FTSE Global Markets

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CANADA’S BANKS TRY TO BREAK OUT I S S U E T W O • J U LY / A U G U S T 2 0 0 4

Ericsson bounces back

CalPERS: The friendly Californian activist

AmSouth looks to Florida for growth

HOW TO INVEST WITH STYLE

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Outlook EDITORIAL DIRECTOR:

Francesca Carnevale, Tel + 44 [0] 20 7074 0008, email: francesca@berlinguer.com CONTRIBUTORS:

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t’s not yet time to bring out the tambourines and trombones to celebrate a market turnaround, suggests the new 2004 Ernst & Young Global IPO Survey. The accounting firm predicts a rebound in IPO activity this year, that could reach the balmy levels of 1998 [which saw some $118bn in deal flow]. But it also sounds a note of caution. David Wilkinson, head of IPOs at Ernst & Young says: “there’s been a strong build-up of demand and I know of several companies that have been waiting for sensible market conditions for some time. But the market is getting indigestion from all the new issues and is getting very selective.”

Even so, there’s little doubt that there’s a mood of cautious, but growing confidence in the market. That optimism underlines some of our stories this month, including the report on the scramble for shares in the Budapest Stock Exchange, as fight for market share in the EU accession states starts to build up steam. Look out for more of the same in upcoming editions. As well, it highlights the fact that stock exchanges are now in a tough fight for survival as investors can increasingly access any stock, anywhere. Bursa Malaysia is one example of the different ways in which the smaller exchanges are rising to the challenge.

Our lead story this month focuses on Ericsson – one of the world’s leading mobile network providers – that is successfully emerging from one of the most comprehensive, painful - but necessary - restructurings in Swedish corporate history. Ericsson CFO Karl-Hendrik Sundström tells us how it was done.

In the North American markets we highlight the growing success of the American southern banks, with our special focus on AmSouth Bancorporation. AmSouth is fast becoming a bellwether for the power of the ‘grey dollar’ in determining tomorrow’s retail banking services. We look at the way the bank has capitalised on the changing demographics of Florida. We also look at the fetters which still, allegedly, constrain the growth of Canada’s big banks and question whether mergers between the banks will really be the way forward. Last, but not least, we look at CalPERS, one of the world’s most powerful pension funds and a keen shareholder activist. Art Detman profiles its investment outlook.

The back office also figures significantly this issue. We look at what investors really want from straight through processing and whether it can actually ever be achieved. As well, we look at the evolving market of the global custodian and include a special section in which we interview the heads of the three of the world’s most powerful custody providers to see whether they are still abreast of investors’ needs.

I

Francesca Carnevale, Editorial Director, June 2004

Subscription Price: £399 per annum [6 issues]

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Contents COVER STORY ERICSSON BOUNCES BACK FROM THE BRINK ..............Page 32 Ericsson, the world’s largest manufacturer of mobile networks is back on track.

Ericsson has endured a market downturn which saw it lose over 50% of its workforce and resulted in a complete overhaul of the company’s infrastructure. CFO Karl-Henrik Sundström talks about the biggest restructuring in Swedish corporate history.

REGULARS NEWS

New IPO rules imminent in India ................................................................................Page 4 Kenya’s markets excite interest..........................................................................................Page 4 AIM tries to avoid EU Directives ................................................................................Page 4

REGIONAL REVIEW

Will China ever revalue the Yuan? ................................................................................Page 6 Oil prices prop up Saudi reforms ..................................................................................Page 9 ETFs expand into new asset classes ............................................................................Page 12 Budapest’s exchange launches new index ................................................................Page 16 Tupras puts Turkish privatisation in the spotlight ..................................................Page 18 Soft dollars hit a hard landing......................................................................................Page 20 New urban legends ........................................................................................................Page 22

ISLAMIC FUNDS DEVELOP APPEAL ............................................Page 67 Patrick Stewart explains their operation.

EQUITY REPORT

WHY STYLE INVESTING STILL COUNTS ................................Page 72 Robert Schwob explains its relevance for today’s investor.

VALUE INVESTING

........................................................................................Page 82 David Simons talks about stocks somebody loves

RMBS LEADS SECURITISATION BOOM

DEBT REPORT

..................................Page 37 Andrew Cavenagh looks at the winners in asset-backed finance

ALTERNATIVES

......................................................................................................Page 78 Do hedge funds really want one stop prime brokerage services?

OPINION

............................................Page 69 Lucy O’Carroll explains the dynamics of new oil prices

INDEX REVIEW

............................Page 85 Yvonne Teixeira and Pablo Ybarra examine the rise of the market Market Reports by FTSE Research ..............................................................................Page 88 Calendar ..........................................................................................................................Page 96

WAY TO GO!

BLACK GOLD TESTS THE MARKET

LATIBEX: GATEWAY TO LATIN AMERICA

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FEATURES CALPERS SHOWS SHAREHOLDER ACTIVISM

..................Page 24 Art Detman talks to the world’s most influential asset owner about its enthusiasm for shareholder rights and its unique investment outlook.

AMSOUTH TASTES THE FRUITS OF FLORIDA

..................Page 28 The southern states of America are providing new market opportunities for smart banks.

David Simons profiles one of America’s new rising stars.

THE GLOBAL CUSTODY REPORT

..................................................Page 41 Winners stay the course in global custody.

THE CUSTODY Q&A State Street: Putting the client first ..............................................................................Page 46 Citigroup: Regional strength and global services ....................................................Page 50 Bank of New York: It’s all in the approach ................................................................Page 52

CANADA’S BANKS FIGHT BACK

....................................................Page 54 Bill Stoneman looks at the impact of impending legislation which could free Canada’s banks from their current shackles. Who will win?

REBRANDED AND READY TO ROLL

............................................Page 58 Bursa Malaysia has a new name and a revitalised business outlook. Is it enough in today’s competitive world?

STP: THE SEARCH FOR PERFECTION

............................................Page 62 Is there really such a thing as straight through processing? Angela May Ward talks to the market makers to find out.

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In the Markets ALMOST 60% OF definedbenefit pension plans in Canada are still in deficit.

Undoubtedy they will require massive cash infusions to head off: “...a looming social and economic crisis,”warns the Certified General Accountants Association of Canada [CGAAC].

“An additional $160bn is required to cover pension plans' current deficits and to provide for future indexation of accrued benefits,”the association said in a study to be released in early June.

THE UK’S ALTERNATIVE Investment Market [AIM] is set to become an exchange-regulated market in October 2004. The move allows AIM to avoid having to keep up with upcoming EU Directives [such as the EU Prospectus Directive and the EU Transparency Obligations Directive] which are due to come into force in 2005.

The market is largely supporting AIM’s moves, to encourage the market’s flexibility but: "It is essential that the extent of AIM's opt out does not risk eroding investor confidence,” says Philip Secrett, a partner at Grant

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Thornton Corporate Finance. AIM-listed companies will be able to avoid a number of new rules such as the requirement for the prevetting of AIM admission documents.

INDIA LOOKS LIKE it is sharpening its IPO regime.

Lengthy paper forms for Indian IPOs may soon be a thing of the past if reforms proposed by India’s Securities and Exchange Board of India's [SEBI’s], Securities Markets Infrastructure Leveraging Expert Task Force [SMILE] committee are implemented.

The committee is looking at the hardware and software infrastructure requirements across the capital market. It is also finding ways to help retail investors by simplifying the investment procedures in the equity market. Bulky paper application forms and multiple point of data capture are believed to have caused the mix-up in basis of allotment of the recent ONGC issue. Several investors are yet to receive their refunds, nearly three months after the public issue.

THE GOING ISN’T always easy for hedge funds it seems. Hedge fund returns have fallen for two consecutive months says Hedge Fund

Research – for the first time since June/July 2002.

It is the worst performance since May/June 2000.

Rising oil prices, interest rates and international uncertainty are beginning to bite. As well, the emergence of China as a major economic driver is also changing the global marketplace.

corporate deal. Celtel indirectly purchased its 60% stake by acquiring a member of the Sameer Group that had, in turn, purchased the shares in KenCell from a Vivendi subsidiary. "Sameer Group had purchased the shares from Kenyan Telecom by way of exercising preemptive rights as minority shareholder in KenCell, explains Corrine Mitchell, partner at Baker & McKenzie and who led the London team advising ING on the deal.

THE KENYAN GOVERNMENT has announced that it wants to sell off part of its 35% shareholding in the Kenya Commercial Bank as part of its programme of privatisation. It is hoped the sale will raise KS25bn in additional capital to improve service delivery and launch the bank's new products. A rights issue will be launched in late June or July, following approval from the Capital Markets Authority.

ACCUMULATED FOREIGN CAPITAL in the Russian economy reached $57.1bn as of the end of March 2004, some 32.6% up on last year , says the Federal State Statistics Service of the Russian Federation. Loans from international credit organizations, trade credits and other loans accounted for 54.5%, while direct investments accounted for 43% of the total.

Portfolio investments languished at 2.5 %. The principal investors in Russia include Germany, the US, Cyprus, the UK, France and the Netherlands, together accounting for 72.4% of total accumulated foreign investment and for 75% of direct investment.

Foreign investment in the Russian economy however amounted to $6.1bn in the first quarter of 2004, some 1.5% less than in the same period in 2003.

STILL IN EAST Africa - a $70m bridge financing facility, arranged by ING Bank, forms part of a recent $230m telecommunications deal supporting Celtel Kenya’s purchase of a 60% stake in KenCell Communications Ltd from Kenyan Telecom – the second largest mobile telephone company in Kenya. The transaction was concluded in early June and has ended up being Kenya’s largest ever

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Regional Review ASIA

Will China ever revalue the Yuan?

Is the Yuan undervalued? And if so, how do you leverage that fact? Neil O’Hara canvasses opinion.

CCORDING TO GEOFFREY Barker, chief Asia-Pacific economist at HSBC, “As far as the speculation regarding Yuan undervaluation, this is difficult to pinpoint because, of course, it has a closed account. But mainland China in global trade is taking market share. It’s difficult to know by how much.”

China’s surplus trade with the US grabs headlines. But the country runs a substantial deficit with the rest of the world that will worsen if the Yuan strengthens against other currencies.“You cannot argue the currency is hugely undervalued. China ran a trade deficit in the first quarter,”explains Jim O’Neill, head of global economic research at Goldman Sachs.

It’s a sensitive issue. “The central bank keeps the Yuan in a managed float of Yuan8.276 to Yuan2.280 versus the US Dollar and has done since 1996 – although pressure to lift the band is massive,” says Kayvon Alexander, manager, emerging markets at Informa Global Markets, the provider of real time market commentary and analysis. “In particular, Japan and other local markets think that because of China’s strong economic performance the authorities should let the Yuan find its natural level.”

Options open to the Chinese central bank

A

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include raising interest rates [very likely, if consumer prices rise by more than 5%-6% this year]; import controls or a relaxation of the exchange rate system. A recent Reuters’ report suggested that the Yuan could be overvalued by as much as 30%. It is a problem for the Chinese economy, which grew by 9.8% last year, fuelling fears of inflation and a rise in bad loans. It’s a particular issue for Japan, whose exports to China have underpinned the Japanese economic recovery [China took 12% of Japanese exports in 2003].

However, the situation is not straightforward. Bernie Shuttleworth, senior international economist at ANZ Banking Group says: “Interest rates may rise, but they are no means the most important instrument of monetary control in China. Chinese authorities are acting on the supply of credit, not the demand for it. I would see an increase in interest rates if it happens, as a decision to put more pressure on the highly geared state owned enterprises [SOEs] to accelerate their restructuring, adding to the pressure already there, arising from World Trade Organisation commitments. They would not use a revaluation of the currency as a de facto tightening of monetary policy.”

Foreign exchange traders buy forward contracts or short-term fixed income

The definitive measure of Chinese Markets

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securities denominated in a target currency the rate looking ahead,” says Informa’s when they believe it will rise in value. For the Alexander.

Currently the Dollar/Yuan spot is quoted Yuan those avenues are closed because the currency is not freely convertible and at 8.2730. Reuters reported [in early June] foreigners cannot buy domestic Chinese NDFs at the following levels, clearly showing a trend for Yuan appreciation: notes or bonds. What can investors do?

1 month around 8.2730 Investors can use foreign direct 2 month around 8.2627 investment, buying a Chinese company or 3 month around 8.2547 entering into a partnership, says Dori 6 month around 8.2020 Levanoni, director and currency product One year around 8.0400 strategist at First Quadrant LP, an Nonetheless, market makers advise institutional asset manager with $3bn under management. Or, he says: “you can buy caution. Goldman Sach’s Jim O’Neill says equities. There are publicly traded B shares the premium makes buying the Yuan riskier for foreign investors and ADRs.” Levanoni than it was 18 months ago. “Other points out though that B shares are traded in currencies in the region may be better plays, local currency and not US or Hong Kong such as the Taiwan Dollar or the Thai baht,” he suggests.

Dollars.

Traders can create indirect exposure in Equity values however depend on many factors beside the exchange rate. If the various ways. “You could buy Chinese market believes China’s growth will slow equities and short the Hang Seng future if after a revaluation, equities may fall and you thought the Hong Kong and Chinese markets were closely correlated,” says First offset any currency gain.

Sophisticated investors have other Quadrant’s Dori Levanoni. “That would options. “You can buy an offshore non- leave a pure currency play.”

The play assumes that the Hong Kong deliverable Yuan forward, settled in US Dollars,” says HSBC’s Barker. “The one-year peg holds, which O’Neill thinks likely. “If price today implies a 3% to 4% appreciation. you look at one-year Yuan, it always stops at 7.80 – the same rate as the Hong Kong That’s down from 5% to 6% last year.”

Dollar,” he explains.

What this means is “If they let it go that the market beyond that rate, it predicts the future would cause real Dollar/Yuan direction problems in Hong from using nonKong.”

However, deliverable forwards O’Neill, as some [NDFs] which are other local analysts, similar to futures. believes that the Yuan Although as their could at some time name suggests, displace the Hong investors do not take Kong Dollar. ANZ’s delivery. They allow Shuttleworth does speculators to take a not concur however. view on a currency He is adamant. “Not that trades within in the foreseeable tight or managed future,” he predicts. ranges. Simply, as you As well, shorting US cannot trade on a treasuries might work. spot basis, you take Asian central bank out an NDF. “It is a purchases covered good way to evaluate Geoffrey Barker, chief Asia-Pacific economist at HSBC

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95% of the US current account deficit in 2003.

“What happens if China and others stop buying and let their currencies rise?”asks Dori Levanoni.

However, Levanoni cautions that proxy hedges can be tricky. Unrelated factors affect the proxy’s rise and if everyone tries to exit at once the intended hedge could move in the wrong direction. QFII investors beware though. At the beginning of June the Chinese central bank signalled that it would not accept speculative currency moves by investors enjoying QFII status.

“China has clearly warned that it will take measures against investors with special status if they operate outside of the traditional equities and bond markets,” says Informa’s Alexander.“Put bluntly, the authorities do not want people using these special rights to speculate on the currency. It’s been made crystal clear that they will reserve the right to withdraw the status if need be.”

Even so, says ANZ’s Bernie Shuttleworth, QFIIs should be pleased at the windfall gain on their RMB investments: “More seriously, because of the ceilings on their investments, they are almost certainly below their desired weights in China and will invest more as and when allowed.”

China had two currencies in the 1980s – the Yuan for external trade and the Remnimbi [RMB] for domestic transactions.“There was a huge black market for Yuan because it gave the Chinese access to goods they otherwise could not have had,” explains John Auerbach, associate managing director and director of Anti-Money Laundering Services in New York at Kroll Inc. Similar pressures exist today, although the Yuan and the remnimbi are used interchangeably these days.

For those in the know, there are also other indicators. “The black market told us what was going on,”says Goldman Sachs’ O’Neill.

“At many borders the Yuan has traded at a premium on the street for 18 months.” The Dollar peg is working loose, he agrees. But then again Yuan buyers must accept unusual risks. The best bet? “A basket of Asian currencies,” concluded O’Neill. Most Asian economist agree, saying that the Yuan will be

Dori Levanoni, general partner at First Quadrant LP in California

pegged eventually to a basket of 10 currencies that would include the Dollar, yen and euro [thereby taking in all of China’s biggest trading partners] as well as some Asian currencies. “Any changes to the RMB regime will be gradual and evolutionary,” thinks ANZ’s Bernie Shuttleworth.

“A step-revaluation against the US dollar is not very likely. The first moves would be simply a widening of the bands, or a link to a basket of currencies,” adds Shuttleworth.

The advantages to the Chinese are clear.

ANZ’s analyst is adamant about the benefits: “It would bring about some fluctuation of the RMB against individual currencies and, in doing so, create a demand for risk management instruments on the part of exporters, importers and investors – it’s a necessary step in the evolution of China’s financial markets.”

“The authorities do not want people using these special rights to speculate on the currency.”

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It’s a vibrant year for the Kingdom of Saudi Arabia [KSA]. Last year the Saudi all-share index rose by 76% and continues to grow at a healthy pace. As well the kingdom is instigating a series of widespread financial reforms, which should further boost capital markets and corporate finance services. The market will also be much more accessible to foreign financial institutions. Will Saudi Arabia’s indigenous institutions respond to the challenges of liberalisation?

AUDI ARABIA SHOULD be on a roll. Despite intermittent terrorism, economic activity has remained remarkably strong, Oil prices are on or near $40 per barrel and have averaged well over $30 per barrel for some time. According to Samba [the former Saudi American Bank], the 2004 budget is based on an output at $19 a barrel for Saudi crude. On this basis, the government had forecast a SR30bn deficit, with revenues at SR200bn. While forecast spending in 2004 is SR230bn – almost 10% up on the 2003 budget projection – this figure is actually 8% down on actual 2003 spending. Now another budget surplus is possible, with National Commercial Bank [NCB] chief economist Said alShaikh forecasting a SR13bn surplus, based on total revenues

S

estimated at SR243bn revenue.

Traditionally Saudi budgets tend to underestimate income and spending. It’s not just caution. It also helps politically. To the global investment community, it shows a tight rein on spending and fiscal prudence. It also suggests that the government understands it needs to address the country’s structural imbalances.

Working hard to provide investor comfort, government plans to implement a Capital Markets Law and set up a Capital Markets Authority by the end of this year are well under way. In the run up to membership of the World Trade Organisation [WTO], market liberalization is a necessity. “It’s a significant enhancement for the Saudi capital markets, putting them

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Oil prices and reforms back Saudi’s Market resurgence

on a par with comparable regulations of other international markets.

Implementation will provide a significant boost to the IPO activity in the Kingdom” explains Nemeh Sabbagh, managing director, Arab National Bank [ANB]. “We have already started to position ourselves to benefit from the expansion in the IPO market.”

The Saudi stock market shot up 76% last year. Both local and domestic investors were eager to take advantage of the upward surge in Saudi Arabia’s growth stocks. The demand for communications stocks was particularly notable. The stock market has continued with strong growth during the first half of 2004 on the back of good corporate earnings and a buoyant economy. Sectors that seem likely to deliver continuing performance for 2004 are the petrochemical sector, on the back of the very strong oil prices and the banking sector – that should continue to benefit from the overall expansion in the economy and the growth in consumer banking.

Telecommunications should also

“Traditionally Saudi budgets tend to underestimate income and spending.” continue to benefit from the expansion of the population and growing demand for communications in the Kingdom. Investors bought up Saudi Telecom Co heavily last year [by 149%], as they banked on fastgrowing local demand for improved telecommunications linkages.

Other choice bites included petrochemical exporter, Saudi Arabian Basic Industries Corporation, and the Saudi Electricity

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Regional Review MIDDLE EAST

Company. “It should be noted that the market has already undergone strong growth, by early June 2004, of nearly 25%,”says Sabbagh.

Privatization will also continue for the foreseeable future as it is the government’s stated intent to divest itself of significant percentages of the companies that they currently fully or partially own. Historically, Saudi Arabia has proved reluctant to sell off state owned assets, but the potential remains huge for private investment in major local companies.

This was amply illustrated by the biggest divestment to date, last year’s $4bn partial privatization of Saudi Telecommunications Company’s capital to local and other Gulf Arab private and institutional investors.

Saudi Telecom was listed on the Saudi Stock Market [SSM] early in 2003 after a 250%-oversubscribed IPO involving some 30% of its total equity; it has since been a major contributor to the boom in the exchange.

The last really big privatization related IPO in the Kingdom involved the sale of 30% of Sabic in 1983, and for most of the past 20 years the company was the SSM’s biggest stock by far. Until Saudi Telecom’s IPO that is. Investors expect a much shorter wait for the next tranche of issues. The most significant privatization expected in the future is that of the National Commercial Bank, although it is likely other smaller issues will be completed in the more immediate future.

Now the government is working on awarding a second mobile telecom licence to a private company – probably a consortium of Saudi investors and an international operator such as Vodafone Group PLC or Orange.

“This will be the second GSM licence for the Kingdom and is being hotly contested by 11 prospective operators. A condition of the licence is

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Nemeh Sabbagh, managing director, Arab National Bank [ANB]

expected to be that 20% of the successful operator’s capital will have to be floated to the public shortly after incorporation. Depending on the

“We have already started to position ourselves to benefit from the expansion in the IPO market.” terms, this is expected to be extremely well received. Clearly banks will seek to play a role in providing the financing as well as in the expected share floatation,”says Sabbagh.

The banking sector in the country will also come under pressure to change. “The most significant challenge that the banking sector will face in the asset management industry in Saudi Arabia over the next few years will come from the liberalization of the banking sector, with particular focus towards investment banking with the implementation of the Capital

Markets Law” expands Sabbagh.

“With the significant potential size of the asset management business in Saudi Arabia, this will be an attractive market for international fund management groups to try to penetrate through establishing authorized offices in the Kingdom to market and support their products,” he says.

The general demand for credit has increased substantially in all sectors in 2004 for both corporate and consumer banking sectors. The government has increased spending on major projects, which will generate further opportunities in the coming months.

ANB meanwhile is “benefiting from the significant increase in activity on the Saudi stock market and increases in customer requests for broking services which, has had a beneficial impact on fee revenues,”explains Sabbagh.

There has been increasing interest from foreign investors in the Saudi stock market over the past year, he notes, notably from the GCC. ANB has a number of accounts from GCC private customers and to a lesser extent institutions – although they are currently unable to invest in the banking sector. Non-GCC nationals are restricted from investing directly into the market. Local investors meanwhile tend to focus on real estate as well as the Saudi stock market.

There’s not doubt that the Kingdom’s rulers are committed both to the pace and extent of financial reforms. Inside the kingdom, local houses welcome the impact of the inevitable influx of foreign financing institutions following liberalisation,.

From the outside, institutions will remain cautious in the short term.

Membership of the WTO later this year could help dispel any remaining concerns they may have about the Kingdom.

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Regional Review EUROPE

ETFs in Europe expand into new asset classes The number of exchange traded funds [ETFs] is rising once more in Europe after a dip near the end of last year. ETFs give investors exposure to an index with a single transaction, are fully tradable, can go short, and pricing is transparent. Now ETFs are expanding into new asset classes.

FTER A SHORT period of consolidation in the last quarter of 2003, European ETFs appear to have rebounded with vigour. Not only are traditional sector based ETFs on the rise once more, but they are joined by a flurry of ETFs in new asset classes. It’s the new buzz around Europe’s financial capitals and product specialists are rushing headlong to provide indigenous investors with ETFs structured around alternative assets, such as gold, fixed income and property [or real estate].

Bruce Lavine, Head of iShares Europe at Barclays Global Investors [BGI], sees a number of important trends emerging. “You’ll see new countries added and increasing usage of fixed income based ETFs because they are great products [transparent, low cost and efficient] and still in their infancy.”

He notes that “we’re already seeing commodity based ETFs beginning with a gold fund listed in London. It’s a slightly different construction. BGI has a gold ETF [iShares Comex Gold Trust] proposal in the US before the SEC. What’s unique about gold based ETFs is that

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you’re buying physical gold and not gold stocks as a proxy for gold.” For Lavine, however, the most notable transitional element in Europe is not product related, but user related instead. “Getting people to use ETFs to their full potential – we’re seeing more of that.”

The key challenge facing managers remain sales and distribution. “It takes time to build awareness,” admits Deborah Fuhr, executive director at Morgan Stanley in London. “The products are every bit as beneficial to a European as a US investor,” adds Lavine. “But there has been less money spent in aggregating and selling them to date – nevertheless, all the trends in Europe are favourable for the category.”

Overall, ETFs have been extremely popular over the past few years,“due to their simplicity, combining the best features of a stock and an investment fund,” says Morgan Stanley’s Deborah Fuhr. During the last four years, ETFs in Europe have been growing at a faster rate than in the US she says. At the end of April there were 304 ETFs globally, with assets of some $227bn, managed by 35 managers on 28 exchanges around

the world. Europe accounts for some 109 ETFs with $25.8bn of assets and, according to Fuhr’s April market report: “Europe has seen overall ETF assets under management double each year since their launch four years ago.”

The arguments in favour of tracker style funds are well known. They offer diversified exposure to equity markets and avoid the risk of exposure to individual stocks. “ETFs cover countries, economic zones, industry sectors or commodities and trade almost in line with net asset value,” explains Fuhr. “Index-linked ETFs have some of the lowest expenses of any registered investment product.” As well ETFs – for the most part – are structured as open ended investment companies [OEICs] in the United Kingdom and offer exposure to an entire index in just one share. ETFs also trade [as normal shares do] at any time the market is open.

“Whether ETFs are used as part of a transition trade in a manager or strategy change, or equities cash and reduce cash drag on fund performance; hedge exposure; implement core/satellite strategies for high net worth individuals or wrap in a guaranteed or structured product, their future in a European context is now guaranteed,” says Marc Russell-Jones, vice president, exchange traded funds, at Bank of New York [BNY] in London.

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Regional Review EUROPE Bruce Lavine, Head of iShares Europe at Barclays Global Investors [BGI]

Both Europe and Japan have shown the most growth in ETF products in the past year. In Europe market expansion “can be attributed to the growth of passive [or index] investment in Europe over the last six years,” explains Russell-Jones, driven by factors such as the dramatic increase in benchmarking of active managers as more emphasis is placed on benchmark relative performance by plan sponsors and consultants. As well “the overhaul of the pension and medium term savings markets in countries such as France and Germany has helped,” he adds.

Unlike the US – where retail investors are increasingly gaining access to ETFs – in Europe, the product remains in the domain of institutional investors, hedge funds and other professional institutions.

In Europe, according to Fuhr’s research at Morgan Stanley, IndExchange is the largest manager in terms of assets under management, with a 27% market share [equivalent to around $7bn] under management. It manages some 31 equity ETFs and a further

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four bond ETFs. Barclays Global Investors [BGI] is second, with just under 24% market share [with assets under management of around $7bn] – although BGI retains its position as the largest manager of ETFs globally, with some 36.5% share of the global market. “We now have over $80bn under management globally and we’re taking in approximately $1bn per week in new assets,” says BGI’s Lavine. Société Générale’s Lyxor International meanwhile in Europe has just under 22% of the market [$5.6bn under management].

The Deutsche Börse meanwhile is the leading exchange on the Continent for ETFs with over 57% of all ETF trading in Europe taking place in Deutsche Börse's XTF segment [its electronic trading platform launched in April 2000 for ETF trading and actively managed funds] and it continues to grow. In January 2004 exchange turnover in XTF reached €3.3bn up 27% on January 2003 with a daily average volume of €157.5m.

Up until the late last year, 93% of ETFs in Europe were based on equity based indices, elucidates Russell-Jones.

During the last eight months or so that has been changing as new and transparent indices are licensed on other asset classes such as commodities and fixed income securities.

Fixed income ETFs are de-rigour in 2004. Among the plethora of bond based ETFs launched in the last nine months, the London arm of passive product specialist Barclays Global Investors [BGI] led the way with the issue of two corporate bond ETFs, while Germany’s HVB launched a government bond ETF which tracks 25 of the most liquid German government bonds. Investors can also buy EuroMTS Global Master Unit – a fixed income ETF launched

by Société Générale’s subsidiary,

Lyxor Asset Management. The ETF was listed on Euronext Paris in January this year and its underlying index, the EuroMTS Global index, is a Euro-denominated index measuring the performance of the entire Eurozone government bond yield curve. Lyxor says it was the first ETF covering the whole Eurozone government bond market. Investors have been able to buy fixed income ETFs in the United States for some time, but it is only a recent development in Europe.

These days, however, it’s not stopping at fixed income however.

AXA Investment Managers [AXA

Deborah Fuhr, executive director at Morgan Stanley in London

IM], for instance, recently released news that it had obtained a licence to launch a European real estate ETF, which would track two of the European real estate indices produced by the European Public Real Estate Association [EPRA]. The new real estate ETF will also be listed on Euronext later this year.

AXA IM is still selecting indices among EPRA Europe, Europe ex UK, Eurozone and UK indices for the ETF to track.

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Regional Review EUROPE

Everyone wants a piece of the Budapest Stock Exchange [BSE]. A bevy of suitors have been lining up over the spring months to add to their equity in the exchange. And why not? BSE is set for a period of unprecedented growth and is confident enough to go it alone in developing its own, new investment benchmarks and indices.

BSE looks to a brighter future T’S BEEN A busy few months in Budapest. In early June, after three months of market consultations, the BSE launched its new Mid and Small Cap Index [BUMIX]. BUMIX will operate as a total return index, that is the dividend payout will also play a role in its performance valuation. “It was an important development for us,” explains Gàbor Kutas, Head of the Business Development and Communications Division at the BSE. “The new index builds nicely on the existing blue-chip BUX index, but it allows investors access to shares that are not in BUX because of their size.”

There is an overlap, says Kutas, between the basket of the new index and the BUX index basket. Only series of shares where the market capitalisation [adjusted for free float] is not above HUF100bn can be admitted. It’s also necessary for the market value turnover of the shares to have reached HUF1,250m over the last six months.

In a market such as Hungary, the development of a small and mid-cap index is an imperative, since index membership is often a pre-condition for investment, according to Kutas.

“Index membership provides

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significant marketing value.”The new index may also become an underlying product for futures trading at some point, he adds. “We are working on developing a number of futures products based on BUMIX which we will introduce, hopefully, in September this year.”

The BSE is also working on plans to integrate trading activity with the Budapest Commodity Exchange [BCE] by autumn 2004. Trading in commodities is planned to start on the

“There’s been much talk of smaller, regional exchanges fading out.”

BSE on September 6, said György Jaksity in a communiqué in early June.

“It’s quite a tight schedule,” admits Kutas, but, he maintains, it will all be in place by September.

More recently a consortium including the Vienna Stock Exchange, Oestereiche Kontrollbank [OeKB], Erste Bank and Raiffeisen Bank, and HVB Bank Hungary, the fully owned subsidiary of HypoVereinsbank [HVB] in Germany together bought a combined stake worth 68% of BSE’s

equity. The Vienna Stock Exchange [Wiener Börse] has around 14%; while HVB-Hungary directly owns around 25% [and indirectly 32.9%, according to sources in Vienna].

For the Wiener Börse, the move was obvious.“We’ve been in talks on closer cooperation with most of the region’s exchanges for years,” says Elvira Zak, spokesman at Wiener Börse. There’s been much talk of smaller regional exchanges fading out to Frankfurt and London. But there’s fighting spirit in Vienna. “We believe we are a solid company with a lot to offer. This was a great chance and the deal was completed within two weeks. We’re tremendously excited by it. The local stock exchanges in Budapest and Vienna play an important role as a platform for raising equity for the regional economies and for promoting a broad domestic and foreign investor base. This must and should continue.”

For Hungary’s market watchers, the move by HVB is reported to carry undertones. HVB is said, by local analysts, to have attempted to secure control of the exchange in order to safeguard its local custody business. As for the exchange, BSE’s Kutas remains upbeat. “The exchange’s implemented strategy to boast both international and domestic interest in the Hungarian capital market has clearly paid off, demonstrated in the transfer of ownership at roughly 10 times a higher price for the stocks of the BSE as they changed hands two years ago. It underscores all the hard work undertaken by the exchange to market Hungarian companies and the opportunities for the Hungarian capital market are still very bright for the future.

