FTSE Global Markets

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MANAGING RISK IN SECURITIES LENDING I S S U E 2 5 • M AY 2 0 0 8

Refining the appeal of active ETFs How to invest in Medvedev’s Russia Can quant strategies still outperform?

HOW TO WIN IN THE SUB PRIME AFTERMATH ROUNDTABLE: THE FUTURE OF ALGORITHMIC TRADING

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The Energy, Commodities and Transportation (ECT) Sector is one of the growth engines for Fortis globally, making DIFC a natural choice for our regional hub. The international regulatory environment, coupled with a ‘can do’ attitude makes DIFC a dynamic and sustainable environment for Fortis and its business Silvan Doorenspleet GENERAL MANAGER Fortis Bank, Middle East Branch

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Wealth Management

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Andrew Cavenagh, John Rumsey, Simon Watkins Lynn Strongin Dodds, Ian Williams, Mark Faithfull, Vanja Sliva.

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F T S E G L O B A L M A R K E T S • M AY 2 0 0 8

onfidence is critical to the efficient working of the global markets. If that disappears, whether it is with counterparties, investment banks, investors or depositors, the consequences can be severe. Our cover story this month focuses on the two immediate casualties of the meltdown in the sub-prime credit markets.The unfortunates were the UK’s Northern Rock, a mid-sized specialty mortgage lender based in the North East corner of England, and Bear Stearns, one of the stars in the US investment banking firmament. The treatment of the two institutions in their hour of need could not have been more different. Lynn Strongin Dodds and Ian Williams variously compare and contrast the experiences of the US and UK banking sectors and the decision making processes of the regulators in both markets. The main difference is that the US monetary authorities acted swiftly and purposefully, while the UK government has, correctly, been accused of procrastinating for so long over the issue that it was lucky that the struggles of a pint sized mortgage specialist did not result in the downfall of some of the UK’s leading high street banks. As Jeremy Tigue, head of global equities at F&C Investments, noted,“It took the UK government about six months to find a solution for Northern Rock, which was far too long… the Fed learnt lessons from this and it acted quickly before the situation at Bear Stearns deteriorated even further.”

Taken in the context of the sub prime experience, the banking sectors on both sides of the Atlantic must count themselves lucky if there is not a spate of new regulations in the pipeline attempting to address some or if not, most of the excesses of the last few years. Whether that regulation covers extremities such as convenant-lite leveraged deals and cubed collateralised debt obligations; or, whether it establishes some effective rules around issues such as debt ratings methodology and/or credit exposure limits, the likelihood is that in the medium term few so-far freewheeling banks will remain completely untouched by a regulator’s hand. One can only hope that regulators will apply a light and highly focused touch. It would be a shame, and likely counterproductive, to lose the best of the post-post-Reagan free markets.

On a happier note, we are introducing two new areas of regular coverage.

The first is commodities. Vanja Sliva, our new contributing commodities correspondent looks at steel, as the London Metals Exchange’s (LME) soft launches steel futures. Steel has traditionally been a very difficult market to penetrate for investors outside the immediate supply chain. It is too early to tell whether the LME will succeed in introducing a new slew of investors into the sector. The history of new product launches in the highly specialised metals sector appears to work on a ultra-low burn basis. Ever keen, we will do our bit to open up the world to our readership. A note to the interested: copper is highlighted in the next edition.

Regular readers will be aware of the special emphasis given to electronic trading in this edition. That’s because we are keen to develop coverage of this segment over the coming months. As trading becomes easier across markets and across asset classes a better understanding of the processes by which those assets held in portfolios actually get there, efficiently, quickly and at the lowest possible cost is an imperative. In a rapidly changing financial marketplace, a keen understanding of the nuts and bolts of investing is as important as overarching investment strategy and country/sector risk. In coming editions we will look more closely at the changing trading landscape, highlighting the major players, newcomers, winners and losers in an exciting and definitely 21st century business. We hope you will enjoy the results.

C

Francesca Carnevale, Editorial Director May 2008

1

Contents COVER STORY ..............................................Page 70 The two most immediate casualties of the meltdown in the sub-prime credit markets were the UK’s Northern Rock, a mid-sized specialty mortgage lender and Bear Stearns, one of the stars in the US investment banking firmament. The treatment of the two institutions in their hour of need could not have been more different. Lynn Strongin Dodds compares and contrasts their experiences and draws some lessons for the future, should it happen again. It won’t, will it?

COVER STORY: DIFFERENT STROKES

DEPARTMENTS MARKET LEADER

........Page 6 The tough markets have highlighted operational flaws: Neil O’Hara reports

TIME TO UPGRADE OTC DERIVATIVES RISK MANAGEMENT?

LIQUID STEEL ........................................................................................................Page 11 Vanja Sliva looks at the prospects of the LME’s new steel futures contract

IN THE MARKETS

WHY ISLAMIC FUNDS MIGHT OUTRUN ETHICAL FUNDS ....Page 18 The DIFC’s Simon Grey looks at the key characteristics of Islamic investments

ARE QUANT FUNDS MAKING A COMEBACK? ............................Page 24 OMAM’s Dermott Keegan tells you why you should look again at quant funds

..................................Page 26 Simon Denham, managing director, Capital Spreads, takes a pessimistic view of the EU

WILL THE ECB BE THE DEATH OF THE EU?

INDEX REVIEW

WHY GREATER CHINA IS WORTH A CLOSER LOOK ..............Page 27

Simon Coxeter argues the case for Greater China investments

......................................................................................Page 30 John Rumsey takes a new look at Brazil’s ethanol stocks

SMELLING SWEETER

COUNTRY REPORTS

..................................Page 33 Simon Watson weighs the risks of investing in Medvedev’s Russia

INVESTING IN RUSSIA AFTER MEDVEDEV

..................................................................................................Page 36 Julia Grindell asks why Greek banks look for growth overseas

NOW VOYAGER

NON MORTGAGE ABS: DEAD OR ALIVE?....................................Page 76

DEBT REPORT

ETFS DATA PAGES 2

It’s life, but not as we know it, argues Neil O’Hara

................................................Page 80 Neil O’Hara explains, in detail, how the credit crunch began...

21ST CENTURY MORTGAGE FRAUD

....................................................Page 88 Neil O’Hara sorts the wheat from the active ETF chaff

THE PROBLEM WITH ACTIVE ETFS

ETF data by Morgan Stanley ........................................................................................Page 92 Securities Lending Trends by Data Explorer ............................................................Page 95 Market Reports by FTSE Research ..............................................................................Page 96 Index Calendar ............................................................................................................Page 104

M AY 2 0 0 8 • F T S E G L O B A L M A R K E T S

Take a view on China.

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Contents FEATURES SECURITIES SERVICES

MANAGING RISK IN SECURITIES LENDING ................................Page 40 As the fallout from the credit crunch continues to play out over markets across the world, the European securities lending industry seems to be weathering the storm.

Volumes are strong and the market turbulence has created opportunities for higher returns, provided the right investment strategy is employed. However, the prolonged uncertainty is also unnerving which is why risk and the measurement of risk-adjusted returns are in sharper focus. By Lynn Strongin Dodds

THE ELECTRONIC TRADING REPORT

DMA: THE BUY SIDE GETS WIRED ....................................................Page 48 By connecting directly to the market’s expanding slate of liquidity pools, buy-side firms using direct market access (DMA) can execute trades with greater speed and efficiency while reducing volatility—and, thanks to increased competition, at significantly lower costs. Dave Simons

MIFID: THE BIG ONE ......................................................................................Page 52 Chris Pickles, head of marketing, Investment Banking & Global Accounts, BT Global Financial Services, and chair of the MiFID Joint Working Group, about the impact of MiFid four months after implementation

ROUNDTABLE: THE FUTURE OF ALGORITHMIC TRADING....Page 55

According to Tim Wildenberg, managing director, head of direct execution services, Europe, UBS: “In the algorithmic and DMA space it is a challenge making an offering available in multiple vendors that can be applied to multiple client desktops. Doing that globally adds another level of complexity. It comes back to high fixed costs and how many players will enter the game.” But the global game is fast become the preserve of only a few, bulge bracket houses.

THE DUAL WORLD OF GLOBAL PORTFOLIO TRADING ..........Page 65 Whether for plain vanilla, investment fund beta traders, or for higher end, high touch alpha traders, the blunt facts are inescapable: the need to trade seamlessly and everrapidly in multiple venues, geographies and asset classes means a continued dialogue with the sell side. Where will this burden carry the bulge bracket investment banks going forward? Francesca Carnevale goes in search of some answers

THE IMPORTANCE OF LATENCY ..............................................................Page 69

Brian Sentance, CEO of Xenomorph outlines the importance of latency in a complex and fragmented trading landscape

COMPANY PROFILE

......................................................Page 84 As a profitable niche business in the Ohio Rustbelt, with an ironic speciality in rustproofing, it could have been swallowed up like the fictional New England Wire & Cable Company in the noted play Other People’s Money—you know, the one which epitomised the “greed is good” era of the 1990s. RPM’s sometimes unprepossessing moniker has little or no brand equity except for the investors who have done rather well out of RPM over the decades. From a $50,000 start up, it is now global company, with $3.3bn in sales worldwide, including $600m in Europe and footholds in India and Latin America. Ian Williams reports

THE LITTLE COMPANY THAT DID

4

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Market Leader RISK MANAGEMENT IN OTC DERIVATIVES

TIME TO UPGRADE RISK MANAGEMENT The freewheeling over the counter (OTC) derivatives market grew up in a benign environment of low interest rates and declining volatility, fuelled by a global glut of liquidity. That all vanished in a heartbeat last summer. The ensuing credit crunch has inflicted immense losses on the major banks and securities houses, crippled numerous hedge funds and forced Bear Stearns into a shotgun merger with JPMorgan Chase. However, while bad bets in OTC derivatives contributed to the carnage, the trading infrastructure proved more robust than naysayers had feared. Nevertheless, the tough markets highlighted operational flaws at some institutions that prompted another look at risk management procedures. Neil O’Hara reports.

FTER REGULATORS SOUNDED the alarm in mid2005, market participants made a concerted effort to curtail a thengrowing backlog of unconfirmed trades that threatened to overwhelm the credit default swaps market. It is a tribute to the industry’s success that processing delays were the great non-event of 2007.

Although the number of trades unconfirmed after 30 days ticked up amid frenetic trading during the third quarter the backlog never approached the level seen two years earlier when both notional value outstanding and trading volume were less than half as large. By the end of the year, the industry cut unconfirmed trades back to almost where they were before the summer surge (Please refer to the chart on page 8).

A

6

It didn’t happen without additional investment in straight through processing, however. Although the major dealers and active buy side players had long since embraced electronic platforms, participants who had just a few trades outstanding saw little reason to abandon paper confirmations. The failure of hedge funds such as Sowood Capital and two others run by Bear Stearns combined with mounting losses at the big dealers prompted the entire market to reexamine ways to curb counterparty risk.

Claire Lobo, head of North America account management at SwapsWire, an electronic trading network that handles interest rate swaps, equity derivatives and credit derivatives, says many smaller banks the company had

courted for years rushed helter-skelter to sign up last autumn. SwapsWire has snagged new buy side customers in the last nine months, too, albeit at a more measured pace.“The banks had a sense of urgency about becoming part of the SwapsWire family,”Lobo says,“The buy side is growing but it hasn’t come in clumps like that.” In some cases, her new clients have attributed their sudden interest specifically to risk management concerns. SwapsWire provides a same day confirmation service that creates a legally binding contract in close to real time. Users can reconcile their books against SwapsWire’s master trading record, so disputes over trade populations seldom if ever arise. The system also handles tripartite novations and trades arranged by interdealer brokers such as ICAP on a same day basis.“Clients will experience very low if not zero settlement issues,”says Lobo.

Depository Trust and Clearing Corporation (DTCC) has experienced rapid growth in demand for its DerivSERV matching and confirmation service for OTC derivatives, too. Judith Inosanto, a spokesperson for DTCC, says DerivSERV now has more than 1,100 customers, up from 1,000 last October and just 50 at the beginning of 2005. Transaction volume soared from 2.6m trades in 2006 to 5.8m in 2007.

Originally created to handle credit default swaps, DerivSERV now processes equity derivatives and interest rate swaps as well.

Market participants have flocked to the DTCC’s Trade Warehouse for credit default swaps, which now contains trade details for about three million contracts. Inosanto says the buy side has made good progress in entering legacy trades, a process called back-loading the dealers have already completed. “It is a global repository that enables people to track contracts over their entire life cycle, including

M AY 2 0 0 8 • F T S E G L O B A L M A R K E T S

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Market Leader RISK MANAGEMENT IN OTC DERIVATIVES

novations,” Inosanto says. In Gooch,“But after the Société Générale funds and traditional fund managers December 2007, DTCC added a experience people are very concerned often did not bother to demand centralised settlement service for OTC about spurious trades on the books.” collateral from bank counterparties credit derivatives in which the Trade Rogue Société Générale trader Jerome even if they were entitled to it because banks were considered Information Warehouse performs Kerviel entered thousands of bogus the credits.

Today, automated payment calculations and trades that caused the French bank to unimpeachable everybody is taking as much collateral netting, and then feeds the incur a €4.9bn loss in January.

A sharp uptick in market volatility as they can get. Traditional fund information to its partner, CLS Bank has given risk managers all the more managers now view collateral as a International, for settlement.

Streamlined trade processing does reason to focus on operations and way to protect themselves against the not eliminate operational risk entirely counterparty exposure. Gooch points banks instead of the other way round. under normal market conditions, let out that investment grade bond “The focus used to be in one direction alone in times of stress. Jeffrey Gooch, indices that used to trade within a 5- but now it’s in both directions,”Gooch executive vice president, valuations point range have dropped more than says, “Both banks and funds are keen and trade processing at derivatives 20 points. “With the markets gyrating to protect themselves.”

Markit has seen an enormous data provider Markit, says last year’s all over the place an out trade is much volume surge revealed that systems more expensive,”he says,“People can’t uptick in demand for its independent put in place to handle higher volumes afford to have disputed trades sitting valuation service for OTC derivatives over the past four months, too. It’s one were not as scalable as expected. out there for long periods.”

Collateral management practices more indication that funds and fund Market participants had to divert resources to bring processing times have tightened up, too. Almost all administrators no longer have back to the industry’s informal OTC derivatives contracts require absolute faith in bank counterparties. target—all trades confirmed no later collateral support, but by convention In the past, funds accepted the marks than T+5. Gooch expects the industry banks do not put up initial margin on banks gave them without question, to move toward T+2 although he a trade if the counterparty is another but now they want a second opinion. recognises that different solutions will bank. Before the credit crisis, hedge “The fund industry feels almost a fiduciary responsibility to be required to get there. verify prices through Even if new trade records Credit Derivatives: Outstanding Confirmations independent valuation contain no errors at all, past sources,”says Gooch. discrepancies leave a legacy 90 Market participants’ that can still lead to valuation 10000 Average Total Outstanding Confirmations current focus on risk disputes. Gooch says that Average Outstanding Confirmations aged over 30 days 8000 management is nothing while trade population 6000 more than a return to basic differences have become less principles, some of which fell common they remain a 4000 by the wayside during the significant problem. An ISDA 2000 go-go years. An institution protocol introduced two years 0 that knows it has the right ago has helped by putting a Sep 05 Dec 05 Mar 06 Jun 06 Sep 06 Dec 06 Mar 07 Jun 07 Sep 07 Dec 07 trades on its books, what the stop to novations in which positions are worth, who the one counterparty stepped out Source: Markitt Quarterly Report December 2007 other side is and has of a transaction but did not confidence that the inform the other side of the © Markitt; reproduced with the kind permission of Markitt. counterparty is good for the trade, despite a documented Jeffrey Gooch, executive vice president, valuations and trade money has eradicated almost obligation to do so. The major processing at derivatives data provider Markit, says last year's all the risk from operations. It banks now try to reconcile volume surge revealed that systems put in place to handle higher still has market risk, of positions among themselves volumes were not as scalable as expected. Market participants had course. “It may have lousy on a regular basis, but bank to to divert resources to bring processing times back to the industry's trading positions,” Gooch customer reconciliations are informal target—all trades confirmed no later than T+5. Gooch says, “But at least it knows still in their infancy.“Coverage expects the industry to move toward T+2 although he recognises where it stands today.” is still relatively low,” says that different solutions will be required to get there.

8

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Market Leader RISK MANAGEMENT IN OTC DERIVATIVES

HEDGING MARKET PRICE DISTORTIONS While the ascendancy of risk managers has imposed renewed discipline on traders, the dictates have in some cases contributed to distortions in market prices, according to Alberto Gallo, head of credit derivatives strategy in the London office of Bear Stearns. For example, most dealers have exposure to monoline insurance companies, which guaranteed some of the structured deals they originated. To offset the monoline risk, Gallo says traders hedge with senior and super senior tranches of credit default swaps indices, betting that if the monolines fail spreads will widen at the top of the capital structure. The hedge may protect against short term marks to market, but longer term the trade does not make economic sense. The default rate needed to impair the super senior tranches is so high— 22% for the European iTraxx index, 30% for the US CDX—that if it ever occurred the other side is not likely to be good for the money.

“In the extreme tail risk of probabilities you will never monetise your hedge because your counterparties will not be there,” says Gallo, “It is a hedge for an unhedgeable scenario. If defaults exceed 30% you have other things to worry about.” Relentless buying pressure from dealers and hedge funds has turned the credit default swaps market on its head. A year ago, the equity tranches accounted for 60%-70% of the total spread on the index and the super senior tranche was a few basis points. Now, Gallo says, the senior and super senior trades at 40% of the spread and the equity has shrivelled to between 30% and 40% of the total. In effect, the spread prices imply a flight away from quality, the exact opposite of what normally happens in a credit crunch.

In late February, the AAA-rated 12-22 tranche of the iTraxx index, which will only suffer losses if default losses exceed 12%, traded at the same spread as the index as a whole, which includes all the junior tranches subject to prior loss. For real money investors—conventional fund managers—the 12-22 tranche offered far better value, but nobody stepped in. When they do, the prices will move back into line and the dealers’ hedges could take a hit.

Anomalies driven by risk management abound throughout the market, according to Gallo. In Europe, the investment grade iTraxx financial sector index is trading at almost the same spread as the corporate index, whereas historically the financials trade at half the corporate spread. As Gallo points out, “Banks

10

Alberto Gallo, head of credit derivatives strategy in the London office of Bear Stearns. Photograph kindly supplied by Bear Stearns, March 2008.

trading at the same spread as the corporates they lend money to is not a long term equilibrium.”

