated in foreign currencies or with shorter maturities) than jumbo issues could readily offer. He also added that DG Hypotheken

Bank had run short of appropriate collateral for large-scale public issuance in the early part of 2006.“There was hardly sufficient cover in our pools for a jumbo issue.”

The VDP does not think that any quantum shift is underway in the pattern of issuance. Its spokesman points out that the ratio between jumbo, traditional and registered instruments had remained “roughly the same” for the past four years—at around a third of the market each. While he acknowledges that private placements offered issuers attractive terms in the current environment, he is adamant that “the jumbo market is still very important”.

The largest pfandbrief issuer Eurohypo supported this view. “You have a very healthy mix of jumbo issuance and private placements,” maintains Marcel Kullmann, head of funding at the Commerzbank subsidiary. Looking ahead to this year, Kullmann says that any change in Eurohypo’s issuance is more likely to involve the underlying collateral.“I think we will probably be seeing more issuance of mortgage pfandbriefe this year and a little less on the public-sector side.” The bank’s issuance of mortgage pfandbriefe should receive a boost as Commerzbank finally starts to refinance its large book of home loans through the instruments. While this is one reason behind Commerzbank’s move to increase its shareholding in Eurohypo to 98% in 2005, the process has

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authorities and obligations to employees. Pension schemes in particular are looking for yield pick-up over the last couple of years, and long-dated covered bonds provide access to durations that better match their liabilities and that are not available through many other instruments.

Asian investors too have been increasingly attracted by the German covered bond market and at the end of January VDP undertook a road show, accompanied by leading market practitioners, to Japan and China to market pfandbrief. Today around 10% of the investment funds in the covered bond segment originate in Asia.

Meanwhile, the extent to which the state-owned landesbanks will participate in the market this year is uncertain. The termination of their state guarantees back in 2005 will invariably drive them to issue pfandbriefe at some point, as the covered bonds will offer them a much Holger Dohra, head of business relations/management on the treasury cheaper source of funding than the senior unsecured side of DG Hypothekenbank. From our point of view, there may be a markets on single-A ratings (or lower in some cases). slight shift towards the private placement market,” agrees Holger However, Moody’s notes that the substantial liquidity Dohra, head of investor relations at DG Hypothekenbank. He holds reserves they built up before their guarantees expired may that the change had been largely investor driven, as increasing mean that the expected additional covered bond issuance numbers of German fund managers and insurers sought more tailor- from this source “may not materialise before the end of made instruments (denominated in foreign currencies or with shorter 2007”. VDP’s spokesman also points to the grandmaturities) than jumbo issues could readily offer. Photograph kindly fathering of the state guarantees covered debt with supplied by DG Hypothekenbank. maturities up to 2015,. Therefore, much of the existing liquidity “should hold for some time”. Nevertheless, he been a painstaking one because each individual loan has says the landesbanks will want to start building their own had to be scrutinised to ensure it complies with the credit curves in the jumbo market and that might lead the collateral pool requirements.“You are talking about a lot of banks to start issuing sooner.

Their own savings banks will offer a ready source of IT and loan officer time,”observes Kullmann.“We just need to see how many of these mortgages make their way over assets for mortgage pfandbriefe, and the refinancing to Eurohypo in 2007. We are hoping that they will drive one register will now make it easier to transfer claims and jumbo issue and maybe some private placements as well, security from such smaller institutions. “There are lots of possibilities for them to make better use of their but it may be more or it may be less.”

Covered bonds are collateralised by a specified asset landesbanks,”comments Kullmann at Eurohypo.

If the past 12 months has seen little change in the overall pool on the balance sheet of the issuer: usually mortgages, residential-mortgage backed securities, public sector loans, levels of annual and outstanding issuance, however, there has been a significant increase in the take-up of jumbo and/or ship loans.

The percentage of the total covered bond primary issues by foreign investors. It is a trend that owes much to issuance backed by public sector assets has declined every the expansion of the covered bond market elsewhere in year since 1996, from around 97% of the new issue market Europe, as a wider band of investors are now buying the in 1996 to around a quarter of the overall market. The instruments. “As the market in Europe expands, we are mortgage-backed business, on the other hand, has being a big beneficiary of that expansion,” confirms Kullmann. He said that boomed. Ship loans are while countries such as also a growth sector, led 3-Year All-Maturities Total Performance Graph (EUR Terms) Portugal would always be by German HSH 112 relatively small issuers of Nordbank, and several 110 bonds—given the size of captives have looked at 108 their underlying car loan collateral.

106 mortgages markets—by Investors find that 104 launching covered-bond covered bonds offer 102 frameworks they were strong asset/liability 100 introducing large matching and a 98 numbers of their own preferential claim on domestic investors to the collateral assets in the product. Given the event of issuer default, limited volume of taking precedence even domestic issuance, such ahead of the tax Source: FTSE Group and Datastream, data as at 31 January 2007.

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investors would inevitably look to the biggest issuers in the 144a market in the second quarter of 2007. “We are Europe.“Overall you are expanding your investor pool much hoping to have a chunk of that go into the US,” said faster than you are losing it to potential issuing competition,” Kullmann.“We are looking at that market very seriously.”

Dohra says DG Hypothekenbank would also “love to he explains. He points to Eurohypo’s latest €2.5bn jumbo pfandbrief in January as a good example of the way the trend do“ a US issue but was currently constrained by its lack of was going. The heavily oversubscribed issue was sold to 161 dollar-denominated assets. But if new business generated investors, 68% of whom came from outside Germany with more loan in the US currency, the bank would certain Scandinavian and Asian buyers accounting for 21% and 18% look at the opportunities. Most analysts agree, however, respectively.“That was much higher than we had seen on any that the catalyst that will really bring US investors into pfandbriefe and other European covered bonds will be previous transaction,”he said.

Smaller pfandbrief issuers also report a similar broadening the launch of a dollar-denominated bond by a US of their investor bases. “We have an increasing number of mortgage lender.“That would really be a landmark,“ says Asian accounts,” says Dohra at DG Hypothekenbank. “We the VDP spokesman. also have a large variety of central banks and investment agencies, which have had a change to their legal status that enable them to buy pfandbriefe.”

Dohra says the increasing participation of central banks in Asia and Central and Eastern Europe, along with that of foreign pension funds and insurance companies, has seen the average domestic take-up of DG Hypothekenbank’s jumbo issues drop from 95% in 2002 to around 50% last year. As a result, he will now be “disappointed” he says, if more than half one of the bank’s jumbo issues did not sell outside Germany. He also notes that the growth of covered-bond programmes in other European countries was working to the benefit of the pfandbrief issuers.“What we find interesting is that other companies in these countries are now buying pfandbriefe as well as their domestic covered bonds,”said Dohra.

Some call it simple.

Foreign participation in the market may take a further significant stride this year, as US Many call it simply good. investors have become a tantalising target for the pfandbrief issuers. Following the entry of the fourth-largest American mortgage lender Washington Mutual into the European covered bond market in September, many clearly see scope for reciprocal trades.

Member of the Cooperative Financial Eurohypo, for one, aims to tap Services Network American investors with a dollar-denominated jumbo DG HYP. The innovative real estate bank. issue it is aiming to launch on

PFAND BRIEF

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2006 was a record-breaking year for fund raising by private equity and buyout firms, according to recent data released by Private Equity Intelligence (PEI). Some 263 new private equity funds had raised over $167bn, with more than $300bn expected to have been raised by year end. In the first half of 2006 143 US based funds raised $108bn, 65 European funds raised $41bn and 55 Asian funds raised $18bn. Some metrics now report private equity assets under management (AUM) exceed hedge fund assets AUM. The 2006 Galante Private Equity and Venture Capital Directory states total private equity AUM approaching $1.6trn, of which $424bn is in Europe, compared to total hedge fund AUM of $1.3trn. No wonder then that mainstream fund administration providers have now begun to gather around the private equity money tree. Francesca Carnevale reports.

THE PRIVATE EQUITY

MONEY TREE Photograph kindly supplied by Dreamstime.com, February 2007.

HE DRIVERS OF the upsurge in fund administration services to private equity firms are familiar to mainstream asset owners. They include improved efficiency, a requirement to gain access to better technology without attendant investment costs, a heightened focus on corporate governance and reporting transparency. To this mix must be added breakneck growth and increased complexity in the private equity industry — particularly with the proliferation of hybrid alternative investment vehicles that possess components of both hedge funds and private equity instruments. The overarching trend is clear. In a dynamic and more complex world, it makes sense for private equity firm to outsource in-house administration services to skilled practitioners. In turn, this trend is opening up new opportunities to custodian banks as “Private equity chief financial officers hire one firm to handle all their accounting and operations requirements,” explains Robert Caporale, head of JP Morgan’s Private Equity Fund Services (PEFS).

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16th ANNUAL CONFERENCE ON INTERNATIONAL SECURITIES LENDING 8-11 May 2007 Fairmont Monte Carlo Monaco N The joint U.S./European Securities Lendi ng Conference sponsored the recognized industry associations.

N Issues that influence lending markets in Europe and around the world Proxy Voting Issues Issues of Transparency Emerging Markets Panel Industry Leaders Panel N This is the conference that identifies best market practices and sets global standards in international securities lending.

Come and join your colleagues for these important updates and discussions!

For more information and to register visit RMA's website: http://www.rmahq.org/RMA/SecuritiesLending/ or contact Kim Gordon (215) 446-4021 E-mail: kgordon@rmahq.org

Conference Chairs Jane Hammond Managing Director Deutsche Bank London

Christopher Kunkle Vice President JPMorgan Chase New York

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Added upside for fund administration providers right now is that “the percentage of funds outsourcing in this industry is still relatively small,” notes Joseph Patellaro, senior vice president, at BISYS, the specialist private equity fund administrator, in New York, suggesting there is more growth to be had in a market where aggressive competition for business has yet to bite. What can be won is exemplified by the decision of HM Capital Partners LLC, a specialist private equity and buyout firm formerly known as Hicks, Muse, Tate & First to go to JPMorgan’s PEFS, for a suite of fund administration services. In an agreement signed at the beginning of this year covering the firm’s $10bn-plus investment portfolio, the deal by-passed the industry’s traditional private equity outsourcing services providers.

The agreement is “one of the largest outsourcing agreements in the private equity industry to date,” claims Caporale.“Rather than focusing purely on the partnership administration itself, this is a more strategic outsourcing arrangement. It is the first of its kind, where a leading, top 25 private equity firm has outsourced all of its funds. As private equity firms deliver value, they are now looking to streamline their processes, and we expect to see more strategic partnerships like this one in the future. Under this agreement we will take care of HM’s administrative processes, and also take on their accounting team, rather than displacing them,”he says.