Listed company performance is far better now in Hungary than in other EU countries and the risk attached to Hungary has decreased a lot with EU accession.”

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Regional Review EUROPE

Tupras decision puts state sell-offs in doubt The annulment of Tatneft’s purchase of Turkish Oil Refineries Corporation [Tupras] raises new questions about Turkey’s privatisation programme.

OLLOWING A LAW-SUIT brought by Petrol-Is, a labour union representing Tupras workers, the Ankara Administrative Court annulled in early June the sale of a 65.76% stake in Turkey’s state oil company to a consortium including Russian oil major Tatneft and Turkish industrial holding company, the Zorlu Group – a deal worth $1.3bn. The Court said that numerous violations were found in the course of the deal.

Turkey’s Privatization Administration Board, which supervised the deal, may appeal this decision in the Council of State. Petrol-Is maintained that the sale was not being carried out according to proper tender regulations.

It is not clear if and how the court’s decision will be reversed; but most Turkey watchers agree that the ruling could have repercussions for the country’s overall privatisation programme which had been agreed

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with the International Monetary Fund under a $19bn loan pact. It had taken a number of years for Turkey to finally agree the sale of Tupras and then to find a committed buyer. Immediately following the court ruling Tupras’ shares lost some value in the Istanbul Stock Exchange, falling to TL9000 – down 1.6%.

A faltering approach by the government to privatisation is not an option. It needs to raise money.

Turkey’s government [consolidated budget] domestic debt at the end of 2003 was $139.3bn. Foreign debt stood at $63.5bn at the end of 2003, up $6.6bn on 2002. The largest part of the outstanding foreign debt – $16.7bn – is owed to the IMF. The government’s domestic debt payments in 2004 will be at least $97bn. From 2005 to 2008, the government will have to service an estimated $48.5bn in foreign debt.

Some 79% of these debts will be payments in principal while 21% will be in interest. Of the foreign debt servicing, $29bn stem from loans received while $19.5bn is the result of bond issues.

“A faltering approach by the government to privatisation is not an option. It needs to raise money.”

Tatneft, Russia's sixth-biggest oil firm in consortium with Zorlu won the tender for the controlling stake in Tupras in early January. The decision was widely regarded as a turning point in Turkey's fitful privatisation programme.

The government is also planning to privatise all three remaining stateowned banks, TC Ziraat Bankasi, Halkbank and Vakifbank. But, as with

Tupras, it’s likely that the government will not find the going easy. Of all three banks under the hammer, Halkbank is the one most likely to succeed as a traditional block sale. It is now working with an adviser and is in discussions with potential investors. Vakifbank has also hired advisers and over the last few years has been divesting itself of extraneous businesses and real estate assets – earning some $120m in the process.

However, the privatisation of Vakifbank will not be easy. Although the bank itself brought in a sound financial performance in 2003, turning a net profit of some $175m, the convoluted shareholding of the bank and its articles of association will have to be unwound before a buyer is found or even approached.

“A rushed sale would not be right for the bank,” says a spokesman. Its sale therefore could – like Tupras before it – end up at the mercy of a court decision. Most likely, Vakifbank will be privatised through a series of share offers, which will gradually dilute the equity of its existing shareholders. “It’s complex but probably the best route forward,”says the spokesman.“Vakifbank is already a private bank in many respects. Its shareholders are charitable foundations – not the government. A traditional sell off would not work in this instance.”

Ziraat, meanwhile, is Turkey’s banking behemoth and will require a radical restructuring – which could take years, before it comes to market.

Ziraat, traditionally, has been the government’s paying agent for all civil service salaries – which makes it a very attractive bet. However, the bank is ubiquitous throughout Turkey and has the largest branch network of all Turkish banks and that’s expensive to maintain, say local analysts.

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Regional Review NORTH AMERICA

Soft dollars Amid the current hue and cry regarding soft dollar commissions, a new report by industry consulting firm Greenwich Associates declares: Soft Dollars Decline Under Specter of New Regulation.

Though an ominous title, the jury is still out whether the practice will disappear completely. One thing is certain however, the industry will have to move quickly to provide full disclosure on soft dollar services, or face an impending crack down by regulators. Karen Jones reports from New York.

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hit a hard landing

NACTED BY CONGRESS over twenty years ago, soft dollars allow investment managers to pay brokerages for third party research without using their own capital.

Depending on the brokerage, a commission is “bundled”to include both execution of trade [hard dollars] and services [soft dollars], primarily research.

Because beneficial owners pay for the commissions and the investment managers accrue the services/benefits from the brokerage, the question has periodically arisen, is the beneficial

E

owner receiving full value? Jim Allen, associate at the Chartered Financial Analysis [CFA] Institute, says “Our view is the value belongs to the pension fund, not the investment manager, but they are the ones who are getting the benefit of the research.

That research may or may not benefit that pension fund.” Formerly the Association for Investment Management and Research, the CFA is a non-profit organization and a leader in promoting ethnics throughout the industry.

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John Meserve, President of Westminster Research at the Bank of New York Securities.

The combination of little disclosure to date regarding commission costs and routine investigations, which can turn up soft dollar abuses, periodically brings the issue to a forefront. “This kind of debate rears its head every ten years,”says John Meserve, President of Westminster Research at the Bank of New York Securities. “Historically there has been a lot of bad press and misconceptions around so called soft dollars.” He adds that they are the leading provider of independent research through agency brokerage and abuses at Westminster “don’t happen.”Unlike Wall Street firms, they provide “full transparent information to the investment manager.”

A 1998 sweep inspection by the US Securities and Exchange Commission found that the majority of soft dollars translated into research. Though nonresearch services can be lawful with full disclosure, the SEC also found some advisors used soft dollars for personal expenses, hotel and car rental costs, personal entertainment, limousines, interior design and more.

Almost half of all US households are invested in the $7.5trn mutual fund

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industry. The House Financial Services Committee launched hearings on mutual fund fees in March 2003 and in April 2004 SEC Chairman William Donaldson addressed the Senate Banking Committee. In addition to advocating “improved disclosure” and transparency, he asked that Congress not “step in”until his internal initiatives to solve industry problems show results.

Donaldson calls soft dollars a “very high priority”and has comprised a task force to “fully understand all aspects of how soft dollars are used, and the pros and cons of various alternative reform approaches, including possible unintended consequences.”

Depending on whom you query, abuses are either part of the landscape or overblown.“I’d say it’s exaggerated out of all sense of proportion, but that depends on what you consider an abuse,” said John Webster, Managing Director at Greenwich Associates, a consulting firm on the institutional providers of financial services. “If it’s research, fine, but if it’s ABC Carpet, I’d like to know why.” He adds that the industry has already been “shaken up quite a bit” and soft dollar usage is shrinking as a result.

The Greenwich Associates report states that of the $11.3bn in US equity commissions generated by US investors in the last year, the soft dollar portion is $1.24bn, down 18% from last year. The average commission rate reported by institutions on soft-dollar trades fell to 4.9 cents per share in 2004 from 5.1 cents in 2003 and 5.6 cents in 2002.

The report also found that 87% of US soft dollar users allocate them to buy financial market quotes and databases. Meanwhile, 74% purchase third–party research by vendors or non-broker dealers and 53% purchase third-party research from independent broker-dealer boutiques. About onehalf of the firms interviewed for the report say they are “opposed” or

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John Webster, Managing Director at Greenwich Associates

“reluctant” to pay for third-party research with “hard dollars,” though if full service commissions become unbundled, that may become standard.

Looking towards the future, Westminster’s Meserve offers that both the US and UK are on a “parallel track” in their approach to revamping soft dollars. “The Financial Services Authority came out on May 7 this year suggesting they were going to abandon the issue of unbundling but urged the Investment Management Association to lead a market initiative that would provide disclosure around a full-service commission.”

Greenwich Associates suggests that in light of the possible impact of regulation on equity research and the downward trends in equity commissions and soft dollar usage,“enhanced transparency in research acquisition would be the most effective means of improving investor performance.”

John Webster adds “more disclosure is ultimately the right solution for the market,” and to actually ban everything“would be an error because there is real value being generated through soft-dollar goods”.

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Regional Review NORTH AMERICA

Sarbanes-Oxley continues to exert its restraining influence on the US market. While European companies are by no means flocking to London in preference to listing on US exchanges that are bound by regulatory burdens, increasingly the word around the City of London and Wall Street is of a growing reticence for listing in the US. Ian Williams investigates.

Jon Edwards, who manages the Russian desk at the London Stock Exchange [LSE] says that a listing in London is a “flight to rational legislation: that is rational to the task in hand without being too prescriptive.”

The recent Davis global corporate governance assessment placed UK corporate governance at the top for many years running, he adds.

The urban legend of a US listing NE OF THE great urban legends of the 19th century was that Russian soldiers had been seen marching at night through Britain with snow on their boots. In the transatlantic financial markets a current version has it that Russian companies – with or without snow on their stock certificates – are flocking to London in preference to New York, dominated as it is by Sarbanes-Oxley regulations.“There’s no hard evidence to actually suggest that this is the case,”says Don Guiney, Partner in the US corporate group at law firm Freshfields Bruckhaus Deringer.

“However, there are lots of European companies expressing reticence about listing in the US. We are hearing it from a lot of bankers and issuers – not that many Russians though.”

Even so, Efes Breweries International, the Russian offshoot of Turkish brewers Efes Anadolu [which still owns 85% of the company] decided to list in London with Credit Suisse First Boston as advisor on the float. With an estimated worth of £279m, the company wants capital to expand its Russian sales.

Exchanges in New York are not talking. Nonetheless, London is seen as growing competition; though in justice they cite the absence of any delisting as proof positive that the US exchanges are still ahead. Scratch them however and

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they will admit that some European companies are beginning to baulk at the idea of a US listing. “Many non-US companies that raise funds in the US through private placements and Rule 144a transactions will avoid most of the Acts provisions,” counsels Freshfields’ Don Guiney. The companies enmeshed under the Act are primarily those that have securities listed on a US exchange or quoted on Nasdaq, he explains.

“Actually it’s really hard to spot the underlying trend, particularly as we’ve just come out of a difficult period in the capital markets with relatively few offerings. I would say though that now a large majority of European IPOs are not SEC registered.”

While the NYSE says that regulatory standards are rising, they are missing the issue of regulatory costs. SarbanesOxley has imposed heavy regulatory costs on all companies. In the past, lobbyists could negotiate exemptions with the SEC. But the Act now locks full provisions into statute. Some sources [The Accountant for one] even suggest that companies could pay up to 35% more in auditing costs. US law firm Foley & Lardner this year calculated that the continuing average cost of being a public company – with annual revenues under $1bn – in the US itself has soared by 130%, or $1.6m since the Act came into being.

“Sarbanes-Oxley must be regarded as evolving legislation.”

Steve Davies, a corporate governance advisor in Boston discounts the whingeing about costs. “If companies had behaved themselves, they wouldn’t have brought this on themselves.” But even he admits that Sarbanes-Oxley’s red tape is a turn off: “It’s only been bearable because of the benefits – mostly the large liquidity.”

Freshfields’ Guiney explains that Sarbanes-Oxley must be regarded as constantly evolving legislation. The latest SEC ruling under SarbanesOxley says law firms now must report to the board of directors any breaches of fiduciary trust and/or material violations of law, says Freshfields’ Guiney. “The final rules don’t look as if they will include the controversial ‘noisy withdrawal’ obligation which would have required lawyers to resign, tell the SEC and disaffirm any documents tainted by violations. That would be virtually impossible to police. But it gives an indication of the fluidity of the overall legislation. I think there will be further refinements, certainly.”

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PROFILE: CALPERS

The laid back look and feel of the $166bn California Public Employees’ Pension System [CalPERS] office in Sacramento belies the true nature of the fund. Love it or loathe it, CalPERS is a powerful market dynamic in the US and abroad.

The target of much of its recent ire has been auditor independence and, in the process, CalPERS itself has been bloodied by a barrage of criticism. Art Detman Jr went to its headquarters in Lincoln Plaza to discover whether CalPERS is saint or sinner.

CALPERS CHALLENGES

THE STATUS QUO IKE SOME FABULOUSLY rich aunt with a sharp tongue, CalPERS is the scold of the equity markets.

Criticizing some companies for their accounting practices and others for poor governance, targeting and forcing change on “focus companies,” rallying like-minded pension funds to beat up on corporate laggards, and even voting against Warren Buffett, patron saint of small investors, CalPERs is itself a market force. Invariably it means CalPERS, which runs America’s largest public pension fund, is a lightning rod for criticism, especially from the political right. But CalPERS’ managers vigorously defend their shareholder activism.

Mark J. P. Anson, chief investment officer – a crispspeaking Tony Blair look-alike who is a chartered financial analyst, certified public accountant, and lawyer – argues that CalPERS has no realistic alternative. CalPERS has to generate $700m every month to pay benefits to its 1.4 m working and retired members, who range from teacher’s aides to judges.

The fund has $100bn of its $166bn in assets invested in equities, while some $46bn is invested in fixed-income securities and the rest – $10bn or so – is in real estate.

Anson says there are three reasons why CalPERS can’t be a traditional passive institutional investor, meekly signaling dissatisfaction with particular companies by selling their

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shares and slinking off into the sunset. First, there simply wouldn’t be enough companies that meet CalPERS’ guidelines in which to invest.“We would have to put all our money in a bank account, and that’s not going to maximize value for our beneficiaries.”Second, even with a staff of 150 and 66 outside managers, $110bn is too much money to actively manage, so $50 billion of it is invested in an internally managed index fund [benchmarked to the Wilshire 2500 Index]. Thus, CalPERS feels compelled to do what it can to raise the financial performance of all large publicly traded companies. Anson’s third reason is especially telling: “If you vote with your feet, you’re selling to someone else who just doesn’t care, who isn’t going to undertake any shareholder activism, who isn’t worried about auditor independence and these other issues. But someone has to do that.”

CalPERS is that someone. Its activism dates back a quarter century to the dark days of greenmail. The practice of corporations’ buying back stock at a stiff premium from highwaymen rightly angered pension funds, and CalPERS took a leading role in pushing for reforms. In recent years its activism, and public profile, have grown sharply.

CalPERS’ Board of Trustees has approved several policies that provide Anson and his staff their marching orders. These positions include banning auditors from doing non-auditing

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Mark J. P. Anson, CalPERS’ chief investment officer

work, guidelines for board independence, and declassifying boards so all directors stand for election at the same time.

After all the scandals involving independent auditors, it is ironic that this issue caused CalPERS so much bad press when it withheld its vote for Buffett as a director of CocaCola. “Our message was lost by the media,” Anson says.

“The message is not about directors; the message is about auditor independence. We withheld our votes from those directors who approved non-audit services from their auditors. At the bottom of every accounting scandal – Enron, WorldCom, Tyco, Adelphia – you found auditors who were not independent.”

Actually, CalPERS’ Coca-Cola vote should have come as no surprise to the media or anyone else. Last year CalPERS notified many companies that it would withhold its vote if they did not take action to achieve auditor independence.

“If we cannot trust the fundamental financial statements that are produced by a company,”Anson asks,“how do we invest? Does Coca-Cola have auditor independence? No, it does not. Its directors approved their auditor to do nonauditor services. The moment you do that, you create a conflict of interest, which brings into doubt the financial statements produced by that firm because the auditor is no longer independent.”

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Although CalPERS did not win the battle at Coke – not yet, anyway – it has had success with other companies, notably American Express, which changed its policy and caused CalPERS to reverse its proxy vote. “We applaud them,”Anson says,“and hope that other companies will get the message and will change.”Meanwhile, expect CalPERS to withhold a lot of votes. By its own reckoning approximately 90% of the 3,000 companies in its various equity portfolios are out of compliance.

“We are not asking public companies to do something that we ourselves have not already done,” Anson says.

“PricewaterhouseCoopers is our independent auditor, and last year we terminated their consulting contracts.”

The actual work of contacting companies to promote CalPERS’ reforms falls to its corporate governance unit, headed by Ted White, a soft-spoken portfolio manager and former deputy state treasurer. He was appointed to the newly created position as part of CalPERS’ effort to build up its ability to engage companies not only on governance but on financial issues as well.

“In the past four years, we have moved the governance program to the investment office, where we’re a unit within Global Equity,”White explains.“Before, it was a legal office function with support from the investment office. And since then that has been reversed.”

The change may have been only cosmetic, but evidently it has helped improve CalPERS’ batting average in arranging company meetings. At one time most companies refused to see CalPERS’ representatives, which is why CalPERS became so publicity savvy. A company could say no to an intrusive visit but not to a critical and widely disseminated press release.

Today, CalPERS seeks to influence corporate governance, and thus financial performance, through not only proxy voting but through its “direct engagement” program. Each year White’s staff screens the CalPERS portfolio, looking for companies that have a combination of financial underperformance and poor governance. This process yields CalPERS’ “focus” list, typically a half dozen or so underachievers. White and his people request a meeting with the company and argue their case for reforms. Typical requests include adding independent directors, as defined

by CalPERS; appointing only independent directors to the audit, compensation and nominating committees; seeking shareholder approval to declassify the board; and adopting performance-based executive compensation plans.

Compliance varies, of course. Last year four companies – Gemstar TV Guide International, JDS Uniphase, Xerox and Manugistics Group – agreed to some of CalPERS’ requests.

Two others – Midway Games and Parametric Technology – haven’t acted on CalPERS’requests or even refused to meet with White or his staff.

Nor does CalPERS always win in its proxy fights. Sure, it engineered a sharp rebuke to the Disney board, forcing it to strip Michael Eisner of the chairmanship. But Eisner remains Chief Executive Officer [CEO], and the board resolutely refuses to act on CalPERS’ demand for a

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succession plan. At Safeway, the big supermarket chain, CalPERS fared even worse. It labeled Safeway’s proposed governance reforms, made in response to CalPERS’ demands, as meaningless and then lost by a wide margin its fight to replace CEO Steven Burd.

CalPERS’ evaluation of companies once consisted primarily of evaluating structural matters. Were the chairman and CEO one and the same? Was the board classified? How many independent directors? Who headed key committees?

Now, with reforms resulting from stiffer listing requirements on the major exchanges and the Sarbanes-Oxley law, evaluation has become more subjective – and more difficult.

“We still have our screening methodologies by which we score companies,” White says.“They do work, but they tend to be just a small portion of our overall analysis and decision about which companies are well-governed and which are not. I don’t know if the screening is 10% of our evaluation or 15% or even 20%. It really doesn’t matter. It is much smaller than our qualitative analysis.”

In other words, a board’s actions are more important than its organization.“That’s the challenge in what we do: figuring out what are the dynamics and challenges of a particular board, its strengths and weaknesses, and how we can affect that. In some cases, it’s that they don’t have sufficient expertise in certain fields. In others, they may simply be dominated by a management team and thus ineffective in fulfilling their oversight function or providing strategic guidance.”

One obvious area is executive compensation. White doesn’t deny that US executives are rewarded far more generously than their European and Japanese counterparts, but he says that’s beside the point.“I know the numbers are very large, but I can’t say that a company should pay no more than X million dollars to its CEO. Besides, I can’t be effective in changing that. But what I can do is affect that equation by trying to force compensation programs into a greater level of pay-for-performance. If there is a sensitivity of pay to performance on the downside equivalent to what it is on the upside, I think that by definition you will solve that overpaid problem to a large degree.”

White disputes the idea that options are the best way to motivate management.“When we engage companies about executive compensation, they tell us, almost without exception,‘Options are the right alignment tool. If the stock goes up, we get rich. If the stock doesn’t go up, we don’t get rich.’ Now, what this doesn’t consider is that options can be very rewarding even for suboptimal performance. If you receive an option exercisable at 10 and your stock is at 10 today and goes to 14 in three years, you’ve made money for your shareholders, right? And you’ve made money for yourself from the option. But what if the peer index went in three years from 10 to 25 or 30 or even 40? And what if all the operational metrics of your company were lower than when you were granted the option, yet somehow the market has increased the price of your stock? It may be nothing more than a rising tide lifting all stocks in an industry.

“We’re not anti-compensation in any way. But these

Ted White, head of CalPERS’ Corporate Governance Unit

equity plans – options, restricted stock, and so forth – should contain other incentives that drive long-term behavior, such as vesting hurdles that are tied to return on capital measures, and peer-performance measures so you’re incentivising superior performance.”

White says that executives claim options put their pay at risk, which he dismisses as largely illusionary. “It usually turns out that the pay is at very little risk because if the stock rose even just a little bit, regardless of how much better peer company stocks may have performed, management could still get rich on that.”

Should stock options be expensed? It’s a question that Saint Warren answers in the affirmative, most Silicon Valley executives vehemently answer in the negative, and CalPERS doesn’t answer at all. Two years ago the staff made a presentation to the board of trustees, arguing that since options are a form of compensation, and compensation is an expense, options should be expensed.

After a great deal of wrangling, board members refused to take a position.

Although White doesn’t have an official position on options, there is one thing is he passionate about: board accountability. “To me, that’s where the magic is. When boards do not feel accountable to external pressures – the capital markets, potential merger/acquisition situations, or shareholder demand to replace directors – they tend to get complacent. It’s human nature. When we are watched, when we are more accountable for our performance, we behave differently. We tend to put more effort into what we’re doing, to take a little more risk, or in the case of boards to watch management a little closer.”

White can point to hard evidence. His corporate

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as being too pro-labor union. CalPERS’ president, Sean Harrigan, is a longtime union man and an executive of the food workers union bloodied in a long and fruitless strike against supermarket chains, including Steven Burd’s Safeway. Most other trustees are either elected by CalPERS members or appointed by the governor. Two serve by grace of their own elective offices, state treasurer Philip Angelides and state controller Steve Westley.

A political board? Sure, but CalPERS is a creation of the state government. Shouldn’t it be responsible to the governor and other elected officers? As for being prounion, that’s in its DNA. After all, nearly all of the public employees served by CalPERS are unionized.

Perhaps a better measure of CalPERS is found in its own performance figures. For the ten years through June 30, 2003, CalPERS’ return averaged 8.2% annually overall. For US equities only, the return averaged 9.8%. And for the 12 months ended March 31, the total return was 29.6% – 38.3% for the US equity portfolio, better than either the Dow Jones 30 or the S&P 500.

Scold, meddler, nanny or activist. Call CalPERS what you will. But it is probably one of the best friends investors have in the world today.

governance unit runs a $3 billion “active management” program, which invests in funds that use CalPERSrecommended strategies – heavy on board accountability, thank you – to turn around ailing companies. For the 12 months ended on March 31, this portfolio achieved a 68.5% return. This is the best performance of any portfolio in Global Equity.

Indeed, even in the less invasive “direct engagement” program, simply being put on CalPERS’ focus list has a positive effect. Some directors may consider CalPERS’ attention nothing but meddling, but apparently investors see it as a rescue operation. The share prices of all six of the 2003 focus companies rose in the 12 months after they were publicly targeted by CalPERS, by 37 to 150%. This happens with such consistency that it’s known as the “CalPERS effect.” But just how much credit can be given CalPERS is unclear. For example, Parametric wouldn’t meet with CalPERS, yet its stock rose 130%. And another focus company, Gemstar-TV Guide, whose stock rose 74%, said it had initiated reforms – including a new management team – well before CalPERS announced its interest in the company.

For all its size and prominence – perhaps because of them – CalPERS is often attacked as being too political, especially

Table 1: CalPERS: Asset Class by Market Value Asset Class Cash Equivalents Global Fixed Income Equities Domestic International Alternatives/Private Equity TOTAL EQUITIES Real Estate Total Equities & Real Estate TOTAL FUND

Market Value $bn

Current Allocation %

Current Target %

Previous Target %

Passive v Active [%] Passive Active

-4.10 47.6

-2.40 28.7

0 26

0 28

0 0

100 100

67.3 35.8 7.8 110.9 11.4 122.3 165.8

40.6 21.6 4.7 66.9 6.9

39 19 7 65 9

39 19 6 64.9 8

84.9 67 0 73.2 6.5

15.1 33 100 26.8 93.5

100

100

100

49.4

50.6

Source: Reproduced with the permission of CalPERS 2004.

Table 2: Growth of Fund and Historical Returns Year 1985 1990 1995 1996 1997 1998 1999 2000 2001 2002 2003

Year end June 30 $bn

Year end Dec 31 $bn

Return year end June 30

Return year end June 30

28.6 58.2 87.8 100.7 119.7 143.3 159.1 172.2 156.0 143.4 144.8

32.7 57.5 96.9 108 128.2 150.6 171.9 165.2 151.8 133.8 161.4

35.4 9.7 16.3 15.3 20.1 19.5 12.5 10.5 -7.2 -5.9 3.9

28 -0.8 25.3 12.8 19 18.5 16 -1.4 -6.2 -9.5 23.3

Source: Reproduced with the permission of CalPERS 2004.

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AMSOUTH

AMSOUTH Oranges aren’t Florida’s only fruit!

At its April shareholders meeting in sunny Tampa, Florida, AmSouth Bancorporation [AmSouth] Chief Executive Officer [CEO] C. Dowd Ritter stood before a video display highlighting the company’s course of action over the near term. “Can you read that in the back of the room?” he asked at one point. But Ritter didn’t need any fancy bar graphs or bulleted mission statements. Proof of his company’s ongoing success lay just outside. David Simons reports on the rise and rise and rise of the regional bank.

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W

ALK OUT OF this building and look around you,” implores C. Dowd Ritter, chairman, president and CEO of AmSouth. “Most of the credit for AmSouth’s growth belongs to the tremendous forces within the Florida market.”

Currently with $47bn in assets, the Birmingham, Alabama-based AmSouth Bank, the principal subsidiary of AmSouth Bancorporation, is soon to rank No. 19 on the domestic big-bank chart [following the JP Morgan /BankOne merger].

AmSouth is undoubtedly a company that’s in the right place at the right time. Regional banks in general have fared nicely over the past few years; as a group they’ve outperformed the S&P 500 by a nearly two to one margin. Things have been particularly sweet in the Southeast, thanks mainly to asset-rich Florida, one of the fastest growing states in the country and the fourth most-populated state of all. “The Florida expansion is relatively new,” explains Amy Eisner, analyst at broker/dealer Freidman Billings and Ramsey [FBR], in Arlington, Virginia. “The growth in the bank’s Florida business has been undertaken only in the last three years.” It was an obvious move, says Eisner, as the population growth trends and household income of Alabama, AmSouth’s home state, is not as strong.

AmSouth is also benefiting from one of the healthiest banking environments in America’s history, maintains Eisner.“If you look at overall credit quality it’s a good story.

The banks are well out of the difficulties they encountered in the 1980s and 1990s. The banking sector is better capitalized and taking more collateral and although credit trends have worsened recently, they are nowhere near where they were in the bad days. Amsouth is also enjoying those conditions.”

Though AmSouth currently operates in six states including Tennessee, Alabama, Mississippi, Louisiana and Georgia, Florida represents the lynch pin for its current and future success. To a lesser extent Tennessee is also providing good business for AmSouth, though its demographics are not as strong as those enjoyed by Florida.

Currently ranked as Florida’s fifth-largest bank, AmSouth is poised to take full advantage of the enormous growth pattern. Hot spots like the Gulf Coast of South Florida – where an estimated 60,000 households have at least $1m in investable assets, according to some estimates – remain a focal point.

“Small business lending, and annuity sales, in particular, have been very strong in this low interest rate environment,” said Ritter. The bank’s three-year strategic plan ending in 2003 was extremely positive, he said, noting that return on equity averaged 20% through the period, with cash-dividend payouts increasing by $900m.

AmSouth is enjoying a strong position as a provider of commercial and retail banking services, says FBR’s Eisner.

“It is also expanding its mortgage banking and investment services operations.”

“

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Dropped Ceiling When lawmakers unveiled the plan to reduce federal estate taxes to zero over a 10-year period back in 2001, those who bothered to read the fine print would have discovered that the reduction came with a price: an incremental cut in the credit individuals receive for paying state taxes, from 75% in 2002, all the way down to nada in 2005. Faced with the decision to raise taxes or risk even greater revenue losses, governors in states like Illinois, New Jersey and Rhode Island had no choice but to decrease their state’s estate-tax exemption threshold to make up for the higher federal ceiling. As a result, wealthier individuals who reside in certain parts of the country may find a lot less joy in the Bush estate-tax rollback once they figure in the local math.

Not so in Florida, where the estate-tax system is known as a “pick-up” tax – meaning that Florida picks up all or a portion of the credit for state death taxes allowed by the federal government on the federal estate tax return. As long as the gross value of an estate is below the federal threshold, a Florida estate-tax return need not be filed. And with the federal exclusion rate heading towards $3.5m by 2009, residents can pour on the Coppertone with the knowledge that the family jewels will be safe for the foreseeable future. As an added incentive, the Florida legislature recently approved changes to the Florida Intangible Personal Property Tax, raising the exemption from $40,000 to $500,000 for joint filers.

C. Dowd Ritter, chairman, president and CEO of AmSouth

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AMSOUTH

The prospect of thousands of Winnebago-driving, tax shelter-seeking individuals streaming across Florida’s state line is an opportunity that senior executive vice president Susan Martinez, recently named head of AmSouth’s Florida Banking Group, is already prepared for. Martinez, who began her career as a community bank teller three decades ago, currently oversees some $7bn in Florida deposits.

Though the company’s stated goal is to reach fourth place in the Florida market, Martinez has bigger game in mind.

“AmSouth's existing Florida footprint is centered on some of the major growth areas of the state, including Central Florida along the I-4 corridor, and the West Coast of Florida,” says Martinez.“Our growth is focused in these key geographic areas, and it's an in-fill strategy that is an extension of our earlier focus on four high-growth cities: Tampa, Orlando, Jacksonville and Naples. We’re expanding that to our entire Florida footprint and adding resources in each line of business.

“The growth also plays to our strength and emphasis on relationships and allows us to leverage the strengths of each line of business,” says Martinez. “We do that through an integrated sales process that includes joint calling efforts, team meetings and close coordination to ensure that we’re making referrals across all of our lines of business.”

Flourishing Floridians AmSouth insists that its future growth hinges on the success of its core market – its consumer division. Florida’s older, more financially conservative crowd has been

predisposed to doing bank business for years; not even a continued fall-off in interest rates could stem the flow of cash headed into AmSouth’s bond and money-market offerings.

Though Internet technology has greatly reduced the role of the local bank in many areas, AmSouth considers its branch system to be the primary vehicle for increasing market share.

The company has opened 30 new branches annually within the Sunshine State, with most locations reaching profitability within 15 months, according to the company. Increasing its Florida exposure in terms of both retail and commercial business has been consistently rewarding for the bank and its shareholders overall, says Martinez.

“Our small business and commercial customers can also be good wealth-management clients,”notes Martinez.“The lines blur between a business owner’s business and personal finances and we can provide comprehensive planning for that overlap.”

Despite the ongoing efforts in the retail sector, over the next few years AmSouth expects its strongest contributions to come from the business-banking and commercial-lending divisions. Additionally, AmSouth hopes to cash in on the potentially large nest-egg influx by beefing up its wealthmanagement division, which it sees contributing an additional 16% in revenue growth through 2006. “We’ve made a significant investment in our wealth-management team in Florida, in everything from brokerage to private client services to trust and institutional,”says AmSouth spokesman Rick Swagler.“A lot of providers have abandoned the typical retiree coming to Florida, someone with $1m or so in a retirement account. Our strategy is to focus on that middlemarket $500,000 to $5m range that our competitors have ignored. We can offer customized solutions, individually managed accounts, at $1m for example, while the competition is offering pre-packaged plans. Around that, we build support for the client in insurance, estate planning, as well as credit and deposit products so that all of their needs are met with personal service.”

Takeover Talk

Susan Martinez, senior executive vice president of AmSouth’s Florida Banking Group,

30

With the number of bank mergers since the start of the year closing in on the century mark, analysts are keeping their eyes peeled for the next plausible merger or acquisition target.

Regional mergers notwithstanding, most experts believe that deals involving AmSouth or other Southern firms probably won’t materialize in the near future – simply because business is too good. On the other hand, acquisition speculation may bode well for AmSouth stock over the near term.