Index equity tranche spreads have fallen to unprecedented lows, too, because fast money investors are seeking convexity—in other words, tranches that are sensitive to changes in credit spreads. A dealer who takes the other side is short convexity and will typically sell equity tranches, which are relatively insensitive to spread movements, as a hedge. Theoretically, a short equity index tranche creates positive convexity, but it also carries the highest risk of default. If an index component goes sour or defaults, the equity spread will widen and the hedge will be under water.

Technical pressures have flattened the spread curve in investment grade credit default swaps, too. Risk managers insist that traders hedge their exposure, but the cheapest way to do so is at the short end of the market. “There is a huge buy in short dated maturities,” Gallo says, “You get the same spread in three-year as five-year credit default swaps.”

In every instance Gallo cites, a risk management mandate has pushed prices to the point where the unintended consequence is an extraordinary opportunity for investors to get a free lunch at the dealer's expense.

The real money is sitting on the sidelines for now, but when market tensions ease the dealing community could take another hit. “The market is in very crowded trades and not all of them are completely justified,” Gallo says, “There is no long term rationality here.”

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In the Markets STEEL: THE OUTLOOK FOR THE LME’S NEW STEEL FUTURES

As an investment steel is extremely interesting at this stage. The futures launch comes at a time when steel prices are high on the back of strong demand and an increase in the price of raw materials—iron ore and hard coking coal—and look set to stay that way.

For comparison, both UK and international equities posted overall growth of just over 5% in 2007—their lowest in five years. In contrast, commodities grew by almost 21% over the 12 months, making them by far the best performing asset class in 2007.

Photograph © Randall Milukas/Dreamstime, supplied March 2008.

Liquid steel?

For what it was, it started with surprisingly little fanfare. The London Metal Exchange (LME) launched its new steel futures contract at the end of February, the first steel futures in the Western world and the LME’s first foray into the world’s second largest commodity. The soft launch of the contract reflects the fact that until now paper investors have had a hard time entering and leveraging the $440bn steel market. Nonetheless, the LME does not underestimate that it will not be easy to create liquidity in contract. Vanja Sliva explains why.

N A TRADING environment in which it would be hard to find another asset class that has performed better than commodities, the timing of LME’s soft launch of its new steel futures was impeccable. In terms of the asset value, the global steel industry is smaller only than oil. Its value is estimated to be around $440bn, compared with about $130bn for base and precious metals. Its annual turnover is a massive $200bn to $300bn, according to Steel Business Briefing, a specialist website. Moreover, until the launch of the LME’s new steel futures contract paper investors had no entry point into the massive steel market, in which a whole host of different products such as rebar, hot-rolled coil or billets, are mostly traded directly between producers and consumers.

Historically, investing in the sector

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has been made difficult by the fact that the industry is vast, fragmented and difficult to understand. It comprises everything from iron ore mining on the one end, via various steel products, steel in construction, white goods, car, to steel scrap at the other end. No wonder then, that the LME was hoping to tap pent up demand: nonetheless, understanding the market in depth the exchange also knew it had a task ahead to create liquidity.

Steel futures trading started over the phone and on the LME’s electronic platform LME Select and is, in fact, a warm up act ahead of the launch of “proper” trading: that is, open outcry on the LME floor alongside other metals such as copper and aluminium, which will kick off on the 28th April this year. The first week of trading was,

not unexpectedly, fairly low key. Some 108 lots (each lot is 65 tonnes) traded, and the total value of exchanged contracts reached approximately $5.5m, according to the LME’s David Wiggin. By comparison, the LME’s aluminium futures, currently the most active of the seven metals traded at the exchange, traded 40m lots in 2007. A very rough calculation, assuming a 50 week trading year, makes it around 800,000 lots a week. “At the moment, the volume is nothing less than what I expected,” says David Rawlings, general manager of the steel division of LN Metals, a London-based metals trading firm. Rawlings says that LN has not yet traded steel futures, however it is planning to take advantage of the opportunities the contract creates “sooner rather than later.”

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In the Markets STEEL: THE OUTLOOK FOR THE LME’S NEW STEEL FUTURES

Given the fact that most other commodities are hitting record high levels [oil, gold and wheat being typical examples] and that the global credit crisis is showing signs of intensifying, rather than abating, this new financial instrument should be of great interest to investors. Yet what it doesn’t have at this stage is liquidity.

Liz Milan, LME’s steel project director, explains that the purpose of the “soft launch”, as the exchange describes it, is to generate a build-up of liquidity in advance of the full launch in April.

That required liquidity can come from one of two sources: the investment community or producers wanting to hedge their production.

On the investment side, there are a number of obstacles to widespread adoption of steel futures. Many funds—specifically if they are domiciled in a European Union (EU) country, or are charity funds—cannot invest in commodities directly because of regulation. What they can do, however, is invest in a commodities index. However, none of the big commodity indices such as AIG-Dow Jones Commodity Index, Reuters Jefferies CRB Futures Price Index or the S&P Goldman Sachs Commodity Index currently include steel futures in their baskets. The new contract will have to wait two years before being included in Standard & Poor’s suite of commodity indices, according to Mike McGlone, director of commodity indexing at Standard & Poor’s. But that rule could be waved if liquidity becomes significant enough to warrant its inclusion, says McGlone. “There could be a special consideration, but that would be quite rare,” he adds.

There is an upside, however.“Once the big indices include steel you can expect large commodities funds to get involved and to see a significant pick up in liquidity,” thinks Robin Bhar, base metals strategist at UBS.

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The current LME product is particularly interesting to Turkish, Russian and Ukrainian steel mills because it is closest to what they produce. The exchange’s contract is for physically delivered steel billets; a semi-finished product that is used produce rebar, which, in turn is used in the construction industry to reinforce concrete – and covers delivery points in what the LME describes as the ‘Mediterranean’ region for the purposes of steel, including Turkey, Russia and former Soviet countries.

On the direct investment side, there are only a few brokerages involved at this stage (Standard Bank and Sempra Metals traded in the first week) although a number of LME member firms said that they will get involved in futures once trading on the floor begins, hedging their comments with a careful “if clients express an interest.”

For other metals the option of exchange traded commodities, or ETCs, has proved very popular with institutional investors. ETCs are exchange listed shares which track a commodity but buffer investors from trading futures or having to buy physical metal.

ETF Securities, the largest provider of exchange traded commodities, is not providing steel future ETCs right now. Nick Bienkowski, head of listings at ETF Securities explains why.“Steel

and iron ore are the two largest commodities after oil but the market is not liquid enough for us to create a product,” he notes. He doesn’t however exclude a listing in the future, saying that ETF is always looking at new products.

Then, there is the small point that some of the largest steel producers, such as Arcelor Mittal, India’s Tata Steel or China’s Baosteel have publicly rejected the idea of using steel futures. Some market watchers believe that if liquidity doesn’t come from big producers it is fairly likely that it will come from medium and smaller size producers who are more vulnerable to price swings and are more likely to want to hedge their production. “The guys further down the chain are simply more vulnerable to price swings and are likely to want to protect their production through hedging,” says a source at an LME brokerage. LN’s Rawlings adds that he expects that once there is a seasonal lull in the physical steel trade in August and September hedging will probably pick up. “There will be more liquidity generated by the mills as they hedge and we expect that Turkish producers will lead liquidity,”he adds.

The current LME product is particularly interesting to Turkish, Russian and Ukrainian steel mills because it is closest to what they produce. The exchange’s contract is for physically delivered steel billets; a semifinished product that is used produce rebar, which, in turn is used in the construction industry to reinforce concrete—and covers delivery points in what the LME describes as the ‘Mediterranean’region for the purposes of steel, including Turkey, Russia and former Soviet countries. Billet is a growing market and has experienced production growth of around 40% since 2000, with analysts suggesting a further 32% growth on today’s annual production of 512m tonnes by 2010.

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In the Markets STEEL: THE OUTLOOK FOR THE LME’S NEW STEEL FUTURES

The billet is actively traded by merchants, but is only a fragment of a vast steel market. But LN’s Rawlings notes that one of the attractions of the LME futures for producers is that they will be able to use it as a reference price for other products, such as reinforcing steel bars, which are one step downstream from billets. They could, for instance, price their steel bar at $40 per tonne on top of the LME price for billets. This is how futures work for other metals and oil—different prices of oil are priced at a premium or a discount to the International Petroleum Exchange (IPE) or NewYork Mercantile Exchange (NYMEX) price, depending on their quality. It tends to bring the widest variety of producers into the market using exchange-listed future prices. Also, the big producers’ reluctance towards futures will change once volumes of trade are large enough to make the price truly representative of demand. The same thing happened with the aluminium contract when it launched at the end of the 1970s. At the time, the chief executive of the world’s largest aluminium producer, Alcoa, was rumoured to have threatened to sack anybody who got involved in futures. Now aluminium is the LME’s biggest contract.

As an investment steel is extremely interesting at this stage. The futures launch comes at a time when steel prices are high on the back of strong demand and an increase in the price of raw materials—iron ore and hard coking coal—and look set to stay that way. For comparison, both UK and international equities posted overall growth of just over 5% in 2007—their lowest in five years. In contrast, commodities grew by almost 21% over the 12 months, making them by far the best performing asset class in 2007. Experts say their robust run will continue in 2008 primarily because of the rising demand from emerging

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What might help LME’s futures gather speed is the fact that its biggest rival, NYMEX, was also planning on launching steel futures. Nymex is currently keeping its cards close to its chest on the issue given that it is in the process of being taken over by Chicago’s CME, the world’s largest commodities exchange, but market participants and analysts believe that they are still likely to happen at some point this year.

economies. There is “genuine structural undersupply”in an industry where demand has grown faster than supply every year for the last six years, and“it has at last absorbed the excess capacity of 200m tonnes that blighted the industry from the early 1990s,” says a report by Credit Suisse.

“With global inventory low, there seems to be a buying acceleration taking place and steel prices have spiked by up to $200 a tonne for hot rolled coil so far in 2008 alone. We believe that price hikes so far are just the beginning,” says Credit Suisse.

The main engine behind a voracious global demand for steel has been China. Mark Mathias of Dawnay Day Quantum, a structured investment provider specialising in commodities, says,“Commodities are really very simple, demand equals the number of people times the

money they spend on it.”This means, that even if there is a recession in the United States, the fact that China is the world’s largest consumer of metals at present will keep overall demand high. Even if China’s gross domestic product (GDP) drops by 1.5% this year compared with 2007 it will still be between 9.5% and 10%, thinks Mathias.

Looking at those periods when South Korea and Taiwan went through a similar expansion and GDP grew at a rapid rate, the consumption of copper per capita was directly correlated to the growth of GDP per capita, explains Mathias. This holds true for fuel and steel. He believes that China is currently at a very low point of its expansion and that its demand will rise sharply over the years. What might help LME’s futures gather speed is the fact that its biggest rival, NYMEX, was also planning on launching steel futures. NYMEX is currently keeping its cards close to its chest on the issue given that it is in the process of being taken over by the Chicago Mercantile Exchange (CME), but market participants and analysts believe that they are still likely to happen at some point this year. Also, the Dubai Gold & Commodities Exchange launched a similar contract late last year, although that contract has not yet gathered momentum.

Some analysts compare the new steel contract to LME’s aluminium futures and the IPE’s oil futures and argue that both of those took almost twenty years before gaining credibility among investors and producers. But that was twenty years ago, in a world in which internet and mobile phones were new and Facebook and instant messaging were a thing of the next century. Also, wiping $13bn of value of stocks in one afternoon seemed like science fiction.

The speed of life has picked up since then, and so may steel futures.

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In the Markets SOCIALLY RESPONSIBLE ISLAMIC INVESTING

Why Islamic funds might outpace ethical funds As Islamic funds gain traction in a market where conventional funds have taken something of a battering, and where the outlook for Islamic finance looks particularly strong, there is increasing focus on the benefits or otherwise of the sector. Is the future for Islamic finance and Islamic funds all plain sailing? How successful are Islamic funds in the context of ethical funds found in conventional socially responsible investing? What does the future hold for Islamic funds?

Moreover, what particular challenges will they face going forward?

What are the core differences and similarities between Shari’a funds and ethical funds? Are Islamic funds poised to outstrip conventional ethical funds at every turn? Simon Gray, director, supervision at the Dubai Financial Services Authority goes in search of answers.

S A NEW industry dating back only 30 years, Islamic finance has made significant inroads as an alternative to conventional ethical finance.

The breakthrough came in the development of Islamic equity investment during the 1980’s with the launch of the first Islamic investment fund.

This triggered a debate amongst Islamic Scholars regarding the Shari’a compliance of equity investments.

The Islamic Fiqh Academy ruled that shares in a company represent an undivided portion of the company’s assets and thus satisfy Shari’a compliance. This ruling opened up the equity sector to Muslims seeking a Shari’a solution for their investments.

Bonds however continue to be a problem for Islamic investment due to

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the existence of unearned income from coupons.

It is important to note that the Shari’a is not a codified system but rather a set of core principles which are open to interpretation.This interpretive approach leads to divergent opinions; much of the current and future success of Shari’a funds will be influenced by a more flexible approach towards investment. Nonetheless, the starting point is to accept that many of the basic precepts of conventional financial markets regulation apply with equal force to Islamic financial markets.

Of course, the main principles of Islamic finance are found in various prohibitions; which include the taking of interest, or riba, with Islamic banking being intolerant of the notion of a risk-

free reward for return. Given recent turmoil in financial markets, Islamic funds have the advantage as they do not suffer the same exposures from the sub prime fall out. The other haram, or banned principles cover uncertainty of contract (gharar), gambling (quimar) and games involving speculation (maysir), as well as unethical investments and unfairness or unjust gain at the expense of the other party.

Of the prohibitions already mentioned, the issue of certainty is paramount which feeds neatly into the concept of gambling and speculation. This is significant given the pace of product innovation and the often divergent views held amongst Islamic scholars.

Contracts entered for purely speculative purposes will be void. This ban does not exclude general commercial speculation where there is a risk of incurring losses as well as earning profits—the test is one of making a gain via chance rather than the use of productive effort. The prohibition on speculation can lead to complications where firms are using financial derivatives, especially where there may be no physical delivery. This restriction could cause difficulties with the use of derivatives in conventional UCITs3 type funds, as lack of physical delivery is banned. However, there are certain Islamic products which have characteristics not dissimilar to conventional derivatives: for example, Salam, Istisna’a and Arbun. It is important to note that each of these

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In the Markets SOCIALLY RESPONSIBLE ISLAMIC INVESTING

products anticipate physical delivery.

Certain strategies used by hedge funds, such as the long/short strategy, will continue to exercise the minds of both alternative asset managers and Shari’a scholars for some time to come.

The ban on unethical investments is actually very similar to investment restrictions imposed on conventional financial products either at a fund level or indeed demanded at an investor level.

For example, Shari’a prohibits a number of activities including gambling, tobacco, armaments, alcohol and pornography.

However, Shari’a scholars have differing views. For example, some might argue that an airline or a hotel which happens to serve alcohol would still be acceptable as an investment using the approach of proportionality, and focusing on the real purpose of these entities. Others might instead argue in favour of a more purist interpretation. Similar concerns can be found in ethical fund management within conventional finance. Personally, I would not ban investment in a supermarket chain just because it might sell alcohol or tobacco.

The case for That the potential of the Islamic fund industry is large is not up for debate: there are some 1.6bn Muslims, representing 24% of the world’s population who might rightly be considered potential investors; added to that are those non-Muslims who might wish to make ethical investments.There are a number of similarities in terms of investment preferences existing between a Shari’a and an ethical fund.

To name but a few; the ban on alcohol, armaments, pornography, tobacco, gambling, environmentally destructive practices; which all lend themselves to investors in both types of funds. Even the restriction of income generated via unproductive effort, such as the coupon payment on a bond, is being rectified by the rapidly growing Sukuk market. It

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still requires some depth through a secondary market in many countries but is a step in the right direction The collective wealth of high-networth individuals and family businesses in the Gulf Cooperation Council (GCC) countries alone is estimated to be $1.3trn (according to Moody’s 2007 Review and 2008 Outlook). Much of this has been directed towards Shari’a compliant funds. There now exist over 300 Islamic equity funds split in almost equal measure between 120 in Asia and 125 in GCC, with approximately 75 being in the Kingdom of Saudi Arabia.

By the end of 2007, the industry approached $20bn in assets; three times what it was five years ago. Much of the growth is from GCC investors and focussed on fund raising in the GCC markets. Indeed, fund investing in these markets represent over half the entire Islamic equity industry. There are now 50 funds investing in the GCC, say Falaika Advisors. Meanwhile, the Islamic Financial Services Board’s (IFSB's) January 2008 report says worldwide assets of the Islamic finance industry including banking assets, funds under management and insurance, are between $700bn and $1trn. The potential for expansion is helped by the concentration of enormous existing wealth in the region and the continued rise in oil prices. This growth shows no signs of slowing.

The case against The Islamic fund industry continues to face a number of challenges, often relating to its own infrastructure. It is becoming a victim of its own success; for example a key impediment is the shortage of available Shari’a Scholars.

These Scholars confirm that an investment is acceptable (halal) rather than unacceptable (haram), and ensure it remains so during the time the investment is held. They therefore

play a key role both at the state of the initial investment and on an ongoing basis; which has cost implications.

Another concern is the time it takes to become a scholar, itself causing an impediment to growth.

Other challenges relate to the lack of standardisation regarding legal contracts, the inbuilt tax prejudice that can arise from the unintended consequence of conventional tax systems triggering additional tax events. Increasingly, governments are modifying legislation to redress this imbalance. Perhaps the most significant of these impediments is the degree of divergence of opinion that can exist amongst Scholars, often a result of culture and geographic area. This is problematic as what is acceptable to a fairly liberal Scholar may not be treated as such by a more conservative Scholar with a purist interpretation of Shari’a.

Key initiatives by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOFI), the Islamic Financial Services Board (IFSB) and the Dubai International Financial Centre’s (DIFC’s) Islamic Finance Advisory Council (IFAC) are helping to create a more level playing field.

The extent of enforceability of the Shari’a interpretation can limit the investment universe of funds, which could adversely affect performance. For example, taking a more proportionate approach might benefit a fund as the investment audience would be less constrained with the identifiable halal part being purified and distributed via zakat. A strictly purist interpretation could significantly limit investment scope with concomitant effect on performance. Of course the Shari’a ban on financial institutions due to the prohibition on riba (interest), has of late worked to the advantage of Islamic funds as they have been less exposed to the turbulence of the global credit crunch.