In what is billed as a landmark private equity outsourcing arrangement, HM Capital’s own fund administration team will become a part of JPMorgan Private Equity Fund Services (PEFS) and will continue to support HM Capital as a third party administrator.

JPMorgan’s PEFS will manage and support various processes including fund accounting, investor tracking, waterfall administration, tax support services and financial reporting requirements for HM Capital’s portfolio of funds.

Based in Dallas, HM Capital currently invests and manages a $1.6bn fund and the remaining Hicks, Muse, Tate & Furst Incorporated portfolio of funds. “Our services enable private equity managers to focus on what they do best: building investor wealth,” says Caporale. JP Morgan’s deal “brings awareness to fund shops that outsourcing is a viable option,”agrees Patellaro at BISYS. Launched in November 2005, JPMorgan Private Equity Fund Services provides middle and back office outsourcing of fund administration services such as fund and partnership accounting, tax support and reporting services to private equity firms and limited partners.

The business is targeting medium-sized and large private equity players. Caporale says PEFS now has over $135bn in assets under administration and “The pace of growth is accelerating,”he says.

JPMorgan is among a growing list of custodian providers, including HSBC and Northern Trust, which have established private equity fund administration businesses during the last two years. Northern Trust, for instance, was the first private equity fund administrator to set up shop in Dublin. The Irish capital is already a centre for hedge fund

administration but Northern Trust was among the first to export its private equity capabilities into town to complement its existing alternative fund administration operations in Guernsey and in London. Dublin is a popular domicile for private equity and private equity-related funds because it has the benefits of being an offshore centre while still being within the European Union. Given the drive towards tax harmonisation between the EU countries, Dublin’s popularity can only increase.

Traditionally, fund administration services in the private equity sector have been provided by smaller, boutique firms with either legal (for tax expertise) or accounting backgrounds, or a combination of the two. Offshore expertise is also regarded as de-rigueur in the private equity world. Typical of the genre is Mourant International Finance Administration, which has around $100bn under administration, and which is part of law firm Mourant du Feu & Jeune. Its clients read like a who’s who of leading private equity firms, including CVC Capital Partners, Alpha Group, AXA Private Equity, Terra Firma, Carlyle Group, Investindustrial and Mercapital. In a move to increase its presence in the Cayman Islands, Mourant announced in October last that it will merge with Cayman firm Quin & Hampson. Subject to regulatory approval, joint operations will begin in April with Quin & Hampson re-branding as Mourant.

Another prominent house is the BISYS Private Equity Services group, formerly Dalessio, Millner and Leben (DML), a professional services firm founded in 1986, which began to focus specifically on providing outsourced accounting, financial, administrative and tax services to the private equity industry over 13 years ago. In 2002, DML was acquired by BISYS, a NYSE-listed parent company.“We grew out of a traditional accounting firm and in the late 1990s saw business opportunities in the private equity space. DML was a pioneer,” explains Steve Alecia, senior vice president, at BISYS Private Equity Services. Although it offers offshore capability, BISYS is firmly rooted in the US market. It offers clients a proprietary private equity fund technology platform, called Investment Café, designed for private equity funds with a focus on “straight-through” processing and transaction accuracy, explains Alecia. The system is based on a Microsoft SQL Server integrates investment and partnership information with accounting and allocation information. “Clients have secure, permission-driven 24/7 web access, as well as a full menu of customisable or downloadable reports and a document management warehouse,” says Alecia. He explains that “It hasn’t been a challenge to service the global market from here.”

“The business is largely a people play. It is a high touch, high service product,” notes Patellaro. Lately, BISYS has “increased our presence” in local markets, getting people on the ground and servicing clients in San Francisco and Boston” adds Alecia, who also says that the firm recently opened up an office in Hong Kong to tap into fund administration opportunities in the burgeoning Asian private equity market.

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There are also other developments in the private equity industry which play into the strengths of both traditional and custodian providers. In May last year private equity giant Kohlberg Kravis Roberts & Co. listed KKR Private Equity Investors LP, a $5 billion fund, on the Euronext exchange in Amsterdam. Just over a year earlier New York-based Ripplewood had listed its holding company RHJ International, in Brussels. And KKR itself offered KKR Financial a real estate investment trust (REIT) last year to investors as well. Although still relatively isolated cases, Ripplewood and KKR’s forays into the public market show an increasing propensity for buyout firms to innovate in raising public money for private equity. KKR’s transaction involved the flotation of units in a Guernsey Limited Partnership, which in turn is beginning to generate activity for Guernsey administrators and law firms who are anxious to repeat KKR’s structure.

It also points to the increasing requirement for fund administrators providing multi-jurisdiction presence.

“General partners want a single contact point with their administrator, who then in turn may have to deal with foreign offices,” acknowledges Alecia. “It is a reflection of the increasingly complex structures now involved in the business and the increased demand for services such as US tax compliance for investors.”

In another development, the private equity industry is also coalescing around two distinct groupings: funds that are sub $1bn (regarded as small or medium size players) and the large funds (in excess of $1bn), it is likely that custodians will focus on the larger players. “The large growth in the private equity market and the introduction of funds greater than $10bn, which was unusual even three years ago, means there is a lot of money in that sector right now,” notes JP Morgan’s Caporale, which he acknowledges has determined the bank’s strategy on focusing on private equity firms with at least $10bn in assets under management.

BISYS’s Patellaro concedes that private equity fund administration is in flux, and having to change and accommodate clients as it undergoes change and becomes a global phenomenon. “The United States and the United Kingdom still dominate the market,” explains Patellaro.

“However, other European markets continue to provide more opportunities and of course Asia is seeing substantial activity.”

A limiting factor in Asia is that the private equity industry is still in its infancy and the legal structure backing limited partnership relationships with private equity firms remains rudimentary. It could temporarily slow the paceof pick up for the asset class in the wider region. In the meantime, Guernsey and Jersey as offshore jurisdictions are adapting quickly to requirements of the industry. Both have over the past two years or so introduced special expert fund regimes, enabling the administrator to take responsibility for due diligence on a fund rather than the regulator. A new fund will thus be approved within days rather than weeks as previously.”

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Robert Caporale, head of JP Morgan’s Private Equity Fund Services (PEFS).

JP Morgan’s agreement with HM Capital is “one of the largest outsourcing agreements in the private equity industry to date," claims Caporale.“Rather than focusing purely on the partnership administration itself, this is a more strategic outsourcing arrangement. It is the first of its kind, where a leading, top 25 private equity firm has outsourced all of its funds. As private equity firms deliver value, they are now looking to streamline their processes, and we expect to see more strategic partnerships like this one in the future. Under this agreement we will take care of HM’s administrative processes, and also take on their accounting team, rather than displacing them,” he says. Photograph kindly supplied by JP Morgan, February 2007.

For now, private equity fund administrators are surfing a rising tide: particularly as limited partners eager to cash in on the private equity growth story requires fund administrators to make sure that all parties conform with limited partnership agreements. That means, that “we are in a good spot, industry wise,”concedes Caporale.

While today’s picture in the private equity industry remains rosy, it is likely that custodian fund administration providers will continue to hover near the money tree.

However, the private equity industry is notoriously cyclical: regularly moving between heightened periods of boom and relative market stagnation. While the influx of investment dollars buoys the private equity industry, that same industry is dependent on the opportunity for exits (either through flotation or private sales) and in particular a booming mergers and acquisitions marketplace. Economic conditions and the over use of leverage within the private equity industry coupled with the prospect of an increase in interest rates may lead to difficult markets for the industry. A decrease in growth for the PE industry would have consequent knock-on effects for the administration industry and could be unsettling, especially for less well established administrators. What is certain, is that with the entry of custodian fund administrators into the equation, the private equity industry is set for further change.

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HEDGE FUND ADMINISTRATION

HORSES

for COURSES

Photograph by Andy Novak, supplied by Dreamstime.com, February 2007.

The continued explosive growth within the hedge-fund industry has created a seemingly endless flow of outsourcing business for providers properly equipped to capitalise on the trend. But along with this opportunity comes a unique set of demands, requiring that providers stay in step—or be trampled underfoot. Dave Simons reports.

UTSOURCING HAS BENEFITED from a climate marked by intense regulatory pressure, rising operational costs and an increasingly complex menu of alternative investments. No surprise then that an efficient outsourcing platform has become a highly valued commodity for asset managers requiring a solid base of support that will allow them to focus on their core competencies.“Some of the larger managers in the United States have found themselves with very substantial operations, to the point where they are reassessing the size of their business in order to ascertain whether it makes sense to engage in outsourcing,”notes David Aldrich, head of securities industry banking at the Bank of New York (BNY) in London.

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However, as Rob Mancuso, senior vice president of Boston-based Investors Bank & Trust (now bought by State Street) suggests, not everyone is cut out for this kind of work. “This is really complex stuff,” says Mancuso, “you have to hire and train the right calibre of people, you have got to have the right technology—it is very expensive and the need is evolving constantly. There is nothing that is mature and stable. It seems like every other week there is some kind of new of derivative or asset that needs to be tracked or accounted for differently from the previous month. While technology helps, I think the most critical factor is having the right kind of people with the proper expertise and knowledge to make it all work. And it is not like there is an unlimited supply of that either.”

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In addition to handling standard back-office administrative duties—from fund accounting to investor and corporate-secretarial services—the rapidly evolving investment landscape has made it necessary for providers to ratchet up their level of expertise in a number of areas.

Recent research from the Bank of New York suggests that institutional investments could account for roughly twothirds of total net flows into hedge funds over the next couple of years. To ensure they have the proper mechanisms in place, managers are increasingly looking to providers to help them meet the challenge. The movement away from a simplistic monthly-only net asset value (NAV) service towards a daily PNL process, with the goal of mitigating computation errors, is one such example; the processing and reporting of derivatives is yet another major focal point.

With all the complexities involved and the technology expense required to deal with these issues, managers are finding it more attractive to simply outsource in order to meet their investment objectives. “The arguments for outsourcing no longer revolve primarily around cost management,” says Michael Taylor, director of Outsourcing at RBC Dexia Investor Services.“Today, asset managers are more concerned about factors such as complexity, regulatory compliance, time to market, global distribution, client retention, and, of course, investment performance.” Such capabilities, however, require continual and substantial investment capital, and those with multiple lines of business may not have the wherewithal to keep up.

Outsourcing transformation A recent report from research-and-advisory firm Celent LLC entitled Trends in Hedge Fund Administration noted a “major transformation” of the fund-servicing business, with provider duties moving beyond basic fund administration and into the realm of full business-process outsourcing (BPO). The report is good news for the likes of Investors Bank & Trust, currently ranked fourth on the hedge-fund administration Top 10 list with over $200bn in US-based alternative investment assets.