“Renewed acquisition activity has bypassed large- and mid-cap Southeast banks to this point, despite the fact that many of these institutions provide buyers with exposure to the nation’s strongest and most resilient regional economy,” says John A. Pandtle, CFA, analyst with Raymond James Associates, whose firm recently rated AmSouth shares as “outperform.”“Given the underlying growth advantage that Southeast banks possess relative to national peers, we are not surprised that so many of the region’s larger players continue to follow the path of independence.”

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million in the first quarter, higher compared with the previous quarter, and the net interest margin was 3.56%.

Compared with the same first quarter in 2003, average loans grew by $1.9bn, a 6.7% increase; average deposits were up by $3.3bn [up 12.1%], while non-interest revenue, which includes earnings from service charges, trust, investment management services, securities gains and other sources of fee income, was $220.4m, up $27.5m [14.3%]. Similarly, service charges rose 23.4%, trust income grew 11.0%, and investment service income rose 25.1%.

Non-interest expenses were $322.3m, up 11.3% reflecting higher staffing costs and investments in new branches.

Net charge-offs were 0.38% of average net loans – an improvement of 22 basis points from 0.60% during the last three months of 2003 – a level not reached since the spring Big Business Balking Though a recent report indicated a 50% rise in venture of 2000. The ratio of loan loss reserves to total loans was capital investments during the first quarter, big business has 1.28% at the end of March, reflecting improvements in credit quality trends and a been slow to capitalize on shift in the loan portfolio Florida’s growth spurt. The mix to include a greater inertia was reflected in the “...We can offer customized solutions, proportion of residential recent numbers of AmSouth, individually managed accounts, at $1m for mortgages. Nonperforming which, like many regional banks, reported only marginal example, while the competition is offering assets continued to decline during the first quarter with improvement in Q1 profits pre-packaged plans...” total nonperforming assets year-to-year [45 cents, versus of $135.9m, [or 0.45% of 44 cents]. Should the loans net of unearned economy begin to move forward in earnest – as some numbers suggest – the long- income, foreclosed properties and repossessions, compared awaited spike in commercial-loan activity could vanquish with $147.8m, or 0.50%, in the last quarter of 2003].

“We are so fortunate to be located in one of the greatest those concerns.

AmSouth also has to contend with some stiff competition parts of the country right now,” Ritter told shareholders from its Alabama neighbours – which are also anxious to during the April meeting.“The activity, progress and good sweep up Florida’s lucrative business. First is South Trust, the things we see around the Florida region will continue to largest bank holding company in Alabama, which has just benefit investors everywhere.”

Concluding his talk, Ritter rolled a brief film that began with acquired FloridaFirst Bancorp. Then there’s the fast growing Regions Financial, which also has been aggressively staking the message, “We’re building something that’s as solid as out territory in the southern states. Already armed with 700 brick, strong as steel, and can last a lifetime.” A familiarbanking offices throughout the South, its planned purchase sounding theme, perhaps – but with Florida playing a sizeable of Union Planters will create one of America’s top 15 banks. role in the company’s long-term growth initiative, Ritter Regions also owns the Memphis headquartered investment believes AmSouth has the wherewithal to make it happen. bank, Morgan Keegan, which itself has been expanding its operations rapidly through its 140 offices in the South as Amsouth Bancorporation vs. FTSE US Banks Index well as in New York and Massachusetts.

(Large/Mid Cap) As it stands, AmSouth remains upbeat. Its 2004 guidance suggests year-to-year growth of anywhere from 6% to 9%, based on such factors as a more stable net-interest margin, continued deposit and earning-asset growth, steady growth in non-interest revenues and a moderate increase in non-interest expenses.“In general when I look at bank stock, I look at interest rate management and credit risk.

AmSouth handles both well,” says FBR’s Eisner [The bank reports a return on average assets of 1.40% and an efficiency ratio of 54.6%.]

Solid growth in loans and deposits, continued improvement in credit quality and growth in core categories of non-interest revenues were key contributors to the first quarter's results. Net interest income was $359.5 Not everyone believes that regional superstars like AmSouth are completely impervious to takeover fever. In a recent report, Citigroup Smith Barney noted that second-tier big banks like Wachovia could respond to the mega-merger activity of JP Morgan Chase and Bank One by making a play for banks such as AmSouth. Wachovia currently ranks No. 2 in Florida with 15% of the market. “There have been rumours,”says FBR’s Eisner,“It’s an attractive footprint.”

In a recent analyst conference call, Wachovia chairman and chief executive Ken Thompson denied such speculation.“We are willing to make acquisitions, but we are only willing to make them if they are attractive to our shareholders,”said Thompson.“We don't need to do a deal.”

150

140

Amsouth Bancorporation FTSE US Banks [large/Mid Cap]

130 120

110 100

90 80

70

31-May-04

29-Feb-04

30-Sep-03

31-Aug-03

31-May-03

28-Feb-03

30-Sep-02

31-Aug-02

31-May-02

28-Feb-02

30-Sep-01

31-Aug-01

60

31-May-01

DOC1.QXD

Source: FTSE

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COVER STORY

Ericsson, the world’s largest manufacturer of mobile networks is back on track. Like other telecoms systems providers Ericsson has endured a market downturn which saw it lose over 50% of its workforce and resulted in a complete overhaul of the company’s infrastructure.

Francesca Carnevale talks to Ericsson CFO KarlHenrik Sundström about the cost and the outcome of the biggest and most comprehensive restructuring in Swedish corporate history.

HESE DAYS THE sun shines brightly on Stockholm’s Highway E4 and its tributaries. Strung along E4’s route out of the capital is Sweden’s informal version of Silicon Valley, where internet and telecoms companies and start ups vie for prominence. A tree-lined junction provides a turn-off to Kista, the industrial suburb that is home to Sweden’s super-company Ericsson.

In late April Ericsson, the world’s largest mobile network manufacturers beat analysts expectations to file a first quarter pre-tax profit of Krona4.3bn [which is equal to around $558m], lower than expected operating expenses, and a strong increase in shipments. It had been achieved in combination with a recovering market as mobile phone operators are once again expanding their networks after several years of under-investment.

It was, though, in large part achieved by one of the most swingeing restructurings the company had ever had to implement. “It’s a remarkable turnaround and it occurred much faster than people thought – particularly as their sales were cut almost in half,” says Håkan Wranne, chief

T

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analyst at Fischer Partners in Stockholm.“Now profitability has recovered and this year the company will grow by around 10%, after dropping by terrible numbers for three years in a row. Today, the company is probably more intrinsically profitable than it has been in the last 15 years.”

Ericsson’s share price has also recovered to around €23 [in mid-May]: “well up on the €3 or so it reached during Ericsson’s darkest days,”adds Wranne.

Ericsson’s order book grew by 22% year-over-year [YOY] in the first quarter [Q1] of 2004, and by 12% over Q4 2003, while net sales in the quarter were up 9% YOY to Krona28.1bn, but for “seasonal reasons”were down on the Q4 2003 by some 22%. “Nonetheless, the company’s gross margin went up three percentage points to 44.7% because of a reduction in sales costs and an improved product mix,” says Karl-Henrik Sundström, Ericsson’s Chief Financial Officer [CFO]. Operating expense reductions continue on track, he adds, with an annualized run rate of Krona35bn in the first three months of this year. Cash flow before financing was Krona2.9bn with the

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company enjoying “positive effects from improved earnings. However, cash flow was also affected by increased work in progress as a result of the higher business activity,” he adds. “Working capital is definitely one of the success factors. Even though you see costs coming out, you always worry about liquidity.” Foreign currency exposure cost the company around Krona0.8bn – a not insignificant sum for a company that exports 97% of its manufacture. Sweden, ironically, is not among the company’s top ten sales markets. [Sweden represents less than 10% of total sales and has done for many years

In spite of the warm glow of profits and Sweden’s spring sunshine, natural caution in the company’s outlook is still strong in the immediate aftermath of restructuring: “Virtually every operator has strengthened their financial position and is upgrading services and products,” says Ericsson Director of Media Relations, Ola Rembe, in the run up to an interview with CFO Sundström.“But even that brings its own challenges,”he adds.

Implicit in Rembe’s smiling explanation is that it is not just Sweden’s highway bound telecoms entrepreneurs who are looking at the sun once more after a long and dark winter of

Ericsson rebounds in a new network world although Ericsson is the number one telecom supplier in the country.] “It’s because of what we are: a business to business vendor,”explains Sundström.

“We have clearly strengthened our market position since last summer,” says Sundström. “Our year started well. We won a number of contracts in key growth areas, such as India and China. A stronger customer focus as a result of the restructuring has contributing to turnaround.” Even so, Sundstrom says the company remains cautious about growth: “We are looking at a market that will grow anywhere between 3% and 9% this year – it’s better than we thought it would be last year, but not as good as many analysts would like perhaps.”

Significant improvements in operating profit, gross margin and cash flow have been achieved through increased efficiency and a reduction in the company’s cost of sales. The major component in the company’s restructuring is now over, with minor adjustments remaining to be completed by the third quarter 2004, he adds quietly.

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recession. So are Ericsson’s competitors. The market in telecoms infrastructure market is itself in flux, bringing in its wake a series of new risks for the company. Equally the fallout at Ericsson has had some interesting effects and considerations wider afield.“We’ve got a more positive view of the Swedish stock market now, but Ericsson’s role is not as significant perhaps going forward as it has been in the past,” says Lars Bergkvist, strategist at Hagstromer & Qviberg Fondkommission in Stockholm.“By this I mean that Ericsson stock may rise by 30, 50 or even 80% – but not by 500% which it has done in the past. I think that is history now. Now we will see more synchronised growth.”

Since the start of this year, Ericsson’s share price has risen by around 80%. Bergkvist says: “The Q1 results were very important and timely, as some analysts were worried that the share price was over-inflated.”Sundström remains tight-lipped.“I never talk about the share price and where it should be. I leave that to others.”

Sundstrom would not, however, disagree with the essentials of Bergkvist’s view.“I don’t think we will go back

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“...Our short term view is that the market for mobile systems will have only moderate growth. But, you know," he muses, "when you come out of a period of huge correction, it’s hard to see the real trend.”

to the days of the 1990s, with high double-digit growth. I think we will consistently achieve high single digit growth.

Our short term view is that the market for mobile systems will have only moderate growth. But, you know,”he muses, “when you come out of a period of huge correction, it’s hard to see the real trend.”

Ericsson’s competitors are America’s Lucent Technologies and Nortel as well as France’s Alcatel – each one with quite different business models and company structures. Direct comparisons therefore are difficult.

Nonetheless every one of the companies has faced similar market conditions over recent years: “conditions which were far worse than any one of them could have predicted - even in their wildest dreams - at the end of the 1990s,” smiles Sundström ruefully.

Equally they have survived the crash using different strategies. All at one time have used or considered asset sales, unwinding of capital positions, refinancing, the slashing of payrolls and product lines that were not profitcritical, outsourcing of non-essential services, and the transfer of manufacturing to lower cost areas. All the companies face a fast changing market where the new foci are third generation [3G] wireless, Internet Protocol [IP] technology, a shrinking traditional marketplace and major dislocations in supplier-customer relationships. Order lead times have shrunk and manufacturing wherever possible has been outsourced [hence some of that sunshine along parts of Highway E-4]. Service prices are also in decline.

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According to Standard & Poor’s Ratings Service, clear product positioning, rapid technology evolution, financial resources and reliable customer support and distribution channels are vital for future growth for Ericsson and its ilk.

Ericsson is the world’s leading supplier of infrastructure that allows telecommunications service providers to offer wireless communications. It enjoys a market share of approximately 40% explains Ola Rembe. Radio base stations provide access and interconnection between mobile phones and their supporting mobile network and Ericsson’s installed radio base stations represent just over one third of all GSM base stations in service throughout the world. A feature of the company’s stations, says Sundström, is that they can be upgraded on a cost effective basis to support the next generation wireless transmissions.

In joint venture with Sony, Ericsson is also one of the world’s five largest mobile telephone makers with a global handset market share of around 5% last year. The joint venture, Sony Ericsson Mobile Communications was established in 2001 and last year sold over 27m units. Sony Ericsson is not consolidated in Ericsson’s accounts however. “We get extra commercial advantage from Sony Ericsson,”smiles Sundstrom.“And the other way around.”

More recently, just after the company’s improved results were announced, Ericsson and Cisco Systems signed an agreement offering joint solutions to wireline telecom carriers: offering Internet Protocol [IP] as the basis for

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networks that can deliver multiple services. It is an tenure. Some of the guys I work or worked with, I’ve known important move in that infrastructure vendors, such as since school. The only way to do it is to do it with dignity.

Ericsson are moving from a data infrastructure based on We couldn’t get people to feel happy about job losses, but at ATM [or asynchronous transfer mode to the uninitiated] to least they could leave in a dignified way,”says Sundström.

There’s also method behind Sundström’s thinking. He’s one that supports IP. The agreement does not preclude either party working with others and has no time limit. not a soft touch by any means and is well-known for his Although the agreement will not necessarily have a impatience and focused – some would say highly driven significant impact on the company in the short term, in the approach.“I’m not turning soft – but I probably worked with optimistic – but still uncertain – days of 2004, the most of the people in Ericsson at some time. A lot of the emergence of strategic alliances such as this illustrates that people who left were very talented and they may come back as an employee. Equally, we will likely meet them out there it is a critical time for public service networks.

Restructuring of the company began some 24 months ago, as a future customer. So the rationale was that the company explains Sundström. “The action was linked to 3G cannot afford to keep them. No one felt useless. You know development with some €120bn transferred from mobile instinctively what’s important and you must always bring operators to governments of Western countries in return for people along with you. Telling the truth wasn’t enough.”

Truth to tell: the impact of the cuts was significant. transmission rights. “Suddenly, mobile operators sat in a tough debt situation,”he explains,“Heads started to roll. The Ericsson went from 107,000 employees down to 50,000.

Some 50% were lost in issues were not only debt but Sweden and 50% outside the debt reduction and cash flow country – “we didn’t play the of which a significant part home game. Fair’s fair was debt restructuring.” “...you have to maintain customer everywhere,” says Rembe. It “We just watched sales fall relationships and continue developing was simply the biggest off and the share price product. It comes at a price. You have to reconstruction of a company tumble,” he grimaces – with then choose what not to do.” in the history of Sweden. obvious connotations not Focus is everything, adds only for Ericsson, but also for Rembe: “we kept the right the Swedish Stock Exchange competence and we did the in which Ericsson is the leading listed company. “When you go through a change right things.” Basically, says Sundström because Ericsson like this it’s devastating and this in an industry of extremely was running at a loss: “the company had to improve working capital, reduce our inventory and reduce exposure. high growth.”

It was a signal indication of a major change for the That’s what drove us.”

The company then went one further. In early 2003 it company.“The top line drops faster than costs and so during a period like that it requires discipline. Not only that, you went beyond Ericsson’s traditional trammels and got a new have to maintain customer relationships and continue Chief Executive Officer [CEO] from outside, for the first developing product. It comes at a price. You have to then time since 1946.“But you are seeing here the shift in culture choose what not to do,” says Sundström. “It’s a surgical and performance.”Sundström himself was appointed CFO approach. Understanding consumer needs is increasingly in April 2003.

Sundström is keen to stress that the company’s important in this industry. The key challenge for both operators and us, as a business partner, is to understand turnaround was not the feat of a single person. “We which services consumers want, what they are willing to pay brought as many people as possible into the equation and gave them responsibility to act and to achieve – I think it for them, and how to adapt business models accordingly.”

The company was fast off the block, instigating a made the difference.” He also stresses the power systemic approach to clawing its way out of loss. triumvirate at the pinnacle of Ericsson as the key driver Everything hinged around regular fortnightly management going forward: “Bringing in Carl-Henric Svanberg was a meetings in which clear targets were set and timelines in departure from our tradition model,” explains Sundström. which to achieve the targets.“Every 14 days I had meetings “He brought a clear focus. We already had a great Deputy with business heads either through teleconferences or live. CEO in Per Arne Sandstrom. It’s created a strong leadership dimension at the top,” says Sundström. The Everyone, but everyone, had to present progress reports.”

A shadow passes across Sundström’s face.“We had to say market agrees: “Ericsson’s management team is stronger goodbye to a lot of friends.” It is not a gratuitous nod to than it has been for some time,” says a Stockholm broker. political correctness. It obviously means something for “The company is also enjoying a market that is rebounding Sundström; and it certainly went against the grain of – which is lucky for them.”

“The mobile infrastructure market has definitely Ericsson’s traditional corporate culture. The company has been around for over 100 years, explains Ola Rembe; most stabilized, traffic continues to grow and operators are employees have worked for the company for over a decade. increasing their focus on network quality and capacity. The “I’ve been in this company for 19 years and it’s a typical year ended with strong sales and we continue to further

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enhance our leading position,”said Carl-Henric Svanberg, sales during the quarter. This year will be important for our President and CEO of Ericsson at the presentation of the industry as commercial launches of 3G gather speed in preparation for a mass market in 2005.” company’s Q4 2003 results.

“In addition, tariffing plays an important role for traffic “More and more operators are considering outsourcing of network integration and management. We recognized this development. The strong traffic growth in North America potential early on, and based on our competitive advantage in over the years has mainly been driven by flat rate pricing. end-to-end solutions and our large installed base, we have Recently, similar tariffing schemes have started to surface in Europe and Asia-Pacific and the market's strongest service are likely to stimulate traffic portfolio,” he added.

Sundström says this “The key challenge for both operators and growth” explains Sundström.

“In emerging markets underlines an important element of the turnaround. us, as a business partner, is to understand subscriber growth continues which services consumers want, what they to be strong. In certain “We had anticipated technology advancements. are willing to pay for them, and how to adapt markets such as China, India and Russia, there is a Continued research and business models accordingly.” continuous need for further development was vital, to capacity enhancements ensure we enjoyed synergy with emerging technology. We knew it would happen; we just driven by this same strong traffic growth.” The emerging had to get there fast, irrespective of what was going on markets will be a strong feature of future sales.

Today, worldwide subscription penetration is only 21% elsewhere in the company.”

“I think sometimes people under-estimated our task. We with a total of 1.34 billion subscriptions. “The global were spread in 140 countries; albeit some areas were less number of mobile subscriptions is estimated to reach two difficult to handle. We were luckier than our competitors in billion during 2008. We believe that our solutions for that we kept research and development and our customer operators in emerging markets could increase this growth rate,”he adds. relationships,”he explains.

There are still a few chills in the air, despite the spring.

“Many operators in mature, capacity driven markets are signalling constraints after several years of limited Ericsson vs. FTSE All-World Information Technology investments and the increasing use of voice and mobile Hardware vs. FTSE Developed Europe data services. 3G is the main focus but there is also a need for investments in capacity enhancements of both 2G and 2.5G,”says Sundström.“It’s not been easy by any means.”

Sundström believes that the corner has been turned, after three consecutive quarters with positive results. It all adds up, he maintains, to a satisfying whole.“We have the most comprehensive experience from all around the world and in all standards. Our leading position in both 2G and 3G is a decisive competitive advantage in supporting operators in all markets and phases of development. We have built this strong position on our cutting-edge technology, large volumes with economies of scale and our ability to offer end-to-end solutions. As market leader we have together with our customers gained key lessons in the early stages of the 3G rollout. This experience provides important advantages and we are encouraged by the 3G Source: FTSE 350

300

250

US$

200

150

100

FTSE All-World – Information Technology Hardware

Ericsson

30-Apr-03

30-Mar-03

30-Feb-03

30-Jan-03

30-Dec-03

30-Nov-03

30-Oct-03

30-Sep-03

30-Aug-03

30-Jul-03

30-Jun-03

0

30-May-03

50

FTSE Developed Europe

Name

SEDOL

Country

Stock

Economic Currency

Sector Group

Sub Sector

Full Market Cap (SEK m)

Ericsson

5959378

Sweden

SEK

Information

Information Technology (90)

Telecommunications Technology Hardware (93)

310,955 Equipment (938)

Source: FTSE, as at 28/05/2004

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SETS A

SECURITISATION

RMBS

The European market for asset-backed securities [ABS] seems certain to set a new record for total bonds issued in 2004. New records have been set each year for the last five years. There’s a seemingly unquenchable investor appetite for an ever larger stream of new issues. Andrew Cavenagh looks at the reasons for the present bull rush and what it means for the market’s future direction.

NEW PACE

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SECURITISATION

HIS YEAR’S STATISTICS imply that total ABS issuance is bound to overtake the €200bn achieved in 2003 by some margin. In its most recent market outlook, Dresdner Kleinwort Benson noted that despite a weak month in April – during which only €8.2bn of bonds were issued – the cumulative total for the year to the end of the month of €63bn was still up 24% on 2003. And the German bank expects to see a further surge before the industry’s stages its main annual conference in Spain between June 14 and 17.

“We expect primary activity to increase in the run-up to Barcelona, with around €20bn equivalent in the current pipeline… Demand remains very strong all the way down the credit curve,”the DKW report concluded.

Residential mortgage-backed securities [RMBS] – consistently the dominant asset class in European securitisation over the past five years – continued to lead the charge. By the end of April, RMBS issuance had reached a third of the level it attained in 2003, and it is continuing to account for about half of all the bonds issued.

“In Europe, it’s certainly become a more dominant asset class this year than it has been in the past two,” observes Richard Paddle, senior investment manager at HBOS Treasury Services.

Rob Ford, head of European ABS and secondary trading at Barclays Capital, adds that the levels of issuance so far in 2004 illustrate that RMBS is now an established product in the eyes of the wider investment community, with highquality originators at the top end of the credit curve and well understood by a broad range of investors.

Ford explains that whereas five years ago, fund managers would complain to him that they needed him to sell the idea to their pension fund clients now it was more a case of “the pension fund manager ringing him up and saying ‘why aren’t we buying this stuff now?’”

T

Guy Hart, the head of structured credit syndicate at BNP Paribas

Ford puts the continuing growth in the market down to three factors – a number of new issuers, new [investor] money, and a desire to be in higher-rated, higher, higheryield products. “There isn't anything else that’s triple-A rated that's 15 basis points over Libor,”he explains.

Investors see value Other asset classes have grown even faster in 2004. Issues supported by sub-prime mortgages, commercial assetbacked securities [CMBS], and collateralised debt obligations [CDOs] have already achieved 50% of their 2003 totals, while bonds backed by project finance and auto loans have exceeded 70% of their aggregates for last year.

Steve White, the executive director at Morgan Stanley who heads up the bank’s syndicate desk in London, says

Table 1: Generic Secondary Spreads [over 3-month LIBOR] [7/5/04] Asset Class Rating WAL Level UK RMBS [E] UK RMBS [£] UK RMBS [US$] UK RMBS Spanish RMBS Dutch RMBS Italian RMBS UK sub-prime UK credit cards Auto loans Italian consumer loans Italian leases Balance sheet CLO

AAA AAA AAA AA AAA AAA AAA A AAA AAA AAA AAA AAA AAA AAA AAA

5 5 5 5 5 5 5 5 2 5 3 3 5 3 5 5

13.75 14.5 13.5 27.5 15.25 15.5 14.25 52 21 12.5 13 14 18 15.5 18.5 25

Change since 1/1/04 -4.25 -3 -5.5 -12.5 -8.75 -8.5 -7.75 -17.5 -19 -5 -5.5 -12 -15 -16.5 -23.5 -14 Source: DKW

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the spectacular take-off in the market this year reflects the fact that asset-backed bonds “very significantly”lagged the pronounced tightening of spreads on unsecured corporate bonds in 2003.

“The investor community at large recognised the compelling values in our market and took action,” he explains. While such corrections have occurred before, White says the difference this time is that the number of new investors in the sector has “grown dramatically” over the past six months, as money managers, insurance companies and non-European buyers have become increasingly significant participants in the market.

The influence that US money managers are now exerting, for instance, was evident in the most recent prime RMBS issue out of Northern Rock’s Granite master trust on 19 May. The four dollardenominated tranches in Granite Mortgages 04-2, totalling US$2.59bn, were all aimed at Graham Bird, global these buyers, with short head of rates markets maturities of less than 1.8 years. at ABN-AMRO Dominic Swan, head of structured investment vehicles at HSBC, says a further factor behind the burgeoning demand for asset-backed bonds this year is that large banks are increasing the size of their ABS portfolios ahead of the introduction of the Basel II capital accords, which will limit the regulatory capital benefits that issuers currently derive from securitisation.

Swan says his own bank is a prime example. “We have probably bought about US$4bn over the last year.”

Guy Hart, the head of structured credit syndicate at BNP Paribas, notes that this growth in the number of conduits and structured investment vehicles established by the large banks has significantly increased the size of individual takes on new issues. “Ticket sizes of over €100m are relatively common these days, whereas two years ago they were pretty rare.”

Tightening spreads/absence of tiering The unprecedented surge of investor interest in ABS has had one inevitable unfortunate consequence for the buyers, if not the issuers – the spreads available on the bonds have narrowed all the way along the credit curve both for new issues and in secondary trading.

DKW comments in its latest outlook that secondary spreads have continued to “grind tighter” across all asset classes since the beginning of the year, with the contractions on triple-A notes ranging from 3-23.5bp [see Table 1].

Meanwhile, Swan at HSBC points to the CMBS sector as an example of how dramatically spreads have come in on

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new issues. “Deals that six months ago were pricing in the mid-40s are now pricing in the mid-20s at the triple-A level.”

And the market does not expect the trend to reverse.“We think there’s going to be continued demand supporting these spreads going forward,” says Holly Hammarstrom, head of ABS research at European Credit Management [ECM]. “Triple-B UK RMBS spreads are not going to the 140bp range where they were historically.”

A knock-on from the general tightening of spreads has been that “tiering” – price distinctions between issuers and geographical locations in the same asset class – has all but disappeared.

Whereas UK prime RMBS would have been expected to price a few points tighter than its Dutch equivalent last year, the €973m triple-A tranche in the Saecure 4 transaction launched on the same day as the latest Granite deal came in at 15bp over the 3-month Euribor benchmark against 14bp for the comparable tranche of the latter. [The Saecure tranche also had a slightly longer maturity – 4.9 years versus 4.2].

These diminishing returns have deterred some of the traditional mainstream ABS buyers from making further investments in the European market – at least in the most affected asset classes.“As an investor, we don't buy RMBS anymore,” says Paddle at HSBC. “It just doesn’t pay enough. Buying something at Libor plus 10 just doesn’t interest us anymore.”

He adds that the same is becoming increasingly true of the entire European asset-backed market and that HSBC is looking instead to the US for such investments. “We’re buying most of our product out of the states these days.”

“There's some relative value in US assets now,” agrees Swan at HSBC. He identifies credit cards, student loans and home equity loans as the asset classes of most interest across the Atlantic. US credit cards, for example, are currently offering spreads of around 30bp at the triple-A level.

However, not all asset-backed investors have the ability to be “cross-over players”in the trans-Atlantic market, and some smaller banks with higher funding costs than the front-line large institutions may find the margins between what they are paying and receiving become just too thin.

“I think it's going to push some of the smaller investors out at triple-A level,” agrees Swan. “Smaller investors – especially banks – are going to get squeezed.”

The tightness of the spreads by triple-A rated bonds in particular is also leading some non-bank investors to devise alternative strategies for ABS investment. “We stopped buying [triple A] massively months ago – too

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SECURITISATION

Table 2: European CDO Pipeline [Public Deals] Issuer Structure

Portfolio

Underlying Asset

Mermaid Cypress 2004-3 Rhodium I Bruckner CDO Petrusse Duchess III CDO Jubilee CDO RMF Euro CDO Natexis Euro CLO I

Static Static Lightly managed Actively managed Actively managed Actively managed Actively managed Actively managed Actively managed

Single-tranche CDOs Single-tranche CDOs ABS and CDOs ABS and CDOs Leveraged loans Leveraged loans Leveraged loans Leveraged loans Leveraged loans

Synthetic Synthetic Cash Cash Cash Cash Cash Cash Cash

Source: DKW

many investors have entered the market in the current situation,” says Fabrizio Viola, ABS analyst and portfolio manager at Italy's Generali Insurance.

Viola points out that triple-A paper paying 15-16bp over a three-month Libor or Euribor benchmark may offer value for large bank conduits but not for insurance companies. Consequently, following a series of meetings with banking analysts in the last month [May] he has decided there is better value to be found in the lower-rated paper of the well-established asset classes.“We are trying to go down the credit curve, starting with RMBS and consumer loans – then CMBS. There’s a lot of value in the single-A tranches of CMBS.”

CDOs – A reasonable alternative Up until the past few weeks, CDOs offered investors a reasonable alternative as spreads on these transactions had not tightened in the same way as the rest of the sector - a legacy of the losses many investors incurred on such deals in 2001 and 2002. “A lot of people who invested in those deals that were done four years ago got their fingers very, very badly burnt,”comments Ford at Barclays Capital.

However, during April and May spreads on the triple-A tranches of CDOs also tightened appreciably, which Ford believes reflects the fact that the “structural naivety” of the deals that ran into difficulties has now been“structured out”.

The current deal pipeline shows a clear preference for more cash-flow structures than synthetic deals, with the dominant underlying assets either leveraged loans or ABS [see table 2].

DKW believes that despite the recent spread tightening, however, CDOs still offer the best value in the European securitisation market as portfolio quality has been improving in both investment-grade and high-yield deals. The bank points out that the triple-A tranches on synthetic deals offer a pick-up of around 20bp on a single-A corporate.

The industry professionals also insist there is still good value to be found elsewhere, although investors will need to be more selective than they have been in the past.

White at Morgan Stanley, for instance, identifies nonconforming RMBS as a strong candidate – particularly the double-A rated paper. He also like CMBS, where he says

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the extremes of the credit curve – triple-A/double-A at the top end and double-B at the bottom – offer the best value.

Hammarstrom at ECM agrees with this recommendation for CMBS.“We see value in some of the mezzanine CMBS deals. Right now they haven’t tightened as much as the other sectors.”

There could also be new opportunities for investors in Germany from June onwards, following the agreement at the end of April on the country’s long-awaited True Sale Initiative – which should in theory expand the nonsynthetic securitisation of mortgages and other loans by German issuers.

Lehman Brothers believes the TSI should generate €17bn of true-sale deals backed by mortgages [€5bn] and SME loans [€12bn] before the end of the year.

As products issued out a new framework, they should price at a slight premium – at least initially.

Fixed-income investors meanwhile will look for a pick-up in the whole-business or corporate securitisation markets, which has refinanced [mostly UK] businesses as diverse as nursing homes and water companies with asset-backed bonds over the past seven years but which has been the one sector to have conspicuously dipped in 2004 to date.

“We’ve been looking at a number of opportunities, but for one reason or another nothing's come forward,” says a banker who has played a leading role in arranging most of the water-sector securitisations. However, he expects to see an improvement in the second half of the year with more water industry transactions once the draft determinations for the next five-year pricing period come out and the long-delayed, multi-billion-pound securitisation for Network Rail due in the fourth quarter.

Viola points out that triple-A paper paying 15-16bp over a three-month Libor or Euribor benchmark may offer value for large bank conduits but not for insurance companies.

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I

Winners

GLOBAL CUSTODY

T IS NOW some two decades since an executive at the Chase Manhattan Bank first coined the phrase ‘global custody’, and while they have not neglected their ‘hold and settle’ heritage – those core services on which the business was founded: safekeeping and settlement, income collection, proxy voting – since the mid-1990s global custodians have worked hard to transcend the transactional side of the business. That process saw numerous contenders fall by the wayside, priced out the market by the scale of the investment required, but those that have stayed the course have successfully reinvented themselves as global market facilitators and aggregators/enhancers of precious market information.

Securities lending, benchmarking services such as performance measurement and risk analytics, compliance monitoring, fund accounting, retail transfer agency, transition management, hedge fund administration – these are just some of the services through which global custodians seek to ‘add value’ for their increasingly sophisticated and globalising institutional clients. Over the coming decade their product offerings will continue to be shaped by the ongoing transformation of investment institutions’ own business models.