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In the Markets SOCIALLY RESPONSIBLE ISLAMIC INVESTING

Another challenge is the cost of initial and ongoing compliance with Shari’a restrictions, with capital gains tax being potentially triggered as a consequence of the need to divest should an investment cease being halal. There is the added danger of the cost exceeding the benefit, especially where analysis of ongoing compliance with Shari’a prohibitions becomes expensive where a non-proportionate approach is taken. This could make compliance with Shari’a restrictions excessively burdensome in terms of cost with the danger that investors will vote with their feet.

It is important for all investors to receive appropriate disclosure of this risk.

One argument for greater convergence between Shari’a and ethical funds lies in the method of policing breaches of investment restrictions. Shari’a could benefit from the experience of ethical funds, which could alleviate some of the pressure on Shari’a Supervisory Boards.

According to the Wall Street Journal, Shari’a funds were among the top fund performers for 2007.

This outperformance was largely due to Islam forbidding the charging of riba or interest, which allowed funds to avoid investing in banks and mortgage companies adversely affected by the sub prime credit crunch. Of course, it is worth remembering that these same funds may not have performed as well when times were good for the financial services equities.

It is premature to speculate that Islamic funds will outstrip conventional ethical funds at every turn. There is little doubt that there is competitive pressure, especially when a Shari’a fund takes a proportionate approach to investment restrictions. Nonetheless, ethical funds and Islamic funds are in fact readily reconcilable and indeed remarkably similar. Such are the opportunities that exist for the growth of Shari’a funds; not

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at the expense of conventional ethical funds, but with both complementing one another. An unlikely but mutually beneficial partnership where the twain can and will meet.

The opinions and views expressed in Simon Gray’s article are his own and may not necessarily be those expressed and considered by the Dubai Financial Services Authority (DFSA).

LESSER KNOWN ISLAMIC FINANCE TERMS MURABAHA A contract whereby a financial institution buys goods for a customer from a third party and then resells the goods to the customer at a pre-agreed price on deferred payment terms.

MUDHARABA A contract in which one party provides capital and the other expertise to initiate investment in a project. The contract is between investors (Rab Al Mal) and the managing trustee (Mudharib). Any accrued profits are shared between the two parties on an agreed basis. The capital Originally invested will be returned to the Rab Al Mal at the end of the agreement. Capital loss is borne by the Rab Al Mal and the Mudharib will lose reward for his efforts, but not share in capital loss unless it is proven that the Mudharib’s negligence resulted in the capital loss.

BIA SALAM A sale of goods of defined specifications whose delivery will be at a future date for a cash price paid in advance. The seller of the goods has to abide by the delivery of the goods of determined specification on a definite due date.

MUSHARAKAH A joint venture agreement in which two parties commit funds and share profits/losses in direct proportion to their contributions.

IJARA WA IKTINA A leasing contract whereby a financial institution purchases an asset upon the request of a customer who pays for the asset with periodic lease payments. The period of the lease and the amount of each instalment are mutually agreed upon by the parties, and the customer will own the asset at the end of the lease period.

IJARA A contract whereby a financial or other institution purchases an asset to lease a customer in return for periodic lease payments. The period of the lease contract is mutually agreed and the asset remains the property of the lessor.

ISTISNA’A Istisna’a is a contract whereby a party undertakes to produce a specific thing that is possible to be made according to certain agreed specifications at a determined price and for a fixed date of delivery. The price may be payable either prior to the work or at a specified time or on delivery. The principle of gharar prevents one from selling something that one does not own. The technique of Istisna’a has been developed as an exception to this. Accordingly, the technique is particularly useful in providing an Islamic element in the construction phase of a project, as it is akin to a fixed price turnkey contract. As the Istisna’a contract is one of procurement and sale of an asset, it also lends itself to non-recourse financing.

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In the Markets QUANT INVESTING: MAKING A COMEBACK

QUANT STRATEGIES: Designed to outperform It always takes time for analysts to revise their assumptions and August 2007 was no different.

It was during this delay that many medium term multi factor quantitative strategies—that rely on these assumptions—remained heavily weighted towards stocks that were attractive before the market turned.

As analysts’ assumptions are now mostly up-to-date, the valuation factors in these strategies should resume their predictive power.

Photograph © Pusicmario : Agency, Dreamstime.com, supplied March 2008.

EDIUM TERM, MULTI factor quantitative investment strategies are predicated on strong views or beliefs and are designed to take advantage of market opportunities. In this respect they are very similar to fundamental investment strategies. These beliefs have been academically proven to have delivered superior risk-adjusted performance over the medium to long term for many investors. Where they differ from fundamental managers is in the systematic way in which they seek to exploit a range of investment opportunities. The availability of the right technology and brain power has allowed these strategies to systematically process and analyse greater volumes of market data faster than conventional investment teams

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are able to do. These processes work by identifying and exploiting investment opportunities which are then automatically de-allocated once they become less attractive on a riskrelative basis.

However, while systematic processes are very good at reallocating assets unemotionally from potentially losing to winning parts of the market, they are ultimately dependant on market data.

Therefore, they tend to struggle at inflection points in the markets, which take place during a shift from one set of assumptions and expectations to a fundamentally different market outlook.

During these periods the available market data becomes less valid.

For example, in the summer of 2007, the consensus forecast for UK corporate earnings growth in 2008 was

Volatile markets last year were a rude awakening for quant funds, with many rethinking their models. However, says Dermot Keegan, managing director, Institutional, Old Mutual Asset Management, not only are these strategies still robust, they also look likely to outperform over the coming months. about 8%. As the severity of the credit crunch unfolded, it became abundantly clear that not only was this forecast far too optimistic but also that the world economy was facing the real prospect of a recession. In consequence, the market took a step change and re-rated stocks accordingly.

It always takes time for analysts to revise their assumptions and August 2007 was no different. It was during this delay that many medium term multi factor quantitative strategies—that rely on these assumptions—remained heavily weighted towards stocks that were attractive before the market turned. As analysts’ assumptions are now mostly up-to-date, the valuation factors in these strategies should resume their predictive power.

Out of a multitude of factors analysed, valuation was, in fact, the dominant attributed cause of the underperformance of many of the exponents of this strategy in the

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latter part of 2007. However, it is not true, as some market commentators have suggested, that this type of quantitative fund is overly reliant on value as an investment style. In times when market data becomes inaccurate, processing of out-of-date information results in inaccurate investment recommendations.

However, bearing in mind that these strategies are designed to outperform the markets over the medium to long term, any spells of market confusion should not last for long enough to make a significant impact on long-term performance.

This is because inaccurate data gets corrected quickly and moreover, good quantitative processes have historically generated positive returns from their valuation factors, regardless of the dominant style in the market. They are equally adept at investing in undervalued ‘growth’ stocks, as well as ‘value’ stocks.

In other words, we should see a return to their normal outperformance pattern as soon as market fundamentals stabilise. In its review of market events

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last August, Peter L Bernstein concluded that “episodic poor average factor performance gets compensated in the subsequent months.”

After a relatively short period of difficult and volatile trading conditions, we believe that the environment for these quantitative strategies will be positive this year, supported by new opportunities created by the increase in crosssectional dispersion of stock returns and by the market having moved beyond the point of inflection that the market witnessed at the end of last year. Volatility is likely to remain high, which should benefit quantitative processes. Higher volatility is caused by strong and not always rational price movements, which tend to overshoot in both directions. This type of investment approach, by its very nature, takes advantage of mean reversion across a large and diverse number of opportunities, so it tends to benefit from volatile markets.

The sub prime situation hit these funds badly in what became known as “Quantmare” or “perfect storm”.

However, such an event is rare and the exposure to the forced selling we saw last year should be mitigated in the future because there has been a significant reduction in assets being managed using systematic processes by investment banks and hedge funds. Those who have stuck to their guns included many clients invested in long only, active extension and hedge that use such processes. These investors have not reduced their allocations because they tend to take a longer term view on performance.

Although the performance of these funds was affected by the sell-off last year, valuations have recently started reverting back to more realistic levels and we believe pension funds are also unlikely to sell now, as many of these investors will see a potentially brighter performance future.

Having fallen from grace over recent months, quantitative funds are now at very attractive levels. There is already some evidence of a recovery, which we expect to continue through 2008. This might just be the time to consider investing.

Don’t work in the dark, who knows what you might find Emerging Markets Report provides a comprehensive overview of the principal deals, trends, opportunities and challenges in fastdeveloping markets. For more information on how to order your individual copy of Emerging Markets Report please contact: Paul Spendiff Tel:44 [0] 20 7680 5153 Fax:44 [0] 20 7680 5155 Email:paul.spendiff@berlinguer.com

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Index Review WILL ECB POLICY UNDERMINE THE EU?

THE DWINDLING POWER OF THE EU What now for the European Union? Its equity markets have gained some confidence from central bank support. However, Europe’s economies appear, on the face of it, to be struggling. The accumulated weight of the cost of doing business, budget and trade deficits and high regulatory government structures is dragging down corporate profitability. Simon Denham, managing director of spread betting firm, Capital Spreads, questions the sustainability of the European Central Bank’s (ECB’s) one-size-fits-all policy.

HE EUROPEAN UNION (EU) model is built on the premise of fiscal probity, independent rate policy and the creation of a huge symbiotic trading bloc. However, the speed with which the politicians agreed and implemented the EU experiment resulted in a one-size-fitsall economic straitjacket, which is causing a series of booms and busts in weaker members of the club. The first requirement in a union of member states should always be the mobility of its workforce. The US has succeeded as surplus employees in one region have freely moved from one side of the Union to the other at a moments notice. Essentially, the populations of Europe do not do this.

This fundamental dislocation in the basic tenet of the EU experiment is also evinced in its one-size-fits-all interest rate and currency model.

Spain, Italy and Ireland needed higher interest rates between 2000 and 2007 to dampen down inflationary growth, but were stuck with the low rate requirements of France and Germany whose employment and growth levels at the time demanded easy money.

Italy and Spain now desperately need a weaker currency to give their exporters some respite, but the ECB is

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concentrating on inflationary pressures elsewhere and pushing a hawkish interest rate/strong currency policy. The Euro has appreciated by 20+% versus the dollar and sterling since last summer. Good perhaps for highly efficient German exporters, but disastrous for the Club Med partners.

Ireland needs lower rates to help home owners who are seeing prices at least 10% off highs and falling. Irish and Spanish banks are as exposed to the mortgage markets as any US sub prime lender and remain reliant on the current ECB liquidity provision.

While economists express woe at the US trade deficit (4.2% in 2007), Spain is presiding over a gap (10%) that is twice as large. No country in living memory has ever recovered from this level of imbalance without a major financial crisis and Spain does not even have the pressure cooker outlet of a falling currency. As the industrial landscape deteriorates in Italy, Greece and Spain, electorates may start to look to their politicians for some form of quick fix and we can see the yield spread for most of the Club Med state debt widen against the Northern block as investors try to factor in the chances of one or all of them breaking away.

Simon Denham, managing director of spread betting firm, Capital Spreads, April 2008.

If unemployment levels in the South start to increase (from already high levels) the pressure on the various governments to think the unmentionable may become very difficult to ignore. Longer term players may now be starting to imagine a return of the various sovereign states and investors in high quality Euro denominated debt may have to factor in the chances of a conversion (Russian style) into local currency bonds. The past six months have seen retail and financials suffer badly as investors focus on the immediate effects of a temporary economic blip.

As evidence mounts that a longer term slowdown may be on the cards our clients are increasingly identifying that these bear moves in these sectors may well have run their course for the time being. We also see evidence that they may now be looking at the relative over-valuations in the industrials, miners and pharmaceuticals. If the financial credit crunch does move into the wider economy then these areas will be the next bricks to drop. With the easy availability of stock borrowing facilities we are seeing some of our more aggressive clients setting up equity swaps in these areas.

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Index Review

Styling

Asia The Greater China equity markets (mainland China, Hong Kong and Taiwan) have undergone something of a roller-coaster ride over the last few years, but the investment universe is anything but homogenous. International investors have retreated from these markets over the last few months, but common assumptions about the region’s markets and economies may overshadow opportunities which exist for outsized returns. Simon Coxeter, founder of AsiaSource Capital, explains.

OTH 2006 AND 2007 were generally good years for the Greater China markets.The MSCI China index rose 78.1% and 63.1% in 2006 and 2007, respectively.

Meanwhile, the mainland A and B share indices registered even more impressive gains, with the FTSE Xinhua All Share Index returning figures of 179.16% and 123.96% in 2006 and 2007 respectively.

However, stratospheric returns were not universal, particularly in 2007. The GEM index, for example, representing over 190 small cap companies on Hong Kong’s exchange, rose by 9.7% in 2007, and annualised a relatively modest +10.9% and +3.3%, respectively, during the three and four year period to the end of 2007. As of March 20th, year-todate performance is -40.6%, erasing the previous three years’ gains. Taiwan’s TAIEX index meanwhile, representing

B

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over $600bn of a total $4.8trn or so market capitalisation within the Greater China region, rose by 8.7% in 2007, and annualised only +11.5% and +9.5%, respectively, during the three and four year period to the end of 2007, underperforming the MSCI Asia-Pacific ex-Japan index’s respective +28.6% and +24.9% performance. The TSEC Taiwan 50 Index meantime rose 7.82% in 2007, with the TSEC Taiwan 50 Index three year annualised performance to end 2007 rising by 10.01% and the TSEC Taiwan 50 Index four year annualised performance to end of 2007: rising by 8.05% The correction since November of last year has been severe. Between October 31st and March 20th, the H share index, representing companies incorporated in China and listed in Hong Kong, fell by 46.0%, and

GREATER CHINA PERSPECTIVE: THE SEARCH FOR ALPHA

Photograph © iloveotto/Dreamstime, supplied March 2008.

January was the worst month since August 1998 and the third worst in the history of the index. In comparison, the FTSE Xinhua H Share Index was down by 47.8% between the end of October last year up to the 20th of March this year. January was probably the toughest month since the Asian financial crisis, and capital flowed out of the region along with the global downturn in sentiment. However, the miasma of elevated risk aversion and macro uncertainties (or just plain misperceptions) may offer attractive investment opportunities.

Nonetheless, valuations are strikingly different across the region.

The mainland China market, with pricing mechanisms largely dictated by imprisoned liquidity, still trades on much higher valuations than the rest of the region, with the Shanghai A Share Index, for example, trading on a 2008 price to earnings (P/E) ratio of approximately 30x. Fortunately, the mainland market constitutes an almost irrelevant percentage of Greater China exposure for most foreign investors, and valuations elsewhere in the region are now undemanding—the Hang Seng, H Share, and TAIEX indices currently trade on 2008 P/E ratios of approximately 11x, 12x, and 11x, respectively.

Within the global context of slowing growth, a market driven by a domestic economy which continues to show robust growth deserves attention. Contrasting views circulate on prospects for the Greater China markets, and debate is complicated by divergences between the economies and markets involved. Interest rates in Hong Kong, for example, are driven by those in the United States because the Hong Kong dollar is pegged to the US dollar. Interest rates in mainland China, however, which are going in the opposite direction at present, are

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Index Review GREATER CHINA PERSPECTIVE: THE SEARCH FOR ALPHA

driven by a combination of different factors; given the relatively closed capital account, lack of currency convertibility, and solid economic activity. Likewise for the capital markets, with Hong Kong buffeted by international capital flows and shifts in global risk aversion, while the mainland remains virtually immune (with its sizeable liquidity pool captive to local stock and property markets, or low-yielding cash instruments).

Large cap proxies for China exposure listed in Hong Kong and the mainland performed well in 2006 and 2007, but a good number of stocks listed in Taiwan and Hong Kong were neglected during the bull market.

While prospects for broader betadriven returns appear more positive after the recent correction, there may also be a rotation into previously ‘unloved’areas. After a couple of years with many investors surfing effortlessly on a tide of momentum, selectivity and good old-fashioned fundamental due diligence may return to the fore in shaping returns. There are, for example, small cap and mid cap companies in the region trading on single-digit P/E multiples, with healthy cash balances, dividend yields and earnings growth. However, they have not been perceived as appropriate liquid proxies for China exposure, and the value-oriented stock pickers invested in them over the last couple of years probably now feel like US value investors back in 1999.

In the ‘unloved’ rankings, Taiwan is gold medal-winner. During a China investment panel discussion at a recent conference in the US, the topic of Taiwan was raised. The response was achingly familiar: investors are tired of waiting, and it is easy to ignore an exportoriented economy as the American consumer withers. Even so, Taiwan has started to show signs of life since the end of January, and local investors have

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started to repatriate capital to invest in the domestic stock market. Although there has been an understandable reluctance to fixate on the presidential elections due in late March this year as some form of catalyst, the KMT party’s victory could have substantive implications for the future of Taiwan, its economy, and prospects for Taiwanese listed companies.

KMT’s warmer stance towards mainland China could lead to direct transport links, increased tourism, and mainland Chinese investing in Taiwan’s stock and real estate markets. Furthermore, any easing of restrictions on Taiwanese companies doing business in their obvious target market will have an obviously beneficial effect. The political uncertainty and cross-straits tension should also subside, and with it factors contributing to the market’s relative underperformance over the last decade. Moreover, while the US slowdown is much more negative for Taiwan than for mainland China, corporate financial leverage is significantly lower than in the late 1990s.

The region’s positive long-term growth trajectory is uncontroversial, although there will certainly be challenges managing the ride upwards without speed bumps. Demographics, improvements in productivity and return-on-capital, the emergence of meaningful domestic consumerism, and the strategic rise of both Chinese corporations and Chinese political clout – all suggest Greater China markets will demand a larger position within global investment portfolios. Naturally, timing market entry has dominated thinking for many international investors; the fear of an excessive bull-run and now an even more perturbing freefall has kept many investors on the sidelines for years.

A key issue is near term growth. If earnings growth over the last two years is anywhere near replicated over the next few years, the recent correction may only be a blip in a multi-year bull market. There will be a few forces at play. The mainland market offers many more ‘cons’ than ‘pros’ at present for foreign investors, and it is difficult to make a credible hypothesis for good risk-adjusted returns through plainvanilla exposure to this market at current valuations. However, if the focus is purely on fundamentals without addressing the quality of the pricing mechanism itself, there are mixed signals.

For example, a significant portion of those mainlandlisted companies’2007 earnings growth was due to stock market gains— companies investing in some cases substantial cash balances speculatively into the stock market, which performed well and had a significant impact on earnings. In extreme cases, companies leveraged the balance sheet to invest more in the stock market.