“Certainly in this sector, business has been very good, and I don’t think we’ve hit the crest just yet,” says IBT’s Mancuso. “I think there are a lot of hedge-fund and private-equity managers who are still doing a great deal of their work in-house, and as they make the move to outsource, we believe the pie will expand even further.

There are a lot of administrators out there right now, ranging from small boutique companies to larger providers like us, but even so demand will continue to be very strong.”

Even as the competition continues to heat up, Mancuso believes that fees will continue to hold steady for these types of complex services, particularly as managers come to understand the intrinsic value of outsourcing. “A lot of hedge-fund and private-equity managers have been exposed to the kind of pain that poor administration can

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Rob Mancuso, senior vice president of Boston-based Investors Bank & Trust suggests, not everyone is cut out for this kind of work.“This is really complex stuff,” says Mancuso,“you have to hire and train the right calibre of people, you have got to have the right technology—it is very expensive and the need is evolving constantly. There is nothing that is mature and stable. It seems like every other week there is some kind of new of derivative or asset that needs to be tracked or accounted for differently from the previous month. While technology helps, I think the most critical factor is having the right kind of people with the proper expertise and knowledge to make it all work. And it is not like there is an unlimited supply of that either.” Photograph kindly supplied by Investors Bank & Trust, February 2007.

cause,” says Mancuso. “As a result, we’ve further refined our marketing focus to try and partner with the types of firms that can really appreciate the kind of value that we can provide, and therefore are willing to pay our fees. We find that we’re spending less time negotiating fees in favor of spending time with the client discussing potential problem areas and what we can do to minimise the risk.

When you can demonstrate to the firm the value of risk management first-hand, the fee game just doesn’t enter into the equation.”

In fact, says Mancuso, the market has already begun to move in that direction.“Naturally there will always be those folks who will be out there searching for the best deal, but

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more and more in this space we’re finding people who would rather put a premium on quality.” Building hedge fund, derivative and alternative-investment capabilities directly into the provider’s core systems and platforms fosters a more efficient outsourcing programme, notes Brian Coughlin, managing director, US and European operations for Investors Bank & Trust. “Competitors who are used to working on a monthly basis might not be able to get things in order until the 20th or 25th day. We don’t think you can run a risk-averse type of product in that kind of environment. Leveraging our engine where we can take our daily work and copy that model to the alternative space has really helped us streamline the entire process.”

Those who have gone out and purchased a niche provider have in effect just “bolted a good-looking garage onto their big mansion,” says Coughlin. “It just isn’t fully integrated. While they may in fact have a unique boutique, the two may not have anything to do with one another— you just don’t have that daily transactional flow that you need in this type of environment.”

enabled us to add value and maintain our position in this field.” With the growth in outsourcing comes a marked increase in best practices, adds West, and from a settlement standpoint, providers must be able to move towards a more consistent level of message formatting particularly with regard to more complex instruments, as well as best practice around the reporting of such instruments. Says West,“You have got to be able to get it right if you’re going to survive in this business.”

RBC Dexia’s Taylor concurs. “Competition among asset managers is more fierce than ever and the cost of staying in the business is rising each year. We are constantly being challenged to do more and to develop specialised asset servicing capabilities that can accommodate complexity and deliver global consistency.”

Provider as partner

For asset managers, establishing a solid partnership with a compatible service provider is paramount, says Alan Greene, executive vice president of State Street Corporation in Boston. “Hedge fund and managed accounts are relationship intensive businesses and service Meeting the challenge As clients increasingly see the importance of providers need to be flexible enough to provide solutions concentrating on their core competencies, global that allow the client to focus on their own client custodians have in turn been well positioned to benefit relationships,” notes Greene. “The more complex it from the rapidly developing outsourcing trend.“There are becomes to do business from an operational, compliance and reporting standpoint, a tremendous number of the more those benefits people looking out for will assert themselves.” service providers, and we Hedge fund and managed As the industry want to be a major player in accounts are relationship intensive continues to move away that space,” says Camie from the relatively West, vice president and businesses and service providers inflexible fixed package of relationship manager at need to be flexible enough to services commonly Northern Trust in Chicago. provide solutions that allow the associated with middle“A lot of these activities client to focus on their own client office outsourcing, a more have been integral to our relationships,” notes Greene. menu-driven outsourcing ongoing custody operations, model is fast emerging, and that translates very well says Aldrich, and is into this field. If you look at the number of funds and the wealth of assets that we’re particularly prevalent in the traditional asset-manager servicing at this time, I think we’re in a great position to space. “If you’re an asset manager, you basically decide what it is you want to outsource, and then you find a take advantage of the trend.”

When it comes to customising outsourcing services, provider who will give you what you are looking for and West underscores the importance of having a global are only going to charge you for those services. What we reach,“regardless of whether the focus is on hedge-fund find is that rather than people coming to us and saying, administration or mid- or back-office outsourcing,” says ‘why don’t you do what these little boutique guys do and West.“We believe that it is necessary to have a specialist’s offer the same suite of services,’they come to us with some look and feel, backed by the kind of institutional strength specific needs, which generally varies from customer to that we can bring to the table—it gives you a level of customer, and ask us to provide them with this particular discipline and control around your core processes. And suite of services. So we are basically providing this because we’re working in many different locations, we customised array of services for each client, which is quite can provide a global processing platform with local different from going out into the market and saying, ‘Yes, expertise around it. We’ve established a consistent we offer middle- and back-office services to all hedge platform and client-delivery database for the core service funds.’ We don’t want to be in that space—we’d rather model, as well as web-space delivery tools for services offer a more spoke-oriented kind of service to a discreet such as white-label reporting and white-label portal number of large and complex fund managers and their access for the underlying client. These extra services have suite of alternative funds.”

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The emerging exchange superleague MID-FEBRUARY statement by the Futures Industry Association (FIA), the national trade organisation for the futures industry, electrified the derivatives market. The statement notes that although the proposed merger of the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT)—the two largest futures exchanges in the United States—could have short-term cost savings and operational efficiencies, it will concentrate significant market power in the new CME Group, substantially lessening competition among US futures exchanges, and raise even higher the barriers to entry for new competitors. “FIA understands that various market structure alternatives could potentially overcome the anti-competitive effects of the merger and is considering internally the efficacy of those alternatives as well as their impact on the long-term competitive landscape of the US futures markets” it stated. The move comes at a sensitive time for the CME/CBOT tie-up, as the exchanges are in the second request phase to the Department of Justice before it receives final approval.

Terry Duffy, chairman of the CME remains undismayed however. The FIA talks of a high level of US market share

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DERIVATIVE EXCHANGE

Who can stay abreast of the rapid and sweeping changes now blowing through the global exchanges industry? With few exceptions, most exchanges—mainstream and derivatives exchanges—are fired by a hot run of record business volumes. How long can this demi-Eden last? Moreover, now that the arguments for the benefits of demutualisation have been well and won, what is next for the exchange landscape as both mainstream and derivatives exchanges jockey for domestic and international dominance in an increasingly complex landscape?

Francesca Carnevale reports on some of the key trends to watch in 2007 and beyond.

(the FIA put the figure at 85%), notes Duffy, yet misses the point. He thinks that CME Group’s ultimate market share should not be measured by US parameters. Instead, he ventures, the measure should focus on global, not domestic market share and here lies the rub. The exchange game (be in mainstream securities or derivatives) has moved beyond the national sphere and nowadays is defined entirely by international boundaries.

FIA caution aside, a combined CME/CBOT entity makes sense. The product lines of the CME and CBOT are almost entirely complementary and the merging of back-office systems should be a breeze, as the CME already clears the CBOT’s trades.

A merged CME/CBOT will have immediate effect on the global market, most likely defining the growth pace of the short term global market in futures. Additionally, with contracts on everything from soybean meal to Eurodollars, their dominance of the US futures markets (highlighted by the FIA) is a foregone conclusion.

Looking longer term, the question is raised whether the CME Group will confine itself to futures, or eventually move into options—perhaps even eventually tying up with

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the derivatives world and has provided an ideal counter to accusations from the options industry that advances in the electronic trading of futures products lags far behind those in the options industry.

Once the merger gets underway, the CBOT business, transaction on its ECBOT system will be moved to the superior Globex platform. It could have far reaching consequences for the market, as two of the world’s biggest exchanges move to a single platform. “It is entirely a technology story,” acknowledges Duffy and the opportunities then, he says, are boundless. “The big think is to reduce cost by consolidating platforms,” acknowledges CBOE chairman and chief executive officer, William J Brodsky, who was also recently elected as vice chairman of the World Federation of Exchanges (WFE) general assembly, the first leader of a derivatives exchange to hold this position.

Aside from the CME/CBOT merger, the other pairing to jump out of 2006 was the New York Stock Exchange (NYSE) and Euronext.

David Krell, president and chief executive, International Securities Exchange.

Much was made of the synergies and Photograph kindly supplied by the ISE, February 2007.

IT savings during the joint press conference in Paris in June last year the Chicago Board Options Exchange (CBOE) or, when the merger was announced. The combination, alternately whether the CME Group will accrete assets NYSE Euronext, with a market capitalisation of around outside the US. The numerous regulatory and logistical €15bn, was sold to the press corp in attendance as hurdles involved in a cross-industry merger or acquisition redefining on a global basis, trading of cash equities and have traditionally proven insurmountable; but with the derivatives securities. Naturally, there was also talk of the CME, never say never. Both the CME and the CBOT have “significant” benefits that will accrue to shareholders, so far avoided directly taking on options exchanges, in the issuers, traders and the world at large. Like the CME and area of equity options, such as the CBOE and the CBOT merger, key to the success of the merger will be the International Securities Exchange (ISE). Instead each has migration of the combined group’s three cash trading leveraged their dominance of the S&P 500 and Dow systems and three derivatives trading systems to a single futures products and thereby established a growing market global cash and a single global derivatives platform over share in the specialised and lucrative index options market. three-years. It will also involve the consolidation of six It was a natural development. With so much of the growth data centres in the US and four in Europe into four in the options markets coming from the institutional sector, globally linked operations.

What is perhaps most interesting about the fallout of this the index options market has become a very desirable niche. It is also a market segment desperately in need of particular merger is that it might just be a harbinger of a new sources of competition, and some would say, an easing broader trend whereby US exchanges will increasingly of the restrictive licensing agreements that abound in the move towards a multi-asset class business model. In Europe the model is common and means exchanges are index world.

CME’s Globex platform has been pivotal in the growth able to offer side-by-side trading of cash, derivatives and of the index options market. It has been the launch pad for fixed-income instruments under one roof, as in the Italian a number of successful products including the E-mini S&P and Spanish bourses.“The NYSE has made it clear that it 500 futures contract. Not only that, the platform has paved wants to drive activity in the derivatives space,”says CBOT the way for the adoption of electronic trading throughout chief executive Bernie Dan. “The cross-Atlantic element

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and desire to get into the futures and options space is there for all to see. We also see the ICE/NYBOT merger in the same vein, although that is not a cross-border merger.”