“I’m amazed that people are still calling us custodians,” says Jeff Conway, managing director, investor services at State Street. “Certainly, at State Street custody is a foundation stone of who or what we are, but these days it is only a small part of our identity.” Richard Beaven, managing director, global custody, Europe at The Bank of New York [BNY] agrees, noting that over the past 18 months very few new deals have been custody-led.

“There is an assumption, certainly when dealing with the big custodians, that they can do it, and do it well, no questions asked,” Beaven says. He cites the deal that BNY

staythe course

There’s a distinct whiff of the Augean Stables about the role of the global custodian. The industry has made significant progress recently in cleaning up the post-trade space – through initiatives aimed at enhancing automation, straightthrough processing, message standardisation and the harmonisation of market practice. But there’s still some way to go before the dream of a wholly seamless mechanism spanning trade execution through to settlement is realised. Tim Steele reports.

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recently struck with Insight Investment Management: “They did not come to us for our ability to hold and settle, but rather for our onshore and offshore transfer agency capabilities – it was about the whole package we can offer, although obviously on the back of that came significant custody assets which we will service for them.”

The acquisition in 2002 of Deutsche Bank’s global custody operation by State Street also signalled an important shift in the dynamics of the business. With some $2.2trn in assets, Deutsche Bank was by some margin the biggest indigenous European custodian. After its acquisition of Bankers Trust three years earlier – in hindsight an ill-starred deal which marked the beginning

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of the end as opposed to any bright new dawn – the bank had been expected to give the big US custodians a run for their money. The long-cherished view that scale was a guarantee of longevity was turned on its head. In reality, Deutsche’s board pulled the plug because it could no longer countenance the level of investment required to keep them at the cutting edge.

José Placido, executive vice-president at RBC Global Services – which, along with Brown Brothers Harriman, has carved a successful niche for itself as a so-called ‘specialist’ provider – acknowledges that economies of scale are vital for any global custodian in order to support its clients’ cross-border activities.

Jeff Conway, However, he goes on to stress that the emergence of managing director, new, cheaper technologies means so-called specialist Investor Services at custodians can now compete on a more equal footing State Street with the larger players when it comes to breadth of product offering, time to market and cost. Placido goes Consequently, custodians are re-imagining existing further. He suggests many of the larger players have, in recent years, inexorably moved closer to a specialist systems and processes to ensure they can tailor strategy. “Focus is more critical than ever – you can no information to better meet client needs.“Whether you are longer be married to the old custody model that the client of a mutual fund, a pension fund or an prioritises quantity over quality,”he says.“Ultimately it is insurance company, global custodians will act as the type of assets that you are servicing that determines integrators of data, capable of distributing information on a real-time basis so clients can make decisions far more profitability.”

Clients’ desire for ever more information has been – and swiftly than before,”says Placido.

Of course, such re-engineering carries a hefty price tag, will continue to be – central to the custodial offering.“We are the repository of a lot of information,” says BNY’s one that increases exponentially as a custodian’s operations Beaven. Technology spend is focused on taking increase in scale.“If you want to stay in this business you are going to have to continue to transactional flows and data spend big bucks on warehouse information and technology – certainly, dissecting, enriching and “Focus is more critical than ever – you bankwide we are spending otherwise manipulating that can no longer be married to the old some $800 million a year on data in a way that adds value IT,”says BNY’s Beaven. to a client: “For instance, we custody model that prioritises quantity However, all this talk of can provide a pension fund over quality,” technology belies the fact which has five fund that global custody remains managers with information at heart a relationship on the effectiveness of each of those managers, not in terms of fund performance but business, and indeed increasingly custodians are looking to position themselves in a more consultative role, operationally,”he adds.

For instance, a particular manager may be hitting the emphasising partnership and shared expectations above performance benchmarks, but how heavily does it rely on and beyond the cold pragmatism of the usual client-vendor inefficient, costly and risky manual processes such as the relationship. “In the past clients looked to us for our tele-fax, which requires re-inputting and could lead to balance sheet and deep pockets – we could be responsible errors and subsequently failed trades.“One reason clients for collecting their income and moving money from one are consolidating and want to use one custodian is that it place to another,”says Nadine Chakar, CEO of ABN AMRO is difficult to get a coherent overview of that data if you Mellon Global Securities Services.

“These days they are looking to the custodian to go out are using ten different providers,”says Beaven.

Performance analytics, compliance monitoring, complex and actively reconcile with the manager, not just handling investment accounting are the new ‘state of the art’, a accounting and calculating net asset values but also paradigm that first began to take shape in the late 1990s, benchmarking and analysing performance. They are also notes RBC’s José Placido. “Those solutions utilise looking to tap our intellectual capital so that they can really enhanced connectivity and linkages to channel data which put their portfolio to work, whether it be through services has been reformatted and enriched to better assist the such as stock loan or enhanced cash management.”This is institutional investor in making vital investment reflected in the mix of staff custodians are now hiring, Chakar adds: “They are no longer just back office experts – decisions,”he says.

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we also have an army of lawyers, analysts and client service professionals as we are now far more active participants in the day-to-day grist of the capital markets.”

Of course, this focus on partnership manifests itself most explicitly in the outsourcing arrangements that are finding increasing favour among asset managers. As Mark Austin, managing director at JPMorgan Investor Services in London, notes, statistics produced by McKinsey suggest that no less then 40% of asset managers will record a loss during the last calendar year. A key study by KPMG/CREATE that appeared last summer outlined how increasing competitive pressures, an fast evolving operating environment and years of poorly conceived and executed investment in both technology and staff will force managers to embrace a new model of ‘lean production’.

Central to this is the outsourcing of any functions that are non-core, do not add value and/or do not differentiate them from the competition. “What is core for fund managers?” says Austin.“Adding alpha – and if an activity is not adding alpha, then it needs to be reassessed.” He firmly believes 2003 was the year that outsourcing “came of age”. “Going forward the true measure of a global custodian is going to assets under administration – a more involved and complex undertaking – rather than mere assets under custody,”he adds.

Austin argues that outsourcing’s rise to prominence will fundamentally reshape the business. “Now it has gone mainstream, the market is splitting between those who offer it and those who don’t – it is, after all, a phenomenal financial build,” he says. The evolution of the global custody model up to this point has centred on incremental changes to an existing business model, or at the very most advances into new areas of that model via so-called value added solutions, he notes.

“Now we are on the one hand building outsourcing platforms that incorporate most of those value added services, while at the same time we are pushing into new areas as diverse as trade execution, hedge fund administration, fund aggregation and trading,”says Austin.

Only time will tell whether outsourcing proves a good return on the significant investment made by custodians.

“The current trend has been driven by a desire to gather up everything along with the outsourcing relationship,” says RBC’s José Placido. “In the next phase, will custodians stick to a bundled model – where they can truly leverage economies of scale – or end up bidding for individual components, such as fund accounting or transfer agency?”

For his part, Jeff Conway expects to see outsourcing spread swiftly across Continental Europe, but warns that such expansion will place added pressures on providers.

“Increasingly if you play in this space you must do so across multiple markets,” he says. “However, the challenges inherent in running outsourcing arrangements across a range of product types not only in the UK, but also Germany and France and so on, should not be underestimated.”

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“Now it has gone mainstream, the market is splitting between those who offer it and those who don’t – it is, after all, a phenomenal financial build,”

Mark Austin, managing director at JPMorgan Investor Services in London

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GLOBAL CUSTODY

Without a doubt, Continental Europe is the crucible in which custodians’ reputations will be forged or immolated. The diversification and regionalisation of portfolios gives the global players – with their geographical reach, broad and deep product sets and financial muscle – a massive advantage over indigenous custodian banks that offer a tightly-focused, marketspecific solutions. Indeed, with national and supranational depository organisations – already strengthened by a series of mergers – making clear their ultimate intention to move into the commercial space that was previously the sole preserve of the banks, the future for these European subcustodians looks bleak.

“We may well see one central European depository and a handful of exchanges, which would as good as eliminate the need for local custodians, especially as global custodians would be looking to access the market directly and so leverage the scale they possess,” says ABN AMRO Mellon’s Nadine Chakar. Adds BNY’s Richard Beaven: “Depository consolidation is going to continue, and it will be interesting to see what they view as their operating space – are they going to muscle in and eat the custodian’s lunch? I can see European depositories offering bare

José Placido, executive vice-president at RBC Global Services

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bones custody, having the scale and volumes to do it to-back picture of a fund and you have a pretty powerful cheaply, and so beginning to nibble away at some of our proposition,”he adds.

A move closer towards the individual is an inevitable margin and clients.”

While he concedes that the European infrastructure next step, Conway believes. “Asset managers are creating model is in a state of flux, José Placido believes the outcome new distribution paths beyond IFAs and supermarkets, and is by no means certain. He agrees that some or all of these custodians have to keep pace with that – aggregation via supermarkets may be taking utilities, historically owned place at the fund level, but by the market, could reside individual recordkeeping under private ownership and custodians’ encroachment up the value won’t go away in the nearcompete directly in the postchain – and the concomitant stretching term,”he says. trade space with various of the custody ‘concept’ – will continue.

With the current focus on participants such as fiduciary risk – as epitomised custodians and brokerby the New Basel Capital dealers. “Alternatively, the regulators and monopoly authorities may intervene to Accord, which seeks to impose stringent new capital adequacy requirements upon banks – going forward, ensure they remain not-for-profit utilities,”he says.

Given their need to shake a massive amount of assets custodians’ operations will need to be supported by a out the Continental investment tree, custodians are now strong balance sheet, says José Placido.“As a result, we may giving serious consideration to partnering with indigenous see further consolidation, as monoline custody players are providers, as evinced by the alliance forged early last year forced to merge with providers that have the sort of between The Bank of New York and ING Bank. In fact, this underlying balance sheet necessary to underpin the level of approach was pioneered some years back by Mellon and assets under administration.”

Nadine Chakar agrees that consolidation looks inevitable.

ABN AMRO – derided at the time, the subsequent success of the venture has meant it now stands as something of a “In ten years time assets will likely be with a handful of template for those players looking to negotiate the providers,” she says. “Clients will increasingly eschew providers that are merely passive deposit taking banks in fragmented and contrary European ‘marketplace’.

“Mellon recognised they could not conquer Europe by favour of more proactive players that are shaping the sitting in Boston, Massachusetts as they didn’t have the industry and can guide them on risk and governance issues.”

A key challenge for custodians, and indeed the industry relationships or the leverage with some of the larger European institutions to just roll up and sign them up,”says as a whole, is to move beyond bilateral changes aimed, for ABN AMRO Mellon’s Nadine Chakar. “The European instance, at improving straight-through processing Union is of course not yet a union when it comes to custody, between participants towards multilateral initiatives that clearing and settlement, and the diverse regulatory and tax will drive efficiencies in and costs out of the market, says JP environments across individual markets requires you be Morgan’s Mark Austin. “There is a need to knock out operational costs in the middle and back offices while there to become a de facto indigenous provider.” gaining a clearer understanding of where your front Looking to the future, it seems assured that office costs lie,”he says. custodians’ encroachment up the value chain – and In the meantime custodians work to contain the concomitant stretching of the custody the chaos engendered by conflicting standards ‘concept’ – will continue. “Trade execution is and protocols, disparate technologies and certainly very pertinent given the current trade settlement cycles, diversity of national regulatory issues around transparency,” regulatory and legal requirements and, last says State Street’s Jeff Conway. but by no means least, the determination Underpinning that will be a greater of many of their clients and focus on what he describes as “total counterparties to communicate trade fund evaluation”: “Asset and liability details via faxes – which require management analysis is a good manual re-inputting and hence give example – tie that all the way back rise to unwanted costs and risks – as into the performance reporting so an acceptable form of automation. that a trustee can get a full front-

Nadine Chakar, CEO of ABN AMRO Mellon Global Securities Services.

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PUTTING THE CLIENT FIRST

With around $20trn of investment assets under custody between them, State Street, Citigroup and Bank of New York are the three undoubted leaders in the field of securities services in both the domestic and cross-border investment markets. We took the opportunity to talk to the leading thinkers and executives in the three banks to canvas their views on current business trends and future developments. We lead with David Spina, Chairman and Chief Executive Officer [CEO], State Street.

Volume counts, particularly in an industry keen on shaving costs. State Street is reckoned to have some $7trn of domestic assets – with the Bank of New York sidling up behind with just over $6.1trn of domestic assets under management. The battle for dominance of the domestic market appears for now to be between the two of you. How will you stay ahead?

Our industry has always been highly competitive. We have found that the best way to maintain our leadership position is to continually deepen our client relationships.

We do that by offering superior products and services. Just as important, we take the time to really get to know our clients and understand their goals so we can always stay a step or two ahead of their needs. Our investment in relationship management is paying off for us. Our top 100 clients use an average of 12.5 State Street products and services. Our top 1000 clients use an average of 7.6.

In worldwide assets you are dominant with around $9.4trn of assets [estimated as of March 2004]. What do you think separates you from other global custodians and explains why you lead the global pack?

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State Street Chairman and Chief Executive Officer Mr David A Spina

Our competitive strength is our focus on serving the needs of institutional investors. We are the only global financial services provider who specializes in serving this market. Our commitment to institutional investors is evident in everything we do – how we serve our clients, how we allocate our resources and how we develop new products and technologies. For example, we devote 20-25% of our annual operating expenses to developing new technology capabilities that keep our clients ahead of their competitors.

During the last year you completed most of the integration of Deutsche Bank’s Global Securities Services businesses, the largest acquisition in your history. How has State Street been able to leverage the GSS acquisition?

The acquisition of the GSS business has moved State Street dramatically ahead in market penetration, especially in Europe.

It gave us new servicing capabilities, such as depotbank services, and broadened our performance measurement and analytics product suite through the addition of The WM Company. Of course, the GSS client base also offers very exciting opportunities for selling new products and services.

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To support the growth of our business in Europe, we recently established a European Executive Board made up of senior managers based on the United Kingdom and continental Europe. This board is empowered to guide and promote State Street’s continued growth in the region.

We are already seeing the benefits of our expanded presence in Europe. We recently announced major depotbank mandates from Lufthansa German Airlines and Aventis Pension Trust. We’ve also secured approximately $60 million in additional revenue that didn’t come as part of the GSS acquisition.

How has the launch of the State Street Investor Confidence Index SM [a quantitative measurement of investor sentiment] fared? What were the reasons behind the launch and what are the key findings? How has it affected your interaction with investment institutions?

The Investor Confidence Index is a groundbreaking effort for State Street. Based on data culled from the $9.4trn of assets we have under custody, it is the first index to measure what investors are actually buying and selling – which enables us to identify shifts in their appetite for risk. The Investor Confidence Index is also a wonderful example of ways in which financial services companies can team up with academia to create leading-edge products and services.

We launched the index in September 2003, and the response from around the world has been extremely encouraging. Among asset owners, investment managers and central banks it is quickly becoming a well-known and highly respected global indicator of institutional investors’ attitude toward risk. In recent months, we have tracked a less-than-exuberant investor psyche as investors have prepared for expected interest rate increases.

Investor appetite for cross-border assets is growing once more.

State Street – unusually in the custodian business – lags significantly behind Citibank in this regard. How important is this business to you? What are the two main challenges you face in getting there?

With the GSS acquisition, we have seen some increase in our custody-only business, which has contributed to the growth of our cross-border assets. However, because we focus on the long-term success of our clients, we take a holistic approach to serving them. Cross-border investing is only one component in the broad spectrum of services we offer institutional investors.

We believe that the market is heading toward more comprehensive servicing relationships – and recent large deals bear that opinion out. As institutional investors’ needs for our fully integrated middle-office, fund accounting, custody and shareholder services grow, our cross-border assets will grow as well.

State Street recently won mandates to service a total of 14 Securities Investment Trust Enterprise [SITE] collective investment funds in Taiwan that collect investment funds from the public and provide an investment channel for small investors.

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How and why did State Street develop expertise in developing servicing solution for these relatively complex investment vehicles? How is State Street applying this expertise elsewhere?

Complexity is nothing new for us. As industry trends have continued to drive investors’ desires for new and more sophisticated vehicles, State Street has helped to develop some of the industry’s most innovative collective investment funds, including exchange-traded funds in Hong Kong and Taiwan. Our long-term commitment to the Asia-Pacific region has positioned us well to handle the explosive growth in alternative investments there, including hedge funds, fund-offunds and asset pooling.

The depth of our experience within the global financial markets, and our ability to implement solutions at scale, enables us to roll out complex investment vehicles anywhere in the world.

In the past year, a surge in new client mandates in the Asia-Pacific region, along with the integration of clients from the acquisition of Deutsche Bank’s Global Securities Services business, has contributed to State Street’s significant business growth in the wider region.

What challenges do you face in building up business in the AsiaPacific market and how do you aim to overcome them?

Our success in Asia-Pacific is the culmination of years of hard work, patience and a long-term commitment to the region. The fact that we continue to see significant new business growth in this market is a direct result of our ability to provide a consistent level of excellence to our clients. And our efforts are getting recognized. This year, The Asset magazine named State Street “Best Custodian” in its 2004 Asset Asian Awards. Asia Asset Management named State Street “Most Improved Institutional Fund House”, gave us the award for “Best Community Service”, and recognized our role in launching Taiwan’s first exchange-traded fund with the “Most Innovative Product” award. We are earning our clients’ confidence and their trust in the Asia-Pacific region. That’s very exciting, and we expect our market presence to continue to grow.

Of course, economic uncertainty is the greatest challenge in the region right now. Even with pension reforms and development of new market vehicles moving slowly, however, we feel the market is ready to take significant strides toward growth over the next several years.

How do you view and hope to leverage the growing Chinese market?

China is a strategic market that is extremely important to our future growth. For years we’ve been working to establish and nurture strong business and consulting relationships with leading organisations such as the National Council for Social Security Funds, China Securities Regulatory Commission, the Shanghai Stock Exchange, China Asset Management Company and E Fund Management Company. Four years ago, we began offering mutual funds, custody, securities lending, foreign exchange and other asset management services to customers of the Industrial Commercial Bank of China.

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GLOBAL CUSTODY

We have entered into innovative industry partnerships as well, including our technology development programme with Zhejiang University.

I think that as the government works to manage growth in China, positive trends that have been spurring growth for us in the North America and Europe will have an effect there as well. Eventually, China will need more retirement savings and diversification of investments.

This will drive pension reforms and loosen investment restrictions – which means more demand for the services we provide.

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What are the two main challenges you face in the global market over the next five years? How do you intend to State Street Corp Bank of New York Citigroup FTSE US Banks [Large/Mid Cap] respond to those challenges?

Source: FTSE Global pension reform is a source of important challenges and opportunities for State Street. We Which area in your business has exhibited the fastest growth must stay in close communication with our clients, working over the last year and why?

Every area of our business is growing right now. with them to develop new investment strategies, employ innovations in technology, and keep their costs down. Because of our ability to provide comprehensive back-, Another challenge for State Street – as for any company middle- and front-office support to our clients, we have doing business today – is risk management and business seen substantial growth in the investment servicing continuity. Our clients count on us to provide flawless work institutional investors are choosing to outsource to service to them one hundred percent of the time. We take us. State Street’s capabilities and experience in providing all types of outsourcing solutions are well respected, and their trust in us very seriously. we continue to be selected to handle some of the State Street enjoys a special niche in the Japanese market: a industry’s largest and most complicated outsourcing notoriously tough market to crack. What unique elements do deals, the latest being our recent business with ABN you bring to that market and what are the principal lessons AMRO Asset Management.

We expect to see increasing demand for services that you have learned from your 12 years of experience of working in the country? How do you leverage those lessons elsewhere? combine our core capabilities – investment management, The fact that we are the only global custodian with an investment servicing and investment research and trading.

With regard to specific services, we’re seeing a great operations centre in Tokyo has helped us demonstrate our long-term commitment to serving the Japanese market deal of demand right now for servicing alternative and enhanced our ability to steadily build client investments, equity execution strategies and enhanced relationships. We were among the first to offer securities index products. lending and transition management services to the market, adding to our leadership position. Our 12-year tenure in What are the two main challenges you face in the global market Japan has enabled us, through a “bricks and mortar over the next five years? How do you intend to respond to those presence,” patience and consistent client contact, to gain challenges?

Global pension reform is a source of important the confidence of many of the country’s largest and most challenges and opportunities for State Street. We must stay sophisticated institutional investors.

Our determination in the market has been rewarded. In in close communication with our clients, working with the past year, State Street’s assets under management in them to develop new investment strategies, employ Tokyo increased by 60% while our asset servicing business innovations in technology, and keep their costs down.

Another challenge for State Street – as for any company also grew significantly – making us the largest foreign trust doing business today – is risk management and business bank in Japan.

We apply a “global scale, local connections” approach to continuity. Our clients count on us to provide flawless each of the markets where we do business. That is a key service to them one hundred percent of the time. We take their trust in us very seriously. differentiator for State Street.

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What are the main shifts or changes you have noted in investment patterns around the world and how has the bank kept in with these changes and leveraged them?

We have seen tremendous growth in alternative investing, with investors of all types seeking ways to diversify their assets and increase their returns. Exchange-traded funds, hedge funds, funds of funds, and pooling are all very “hot” right now. With our 80 years of experience in asset servicing, State Street has developed flexible, scalable platforms that we can easily adapt to the changing regulations and servicing needs of new types of investments.

In investment management, volatility in equity markets has created a very strong interest in enhanced indexing.

State Street Global Advisors, our investment management arm, has long been a leader in indexing and is well prepared to support clients who want to increase their returns without significantly increasing risk.

Europe is affording some peculiar challenges. While much is being said currently about the widening of the European Union membership, much regulatory tape and decision-making is still made at the national level. How is this impinging on your efforts to encourage new business in the European market? How do you work with the WM Company in this regard?

Given the varied stages of reform among EU members, I believe it will take some time before we see true EU-wide regulations. Because we have local offices in the majority of the EU member countries, we have been doing business successfully at the national level for decades.

Our acquisition of The WM Company has expanded our

suite of research and analytics services and greatly expanded our knowledge capital with regard to European investor trends. As one of the world's leading investment performance measurement companies, WM measures more than 7,000 investment portfolios based in the key global investment centres. This kind of comprehensive research helps us stay ahead of trends that are shaping the European investment environment, especially in the pension fund arena. By keeping our finger on the pulse of the industry, we are well prepared to respond to the changing needs of our clients.

For the global custody industry the contrast between now and two years ago could not be starker or more heartening. How has State Street increased market share during this upturn? How long do you think it will last?

The past two years have been immensely challenging in every part of the world. It’s true that market conditions have improved, but gains have been slow and inconsistent. Industry consolidation, geopolitical instability, low interest rates and cost pressures will continue to affect our business. These things also deeply affect our clients’ businesses, and therein lies our opportunity. In a fiercely competitive market, institutional investors are increasingly looking for technological innovation, reliable service and sophisticated investment strategies – and State Street is in a better position than anyone else to give them what they need.

State Street is gaining market share because we’re sticking to our primary business strategy, which is to offer institutional investors everything they need to succeed.

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GLOBAL CUSTODY

REGIONAL STRENGTH AND GLOBAL SERVICES Citigroup’s Global Transaction Services comprises four business lines: cash management, trade services, fund services and securities services. The Securities Services business has over $6.6trn in assets under custody and the largest proprietary branch network. Steve Bernstein, managing director and head of securities services, took the helm in January 2003 after serving as head of business continuity for Citigroup’s investment banking group.

Volume counts in an industry where efficiencies and competitive pressures are shaving margins ever slimmer. According to a recent independent survey that measures cross-border assets, Citigroup is the market leader, with $4.2trn assets under custody [according to global custody.net 2004 Table of Cross-Border Assets]. Why is Citigroup so dominant in the cross-border market?

We have always had a long-term focus and we have over a hundred years of banking history behind us. We work directly through a proprietary global network – it is not something many of our competitors can offer. Many of our competitors use us as a custodian in many markets. One of our strengths is that we are unrivalled on a global basis. Although BNP would, for instance, be dominant in a European context and HSBC equally so in Asia we have no single competitor across Asia, EMEA, Latin America or North America. We are on the ground in 60 countries for custody – enabling us to work on a timely basis on behalf of our clients and making sure we provide pertinent local market intelligence, I’m thinking here, for example, of the regulatory environment.

What segment of the investment fund management industry are you targeting? Is there a wider strategy?

We are looking at providing services for all fund managers targeting all money managers and all products.

We have the ability with the acquisition of Forum Financial to provide Fund Accounting and Fund Administration. We continue to focus on hedge funds as well. Our intention is to build out a platform to provide securities processing and administration services for all fund managers.

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Steve Bernstein, managing director and head of securities services

What do you think are your unique selling points? What do you think separates you from other custodians and explains why you have recently won a spate of deals?

I think it is our commitment. Last year we spent a significant amount on technology, much of it on new developments that enable us to streamline services and costs. Technology initiatives will continue to be very important in this industry.You have to do this as clients are looking for better, faster and cheaper solutions. Also we bring the services throughout the group to bear on our product solutions. I think what keeps us ahead is constant dialogue with our clients. Equally Citigroup’s securities processing and administration services are constantly being upgraded, while the Global Markets operations are working increasingly closely with the hedge fund sector.

There are few players which are like us and who can offer all the relevant product extensions around the globe.

Outsourcing is an important and growing area for us. We recently won one of the largest outsourcing deals to date from Standard Life – I think that says a lot about where the market thinks we are today. I would say that our clients think we are innovative, hardworking and a very safe pair of hands.

You said in a recent article that you think it is time that Citigroup focused more on the domestic market. Why do you think so?

We think this is an opportune time to develop our local market. We continue to grow overseas, but we also see opportunity in North America. It plays directly to our

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strength of acting regionally, operating globally. Also the US is often a template for product development which can be rolled out elsewhere. As the market becomes more global then the range of services – foreign exchange, financial services, fund accounting and the like are constantly brought up to new standards, which we can also leverage in the home market.

An increasingly complex regulatory environment and the continuing need to find a balance between service and cost are among the many challenges the custody industry faces in 2004 and 2005. What do you think are the two main challenges you face over the next three years and how do you intend to respond to those challenges?

Basle II is a big issue. Some clients will handle it inhouse – others will use us for solutions. Again, it goes back to a point I made earlier. Our challenge is to provide local expertise within a global context. Our role is to provide solutions but we can also offer local expertise on regulatory or compliance issues. With interest rates low as well, then there is also a shift away from fixed income.

So the challenge is continuing to be the provider of choice that can work across a spectrum of products, regions and maintain operations and guidance for customers. We see it not so much as a challenge, but as a great business opportunity.

What are the main shifts or changes you have noted in investment patterns around the world and how has the bank kept in with these changes and leveraged them?

With historically low interest rates in the US investors are looking for a higher yield in the emerging markets and Asia. We are seeing larger investors wanting direct access to certain markets and we have the ability to facilitate that access. We can provide service and scale to clients and we have local market expertise on the ground. Also business is up across the board. We’ve seen a lot of cross-border activity, Asia is strong and we see record flows in Latin America and Eastern Europe. Fund managers continue to look for global opportunities.

Which area in your business has exhibited the fast growth over the last year and why?

The fastest growing region is the Asia Pacific. We have a good team established there, who are working closely with local institutions. We see great opportunity there and we are anxious to leverage it. We were one of the first players to achieve QFII status and we rightly claim 69% of the market in remitted capital. We were also the first licensed custodian bank to be established in China. In China, I think we can say we are ahead of the curve.

The Forum Financial Group acquisition makes particular good sense in this regard as it is a high quality provider to the global mutual fund, hedge fund and offshore fund industries.

The future is about innovation [and we believe we are a leader in this regard] and globalisation, which plays to our

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strengths. Increasingly the web will be utilised more fully and we are working now to develop secure networks and linkages between major players.

The rise of hedge funds must place particular strains and demands on global custodians. What are the key changes in your overall approach to business because of this development?

We bought Forum Financial – a fund administration company – which has helped a lot. Hedge funds have always been a significant group of clients – whether they have $80million or $8billion under management. I think it is an important area for us and we work with new hedge funds all the time. We don’t care how small the new funds are because hedge funds grow incredibly quickly, so if we believe in the rationale of a particular fund, we will support it so that when it does become large we are well positioned to service it.

In Europe, how are you meeting the challenge of Euroclear and the rise of regional clearing houses, such as recent efforts to begin merging the Nordic CSDs? What’s your thinking on the matter?

We have a very strong relationship with Euroclear both as a service provider and a client. We are certainly involved in the dialogue over the changing face of Europe. We may not always agree but we continue to have a healthy dialogue. Will we end up with a central depository system, just like in the United States? I don’t know. Undoubtedly there will be some vertical integration with the CSDs but how this will play out in reality – well, I think it’s too early to tell. I think the model for Europe will be different from that in the United States. But I also do not think that the US infrastructure is necessarily one that should be adopted elsewhere. It works here, that’s all I can say.

In Europe there are obvious challenges, particularly with the growth of the EU. We have a presence throughout the continent and we continue to provide opportunities there.

And whether we are competing with BNP or others, we realistically claim that we have a broader network and we offer inflow and outflow services. We are also seeing more institutions come over to us because of this reason, particularly in France, Germany and Italy. European investment institutions are themselves becoming more confident in investing overseas – working with our custody presence then naturally follows.

Equally, Russia’s market is providing interesting challenges – in a different way. What are your objectives in Russia?

Our job is to give our clients comfort while they engage in cross-border investment in Russia. Clients are looking for a good service provider and good intelligence. If they deal with us, they know they have a world-class service provider working with them. We have been in the market for over 10 years and we know the institutions and the issues. We’re confident in our service abilities in the country and we will be ready to expand when the market really opens up.

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GLOBAL CUSTODY

The battle for dominance of the domestic market appears for now to be between Bank of New York and State Steet. How do you plan to take the domestic crown from State Street?

The United States is where we started and represents a major piece of our business, which is one reason why some institutions that are looking for growth have focused elsewhere. Today securities servicing is our primary business and when people look at who to do business with there are only a few of us – who are serious players – to choose from. I do not say that lightly. This business takes commitment and investment and few institutions can sustain that commitment and breadth. Over 70% of our business is now processing related. An immense transition has taken place at Bank of New York during the last 15 years, and it has accelerated as of late.

Tom Perna, joined Bank of New York in 1986 when it acquired the investment administration firm, Fidata Corporation. After BNY bought Irving Trust in 1988 it began to accord more priority to its securities processing business. On the acquisition trail BNY bought Bank of America’s custody business in 1995 and later JP Morgan's and RBS Trust Bank’s global custody operations. BNY is now in the big time.

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What do you think are your unique selling points? What do you think separates you from other custodians and explains why you have recently won a spate of deals?

We have a straightforward approach.

We model our strategy around our client’s needs. When we combine our team of experts, our range of services and our focus on this business, we offer our clients one of the most unique, longterm partnerships in the marketplace.

We basically supply the entire range of securities services from fund accounting and administration through securities lending to foreign exchange. We have more products and services that we can offer to any one of our customers. This allows us to cater to a diverse range of clients while gaining efficiencies in each product area. The latest battle is around outsourcing services and the quest to find the right partner Shifting gears to the hedge fund marketplace. We do not offer prime brokerage services – in fact some of our best customers are prime brokers.

The hedge fund sector is benefiting from tremendous inflows of funds yet at the same time has been undergoing significant change as they have come under tremendous scrutiny. A few years ago people did not really ask who runs the books and records. Nowadays the authorities and investors are pushing for more transparency – they are comforted

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by third party involvement by companies like as The Bank of New York, which provides services that ensure our clients keep abreast of SEC rules.

Any weaknesses?

If we have a weakness it is in marketing. I’m not convinced we sell ourselves as well as we could.

Investor appetite for cross-border assets is growing once more.

Bank of New York, with around $2,500bn of cross border assets is running neck and neck with State Street in second or third place behind Citibank. How important is this business to you and taking on both Citibank and State Street for top slot? What are the two most significant challenges you face in getting there?

We don’t really compete with Citibank. They use some of our services and we rely on their subcustodian network in many markets – they do an excellent job in local markets.

Our network is important especially as we see cross-border investing becoming more of a feature of our clients’business.