As the market retraces, there will be a year-on-year fall in that segment of corporate profits – analysts suggest stock gains were as much as 30% of last year’s reported earnings for the mainland A share market. Such excesses appear to have moderated, and government agencies cracked down on corporate stock market speculation over the last few months, but there is still some way to go. On the flip side, there are a number of favorable tax changes in the People’s Republic of China this year which will boost earnings. Another driver with potential for earnings accretion, particularly for mainland-listed companies, is mergers and acquisitions activity. An acceleration in asset injections is generally expected as the government continues to rationalise state-owned assets.

Approximately two-thirds of state

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assets are not yet within listed vehicles, and although some are of low quality, asset injections near book value could significantly enhance both near-term earnings and the strategic positioning of listed companies―in line with the government’s ‘top 3 or out’ rule for state-owned enterprises.

Currency appreciation is another positive driver for the region. While it seems unlikely China will ever commit to a revaluation along the lines of the Plaza Accord, the market should at least witness a steady annual appreciation in the Renminbi.

Although some economists, and certainly many foreign governments call for such a full-scale revaluation, it would be unwise to lose sight of the differences between Japan’s economy back at the time of the Accord in 1985 and China’s economy today. Japan was in a better position to adjust to a currency shock, and was able to shift manufacturing rapidly up the value curve. A revaluation similar to that in Singapore makes more sense given that China is much more open to foreign goods than Japan was in the 1980s. The Taiwanese currency is also trending up against the US dollar, and as capital outflows stabilize and reverse, this trend should continue.

Macro (mis)perceptions There are currently a number of common concerns on investing in China, some of which are amplified and distorted by the media and even some sell-side research. The most topical concern relates to the deterioration in the US economy and the resulting impact on China’s economy. Decoupling is the mot du jour during any discussion of Asian markets. While it seems unlikely markets or economies will ever completely decouple on what is an increasingly transnational playing

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Simon Coxeter, founder of AsiaSource Capital.While prospects for broader beta-driven returns appear more positive after the recent correction, there may also be a rotation into previously‘unloved’ areas, writes Coxeter. After a couple of years with many investors surfing effortlessly on a tide of momentum, selectivity and good old-fashioned fundamental due diligence may return to the fore in shaping returns.There are, for example, small cap and mid cap companies in the region trading on single-digit price to earning (P/E) multiples, with healthy cash balances, dividend yields and earnings growth. Photograph kindly supplied by AsiaSource Capital, March 2008.

field, the Chinese economy is misunderstood by many. Some point to China’s high export-to-GDP ratio of nearly 40%, and herald Armageddon in the event of a slowing US economy. The facts, however, suggest otherwise.

Headline export numbers are meaningless when compared to a value-added measure such as gross domestic product. Net exports (i.e. stripping out the import content from exports), adjusted for inputs from other domestic sectors, gives a relevant measure of the economy’s exposure to exports; and China has one of the lower ratios in Asia (at approximately 10%). There is also significant evidence from previous export downturns that the aggregate impact on the Chinese economy is small. In addition, the force of domestic demand, although still in the early stages of development in China, is nonetheless meaningful enough to buffer against slowing external demand.

Moreover, there is little doubt the emergence of a middle class in China will create consumption momentum to drive several decades of enviable growth within a global context. Of course, the ride is unlikely to be without the occasional pit-stop.

President Hu Jintao’s focus on a

“harmonious society” at the last National People’s Congress was not without good reason. The rural-urban wealth gap has been growing for the last decade, and with the rural population accounting for over half the total, this is significant.

Job creation itself will be another challenge.The working-age population is forecast to grow by approximately 70m over the next decade, equivalent to the entire population of the United Kingdom. Structural changes in the economy will help to address these challenges, including a shift towards the service sector already in progress.

Also, the government has significant leeway to increase fiscal stimulus over the coming years to bolster the domestic economy, and plans are underway for greater investment in public housing, healthcare, social security, and infrastructure.

Another popular concern forecasts a deterioration in the economy after the Olympics in Beijing this summer. Again, the facts suggest otherwise. Total Olympics-related spending in China has been about 0.3% of GDP, much lower than for recent Olympics in Greece (approx. 4.2% of GDP) and Australia (approx. 1% of GDP), and modest in comparison to the slew of infrastructure projects planned over the coming years.

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Country Report BRAZIL’S ETHANOL MARKET STIRS

Smelling sweeter Even with the global hullabaloo over ethanol and alternative energy sources, Brazil’s own ethanol stocks have posted dire results of late. Last year’s results were affected by a glut of money that pushed up asset prices, just as sugar prices tumbled and developed markets failed to open up, even by a crack, to Brazilian ethanol. Is a turnaround now on the cards? John Rumsey reports.

Photograph kindly supplied by istockphotos.com, April 2008.

HARES IN BRAZIL’S ethanol market leader Cosan halved in value last year (falling 51.8%) giving it the dubious honour of being the worst performer on Brazil’s Bovespa. That fall can be attributed to questions over the firm’s corporate governance. But then, Bovespa’s two other listed ethanol companies also saw significant price drops. São Martinho, the market’s number two ethanol stock, fell 11.7% and Açúcar Guarani more than 20%, compared with the 44% increase of the Bovespa benchmark.

Last year’s price falls were partly sown by unrealistic expectations. The ethanol segment was not represented on the Bovespa exchange before Cosan’s listing in November 2005, which raised R$886m. The listing itself was propitious as valuations on the exchange were taking off; propelled by economic stability, the launch of the

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Novo Mercado (with its tighter corporate governance regulations) and pent-up demand.

Moreover, biofuels are all the rage, with talk of global warming uppermost in people’s minds. Private equity money has poured into the industry and the buzz holds that international markets will open up for Brazil’s cost-effective, sugar-based ethanol, giving the industry a further boost. Foreign investors in fact accounted for 72% of the take up of Cosan’s initial public offering (IPO).

“The share price increases didn’t reflect reality. Investors did not know the sector, they were not familiar with the business. It was the flavour of the month with [President George] Bush ‘advertising’ biofuels in the US. Investors bought these shares without deep analysis,” according to Cosan CFO Paulo Diniz. “It was a completely new industry: if you

wanted exposure to ethanol, you had to buy Cosan and many people bought into it,” agrees Antonio Augusto Duva, manager of the soft commodities desk at BNP Paribas in São Paulo. Initially, Cosan performed spectacularly. Kicking off at R$18.54, shares touched R$63 by May 2006.

It took a while though for others to join the fray. In 2007, however, São Martinho came to market on in mid February raising R$424m with 53% sold to foreign investors and then Açúcar Guarani which listed in late July 23rd raising R$666m, with foreigners buying 45% of the offer.

These shares have struggled to find liquidity, says Duva. Indeed, São Martinho has asked Credit Suisse to investigate ways to stimulate trading, he notes.

The hangover of 2007 started when prices for land, mill and distilleries skyrocketed. Cosan opted for a

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:fee\Zk`e^ 9iXq`cËj gi\d`\i ZfdgXe`\j kf `em\jkfij nfic[n`[\% 9iXq`cËj `em\jkd\ek Zc`dXk\ `j _fk% 8;Ij Xe[ >;Ij Xi\ kiX[`e^ dfi\ XZk`m\cp k_Xe \m\i% Fm\i ('' ;I gif^iXdj Xi\ efn XmX`cXYc\ kf ^cfYXc `em\jkfij Xe[ dfi\ k_Xe k_i\\$hlXik\ij f] 9iXq`c`Xe `jjl\ij kiljk fe\ [\gfj`kXip YXeb kf [\c`m\i k_\d Æ K_\ 9Xeb f] E\n Pfib D\ccfe% N\ Xi\ k_\ c\X[`e^ [\gfj`kXip YXeb# jgfejfi`e^ -+ f] k_\ nfic[Ëj ;Ij% K_\ i\Xjfe6 N\ Zfej`jk\ekcp X[[ mXcl\ kf ;I gif^iXdj% J\Zli`k`\j j\im`Z`e^ `j fli Zfi\ Ylj`e\jj% 8e[ n\ XkkiXZk k_\ Y\jk g\fgc\ `e k_\ Ylj`e\jj% Jf pfl ZXe ]\\c j\Zli\ k_Xk pfli ;I gif^iXd n`cc Y\ gcXZ\[ `e k_\ dfjk ZXgXYc\ _Xe[j k_\ nfic[ _Xj kf f]]\i% Kf c\Xie dfi\# ZXcc lj%

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Country Report BRAZIL’S ETHANOL MARKET STIRS

thorough-going change of strategy, moving away from an aggressive stance of acquisition-led growth. On April 12th, 2007, the company convened a press conference in São Paulo. At the time, its share price was R$38. Cosan managers admitted that the future of acquisitions in the sector looked bleak with prices of assets “through the clouds”. That meant expansion would be, at least in part, through organic growth in the centre of Brazil, an area where land prices were lower. The strategy, however, presented a couple of problems. First, one of the big bets had been a rapid consolidation of the industry; with a few mega players taking over smaller, less efficient producers, with all the economies of scale that industrialisation of the process implied. In an industry where Cosan had just 8.2% of the market and the top five players only 17.4% of the total, the idea proved bewitching. That hope now lay in tatters.

Furthermore, there is a significant and real logistics difficulty associated with expansion into the centre of Brazil, outside the traditional sugar growing area of São Paulo state.

Brazil’s huge size and neglected road infrastructure makes expansion in the area a costly proposition thanks to high transportation costs. The real deciding dynamic for the industry, was very basic. The cost of sugar was nosediving, reaching a low of nine cents per pound in autumn last year, down from a high of 19 cents. Naturally, the fate of Brazilian ethanol producers, made from sugar cane, tends to be highly correlated to the price of sugar.

Indeed, ethanol producers have the option of opting to produce sugar or ethanol and tend to choose between the two on an opportunistic basis.

Some blame for the collapse in sugar prices lies with the underestimation of India’s production.

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Consensus predictions were for output of 28m tons, when the reality was 33m, says Eduardo Correa, commercial director, sugar and ethanol, at São Paulo-based Equipav.

Analysts had adjust production forecasts, raising estimates over some 12 months by 25%. As India produced more than expected, sugar prices fell and proved a major competitor in external markets. The difficulty in projecting sugar production out of India continues, thanks to an antiquated government buying system, Correa explains.

Sugar is once again the main driver behind this year’s price surge for ethanol stocks. Prices have firmed back up and sugar was trading at close to 14 cents per pound by mid-February.

There are two reasons. Hedge funds are buying heavily in soft commodities, including sugar, betting that demand growth out of Asia, will continue to spread into agricultural products. That also explains the skyhigh appreciation in foodstuffs, such as corn and soya last year, though sugar remains the Cinderella and the cheapest commodity in the world, says Correa.

Furthermore, recent predictions that Indian production will be four or five tons less than the forecast has reduced the risk of massive oversupply. There’s a risk that investors will get carried away. Supply-demand fundamentals are weak for the industry and although there will be some improvement this year, longterm over-production problems have not gone away, worries Duva.

There are lessons for the industry from the sticky mess. First is that second guessing trade politics is a fool’s game. Investors in Brazilian ethanol were counting in the possibility of a big increase in exports to one or more of the EU, US and

Japan. That never came about. The EU’s focus has been on developing biodiesel, the US has been subsidising home-grown corn ethanol and Japan has not moved to increase ethanol levels in its fuels, pointed out Marcos Paulo Pereira, an analyst at Banco Fator.

The inability to open markets suggests the industry needs an image make-over.

Fernando Reinach, executive director at Votorantim New Energy in São Paulo, said scares that ethanol will lead to deforestation of the Amazon and that its production competes with food have impacted on prices. These fears are unfounded in Brazil because of the large amount of fallow and degraded land that can be used for agriculture. Nevertheless, the wholesome green image Brazilian ethanol had two years ago has been tainted, allowing developed countries to keep the stuff out.

Ambitious expectations for investment in the sector will be tested in the near future, says Correa.

It is not easy to buy and sell mills and that implies that when you buy a company, you are taking a 20 year decision. Most funds intend to invest and then IPO the assets that they have, probably with a two or three year time horizon. Diniz argued that the company’s shares suffered mostly on a misreading of fundamentals and not on its manoeuvres.

“Fundamentals were out of touch with reality,” he said. Cosan had warned investors that sugar prices were unsustainable and had predicted poor share price performance in 2007. Cosan is still waiting for a green light from stock market regulators in Brazil and the US on its plan to offer shareholders in Cosan SA a one-for-one swap into shares of Cosan Ltd, which is likely to lead to a mass migration to the New York Stock Exchange.

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Country Report

HE WIDESPREAD VIEW is that incoming president Medvedev favours further liberalisation of Russia’s capital and investment markets. Moreover, investors also believe that Russia is an extremely reasonably priced emerging market at current levels. Uppermost in all investor thinking however is whether the cosy relationship between Russia’s president and premier will last the course and whether, in either event, how best to profit from the outcomes through Russia funds.

In recent days, both Medvedev and Putin have (separately) claimed that each will enjoy ‘the highest executive power’ going forward.“The conflict has already

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PROFITING FROM MEDVEDEV’S ELECTION

LEVERAGING RUSSIA’S INFRASTRUCTURE NEEDS

Photo: Urban Background, supplied by Istockphoto.com, March 2008.

With Dmitry Medvedev’s predictable victory in Russia’s presidential elections in early March and the equally predictable decision to appoint former president Vladimir Putin as premier, many investors have found it difficult not to revisit their Russian investment radar screens in the past few weeks. Simon Watkins looks at the potential repercussions of the election outcome on the performance of sector funds invested in Russia. started,” says Sam Barden, head of SBI Fund Management, in Moscow.

However, he thinks that while Putin’s allies will continue to occupy key government posts, Medvedev will ultimately be in a stronger position. In this respect, talk that Putin will become the puppet master for Medvedev is a likely picture, at least for the immediate future. Why is that a bad thing, asks

Barden? “Putin will give Medvedev the support he will need in his first two years, but after that Putin will have a much more important role to play than clinging to power,”he avers.“He will be the first post-Soviet era president of Russia, who is young and capable, who will be able to travel the globe, promoting Russia’s interests, without the shackles of the Kremlin and the presidency.”

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Country Report PROFITING FROM MEDVEDEV’S ELECTION

Given that Russia now trades at around a single-digit price-to-earnings ratio, then (compared to around multiples of 22 for India, 18 for China, and 14 in the US), Bryan Collings, fund manager at Hexam Capital, which manages the Resolution Global Emerging Markets fund, thinks the country appears rather cheap as a whole. Additionally, while investors have been put off by the Litvinenko and Khodorkovsky scandals in recent times, Collings holds the view that: “The real threats are no different to many other places in the world and nor is corporate governance.” Indeed, says Jorge Parente, head of the JPM Fund, in London, “There are a lot more independent directors, more international accounting standards, and many companies are now paying dividends.” Equally propitious, he maintains, is that Russia has by and large avoided fall-out from the ongoing sub prime crisis, on the basis that its credit markets are relatively undeveloped, with a general lack of locals holding mortgages or credit facilities of any type.

With these positive developments also underpinned by average annual GDP growth of between 5% and 7% over the past eight years, which sectors are preferred by the smart money funds? Clearly, the oil and gas sector remains highly attractive to all but a few. “High oil prices no longer translate directly into economic growth for Russia, since the creation of the Stabilisation Fund, state revenues gleaned from the rapidly rising price of oil have been isolated from the economy,” says Mary Daunter, head of Daunter Russia Securities, in Moscow. “As such, the inflationary pressures that would normally arise from such huge cash flows have therefore been sterilised.”

That said, oil and gas revenues remain the major contributors to the

34

federal budget and hence the main source of funding for planned spending programmes. For example, in 2007 more than 60% of federal budget revenues came from oil and gas taxes. In this vein, of course, says Barden, the single natural investment choice would be Gazprom, as it is set to benefit from a long-term re-rating to reflect the benefits of expanding its main business units and a better pricing environment. Gazpromneft and Rosneft also look as though they may help to bolster the whole sector, as they will be the first in line to receive new licenses for major oil and gas fields, new upstream and downstream assets, and to benefit from tax breaks.

Similarly attractive, thinks Naheem Majid, head of Sinaco Global Trading, is the commodities sector, and he thinks that fears that commodities exports may be adversely affected this year in the face of the ongoing global slowdown are misplaced in the case of Russia’s metals and mining companies. “Russia is well cushioned to avoid much of the fallout, as it now has a more important trading relationship with China than with the US as about 43% of Russia’s exports

go to China.” Robin Geffen, manager of the Neptune Russia and Greater Russia fund, in Moscow, meanwhile says that Russia is also seeing a growing internal market for commodities as it builds infrastructure to support its development.

Nonetheless, Majid maintains that we are already into a new supercycle for metals prices as a whole. “Its primary drivers are the industrialisation of the world’s largest country [China] and a mining industry that faces unprecedented supply issues as a result of systematic underinvestment due to a 30-year strategy of repositioning for continued slowing demand growth,” he underlines. “This very powerful combination has been enhanced by the rebirth of commodities as a financial asset class in the past couple of years, which, it has been estimated, may have seen pension and mutual funds invest $120bn to $150bn in commodities, as part of a portfolio diversification strategy, and that significant further funds remain to be invested,”he says.

It is the combination of these three factors, adds Majid, that is set to drive the ‘stronger for longer’ theme for a

Energy, Finance & Natural Resources dominate Russia’s listed equities COMPANY Gazprom Rosneft Oil Sberbank Lukoil Norilsk Nickel Unified Energy Vimpelcom Surgutneftegaz Mobile Telesystems TNK-BP VTB Bank Gazpromneft Novoipletsk Steel Severstal Novatek

SECTOR

MARKET CAP ($millions)

Energy Energy Finance Energy Natural Resources Utilities Telecommunications Energy Telecommunications Energy Finance Energy Natural Resources Natural Resources Energy

305 86 72 61 55 46 38 32 32 28 27 27 26 25 23

Sources: Bloomberg: February 2008 & Raffeissen Capital Management, March 2008.

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number of years, although there will be high savings rates.” Indeed, it would growth, however he points out that inevitable pauses along the way. seem to be the case. The investment “net imports will put a drag on growth Recent pullbacks in oil and gold (and case for the Russian consumer goods as they outstrip exports. Nonetheless, slightly further back, the US dollar) and retail sector remains compelling, banking credits are expected to rise represent just such pauses, he as the sector offers a pure play on from 35% of GDP to more than 80% concludes, which gained further (and domestic demand in a market that is by 2020—so there is reasonable unjustified) weight by significant well insulated from global credit risks. potential there, for the banking sector, piggy-back.“The trigger for these sell- In addition, the government does not compared to the Eurozone.” It offs has been increased investor consider the consumer sector to be corresponds to annual credit growth in concern about the US and global strategic, which implies minimal or no “the region of 30+%,”he notes.