David Krell, president and chief executive at the ISE underscores the point. “More mainstream exchanges are interested in derivatives for the simple reason that the business has grown much faster than non-derivatives business.” He also points to a trend moving in the other direction, particularly in the United States. Four of the six US major options exchanges are already either part of or affiliated with a stock exchange. These are the Boston (BOX), Philadelphia (PHLX) and American (AMEX) stock exchanges, as well as NYSE Arca Options. A renewed focus on equities is hardly surprising, the exchanges have already revamped their equity trading systems to offer increased functionality.

Krell himself jumped on this bandwagon last year, launching the ISE Stock Exchange in September 2006. The CBOE has also moved into equities and will launch its own cash equity exchange in March. Although their strategies might look similar, the practical application of their plans is quite different. CBOE’s Stock Exchange complements its existing Hybrid Trading System, which combines openoutcry execution with electronic trading. It has also established Designated Primary Market-Makers (DPMs) on its trading floor to facilitate order flow and will offer 2500 listings at launch. The ISE meantime opted for a streamlined approach, launching with just 10 stocks, although over 5,600 securities are now traded on the platform. ISE Stock Exchange was created using proprietary technology. The exchange’s first product is called MidPoint Match, an anonymous matching system.

“It fills a need in the marketplace for continuous price improvement,”says Krell. MidPoint Match was integrated with a fully displayed stock market in December 2006, providing traders with enhanced functionality through access to both non-displayed and displayed liquidity pools.

The CBOE and ISE, meanwhile, insist they are sitting pretty and have a future of powerful consolation before them. The CBOE maintains a monopoly on the popular S&P and Dow indexes. The situation has frustrated exchanges, such as the ISE, which recently launched a federal lawsuit to challenge the validity of restrictive options licensing agreements. Market watchers now look with interest at the possible outcomes of that particular tussle.

Tighter market linkages, the advent of smart order routing and subsequent development of algorithmic trading and direct market access have played their role as drivers of exchange consolidation. Both mainstream and derivatives exchanges have had to respond to the increased velocity of trading that accompanied these developments.

Those exchanges that are either too small or which lacked the technical clout or will to keep up these trends have been forced to consider the benefits of merging with stronger players with greater global reach. Additionally, exchanges that took the demutualisation route and have

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become public companies have also been subject to shareholder pressures to see stock price growth. According to a recent report by Accenture, released at the end of 2006, there has been an eightfold increase in stock market capitalisation on publicly traded exchanges: moving up from a relatively lowly 8% in 2001 to 63% last year.

From a regulatory standpoint, the Markets in Financial Instruments Directive (MiFID) in Europe and Reg NMS in the US have also played to the consolidation gallery. Both MiFID and Reg NMS deal with best execution, specifying that orders are sent to markets offering the best price, whether that is available on an exchange, alternative trading system or in an investment firm that matches trades.“In the face of these new trends, exchanges will need to devise aggressive new product and service strategies, leveraging advanced technologies in order to retain customers and compete,” says Krell. “For both retail and institutional investors, these changes will mean faster trade executions, tighter spreads and more choices of trading venues,”wrote

Bernard Dan, CBOT president and CEO. Photograph kindly supplied by the CBOT, February 2007.

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American Stock Exchange Bill Cline, global managing and is in the process of director of Accenture’s creating even more Capital Markets practice in alliances. It is also linked the Accenture report. “But to its ASEAN neighbours. while the prospective The importance of the benefits for investors are linkages should not be clear, the best way forward underestimated however, for traditional exchanges as they bring in offshore will be elusive and require order flow and allow local differentiated strategies brokers easier access to and new approaches to foreign markets. Even so, business growth.” the CBOE’s Brodsky Accenture’s report remains upbeat on Asia, highlights the fact that having “signed more than 96% of the US memoranda of debt and 83% of the global understanding with five derivatives currently trade exchanges in China and over the counter, and that you cannot ignore the competitive pressures will potential of Taiwan, rapidly motivate Singapore and India.” exchanges to pursue Brodsky points to the fact growth within untapped that the CBOE website debt and derivatives also has a Mandarin markets. CBOT chief language version, “the executive Bernie Dan, clearest indication of the “When you look at the level of our interest in the OTC market it is at least opportunities for the five times that of the options business in Asia.” exchange traded market The current round of and it will not go away. exchange consolidation is That and the cash market.

Bill Brodsky, chairman and chief executive of the Chicago Board barely underway then and That is where we define Options Exchange (CBOE) Photograph kindly supplied by the CBOE. most market practitioners our competitive focus.”

February 2007. agree that ultimately a CBOE’s Brodsky takes a different tack. “We look at the OTC market as super league of global exchanges, where the largest complementary, rather than competition. We say that our companies will ultimately list and create deep pools of market is more liquid and transparent that therefore its liquidity is the ultimate outcome. In an equal and opposite reaction, it is likely that a ream of regional and advantages are self-evident,”he says.

China and India must also be factored into the long term local exchange operators will also consolidate their equation and in the medium term, the focus of exchange position, either servicing a specific market (catering for market consolidation will eventually shift to Asia—India, small and medium-sized enterprises or Islamic issues) or for example, currently has more than 20 exchanges, which geographic area (the Middle East or the Nordic Zone). eventually will be whittled down to three or four trading That, in turn, will be matched against an increasingly hubs. Germany’s Deutsche Börse has already been complex OTC market. Broker-sponsored "dark pools" of scouting the market and recently agreed to buy a 5% stake liquidity exploded in 2006 and these “dark exchange” in the Bombay Stock Exchange (BSE). However, the offerings now vie in contention with independent growing super-league exchanges are unlikely in the short providers such as ITG, Liquidnet, Pipeline, and NYFIX term to make any significant purchases in the Asia-Pacific Millennium. Exchanges might, however, prove more region, as the exchanges in many Asian countries are effective challengers to current dark pool providers over regarded as strategic to the national interest and are the longer term, using scale and price as weapons. The thereby often protected against foreign ownership. What key says ISE’s Krell, whatever the size of the operation, is has emerged instead is a raft of cooperative agreements the ability to differentiate as a business.“It is what every between national exchanges in areas that are not a direct business line has to do. Everyone has to find their niche competitive threat, as well as some consolidation within and audience. We think we should stay focused on what we do best. That’s why we launched the ISE Stock domestic markets.

The Singapore Exchange (SGX) for example, has Exchange. What we say to everyone now is: Help us alliances with both the Australian Stock Exchange and the expand the pie.”

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OUR RECENT TRANSACTIONS likely herald a new dawn for American Depositary Receipts (ADRs).

JPMorgan Worldwide Securities Services (WSS) became successor depositary bank for the common and preferred share American Depositary Receipt (ADR) programmes for Petroleo Brasileiro SA (Petrobras) as 2006 opened. The deal is significant, for many reasons. Petrobras’ programme reinforced Brazil as the dominant market in Latin America, representing almost two-thirds of DR extant from the region. Second, JPMorgan had wrested the right to manage Petrobras’ ADR programme from Citigroup, which had been Petrobras’ depositary bank since the launch of its ADRs back in February 2001. Third, the deal propelled JPMorgan into a leading role as a depositary bank in Latin America—maintaining more than 65% of Brazil’s ADR market as measured by ADRs held by institutional investors (based on the most recent Form 13F filings with the SEC).

That market share was significantly bolstered by Petrobras, Brazil’s largest integrated energy firm, with a market capitalisation of some $108bn. More significantly, perhaps, after a period of paucity in which ADRs had largely taken a back seat to Global Depositary Receipt (GDR) filings in London and Luxembourg, the renewal of Petrobras’ DR programme finally hinted at something of resurgence in the fortunes of the ADR market.

As if to underline that fact, JPMorgan soon followed that deal with another. In late January, the bank announced it had been appointed as depositary bank for the Intesa Sanpaolo’s ADR programme, which replaced Sanpaolo’s previous ADR programme, following its merger with Banca Intesa on January 1st. JPMorgan had managed Sanpaolo’s ADR programme for some eight years, which were traded on the US OTC market. The two deals were a major fillip for JP Morgan, which manages more than 70 blue-chip ADR programmes in Europe, including significant Italian ADR programmes. According to James Keane, head of ADRs in EMEA, JPMorgan WSS, Intesa Sanpaolo, had established a Level I ADR programme“to help facilitate the share exchange”.

In similar vein, The Bank of New York (BNY), which dominates the global DR market, won the role of depositary bank for Grupo Aeroportuario del Centro Norte’s (OMA’s) new ADR programme in January. The ADRs trade on both the NASDAQ National Market and the Mexican Stock Exchange. In the same month, Bank of New York was also selected by Solarfun Power Holdings Co., Ltd. as the depositary bank for its Level III American depositary receipt (ADR) programme. Christopher Sturdy,

F

DRs IN DEMAND Depositary Receipts (DRs) are on a new high.

Trading volumes are up 22% to 57bn shares, while trading values increased 58% in 2006 to just under $1.9bn in 2006. A new study by the Bank of New York says that total investment in American and global depositary receipts (GDRs) rose by 18+% over the year, exceeding $1.3trn. DR issuance continues to grow, especially in countries such as Brazil, China, India and Russia. As US domestic investors continue to cast their nets abroad—and with some easing of stifling SOX regulations—DR mavens think 2007 could be even better. Dave Simons reports.

FTSE GLOBAL MARKETS • MARCH/APRIL 2007

DEPOSITARY RECEIPTS

Brazil’s oil company Petrobras President Jose Sergio Gabrielli talks during a press conference in Rio de Janeiro, Tuesday, January 30th, 2007. Brazil’s government-run oil firm Petrobras said it has begun talks with India’s Oil & Natural Gas Corp. on a possible swap of oil and gas exploration areas. Earlier in the month, Petrobras had appointed JPMorgan as its depositary bank for its common and preferred share ADR programmes. Photograph by Ricardo Moraes, supplied by Associated Press/EMPICs, February 2007.

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DEPOSITARY RECEIPTS

Christopher Sturdy, executive vice president and head of The Bank of New York’s Depositary Receipt Division explains that the bank manages,“almost 70% of all ADR programmes from China”, and is the depositary for more than 1,250 American and global depositary receipt programmes, an approximately 64% market share.

Photograph kindly supplied by Bank of New York, February 2007.

executive vice president and head of BNY’s DR division explains that the bank manages “almost 70% of all ADR programmes from China,” and is the depositary for more than 1,250 American and global depositary receipt programmes, an approximate 64% market share.