In the past year there’s been a surge in new client mandates in the Asia Pacific region – particularly in East Asia. What is your business development strategy in the region?

We are committed to Asia. Some day the Chinese market will explode. Our strategy is to build relationships with key institutions and offer the services that help them achieve their strategic goals. Asia is especially important and we have a lot of product specialists and relationship people on the ground. They focus their time on understanding the client’s needs and bringing in the team of global experts appropriate to the suite of services being offered to the client. We travel to China frequently and I want to see us expanding our team in China over the next few years. The Hong Kong perspective is easier – we’ve been there longer.

In China we are still taking time to figure out the right mix of experts and infrastructure.

Which area in your business has exhibited the fastest growth over the last year and why?

Without a doubt it is in global fund services in Europe.

Here we have witnessed double-digit growth. The other area is broker/dealer related products – especially around global collateral management. We believe this service to be an industry leader In Eastern Europe also?

I can’t say we’ve seen a wave of business from Eastern Europe. Everyone expects they will come along at some point …

In Europe, how are you meeting the challenge of Euroclear and the rise of regional clearing houses, such as recent efforts to begin merging the Nordic CSDs? What’s your thinking on the matter?

We’re definitely on board and, in fact, we are on the Board of Euroclear. We support what they are trying to do.

We believe it is in the best interests of everyone to have an

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equivalent of the DTCC in Europe.

At the same time we are also working with sub-regional trends. We can support Euroclear, but we also support the other efforts that will move the markets along. I don’t think that over the long-term it’s in the market’s interest to have that fragmentation. But if it is a consolidated, industry controlled approach then the move can give the market an efficient platform and the best of all worlds.

Equally, Russia’s market is providing interesting challenges – in a different way. What are your objectives in Russia?

Frankly, we are only interested if our clients want to be there. We have correspondent relationships on the ground, but I cannot say it is a significant market for us yet.

What are the two main challenges you face in the global market over the next five years? How do you intend to respond to those challenges?

The biggest challenge we face is from irrational competitors. I mean that seriously. We’re fully involved in this business. We see other organisations and they are perhaps perceived as being large and well able to meet the requirements of a global house. But in reality size is not, in itself, enough. You find so many institutions with pretensions in the arena of custody and there is no real focus from the top and people therefore do irrational things. The second challenge is continuing to deal with the requirements of technology spend and globalisation and their attendant needs.

What are the main shifts or changes you have noted in investment patterns around the world and how has the bank kept in with these changes and leveraged them?

We see changes all the time. We’ve a good window into our clients’ activities – especially in the area of ADRs and foreign exchange business and seeing movements of money from place to place. This past year we’ve probably started seeing people moving back into less developed markets as people shift investment strategy. Globally too we are seeing a movement away from fixed income.

Do the emerging markets remain strong?

They have been for the last couple of years. Years ago every day you pick up the paper and read about some market you have never heard of. Today the rush to get into these markets has subsided. We continue to focus on new markets our clients want to enter.

For the global custody industry the contrast between now and two years ago could not be starker or more heartening. How long do you think it will last?

I tell you, given the extreme downturn we’ve just been through and what caused it, we are cautiously optimistic.

And when you look around today and see so much that is just ‘unsettled’I would be very reluctant to predict anything and so I emphasise that we are cautious in the extreme in terms of outlook.

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CANADA

SAME BOX SAME COLOUR

SAME BANKS Government consideration of new rules that would open the door to mergers among Canada’s large banks is heightening interest. The government says a review of existing rules will be finished by the end of June. But a national election on June 28 is expected to delay the project for at least a month or two. And the possibility that the ruling Liberal Party could lose its parliamentary majority could derail the issue entirely. Bill Stoneman reports.

IVE LARGE BANKS that dominate Canada’s financial services market might have become a Big Three back in 1998. Royal Bank of Canada struck a deal to take over Bank of Montreal and Canadian Imperial Bank of Commerce was set to hook up with Toronto Dominion Bank. The national government blocked the combinations, however, amid protests by consumer groups that further industry concentration would likely harm customer service.

Then, though a deal was never announced, Canadian media reported that Bank of Nova Scotia sought to take over Bank of Montreal in late 2002, only to be told no by the government. Representatives of the biggest Canadian banks are given to saying now that they don’t need to merge, that their futures are bright the way they are. “It’s something we would like to have the possibility of considering,” says Frank Switzer, director of public affairs for Bank of Nova Scotia, which with C$291bn in assets is the second largest of the Big Five. “But we don’t feel we need a domestic merger to continue to grow.”

A Bank of Montreal spokesman similarly downplayed merger talk.“We’ve said all along, a merger is a tactic. In order to succeed, you need a strategy,”says Ian Blair, a spokesman for the smallest of the Big Five, with C$249bn in assets.

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Such declarations seem reasonable. The banks are performing well and they’re regularly completing modestsized acquisitions outside of Canada. Rising profits from investment banking and lower write-offs for bad loans have helped the banks’ report improved profits in the first quarter. Together, Canada’s Big Five banks earned $3.24bn for the three months ended Jan. 31.

Of some concern going forward is the possibility of rising interest rates which could mean lower profit margins. Low mortgage rates over the past several years have kept banks busy on the consumer side of the business, especially in providing loans for people to buy homes or refinance the ones they already own. As there is a chance that the US Federal Reserve may boost short-term interest rates later this year. Long-term rates, such as those for mortgages, have been recently on the rise.

Analyst Darko Mihelic of Research Capital wrote in a research report that he expects Canadian bank earnings growth of 22% compared with a year ago, due to lower loan loss provisions and revenues outpacing expenses, but a two per cent decline compared with the first quarter. In the same report Mihelic suggested Bank of Montreal, Scotiabank, Royal Bank and TD may all report lower earnings per share in the second quarter than in the first.

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At the same time, it’s widely believed that the big banks are champing at the bit to start a new round of merger talks. They’ve argued regularly that they’re falling behind the leading global banks in size and risk losing business if they don’t keep up. And though combining with one another isn’t necessarily the only way to achieve the scale they say that they need, it’s surely the quickest way.

Moreover, ongoing government consideration of new rules that would open the door to mergers among the large banks is heightening interest. The government had said that it would complete a review of existing rules by the end of June, but a national election on June 28 is expected to delay the project for at least a month or two.

And the possibility that the ruling Liberal Party could lose its parliamentary majority could derail the issue entirely.

Meanwhile, the banks are waiting for clarity from Ottawa mergers. A Commons finance committee report last year recommended that job cuts should be limited in any future mergers, and that banks should be required to increase William Downe, loans to small and mid-sized businesses. Finance Minister deputy chairman of Ralph Goodale is now reviewing final submissions from Bank of Montreal the banks on what Ottawa should consider in reviewing merger proposals.

In the short term, the share prices of potential takeover over the same quarter a year earlier. Earnings rose 47% year targets might be getting a lift from speculation about their over year at BMO Financial Group, the parent to Bank of future. The question remains though as to whether mergers Montreal. And earnings soared 66% for Canadian Imperial’s among Canadian banks can fulfill longer-term needs of parent, CIBC, fourth in size among the Big Five, with C$269bn their shareholders or their home country. “One of the in assets. In addition, the banks are all well capitalized.

Longer term, however, the banks are facing a significant advantages that would come from domestic mergers being permitted is that it would open up a universe of large banks challenge. Their earnings growth at home, where they offer in the United States that you could fold into a bank like everything from consumer loans to investment brokerage ours without destroying shareholder value,” says William services to underwriting corporate debt and equity, is Downe, deputy chairman of Bank of Montreal and head of constrained by meagre growth in Canadian population and its US operations. But smaller deals haven’t always been the maturity of the country’s economy. Grabbing a bigger smashing successes, leading observers to doubt that bigger share of the Canadian market is difficult, with five players already holding some 85% of banking assets in the country. ones would necessarily do better.

“They have not performed all that well,” comments In fact, there’s arguably little point in deploying too much of Harry Ort, national practice leader in Canada for financial their excess capital at home.

But beyond the limited services with KPMG LLP, the growth that Canada is likely audit, tax and advisory Canadian bank earnings growth of to provide, bank executives services firm. and a trade association Canada’s banks, at least at 22% compared with a year ago, due to representative say they risk first glance, appear to be in lower loan loss provisions and revenues losing domestic corporate rather good shape. The outpacing expenses and investment banking Boston Consulting Group, in business to foreign a report about global financial companies issued in May, Winners in the Age of competitors, especially in the United States, if they don’t Titans, said Canadian banks as a group were among the grow much bigger and do it fast.

“Many corporate customers are getting bigger and most profitable worldwide. Bank of Nova Scotia, or Scotiabank as it’s commonly known, had a 17.5% annual moving across borders,” said Raymond Protti, president of risk-adjusted relative total shareholder return from 1999 to the Canadian Bankers Association in a speech in Ottawa in 2003, according to a computation created by the consulting November 2002. “So their capital needs are growing and firm, placing it ahead of the entire field except Lehman moving with them. With scale, organizations can outspend their rivals on branding. And, building strong brand Brothers, Société Générale and Citigroup.

Financial results for the banks’ second quarter, ended April recognition and loyalty is an increasingly important 30, were solid as well. RBC Financial Group, parent to Royal differentiator in a commodity.”John Hunkin, president and Bank of Canada, reported a 12% improvement in earnings chief executive officer of CIBC, suggested before a

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CANADA

parliamentary committee around the same time that his Group of Seven country, the banks must give foreign bank couldn’t keep up with the financing needs of big markets an awful lot of their attention – which they do, corporate customers like Bombardier Inc., the Montreal- though with strikingly different approaches.

Bank of Montreal bought Harris Bank in Chicago in based aerospace and transportation system manufacturer, and Bell Canadian Enterprises, the country’s main 1984. It has built what was a small wholesale bank into a mid-sized full-service institution with a combination of telephone company.

“Canadian banks’ lending capacities have not grown as small acquisitions and new branches. Now the company is quickly as those of our major international competitors,” he trying to take the Harris name across the US, by combining its commercial business said. “In our case, we have made a with a US division of its investment conscious decision to limit our risks to banking arm, Nesbitt Burns, and a levels that are prudent for an institution small New York City-based brokerage of our size.” firm, Gerard Klauer Mattison, that it With assets ranging from Bank of acquired in July 2003. Knitted together Montreal’s C$249bn to C$373bn for as Harris Nesbitt, the US subsidiary Royal Bank, the Big Five are not small can offer commercial and investment by world standard, but not so large banking to middle market companies. either. Royal, according to a ranking Royal Bank purchased a commercial compiled by the Canadian Bankers banking foothold in the Southeast of Association, ranked 51st in the world the United States in 2000, when it in July 2003, followed by Scotiabank at acquired Centura Bank in North No. 60; Toronto Dominion, with C$273 Carolina. It has purchased other smaller bn in assets, No. 64; Canadian banks in the same region since then, as Imperial, 65; and Bank of Montreal, 66.

Ranu Dayal, one of the authors of the well as mortgage companies and retail Not too many years ago, top Canadian Boston Consulting Group report brokerage companies. CIBC gained a bankers lament, the largest among Wall Street address when it purchased Oppenheimer, an them was in the world’s top 25.

While Scotiabank spokesman Switzer says merging with investment banking and brokerage company, in 1997. It another Canadian bank isn’t necessarily the top priority for has since sold the company’s retail business.

Toronto Dominion owns TD Waterhouse, a major his bank, Richard Waugh, the company’s chief executive officer, told the Toronto Globe and Mail in January that the discount brokerage company in the US. Though it also planned acquisition of Chicago-based Bank One Corp. by does corporate banking in the States, Scotiabank has J.P. Morgan Chase & Co. in New York reinforced the concentrated on the Caribbean and Latin America. Its importance of allowing similar deals in Canada. “The gap Scotiabank Inverlat is the seventh largest bank in Mexico.

Problem is, while the banks have done well enough to between us, the Canadian financial institutions, and some of our competitors obviously widens,” Waugh was quoted assert that they’ve been successful outside of Canada, they’ve also made enough missteps to raise doubts about saying by the Toronto newspaper.

Cost cutting might be pursued more aggressively to keep their execution skills. Royal Bank in particular, which has domestic earnings growing, observers say. But to keep spent $6bn in US acquisitions since 2000, has not achieved serving companies like Bombardier and Bell Canada, to its growth or profit goals, by its own acknowledgement. As grow revenue anywhere near the pace that shareholders a result, its president and chief executive officer, Gordon expect, and to be a player on the world stage, befitting a Nixon, said in March that it would focus on improving

FTSE Canada – Banks: Constituent List

56

As at 28-May-2004

Constituent

Economic Group

Royal Bank of Canada Bank of Nova Scotia Toronto-Dominion Com Bank of Montreal Canadian Imperial Bank of Commerce Natl Bk of Canada Cap

Financials Financials Financials Financials Financials Financials

Sector

(80) (80) (80) (80) (80) (80)

Banks Banks Banks Banks Banks Banks

(81) (81) (81) (81) (81) (81)

Exchange

ISIN

SEDOL

Toronto Toronto Toronto Toronto Toronto Toronto

CA7800871021 CA0641491075 CA8911605092 CA0636711016 CA1360691010 CA6330671034

2754383 2076281 2897222 2076009 2170525 2077303

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operations of its US holdings in the year ahead, rather than FTSE Canada vs. Selected Banks adding to its portfolio.

CIBC operated briefly operated retail banks in the US in partnership with two different supermarket chains, but shut them down after attracting scant customer traffic.

Bank of Montreal’s Harris Bank is generally regarded as a successful venture today, but hardly an overnight success.

Part of the problem, to one long-time observer of the Toronto-based Canadian financial business, is that banks have purchased US positions one small piece at a time. L. Robin Cornwell, head of Catalyst Research in Toronto, called Royal Bank’s experience to date a “dismal failure.”

But rather than holding its failure up as a sign that Canadian banks should be careful about international expansion, he said that Royal might have done better if it had the capital base to buy a bigger bank than Centura in Source: FTSE the first place.

“Should they have gone and bought the biggest Florida much a testament to world-class management as it is a bank they could find,” he asked rhetorically. “One result of operating in a fairly sheltered environment in Canada. Foreign ownership of Canadian banks is limited to acquisition and bank, you’re there.”

Perhaps. But the key issue to Ranu Dayal, one of the 20%, which dampens interest in entering the slow-growth author’s of the Boston Consulting Group report, is that the market at all.

Except for Catalyst Research’s Cornwell, who expects the best performers internationally either have great strength in government to open the narrowly focused businesses, door first to mergers like the US credit card issuer CIBC gained a Wall Street address when between banks and life MBNA Corp. and mortgage it purchased Oppenheimer, an investment insurance companies and lender Countrywide Financial Corp., or they have banking and brokerage company, in 1997. then among the large banks, most observers say they’d exceptional ability to manage It has since sold the company’s rather not speculate on what a portfolio of businesses. He retail business. will happen. By most cited Citigroup and Londonaccounts, the Canadian based HSBC Group as examples of portfolio managers.“I don’t think the Canadian banks aren’t likely to make huge bets anywhere while institutions have demonstrated the ability to manage their they’re waiting for a decision from the government. That portfolios as well and as aggressively as Citigroup and likely means more small acquisitions, as Bank of Montreal HSBC have done,” he says. “Nor have they shown the has recently pursued. It completed the purchase of a twoexcellence in driving their monoline businesses as more branch bank near Chicago in March and an eight-branch bank in June. focused institutions in the US do.”

It’s a slow route to the top of the list of global banking They could excel at either approach, perhaps, but would first have to choose which approach even merited the players, but the route that appears most likely, at least for effort, he said. Their strong profitability thus far, is not so the moment.

250

200

150

FTSE Canada Index (Large/Mid Cap) Royal Bank Of Canada Canadian Imperial Bank of Commerce Bank of Nova Scotia Toronto-Dominion Com Bank of Montreal

100

50

Full

Investible Market Cap (millions) (Local)

Shares Market Cap (millions) (Local)

Weight In Issue

Current 5 Year Annualised Return

Current 5 Year Annualised Volatility

Banded Free Float

58.9 33.8 45.75 53.37 64.9 43.7

38,640 33,929 30,188 26,665 23,838 7,715

38,640 33,929 30,188 26,665 23,838 7,715

656021000 1003830000 659837000 499632000 367296000 176555000

24.00% 21.08% 18.75% 16.56% 14.81% 4.79%

-2.34% 0.94% -8.87% -1.88% 13.68% 15.15%

46.08% 47.70% 50.85% 48.02% 30.77% 27.31%

100% 100% 100% 100% 100% 100%

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Mar-04

May-04

Jul-03

Sep-03

Price (Local)

Nov-03

May-03

Jan-03

Nov-02

Mar-03

Jul-02

Sep-02

Jan-02

Mar-02

May-02

Jul-01

Sep-01

Nov-01

May-01

Jan-01

Nov-00

Mar-01

Jul-00

Sep-00

Jan-00

Mar-00

May-00

Jul-99

Sep-99

Nov-99

May-99

0

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RE-BRANDED AND READY TO ROLL De-mutualisation has created certain expectations of the former Kuala Lumpur Stock Exchange â&#x20AC;&#x201C; re-branded as Bursa Malaysia in April this year. A change of name is not enough, says CEO Yusli Mohamed Yusoff. To survive in an increasingly competitive market the Bursa Malaysia has to change in more ways than one. Francesca Carnevale reports.

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HE ATTRACTIVENESS OF the Malaysian equities market weighs heavily on Yusli Mohamed Yusoff, chief executive officer [CEO] of the newly re-branded Bursa Malaysia Berhad Group.

The reasons are many. Malaysia – despite a great economic performance in 2003 and the opening months of 2004 is still struggling behind Taiwan, China and Thailand as a preferred destination for foreign investment dollars. Second, like many exchanges in leading developing markets, Bursa Malaysia is pedalling fast to market its performance and advantages to the global investment community and carve out a leading role for itself in the wider Association of Southeast Asian Nations [Asean] region.

Third, like most markets in the second quarter of 2004, it has suffered from the same geopolitical shocks endured elsewhere. But for Yusli, the fact that every market suffered some downturn is not good enough.“I’d like investors to take another look at Malaysia,”says Yusli.

“In January through to March the market rose 15% – although it has fallen back somewhat. But to be honest with you, we think that Malaysia should be inured from the shocks and the geopolitical considerations at play elsewhere. We are a net exporter of oil, our exposure to China is relatively small – less than 10% of our exports and our economy’s fundamentals are good. But I guess when there are concerns in the market; we get treated like everyone else.”

Nonetheless, says Yusli, “We are noting a significant increase in inward investment flows since the third quarter of last year and a growing interest in our companies. European investors are more evident – US investors less so – but we have to capitalise on this interest and encourage it.”

Within this context the drive towards rationalisation and modernisation of the exchange becomes an imperative.

“A commercially driven Bursa Malaysia will be more inclined to have as many participants in the market as possible,”says Yusli,“The exchange will be more inclined to introduce more products and services that bring it more earnings and which will make the Malaysian capital market more exciting.”

In spite of the short term problems, the commercialisation efforts of the exchange are, in fact, rather timely. Malaysia’s capital market is thriving.

GDP growth is relative robust at 5.2% last year [the best for three years], external reserves are at an alltime high of $49.2bn and Standard & Poor’s upgraded Malaysia’s sovereign credit from BBB+ to A- in October last year. Analysts agree that the Ringgit’s [RM’s] exchange rate peg against the US dollar understates the currency’s underlying strength. There’s pent-up demand “for corporate finance, M&A and IPOs,” says Zarir J. Cama, deputy chairman and CEO of HSBC Malaysia. Nowhere else is this more evident than in the IPO market on Bursa Malaysia. A total of 58 companies listed last year – the best volume since 1997 –

T

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raising some RM7.8bn [US$2.1bn], including rights and warrants. For the 58 IPOs last year, the first day closing price fetched an average premium of 47% over the offer price.

Yusli Mohamed Yusoff, chief executive officer [CEO] of Bursa Malaysia Berhad Group

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According to HSBC’s Cama: “The optimism and interest in Malaysia is not unjustified. Political stability, which has been one of the mainstays of Malaysia’s value propositions, is being used again to argue for the Malaysian market’s premium over regional peers. The stock market tends to perform well in years where there is a general election, but trading activity and stock prices tend to rise, in particular, after the election.”Yusli agrees:“I think the best you can say of the March 21 national elections is that no one had anything to say about it. We are probably boringly stable.

Indeed, the Malaysian government is arguably at its strongest these days.”

The government has also made it easier for foreign companies to raise capital on the equity bourse. A major relaxation in the rules was introduced in September last year when the SC issued Guidance Note 7A and B under the country’s Guidelines on Issue and Offer of Securities.

Prior to the relaxation, a company seeking listing on the Bursa had to be Malaysian-incorporated, have a majority of its operations in Malaysia although it could be either Malaysian and/or foreign owned.

Mr Zarir J. Cama, deputy chairman and CEO, HSBC, Malaysia

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Malaysian incorporated companies with substantial operations abroad and controlled by Malaysians or foreignincorporated companies with substantial operations abroad and controlled by Malaysians; explains Cama. “It’s made a huge difference and with the corporate bond market slowing down in the second half of last year, merchant bankers now expecting equity-related activities to drive growth this year.”

Cama explains that much work has been done to revamp the country’s investment regime, even outside the equities market. “The capital market was changed to a disclosure-based regulatory [DBR] framework for fund raising in April last year while the SC revised fund raising guidelines. It’s more attractive for originators and a pivotal point in our progress towards a more sophisticated and diversified financial system,” he says.

The move promotes better disclosure by issuers, and greater transparency empowering investors to make informed investment decisions.

“Malaysia was much maligned in the past for currency restrictions – which are now history – the lack of corporate governance.” But, he continues; “Malaysia has made significant strides towards good corporate governance practices with the introduction of the Code on Corporate Governance. With it, the roles of independent directors have been clearly defined and shareholder activism given a new breath of life.”

This confluence of events bodes well for the success of Yusli’s efforts to modernise the exchange. He is well aware that has a series of important tasks ahead. The first is to bring to a successful conclusion a long running process of commercialisation of the exchange, which began with the merger of all exchanges in 2002, the demutualisation of the exchange in January 2004 and which will culminate in an initial public offering [IPO] of the Bursa Malaysia shares in early 2005. “We are just commencing preparation for the listing in Malaysia – to start with. We‘ll announce the appointment of a local advisor over the next few weeks, followed by the appointment of a foreign advisor a few months later” says Yusli.

The listing is the final piece in a series of moves following on from the exchange’s de-mutualisation process. “The point is we are not listing for the sake of listing. We have to make sure that Bursa Malaysia is performing well. We have to become more a commercial and focussed organisation, so, there are a lot of changes to be made,”he explains.

It’s not a capital raising exercise either, continues Yusli, as “Bursa Malaysia already has cash on balance” and so it will list by way of its existing shareholders selling down their holdings. The relationships within the group will remain largely intact – as we are listing the holding company, the Bursa Malaysia Berhad Group” he says. Nonetheless, it is widely expected that some of the cash raised will be used to finance the establishment of Capital Market Development Fund [CMDF] which will undertake initiatives and activities

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in the areas of market promotion, research and development, moved quickly following the recent Asean Finance Ministers’ Meeting in Singapore, where an “Asian Equities training and skills enhancement for market participants.

A comprehensive public interest framework has been put Market” idea was floated. Yusli says, "It’s too early to in place, explains Yusli to address “potential conflict, which disclose any specific plans that both the exchanges would may arise from a profit-oriented entity performing regulatory like to see take place. But the suggestion has been made functions.” To pre-empt this, Bursa Malaysia established a that the two exchanges work together and explore areas of number of operating rules. It now has a balanced board possible collaboration. It’s an obvious development structure representing public interests and shareholder- because of the historical link and the good relationship between the two countries.” elected directors, says Yusli.

Bursa Malaysia has no Limits will be imposed on the choice but to engage, shareholding and decision“Malaysia has made significant strides maintains Yusli. “If we are to making capacity of the towards good corporate governance remain relevant and not exchange and supervision of the listed entity will be practices with the introduction of the Code become marginalised we need to go out and become undertaken by Malaysia’s SC on Corporate Governance.” more market driven. Smaller rather than the exchange exchanges will have a harder itself. Further, the newly time surviving over the established CMDF will ensure that “market development efforts will not be coming years. In the context of Asean, together we can be compromised in the quest for profit,” explains Yusli. Special big, but on our own we are small – so we have to work procedures are also in place to ensure the objectivity and together as a group.”

A working group had been formed to look into the possible independence of the exchange, while ensuring that “proper risk management mechanisms, which protect the exchange areas of benefit for Malaysia. He said that it was still too early itself and investors are in place,” adds HSBC’s CEO Cama. for details and that Bursa Malaysia was still in talks with SGX. “Altogether it adds up to the fact that Bursa Malaysia has He adds that there are many areas in which the two exchanges made it much easier for people to trade – be they domestic or could work“Dual-listing of companies could be one of them,” he says.“Such an alliance will help the exchanges increase the overseas investors.”

Commercialisation will come at a price, admits Yusli. In size and liquidity of the market as well as enable more foreign the run up to listing, he faces the difficult task of reducing investors to invest in the region.”The Jakarta Stock Exchange staffing levels throughout the group by around 40%. “We [JSX] is also keen to have a strategic alliance with Bursa think we can achieve this through the re-engineering of Malaysia in its efforts to strengthen Indonesia’s capital market, internal processes and introducing new technology. This according to a recent statement by Indonesia’s Capital Market must be completed by the end of this year, ready for the Supervisory Agency [Bapepam] – Indonesia’s equivalent of equity-raising in 2005,”he says.Yusli explains that based on Malaysia’s Securities Commission [SC]. JSX has a market studies on right sizing manpower requirements by capitalisation of about US$50bn with 315 listed companies, independent consultants, a manpower surplus in Bursa while Bursa Malaysia has a market capitalisation of around $175bn with 927 listed Malaysia had clearly been companies. (as at Friday, 4 June identified. “At the moment, 2004: Market capitalisation is Bursa Malaysia has the “The capital market was changed to at RM630billion/ largest number of staff count a disclosure-based regulatory [DBR] USD166billion [USD 1.00 = in comparison to deRM3.80] and there are 930 mutualised exchanges in framework for fund raising in April last companies listed) Singapore, Hong Kong and year while the SC revised fund The next step, says Yusli will Australia,”he adds. raising guidelines.” be diversification of the There are also wider, market.“We’d like to see more regional considerations. While Islamic funds in our market.”

Yusli is adamant that Malaysia is not striving to become the exchange hub for the Asean Malaysia has done much to promote itself as a centre for region: “We are not looking at that for now.”He is encouraging Islamic finance. The SC said in its 2003 Annual Report that whole-heartedly “ways in which we can work more closely foreign direct investment [FDI] rose 78.5% to RM11.6bn with Singapore and Indonesia and arrive at mutually beneficial compared with 2002 and one of the biggest investments was alliances – sharing technology and costs and generally from the United Arab Emirates, amounting to RM3.9bn.Yusli improving the utilisation of our resources,” he says. says “Shariah-approved companies in the equity market Nonetheless he agrees that;“having a single Asean exchange is today represent more than 60% of the total number of listed companies in Bursa Malaysia, however, it does take a long certainly an interesting proposition.”

Last month, Bursa Malaysia started discussions with the time to develop the required relationships with the Middle Singapore Exchange [SGX] on strategic cooperation. Yusli East, but we see the potential.”

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STP “Firms across the world continue to implement STP solutions so they can improve their bottom line, more effectively control their operational risk and prepare for the future growth of their businesses,”

Richard Hughes, Managing Director EMEA at Omgeo

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Up to now it appears that a single IT provider cannot provide all possible processing solutions to fund management groups. As well, a single processing solution may simply not exist. So should the market now call time on the search for straight through processing [STP]? Or should the search continue under a new moniker – Trade Lifecycle Automation perhaps? It doesn’t really have the same catchy ring as STP. But does that matter?

Angela May Ward seeks answers to some testing questions about the future of trade related technology.

STP

SEARCHES FOR PERFECTION

S A TERM STP has certainly had vocal detractors over recent months. Tim Lind, a senior analyst in the investment management practice at TowerGroup is one. Lind has even gone as far as writing a eulogy for ‘STP and the asset manager’.

“STP as an acronym and a unifying concept has served us well in the past, but to increase the adoption of posttrade technology among asset managers, we need to emphasise connectivity, messaging and business applications in a different way,” says Lind. “We need to articulate how automation will lead to an improvement in portfolio return, client service and the bottom line.”

Chris Skinner, a director at TowerGroup International Advisory Services in London adds: “The future of STP is one where it will need a new moniker – perhaps something like ‘trade lifecycle automation’. STP has lost its shine because it has been discussed for over a decade, but is yet to be delivered. This is due to the lack of fully integrated end-to-end solutions and the fact that STP attacks an enterprise issue, while most organisations implement technology at a functional level.”

Not everyone is convinced. Gert Raeves, STP specialist at CheckFree, a provider of financial electronic commerce services and products is one such person. “Reports of the death of STP are somewhat exaggerated – there is still a very robust requirement for improved connectivity, data integration and workflow harmonisation.”

Maybe it has something to do with how we define STP? Even that appears to be a complicated issue these days. Joe Cassidy, head of capital markets and asset management consultancy at Buttonwood Tree, the business infrastructure solutions company, says there are three definitions. “It can be within an organisation [unilateral]; between two organisations [bi-lateral, between a broker and an asset manager for example]; or between multiple

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organisations [multi-lateral],”he explains.

He explains that each type of STP has different characteristics. For example, unilateral STP means you can do ‘more for less’ at a higher level of service than your competitors. Bilateral STP may see you identifying your most profitable clients and re-engineering your business and technology interfaces between them and you for greater efficiency. Multi-lateral is the most difficult to achieve, as it requires groups of organisations to have a similar appetite for change and risk.

“The drivers behind STP, namely reducing cost and risk, remain as important as ever,” says Richard Hughes, managing director EMEA at Omgeo a provider of posttrade pre-settlement trade management solutions. Omgeo is a joint venture between The Depository Trust & Clearing Corporation [DTCC], the world's largest post-trade processing infrastructure provider, and Thomson Financial.

“Firms across the world continue to implement STP solutions so they can improve their bottom line, more effectively control their operational risk and prepare for the future growth of their businesses,”adds Hughes.

Four years ago, there was plenty momentum to drive STP forward, driven primarily by a looming T+1 deadline.There was even the creation of the Global Straight Through Processing Association [GSTPA], an industry initiative established to achieve STP through a global trade management system. It went live in September 2002, but collapsed after just two months, the blame being put on the abandonment of T+1 and a lack of investment in the association.

“There are many examples of huge amounts of intellectual capital being focused on initiatives that come to nothing,” says Domenic Constanza, head of transaction services at Barclays Global Investors [BGI].“Focus and cooperation between the securities community both locally and globally is of primary importance, so that we don’t

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STP of failed trades that comes from communicating by fax. continue to see firms supporting competing initiatives.”

“But, times are changing and we are now finding According to Constanza, BGI has invested in STP solutions that allow the company to maximise its efficiency increased demand from smaller fund managers and their and minimise risk. He explains: “A key enabler has always brokers for light, web-based, easier to implement STP been industry standards and we have been reasonably solutions that can drastically improve the communication successful in our use of messaging to support our trade, of trade information,”says Omgeo’s Richard Hughes.

At the Sibos meeting in Singapore last October corporate actions and reconciliation processes.”

Today, there remains pressure for transparency, [organised by SWIFT], Ian Bessarabia, business manager governance and international harmonisation, which has STP, RMB Asset Management in South Africa, led to a number of initiatives from bodies including the acknowledged that many fund management organisations are not as committed to STP Group of 30 [worldwide], the as his own organisation.“We SEC [in the US], and the need to encourage all parties Giovannini group, the ESCBto raise their game by CESR and the EU “STP lives or dies on the adherence increasing their STP Commission [in Europe], and to market practice and unless these investment,”Bessarabia said. the FSA, Treasury and the are tight and uniform across all markets, “Achieving STP success is an Bank of England [in the UK]. the process breaks,” addiction – once you have it, Pressure is also coming due you constantly crave more of to the increasing industry that success.” focus on Basel II, while Henry Raschen, market Sarbanes-Oxley legislation developments manager at HSBC Securities Services and the USA Patriot Act are also playing their part.