Last, but not least, is the telecoms growth outlook for 2007, and fears state interference. “We believe about rising inflation and interest rates, minority investors will benefit from a sector, says Parente. “The impressive but I believe such fears are overdone, re-rating of consumer stocks in 2008 operating and financial improvements displayed by VimpelCom and, in any event are and MTS in 2007 reflect outweighed by technical progressive expansion of market factors, and that a operations in Russia and transition in the growth abroad, which stimulated mix is underway,” Robin Geffen, manager of the Neptune mobile usage, relative explains Majid. mobile tariff stabilisation As economic Russia and Greater Russia fund, in [helped by rouble restructuring in Russia Moscow, meanwhile says that Russia is appreciation], and improved gains momentum, Peter also seeing a growing internal market for cost control,” he says. “The Brezinchek, head of commodities as it builds infrastructure to growth prospects of both Raffeisen Research at support its development. companies remain strong for RZB Group in Austria 2008 thanks to anticipated says that: “In upcoming growth in voice services and years we will see a shift subscriber numbers.” from manufacturing, Equally, he adds, as mobile which has been growing for the last 15 years, driven by the [they forecast average share price usage for voice services is finite, the natural resource sector, towards the appreciation of 26% for the stocks in share of non-voice revenue in total service industry.” One reasons for this sector that they cover], reflecting revenue remains low and 3G this, explains Brezinschek, is the sustainable growth prospects.” In fact, implementation is unlikely, the slowdown in the oil and gas sector the Russian consumer sector generally companies trade at high multiples, which is currently growing at just 2% trades in line with international peers, which signal future growth prospects are to 3% per year on average, compared but it offers considerably higher not already priced in. As an adjunct to to high value-added industries growth potential and thus justifies a this, he underlines, Russia’s under growing at 5% to 15%. “The premium. As such, Fox forecasts a penetrated modern telecom services restructuring should also boost 2006-2010 estimated sector earnings (internet and pay-TV) market should construction,” he adds,” as per share (EPS) at a compounded provide fixed-line telecoms with a strong infrastructure development will deep annual growth rate of (CAGR) of driver for the next two to three years, demand high over the next ten to 25.5% versus 19.6% for emerging and support average revenue growth of market peers. Geffen adds:“There has 12% for the 2007 to 2010 (versus just 20 years.”

Similarly, Roy Fox, head of Fox Fund been very strong growth in the middle several percentage points of growth by Management, in London, thinks that class, which has quadrupled since international peers). Furthermore, the the consumer sector offers attractive Putin came to power. Most people strong rouble will provide additional returns: “Everyone is willing to spend have seen a 20% nominal pay rise over support for the sector and provide a like there is no tomorrow, and they still each of the last four years.” Brezinchek defence against rouble appreciation, in haven’t got to the point where they are at Raffeisen agrees that Russian contrast to resource sectors, which are using debt, and thus they have very households will be a strong driver of exposed to currency fluctuations.

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Country Report GREEK BANKS LEVERAGE OPPORTUNITY ABROAD

NOW VOYAGER Photograph © Spectral-design/Agency: Dreamstime, supplied April 2008.

Greek banks have enjoyed beneficent growth in recent years in their local mortgage, retail and small to medium sized enterprise (SME) segments. However, as these sectors reach maturity and/or saturation, the banks are pushing for new business abroad.

Turkey, Southeastern Europe, Egypt and the Ukraine are popular options, as rapid consumer growth provides fertile business opportunities. However, other European banks now tread the same path, forcing down margins and testing the resolve of the Greek banks. Are they sufficiently competitive to stay the course?

Julia Grindell reports from Athens.

ELATIVELY SHELTERED IN a home market where the banking sector has honed its skills following protracted exercises in privatisation, market consolidation and internal restructuring, Greek banks have enjoyed halcyon days over the last decade. “Since 2001 when Greece joined Europe’s Monetary Union local banks have grown in leaps and bounds,” says Michael Massourakis, group chief economist at Alpha Bank, Greece’s third largest bank.“Over a period of almost 8 years, interest rates have been falling, causing a big increase in domestic credit expansion.”

Total credit to gross domestic product (GDP) ratio is at 93%, up from 50% in 2001: a trend facilitated by the easing of restrictions on

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consumer loans by the Greek central bank, in 2003. George Marinopoulos, manager of business planning and investor relations at Piraeus Bank Group explains, “Greeks were able to take longer-term consumer loans with much lower interest rates. This had a significant impact on consumer lending growth.”

The result was a wholesale shift away from corporate banking towards the retail market. Other considerations were also in play. Competition to serve the 400 or so large companies in Greece is particularly intense.

“Corporate banking is becoming less important. it used to be the backbone of the Greek banking system,” says Marinopoulos. “Since the sharp decline in interest rates the retail and SME banking sectors really took off.”

Mortgage credit in Greece was 11% of GDP in 2001 and is now 30%, only 9% off the European average.

Consumer credit tells a similar story, standing at 6% of GDP in 2001 to top 15% today, a mere 1% below the European average. The favourable conditions for retail borrowers present over the last several years has been driving year-on-year retail lending growth rates in excess of 25%. No surprise then that as the domestic consumer lending market reached saturation, growth began to slow.

“Growth in mortgage loans decelerated in 2007,” says Marinopoulos. In 2007 mortgage loan growth figures stood at 21.4% versus 25.8% in 2006. Consumer loans also slowed from 22.4% in 2006 to 21.2% last year.

To counteract market saturation at home and still maintain growth Greek banks have expanded operations abroad.“All the major Greek banks have been diversifying into Southeastern Europe (SEE),” says Massourakis. “The region has been a growing contributor to income and this is expected to increase further as the branch networks continue to expand.”Paul Mylonas, chief economist of National Bank of Greece (NBG), explains the dynamic.

“Following the fall of the iron curtain in the early 1990s the SEE region reappeared on our doorstep. As the markets opened up, Greek businesses went in and it is natural that Greek banks would follow to serve its corporate customers,” he says. It was a move that allowed the banks to build up SEE corporate business at first remove.

However, “as the economies in the region stabilised, and incomes increased, consumer demand has risen, resulting in a shift towards retail lending,”adds Massourakis. Alpha Bank has been in the region since 1994 when it entered Romania, where it now enjoys a 6% retail market share, via a 125 strong branch network.

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Following Bulgaria’s and Romania's EU accession, GDP growth rates rose to 6%, creating “growing opportunities,” says Massourakis. For a while, Greek banks enjoyed first mover advantage.

However,“The SEE countries privatised all of their banks very quickly and are now almost exclusively in the hands of other Western European banks and the weight of these very competitive banks are up against us,”says Mylonas. Credit Agricole, Raiffeisen Bank and Unicredit are all active in the region.

Nonetheless, Greek banks retain some advantages; not least because of early entry.“As the Greek businessman has been there for some time he can act as a leader for us and help us gain intelligence on the markets,” says Mylonas. Other bankers comment on

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the cultural affinity between Greece and SEE. Marinopoulos explains:“The region is our bread and butter. For certain foreign banks however, these countries represent just a few out of 60 or so other nations they operate in; and sometimes they don’t put enough focus on the region.” Greek banks hope to hone that focus into aggressive expansion targets.

Alpha Bank, for one, is keen to accelerate organic growth, which is expected to provide 30% of group earnings by 2010.“In the last two years we have increased our branch network tremendously,” says Massourakis.

Alpha Bank has 400 branches outside of Greece, “but we plan to build another 600 over the next couple of years and around 1000 branches in

SEE by 2010, bringing us somewhere in excess of 10% market share in the region. This is our interim target.”

Others grow through acquisition.

Marinopoulos says Piraeus has focused on “smaller acquisitions that are a manageable size in order that we can quickly restructure them and attack the markets. In Serbia for example we entered in 2005 through the acquisition of Belgrade-based Atlas Bank with 11 branches. Now we have 45 and our market share has reached 4%.”

However, there are risks: such as political risk in Serbia for instance.

Standard & Poor's recently revised its outlook on the country to negative, noting the impact of political tensions on macroeconomic policy and reforms.

Regardless, the country exhibits strong

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Country Report GREEK BANKS LEVERAGE OPPORTUNITY ABROAD

growth (7.5% last year) and Greek “there are Russian funds already linked we have over other foreign banks,” banks remain positive. “We are not to the regions we are invested in, such says Mylonas. To help finance deterred by political issues that have as the Ukraine and even Cyprus. Such a acquisitions, NBG divested its arisen in the last few months in terms move therefore compliments our investments in lower growth of our commitment to continue with business; though no decisions have countries. In 2006 the bank sold its made yet,” explains North American arm, Atlantic Bank of our investment,” says Massourakis. been However, Chris Elafros, head of equity Marinopoulos. Because of the specific New York, to New York Community research at EFG Eurobank Securities challenges presented by the Russian Bancorp for $400m (€253m).

Greek banks have been lucky enough meanwhile highlights the risks of rapid market,“it would have to be a very well to avoid the current turmoil in global credit expansion. SEE “governments thought out movement,”he iterates.

Most recently NBG has been financial markets which could set them and central banks need to keep an eye on credit as well as fiscal deficit growth looking at acquisition targets in the up well to continue financing their in order to avoid imbalances,”he notes. Ukraine, as long as the price is right, aggressive expansion plans. “The “The imbalances have to be tackled says Mylonas. It has already made country’s banks have enjoyed great and obviously this creates a investments in Turkey, holding an 86% lending growth for many years in Greece with comfortably high spread challenging environment.” products. Therefore there hasn’t To prevent overheating, been a need to search for yield, some countries have set allowing us to avoid toxic higher reserve Acquisitions in the Ukraine, Turkey, instruments. [Greek] banks requirements. In Romania Poland and Egypt have all been have not been affected by the the central bank imposed concluded recently. Piraeus Bank sub prime crisis on their balance a 40% minimum reserve acquired Egyptian Commercial Bank in sheets,” says Mylonas. requirement on banks for 2005, focusing on corporate lending, Eurobank’s Elafros meanwhile foreign exchange and 20% thinks that Greek banks will also for RON-denominated though with a view to expand retail benefit from lower acquisition loans to limit the growth lending in due course. “Egypt offers costs in their hinterlands as of foreign exchange loans. huge potential,” says Marinopoulos. other global players with sub The measures have posed “With a population of some 75m, only prime exposure are forced to a small hurdle to banks.

10m have a banking relationship.” bow out of riskier markets (even However, “it is common for a short time). “With the practice to bypass this current turmoil, we will see problem by booking loans acquisitions at a better price. My in countries with lower reserve requirements,” admits one stake in Finansbank, its fifth largest feeling is that the next deal that comes private bank. NBG’s international through will be a better valuation than banker.

Now Greek banks are looking further subsidiaries generated over 35% of the past because the risk of the area has out. Acquisitions in the Ukraine,Turkey, total group profit last year. Finansbank also changed for the worse,”he says.

Alpha Bank’s Massourakis thinks Poland and Egypt have all been made the largest contribution concluded recently. Piraeus Bank delivering net profit of €448m. In 2007 that despite increasing competition acquired Egyptian Commercial Bank in retail and mortgage lending at within SEE and surrounding grew by 64%, countries, Greek banks with their 2005, focusing on corporate lending, Finansbank the level of geographic location and regional though with a view to expand retail demonstrating lending in due course. “Egypt offers opportunity in the country. “The know-how, combined with their huge potential,” says Marinopoulos. situation is very similar to that in strong liquidity positions and “With a population of some 75m, only Greece a decade ago in terms of commitment to even higher risk 10m have a banking relationship.”The reform efforts, falling interest rates, regions, have a future of powerful bank is now setting its sights on Russia and demand for retail and SME consolation before them. “Overall we and set up a representative office in lending growing from a very low base. are in a good position to weather the Moscow last year. By entering Russia, We have gone through this cycle current storm and continue forwards,” the bank hopes to lever a business loop: before and I think this is an advantage he concludes.

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FTSE. IT’S HOW THE WORLD SAYS INDEX. We like to think we’re the world’s leading index provider and so it seems do our clients. FTSE was named by Global Pensions magazine as Index Provider of the Year for 2008. For more details on our innovative range of indices, global benchmarks and customisable solutions please visit www.ftse.com or call us on +44 (0) 20 7866 1810 © FTSE International Limited (‘FTSE’) 2008. All rights reserved. FTSE ® is a trade mark jointly owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE under licence.

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The main challenges for lenders and their agents have been to maintain cash collateral balances, avoid crystallising their losses on existing positions while at the same time taking advantage of significant re-investment returns. The securities lending industry rose to the challenge. Photograph Š Scott Maxwell/Dreamstime. Supplied April 2008.

Risk in Focus As the fallout from the credit crunch continues to play out over markets across the world, the European securities lending industry seems to be weathering the storm. Volumes are strong and the market turbulence has created opportunities for higher returns, provided the right investment strategy is employed.

However, the prolonged uncertainty is also unnerving which is why risk and the measurement of risk-adjusted returns are in sharper focus. Lynn Strongin Dodds

HE ROOTS OF the US sub prime crisis and the havoc it is wreaking on the global economy and markets have been well-documented. The short, sharp shock many had hoped for in the summer now looks like a long drawn out affair with liquidity becoming ever tighter and borrowing terms more stringent. The latest victims have included Carlyle Capital Group, the $14bn leveraged fund of the United States private equity group sponsor Carlyle Group, which went into liquidation in March. This was rapidly followed by the spectacular implosion of Bear Stearns, whose dramatic rescue by the New York Federal Reserve and subsequent sale to JP Morgan for $10 a share, shocked the investment community as well as the general public in the US.

T

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Guy d’Albrand, global head of liquidity management Société Générale Securities Services, says,“In many ways, the credit crisis turned in our favour with an increased focus on the generation of cash collateral and the returns generated through the re-investment of cash. However, many clients are more cautious about the quality of collateral and are looking for a more diversified investment strategy from their lenders. In general though, the credit crunch has emphasised the importance of strict risk and collateral management.” Photograph kindly supplied by Société Générale Securities Services, April 2008.

A recent report on the impact of the credit crunch, written

by Spitalfields Advisors, the London-based securities lending advisory firm, after the crisis hit in the summer, highlighted the growing list of challenges facing securities lenders and borrowers. The main challenges for lenders and their agents have been to maintain cash collateral balances, avoid crystallising their losses on existing positions while at the same time taking advantage of significant re-investment returns. The securities lending industry rose to the challenge.

As the Spitalfields report noted, “For an industry that is so often the whipping boy for market instability, it is most welcomed and unusual to be recognised as part of the solution rather than part of the problem.”

Ed Oliver, senior business consultant with Spitalfields, pointed out that lenders were not only able to maintain their credit balances but they also took advantage of opportunities presented by the volatile market conditions. “As credit spreads widened with the crisis, an environment was created for securities lenders to earn significantly greater returns.

Lenders who re-invested cash collateral were able to follow the same re-investment guidelines as before but the reward in some cases was two to three times higher for ostensibly taking the same risk.” Data from Performance Explorer Service (Spitalfields’ sister company) showed that reinvestment returns made by beneficial owner lenders from collateral re-investment rose to multiples of average 2007 levels across all asset classes. Although it is still too early to predict the impact the ongoing crisis will have on securities lending, industry participants are fairly optimistic that the industry will continue to prosper, although the returns are likely to lower. One reason is that all financial institutions are holding on ever more tightly to their cash resulting in an increase in demand for non cash instruments which typically includes government, corporate or convertible bonds, equities or certificates of deposit. It is no surprise that

investors have taken flight to quality assets and plain vanilla, government bonds are now flavour of the month.

As Paul Wilson, managing director and global head of client management for JPMorgan securities lending says, “The industry is increasingly seeing the desire from the broker/dealer to use less cash and more non cash collateral, particularly fixed income. In general, the dislocation in the credit market has meant that there has been a significantly greater demand for high-quality securities such as US Treasuries and European government bonds.”

As a result, collateral flexibility has become increasingly important. A successful lending programme encompasses identifying and quantifying the risk profiles and tolerances of beneficial owners but the winners today will be those players that can accept a broad range of non-collateral, regardless of the jurisdiction.“The most successful firms will be those who can accept a broader range of collateral options, regardless of their jurisdiction”, states Chris Jaynes, president of eSecLending. “Historically in the US, lenders have primarily accepted US dollars cash as collateral. This differs in Europe where lenders have more commonly accepted non-cash collateral, such as government debt. The recent credit and liquidity crunch has heightened the demand for lenders to increase their collateral flexibility because borrowers, who are looking to manage their balance sheets more proactively, will offer premiums to those clients who can accommodate different collateral types including US dollar cash, Euro cash, and non-cash collateral.”

Guy d’Albrand, global head of liquidity management Société Générale Securities Services (SGSS), echoes these sentiments. “In many ways, the credit crisis turned in our favour with an increased focus on the generation of cash collateral and the returns generated through the reinvestment of cash. However, many clients are more cautious about the quality of collateral and are looking for a more diversified investment strategy from their lenders. In general though, the credit crunch has emphasised the importance of strict risk and collateral management.”

It is no surprise, against the current background that beneficial owners are asking more questions and paying closer attention to the fine print of their lending programmes.

While regular reviews are conducted, counterparty credit risk, indemnifications and collateral guidelines have taken on new meaning in the current precarious environment. Pension plans, insurance and life companies are carefully examining the parameters of their lending and collateral guidelines, as well as the terms of their contracts, in order to identify any potential risks.

As Chris Taylor, senior managing director for State Street’s securities finance division, points out,“Rigorous due diligence is not a new trend and in fact over the past two years, we have seen clients ‘kicking the tires’ much more and place greater emphasis on transparency and risk management. The credit crunch has only heightened this focus. We are having many more conversations with our clients about their lending programmes and are seeing a greater demand for information around guidelines, reporting and collateral

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Chris Jaynes, president of eSecLending.“Historically in the US, lenders have primarily accepted US dollars cash as collateral. This differs in Europe where lenders have more commonly accepted non-cash collateral, such as government debt. The recent credit and liquidity crunch has heightened the demand for lenders to increase their collateral flexibility because borrowers, who are looking to manage their balance sheets more proactively, will offer premiums to those clients who can accommodate different collateral types including US dollar cash, Euro cash, and noncash collateral.” Photograph kindly supplied by eSecLending, April 2008.