It was only a matter of time that ADRs made a comeback. DRs—bank-issued instruments that represent a foreign company’s shares but traded on exchanges outside of the issuer’s native country—have been among the hottest tickets on the global marketplace of late. DR liquidity is approaching stratospheric levels and valuations now exceed highs recorded at the start of the decade. With emerging markets setting the pace, issuers completed 137 DR offerings totaling $44.5bn. US investments in non-US equities reached $3.5trn (as of September 30th 2006), an increase of 25% year over year. “The depositary receipt continues to be the vehicle of choice for issuers to efficiently access global capital markets and for investors to gain global equity exposure,”says Claudine Cardillo-Rivot, global head of JPMorgan’s depositary receipts business.

The combination of capital-hungry issuers and investors seeking easily accessible global platforms has fostered the growth DR programmes. Andy Nybo, senior consultant for the Westborough, Massachusetts-based TABB Group and author of the market study Global Exchanges and Depositary Receipts: Can They Co-Exist? says, “It is even more critical since some investors, due to investment covenants or national regulatory cycles, can only invest in their native currencies and must buy DRs to gain international exposure,”he adds. As DR investment volume continues to rise, the added liquidity will in turn promote increased activity as DR programmes become even more accessible and cost-effective. So powerful is the trend, in fact, that not

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even a move towards global-exchange consolidation will stem the tide, adds Nybo.

From his vantage point in midtown Manhattan, BNY’s Sturdy, can scarcely hide his delight. “All this coming at a time when the Dow is reaching all-time highs,”he notes.“It is the realisation that, although the US market has been doing great [sic], there are markets around the world that are doing even better. … We are also seeing investors who are already in and are looking for ways to make more decisions within the emerging markets, and that is driving volume as well. A comfort factor has begun to emerge, which is significant—because once you have that piece of mind, it paves the way for an increasingly larger portion of the portfolio into non-US stocks.”

For those investors with a hankering for global diversification, DRs are a vehicle of choice. Moreover, with good reason. In 2006, BNY’s ADR Composite Index scored a total return of 27.4%, or twice the year to date return of the Dow. “Naturally we will see some bumps in the road for certain markets, which always happens,” says Sturdy, “but the interesting thing is that people seem to have bought into the notion that investing through depositary receipts allows you to be nimble. Therefore, there is a hiccup in Venezuela—that is fine, you can move on.

Alternatively, the realisation that Taiwan has reached its peak, and now you want to be in India. I think you are seeing this kind of rotation, which is really helping this market immeasurably.”

New SOX While there is no mistaking the DR boom, its epicentre remains a good 3500 miles from Sturdy’s New York offices.

During 2006, the US market for depositary receipts continued to be hampered by restrictive Sarbanes-Oxley (SOX) regulatory requirements, resulting in the lion’s share of issuer activity taking place on the London and Luxembourg stock exchanges in the form of global depositary receipts (GDRs).

Last year, GDRs outpaced their US counterparts by a nearly three to one margin; only 21 new foreign-company listings appeared on the US exchange, eight fewer than a year earlier and a far cry from the pre-SOX days when over 100 DRs made their home in New York.

However, recent efforts by the US Securities and Exchange Commission (SEC), which included new guidance related to SOX section 404 compliance as well as proposed rule revisions for de-registration of non-US issuers, may help address some of the concerns that have long frustrated foreign issuers. Even with some liberalisation of SOX in place, Sturdy still does not see a torrent of business returning to the domestic market.

“Those who have been on the brink of coming over will probably be the first to make the move, which has the potential to help stop the bleeding we’ve seen over the past several years,” says Sturdy.“So while I believe we’ll see an upturn of sorts, I don’t expect it to be vertical.”JP Morgan’s Keane meanwhile believes that any re-working of regulatory guidelines under SOX will be volume-based,

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particularly with regard to equity programmes.“It is likely that if you do not have a particularly liquid ADR programme it is going to be easier to de-register from the SEC,”he says.

Despite the current global imbalance, the recent GDR trend included a spate of emerging-market listings on US exchanges, and Sturdy expects to see more of the same in the current year.“These are companies that are coming out of the private-equity space and want their valuations to be set over here,”says Sturdy. Moreover, by submitting to SOX 404, such companies can gain a legitimacy that they cannot get elsewhere, he says.“Which is the main reason why were seeing fewer EU listings, where legitimacy is not an issue.

And those are the ones that I hope we will start seeing coming over in the near future.”

In Asia, the GDR was dominant, particularly in Korea, Taiwan and India. Last year also saw the rise of new James Keane, head of ADRs in EMEA, JPMorganWSS. markets, such as Pakistan and Vietnam. The principal forces “In terms of new issuance, we are seeing a very large pipeline from driving new issuance in these markets were privatisation, the emerging markets, and in particular Russia, including a number coupled with an increasing appetite for emerging market of large deals over the next couple of months involving the real-estate, exposures. In Europe, DR capital raisings were dominated consumer and financial-services sectors, in addition to the oil and gas

by Russian issuers, with Russian oil and gas giant Rosneft sector,” notes Keane. “And there will also be a very buoyant pipeline Oil Company JSC raising approximately $6.4bn in DR out of China through the next several quarters as well.” form, the largest-ever offering of its kind.

Photograph kindly supplied by JP Morgan, February 2007.

Another 12 Russian issuers raised capital in DR form, the dominant sectors being metals & mining, and oil and gas, Technologies by Paris-based Alcatel SA via a $13.4bn share adds JP Morgan’s Keane. At JPMorgan, trading volumes swap bears watching, notes Sturdy. “Here was one of the advanced 22% during 2006, a record high, largely on the world’s largest-ever cross-border M&A transactions, done strength of new issuances out of Russia and Asia. 100% in ADR form. And all made possible because Alcatel Additionally, investment in existing depositary programmes had an NYSE-listed ADR. That alone speaks volumes for the increased, explains Keane, as US investors continued to importance of having this kind of presence in this market.”

A fundamental driver of liquidity for any issuer is visibility become less biased towards the domestic markets and found it advantageous to access the emerging markets via within the target market, says Keane, and to that end, depositary receipts. That trend should continue well into the JPMorgan encourages its DR clients to develop a sound current year, asserts Keane.“In terms of new issuance, we are marketing programme overseas, including having seeing a very large pipeline from the emerging markets, and representatives respond to investor interest in a timely and in particular Russia, including a number of large deals over consistent manner. “Additionally, technology is important, the next couple of months involving the real-estate, and products such as our online system ADR MAX, which consumer and financial-services sectors, in addition to the oil we launched several years ago, helps promote liquidity by and gas sector,” notes Keane.“And there will also be a very allowing efficient, low-cost cross trading, which in turn stimulates activity within buoyant pipeline out of London benefits from Russian GDRs the markets,”he adds.

China through the next FTSE Russia IOB Index 3-Year Performance (USD) Today the US, which several quarters as well.”

400 once accounted for nearly In Latin America, 350 three-fourths of the meantime, renewed 300 world’s total market interest in Argentina was 250 capitalisation, now stands also evident, as 2006 200 at just 40%, the result of a brought about the first 150 pronounced shift towards internationally placed IPOs 100 the emerging countries of (initial public offering) 50 Brazil, Russia, India, and from the country since 0 China. While international 2001. Last year also equities still represent only brought innovations of a a relatively small portion of different kind to the DR *based on backcast data the average domestic market.

The recent *The FTSE Russia IOB Index represents the performance of the 10 biggest Russian portfolio, the trend is purchase of telephonecompanies by full market capitalisation trading on the London Stock Exchange’s Source: FTSE Group and Datastream, data as at 31 January 2007. unmistakable,”says Sturdy. equipment provider Lucent

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SECTOR REPORT: TOBACCO

ASIA LIGHTS UP

One of the most profitable legal businesses in the world, the tobacco industry is a major engine of globalisation, economic growth, government revenue raising and of capital transfers. Recently it has seen huge mergers and consolidation, concentrating ownership in a handful of giant multinationals.

However, because of the opprobrium attached to tobacco and its health risks, there is little attention paid to an industry that nowadays actually prefers to operate under the radar. Ian Williams looks at the growing influence of tobacco in Asia.

Sometimes, such pressures to open up markets can awake a sleeping giant.

Overseas free trade pressure fuelled by companies eager to break into the Japanese market, where the salarymen smoke with Samurai fervour, forced Tokyo to partly privatise its tobacco monopoly and to open up its markets. As a result Japan is now Philip Morris Internationalâ&#x20AC;&#x2122;s most profitable sales venue with 15% of the market.

Photograph provided by Dreamstime.com, February 2007.

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APAN TOBACCO’S IMPENDING $14.7bn takeover bid for the British giant Gallaher gives some insight into what is at stake in a market that is paradoxically contriving to become more regulated and more globalised at the same time. The purchase was the largest ever by a Japanese company and the largest ever tobacco industry takeover. It may soon be rivalled by another, as Imperial Tobacco, the British giant is reported to be considering a $13bn offer for Altadis, the Franco-Spanish company that makes the iconic Gauloise brand.

Up for grabs are what one might call—forgive the puns—the fag ends or stubs of empire. TheseEuropean companies have developed worldwide brand identities in the developing world. Those emerging markets are now a big draw. That is because in industrialised countries smoker numbers are shrinking, having come under concerted social and governmental pressures. Inevitably, tobacco firms are using their still large profits to expand abroad into emerging markets.

Cigarettes are sometimes referred to fast moving consumer goods (FMCG’s) and they challenge marketwatchers on many levels. Few other legal businesses sell products that cause clinical addiction in their customers, while incidentally shortening the lives of many of them.

That guaranteed demand gives high price resilience: not only for the manufacturers but also for many governments that increase the price of cigarettes confident that while they may constrict the breathing of the Golden Goose, it will continue to lay golden eggs a-plenty for both the makers and the national exchequer. Equally, These very same economic considerations also have an impact on the global community, which increasingly shows are such that the global community shows distinct signs of schizophrenia over it. On the one hand, the World Health Organization presses governments to adhere to the Framework Convention on Tobacco Control (FCTC), designed to dissuade people from smoking, and on the other, in the name of free trade, the WTO has been pushing them to open up their tobacco markets to competition from foreign companies.

The American giant Altria epitomises the trend. It has maintained immense profitability in its shrinking domestic markets by raising prices since it successfully discerned that its customers have high tolerance for equally high prices.

Until the 1990s, when it was known as Philip Morris, it used its tobacco profits to buy alternative assets, such as food and drink, in an attempt to lose the tobacco discount on its stock price. That discount was not the result of mere prissy moral aversions on the part of the investors—the threat of litigation from afflicted American smokers has severely affected tobacco company valuations. The diversification strategy also failed because markets promptly discounted the new valuations of the newly acquired food assets since they were regarded as being equally at risk from litigation once they were linked to tobacco. Not even generous dividend and share buybacks could bridge that tobacco discount gap.