“STP lives or dies on the adherence to market practice Europe, says that there are still companies out there and unless these are tight and uniform across all markets, dragging their feet when it comes to implementing STP. the process breaks,” says Justin Chapman, principal “These include some small volume participants, unable to consultant at Mondas, the supplier of global corporate justify the investment to move away from paper and fax processing,” he says. “STP is also held back by systems actions processing systems.

While large fund management groups have been driving which are not integrated, where major STP systems do not forward STP, the smaller fund managers are less STP- connect electronically and require ‘straight to printer’ enabled. Traditionally, they have not only lacked the followed by re-keying into another system, with all the technological resources to implement STP, but have also associated bottleneck, staffing and operational error issues.”

Raschen adds: “At HSBC Securities Services Europe, we not felt the pain of manual trading, as it is their broker counterparts who have had to deal with the increased risk automated our share settlement systems in the 1990s, and interest and dividends have long been paid electronically through BACS or other routes. Corporate actions has been the main progress area since 2000, and there is focus generally on systems integration and standardisation of inputs to avoid having to build a wide range of bespoke interfaces.”

One of the first questions firms ask themselves when implementing STP is whether to do it all in-house, or to outsource some of the functions. The primary motivation for outsourcing is usually economic, although technology risk figures highly as well.

“The investment market is considering re-investing in its IT operations, but does not necessarily have the staff or solutions available to make the investments worthwhile,” says Chris Skinner. “This will be a challenge for many Chris Skinner, Director, through 2004 and may lead to more outsourcing TowerGroup International arrangements, such as that between JP Morgan and IBM. Advisory Services The reason for outsourcing in this context is obviously to gain control of cost for computing, but it can also realise benefits in terms of access to a wider range of skills and solutions.”

Adds Gert Raeves of CheckFree: “Increasingly, the provision of specific middle and back-office functions is a very attractive outsourcing target. The standardisation of

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processes that is needed to be able to offer a cost-effective outsourced operation is now a realistic proposition.”

Nonetheless says Buttonwood Tree’s Joe Cassidy adds a word of caution: “No organisation should look at outsourcing as a means of addressing STP in its entirety. It is no panacea – if you outsource a mess, you’ll have a bigger mess in my experience.”

One of the key problems with STP is that there is not one single solution and a single IT provider doesn’t usually have all the solutions. “If you can achieve STP by using a number of vendors, then there are fewer compelling reasons to go for a single provider,” says Justin Wheatley, chief executive of StatPro, which focuses on portfolio analytics, providing automation from receipt of data to publishing it on a website. Small asset managers might find a single vendor solution more effective, but it could well be impractical for larger businesses spread over many offices.

“Centralisation reduces costs, but it also jams up processes and frequently reduces the level of service provided,” adds Wheatley. “Remote offices often adopt tactical solutions to deal with immediate problems but this, in turn, makes a centralised solution even harder to implement and soon the tactical solution becomes permanent. In the end, it is an old story about the benefits of multi-skilled businesses versus specialised ones.”

Traditionally, the US and UK have been the most advanced in terms of operational efficiency. But, according to Richard Hughes, some continental European markets, such as France, Italy and Scandinavia, have also increasingly embraced STP solutions over the past few years.“We expect this growth to continue over the coming years, with markets such as Spain and Germany also seeing the benefits of automated trading,”he adds.

In the United States a number of issues have emerged, not least that the variety of solutions developed has not been particularly integrated. It’s a problem noted elsewhere in the world and the rest of the world has acted on it. By watching the US experience difficulties, Europe and Asia have been able to start with a ‘clean sheet of paper’ and build more developed, proven and end-to-end applications.

However, “this does not mean that European and Asian banks have taken this opportunity to heart.

Investment has been patchy to say the least,” says Chris Skinner.“A few banks in the City, Frankfurt, Hong Kong and Tokyo, are nonetheless demonstrating valuable examples of how an integrated end-to-end approach can deliver efficiency gains and value. But there is still much to be done elsewhere.”

Omgeo recently published a report ‘How Ready is Asia for STP?’ examining the drivers and obstacles to STP adoption in Asia and found that STP will be the most important investment focus for Asian investment managers in 2004. The study showed that Australia leads the region in terms of automation, followed by Hong Kong, Singapore and then Japan, while Hong Kong stands out in the region as a leader in fixed income trade automation.

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Henry Raschen, market developments manager at HSBC Securities Services Europe

The report highlights that Australia, a highly domestic trading market [91% domestic trades], has invested heavily in back office automation over the last 10 years. Australia’s trade exceptions [1%] and trade failures [<1%] are lower than in any other market in Asia.

At Sibos, an exhibition and networking event for the global financial community, Chris Hamilton, executive general manager, clearing and settlement, Australian Stock Exchange, said he expects to see post-trade/pre-settlement solutions coming to the fore over the next few years.

“Asian markets, more than any others, have been playing catch-up in terms of clearing and settlement,” adds Hamilton. “The priority during this time has been the development of central counterparties and the evolution of depository capabilities. Now most of the key markets in this region have effected those major structural changes, I expect to see more interest in those post-trade/presettlement solutions.”

So what does the future hold for STP? “The challenge, as for business generally, is to assess correctly what will happen and to plan for it,” says HSBC Securities Services’ Henry Raschen. “There have been plenty of financial services’ STP projects built with good intentions for a market that did not exist, as user requirements had either moved on or, indeed, were never there.”

But the final word goes to CheckFree’s Gert Raeves who maintains that “STP is a useful shorthand term for the perceived end-goal of automation projects, but the specific objective, method and technology will continue to be different at any given time. The main challenge of the industry is therefore to keep an open mind, prepare to be challenged in your business and IT approach and have the mindset to play a long game.”

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STP WHAT ASSET MANAGERS REALLY THINK OF STP

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VERY TWO YEARS Trema, the strategic software solutions company, canvasses market opinion among 100 of Europe’s fund management firms.

“Opinions are canvassed across a mix of funds, large and small. But there’s not a significant difference between the responses, but it is a tremendous indicator of market needs,” says Jeff Smith, Sales Director at Trema.

It’s most recent survey, issued at the beginning of June, shows that while only 40% of asset management enjoy fully integrated STP solutions, more than 60% identify these as desirable – suggesting that, rather than outsourcing, many asset managers are planning address the issues in-house. It’s a legacy issue, explains Smith of resulting from purchasing decisions often made in the 1990s: “in many cases fund management companies are restricted by using second and third generation systems. “The 40% number is shockingly low.”

The response is surprising, says Smith, as the pressure from asset management firms is to encourage technology providers to support real time processing. “But quite a few firms have yet to get to second base,” he says. “the pressure is on as fund management companies are moving away from Jeff Smith, Sales Director at Trema timed, batch processing.”

According to the survey nearly half of the respondents consider the reduction of operational risk and automation of trades (STP) to be a considerable driver within their organisation. Yet only one third of the participants feel that they have the ‘right’ technology in place to address these operational risk and automation issues. It’s a significant issues admits Smith: “One of the cornerstones of the sales effort is that STP programmes will save money and reduce costs. But the truth is that often linkage systems which bridge the back and the front offices – known as middle ware – is not cheap. No-one is really saving money.” The lesson, Smith believes, is that fund management companies are still struggling with the fact that: “STP is still evolving.” This points to a key issue in the establishment of STP services says Smith. Fund management companies are still focused on links with institutions outside the firm, rather than internal systems which link the front and back offices.

Interestingly, however, where many predict that the market will turn to outsourcing to help address these issues, according to the study two thirds of those Asset Managers surveyed are NOT considering outsourcing.

Improving investment analysis and decision-making are thought to be considerable or crucial drivers for 59% of the Investment Management industry’s business – with risk management and analysis seen as a priority. “It’s particularly the case in the larger funds,” says Smith, “where the high volume of transactions can lead to mistakes and processing errors. It’s used almost as a scorecard,” he explains.

What do you consider to be the most important issues related to technology in the next 2-3 years in the area of investment management process?

Automation of internal processes from front through middle to back office Customer service Reduction of operational risk Reduction of operational costs Compliance and limits monitoring Improving investment analysis and decision making Automation of external processes counterparties Monitoring of money laundering and fraud Improving reference and market data management GIPS compliance Outsourcing business processes 0%

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Importance

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ISLAMIC FUNDS

measure of Islamic finance Getting the

Islamic investment funds remain an enigma to most investors. But the differences between Islamic and non Islamic funds are not that marked says Patrick Stewart, Counsel, Banking & Finance at law firm Bryan Cave.

he terminology and structures employed in Islamic funds differ from more familiar investment vehicles – but they are easy to understand. Equally, Islamic models do not present any particular problems in complying with regulations imposed on non-Islamic Funds so international investors can approach them without trepidation.

There is one fundamental characteristic of an Islamic fund: namely that its investments and structures must comply with the principles of Islamic law, the Shari’a. However, the Shari’a is not a monolithic body of law and so is open to interpretation within the different sects of Islam. Within the majority Sunni branch of Islam, for example, there are four major schools of jurisprudence, which cover not just commerce and finance, but every aspect of life. The Shiite branch also has its own jurisprudence. It means that Islamic financial institutions invariably have to appoint a Shari’a Board to vet new products for compliance with Islamic law and to resolve any uncertainties. The fatwa [decision] of the Board in approving any fund is therefore an essential prerequisite before a fund can be marketed to investors.

Nonetheless there are a basic precepts recognized by all schools. The most well known is the prohibition on riba – frequently translated as a ban on interest. While riba does actually include interest, the term covers all forms of unlawful gain. Other principles relevant to Islamic funds are the ban on trading in debt, the prohibition of gharar – unlawful risk or uncertainty – and the obligation only to invest in halal [permitted] activities. The Shari’a does not forbid making a profit, but it is firmly based on the concept of risk sharing. An investor is not entitled to a guaranteed

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fixed return on funds and generally may only earn a profit proportional to the original investment.

Within these basic parameters Islamic investment funds adopt a variety of vehicles which are not basically dissimilar from non Islamic models, such as Open-Ended Investment Companies [OEICs], Unit Trusts and private equity schemes. The major differences between Islamic and non Islamic funds may be briefly summarized as follows.

As noted, an Islamic investment fund may only invest in companies engaged in permitted activities. Breweries, casinos and businesses involved the arms industry are not, therefore, permitted investments, nor are non Islamic finance companies and banks.This aspect of Islamic investment funds has a good deal of similarity with non Islamic “ethical”funds.

The Shari’a does, however, posses a certain flexibility by recognizing that an impermissible incidental activity does not necessarily taint a permissible one. Accordingly, investment in a hotel – which may serve alcohol – is not necessarily forbidden to Islamic investors. In a recent project in which Bryan Cave participated, the Shari’a Board had to decide whether a hotel’s mixed swimming pool was an insurmountable obstacle to Shari’a compliance. It was finally decided it did not. This is an interesting example of what a non Islamic fund manager might regard as an unusual issue.

The principle of the impermissible not negating the permissible also impacts on the issue of investing in businesses which place money on interest bearing accounts or borrow money on interest. Some scholars hold that if some portion of profit derives from a business’s income from interest-bearing accounts that portion must

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percentage of the net asset value of the fund.

As can be seen, there are differences between Islamic and non Islamic funds, but these are not particularly difficult to understand. Most importantly, none of these differences would cause the UK regulatory authorities any problem, as can be seen from the increasing number of Islamic funds becoming available in the UK. These include earlier this year a Shari’a compliant fund with an ISA wrapper. Perhaps compliance with investment regulations not being a problem is unsurprising. A fundamental tenet of Islamic finance is openness and transparency.

There are indeed some Islamic scholars who emphasise that Shari’a compliant funds offer more protection to investors. They say, for example, that no Islamic fund would have invested in companies such as Enron, because of the financial structure of such entities. Whether or Islamic funds are safer or offer better returns than non Islamic investment vehicles is open to debate. The Shari’a inhibits the use of derivatives and hedging structures employed by many non Islamic funds. Islamic funds also face serious issues with the use of mixed currencies and foreign exchange.

Probably the two biggest restraints on the future development of Islamic funds are that up until now the majority of investments tend to be aimed at high net worth individuals and the lack of a significant secondary market.

It remains to be seen if in the coming years these inhibiting factors can be overcome. Conversely, there can be no doubt that there are a significant number of Islamic scholars and jurists committed to the development of new Shari’a compliant models and structures to meet the growing demand for this type of product. Many of the international banks and financial institutions are also eager to develop of this potentially lucrative market.

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be given to charity. Others say that if the portion is a relatively small part of the profit it is still permissible. The same arguments are applied to investment in businesses with significant liquid assets in the form of cash reserves.

The reason why a business’s liquid assets present a problem is that the Shari’a forbids trading in money or debt, which cannot be purchased or sold except at par value. This gave rise to the debate as to whether certificates showing ownership in a fund could be traded. The issues were resolved by determining that a certificate represented a share in the ownership of the underlying assets of a business.

This principle is the foundation of one of the most popular models for Islamic investment funds, the ijarah fund. In this model, investor funds are used to purchase assets such as real estate or motor vehicles, which are leased to third parties. The income from the rentals is distributed pro rated to the investors. Each investor receives a certificate usually called a sukuk representing a share in the assets of the fund. A sukuk is fully negotiable and can be sold and purchased in the secondary market at a profit depending on market conditions.

Another type of Islamic fund is the commodity fund.

Here subscriptions are used to purchase different assets on a rolling basis with the profits of the resale being distributed to the investors. In order to comply with the Shari’a code the commodity must be owned by the seller at the time of sale. A short sale where a person sells an asset before he owns is not permitted.

This requirement means that Islamic funds cannot trade in futures. Most scholars also hold that options are also forbidden, although some argue that this activity is permissible on the basis of an arbun contract, literally an “earnest money contract”.This is a conditional sale agreement in which a security deposit is given in advance as a partial payment towards the price of the asset purchased. This deposit is forfeit if the buyer fails to meet his obligation. The legitimacy of this model is by no means a universally accepted view, although it is increasingly popular and was approved some years ago by the Organisation of the Islamic Conference Academy [OIC], a well respected body of scholars which issues rulings on the Shari’a from time to time.

A murabahah fund is based on a structure where assets are purchased and re-sold on a cost-plus basis. Islamic banks and financial institutions purchase and sell assets on to third parties on an deferred payment instalment basis for the benefit of fund. This is a closed-end fund and its units cannot be negotiable in a secondary market, because the portfolio of a murabahah fund does not consist of tangible assets [these are purchased and re-sold almost simultaneously], but cash or receivables. As explained earlier, cash and debts cannot be sold at a profit.

The management of Islamic funds is usually carried out in one of two ways. The managers of the fund may act as mudaribs for the subscriber. In this case, the fee is a percentage of the annual profit of the fund. The second option is the management acting as agent for the investors.

In this case, the management earns a pre agreed fixed fee for its services. This fee may be a lump sum or based on a

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Source: FTSE

The FTSE Global Islamic Index Series (GIIS) is a group of equity benchmark indices designed to track the performance of leading publicly traded companies whose activities are consistent with Islamic Sharia law The Index is pioneered by The International investor (TII), calculated by FTSE and designed for those who wish to invest according to Islamic investment guidelines. In essence, it is an Islamic stock market indicator.

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SECTOR REVIEW: OIL

Oil prices have become big news. Prices have risen rapidly in the past year. Now oil prices are at levels that, in the past, have trailed recession in their wake. It’s little wonder then that concern is rising about the impact of rising prices on the fledgling global economic recovery. Lucy O’Carroll, of the Royal Bank of Scotland Group asks if these worries are really justified.

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N NOMINAL TERMS, the Brent Crude price of oil has almost quadrupled from its recent low of below $10 per barrel [p/b] at the end of 1998 to around $37 p/b at present. Taking into account the effects of inflation, however, recent oil price rises look less worrying. In today's prices, oil would have to rise to $80 p/b to reach the real-terms equivalent of its early 1980s’ levels. Furthermore, since oil is quoted in US dollars, exchange rate movements could have sizeable differential impacts on different economies. In the United Kingdom until recently, for example, sterling's strength helped to cushion companies from oil price movements. Prices only began to pick up sharply in sterling terms in February this year, though since then they have risen by 40%.

I

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questions have been raised over its ability to do this on a sustained basis. Nevertheless, the International Energy Agency [IEA] expects the increase in oil production to outstrip the increase in demand this year overall, and a pick-up in investment since mid-2003 should help the longer-term position. As a result, prices should fall back in due course.

However, worries over the stability of the Gulf region have helped to sustain oil's recent rise. Hedge funds and other speculators betting on the possibility of higher prices have also exacerbated price pressures. This ‘fear factor’ could therefore continue to underpin oil prices during the coming months, despite the improvement in the fundamental supply-demand balance.

High oil prices and the global economy The first impact of higher oil prices is to increase global inflationary pressures. The size of this impact on continuing inflation trends will depend on whether consumers try to offset declining real incomes through higher wage increases, and the extent to which producers can restore profit margins by raising their charges.

Such responses could create a damaging wage-price spiral, as occurred during the oil shock of the 1970s. On our estimates, a sustained further rise of $10 p/b in the oil price would add around 0.4 percentage points to inflation in developed economies within two years.These magnitudes are Lucy O’Carroll, not huge but, at a time when the global economic recovery of the Royal Bank of has already shifted the inflation risks to the upside, such price Scotland Group accelerations could breach inflation targets – forcing monetary authorities at least to consider raising interest rates.

Higher oil prices also subdue activity, however, which can have a downward effect on inflationary pressures in the Why prices are rising A strong pick-up in demand, supply limitations and market longer term. Income is transferred from oil consumers to oil uncertainties have combined to explain the rise in oil prices in producers. Past experience shows that oil-producing countries take time to spend their additional income, the past year.

Demand is set to increase by nearly 2m barrels per day whereas the adverse impact on demand in oil-consuming [b/p/d] this year, its largest expansion for 16 years, countries is almost immediate – leading to a net reduction reflecting the impact of the global economic recovery and in global trade and activity. Following the oil-price booms stock rebuilding. The United States is the largest consumer of the early 1970s and 1980s, for example, oil-producing of oil, accounting for nearly 25% of global demand, but the countries continued saving each year until 1982, and then drew down their financial spectacular increase in balances only slowly.

Chinese oil demand is the Higher oil prices raise main impetus behind recent Demand is set to increase by nearly 2m production costs, putting trends. China’s investment barrels per day [b/p/d] this year, its largest pressure on profit margins. In programme has taken off, expansion for 16 years, recent decades, the oilcar sales have expanded intensity of production in rapidly and electricity developed economies has shortages have prompted manufacturers to switch to diesel generators. As a result, fallen. As a result, the impact on the wider economy is lower.

Chinese oil demand has risen by one million b/p/d during Our simulations show that a sustained $10 p/b rise in the oil the past year – equivalent to the average annual increase price could cut developed economy GDP growth by around 0.2 percentage points at the end of the first year and 0.5 in global demand during the 1990s.

Concerns over the supply situation have also pushed up percentage points by the end of the second. In the long run, prices. Under-investment in production, transportation, the output impacts would be largest in the United States, refinery and storage capacity in recent years has created which has a relatively high share of oil consumption in GDP, bottlenecks. Saudi Arabia has stated that it can increase and Japan, which has a complete dependence on imported production to 10.5m b/p/d to stabilise the market, though oil, with an 0.6-0.7 percentage point reduction in the level of

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GDP. Oil-importing developing countries would be more seriously hit, as they are less energy efficient and their access to global capital markets [to smooth oil consumption by borrowing] is restricted.

Other effects will be transmitted via changes in equity and bond valuations, and exchange rates, in response to actual and anticipated developments in economic activity, corporate earnings, inflation and monetary policy following the oil price rise.

Monetary policy in the spotlight

taking real short-term interest rates into negative territory, but the shock eventually spread elsewhere into the price structure of the economy. At the end of the 1970s, in contrast, the UK authorities almost trebled interest rates in the space of a year in response to the inflationary impact of higher commodity prices. These actions, alongside a series of deflationary budgets, squeezed demand sharply and probably deepened the subsequent recession. Avoiding damaging ‘stagflation’ – weak output growth combined with rapid inflation – is a delicate policy balancing-act.

Oil price ($)

Even if oil prices were to rise to $50 p/b on a sustained basis, therefore, our simulations suggest that the Conclusion reduction in activity and pick-up in inflation in most Demand and supply fundamentals suggest that the oil countries is disappointing rather than dramatic. This price should fall back markedly when Middle East relatively sanguine view is, however, based on the uncertainties diminish. If oil prices were to remain at assumption that monetary policy is appropriate in terms current levels, or even rise to $50 p/b, however, the of the timing and size of any interest rate changes. But by adjustment would be painful but the global economy both adding to price pressures and subduing activity, high should cope without a return to recession. In the longer oil prices create a dilemma for monetary policy. Central term, moreover, energy suppliers have an incentive to banks will be concerned to avoid damaging wage-price increase production and investment, and consumers have spirals but, on the other hand, will not want to compound an incentive to economise on their oil use. These factors the dampening effect on activity of rising oil prices. together would tend to put downward pressure on prices.

In these circumstances, central banks would have to take The impact of continued strong demand from rapidly a view on whether the initial inflationary impact of high oil developing economies such as China and India adds a new prices is likely to become embedded in the economy twist, however, and one that is reflected in high prices in through higher wages and increased charges. In economies forward markets at present. with flexible labour markets, low current levels of inflation Global monetary policy would be critical in an and credible monetary policies, central banks may now environment of continuing high prices. In recent years, have more room to ‘wait and see’ on oil prices. The United policy has helped to achieve reduced output volatility, low Kingdom [UK] qualifies on all three counts, but the UK inflation and low interest rates, despite the effects of the economy's cyclical position – close-to-full employment Asian Crisis, September 11th and the global economic and tight capacity constraints – has left the Monetary Policy downturn that followed the late 1990s’ investment boom.

Committee unwilling to take risks. The Committee cited Central banks are well aware, however, that high oil prices high oil prices as one reason for raising rates in May, and could be at least as much of a test of this record as those oil prices could add to the momentum behind further rate previous challenges. tightening this year.

Other policy-makers have taken a Graph 1: Current oil prices are lower in real terms than in normal terms more relaxed view. Bundesbank 90 President Axel Weber, a member of the European Central Bank Board, has focused on the negative impact of higher oil prices on demand, rather than the initial upward push to inflation, 60 suggesting that Eurozone interest rates could be cut in response. Influential US Federal Reserve Governing Council member Ben Bernanke has also argued that increases in oil prices could to lead to 30 looser monetary policy, and that excessive rate hikes were as much the cause of previous economic downturns as oil-price shocks.

Past experience is certainly not 0 encouraging. The US Federal Reserve’s 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 initial response to rapidly rising oil Nominal Real (2004 prices) prices in the early 1970s was limited, Source: Royal Bank of Scotland

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STYLE

As an investment strategy Style can be traced back to the hardy days of the mid-1930s and the Great Depression in the United States. Sixty years on Style still matters and is becoming a recognized investment consideration in much of the rest of the developed market world. Robert Schwob, managing director of Style Research explains its relevance for today’s investor.

Why Style still counts

F STYLE INVESTING is regarded as an American phenomenon it’s because of an historical incongruity. The anomaly arose out of a number of institutional features that distinguishes the US savings industry from its international counterparts. Enthusiasm for Style products and services in the US was encouraged by the combination of factors – not least the existence of a large personal savings sector. America has one of the largest discretionary savings markets in the world that provided a ready audience for the clarity and convenience of Style investing. Further, because of its longevity, Style investing attracted around itself a substantial degree of intellectual rigour and debate among the circles of US academic investment literati. Specialist investment managers in the institutional savings industry rapidly adopted a Style approach and equally as quickly these managers attributed a professional patina to the strategy. There were good grounds for doing so. There was clear evidence that Style mattered in investment decisions.

In contrast, in Europe and the Far East, without the commercial motivation for the development of Style-related products, Style was considered no more than an interesting North American peculiarity until well into the 1990s. However, rapid structural evolution across the global savings industry at the end of the last

I

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LARGE VALUE Attribution

Identity 125

0.84

120

Cumulative Relative Return

Style Beta

Portfolio # / Univ # 270 ------7942

115

T/O 32.4%

110

105

St. D 16.2% (18.1%)

100

95

T.E 7.3% (2.8%)

Identity

96%

115

Regularity

3M 0.13

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

90

Returns Per Annum (12 M): -1.2% (ALL): 0.8%

Style Beta

6M 0.08

12M 0.25

Attribution

1.6 [33%]

Return to 20-100 Market Cap, 51-100 Value (SA) Portfolio # / Univ # 98 ------1936

1.00 110

T/O 38.8%

105

100

St. D 16.6% (19.2%)

95

UK

Cumulative Relative Return

5.2 [73%]

Return to 20-100 Market Cap, 51-100 Value (SA)

100%

US

90

T.E 5.7%

(12 M): (ALL):

Regularity

2.4%

3M 0.10

0.6%

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

Returns Per Annum

1985

1984

85

6M -0.10

(2.6%)

12M -0.08

Attribution

Identity

3.4 [68%]

100% Return to 20-100 Market Cap, 51-100 Value (CASA) Portfolio # / Univ # 125

Style Beta

318 ------3004

1.08

Cumulative Relative Return

120

T/O 33.3%

115

110

St. D 21.2% (25.7%)

105

100

T.E 3.3% (3.9%)

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

95

Returns Per Annum (12 M): (ALL):

Regularity

2.7%

3M -0.06

0.8%

Identity

100%

Style Beta

135

0.90

130

6M -0.06

Euro Zone

12M -0.09

Attribution

7.7 [84%]

[76%] Return to 20-100 Market Cap, 51-100 Value (CASA) Portfolio # 5.4 / Univ # 1233 ------10958

125

T/O 35.3%

120 115 110

St. D 16.6% (15.2%)

105 100

SE Asia

95

(12 M):

2.0%

(ALL):

1.4%

Regularity

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

Returns Per Annum

1986

90 1985

century and dramatically divergent Style return patterns changed everything.

These structural changes happened across the globe. A confluence of common factors helped propel the popularity of Style investing. Not least was the growth in defined contribution plans and various self-managed savings programmes across Europe, Southeast Asia, Africa and South America. It mirrored earlier developments in North America and similarly encouraged the use of Style concepts and descriptions in promoting mutual funds to an increasingly informed and involved personal savings sector.

Equally, the formation of the euro zone accelerated convergence among European equity markets and facilitated the broadening usage of mutual funds across the personal savings market. Because of it, European fund managers found themselves under increasing pressures to abandon narrow country-specific investment practices and to adopt a pan-European approach. Style offered a convenient, and effective, process to analyze European equity markets and to communicate investment ideas. It also provided a basic practical framework for portfolio construction and a common vocabulary to describe portfolio investments and strategy.

Academic literature began to focus on the applicability of Style definitions across markets outside North America, applying a number of sophisticated statistical techniques to establish relevance. And, in all major markets and regions, Style easily cleared the academic hurdles. On the basis of these analyses it became clear that the same simple definitions of Value, Growth and Size [as well as most of the more complex definitions] described groups of securities that: • Perform in a distinguishing manner that cannot not be accounted for simply by random processes of portfolio construction; • cluster together in terms of performance in a systematic manner and, generally, • offer a regular pattern of market-relative returns, frequently establishing trends and also broadly responding to macro-economic and market events and turning points.

Most of all, the importance of Style within global markets had become proven by investor experience. The charts opposite illustrate the market-relative returns of the four basic Style portfolios over 20 years of history in four major regional markets.

The periods of outperformance and underperformance of the four basic Styles are dramatic and persistent in each of the US, UK, Eurozone and Southeast Asia. They are also independent of market or industrial sector effects [the graphs have been calculated from the returns of portfolios that have been rebalanced every six months to be market neutral and sector neutral. There is also very strong evidence of global Style linkage].

It is therefore completely understandable that over the past ten years Style practices have become increasingly popular across global markets. And, in tandem with Style’s rising popularity, numerous Style techniques also developed to satisfy a growing need for services.

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Cumulative Relative Return

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T.E 5.3% (1.9%)

3M

6M

12M

0.14

0.13

0.02

Source: Style Research

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FTSE Developed Europe Value vs. FTSE Developed Europe Growth 120

100

80

60

FTSE Developed Europe Value

Apr-04

May-04

Mar-04

Jan-04

Feb-04

Dec-03

Oct-03

Nov-03

Sep-03

Jul-03

Aug-03

Jun-03

Apr-03

May-03

Mar-03

Jan-03

Feb-03

Dec-02

Oct-02

Nov-02

Sep-02

0

Jul-02

FTSE Developed Europe Growth

FTSE World Value and Growth Annual Returns Relative to FTSE World 15.00%

10.00%

5.00%

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

0.00%

-5.00%

-10.00%

-15.00%

FTSE World Growth

FTSE World Value

FTSE Developed Value and Growth Cumulative Returns Relative to FTSE Developed 25%

20%

15%

10%

5%

0%

-5%

-10%

-15%

-20%

FTSE Developed Growth Index

FTSE Developed Value Index

Nov-03

Mar-04

Jul-03

Mar-03

Nov-02

Jul-02

Mar-02

Nov-01

Jul-01

Nov-00

Mar-01

Jul-00

Mar-00

Jul-99

-25%

Nov-99

S

TYLE IS ABOUT the basic philosophy or approach used to select stocks. Itâ&#x20AC;&#x2122;s really the study of asset prices. Style assumes that investors place inherently risky assets into different investment styles and move money between these styles depending on their relative performance. Each has its own methodology and carries its own attendant risks.

Broadly speaking, there are two main investment styles: growth and value. While there are fund managers who swear by one or the other, in practice asset managers use both. Growth stock and value stock don't usually move in tandem. So, by combining both value and growth-oriented investments investors are reckoned to enjoy a balanced, diversified and performing portfolio.

Value-style managers buy companies that trade below their intrinsic value, but whose true worth [they think] will eventually increase. These shares often have low prices relative to earnings or book value, and invariably provide a higher dividend yield. A stock's price can be considered low relative to the market, relative to the industry, relative to its competitors, relative to a financial variable such as earnings, or relative to the historical price of the stock. Often a stock that pops up in these types of value tests is a slower growing mature company that has suffered a temporary setback, such as disappointing earnings or legal problems. Value companies may be in industries that are less fashionable or are simply off most investors' radar screens. Think utilities and banks.

Growth investors on the other hand look for companies with above-average earnings growth and profits and which they think will be even more valuable tomorrow. Because these companies are growing earnings at a fast pace, they tend to have higher prices relative to earnings [P/E ratio].

Aug-02

DEFINING STYLE

and sensitivity to nuance. From these services it became possible to delve more deeply into the thought processes of fund managers. It allows exploration, for example, of the character of Value bets and tilts, and whether Value is being achieved at the cost of future growth potential. Alternately it will also show if a manager is simply avoiding popular stocks with impressive growth histories.

Holdings-based analysis also encourages detailed analyses of Style orientations within sectors, the comprehensive analysis of fund risk and a parallel analysis of performance relative to risk. For this reason, this model of fund Style analysis is particularly successful in popularizing the use of Style within institutional markets. Holdingsbased Style analysis services are now widely used by investment managers, investment consultants, fund of fund managers, private client fund managers, hedge funds and independent financial advisors across Europe, Southeast Asia, South Africa and South America in both institutional

1993

The earliest portfolio analysis services were simply UScentred. Essentially they were returns-based Style analysis techniques which, by mathematically comparing fund performance against the returns of Style benchmark portfolios, explained performance in terms of an imputed Style structure of the fund. But investor needs soon extended the range. The increasing availability of practical Style benchmarks in non-US markets and regions contributed to the popularity and sophistication of returnsbased analysis â&#x20AC;&#x201C; particularly across Europe. They were also constructed so as not to be susceptible to the same awkward, un-investable sector or country imbalances and erratic swings as the older US benchmarks.