Paul Wilson, managing director and global head of client management for JPMorgan securities lending, says,“The industry is increasingly seeing the desire from the broker/dealer to use less cash and more non cash collateral, particularly fixed income. In general, the dislocation in the credit market has meant that there has been a significantly greater demand for high-quality securities such as US Treasuries and European government bonds.” Photograph kindly supplied by JPMorgan, April 2008.

management.”According to d’Albrand,“the two major risks today are liquidity and counterparty risk due to the credit crunch. Beneficial owners want to know who we are lending to and that they will be indemnified in case of counterparty default. As for liquidity risk, it can be mitigated through increasing collateral quality and reinvesting cash among diversified investments.”

Another major cause for concern is cash re-investment.

As Oliver points out, that while the returns from cash reinvestment have been stellar, “the value of the assets held may not be as transparent as the lender may believe because the mark-to-market issues around some bonds have affected the cash re-investment market. This is why the focus on potential changes to the risk/reward ratio is critical right now – there is no such thing as a free lunch.”

JPMorgan’s Wilson notes.“You will not be surprised to learn that not all cash reinvestment programmes are born equal.

Some providers have large co-mingled money market funds which have a set of fixed guidelines that dictates how the cash is invested. Others run their cash reinvestment programme to allow the clients to specify exactly how cash collateral is reinvested. Some lenders’ business model is to generate revenues by, for example, lending AAA-rated securities and reinvesting the cash, say, into A-rated securities. Others extract the intrinsic value of the security and invest the cash conservatively. At JPMorgan, we tailor our programme to our client’s needs which we think creates the greatest level of transparency and minimises the potential for issues.”

Overall, industry participants believe that relationships are not being put to the test but are being strengthened by the increased analysis.“The relationship is key and we view these ongoing dialogues as a positive outcome of the credit crunch,”notes Oliver.“Beneficial owners are looking at the risks across the whole range of asset classes and may want

to change the dynamics of their re-investment programmes to a more conservatively managed strategy.”

While it is more than likely that these turbulent times will persist throughout the year, the appetite for securities lending has not diminished. Since the end of 2003, the value of securities for loan in the global markets has grown at an estimated compound annual rate of 15% to 20%. The latest figures from Data Explorers reveal that the global balances are $14.1trn lendable with $3.6trn on loan as of 25 March 2008. Aite Group estimates that the global lendable asset market is about $16trn with $4.3trn on loan at any time. The main drivers behind the market continue to be investment strategies and the search for alpha as well as ongoing tax and regulatory changes. In Europe alone, the past few years has seen the introduction of the Undertakings for Collective Investment in Transferable Securities III (UCITs), Basel II and most recently, the Markets in Financial Instruments Directive (MiFID). Under MiFID, achieving best execution is compulsory which is forcing fund managers to carefully examine how they trade and the best ways to extract value.

Although typically securities lending only generates between 10 to 20 basis points (bps), depending on the programme, in today’s environment, every basis point counts.

Also, the extra return may prove to be the fine line between funds being in the top or bottom quartile. Industry participants report that the pipelines for new business are healthy with existing clients expressing more interest due to their exposures to emerging markets, particularly in Asia, as well as long/short extension strategies such as 130/30 funds.

These 130/30 funds are expected to proliferate in Europe thanks to UCITs III, which allows shorting as well as the general pursuit of absolute return strategies to better match liabilities. They are not that easy to service though and require fully integrated securities lending, borrowing and collateral management as well as execution services for both the initial

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short sale and buyback. Blair McPherson, director, technical sales for Europe, Middle East and Africa at RBC Dexia, notes, “The potential for growth of 130/30 funds in the securities lending business is significant as traditional long only managers are increasingly moving into these types of shorting strategies. However, the operational and risk management challenges are also great which is why beneficial owners should look for providers, whether it be custodians, prime brokers or both who have the expertise in this area.”

According to a report by Spitalfields Advisors commissioned by Deutsche Bank last year, if the long/short strategy attracts the scale of predicted investment, this could generate an additional $600bn of borrowing demand by 2010. Tabb Group, a global research firm predicts the 130/30, which is currently estimated at $140bn assets under management (AUM) could have the potential to grow to over $2trn AUM in the next three years. The strategy may prove particularly appealing in a difficult market because if the market does drop, the fund still stands to make at least some money on the bearish bets. Typically, $130 is invested in stocks managers believe will rise in price, while $30 is bet against those they consider overpriced. Anthony Byrne, managing director and global head of securities lending at

Deutsche Bank, adds that the selection of a prime broker or custodian to support a 130/30 strategy is a critical decision for a fund.“Overall, though, we view the relationship with a hedge fund, lending agent or beneficial owner as a strategic partnership that is constantly evolving. I think going forward there is likely to be more business concentrated in fewer hands with the winners being those that have the strongest balance sheets and credit ratings, can offer a full range of products, an established platform in prime brokerage and synthetic lending, as well as a global footprint.”

Others, though, think that competition may become more intense as beneficial owners continue to unbundle the securities lending function from the custody business. Over the past two years institutions have been using multiple providers across different parts of their lendable asset base. Typically, the larger players have between two or four providers instead of one. Jean Robert Wilkin, executive director head of GSF product management at Clearstream, says, “I think the different lending models, whether it is a custodian, third party agent, investment bank, independent player or electronic trading platform, will remain. The biggest challenge today is liquidity and institutions will choose those providers they believe can add value in particular asset classes and markets.”

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F T S E G L O B A L M A R K E T S • M AY 2 0 0 8

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How Central Bank Sec-lending Eased Liquidity

Photograph Š Scott Maxwell/Dreamstime.

Supplied April 2008.

Since the coordinated actions taken in December 2007, the G-10 central banks have continued to work together closely and to consult regularly on liquidity pressures in funding markets. Pressures in some of these markets have recently increased again. In a move co-ordinated with three European central banks and the Bank of Canada, the Federal Reserve (Fed) expanded its securities lending to enable bond dealers to borrow up to $200bn worth of treasuries against mortgage backed securities (MBS). The lending was also expanded to 28 days instead of the standard overnight lending procedure that was in place. By short-circuiting the banks and passing more credit directly to primary dealers and, at the same time, taking mortgage-backed securities off the market, central banks are striking at the root of the sub prime mortgage crisis. The Fed also announced increases in its dollar 'swap' arrangements with the other central banks, which led to a co-ordinated boost in the dollar credit available to primary dealers in the US and European Union. t the end of March the Federal Reserve (the Fed) announced an expansion of its securities lending programme. Struggling to contain a crisis of confidence in credit markets, the Fed is lending Treasuries for 28-day periods in return for debt including AAA-rated mortgage securities sold by Fannie Mae, Freddie Mac and by banks.

Under the new Term Securities Lending Facility (TSLF), the Federal Reserve is lending up to $200bn of Treasury securities to primary dealers (the 20 or so firms that deal directly with the central bank) secured for a term of 28 days (rather than overnight, as in the existing programme) by a

A

pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS. The scheme encourages prime dealers to switch debt that is less liquid for US government securities that are easily tradable and will lend the Treasuries on to other firms in return for cash. That will help the dealers finance their balance sheets and foster the functioning of financial markets more generally.

As is the case with the current securities lending programme, securities will be made available through an auction process. Auctions will be held on a weekly basis,

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which began on March 27th 2008. The Federal Reserve has and will continue to consult with primary dealers, which includes Merrill Lynch and Goldman Sachs, on technical design features of the TSLF. The Fed is reckoned to hold around $713bn of Treasuries on its balance sheet. The actions supplement the measures implemented by the Fed a few days earlier to boost the size of the Term Auction Facility to $100bn and to undertake a series of term repurchase transactions that will cumulate to $100bn.

The Fed coordinated this latest effort with central banks in Europe and Canada, which in turn injected up to $45bn into their banking systems. The relief to the US credit markets was immediate as the premiums investors demand for debt backed by home loans guaranteed by Fannie Mae retreated from close to a 22-year high. Fannie Mae and Freddie Mac, chartered by the government, are the largest sources of money for US home loans. The European Central Bank (ECB) is lending banks up to $15bn for 28 days and the Swiss National Bank (SNB) announced a similar auction of up to $6bn. The Bank of England offered $20bn of three-month loans on March 18th and intends to hold another auction on April 15th.

In addition, the Federal Open Market Committee (FOMC) has authorised increases in its existing temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB).

The Federal Open Market Committee (FOMC), a component of the Federal Reserve System, is charged under US law with overseeing open market operations and is the principal tool of US national monetary policy (open market operations are the buying and selling of government securities). The Committee sets monetary policy by specifying the short-term objective for those operations, which is currently a target level for the federal funds rate (the rate that commercial banks charge on overnight loans among themselves). The FOMC also directs operations undertaken by the Federal Reserve System in

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foreign exchange markets, although any intervention in foreign exchange markets is coordinated with the US Treasury, which has responsibility for formulating US policies regarding the exchange value of the dollar. These arrangements will now provide dollars in amounts of up to $30bn and $6bn to the ECB and the SNB, respectively, representing increases of $10bn and $2bn. The FOMC extended the term of these swap lines through September 30th this year.

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LOW COST DIRECT MARKET ACCESS

While demand for DMA quickened with the liquidity fragmentation precipitated by RegNMS, it was in the late 1990s that DMA first found its feet in the US, led by hedge-fund managers who employed DMA as a foundation for more complex algorithmic trading/statistical arbitrage strategies. In recent years, the proliferation of faster and more affordable technology solutions, including order management systems (OMS) and execution management systems (EMS), has spurred DMA growth among traditional classes such as asset managers, equity firms and brokerages.

Photograph © Solarseven/Dreamstime, supplied March 2008.

DMA: THE BUY SIDE GETS WIRED

By connecting directly to the market’s expanding slate of liquidity pools, buy-side firms using direct market access (DMA) can execute trades with greater speed and efficiency while reducing volatility—and, thanks to increased competition, at significantly lower costs. Dave Simons reports.

HE MARKET STRUCTURE post-Regulation NMS and MiFID finds pools of liquidity spread across an increasingly vast assortment of trading venues, compelling financial services firms to seek the most efficient execution arrangements possible.

The rapidly expanding landscape has done wonders for the proliferation of high-speed trading systems and other advanced distribution processes necessary to meet the multi-platform demands of best execution.

The acquisition of electronic communications network provider Archipelago by the New York Stock Exchange (NYSE) two years ago was

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a direct response to the SEC’s approval of RegNMS. With the arrival of the Markets in Financial Instruments Directive (MiFID) last November, trading venues in Europe have scrambled to shore up their technology infrastructure in order to deliver efficiency, stay competitive and meet best-execution requirements.

All of which has put the spotlight back on direct market access (DMA) trading solutions. Utilising a direct link to the market’s various liquidity pools, DMA enables buyside firms to execute trades with greater speed and efficiency, enhancing order control while reducing

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volatility, all at increasingly lower costs. “DMA provides very fast execution with minimal downside risk for traders at high velocity buy-side shops,” notes Matt Simon, research analyst for Boston-based TABB Group. “Tagged alongside algorithmic trading, it becomes a perfect combination of velocity and curvature—the fastball of a trader’s pitch selection, so to speak.”

While demand for DMA quickened with the liquidity fragmentation precipitated by RegNMS, it was in the late 1990s that DMA first found its feet in the US, led by hedgefund managers who employed DMA as a foundation for more complex algorithmic trading/statistical arbitrage strategies. In recent years, the proliferation of faster and more affordable technology solutions, including order management systems (OMS) and execution management systems (EMS), has spurred DMA growth among traditional classes such as asset managers, equity firms and brokerages. “When clients want to get something done right away—without concern about market impact— DMA is a very appropriate choice,”says Will Sterling, head of institutional electronic trading at UBS. Clients increasingly prefer DMA to traditional voice brokerage when they are working in highly liquid names or on fairly straightforward orders, says Sterling, because it gives them control over the order type and timing.

With the advent of smart routing technology, clients can also be reasonably assured of finding best price in the most efficient manner. DMA is also less expensive for the buy side on an order-by-order basis than traditional voice brokerage, adds Sterling. “The efficiency that always follows innovation is at work here, with great benefit to both the buy and sell sides.”Business has been quite brisk of late. A newly issued report from Boston-based research and advisory firm Celent entitled The Evolution of Direct Market Access (DMA) Trading Services in the US and Europe estimates that DMA flow will increase to 20% of equity share volume by 2010, replacing manually executed trading forms.“The long and short of it is that DMA makes trading cheaper and faster and is a growing option for traders,”says David Easthope, senior analyst with Celent’s Securities & Investments group and co-author of the report. DMA puts positive pressure on exchanges and other liquidity venues to improve their technological standards and execution quality in order to stay in line with DMA developments, he adds. Because it is viewed as basic equipment when implementing more sophisticated tools such as algorithms and smart-order routing, DMA should continue to see increased demand in the electronic trading age, adds co-author Chermaine Lee, analyst with Celent’s Securities & Investments division.

In Europe, the introduction of MiFID has ushered in a similar kind of liquidity fragmentation through the formalised entry of multilateral trading facilities (MTF) such as Chi-, the impending Project Turquoise and similar entities.“It has allowed for a whole new breed of arbitrage, traders and hedge funds who are looking to make markets in these different venues,”says Ashok Krishnan, managing

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Ashok Krishnan, managing director in direct market access for Merrill Lynch in London.“All of these emerging trading styles that are the byproduct of MiFID can be very efficiently facilitated through DMA. Hence, we have seen significantly increased DMA take-up in Europe as a result.” Indeed, while Europe had lagged the US in DMA uptake prior to MiFID, direct-to-market flow is expected to nearly double over the next three years, reaching an estimated 15% of traded value, fueled by the proliferation of alternative trading systems (ATSs) and multilateral trading facilities; as well as the need for faster execution and compliance. Photograph kindly supplied by Merrill Lynch, April 2008.

Jarrod Yuster, Merrill Lynch’s head of global portfolio and electronic trading in New York.“Because of the growing number of equitytrading venues, having direct access doesn’t necessarily guarantee best execution—hence the interest in using smart routers or algos in order to enhance the DMA execution experience.” Photograph kindly supplied by Merrill Lynch, April 2008.

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Matt Simon, research analyst for Boston-based TABB Group. Simon says,“DMA provides very fast execution with minimal downside risk for traders at high velocity buy-side shops,” adding that “Tagged alongside algorithmic trading, it becomes a perfect combination of velocity and curvature—the fastball of a trader’s pitch selection, so to speak.” Photograph kindly supplied by TABB Group, March 2008.

Toby Bayliss, head of electronic execution sales, Europe for Citi.,“Since large orders must be sliced into increasingly smaller components to avoid excessive impact and maintain anonymity. As the total cost of trading continues to go down, it becomes possible to take advantage of ever smaller price anomalies, allowing more quantitative, statistical arbitrage players to increase their level of market participation,” he says. Photograph kindly supplied by Citi, April 2008.

director in direct market access for Merrill Lynch in London. “All of these emerging trading styles that are the byproduct of MiFID can be very efficiently facilitated through DMA. Hence, we have seen significantly increased DMA take-up in Europe as a result.”Indeed, while Europe had lagged the US in DMA uptake prior to MiFID, directto-market flow is expected to nearly double over the next three years, reaching an estimated 15% of traded value, fueled by the proliferation of alternative trading systems (ATSs) and multilateral trading facilities; as well as the need for faster execution and compliance.

Adam Sussman, senior research analyst for TABB Group, says that DMA will help promote the quest for greater efficiency and lower-cost trade execution that is the underlying objective of MiFID. “These trends position Europe for rapid growth in electronic trading as we see both direct market access and algorithmic trading flow growing at an approximate compound annual growth rate of 50% through 2009,” remarked Sussman in a recent report on European buy-side trends in institutional equity trading.

DMA has also shown significant growth in the Asian markets, a reflection of the steady surge in investment activity throughout the region. Recent from TABB Group found that as much as 20% of buy-side orders in Asia are being routed electronically to brokers’ algorithms. Going forward, worldwide demand for DMA is such that any regional gaps are closing rapidly, says UBS’s Sterling.

“Whereas Asia-Pacific and other emerging markets once trailed the US and EU, the uptake has started to accelerate to such a degree that soon we won’t notice any appreciable differences in the ‘amount’ of electronification in each region. Rather, we will begin to notice market structureoriented variation in ‘how’ we all trade electronically.”

Because expectations vary greatly from client to client, there is no one-size-fits-all DMA solution. “On the buyside, DMA users include everyone from professional traders and hedge funds, right up to the larger institutions,” says Krishnan. “And all the members of that client base can have very different needs. From a professional trading or hedge-fund perspective, there has long been a high level of interest in using DMA as an entryway into algorithmic trading—it’s practically the only way those groups will trade.” By contrast, large asset managers who use DMA very sparingly typically want a solution with add-ons, says Jarrod Yuster, Merrill Lynch’s head of global portfolio and electronic trading in NewYork.

“Because of the growing number of equity-trading venues, having direct access doesn’t necessarily guarantee best execution—hence the interest in using smart routers or algos in order to enhance the DMA execution experience.”

Emerging technologies are making DMA order processing “smarter” than ever, notes Sterling. “Advanced order types, such as those we are implementing here at UBS, enable clients to manage and slice their orders against benchmarks, or factors of their choice, ‘preference’ venues, and even access non-displayed liquidity with the speed of DMA. The lines are blurring between algorithmic trading and DMA. These new order types are combining the strategic intelligence, subtlety and adaptive logic of algorithms with the immediacy and simplicity of DMA— something we realized our clients have been seeking.”

Despite the many benefits of DMA, there are a number of potentially significant hazards, particularly as DMA usage rises among less tech-savvy clients. “Advantages such as increased control, access and transparency can easily become disadvantages if used improperly,”notes Krishnan.

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the order book has “You might have these decreased,” says Toby larger institutional In the final analysis, the move toward a Bayliss, head of dealing desks that have more “venue-neutral” marketplace will electronic execution been placing orders require that trading infrastructure stay one sales, Europe for Citi. over the phone for This has pushed many many years and are step ahead of the game, and that bodes well traditional dealing desks suddenly thrust into an for buy-side clients seeking DMA solutions, away from using pure environment where you says Sterling. “A higher level of competition DMA and more towards just have to press a among the venues will ultimately affect the algorithmic trading, says button to make it cost of trading—and as a result, clients will Bayliss, “Since large happen.”In order to use orders must be sliced DMA efficiently, clients experience a significantly heightened ability into increasingly smaller need to be able to to manage price impact and information components to avoid understand how to leakage, while increasing the opportunity to excessive impact and manage their order flow find diverse liquidity.” maintain anonymity. As on their own, says the total cost of trading Krishnan, which is why continues to go down, it many clients have traditionally wanted a broker in between to hand-hold becomes possible to take advantage of ever smaller price them through the trading process. While that culture is anomalies, allowing more quantitative, statistical arbitrage rapidly moving towards one of complete ownership, the players to increase their level of market participation.”