J

FTSE GLOBAL MARKETS • MARCH/APRIL 2007

Japan Tobacco Inc (JT), president and chief executive Hiroshi Kimura speaks at a news conference in Tokyo Friday, December 15th 2006.

Kimura announced that JT, the world’s third-largest tobacco company, would acquire Britain’s Gallaher Group PLC for Yen2.2trn (about $19.1bn) in reportedly the largest-ever corporate acquisition by a Japanese company. Photograph by Shizuo Kambayashi, supplied by Associated Press/EMPICs, February 2007.

Philip Morris’s strategy was, for the industry, revolutionary. The company changed its name to Altria, which was the holding company that owned Kraft, Philip Morris USA and Philip Morris International and shortly sold its Miller brewing subsidiary to South African Breweries. With other US companies, it agreed that smoking was bad, without prejudice, and reached a settlement with most of the state governments, which involved handing over a whopping $206bn.

The money for that payout came from a hefty price hike.

It actually meant that more people stopped smoking—but the customers that continued to smoke and buy cigarettes more than compensated for the one’s that managed to kick the habit. Altria’s profits continued to rise, but now it had a devoted political constituency in the US to help it stave off attempts to bankrupt it. Officially, the money was to be used for anti-smoking programmes—but, in fact, many state governments treated the windfall as discretionary spending money.

Altria is now hoping to hive off its food interests at a considerable profit as it recoups the tobacco discount.

However, as for the European and Japanese companies, the US domestic tobacco market is a holding operation, albeit

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a highly profitable one. The domestic markets are simply bases for expansion overseas, where demand for cigarettes is still growing.

A side effect of the FCTC has been to raise the barriers against entry of new brands by restricting the advertising and promotions that they would need to break into established markets. One hopes that this was not designed to be so, but at the very least, it is an aspect of the Convention that the tobacco majors can take comfort from and invariably it lessened their resistance to it. Certainly, Philip Morris is such a powerful world brand that its own growth or ‘brand momentum’will probably expand its sales in new markets. However, for that growth to be truly significant, like other global companies, mergers and acquisitions must be the major means of expansion.

Tobacco production and sales are so considerable, economically and fiscally, that governments, particularly, but by no means exclusively, in the Third World, are ambivalent in their attitudes to its regulation. As is the case for smokers themselves, the health costs are only billable in the relatively far future, while there is immediate satisfaction in the quick fix that cigarettes can give a smoker or a national exchequer. This approach is typified

by Fahmi Idris, the Indonesian industry minister who on the 12th of January this year confessed to the press that: “We are reluctant to sign the FCTC because the cigarette industry is able to boost the agriculture sector and paper industry … The industry’s multiplier effect is great as it absorbs a huge workforce and contributes a great share of state revenue.” He added, “The FCTC policy is conflicting with the government’s policy of pro-poor, pro-job and probusiness.” In fact, tobacco in Indonesia supports about 7m people and accounts for a tenth of its tax revenue. Some 70m Indonesian smokers puffed through 220bn kretek (clove-flavoured cigarettes) last year. Indonesia’s $8bn tobacco industry, mostly based on a very high rate of smoking krekets, has also attracted attention from internationals like Philip Morris. In 2005, the company bought Sampoerna, Indonesia’s third largest tobacco company for $5.3bn.

Sometimes, such pressures to open up markets can awake a sleeping giant. Overseas free trade pressure fuelled by companies eager to break into the Japanese market, where the salarymen smoke with Samurai fervour, forced Tokyo to partly privatise its tobacco monopoly and to open up its markets. As a result, Japan is now Philip Morris International’s most profitable sales venue with 15% of the market.

With its domestic monopoly breached, and freed by its public listing, the Japan Tobacco Company followed its electronic and automobile compatriots onto the world market. Previously, its job was to feed profits and taxes to the government, but the partially privatised company’s profits amassed a multi-billion war chest that has allowed it to make overseas acquisitions. These include buying RJR Nabisco’s non-US assets in 1999; trying to buy the Turkish state-owned tobacco company Tekel; and culminating this

A man buys a cigarette by a vending machine in Tokyo Friday, December 15th 2006. In Europe and Japan the domestic tobacco markets are holding operations—albeit a highly profitable operations—operating mainly as bases for expansion overseas where the markets are still growing. China, for one, is a particularly appealing market to tobacco companies. Photograph by Shizuo Kambayashi, supplied by Associated Press/EMPICs, February 2007.

year in its successful takeover of Gallaher. Combined with its existing operations that makes Japan Tobacco Company the biggest company in the huge Russian market with over a third of sales.

Of course, the two big untapped markets are China and India. Both are both heavily populated countries that are first and second in the world with the acreage they use for tobacco leaf. As the second biggest producer of tobacco in the world, and the third biggest consumer, India is superficially attractive to outsiders. With 6m tobacco farmers and another 20m working in the industry, UN agencies estimate that a 100m 5% of the government’s overall tax take.

On the face of it, those figures imply a huge potential market. However, 90% of Indian smokers smoke handmade bidis rather than ready-made cigarettes. In addition, any international incursions into India would meet serious social and governmental resistance. Even worse, they would encounter strong governmental prejudices against market preferences. The conical shaped, hand-rolled bidi, with a leaf tied with string around loose tobacco might have been divinely inspired to resist industrialised mass production.

The big one then is China, which is the world’s largest cigarette producer and consumer. The third of the Chinese who smoke puffed away at over 2 trn cigarettes in 2006, and with rising affluence, seem determined to try even harder. Beijing signed the FCTC in 2003 and ratified it in 2005, but in joining the World Trade Organisation (WTO) in 2001, it has also had to lower barriers to foreign imports.

Foreign brands are still distributed under license by the State Tobacco Monopoly Administration—the alter ego of

MARCH/APRIL 2007 • FTSE GLOBAL MARKETS

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the China National Tobacco Corporation—the world’s Korea, Taiwan, Thailand, and they know that the life biggest cigarette company with which it shares both offices expectancy of a monopoly is not going to be that long. and a director. However, it is not as centralised as that Although they don’t talk about it in public, they are would imply. There are over a thousand separate brands considering the options, and Japan is a model, so they and factories, each of which are major employers and think that privatization down the road is the way to go.”

Attempts by foreign companies for joint ventures with revenue producers for local, as well as central government.

In 1996, 11.2% of the central government revenues came local companies have been discretely squashed, as the state from tobacco. As the economy diversified, that dependence decreed a ban on new factories. So far they have had to content themselves with licensing foreign brands to the has lessened, but it is still huge, standing at 7.4% in 2004.

The tensions between economic benefits and health state companies. Hu explains,“You often see news of major effects are even stronger than in Indonesia because internationals having joint ventures with Chinese government at every level benefits. With both Mao Tse companies. Nevertheless, China Reform Commission Tung and Deng Xia Ping inveterate chain smokers, China officials told me that it has not permitted joint ventures. was late to accept health risks—even now the health Even though the local company floated the news it was a minister smokes! Professor Teh-wei Hu of the University of sort of trial balloon on their part. The government policy is California, Berkeley, comments that China ratified the to say no to foreign joint ventures.”

Although official import penetration is low, FCTC, because of global peer pressure.“It would look bad not to sign, but since it is a monopoly company they know counterfeiting foreign brands is a huge problem, but Hu how to deal with it even if they sign it and they have points out that both the State Monopoly and the foreign restricted public smoking and advertising. [However,] the companies have a convergence of interests in stopping this. most effective method is increasing the price through However, smuggling, which some estimates put at up to taxation, and they are not eager to do that because of the 9% of total consumption, is a form of import penetration that the authorities for fiscal as much as protectionist effect on employment.”

Because manufactured cigarettes dominate the market, reasons, try to control. Hu suggests that the initial reaction employment is not as big an issue as in hand-rolling India, will be defensive, trying to preserve domestic market share. but it is still significant. It is fiscal pressures that distort the Presently China only exports one per cent of its product, market since tobacco and cigarettes are significant revenue mostly to South East Asia. “Foreign markets are not their source for local and national governments. Hu and his top priority now, with so much market [potential] in China. colleagues surveyed tobacco leaf farmers and found that for However, five or ten years down the road, when they have many of them it was a less profitable crop than fruit, beans consolidated, it may be different.”

Even then, the strictures of the FCTC raises the entry cost or oil. He comments, “The government presents tobacco growing as an antipoverty level. In fact, it is not. In fact of new brands and Chinese brands not in a big position to there is over production, because local government compete outside of the mainland’s cultural sphere in encourages it so they can get the 20% revenue.”Beijing has Southeast Asia. There is a possibility of off-shoring, now abolished taxes on other agricultural produce, so producing foreign brands for exports, but cigarette tobacco is fiscally advantageous for local governments, manufacturing is so highly mechanized a process that low Chinese labour costs may not offer sufficient discount regardless of the effect on farmers.

China is responding to the WTO strictures by gearing against shipping. Taken together, the long term planning itself up for international competition, both against imports from the China Tobacco Corporation suggests that after in the early stages, and then, longer term, towards preparing the industry to compete efficiently at home, in the longer term a competing on the world Asia lights up privatised China Tobacco market with those global 3-Year Performance of FTSE All-World Index – Tobacco will follow Japan into the companies who have been (USD Terms) global mergers and banging at the gates. So acquisitions business— far, privatisation is not on 200 backed by a war chest to the agenda for China.

180 which one third of the Consolidation is however.

160 world’s smokers will be In 2006, the number of 140 contributing. Indeed, it will number of cigarette be following not just factories was cut from 47 120 Japan, but its own to 31 and the 1800 brands 100 domestic examples such as that were sold in 2001 80 Lenovo in off shoring its were to 224. Professor Hu marketing. reports that “Some In the foggy world of Chinese policy makers smoking, it will be a major have been studying the shakeup. effect of the WTO in Source: FTSE Group and Datastream, data as at 31 January 2007.