As the relevance of a wider range of Style factors became evident, and comprehensive and more reliable fundamental securities data became available, holdingsbased Style analysis services filled a need for greater subtlety

Mar-99

STYLE

Developing Style in International Markets

Rebased Values

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LARGE GROWTH Style Beta

120

1.09

115

Portfolio # / Univ # 277 ------7942

110

T/O 31.7%

105 100

St. D 19.4% (15.7%)

90 85

T.E 4.7% (3.1%)

Regularity

3M 0.37

2004

6M 0.77

12M 1.50

Attribution

Identity

Portfolio # / Univ #

110

105

95 ------1936

100

T/O 42.2%

95

UK

St. D 16.4% (18.9%)

90

85

T.E 4.5% (3.9%)

Identity

100%

105

Regularity

3M 0.12

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

Returns Per Annum (12 M): -8.5% (ALL): -0.8%

1987

1986

1985

1984

80

Style Beta

1.6 [33%]

Return to 20-100 Market Cap, 0-50 Value (SA)

100%

Cumulative Relative Return

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

80

1.01

US

95

Returns Per Annum (12 M): -5.4% (ALL): -0.9%

Style Beta

5.2 [73%]

Return to 20-100 Market Cap, 0-50 Value (SA)

100%

Benchmarks and tracking error

6M 0.14

12M 0.26

Attribution

280 ------3004

1.04 100

Cumulative Relative Return

3.4 [68%]

Return to 20-100 Market Cap, 0-50 Value (CASA) Portfolio # / Univ #

T/O 32.9%

95

90

St. D 20.4% (22.1%)

85

Risk-based portfolio Style analysis

Returns Per Annum

There is more to Style investment than simply being overweight or tilted towards Value or Growth or Large or Small.Value managers are, or at least should be, specialists in choosing stocks within the Value universe of stocks; and similarly for Growth managers within the Growth universe.

Yet, against a broad Style-neutral benchmark, simple returns-based and holdings-based portfolio Style analysis methodologies are not capable of distinguishing genuine Value managers [who are overweight in Value stocks and who take most of their bets positioning Value stocks against other Value stocks] from faux Value managers who may appear to be Value simply due to uniform overweighting of Value stocks but who manage very uneven investments with many dramatic negative bets within the Growth universe.

This practice is identified only by decomposing total

(12 M): (ALL):

2004

2003

2002

2001

6M 0.26

12M 0.20

7.7 [84%] 5.4 [76%] Portfolio # / Univ #

Return to 20-100 Market Cap, 0-50 Value (CASA)

100%

100

T.E 2.7% (2.3%)

Attribution

Identity

1.12

2000

3M 0.16

-1.2%

105

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

Regularity

-4.9%

Style Beta

1019 ------10958

95

T/O 34.7%

90 85 80

St. D 20.3% (15.7%)

75 70

SE Asia

Cumulative Relative Return

1986

75

1985

80

Euro Zone

65

(12 M):

-3.0%

(ALL):

-2.2%

Regularity

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

Returns Per Annum

1988

1984

60 1987

Typically, as investment themes become established, tracking error estimates go out the window. This happened during the late 1990s as Value was trending downwards and Growth was booming within the dot com bubble. It is also a threat now. Established, industry-wide, calculation methods for estimating annual tracking error depend on extrapolating monthly risk estimates on the basis of a presumed independence of monthly relative returns. But the process is not suited to the analysis of Style based portfolios when Styles are delivering non-random, serially correlated market-relative returns. That is, when Styles trend. In these circumstances the industry-wide extrapolation methods seriously underestimate the annual tracking error risk of Style-based portfolios.

Reflection reveals that these tracking error problems can arise when theme-based funds are assessed against a comprehensive market benchmark or the market itself.

Furthermore, they will all but evaporate if theme-based funds are compared against benchmarks which also represent the same underlying investment themes [that is, Style benchmarks].

Consequently, it should be in the interests of managers to encourage clients to set Style benchmarks that reflect the agreed terms of investment mandates. Tracking errors that can embarrass managers would then be significantly reduced and the theme-based risk â&#x20AC;&#x201C; the initial cause of manager embarrassment â&#x20AC;&#x201C; would be managed deliberately by investment sponsors, most likely with the advice and assistance of investment consultants.

With the growing evidence that Style return patterns are predictable from macro phenomena, this division of labour would offer an entry-point for consultants to offer systematic Style-based advice targeted to the solution of complex asset-liability matching problems.

Attribution

Identity

1986

and informed retail environments. With the broad availability and acceptance of market Style analysis techniques, it is now imperative to consider some of the current questions surrounding Style. Much of the future look of Style depends on how these issues are resolved.

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T.E 5.1% (2.8%)

3M

6M

12M

0.25

0.28

0.27

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STYLE

SMALL VALUE Attribution

Identity Style Beta

Portfolio # / Univ # 3223 ------7942

130

0.98

US

Cumulative Relative Return

120

T/O 40.9%

110 100 90

St. D 18.9% (18.8%)

80

70

T.E 8.9% (7.1%)

100%

0.86

135

UK

Cumulative Relative Return

145

3M 0.24

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

Regularity

6M 0.47

12M 1.01

Attribution

Identity Style Beta

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

60

Returns Per Annum (12 M): 15.0% (ALL): 1.2%

Return to 0-20 Market Cap, 51-100 Value (SA)

874 ------1936

125

T/O 47.3%

115

105

St. D 15.9% (18.3%)

95

85

Identity

100%

150

Regularity

3M 0.24

T.E 9.0% (8.1%)

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

Returns Per Annum (12 M): 14.1% (ALL): 1.4%

6M 0.54

12M 0.85

Attribution

1494 ------3004

Euro Zone

Cumulative Relative Return

140

T/O 46.2%

130

120

St. D 14.6% (16.8%)

110

100

T.E 7.6% (7.8%)

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

90

Returns Per Annum (12 M): (ALL):

3M 0.00

1.9%

6M 0.05

12M 0.38

Attribution

7.7 [84%] 5.4 [76%] Portfolio # / Univ #

Return to 0-20 Market Cap, 51-100 Value (CASA)

100%

4998 ------10958

175 165

Cumulative Relative Return

SE Asia

Regularity

9.3%

Identity

0.83

3.4 [68%]

Return to 0-20 Market Cap, 51-100 Value (CASA) Portfolio # / Univ #

0.71

Style Beta

1.6 [33%]

Portfolio # / Univ #

75

Style Beta

5.2 [73%]

Return to 0-20 Market Cap, 51-100 Value (SA)

100%

155

T/O 46.2%

145 135 125

St. D 16.1% (13.7%)

115 105 95

(12 M):

5.2%

(ALL):

3.0%

Regularity

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

Returns Per Annum

1985

1984

85

T.E 7.4% (5.0%)

3M

6M

12M

0.21

0.35

0.48

portfolio risk, or tracking variance, into its component parts and identifying, at the stock level, where, among Large Value, Large Growth, Small Value, Small Growth, most of the risk resides. This risk-based Style analysis is currently an important practical issue in markets and regions where managers of a particular Style are not able to compare their performance against Style specific benchmarks but have to compete broadly across the entire market and the full range of competing Styles. And this is currently the case within the euro zone where Growth managers have been struggling to provide products capable of competing successfully during a protracted period of strong Value performance.

Growth managers masquerading as faux Value managers are, nonetheless, delivering a genuine Value product. But they are doing so by exploiting their skills as Growth stock specialists. While it is tempting to cry foul and disallow these practices, this would be too narrow-minded a position.

Instead, these practices should be considered alongside other modern approaches to delivering outperformance, such as “portable alpha”[where, for example, stock selection skill in Taiwan equities can, through the nimble use of stock index futures, deliver positive benchmark-relative returns in the United Kingdom], and used where appropriate.

In fact, since Value strategies and Value performance can be delivered both by Value managers and by Growth managers, it might become commonplace for mandates to specify what type of management is expected; and it might also make sense in larger markets to consider the appointment of two Value managers for one Value mandate – one managing Value stocks to deliver Value returns and the other managing Growth stocks with the same objective.

Can you transfer Style skills?

Can good Value managers also be good Growth managers? If the answer is yes, then there is very little reason to anguish over the appointment of separate Value and Growth managers. Good managers would be able to turn their skills towards the management of either Style portfolio; and investment sponsors would have little reason [aside from prudent diversification] not to put all their equity funds with collective managers. Perhaps sponsors might specify that investments be split between Value and Growth funds according to changeable or set proportions; but there would be no need to require consultants to assist in separate manager selection. If the answer is no, then we should explore what qualities of management identify good Value managers and good Growth managers so that our manager selection processes can be redesigned accordingly.

On the basis of preliminary research conducted at Style Research, it appears that in many of the major developed markets, systematic programmes of securities research based on objective fundamental securities data and disciplined buy and sell strategies can define successful investment practices within the Value universe of stocks. By contrast, no similar systematic programmes of investment appear capable of delivering outperformance within the Growth universe of stocks.

Source: Style Research

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SMALL GROWTH Attribution

Identity

100%

Style Beta

105

1.29

100

5.2 [73%]

Return to 0-20 Market Cap, 0-50 Value (SA) Portfolio # / Univ # 4139 ------7942

Cumulative Relative Return

95

T/O 40.1%

90 85 80

St. D 26.6% (18.8%)

75 70

US

65

T.E 15.0%

Regularity

3M 0.00

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

60

Returns Per Annum (12 M): 12.5% (ALL): -1.2%

6M -0.15

(6.4%)

12M -0.14

Attribution

Identity

Portfolio # / Univ # 878 ------1936

110

Cumulative Relative Return

1.10

T/O 47.4% 90

80

St. D 20.9% (17.6%)

70

T.E 12.0% (7.3%)

Returns Per Annum (12 M): 11.2% (ALL): -1.0%

110

2004

2003

2002

2000

1999

1998

1997

1996

1995

2001

6M 0.06

12M 0.18

1209 ------3004

105

T/O 48.1%

100 95 90

St. D 16.4%

85

(14.7%)

80

T.E 7.0%

Returns Per Annum (12 M): -0.1% (ALL): -0.6%

Regularity

3M -0.19

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

75

6M -0.27

(8.7%)

12M -0.20

Attribution

Identity

97%

7.7 [84%] 5.4 [76%] Portfolio # / Univ #

Return to 0-20 Market Cap, 0-50 Value (CASA)

130

1.06

3.4 [68%]

Portfolio # / Univ #

Euro Zone

Cumulative Relative Return

0.79

3M 0.11

Return to 0-20 Market Cap, 0-50 Value (CASA)

100%

115

Regularity

Attribution

Identity Style Beta

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

60

Style Beta

1.6 [33%]

Return to 0-20 Market Cap, 0-50 Value (SA)

100%

Style Beta

UK

4014 ------10958

120

110

T/O 54.2%

100

90

St. D 20.0% (15.3%)

80

SE Asia

70

(12 M):

6.6%

(ALL):

-1.5%

Regularity

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

Returns Per Annum

1986

60 1985

While this analysis is still in the preliminary stages, it does appear to match our intuition. It supports the view that Value managers can be successful by doing broad stock screening according to objective fundamental criteria and by applying disciplined strategies of diversified portfolio construction – and this tallies with much of what we are regularly told by Value managers.

According to the academics, Value portfolios ought to do well since, in an efficient market, investors in these securities can, by diversifying away stock specific risk, capture the extra reward available from the market for holding such out of favour, discounted, stocks. It is a neat completion of the circle that the very strategies that exploit these features can be shown to have been successful.

Growth managers, however appear to gain little systematic benefit from broad systematic stock screening. Therefore they need to apply other management skills to outperform the Growth benchmarks – perhaps smaller, punchier portfolios based on a more intimate knowledge of each company’s product development cycle and potential are the more likely keys to success within the Growth stock universe.

Should further research confirm these findings, it would appear that the investment practices of Value managers should differ fundamentally from those of Growth managers; so much so that it would be most unlikely to find individuals, let alone investment teams behaviourally suited to managing within both environments. This conclusion would have immediate practical implications. It would relegate Style rotation strategies to a Style allocation role, regularly rebalancing among independently managed funds, rather than the common current practice of managing a changeable rotating Style structure within one portfolio managed by one team or individual. And it would forever change the management selection process for Value and Growth mandates. Value selection criteria would be based formally on process and research. But it might be more relevant to ask Growth managers about their knowledge of individual securities and their specific insights and speculations. But we’re running ahead of ourselves.

The commercially motivated and successful introduction of Style concepts across Europe, the Far East, South America and South Africa has resulted in the development of a wide range of global Style services, the appearance of considerable applied research, and evolution and change to the fabric of Style itself. From an understanding of the current areas of live research and debate, and because Style services are now an integral part of an ever-changing global commercial investment environment, Style is certain to develop and evolve further over the years ahead. While many of the issues may appear to call for complex and arcane solutions, this is not in the character of Style.

Whatever course the evolution of Style may take over the years ahead, some things are certain. Style, by its nature, will continue to provide practical commonsense ways to understand investment themes, structure and analyze investment portfolios, communicate portfolio strategy and tactics, and to demystify the investment process.

1984

4:33 pm

Cumulative Relative Return

11/6/04

1984

DOC2.QXD copy

T.E 7.0% (5.0%)

3M

6M

12M

-0.02

0.04

0.18

Source: Style Research

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ALTERNATIVES

WAY TO GO! There was a time when prime brokers were content to stay in the back office. Later, they emerged to declare they could offer all things to all hedge funds. Do hedge funds really want a one-stop service, or would they really prefer to shop around specialist shops?

Dave Burrows finds out.

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HE GLOBALISATION OF hedge funds and their sole prime broker it is far more feasible in terms of tendency to use a diverse mixture of financial software capabilities. I would say that as things stand it is instruments is forcing the pace of change in prime still rather more in the admin rather than the pure prime brokerage. The question now is, how will prime brokers brokerage that the benefits are prevalent. The tech spends respond to increasing competition and market on basics is still vital as inefficiencies create mistakes.”

The expenditure Bohart regards as vital is diversity? There are arguably some 20 services that prime brokers are expected to offer at different stages of considerable. As prime brokers commit themselves to a hedge fund’s life-cycle. Among the basics are custody, straight-through processing, [always with an eye on the clearing, reporting, securities lending, cash lending, impending deadline for the industry-wide T+1 execution, leverage and pricing. To that list you now initiative], their IT spending is estimated to hit in excess have to add: capital introduction, start-up services, of US$1.2bn a year by 2006.

One of the biggest trends in European prime brokerage credit inter-mediation, risk management, straightthrough processing, futures and options clearing, is the move by hedge fund managers to use multiple research, initial public offerings, and contracts for prime brokers. This process is being driven by the search for better service and the attempt to lower exposure to difference and swaps.

Expertise in structuring and selling product for risk one investment banking house. However, there is another arbitrage strategists through a prime broker’s key reason for this trend: the need for specialists.

Europe’s new dynamic infrastructure, represents a financial markets require significant advantage to a strategies for aggressive hedge fund client, who growth, distressed securities, would otherwise have to The strategy is carrot and stick, with and emerging markets, for bring together the the hedge fund able to use the stick of instance. There is also a need individual variables, such as threatening to take its business for expertise in financial execution or borrowing, elsewhere, but also offer the carrot of services, market neutral itself. Using a prime broker putting most of its business the way arbitrage and securities in this manner can offer hedging, and convertible hedge fund important of a single prime broker. arbitrage. operational efficiencies. If a Capital start ups are also hedge fund has to generate a growing element of the ‘alpha’ in its investment strategy, for example, then it makes sense to integrate a prime brokerage service and in recent years there has fund’s ‘front-end’ abilities with top-tier prime brokerage been huge demand from hedge funds for support. Prime brokers are anxious to help fledgling hedge funds, but it service provision.

Hedge funds are constantly demanding more. It means is a costly business. Scale determines how worthwhile an increased competition between prime brokers and activity it is for brokers, as Bohart explains: “A £50m pressure on them to either offer an ever-expanding pack hedge fund is just not profitable to us. On the whole of services or limit themselves to a lucrative and specialist though, supporting hedge funds is good for us and the niche. It’s a dynamic that is not yet resolved – but it does market but it is something we do not take lightly. As far put hedge funds in a powerful negotiating position. The as capital start ups are concerned we run things on a very strategy is carrot and stick, with the hedge fund able to selective basis.” use the stick of threatening to take its business elsewhere, but also offer the carrot of putting most of its business the Increased competition way of a single prime broker. Until now, prime brokers The increasing numbers of hedge funds has attracted new have attempted to lock managers into exclusive players into the market offering prime broker services, a relationships by offering added-value in terms of help trend that has brought mixed blessings. Stuart Bohart of with raising finance; assistance with starting up the hedge Morgan Stanley genuinely believes increased competition fund, or better technology. is a good thing. Even so, he underscores the fact that Technology is a particular consideration in creating the distinctions in services offered should remain the defining single stop prime broking house, and competition among factor for clients. “The hedge fund revenue pool is really prime brokers in the area of technology is fierce. Barclays growing and this is driving new entrants. This is not Capital, Lehman Brothers, and Dresdner regard their necessarily impacting hugely on the leading players, as highly developed online systems as crucial for advanced most of the new entrants are niche players – that only product and service delivery. But as Stuart Bohart, offer some of the services.” Bohart believes only a very managing director and head of prime brokerage at select few offer the full range of services. “You are only Morgan Stanley Europe & Asia explains, technology can realistically looking at Morgan Stanley and Goldman only go so far: “It is hard to offer technology that you can Sachs with perhaps UBS coming into the frame. I would utilise if someone is using multiple prime brokers. With a say that the added value we bring to clients is in the

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The FSA also recorded its concerns about the increasing people and resources we bring into the equation. I’d specifically mention the start-up services and consulting number of investment bankers setting up their own hedge funds and the knock-on effects this will have on services we provide after launch.”

Bohart’s approach is a confident one, backed by the the prime brokerage arena. “As new start-ups enter the large resources of a global bank, but not everyone agrees industry, it is important that their prime brokers understand their risk – Maurits Schouten for one. appetites and incentive The managing director of structures,”the paper said. equity-linked business at Barclays Capital’s Schouten Barclays Capital suggests responds by saying it was that offering all things to all As hedge funds move into global important that the FSA aired people is not necessarily the markets, increasing pressure is put on its grievances and agreed that right or only strategy.“It is a the big financial institutions to offer a there were issues about an very crowded stage and truly global service. overcrowded market.“I think Goldman Sachs and the market has become topMorgan Stanley are clear heavy in terms of the number leaders in terms of market of players and this has share. But there is a lot of brought with it certain room to differentiate your firm and your services.” Barclays Capital prides itself on pressures. But I think the FSA is more concerned with overoffering four financing activities from the same platform collateralisation rather than the spread.” under one management structure. It integrates services for execution, derivatives, and clearing of equities, futures Best of breed business and fixed income products from the platform. “It is true Both Morgan Stanley and Goldman Sachs primarily chase we don’t do capital introduction but we are able to ‘best of breed’ business, in that the focus is on the biggest, differentiate ourselves through more structured aspects most established hedge fund clients. “In the main we of financing, notably fund link derivatives and providing focus on the biggest clients; that is where we position our financing for fund of funds,” explains Schouten. business and we provide a comprehensive service,” says There is an argument to say that a bigger revenue pool Bohart. Barclays Capital also focuses on the large hedge is a good thing in itself. Because the pool is so big, it is funds. Since they are not a fully fledged equity house they possible to work at lower spreads. Certainly in terms of can’t deal with IPOs so there are imposed restrictions on costs, the likes of UBS has driven down costs according to what they can offer. market commentators. But price is not necessarily the A relatively new face on the prime brokerage scene is only consideration. The argument here is that it is not just Deutsche Bank. The company unveiled its prime the quality of the cloth, but also the width that counts, brokerage business back 1999, and in the first year alone, and for that, there’s a cost. Morgan Stanley’s Bohart secured more than 60 new mandates. Previous big wins insists it is important to take on board the flexibility have included Jupiter Asset Management’s Hyde Park offered by a prime broker with regard to what they can Hedge Fund and New Star Asset Management’s UK feasibly provide and what they have spent on developing equity long/short fund. their service.“Not all prime brokers or new entrants offer Interestingly, from a marketing point of view, a full service; most try to do capital introduction but after Deutsche’s entire business model – which encompasses that there is a great deal of variation.” stock lending, prime brokerage, structured finance and the value added services such as capital introduction – is referred to as ‘prime services’, further emphasising the FSA Warnings Talk of bespoke services is all very well, but as far as the point previously made that prime brokers are significantly Financial Services Authority [FSA] is concerned, there are stretching their initially straightforward role.

As hedge funds move into global markets, increasing issues relating to the number of new entrants to the pressure is put on the big financial institutions to offer a market and the increased pressure on margins.

The FSA has voiced concerns that increased truly global service. Will this inevitably push the competitive pressures in the prime brokerage market business into fewer and fewer hands? Bohart of Morgan could result in a dangerous relaxation of risk supervision. Stanley believes true global presence will be limited to In its paper ‘Financial Risk Outlook for 2004’ the the larger and already established companies.“I think it watchdog warned: “There is a risk that competitive is important to have a presence in the key regions. We pressures could result in brokers relaxing counterparty have three regional offices – in the US, Europe and Asia. credit risk management standards, in terms of both This means we have a presence in all the right time margin requirements and ‘lockups’ [guarantees that prime zones. It is not just about client contact – it is about the brokers will not withdraw lines or change financing rates complexity of regional business. We set up global teams so that in any time zone, someone can have access to for a specified period of time].

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their current positions. Prime brokerage will not be so US dominated as before.”

Bohart continues,“Europe is the second most important area and like Asia, which is in third place, companies are increasing their presence there.” Morgan Stanley was the first to set up an international prime brokerage platform in London in 1989, and has always been close to the top of the favourite prime broker rankings. In Europe, it has always seen itself at the forefront of innovation and this is principally why it has maintained a strong position there.

But as the market has matured, Morgan Stanley has increasingly been obliged to share the European hedge fund market space with Goldman Sachs, which established its international prime brokerage platform in London in 1996. An important part of Goldman’s structure is the fact that it sits alongside offshore fund administration, stock lending and equity finance, all housed in the equities division.

Bohart’s take on the situation is that the big players will continue to snap up the bulk of the business with niche players on the fringes. Certainly, if you were to list true those with true global presence, UBS, Goldman Sachs, Morgan Stanley and Deutsche Bank would probably be the names in the frame.

But there are other names extending their sphere of influence.

Bank of America continues to develop an international platform, while Citigroup (which owns the former Salomon Smith Barney prime brokerage business), Barclays Capital and Dresdner Kleinwort Wasserstein have also been added to the ranks of those going live with international platforms.

Schouten of Barclays Capital explains how the company aims to extend its profile and reach.

“Barclays Capital has traditionally been European focused, but we are changing that. We have steadily been increasing our presence in the US and are expanding our business in Asia. We do not have critical mass in Asia yet, but we will have it within a year. While I would say that the prime brokerage market is overcrowded now [and I would suggest some companies may want to ask themselves whether they want to be in it], to Barclays it is an important business and to that extent we are committed to increasing our global presence.”

A spokesman for Citigroup Canary Wharf, London closely echoed the comments

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from Barclays Capital. “With the resources at our disposal we are in a position to expand on a global basis and take a greater market share. This will happen and we will be building on our established position in the US to achieve this aim.”

Bear Stearns, a long established US prime brokerage business, has invested time and money in its platform in Europe. Over recent years it has been building up prime brokerage sales to European hedge funds, securing mandates in Europe, particularly France, Benelux, and Scandinavia. But how far Bear Stearns will penetrate, in terms of global market share and the levels of business it will take from established names, remains to be seen.

The possession of a truly global presence may be the deciding factor as to who takes the lion’s share of highlevel business, but the diversity of hedge fund strategies makes the market highly segmented. There is, one can argue, room for many players to coexist, so long as they are committed to their various niches. While these niches remain profitable, talk of any operators exiting the prime broker market may be a little premature.

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VALUE

Value investors V find their stride

They are the stocks nobody loves – the onceproud shares of basically good companies that, due to circumstances beyond their control, have been battered and bruised beyond recognition.

But long after the herd has departed, there remain a handful of true believers who gaze beneath the charred surface of these castaways in hopes of finding something – anything – worth sticking around for. David Simons reports.

ALUE-FUND MANAGERS are a unique group of investor. They’re the industry’s tireless tire kickers, perpetually scouring the market for unfairly under-priced shares in hopes of turning today’s lump of coal into tomorrow’s sparkling diamond. By nature, good value managers are principled types who tend to move against the grain of the market. While investors were snapping up dot-com hotties such as Etoys or Drkoop near the end of the ‘90s, value players steered clear. Today, shares of bankrupt eToys trade as mementoes on eBay – while fundamentals-based value funds are finally back in vogue.

Benjamin Graham, the acknowledged “founding father of value,” initiated the value-based approach after losing most of his wealth in the crash of 1929. In his 1934 book Security Analysis Graham argued that by using discipline and good judgment, investors could profit on the stock of any reasonably sound company simply by looking for shares that traded at a significant discount to the “intrinsic value”of the company.

Graham began his comeback in the midst of the Great Depression; by the 1940s, he had regained his wealth and the respect of the investment world. Today, Graham’s leading disciple is Berkshire Hathaway’s Warren Buffett, who went to work for Graham in the 1950s. And while

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Buffett would later develop his own value-based methodology, the teachings of Graham remain at its core.

Old-school strategies can be a tough sell in today’s wired world, but after the carnage of 2000/2002, investors are finding peace – and profitability – in the methodical world of value. Standard & Poor's reports that value-based funds were among the front-runners during the first quarter, with an average return of 4.41% for the first three months. In the last 12 months US mid- and small-cap value funds have averaged roughly 30%, with large caps pulling in close to 21%, according to Morningstar. In fact, value funds were among the largest recipients of new cash in all of 2003.

“Value investments may have gained due to defensive market sentiment,” explains Ken Shea, managing director of global equity research at Standard & Poor’s.“History has shown that investors have traditionally moved toward defensive areas in the second year of bull markets.”

Rosanne Pane, an S&P mutual fund strategist, says investors consider value funds to be a good bet during times of uncertainty. “In February and March, investors became cautious about the longevity of the market recovery, consumer confidence started to fall and questions arose over whether or not the growth phase of the recovery was over. It was at this point that investors began to run away from growth and rotate into value, consumer staples, and dividend payers.”

Finding Value Unlike mainstream funds that proudly display the hottest ‘flavours-of-the-month’, value stocks don’t always make for the prettiest portfolio. “Value managers usually tend to gravitate toward less exciting sectors, such as utilities, financials, and industrial companies,” observes Emily Hall, senior analyst with Morningstar. Value players in general typically avoid high-flyers such as initial public offerings [IPOs], micro-techs or just about anything trading at outrageous earnings multiples.“Biotechnology and medical device stocks also are often out of the realm of value managers,”says Hall.“Of course, plenty of value funds have owned technology stocks and even a biotechnology name or two. Just because a value fund dabbles in technology doesn't mean that it’s necessarily cheating. But, on average, value funds tend to be more heavily invested in stodgier companies with fewer “sexy” product ideas. Of course, for the right price, value managers are usually open to buying stocks that land in so-called growth sectors.”

Most value managers employ the same basic rules of thumb – namely buying stocks with lower-than-normal P/E multiples and going for absolute as opposed to relative rates of return.

Some, like Carl Marker IMS Capital Management in Portland, Oregon, apply their own set of criteria when hunting for portfolio candidates. “Our strategy combines value with momentum in a quest to find ‘seasoned’ stocks,” says Marker, who manages the diminutive IMS Capital Value Fund [approximately $78 million in assets as of March 31].

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Marker’s idea of a “seasoned” issue is one that has been in the dumps for a good 18 to 24 months. Only when the company begins to show some forward momentum does Marker take the plunge. A 36-point scoring model that measures a company’s P/E ratio, debt level and other factors helps Marker decide if the time is right. “Our process has been highly effective in both up and down markets, and the results speak for themselves,” says Marker, whose fund was up 8% through Q1 this year and a whopping 64.82% over the past 12 months.

Of course, stocks don’t usually wind up in the bargain bin without a good reason. While some are unfairly kneecapped as part of an exaggerated sector sell-off, others have been victims of some highly publicised scandal involving the parent company. Chief Executive Officers [CEO] in handcuffs or bacteria-laced hamburgers might send the average investor fleeing, but for the astute value manager, such news is often a clarion call. As Edwin Walczak of Vontobel Asset Management once opined,“My goal is to buy stock in Michael Jordan when he's having a bad season.”

One company that wound up on the shopping list of innumerable value-fund buyers was Tyco International [TYC], an all-purpose conglomerate that once traded as high as $60. In late 2002, former CEO L. Dennis Kozlowski and former Chief Finance Officer [CFO] Mark Swartz were charged with enterprise corruption and grand larceny for allegedly stealing $600m from the multibillion-dollar international conglomerate, sending shares of Tyco into the single digits. That’s when Harris Leviton of Fidelity’s Value

Barbara Marcin, manager of Gabelli Blue Chip Value Fund

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VALUE

Strategies Fund became interested; today, Tyco remains one of the fund’s Top 10 holdings.

"While the rest of the world was focusing on Dennis Kozlowski's expensive shower curtains,”reported Leviton, “our analysts and I were focused on Tyco's inexpensive stock. We knew the quality of the underlying assets, and with the dual catalysts of new management and asset sales, the stock has been a strong performer for the fund.”

Other Tyco takers have included David L. King of Putnam New Value Fund, Bill Miller of the Legg Mason Value Trust, as well as the team that heads up the Clipper Fund.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 included a particularly sweet bonus: a change in the tax treatment of dividends, from ordinary income to capital gains. The accompanying dividend rate reduction – previously as high as 38.6%, now a frugal flat rate of 15% – has created a new opportunity for income-seeking investors in the form of dividend-paying value funds.

“In response to the legislation, many companies changed their dividend policies,”notes Paul Herbert, senior fund analyst with Morningstar. “Cash hoarder Microsoft initiated a dividend-payment schedule and firms such as McDonald's boosted their payouts. And while market returns wax and wane, public firms are often reluctant to reduce or eliminate income distributions, lest they risk angering shareholders accustomed to such payments.”

Barbara Marcin, manager of Gabelli Blue Chip Value Fund, says the concrete returns offered by such high-paying

dividend funds are a good fit for the newer, more-rational investor.“Dividends are real,”Marcin told the gathering at a recent Financial Planning Association of New York conference,“while other financial numbers you get may not always be.” Companies that offer higher dividends are a solid bet, says Marcin,“because they don’t usually increase their dividends unless they can maintain them.”

Despite the uncertainty that continues to dog the market, stingy interest rates have kept the market’s liquid asset ratio just a hair above 4%, among the lowest levels in recent history. Not surprisingly, value managers are bucking the anti-cash trend; many have been gradually raising their cash positions since the first of the year. Having the presence of mind to get out of the market – and stay out – once valuations have jumped is often what sets value managers apart from the peers. Such patience also prevents managers from inadvertently jumping back into a “value trap”– a stock that looks cheap, and then stays that way for years.

“Over the last few months, higher stock prices allowed us to sell or trim positions in our portfolio that have reached their price targets,” Vontobel’s Walczak recently noted.“However, we have not been able to invest our cash position fully as the valuations of stocks do not offer us attractive entry points.”

A harbinger for the market near-term? Time will tell. But if a drop in the FTSE results in a whole new crop of underpriced equities, you can be sure that those champions of value will be ready to go shopping once more.

GETTING THERE IS EASY FTSE Global Markets is your passport to 20,000 issuers, fund managers, pension plan sponsors, investment bankers, brokers, consultants, stock exchanges, and specialist data providers.

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In December 1999, Bolsa de Madrid launched Latibex, a market segment for Latin American securities within the Spanish electronic trading platform [SIBE] or Mercado Continuo. Starting with only five listed stocks, Latibex has grown to include 31 stocks, most of them Latin Blue Chips. Yvonne Teixeira and Pablo Ybarra explain the success of the market.

ATIBEX IS BEST known as the Euro market for Latin American companies. While Latibex is a Eurodenominated market, the stocks traded in it are exactly those traded on local Latin American markets [even including the ISIN code]. They remain, in effect, Latin American stocks, but in practice are considered a domestic security by Spanish custodians, both in terms of procedures and fees. “The fact of having a Euro-denominated benchmark is an advantage in marketing terms to fund participants”says Jonás González from Renta 4 Gestión.