Increased market fragmentation has also led to a change unfettered control and access into the market that DMA offers “can also be pretty lethal if one does not know how in DMA product offering, says Bayliss. Responding to MiFID implementation in Europe, Citi now includes to use it properly,”warns Krishnan.

Those clients, who are just now getting their feet wet advanced DMA order types, which take advantage of may have a bit of learning curve ahead of them.“There is a multiple execution venues such as Chi-X in an effort to level of sophistication that is required to use these tools,” capture the best price in the market and maximise fill rates, saysYuster,“which is why it is imperative that brokers have says Bayliss. In addition to faster, direct-to-market trading oversight and compliance mechanisms in place, along mechanisms, experts contend that clients will also require with other tools including service and support, that can trading tools capable of managing the entire spectrum of prevent order errors from making it to market. After all, if complex global opportunities, including cross-asset trades you’re the sponsor, you’re allowing clients to go out to the in equities, derivatives and other asset classes. “Access to exchange in your name—and you don’t want them using markets throughout the world, many with different trading protocols and market structures, will become imperative, your name inappropriately.”

From Sterling’s point of view, the main issue with DMA feeding the alpha-seeking beast,” suggests Andy Nybo, isn’t so much how to use it, but when to use it. Because orders senior research analyst at TABB Group. “It is no longer are visible to the general market, traders need to understand feasible for firms to view strategies in disconnected the perils of information leakage. “Most medium and large isolation.”With the boundaries separating OMS, EMS and buy-side institutions have been using DMA for a very long DMA becoming increasingly blurred, it is crucial that time, and are thoroughly experienced at training their new clients select the product that best suits their needs, traders. Potentially, in smaller practices, there is a risk that a particularly when executing multiple strategies across new trader may not have a full appreciation of the potential markets with dissimilar liquidity profiles, says Nybo. All of impact of a DMA order.”In such instances, however, brokers which points to the growing significance of multi-faceted, are only too happy to handhold the client through the DMA cross-asset products that can tap directly into a vast array process, as well as other electronic trading capabilities such as of global liquidity pools. Systems supporting such trading algorithmic trading.“For example, at UBS, we provide client- complexities are fast becoming the norm, says TABB Group tailored ‘teach-ins’ where we visit a client in their offices and head Larry Tabb. “In our opinion, they will become review the suite of our offerings, and an overview of best indispensable to trading desks embracing the aggressive practices. EMS and OMS providers are also very astute at use of technology.”In the final analysis, the move toward a bringing new clients up to speed with their systems’ more“venue-neutral”marketplace will require that trading infrastructure stay one step ahead of the game, and that capabilities and best uses.”

While increased competition through MiFID and bodes well for buy-side clients seeking DMA solutions, RegNMS has paved the way for a much more efficient, says Sterling. “A higher level of competition among the electronically driven market, the change in regulation has venues will ultimately affect the cost of trading—and as a helped redefine the structure of the visible order book, result, clients will experience a significantly heightened particularly as tic size continues to tighten. “Spreads have ability to manage price impact and information leakage, become narrower, and the volume of liquidity displayed in while increasing the opportunity to find diverse liquidity.”

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THE IMPACT OF MIFID

THE IMPACT OF THE BIG ONE Photograph © Paul Moore/Agency: Dreamstime, supplied April 2008.

The Markets in Financial Services Directive, (MiFID) is the poster child of the European Union's Financial Services Action Plan (FSAP), a regulatory framework to enforce a competitive yet harmonised trading environment across the European Union. FTSE Global Markets talked to Chris Pickles, head of marketing, Investment Banking & Global Accounts, BT Global Financial Services, co-chair of the Global Education & Marketing Committee of FIX Protocol Ltd, a member of the executive committee of SIIA/FISD, and chair of the MiFID Joint Working Group, about the impact of MiFid four months after implementation. “

IFID IS THE big one,” says Chris Pickles, “removing those concentration rules erected by national governments that had stymied any real development of a single market, where trading is permitted anywhere without the need for a physical presence.” The directive, “will trigger the most radical transformation the financial services industry has undergone to date,” adds Pickles. He sees the impact of MiFid in three key areas, each one building on the impact of the other. First,“the overriding of concentration rules is allowing order flow away from traditional exchanges”. It was time the trend was formalised, says Pickles, as “some 30% to 50% of equity trading in Europe was happening off exchange in any case.”

That falls neatly into the second area, which is the rise of new trading venues. “Margins have been dropping for the sell-side, and will continue to drop in a post-MiFID world, so, naturally, the sell-side will push the buy-side to trade electronically with them in order to lower their cost in servicing the execution,”he adds. Third, MiFiD ensures that traders must look at all relevant venues to ensure best

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execution. “Best execution is the heart of MiFiD. It will become increasing difficult to prove that you have achieved best execution if you cannot execute quickly, and this means electronically. Furthermore, the best way of handling the increased numbers of trading venues is through electronic routing,” he says. However, while MiFiD defines best execution in article 21, “it is not prescriptive and does not specify how a trading professional must act in all situations.”

It is an evolving process, based on principle based regulations propones Pickles, at the core of which is that best execution means that the best result possible is secured for the client. In this sense, “MiFiD reflects best practice.”Reality bites, however and Pickles acknowledges that “of the 12,000 broking firms within the European Union, not all can handle the post-MiFiD world. Even if the smaller brokers are able to produce the best result, the client will always gravitate to the larger houses which can offer low latency and access to the widest number of trading venues. In that respect, MiFiD will continue to rewrite the trading landscape across the whole continent. ” Moreover, the directive's focus on best execution encourages the rise of trading techniques such as algorithmic trading, since traders will often include algorithms in their set of choices when determining the best method to use in executing an order. Again that has the effect of concentrating business into the trading rooms of the bulge bracket trading houses.

Even so, in the immediate aftermath, Pickles sees some of the most dramatic transformation in the exchange area.

“Look at the New York Stock Exchange link up with Euronext and the London Stock Exchange’s link up with the Italian Borse: these are clear indications of US and European exchanges moving in a strategic way that would not have been feasible or possible without MiFiD and it is a sign that they recognise the competitive pressures that MiFiD places upon them with the rise of alternative trading venues.”

Other changes in a MiFID world will be the requirement to be able to identify exactly what asset is traded, what market it is associated with and where the trade is actually executed and where it is settled. The place of listing and place of trade, as well the market identifier, will be required to give the degree of precision that is required by the directive. At the same time, traders who trade their own book in a substantial way are now required to be transparent in their pre-trade and post-trade dealings.

The good news, concludes Pickles is that this is a first iteration of MiFiD, which concentrates on equity trading.

Iteration two of the directive will encompass all asset classes.“It is an ongoing exercise to ensure that Europe can compete on the same terms as the US in the global markets, so the European Commission is now reviewing the directive in terms of what it might mean for the bond and derivatives markets,” he explains. “It is all directed at working in the best interests of the investor, even if the entire structure of European trading has to be overhauled to achieve it. Wonderful, isn’t it?”

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2008 THOUGHT LEADERSHIP ROUNDTABLE SERIES

THE RISE AND RISE OF ALGORITHMIC TRADING

Participants:

Supported by:

Attendees: from left to right RICHARD HILLS, head of electronic trading services, Société Générale Corporate& Investment Banking (SG CIB) SCOTT COWLING, European head of trading, Barclays Global Investors (BGI) FRANCESCA CARNEVALE, editor, FTSE Global Markets TIM WILDENBERG, managing director, head of direct execution services, Europe, UBS MICHAEL ROSE, head of centralised dealing, Old Mutual Asset Managers (OMAM) CHRIS SIMS, head of investment operations, Gartmore Investment Services CHRIS MARSH, head of AES trading and development, EMEA, Credit Suisse

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KEY INFLUENCES & TRENDS MICHAEL ROSE, OMAM: We have several key product areas, each of which requires its own trading strategies and varying degrees of interaction with the many trading tools now available to us. Our single stock trading encompasses most of the major world markets, but we have particular strength in the mid and small cap UK sector. We find that far from helping us to source liquidity, algorithms can in fact hinder us and make life difficult at times. Therefore, we tend to employ a mix of capital commitment and worked orders; the first port of call always being to look for natural business in order to reduce market impact. Away from that, we have statistical arbitrage products that are perfect for algorithmic strategies. The fund managers trade a portion of their business utilising algorithms (algos) that they have written themselves with the rest of the business going through the centralised dealing desk where we employ a number of broker algos to achieve different benchmarks such as market on close and volume weighted average price (VWAP). We also have quant products which rebalance monthly. The size of this business requires a fair amount of pre-trade analysis to try and help us decide on the best strategies to achieve the sort of execution results we demand, whether that be the use of brokers’ capital, algorithms or straight agency.

RICHARD HILLS, SG CIB: The industry is impacted by a number of trends. The first is the changing liquidity landscape in Europe, which is very exciting and very good for the industry as a whole. Moreover, it is picking up pace.

Over the last few weeks, we have seen liquidity growth on Chi-X; Turquoise with firm roll-out plans; and there are some other multi-lateral trading facilities (MTFs) that we are talking to that seem quite firm in their planning. The algorithms themselves are ready for next step which we feel is to follow the US model, where there are two layers: a smart routing layer and then an algorithmic layer, meshing the two, talking to each other and getting the best out of both functionality sets. Another big opportunity is in the international market, where we are seeing a lot of growth in US funds trading into Asia. The growth of electronic trading in Asia is providing an opportunity to better automate the process, to make it more efficient and to deliver the same products on a more international basis.

It is here, therefore, where I see most of our development going into, international trading and the smart routing/liquidity access, particularly in Europe.

CHRIS SIMS, GARTMORE: From a Gartmore point of view we keep looking at the various offerings. We look at algorithms from the point of view of whether they are valid in terms of what we are doing at the moment. The way that our business is conducted is very close to Michael’s in terms of the spread of the trading. However, from the sell side, there still seems to be an awful lot of selling going on rather than actually showing the buy side that the tools they offer can add value consistently across the trades.

MICHAEL ROSE, head of centralised dealing, Old Mutual Asset Managers (OMAM) TIM WILDENBERG, UBS: There has been an awful lot of noise in the algorithmic trading space and there is no question that it is not some sort of passing fad, in terms of some of the volumes we are seeing. Over the last 18 to 24 months, we have seen a movement towards a directed execution model, in an unprecedented fashion really. Even firms or people that you simply would not have expected to be interested are now really focusing on it. The great thing is, and this underscores Chris’s point, is that we are also seeing the client base becoming a lot smarter.There are a lot of people tiptoeing into algorithmic trading, and that is fair enough. However, there are lots of people who have been doing it for some time now and the questions they now ask, the analysis they ask for and the improvements and customisation they request means that algorithms are now being taken to another level entirely.

There is also a big movement towards liquidity seeking algorithms, and we have an algorithm called TAP which we developed in response to that. Some of our clients care about the Markets in Financial Instruments Directive (MiFiD), dark pools and the way in which smart order routing (SOR) works.

At one time it was simply a question of whether we provided SOR, but now it is: “let’s get down, deep and dirty around exactly how it is all working”. We are being asked,“Where are you posting, where are you not posting, what are your rules for posting, what are your rules for probing?” It is a really interesting time at the moment.

SCOTT COWLING, BGI: I see the growth of algorithmic trading as both an opportunity and a challenge. The goal is to implement more efficiently or, in other terms, reduce cost. We believe that through the smart use of algorithms we can do a better job for our clients however therein also lies the challenge. There have been many advances in recent years and I would not automatically assume that the use of electronic trading techniques will, in aggregate, reduce cost for portfolio managers. The other aspect that I see as a challenge is the ability to appropriately differentiate across all the products that are available.

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CHRIS MARSH, CREDIT SUISSE: As

people use algorithmic trading tools they are becoming more sophisticated and many of these investors are noting that not all tools perform the same.That is an exciting trend to us.

We further feel that the spread of capabilities is going to widen as the European markets become more complicated and fragmentation accelerates. The fact that we have seen, in recent days, that alternative trading venues have taken 15% of the London Stock Exchangeâ&#x20AC;&#x2122;s ( LSEâ&#x20AC;&#x2122;s) top volume leads us to think that houses that are effectively able to leverage those trends are the ones that are going to best deliver value to clients. Moreover, in the global space, we have seen instances where algorithms are delivering value where you might not expect. In the US, we have seen large reductions in impact and short term reversion for virtual block trades created by liquidity seeking algos when measured against their traditional cousins. This was quite unexpected, as we think of algorithms generally helping by spreading trades out instead of clumping them all together like single point block trades.

WHAT DOES THE BUY SIDE WANT? CHRIS SIMS: The honest thing to say is that the buy side will, in the first instance, use algorithm providers that they have relationships with, in particular markets. They will work with those houses they feel comfortable with. Equally, the choice of using the algo provider might not be exactly price in the first instance. However, it might be ease of trading or it might also be managing commission generation with a particular broker. If we are realistic about these things, I am not sure that we have got to the stage where we are choosing algo providers independently of the rest of the trading flow.

TIM: When you start using algorithms you obviously turn to the people that you know well and trust, which is logical. This is particularly true as we find ourselves in an evolutionary phase in the market where there is a lot of talk about unbundling; and while some people are unbundling, others are not. Right now, the client still looks at the overall relationship and the spend of commission dollars. In that context, they might not allocate or choose providers on execution quality alone. It is an interesting stage in the industry. Everyone talks about algorithms but actually the service level is much more than that: you have to write a good algo and keep re-writing it, for instance.

You cannot write an algo only once and leave it at that.

There are constant evolutions that you have to take in account. Moreover, our clients tell us that it is the overall service package that counts. That means they ask us: is the algo reliable, for instance? Did it go in easily? Was I educated properly on it? Do I get the right kind of support when I am using it? Am I going to get follow up? And finally, am I getting introduced to new products? It all adds up to the fact that the overall decision is still very much based around the people you trust to provide you with a good job.

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CHRIS MARSH, head of AES trading and development, EMEA, Credit Suisse CHRIS MARSH: I would like to add that the bar in this

space has been raised. Being in the algorithm game, say three years ago, was less difficult and less resourceintensive than it is now; and is only going to become more difficult and resource intensive as the markets evolve. This will change the concentrations of flow, as it becomes a volume play in part, and only the brokers that invest heavily will stay competitive. Moreover, regarding the value proposition in terms of algorithms, there are of course clients where the overall relationship is the most important. However, there are others where the focus on absolute returns and costs is unrelenting. In those cases, costs and slippage do actually take a much higher percentage of the relationship than almost anything else, and the search for the best provider is ceaseless.

SCOTT: Just to state the obvious for a second. If there was an initial goal of: does algorithmic trading really add value? Does it introduce efficiency? The answer is yes, it does introduce efficiencies. One might possibly achieve a similar outcome in certain circumstances with a floor of one hundred traders, but you can do it now using electronic execution. The other aspect is that it reduces the variance or the volatility around the average, so individual traders can on occasion do a good job and even a better job. However, they will have greater volatility around the average. I would also note that it does vary across markets. There are certain markets where I would perceive it would be extremely difficult to execute manually nowadays, in that that they are highly electronic and therefore you need these tools to help access those markets, for example Germany.

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CHRIS SIMS: I am not sure how many algo providers there actually are. If you said three, that is probably a bit too low.

However if you said ten that might be verging on the top of the line and why is that? Is that because of the large amounts of investment that are required in order to provide a useful service? I am not sure. Alternately, it is misleading to say that you are only going to take algorithms from the brokers that you have historically done a lot of business with. However, they are possibly the only people with deep enough pockets to actually do the building to give you the algorithm that you are going to use. I am not seeing our traders showing any interest in some of the start up companies providing an algo, which is not the way that the business is going at all. Nor am I sure that we are seeing much in terms of offerings from the wider sell side, developments seem to be concentrated more and more on the top ten and then within that, as Tim might suggest, a few.

RICHARD: That is absolutely the point. We keep track of everybody offering algorithms and it is around 60 globally and I would say that there are ten serious players who are making significant revenues out of it. Moreover, there are maybe three that have the quantitative trading skills that are required in order to then deliver the necessary product and the spend needed to provide it. That spend is in two parts: the first is in expertise, because people with that skill set are expensive. Generally they have to have come from a trading background and they have to have spent a lot of time in quantitative trading. Very often most of our quants have started on our stat arb and volatility business and they then have gone onto developing algos on the desk and using them to trade. The second expense, and by far the biggest (about 80%), is the deploying of the necessary technology to deliver your service with the growth of smart routing being the main driver of these increased costs. If you take the top ten algo providers, the majority develop their own technology for market access, order routing, and all the bits and pieces that are required not just to deliver the performance but simply to make sure you can handle the order flow. The number of brokers outside the top ten that have got smart router is actually very, very small. Unless you have developed it yourself (which is expensive and complicated technology to build) then you cannot provide the kind of product to sweep all the dark pools with the result being that your algorithms are not going to be fast enough to react to the market, thereby giving you poor performance. That must mean that we are going to see very rapid technology consolidation over the next 18 months, into first the top ten and then the top four or five.

CHRIS MARSH: The fundamentals of trading have changed.

It has gone from a low fixed cost, high variable cost model to a very high fixed cost very low variable cost business. Once providers have built all their machines it costs next to nothing to put more flow through it, but getting to that point is incredibly expensive and becoming more so. From Scott’s point that with machines you can do the same as one hundred traders, the real gain is when you double that again — it’s just a few more machines as opposed to yet another hundred traders. Five years ago, if you wanted to talk to a

CHRIS SIMMS, head of investment operations, Gartmore Investment Services

small broker in some country, they probably would have had an exchange terminal that had been given to them with their exchange membership. It cost them very little once they signed up to trade, but once they decided to expand their business, cost scaled exactly with growth. They needed another head, another terminal, another almost everything.

CHANGES IN THE BUY SIDE/SELL SIDE RELATIONSHIP TIM: Both clients and the brokers are starting to understand

the various styles of service clients like to buy. Certainly over the last five years, we have seen a much, much smarter client base who are not quite cherry-picking, but are very selective about which services they buy and from whom. We expect we will continue to see growth in volume around the direct execution space and we also see that certain clients and certain styles of trade will predominate. However, we are not saying that the whole world is going to trade algorithms to the exclusion of everything else.