FTSE GLOBAL MARKETS • MARCH/APRIL 2007

91

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MARKET REPORTS BY FTSE RESEARCH

FT SE

MARKET REPORTS 18.qxd Page 92

FTSE Global Equity Index Series – Global

31 January 2006 to 31 January 2007

FTSE All Cap Regional Indices (USD) 130

FTSE Global AC

120

FTSE Developed Europe AC

110

FTSE Japan AC

100

FTSE Asia Pacific AC ex Japan

90

FTSE Middle East & Africa AC

80

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70

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20

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50

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10

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0

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

MARCH/APRIL 2007 • FTSE GLOBAL MARKETS

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FTSE All-Emerging Country Indices – Capital Returns 70 60 50 40

%

30

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Stock Performance Best Performing FTSE All-World Index Stocks (USD/%) Rostelecom RUS 251.6 Manila Electric B PHIL 236.5 Minara Resources AU 220.6 HK 201.5 Tencent Holdings China Insurance International Holdings (Red Chip) HK 192.4

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

Worst Performing FTSE All-World Index Stocks (USD/%) ITV PCL THAI -88.5 Partygaming UK -74.7 Tokyu Construction JA -67.3 UFJ Nicos JA -65.6 EFG-Hermes Holding SAE EGY -65.2

No. of Consts

Value

3 M (%)

8,075 1,202 1,700 5,173 2,902 1,778 203 113 1,677 208 2,730 1,366

405.74 386.12 555.91 502.47 241.20 519.90 975.85 860.44 468.18 629.96 352.12 409.21

6.2 5.3 7.1 8.7 5.9 10.0 14.4 9.4 7.9 13.8 4.7 3.2

6 M (%) 12 M (%)

14.2 12.8 15.8 18.2 13.6 20.7 26.6 12.9 17.1 19.2 12.9 4.0

15.1 14.4 15.2 15.8 15.0 21.0 23.5 15.1 25.1 2.8 11.9 -1.4

YTD (%) Actual DIv Yld (%)

1.0 0.8 1.7 2.0 0.9 -0.6 1.5 -2.9 0.7 1.0 1.7 0.8

1.96 2.11 1.65 1.45 2.03 2.54 2.74 1.56 2.51 2.63 1.65 0.99

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

FTSE GLOBAL MARKETS • MARCH/APRIL 2007

93

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MARKET REPORTS BY FTSE RESEARCH

O

MARKET REPORTS 18.qxd Page 94

FTSE Global Equity Index Series – Developed ex US

31 January 2006 to 31 January 2007

130 130

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

120 120

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110 110

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100 100

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

MARCH/APRIL 2007 • FTSE GLOBAL MARKETS

MARKET REPORTS 18.qxd

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Stock Performance Best Performing FTSE Developed ex US Index Stocks (USD/%) Minara Resources AU 220.6 Tencent Holdings HK 201.5 China Insurance International Holdings (Red Chip) HK 192.4 SI 148.9 Keppel Land Sacyr-Vallehermoso SP 146.1

Overall Index Return (USD)

Worst Performing FTSE Developed ex US Index Stocks (USD/%) Partygaming UK -74.7 Tokyu Construction JA -67.3 UFJ Nicos JA -65.6 OMC Card JA -65.1 Nidec Sanyo JA -62.0

No. of Consts

Value

3 M (%)

FTSE Developed ex US Index (LC/MC) 1,339 FTSE USA Index (LC/MC) 697 FTSE Developed Index (LC/MC) 2,036 FTSE All-Emerging Index (LC/MC) 866 513 FTSE Developed Europe Index (LC/MC) FTSE Developed Asia Pacific Index (LC/MC) 767 FTSE Developed Asia Pacific ex Japan Index (LC/MC) 283 FTSE Developed ex US AC Index 3,878 FTSE Developed ex US LC Index 572 FTSE Developed ex US MC Index 1,700 FTSE Developed ex US SC Index 5,173

273.89 597.64 233.02 442.61 277.23 247.90 431.26 464.21 425.13 567.12 617.48

6.3 4.6 5.4 10.9 7.0 5.4 10.4 6.8 5.8 8.6 10.8

6 M (%) 12 M (%)

13.2 13.0 13.1 19.8 15.8 8.9 20.4 14.1 12.3 17.6 20.3

17.3 12.4 14.8 15.7 23.6 6.9 24.8 17.9 16.5 21.2 21.8

YTD (%) Actual Div Yld (%)

0.6 1.6 1.1 -1.2 0.5 0.9 1.2 0.7 0.5 1.1 1.6

2.29 1.73 2.01 2.24 2.62 1.65 3.08 2.20 2.38 1.65 1.45

FTSE Global Equity Index Series – Asia Pacific 31 January 2006 to 31 January 2007

FTSE Asia Pacific All-Cap (AC) Regional Indices (USD) 130

FTSE Global AC

120

FTSE Developed Asia Pacific (LC/MC)

110

FTSE Developed Asia Pacific ex Japan (LC/MC) FTSE Asia Pacific (LC/MC)

100

FTSE All-Emerging Asia Pacific AC 90

FTSE Japan (LC/MC)

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FTSE GLOBAL MARKETS • MARCH/APRIL 2007

95

MARKET REPORTS 18.qxd

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30 25 20

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MARKET REPORTS BY FTSE RESEARCH

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

Stock Performance Best Performing FTSE Asia Pacific Index Stocks Manila Electric B Minara Resources Tencent Holdings China Insurance International Holdings (Red Chip) China Life Insurance (H)

(USD/%) PHIL 236.5 AU 220.6 HK 201.5 HK 192.4 CHN 192.2

Worst Performing FTSE Asia Pacific Index Stocks (USD/%) ITV PCL THAI -88.5 Tokyu Construction JA -67.3 UFJ Nicos JA -65.6 OMC Card JA -65.1 Nidec Sankyo JA -62.0

Overall Index Return (USD) No. of Consts

Value

3 M (%)

8,075 FTSE Global AC Index 3,144 FTSE Asia Pacific AC Index FTSE Asia Pacific Index (LC/MC) 1,297 FTSE Asia Pacific LC Index 527 770 FTSE Asia Pacific MC Index FTSE Asia Pacific SC Index 1,847 FTSE Developed Asia Pacific ex Japan Index (LC/MC) 283 FTSE Developed Asia Pacific Index (LC/MC) 767 FTSE All-Emerging Asia Pacific Index (LC/MC) 530 FTSE Japan Index (LC/MC) 484

405.74 456.13 259.94 441.31 496.63 503.64 431.26 247.90 310.09 153.88

6.2 6.4 6.3 6.4 6.1 7.1 10.4 5.4 9.2 3.3

6 M (%) 12 M (%)

14.2 11.6 11.4 11.3 11.6 13.3 20.4 8.9 19.7 4.3

15.1 8.4 9.2 10.2 4.6 2.5 24.8 6.9 16.7 0.2

YTD (%) Actual DIv Yld (%)

1.0 0.1 0.1 0.0 0.7 0.5 1.2 0.9 -2.3 0.7

1.96 1.76 1.76 1.77 1.67 1.75 3.08 1.65 2.08 0.98

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

96

MARCH/APRIL 2007 • FTSE GLOBAL MARKETS

il

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MARKET REPORTS 18.qxd Page 97

FTSE Global Equity Index Series – Europe

31 January 2006 to 31 January 2007

FTSE European 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 Europe All Cap Indices – Capital Returns (EUR)

30

25

% 20

15

10

5

0

F

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

70

60

50

40

30

20

Capital

10

Total Return

0

-10

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

97

MARKET REPORTS 18.qxd

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MARKET REPORTS BY FTSE RESEARCH

Stock Performance Best Performing FTSE Developed Europe Index Stocks (EUR/%) Sacyr-Vallehermoso SP 146.1 Metrovacesa SP 143.6 Outokumpu FIN 131.4 Vestas Wind Systems DEN 123.6 Fiat ITA 120.5

Overall Index Return (EUR)

Worst Performing FTSE Developed Europe Index Stocks (EUR/%) Partygaming UK -74.7 Tietoenator Oyj FIN -31.1 Atos Origin FRA -24.7 OMV OEST -24.4 British Energy Group UK -21.1

No. of Consts

Value

3 M (%)

8,075 1,790 245 332 1,213 1,677 113 858 1,194 300 80 100

359.55 419.27 444.85 558.88 607.36 414.88 762.49 438.25 446.22 1514.65 5312.01 4781.03

4.4 6.0 4.4 8.9 11.9 6.0 7.5 7.0 7.5 4.9 5.2 3.1

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

6 M (%) 12 M (%)

12.2 14.8 12.3 21.0 24.7 15.0 10.9 17.3 17.7 13.2 14.5 9.8

YTD (%) Actual Div Yld (%)

7.5 16.7 13.8 24.3 27.8 16.9 7.6 18.7 19.1 14.8 15.3 11.2

2.5 2.0 1.9 2.5 3.2 2.2 -1.4 2.3 2.7 2.1 2.0 1.6

1.96 2.48 2.70 2.02 1.69 2.51 1.56 2.51 2.33 2.63 2.90 2.99

FTSE UK Index Series 31 January 2006 to 31 January 2007

FTSE UK Index Series (GBP) 130

FTSE 100

120

FTSE 250 FTSE 350

110

FTSE SmallCap 100

FTSE All-Share 90

FTSE Fledgling 6

FTSE AIM All-Share

-0

06 vNo

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FTSE techMARK

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

98

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FTSE All-Share Sector Indices – Capital Returns (GBP) 80

60

40

% Capital

20

Total Return 0

O

il

Eq

ui pm e O nt,

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

-20

FTSE UK Indices – Capital Return (GBP) 30

20

10

0

AR F K TS 10 E 0 M te

ch

FT Al S E l-S A ha IM re

g gl in Fl

ed

ar e

FT SE

FT SE

FT SE

Al l-S h

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0

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FT SE

10

0

-10

Stock Performance Best Performing FTSE All-Share Index Stocks (GBP/%) Manganese Bronze Hldgs UK Coal Nord Anglia Education Aveva Group Ashley (Laura) Holdings

Worst Performing FTSE All-Share Index Stocks (GBP/%) Partygaming -77.0 iSOFT Group -72.3 Agcert International -57.8 Alba -57.0 888 Holdings -52.5

209.1 179.0 175.5 159.9 128.0

Overall Index Return (GBP) No. of Consts

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

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

100 6203.09 250 11100.30 350 3261.36 339 3947.44 689 3211.84 251 4457.74 1,159 1078.75 100 1539.59

1.2 7.0 2.1 8.5 2.3 7.4 7.7 6.4

4.6 18.6 6.6 16.7 6.9 18.4 3.1 15.0

7.7 21.0 9.6 13.0 9.7 13.4 -5.3 2.8

YTD (%)

Actual Div Yld (%)

Net Cover

P/E Ratio

-0.3 -0.7 -0.3 1.1 -0.3 1.6 2.3 1.8

3.03 2.02 2.87 1.65 2.83 1.69 0.46 1.35

2.37 2.60 2.39 1.50 2.37 -0.77 -0.55 -

13.96 19.08 14.55 40.28 14.89 0.00 0.00 -

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

FTSE GLOBAL MARKETS • MARCH/APRIL 2007

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31 January 2006 to 31 January 2007

FTSE Xinhua Index Series (CNY/HKD) 280

FTSE/Xinhua China 25 (HKD)