Jesús Gonzalez, director of Market Development at Bolsa Madrid and Coordinating Director of Latibex, says “For investors, the selling point is the ability to trade – in one spot – all relevant Latin American stocks in your own currency and using your traditional trading and settlement tools. For companies, the message we give is that Latibex provides access to the Euro capital markets.”

It helps that Latibex is primarily a blue chip market.

Petrobas, for example – with a market cap of some $26bn and one of the world’s largest oil companies – was among the first 20 or so companies to list both its common and

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EUROPE’S GATEWAY TO LATIN AMERICA’S HOT STOCKS preferred stock capital on the market. There are now 31 leading Latin American stocks listed on Latibex: “enough to build an index that correlates well,”says Jesús Gonzalez.

When investors buy through Latibex, they enjoy the same rights as regular shareholders and can freely transfer securities to local Latin American exchanges. Equally they can transfer shares bought locally in Latin America and trade them through Latibex. The cost, however, is between 5 to 10 times lower than those of the creation/redemption of depository receipts.

The market has responded enthusiastically; with the value of trading exceeding €30m in May – an increase of some 31% compared with the same month last year. This is indicative of a significant growth trend which began at the start of 2004. It is part also of a wider improvement in trading in the Spanish market – which through SIBE reached €58.34bn – a 58% increase on May trading in 2003.

“Cost savings is the main advantage of Latibex,” says Renta 4 Gestión’s González,“trading, clearing and custody fees have been reduced considerably. Administrative costs have also been reduced compared to those of the previous year, due to the lower number of foreign currency trades [non-Euro] and of stocks in portfolio, after transferring all fungible securities to Latibex.”

Jacobo de Peñaranda from Barclays Gestión expands: “Latibex is as representative of Latin American markets as our previous benchmark, given the high correlation between them. In addition to that, liquidity, bid/ask spreads and diversification are improving at a fast pace with the inclusion of new constituents and the growing number of

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institutional investors following Latibex. Operationally the fungibility of the stock, market specialists are able to track FTSE Latibex indices are superior for a European investor bid and ask prices of local exchanges on Latibex, with a because of the many benefits of being Euro-denominated”. very tight spread. Juan Pablo Jimeno, Equities Managing Savings gained when avoiding costs of foreign Director at BBVA explains: “At the end of the day buying through Latibex saves money exchange against Latin due to the lower fees charged American currencies and “The fact of having a Euro-denominated along the cycle of the order. local sub-custodians, not to On request we can provide mention the advantage of benchmark is an advantage in marketing through Latibex all liquidity using trading and terms to fund participants” available on local markets”. settlement systems at Prices on Latibex are used European standards are an important consideration, say local asset managers. to calculate the FTSE Latibex indices on real time during the Explains González: “There are also qualitative factors trading session. The strong correlation of the FTSE Latibex which make the migration into Latibex a success. For indices against other regional indices calculated with local example, a fund manager can adjust the agenda to a prices is probably the best way to measure the accuracy of European schedule and has the same stocks that are listed prices on Latibex. FTSE and Bolsa de Madrid calculate the FTSE Latibex indices weighted by market capitalisation and on local markets, instead of depository receipts”.

He adds:“Our experience is very satisfactory given that our adjusted by free-float.

The FTSE Latibex All Share Index comprises all stocks new benchmark has a relatively low number of constituents – what implies lower costs – and we are having a very high listed on Latibex and has been measuring the overall performance of the market since its first trading session. correlation against broader indices taken in Euro terms.

Latibex, as with the rest of Sistema de Interconexión When tracking a historical graph of the index (see graph 1) Bursátil Español [SIBE], the Spanish electronic trading we can check its reliability, since it clearly reflects the platform, runs as an order-driven market. However, there events that have had an impact on Latin American equity are also market specialists including the local Ahorro markets in the last years.

The growing number of stocks listed on the market, and Corporación [the Spanish Savings Banks broker], BBVA, Benito y Monjardín [part of Banco Espirito Santo] and specially the significance of some of them, has been a Santander Central Hispano Bolsa that concentrate on crucial aspect to increase further the reputation of the index particular stocks. But the market makers compete with as an accredited benchmark for the region. This can be each other.“There is no exclusivity and the market makers measured by comparing the correlation and tracking error are not limited to their specialisation. Trades can be of the FTSE Latibex All Share against the FTSE AW Latin America since July 2002, when Petrobras common and conducted by any accredited broker,”says Jesús Gonzalez.

Market makers act primarily as providers of liquidity and preferred stock joined Latibex – a turning point in the lead trading. Given the low transference costs and composition of the index.

Table 1: Composition of FTSE Latibex Symbol Stock XAMXL XTMXL XBBDC XVALP XPBRA XARAB XEOC XGMD XENI XGGB XCMIG XALFA XELTB XDYS XBRK Closing

AMERICAMOVIL TELMEX B.BRADESCO VALE DO RIO PETROBRAS PR ARACRUZ B ENDESA CHILE GRUPO MODELO ENERSIS, ORD GERDAU PREF CEMIG ALFA ELETROBRAS B DISTR.Y SERV BRASKEM

#Units

85.180.387 80.208.404 57.627.121 55.032.477 101.574.923 539.071.543 136.695.909 65.035.192 261.209.332 145.328.680 88.398.748 30.000.000 169.834.594 27.600.000 20.492.343 1.863.289.653 FTSE Latibex Top : 1.282

Closing €

Capitalisation €

% Weighting

28,73 27,19 33,01 33,85 18,13 2,64 9,97 20,3 4,84 7,85 9,82 25,6 3,36 11,7 10,71

2.447.232.518,51 2.180.866.504,76 1.902.271.264,21 1.862.849.346,45 1.841.553.353,99 1.423.148.873,52 1.362.858.212,73 1.320.214.397,60 1.264.253.166,88 1.140.830.138,00 868.075.705,36 768.000.000,00 570.644.235,84 322.920.000,00 219.472.993,53

12,55 11,19 9,76 9,56 9,45 7,3 6,99 6,77 6,48 5,85 4,45 3,94 2,93 1,66 1,13 100

Capitalisation: 19.495.190.711,38 € Source: Latibex

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There is now a sea change in the selling of Latibex.“We Eletrobras, Endesa Chile and Vale do Rio. In order to comply used to concentrate on getting companies to list,”explains with the UCITS Product Directive the maximum weighting Jesús Gonzalez, “Now we are concentrating on the of any constituent is capped at 10% at index reviews. The investors.” To date, he explains, the bulk of investment result is an index with only 15 constituents that in the long term is tracking fairly well money passing through against the much broaderLatibex is from Spanish based FTSE AW Latin investment funds – although “At the end of the day buying through America where there is a he notes increasing interest Latibex saves money due to the lower fees 99.39% correlation between from outside Spain. charged along the cycle of the order.” prices and a tracking error of At the beginning of this only 0.63%. year FTSE and Bolsa de Some fund managers Madrid also began distributing a new index: the FTSE Latibex TOP, made up of have concentrated all their holdings of Latin American 15 stocks among the largest in Latibex, considering only one equities on Latibex, using the FTSE Latibex indices as their stock per issuer. The number of constituents has not been benchmark, while others are already using Latibex to trade fixed to a specific number in order to keep the door open to selected stocks on their portfolios. According to Peñaranda new companies joining the market. The FTSE Latibex TOP from Barclays Gestión: “We considered several factors. We Index was launched in February this year and was designed saw the benefits derived from the high representation of to provide a manageable and shorter index that could be Latin American equity markets and liquidity granted by easily tracked and could be used as an underlying asset for market specialists – at controlled spreads. Lower fees in derivative products. It comprises the 15 most capitalised and trading, settlement and custody, were also factors and, last liquid stocks in Latibex, including AmericaMovil, Alfa, but not least, operational and regulatory factors”.

FTSE Latibex Top Weightings Breakdown by Country

FTSE Latibex All Share Weightings Breakdown by Country 51% 15% 34%

Brazil Chile Mexico

53.01% 4.99% 41.17% 0.29% 0.05% 0.17% 0.32%

Brazil Chile Mexico Puerto Rico Panama Peru Argentina

Source: Latibex

FTSE Latibex: Historical Performance

1200 1100 1000 900 800 700 600 500 29/02/04

30/11/03

30/08/03

30/05/03

28/02/03

30/11/02

30/08/02

30/05/02

28/02/02

30/11/01

30/08/01

30/05/01

28/02/01

30/11/00

30/08/00

30/05/00

29/02/00

30/11/99

400

Source: Latibex

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FTSE Global Equity Index Series – Global YTD 2004 FTSE Regional All Cap Indices Performance 130 125 120 115 110 105 100 95 90 85 Dec03

Jan04 FTSE Global AC (US$) FTSE Developed Europe AC (US$)

Feb04

Mar04

FTSE Japan AC (US$) FTSE Asia Pacific AC ex Japan (US$)

Apr04

FTSE Middle East & Africa AC (US$) FTSE Emerging Europe AC (US$)

May04

FTSE Latin America AC (US$) FTSE North America AC (US$)

FTSE Regional Indices Capital Returns YTD [US$] 10

5

%

0

-5

-10

FTSE Global AC

FTSE All-World (LC/MC)

FTSE Global LC

FTSE FTSE Global MC Global SC

FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE Developed Adv Emerging All-Emerging Latin Middle East North Asia Pacific Japan AC AC Emerging AC AC AC America AC & Africa AC America AC ex Japan AC

FTSE FTSE Dev Emerging Europe AC Europe AC

FTSE Country All Cap Indices YTD FTSE Developed Country All Cap Indices Capital Returns YTD [US$] 20 15 10 5 0 % -5 -10 -15

FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE Australia Austria Belgium/ Canada Denmark Finland France Germany Greece Hong Ireland AC AC Lux AC AC AC AC AC AC AC Kong AC China AC

Dollar value

Data as at 31st May 2004

88

FTSE Italy AC

FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE Japan Nether- New Norway PortugalSingapore Spain Sweden Switz- United USA AC lands AC Zealand AC AC AC AC AC erland Kingdom AC AC AC AC

Local Currency value

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

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FTSE All-Emerging All Cap Indices Capital Returns YTD [US$] 30 20 10 0 % -10 -20 -30

FTSE FTSE Argentina Brazil AC AC

FTSE Chile AC

FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE China Columbia Czech Egypt Hungary India Indonesia Israel AC AC Republic AC AC AC AC AC AC

Dollar value

FTSE FTSE FTSE FTSE FTSE FTSE Korea Malaysia Mexico Morocco Pakistan Peru AC AC AC AC AC AC

FTSE FTSE FTSE FTSE FTSE FTSE FTSE Philip- Poland Russia South Taiwan Thailand Turkey pines AC AC Africa AC AC AC AC AC

Local Currency value

FTSE Global All Cap Index Sector Capital Returns YTD [US$] 15

10

5 %

0

Real Estate

Speciality & Other Finance

Investment Companies

Life Assurance

Banks

Insurance

Electricity

Utilities – other

Telecommunication Services

Transport

Food & Drug Retailers

Media & Entertainment

Support Services

Leisure & Hotels

Tobacco

General Retailers

Total Return

Information Technology Hardware Software & Computer Services

Capital

Pharmaceuticals & Biotechnology

Health

Personal Care & Household Products

Beverages

Food Products & Processors

Household Goods & Textiles

Electronic & Electrical Equipment Engineering & Machinery Automobiles & Parts

Aerospace & Defence Diversified Industrials

Steel & Other Metals

Forestry & Paper

Chemicals

Construction & Building Materials

Mining

-10

Oil & Gas

-5

Stock Performance Best Performing FTSE All-World Index Stocks [US$] Nishi-Nippon Bank 155.2% Aristocrat Leisure 136.2% Chi Mei Optoelectronics 110.2% Hynix Semiconductor 98.2% LG Corp 96.8%

Worst Performing FTSE All-World Index Stocks [US$] LG Card -89.0% Natural Park Co -64.9% Interchina Co Holdings -60.0% Seat-Pagine Gialle -58.1% ITV -50.8%

Overall Market Return FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE

No. of Consts 7,123 1,003 1,760 4,360 2,763 1,611 149 80 1,435 170 2,450 1,228

Global All Cap Global Large Cap Global Mid Cap Global Small Cap All-World Asia Pacific All Cap ex Japan Latin America All Cap All Emerging Europe All Cap Developed Europe All Cap Middle East & Africa All Cap North Americas All Cap Japan All Cap

Data as at 31st May 2004

Value

1M

3M

YTD

269.51 269.91 337.27 305.18 162.16 285.01 321.41 332.44 274.84 303.25 261.49 289.41

0.5% 0.4% 1.3% 0.7% 0.5% -2.5% -1.0% -4.1% 1.0% 5.8% 1.4% -3.7%

-2.7% -2.8% -2.2% -2.4% -2.8% -9.2% -10.3% -7.3% -3.9% 0.8% -2.3% 4.3%

1.1% 0.2% 3.6% 3.8% 0.7% -1.2% -4.2% 4.0% 0.5% 3.1% 1.0% 5.9%

Actual Div Yld 1.98% 2.12% 1.71% 1.60% 2.03% 2.69% 3.32% 2.67% 2.77% 2.98% 1.64% 0.95%

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

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FTSE Global Equity Index Series – Developed ex-US YTD 2004 FTSE Developed Regional Indices [Large/Mid Cap] 115

110

105

100

95

90 Dec03

Jan04

Feb04

FTSE Developed (LC/MC) FTSE Developed Europe (LC/MC)

Mar04

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

Apr04

FTSE Developed ex US (LC/MC) FTSE US (LC/MC)

May04

FTSE Developed Asia Pacific ex Japan (LC/MC)

FTSE Developed Regional Indices Capital Returns YTD [US$] 10

5

% 0

-5

FTSE Developed

FTSE All-Emerging

FTSE Developed ex US

FTSE Developed Europe

FTSE Developed Asia Pacific

FTSE Developed Asia Pacific ex Japan

FTSE Eurobloc

FTSE US

FTSE Developed AC ex US

FTSE Developed LC ex US

FTSE Developed MC ex US

FTSE Developed SC ex US

FTSE Developed ex US Index [Large/Mid Cap] Sector Capital Returns YTD [US$] 20

15

10

%

5

0

-5

Data as at 31st May 2004

90

Information Technology Hardware Software & Computer Services

Real Estate

Speciality & Other Finance

Investment Companies

Insurance

Life Assurance

Banks

Electricity

Utilities – other

Telecommunication Services

Transport

Food & Drug Retailers

Support Services

Media & Entertainment

Leisure & Hotels

Tobacco

General Retailers

Pharmaceuticals & Biotechnology

Health

Capital

Personal Care & Household Products

Beverages

Food Products & Processors

Household Goods & Textiles

Electronic & Electrical Equipment Engineering & Machinery Automobiles & Parts

Aerospace & Defence Diversified Industrials

Steel & Other Metals

Forestry & Paper

Chemicals

Construction & Building Materials

Mining

Oil & Gas

-10

Total Return

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

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Stock Performance Best Performing FTSE Developed ex US Index Stocks [US$] Nishi-Nippon Bank 155.2% Aristocrat Leisure 136.2% Caltex Australia 77.1% Sanyo Shinpan Finance 66.1% Reuters Group 58.7%

Worst Performing FTSE Developed ex US Index Stocks [US$] Interchina Holdings -60.0% Seat-Pagine Gialle -58.1% China Everbright [Red Chip] -41.9% Ryanair Holdings -36.2% Leighton Holdings -35.4%

Overall Market Return FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE

No. of Consts 1,282 637 1,919 844 477 734 299 3,392 487 1,760 4,360

Developed ex US [LC/MC] USA [LC/MC] Developed [LC/MC] All-Emerging [LC/MC] Developed Europe [LC/MC] Developed Asia Pacific [LC/MC] Developed Asia Pacific ex Japan [LC/MC] Developed All-Cap ex US [LC/MC] Developed Large Cap ex US Developed Mid Cap ex US Developed Small Cap ex US

Value

1M

3M

YTD

167.77 457.98 160.59 209.97 167.28 161.03 232.60 279.69 267.93 307.15 326.35

0.1% 1.2% 0.7% -2.5% 1.1% -2.6% 0.2% 0.0% 0.0% 0.4% -0.4%

-2.9% -2.1% -2.4% -8.6% -3.8% 0.2% -7.5% -2.7% -3.0% -2.4% -1.0%

0.7% 0.9% 0.8% -0.6% -0.1% 3.2% -0.8% 1.3% 0.0% 3.2% 6.8%

Actual Div Yld 2.42% 1.69% 2.01% 2.39% 2.81% 1.62% 3.37% 2.37% 2.48% 1.71% 1.60%

FTSE Global Equity Index Series – Asia Pacific YTD 2004 FTSE Asia Pacific All Cap Regional Performance 120 115 110 105 100 95 90 85 Dec03

Jan04 FTSE Global AC FTSE Developed Asia Pacific (LC/MC)

Feb04 Mar04 FTSE Developed Asia Pacific ex Japan (LC/MC) FTSE Asia Pacific AC

Apr04 May04 FTSE All-Emerging Asia Pacific AC FTSE Japan (LC/MC)

FTSE Asia Pacific Regional Indices Capital Returns YTD [US$] 10

5

% 0

-5 FTSE Asia Pacific AC

FTSE Global AC

Data as at 31st May 2004

FTSE Developed Asia Pacific (LC/MC)

FTSE Developed Asia Pacific ex Japan (LC/MC)

FTSE All-Emerging Asia Pacific AC

FTSE Developed Asia Pacific AC

FTSE Japan Index (LC/MC)

FTSE Asia Pacific (LC/MC)

FTSE Asia Pacific MC

FTSE Asia Pacific SC

FTSE Asia Pacific LC

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

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20

15

10

5

0 % -5

Information Technology Hardware Software & Computer Services

Real Estate

Speciality & Other Finance

Investment Companies

Insurance

Life Assurance

Banks

Electricity

Utilities – other

Telecommunication Services

Transport

Food & Drug Retailers

Support Services

Media & Entertainment

Leisure & Hotels

Tobacco

General Retailers

Pharmaceuticals & Biotechnology

Health

Capital

Personal Care & Household Products

Beverages

Food Products & Processors

Household Goods & Textiles

Electronic & Electrical Equipment Engineering & Machinery Automobiles & Parts

Aerospace & Defence Diversified Industrials

Steel & Other Metals

Forestry & Paper

Chemicals

Construction & Building Materials

-15

Mining

-10

Oil & Gas

MARKET REPORTS BY FTSE RESEARCH

FTSE Asia Pacific All Cap Indices Capital Returns YTD [US$]

Total Return

Stock Performance Best Performing FTSE Asia Pacific Index [LC/MC] Stocks [US$] Worst Performing FTSE Asia Pacific Index [LC/MC] Stocks [US$] Nishi-Nippon Bank 155.17% Natural Park Ltd -64.9% Aristocrat Leisure 136.23% ITV PCL -50.8% Chi Mei Optoelectronics 110.17% Shipping Corporation of India -50.2% Hynix Semiconductor 98.17% Quanta Storage -47.1% LG Corp 96.79% Asia aluminum Holdings -45.0%

Overall Market Return

FTSE Global All Cap FTSE Asia Pacific All-Cap Index FTSE Asia Pacific [LC/MC] FTSE Asia Pacific Large Cap FTSE Asia Pacific Mid Cap FTSE Asia Pacific Small Cap FTSE Developed Asia Pacific ex Japan Index [LC/MC] FTSE Developed Asia Pacific Index [LC/MC] FTSE All-Emerging Asia-Pacific FTSE Japan Index [LC/MC]

Data as at 31st May 2004

92

No. of Consts 7123 2839 1293 457 836 1546 299 734 559 435

Value

1M

3M

YTD

269.51 287.09 163.13 277.38 311.19 322.23 232.60 161.03 173.25 108.37

0.54% -3.22% -3.00% -2.90% -3.44% -5.13% 0.15% -2.56% -4.77% -3.60%

-2.75% -1.78% -2.10% -2.30% -1.30% 1.45% -7.47% 0.18% -10.43% 3.53%

1.08% 2.84% 2.34% 2.15% 3.08% 7.83% -0.81% 3.22% -1.03% 4.90%

Actual Div Yld 1.98% 1.68% 1.69% 1.73% 1.52% 1.58% 3.37% 1.62% 1.95% 0.93%

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

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FTSE Global Equity Index Series – Europe YTD 2004 FTSE Europe Regional Indices Performance 115

110

105

100

95 Dec03

Jan04

Feb04

Mar04

FTSE Eurotop 300 (EUR) FTSE Developed Europe AC (EUR)

FTSE Global AC (EUR) FTSE Developed Europe ex UK LC/MC (EUR)

Apr04

FTSE Eurofirst 100 (EUR) FTSE Eurobloc LC/MC (EUR)

May04

FTSE Eurofirst 80 (EUR)

FTSE Europe Regional Indices Capital Return YTD [EUR] 10

5

% 0

-5 FTSE Global AC

FTSE Europe AC

FTSE Europe LC

FTSE Europe MC

FTSE Europe SC

FTSE Developed Europe AC

FTSE All-Emerging Europe AC

FTSE FTSE FTSE Eurobloc Developed Eurotop 300 LC/MC Europe ex UK LC/MC

FTSE Eurofirst 80

FTSE Eurofirst 100

FTSE Europe Index Sector Return YTD [EUR] 20

15

10 % 5

Data as at 31st May 2004

Information Technology Hardware Software & Computer Services

Real Estate

Speciality & Other Finance

Investment Companies

Life Assurance

Banks

Insurance

Electricity

Utilities – other

Telecommunication Services

Transport

Food & Drug Retailers

Media & Entertainment

Support Services

Leisure & Hotels

Tobacco

General Retailers

Pharmaceuticals & Biotechnology

Health

Capital

Personal Care & Household Products

Beverages

Food Products & Processors

Household Goods & Textiles

Electronic & Electrical Equipment Engineering & Machinery Automobiles & Parts

Aerospace & Defence Diversified Industrials

Steel & Other Metals

Forestry & Paper

Chemicals

Construction & Building Materials

Mining

-5

Oil & Gas

0

Total Return

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

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Stock Performance Best Performing FTSE Europe Index Stocks [€] Reuters Group 64.0% Ericsson B 60.7% Nobel Biocare Holding 51.2% Verbund Oesterreich Elektrizitats 46.8% EMI Group 45.9%

Worst Performing FTSE Europe Index Stocks [€] Seat-Pagine Gialle Ryanair Holdings LogicaCMG Adecco Bayerische Hypo-Und Vereinsbank

-56.7% -34.1% -22.8% -22.6% -21.4%

Overall Market Return No. of Consts 7123 1515 201 331 983 1435 80 686 946 311 81 100

FTSE Global All Cap FTSE Europe All Cap FTSE Europe Large Cap FTSE Europe Mid Cap FTSE Europe Small Cap FTSE Developed Europe All Cap FTSE All-Emerging Europe All Cap FTSE Eurobloc All Cap FTSE Developed Europe ex UK All Cap FTSE Eurotop 300 FTSEurofirst 80 FTSEurofirst 100

Value

1M

3M

YTD

269.51 259.78 296.47 302.31 302.62 259.17 313.48 263.54 265.51 986.44 3435.37 3326.31

0.54% -0.90% -0.77% -0.61% -1.68% -0.83% -5.82% -1.44% -1.27% -0.70% -1.16% -0.59%

-2.75% -2.23% -2.30% -1.52% -2.43% -2.18% -5.69% -3.58% -2.75% -2.14% -4.29% -2.81%

1.08% 3.81% 2.31% 7.18% 9.02% 3.76% 7.37% 1.63% 2.78% 2.98% -0.14% 1.23%

Actual Div Yld 1.98% 2.77% 2.85% 2.63% 2.42% 2.77% 2.67% 2.70% 2.52% 2.82% 2.78% 3.02%

FTSE UK Index Series – YTD 2004 Overall Market Performance

125

120

115

110

105

100

95 Dec03

Jan04 FTSE 100 FTSE All-Share

Data as at 31st May 2004

94

Feb04 FTSE 250 FTSE Fledgling

Mar04 FTSE 350 FTSE AIM

Apr04

May04

FTSE SmallCap FTSE techMARK 100

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

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FTSE All-Share Index Sector Capital Returns YTD [GBP] 20

10

%

0

Capital

Software & Computer Services

Information Technology Hardware

Real Estate

Speciality & Other Finance

Investment Companies

Life Assurance

Banks

Insurance

Electricity

Utilities – other

Telecommunication Services

Transport

Food & Drug Retailers

Support Services

Media & Entertainment

Leisure & Hotels

General Retailers

Tobacco

Pharmaceuticals & Biotechnology

Health

Personal Care & Household Products

Beverages

Food Products & Processors

Automobiles & Parts

Household Goods & Textiles

Engineering & Machinery

Electronic & Electrical Equipment

Aerospace & Defence

Steel & Other Metals

Forestry & Paper

Chemicals

Construction & Building Materials

Mining

Oil & Gas

-10

Total Return

Stock Performance Best Performing FTSE All-Share Index Stocks [GBP] Cairn Energy Plc 163.1% Bell Group 82.5% London Bridge Software 79.2% London Clubs International 67.3% Alvis 63.7%

Worst Performing FTSE All-Share Index Stocks [GBP] Jarvis -60.2% Antisoma -57.1% Molins -54.5% Bookham Technology -51.2% Ultraframe -51.1%

Overall Market Return

FTSE FTSE FTSE FTSE FTSE FTSE FTSE FTSE

100 250 350 SmallCap All-Share Fledgling AIM techMARK 100

No. of Consts 100 250 350 342 692 424 748 100

Value

1M

3M

YTD

4430.69 6053.55 2241.60 2508.36 2201.81 2732.59 860.72 1143.71

-1.3% -2.5% -1.5% -4.5% -1.6% -5.3% -3.3% -2.3%

-1.4% -3.5% -1.7% -7.0% -1.9% -6.7% -7.4% -3.6%

-1.0% 4.3% -0.3% 1.3% -0.3% 4.1% 3.0% 12.7%

Actual Div Yld 3.29% 2.73% 3.21% 2.39% 3.18% 2.66% 0.74% 1.31%

Net Cover 1.84 1.97 1.86 1.03 1.84 -2.75 -2.20 -

P/E Ratio 16.52 18.52 16.77 40.63 17.10 -13.68 -61.22 -

FTSE Market Reports are researched and produced on a monthly basis by FTSE Research. For more information about market analysis based on FTSE indices, please contact Gareth Parker, Head of Global Research, FTSE Group at gareth.parker@ftse.com Data as at 31st May 2004

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

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CALENDAR

Index Reviews July-October 2004 Date

Index Series

Review Type

Effective [Close of business]

Data Cut-off

Early Jul Mid Jul 8-Jul 18-Jul 26-Jul 30-Jul Jul/Aug End Jul/Aug Early Aug 17-Aug 18-Aug Early Sep Early Sep 1-Sep 1-Sep 7-Sep 8-Sep 8-Sep 8-Sep 9-Sep 9-Sep 9-Sep 9-Sep 9-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 13-Sep 13-Sep 13-Sep 13-Sep 13-Sep 13-Sep 13-Sep 13-Sep 13-Sep 13-Sep 15-Sep 15-Sep 15-Sep Mid Sep 15-Sep Early Oct 6-Oct 6-Oct 7-Oct 17-Oct 25-Oct End Oct Oct/Nov Oct/Nov

S&P/TSX Composite Hex 25 Taiwan 50 AEX Hex 25 Topix CAC 40 Hang Seng DAX 30 STOXX MSCI MIB 30 ATX STOXX BLUE CHIPS SMI FTSE Goldmines Index Series FTSE/JSE Africa Index Series FTSE UK Index Series FTSE All Share FTSE Eurotop 300 FTSE Euromid FTSE Global Equity Index Series FTSE/Hang Seng Asian Sectors FTSEurofirst FTSE/Hang Seng Asiatop NZSX FTSE Multinational FTSE/JSE Africa Index Series FTSE4Good Index Series FTSE Global Islamic FTSE European Sectors FTSE Global Style Index Series FTSE exUK 100 FTSE Global Sectors FTSE Global 100 S&P/ASX 200 NASDAQ 100 FTSE techMark 100 FTSE eTX FTSE TMT STOXX S&P 500 S&P / TSX 60 Nikkei 225 S&P MidCap 400 S&P / TSX Composite FTSE/Xinhua Index Series FTSE NOREX Taiwan 50 AEX Hex 25 FTSE/ASE 20 Index Hang Seng CAC 40

Quarterly review Semi-annual review Quarterly review Quarterly review stock classification Quarterly review of the number of shares Annual review Quarterly review Semi annual review Annual review Quarterly review [components] Quarterly review Semi-annual review Semi-annual review / number of shares Annual review Annual review/Semi annual rebalance Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Annual review Developed Europe & Japan Semi-annual review Annual review Semi-annual review Quarterly review Annual review Quarterly review Semi annual review Semi annual review Semi annual review Semi annual review Quarterly review Semi annual review Quarterly review Quarterly review Quarterly share adjustment Quarterly review Quarterly review Annual review Quarterly share adjustment Quarterly share adjustment Quarterly share adjustment Annual review Quarterly share adjustment Quarterly review Quarterly review Semi annual review Quarterly review Quarterly review stock classification Quarterly review of number of shares Semi-annual review Semi annual review Quarterly review

16-Jul 30-Jul 16-Jul 2-Aug 30-Jul 10-Sep Aug/Sep 17-Sep 17-Sep 17-Sep 31-Aug 20-Sep 30-Sep 17-Sep 30-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 30-Sep 17-Sep 17-Dec 17-Sep 17-Sep 17-Sep 17-Dec 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 30-Sep 17-Sep 15-Oct 22-Oct 15-Oct 15-Oct 1-Nov 29-Oct 30-Nov 30-Nov Nov/Dec

28-Jun 30-Jun 30-Jun

30-Jul 30-Jul 31-Aug 31-Aug 31-Aug 30-Jul 24-Aug 3-Sep 7-Sep 7-Sep 3-Sep 3-Sep 30-Jun 31-Aug 31-Aug 31-Aug 30-Jun 3-Dec 31-Aug 1-Sep 31-Aug 30-Nov 3-Sep 31-Aug 31-Aug

31-Aug 3-Sep 7-Sep 15-Sep

15-Sep 24-Sep 30-Sep 30-Sep

30-Sep

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

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To find out more about how you and your company can help UNICEF when an emergency occurs, please go to: www.unicef.org.uk/emergencyrelief if you are in the UK or www.supportunicef.org if you´re outside of the UK. Thank you for your support

AP/Wide World Photos

The earthquake that hit Iran in December 2003 left more than 40,000 dead and injured tens of thousands more.

Images like the one you see right are now unfortunately a regular feature not only in Iran but in many countries affected each year by humanitarian disaster.

With a presence in over 190 countries, UNICEF (The United Nations Childrens Fund) is uniquely positioned to react quickly to these emergency situations by providing clean water and sanitation, healthcare, nutritional and emergency education supplies. As we receive no funding from the UN, we desperately need the help of individuals and companies to support this work.

FTSE already support UNICEF (nearly ÂŁ1,000,000 donated through FTSE4Good so far) and in doing so help us to alleviate the distress and hardship caused to children who find themselves suffering in the aftermath of emergencies such as the recent earthquake in Iran.

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Authorised by Commission Bancaire in France and by the Financial Services Authority; regulated by the Financial Services Authority for the conduct of UK business.

FCB

MARKET REPORTS.QXD

Expanding was the least we could do to help you reach the top The merger between CrĂŠdit Agricole Indosuez and CrĂŠdit Lyonnais's Corporate and Investment banking unit has created a new big name: CALYON. The complementary nature of these two institutions makes CALYON one of the leading European banks. CALYON enjoys a global coverage (60 countries), a full range of products and services, and a top rating (AA- Standard and Poor's, Aa2 Moody's, AA FitchRatings). All of these benefits are yours too, because your company lies at the heart of our business model.

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