240

FTSE Xinhua All-Share (CNY) FTSE Xinhua Small Cap (CNY)

200

FTSE/Xinhua China A50 (CNY) 160

FTSE Xinhua 600 (CNY) 120

FTSE Xinhua China Government Bond Total Return Index (CNY)

30

6 31

-D

ov -N

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-0

-0

6

06 ct-O 31

-S

ep

-0

-0 30

ug 31

-A

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-Ju 30

6

6

6 l-0

06 n-

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30

31

6

6 -A

pr -0

6 ar -0 -M

b-Fe 28

-Ja n-

06

06

80

31

MARKET REPORTS BY FTSE RESEARCH

FTSE Xinhua Index Series

FTSE Xinhua Index Series 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 51 1,001 600 401 31

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

15586.50 10290.61 5395.62 5898.59 3414.33 96.88

24.2 73.6 54.9 58.2 31.8 0.2

34.5 108.8 72.3 76.7 42.2 2.3

48.6 146.2 133.5 136.0 110.0 1.6

Actual Div Yld (%)

-6.1 11.8 18.0 17.1 26.2 0.4

1.68 0.87 0.95 1.00 0.51 3.02

FTSE Hedge Index Series FTSE Hedge Management Styles (USD) – 5-Year Performance 150

FTSE Hedge

140

FTSE Hedge Directional

130

FTSE Hedge Event Driven 120

FTSE Hedge Non-Directional 110 100 90

7 -0 Ja n

6 l-0 Ju

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5 Ju l-0

5 -0 Ja n

4 l-0 Ju

-0 4 Ja n

3 Ju l-0

-0 3 Ja n

2 Ju l-0

Ja n

-0 2

80

Based upon indicative index values as at 29 December 2006 and 31 January 2007

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

100

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FTSE Hedge – Management Styles & Strategies (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 (%)

5534.72 3379.39 2455.37 2146.08 1995.37 3485.98 2207.36 2432.34 3148.04 2080.68 2135.57 2090.21

2.9 4.3 4.8 5.7 0.4 3.0 1.6 4.3 1.0 0.3 0.6 2.3

6 M 12 M (%) (%)

4.7 7.5 12.1 5.6 3.5 4.8 2.4 7.0 1.7 2.5 0.8 2.2

5.0 5.2 9.6 6.2 -0.9 7.6 6.7 8.5 4.4 6.4 6.0 3.1

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

1.0 0.7 2.7 1.4 0.1 1.3 0.9 2.0 1.0 0.7 1.0 1.4

5.2 7.0 7.9 8.5 4.7 4.6 2.1 6.8 2.9 5.5 3.3 1.5

2.9 5.0 5.2 10.4 6.0 2.8 2.2 4.0 1.5 2.9 2.4 1.8

* Based upon indicative index values as at 29 December 2006 and 31 January 2007

FTSE EPRA/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

n07

6 31

-Ja

c-0 De 31 -

30

-N

ov -

t-0

06

6

6 -0

31 -O c

ep 30

-S

ug

-0

6

6 -A 31

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n-Ju 30

ay

-0

06

6

6 M 31 -

6

pr -0 -A 30

-M

ar -0

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Fe b 28 -

31

-Ja

n-

06

6

90

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

Consts

Value

3 M (%)

FTSE EPRA/NAREIT Global Index (USD) 334 FTSE EPRA/NAREIT North America Index Index (USD) 136 FTSE EPRA/NAREIT Europe Index (EUR) 103 FTSE EPRA/NAREIT Euro Zone Index (EUR) 47 FTSE EPRA/NAREIT Asia Index (USD) 95

3761.27 4498.86 3837.32 4160.40 2753.86

13.1 11.7 10.9 15.3 15.4

6 M (%) 12 M (%)

26.8 25.9 23.5 27.4 29.0

39.9 38.4 41.0 45.7 35.4

YTD (%)

Actual Div Yld (%)

4.8 8.5 -0.5 3.5 4.4

2.86 3.34 2.03 2.31 2.72

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

FTSE GLOBAL MARKETS • MARCH/APRIL 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)

105

103

101

99

97

-0 6

-N ov 30

FTSE Euro Emerging Markets Bond Index (EUR) FTSE Gilts Fixed All-Stocks (GBP)

31 -D ec

06

06 ct31 -O

p-

06

-0 6

30 -S e

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31 -Ju l-0 6

30 -Ju n06

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28 -Fe b

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95

31 -Ja n06

MARKET REPORTS BY FTSE RESEARCH

FTSE Bond Indices

FTSE Bond Indices (Total Return) Index Name

Consts

Value

3 M (%)

239 389 38 320 11 28 128 243 31

154.00 177.08 214.09 144.51 2038.29 1922.64 151.16 110.90 96.88

-1.1 -0.6 0.3 -0.2 -3.1 -2.4 0.0 0.6 0.2

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 (%)

1.0 1.0 2.4 1.6 0.1 -0.2 2.9 2.1 2.3

0.1 0.5 2.4 1.2 0.0 -1.4 3.2 0.8 1.6

Annual Redemption YTD (%) Yld (%)

-0.4 -0.2 -0.1 0.0 -1.5 -1.3 -0.2 0.2 0.4

4.21 4.27 4.99 4.64 1.67* 4.67 5.01 1.56 3.02

* Based on 0% inflation

FTSE GWA Index Series FTSE GWA Index Series – 5-Year Performance (Total Return Basis) 300

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)

250

200

150

100

-0 7 Ja n

6 l-0 Ju

-0 6 Ja n

l-0 5 Ju

-0 5 Ja n

l-0 4 Ju

04 Ja n-

03 Ju l-

-0 3 Ja n

2 l-0 Ju

Ja n

-0 2

50

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

102

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FTSE GWA Indices (Total Return) Index Name

Consts

Value

3 M (%)

2036 1339 1552 513 694

4147.14 4493.60 4132.68 4253.14 3932.19

6.1 6.8 6.3 5.4 2.7

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 (%)

14.5 15.1 15.6 15.5 8.6

19.5 22.6 21.5 20.4 13.5

YTD (%)

Actual Div Yld (%)

1.0 0.6 1.0 1.9 -0.5

2.19 2.43 2.32 2.79 3.00

FTSE RAFI Index Series FTSE RAFI Index Series – 5-Year Performance (Total Return Basis) 300

FTSE RAFI US 1000 Index (USD)

250

FTSE RAFI Global ex US 1000 Index (USD)

200

FTSE RAFI Kaigai 1000 Index (USD) FTSE RAFI Europe Index (EUR)

150

FTSE RAFI Eurozone Index (GBP) 100

-0 7 Ja n

6 Ju

l-0

-0 6

l-0 Ju

Ja n

5

5 -0

l-0 Ju

Ja n

4

4 -0 Ja n

Ju

l-0

3

3 -0 Ja n

2 l-0 Ju

Ja n

-0

2

50

FTSE RAFI Indices (Total Return) Index Name

FTSE RAFI US 1000 Index (USD) FTSE RAFI Global 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 (%)

977 997 1009 451 263

6201.42 6736.89 5944.86 6307.98 6431.49

5.8 7.5 6.6 6.1 6.7

6 M (%) 12 M (%)

14.8 15.5 16.1 16.2 18.0

18.5 22.6 22.8 21.5 23.3

YTD (%)

Actual Div Yld (%)

2.1 0.9 1.3 2.2 2.2

2.02 2.40 2.41 2.72 2.69

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

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

Kamila Lewandowski Research Analyst 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 • MARCH/APRIL 2007

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Page 104

CALENDAR

Index Reviews March – June 2007 Date

Index Series

Review Type

Effective Data Cut-off (Close of business)

Early Mar Early Mar Early Mar 2-Mar 2-Mar 3-Mar 7-Mar 7-Mar 7-Mar 7-Mar 7-Mar 7-Mar 7-Mar 7-Mar

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

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

28-Feb 28-Feb 28-Feb 12 Mar 28-Feb 28-Feb 28 Feb 6-Mar 29-Dec 28-Feb 28-Feb 28-Feb 2-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 4-Jun 5-Jun 6-Jun 6-Jun

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 FTSE/JSE Africa Index Series FTSE EPRA/NAREIT Global Real Estate Index Series 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 S&P BRIC 40 S&P / ASX Indices DJ Global Titans 50 OMX S30 DAX FTSE UK FTSE All-World

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 30-Apr 31-May 1-Jun 31-May 29-Jun 8-Jun 2-Jul 15-Jun 22-Jun 15-Jun 15-Jun 15-Jun 15-Jun 30-Jun 15-Jun 15-Jun

2-Mar 28-Feb 28-Feb 12-Mar 20-Feb 1-Mar

6-Jun 6-Jun 6-Jun

FTSE techMARK 100 FTSEurofirst 300 FTSE eTX

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 - shares in issue Semi-annual review Quarterly review Annual review Quarterly review Annual review Semi-annual review Quarterly review Semi-annual review Quarterly review Semi-annual review - constituents Quarterly Review Annual review of index composition Semi-annual review Quarterly review Quarterly review Annual review - Emgng Eur, ME, Africa, Latin America Quarterly review Quarterly review Quarterly review

15-Jun 15-Jun 15-Jun 15-Jun

28-Feb 30-Mar 30-Apr 30-Mar 30-Mar 30-Apr 31-May 31-May 31-May 31-May 31-May 31-May 31-May 30-Apr 31-May 31-May 5-Jun 30-Mar 31-May 31-May 31-May

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

104

MARCH/APRIL 2007 • FTSE GLOBAL MARKETS

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Page IBC1

THE FTSE GLOBAL EQUITY INDEX SERIES. AHEAD OF THE CROWD. FTSE adds emerging markets to the global universe with the inception of the FTSE All-World FTSE introduces free float adjusted indexes

2000

2001

The FTSE Multinational Index Series is launched

FTSE extends the global universe to 98% with the launch of the FTSE Global Equity Index Series

The FTSE4Good Index Series is launched

FTSE introduces Non-market Cap Weighted Indexes

2002

2003

2004

2005

FTSE was the first index provider to pioneer the move to a seamless global index series covering Large, Mid and Small Cap stocks in 2003. The FTSE Global Equity Index Series offers unparalleled coverage of the global investable opportunity set.

FTSE has continued to stride ahead with new innovations. We make it easier to manage the entirety of an asset owner’s investments, no matter what the mandate. Whether it is fixed income, alternative asset classes, socially responsible investment or new perspectives on equity investing, FTSE measures up with the index solution.

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 International Limited (“FTSE”) 2007. FTSE is a trademark of the London Stock Exchange Plc and the Financial Times Limited and is used under license by FTSE International Limited. All rights in and to the FTSE Global Equity Index Series are vested in FTSE.

GM EDITORIAL 18.qxd

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14:58

Page OBC1

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