MIKE: It feels like the algo market has reached a level of maturity in many ways. We are seeing some sell side firms setting up desks specifically to provide advice and monitor the strategies we have chosen on our behalf and trying to add a new level of value added service. We shouldn’t lose sight of the fact that algorithms are just another tool in the ever expanding box and that they should be used as and when it is appropriate to do so. It is ultimately our job as buy side dealers to source liquidity while minimising our footprint in the market. However we do this it is up to us, to ensure that we achieve this in the best way for our customers.

CHRIS MARSH: Along the lines that Tim highlighted, it is nuanced. There are some clients that want the proactive call, want to talk to you while the trade is going on, and would like know your views about strategy selection for particular trades. This looks somewhat like full service broking. On the other hand, we have stat arb players and brokers that are

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buying the connection, the routing and the infrastructure that comes with the larger banks, but nothing else. They want no chit-chat, no research, none of the other services that the bank has to offer and the price that they are willing to pay reflects that. So we already face a broad spectrum of clients today—much like the industry at large does across all distribution channels.

SCOTT: It is quite difficult for the sell side because every client wants a different level of service and I would speculate that every client has a different style of trading. So that is two complications to deal with and therefore it is inevitably difficult to find the balance as we find that the market moves to more automation and reduction in people to match off against the nuances of every individual client.

RICHARD: As the client starts to learn more, they become more independent, they start to evaluate the performance that they get from your algorithms. We also see clients coming to us for risk, particularly on portfolio trading, who then progress to Direct Strategy Access (DSA) and using the algos directly, initially using shortfall and then going to VWAP to do with volumes.The other major factor is the use of commission sharing agreements (CSAs) effecting which brokers an institution wants to use. That is because it has now becomes standard practice for brokers to get paid through DMA and algorithmic trading, whereas two years that was regarded as being off limits. So, internally, we are working much more closely with sales trading, program trading and, electronic trading, which are the three main products strands. You have to look at the big picture when reviewing how the account is doing overall, as increasingly the way research and sales coverage is paid for is dictated by the services a broker offers.

LIQUIDITY, LIQUIDITY, LIQUIDITY TIM: One of the key questions our clients ask us is about crossing rates. They look at the crossing rates as a whole, they look at them by index, and they look at them by market.

We are pretty proud of our internal crossing rate, and that says a lot about the type of liquidity we have in the pool, it reflects the type of clients we have and do business with.Yes, liquidity is a key differentiator. Not everyone cares about it though. Nonetheless, it is becoming increasingly a topic of conversation. So, at the end of every night we provide some rather complex analysis around how much we crossed; and if you trade with us, you will see on your fills this one crossed, this one didn’t. Of course, now, with post MiFiD smart order routing, we are also providing a breakdown showing how much in Chi-X, this much in Euro Millenium, or wherever the trade was undertaken.

MIKE: I would like to ask some questions of the sell side here. Do you have any control over what you goes into the dark pools? Do you keep anything out of it? I ask because there are occasionally questions on the quality of business that is actually within the dark pools.

TIM: Yes, we are pretty strict about that.

MIKE: Does everything go in?

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TIM WILDENBERG, managing director, head of direct execution services, Europe, UBS TIM: Absolutely, yes. Assuming our clients want it too, of course.

CHRIS MARSH: The way that we approach this at Credit Suisse is to make it as inclusive as possible, with the realisation that there are certain clients who view some flow as toxic. So, we give them the choice to not cross against particular styles of flow. You could come to us and say, “I do not want to trade against proprietary flow”, or“I am only willing to cross at mids or better”.Well this is your right, and it is just a box to tick as you sign up to Crossfinder. Basically we allow you to put boxes around how you trade and who with. On the other end of it, we continually monitor for abuse or trades of discovery, and can place fair value calculations around the prices that we leave in the system on your behalf to reduce negative selection. But within that context, our view is that as long as we do our jobs properly then you should be able to trade everywhere, swim with the sharks in the pool on their terms and still get good fills.

MIKE: We are now looking at dark pool aggregators on my desk. If we place a trade through your systems which scans liquidity pools other than your own, how are you going to vouch for the quality of business as obviously you do not have any control over these?

CHRIS MARSH: Well we do not have control, they run their own show and are subject to the regulators in their own right. However, if we see negative selection or if a client has suspicions then we can approach the venue with questions or in the worst case just switch them off. If we have access to pools A,B, C and D, its very easy to say hold on pool D, I do not want to trade with them, because they have flow that I do not want to interact with. Well, okay that is your right, and we will very quickly switch you off of pool D. But with our ability to protect trades with fair value calculations, we don’t actually get many requests like that.

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RICHARD HILLS, head of electronic trading services, corporate and investment banking, Société Générale MIKE: I’m not trying to make it sound like we are suspicious of everyone in these dark pools. Ultimately we just want to source that liquidity wherever it may be and achieve our trading aims. Nonetheless, these are important questions that are being raised from my peers on the buy side.

CHRIS MARSH: Absolutely, in the institutional space it is a very widely held concern and the thinking is to source liquidity from other naturals and avoid the stat arb type players, which are generally viewed as predatory. But stat arbs and the like provide a lot of liquidity to the markets, and the liquidity seeking algorithms, such as Guerrilla and Sniper, have as one of their basic elements the ability to source from these very savvy, intelligent players on their terms. If you can do this, then you can use their shares to your advantage while protecting yourself at the same time.

RICHARD: There are two levels to that. One is just looking into the future and the exchanges do worry about the whole threat that is posed by the MTFs. If you look at Euronext Paris, with their crossing service, to my mind, that is ideal solution. We want all of the exchanges to respond in that way to maintain liquidity concentration, it is no coincidence that most of the liquidity that is available and the volume that is going through Chi-X is from the LSE, Amsterdam and Germany. The benefit of the Paris model is that flow stays lit, the market remains transparent and is not so fragmented, which, by the way, goes against the consolidation trend, because it is easier for the smaller brokers to place their liquidity upon the exchange and for their clients to gain benefits from that liquidity. This is a big benefit, as we see an average crossing rate on the CAC of 15%, that is going up all the time. We have seen days when it is as high as 40%, so that it is clearly of benefit for the exchange to do that. If it went through a dark pool or an

internal market belonging to a broker, it would not be visible to the rest of the market. We are looking at our plans with our internal markets which is due to launch later on this year. We are looking very carefully at what that means for our client base, particularly for DSA trading. There is no question that DSA needs to sweep all liquidity pools. In the US we see a lot of liquidity on some pools, however towards the tail end they are really mere dark puddles, and there is minimal value in having to sweep 13 or 14 different venues and then coming back to the start with nothing.You end up losing time when you had rather be up in one of the more liquid pools. So we need to see, particularly in the European market structure, how things will evolve, over the next 15 to 18 months.

CHRIS MARSH: I would have to disagree with just one point concerning the latency cost of sweeping these pools either in Europe or the US. In our view the latencies on the primary European exchanges are unacceptable. I agree that if the latencies of all of these new MTFs and dark pools were on the scale of Euronext, say 50 or 60 milliseconds, then it is completely impractical to sweep 10 of them as you will then have wasted half a second on many potentially empty pools.

However, the market comes up with solutions to these things and the reality is that the latencies are between five and 10 milliseconds. So you can actually check ten of those pools and return if there are fills in less time than it actually takes to go to Euronext a single time. Within the next year in the US, the expectation is that the going speed necessary to stay in the game will be below a single millisecond, so you will be able to search out 50 of these places in this time, and we already have MTF’s in waiting that are stating they will be roughly the same speeds here in Europe.

TIM: Don’t you think though that a lot of the latency discussion in the States is because there is a lot of co-hosting among the exchanges? Many of the physical locations of the exchange machines are in the same place, so people are getting the sort of sub-five millisecond access while parking their co-hosted server in the same data centre as the exchange crossing engine. In Europe, you must not forget that there are different exchanges in different countries and what ever happens there has been a natural latency between London and Paris.

CHRIS MARSH: I absolutely agree with that, and MTF’s are starting to locate boxes in and around the City of London for speedy access to the City. But we measure these exchanges all the time, and we see a step change in the new MTF’s latency versus the more established exchanges. They’re not just slightly better, but more like an order of magnitude and this cannot be explained by distance alone. I was speaking to Chi-X this morning concerning speed, they are in the region of five milliseconds now, and we were discussing that despite the fact their message count was reaching LSE levels, they were still between four and five times faster round trip.

It is these kinds of things that is going to change the market, and as it becomes more competitive and as more people enter the space the market will only get better, faster and more efficient.

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FRANCESCA: Scott, what’s important to you? Latency or

liquidity, or both?

SCOTT: I think it’s neither. To start with, I do not think that liquidity is everything, for example, an active investor thinks that they have an idea and that that idea will start to realise return immediately. If that is the case and all you care about is your execution then you would access every pool at the earliest opportunity and then when you had filled your order you would look at what impact you had incurred. However, the fact is that realising returns does not happen straightaway and you cannot fill an order straight away therefore just accessing every pool is not in the bottom line interests of the investor. Similarly on the latency point: from the institutions represented at this table, we are talking about investing millions if not billions, we are talking about transaction costs certainly in the millions. There are bigger issues to consider than the fact if something occurs within one millisecond or two.

CHRIS MARSH: In some aspects I completely agree with him, there are of course larger concerns in investing than just the latencies on the exchanges. However one thing that needs to be taken into account is that what we are seeing is a structural shift in the way the markets present themselves.

We are moving away from an era of national monopolies to one of an overall highly competitive space. This creates a lot of things, latency being just the start. The ability to trade in multiple venues then derives from this, so you can access everything without restrictive delays in time. With that, you get competition, you get cheaper prices, and you get innovation- all of this on the exchange level. So you start to get flow and models that might otherwise not be profitable and that deepens the liquidity pool which everybody can use to their advantage. We have seen this in the US, where the overall volumes have marched up monotonically while the European marketplace has remained more or less flat – excepting spikes at the end of the summer and the beginning of this year. More volume of course leads to lower transaction costs, lower implementation shortfalls and better performance for the end investor. These are all big wins, and we consider it our job to harness them for our clients.

TIM: There is a reason for that. If you wound the clocks back to a year ago when you didn’t have so much market fragmentation in Europe or multiple trading venues, at that time people who spoke to me about latency were the stat arb traders. Regularly we would get some guy who would back his truck up and plug it all in and test us in real time and do all the ping tests and everything and look at it and make a buying decision based on our latency. However there were not 150 of those guys. That is quite a niche play–even still now. Still, HiVolume DMA is a pure execution service in its own right and is still relatively niche; it is the algorithmic trading models that are generally taking over the wider market and the market is changing rapidly in that regard.

However, it used to be that only DMA specialists really cared about latency. But while Chris or Scott or Mike do not think they care about latency, what they do care about is that our machine is quick enough to catch something on their behalf

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if there is an opportunity on one of any number of exchanges that we smart order route to, and that is where the latency stuff matters.

CHRIS SIMS: I would agree. Equally to get back to technology budgets again, we are always going to be going through the brokers’ system. The primary source of latency will be us communicating to the broker systems.

TIM: While there is a human trader managing the order who is pressing a button then latency is largely irrelevant (provided it is quick). A human simply does not understand whether it was one second, half a second or a millisecond: these differences are invisible to the naked eye. The people that did care before were people who had machines measuring Latency and as I say they were the stat arb guys, However now in a fragmented marketplace it becomes important as people now have more to decide: e.g. do you go first to Chi-X or second to Chi-X. Which market to try first?

Latency means that if I can get to market B three times before I have to go to market A, then I might as well go to market B. Or, while I am getting to market B, I might as well try market C, because I might find something I didn’t know was there.

CHRIS MARSH: There is something equally important to add to that. It is not just getting there, but also knowing about where you are most likely to get good fill—be it looking at the products themselves, or looking at the flow patterns of individual stocks- that goes part and parcel of this whole game. Although it behoves you to be as fast as you can so that you don’t miss price points, if you go to the wrong place all the time, well then speed is not so important.

You could have a slower machine if it goes to the right place first every time. This is the basis of the AES heat map technology which we place around every order we send out; we note the most active destinations, and preference our intentions there.

SCOTT: It is possibly a micro versus macro question. One thing I would contest is that if there is a participant on a venue that starts the day with no holding and ends the day with no holding then interacting with them won’t necessarily reduce my transaction costs. That is on a macro sense. On a micro sense, our counterparts are going to feel it necessary, from a best execution perspective, that wherever the lowest prevailing offer is on a buy order, that they must access that. It is different alignment.

CHRIS MARSH: As we discussed earlier, every buy side client has their own individual needs. As a sell side institution if we do not ultimately fit a suitable solution, be it delivering liquidity, customising an algorithm or giving high levels of service pre, during or post trade–basically keeping them happy—then they will take their business elsewhere.

That is relatively straightforward and relatively unchanged from say, trading ten years ago; a new take on an old game with identical goals. The institutions want to buy some stock and at the end of the day they want to have a good feeling about the trade, because the price was good and the service was good. Our goal as these markets are changing is to make the transition as seamless and as painless as possible.

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We’ve seen it coming and we know it can deliver a lot of benefits, but it isn’t without costs hence our concerns.

Ultimately then, these are based around the vision that if we do our job correctly, we can deliver all the benefits of the ensuing chaos while masking all its problems and shortcomings. Clients will be able to see and transact with all markets, they will have deeper liquidity to access, and they will better be able to mask their trading intentions. And all this without the worries that we will contain within our desk: fragmentation, latencies and making sure we access correctly all the pools where liquidity resides.

MIKE: At the outset, it was very much a case of here you go, these are our offerings, good luck! Now the buy side has been empowered such that we can state our requirements and pretty much expect them to be delivered. Relationships are ever more important especially with the unbundling of commissions as we are all now looking to the nth degree at how much money is spent servicing clients. We need to utilise every part of the buy side/ sell side relationship to achieve both our aims.

HELPING THE BUY SIDE WITH TECHNOLOGY FRANCESCA: How much is technology involved in this process of osmosis of expertise across the table from the sell side to the buy side, so that the buy side can now take your service for granted?

RICHARD: That is fundamental to the service that the sell side offers. The most extreme example is the sell side providing a network of memberships of market access and a technology platform that is well supported and reliable. For the stat arb house that is absolutely perfect. They will deal with the investment decisions and the trading styles. At the other end of the scale, we need to be able to leverage the other assets that we have, the liquidity provision is the most obvious one. However, portfolio trading which we have not really talked about today is very significant. To put some data around it, we are doing 85% of our portfolio trading business both risk and agency through the algos, this figure we think is about optimal, I do not think it will go above that because there is usually always 15% of flow which is about small and mid caps, stocks with news, where we have blocks come up and we will take them out of the algorithms and give that benefit to our clients, so all we do ultimately is client related.

The 15% of the added value is where we are bringing our trading expertise which tends to be quite market focused, sector focused, and we are allowing the buy side desk to leverage our expertise almost on a temporary basis. If you have a big portfolio, we are taking part of that off your hands whilst you focus on what you really want to concentrate on: perhaps by responding to IOIs or talking to a sales trader, or using DMA pipes. I have noticed though with the sophisticated buy side, that they will use all of the tools interactively throughout the day. They will have TCA decision support tools helping them with the decision on which pipe to use at which moment, and that will vary

throughout the day and is best practice if you like. The broker on the other end has to be able to handle risk trading, facilitation, sales trading, DMA, DSA, all of the above in a consistent way on a consistent technology platform.

TIM: The key is that, especially for sophisticated institutions, for some reason clients still do not want to trade with just one broker. So, as a result, they want technology that allows them to communicate with more than one broker. Moreover, they do not want a system from me and a system from somebody else—because that is a bit of a pain—and they also want their solution plumbed into their infrastructure. They want it to be seamlessly driven and it is better for them to control that technology. They do not want to get me building their internal infrastructure, as much as I would love to do it obviously. They want me to be their execution provider, or their research provider. In my view, it is a healthy development that they drive their own technology to suit their own needs.

CHRIS SIMS: Our primary technology focus is automation, removing manual intervention. It’s about workflow from the fund manager to the dealer from the dealer to the broker, out to the back office, then back to the front office, real time positions, and adjustments for events. I do not think that there are many buy sides in the same space as us that are spending money on the same technology that UBS, CS and SG are developing.

SCOTT: I am not sure exactly what alternative technologies refers to, however, I presume you mean that they are something that we can utilise to develop our own algorithms, I would then ask: why would you do that when you can access the broker sponsored engines for relatively low commission rates? You could purchase and develop this technology to route orders but if you are not an exchange member you still need to route via an exchange member.

Also, one must consider the need for smart routing technology to route appropriately across different venues, all this will require a commission. So I think you are looking at the differential between the direct market rate versus paying for use of an algorithm, and once you take into account the data that you would have to manage and cleanse and harvest, I personally think it is very difficult for the vast majority of investors to justify that sort of expense.

CHRIS MARSH: It is becoming more expensive as well, this comes back to the discussion earlier about the economics of the game now becoming high fixed cost, low variable cost. If you spoke to buy side institutions five years ago, most of them would have said, “We are going to build our own algorithms,” and five years ago it would have made sense.

The markets were simpler and the algorithms were simpler.

However going forward, as algorithm complexity increases, the investment required increases and the comm rates fall, people are re-evaluating the choices they made five years ago and actually taking the opposite view.

TIM: There is a market change going on and in certain of the execution spaces, it is clear that maybe today it is six, perhaps ten serious players. However that number has to contract. The point is, that it is no longer about people

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fighting to get 4% or 5% market share. The point is that you have to be coming up with 25% market share to justify the investment. However, I stress, not across all execution channels, just in certain niches. If we have already got brokers coming to us asking:“can I rent your technology to get me smart routing?” or even just simple pipes into exchanges, over time, I can see that fragmentation says there will be market access providers and there will be execution providers and these might even be different people. Then there might be brokers, which might be a completely different thing: execution advice providers, or liquidity providers for example. Then again, maybe an execution advice or research providing broker will line up an access provider and an execution provider, or other firms, just to provide his overall service RICHARD: I am not sure. Just to provide something to argue about. This has not been the case in the US has it? We have seen very specialist algo providers coming up.

CHRIS MARSH: But have they taken serious market share?

RICHARD: Well, cumulatively, if you took your argument then you would say that the market would shrink down to two, three, four maybe five players, given where the current players are in terms of investment. However in the US that has not happened and there is still quite a large number I would say—probably 20, 25—who have taken significant volumes. Yes, Europe is always going to be behind the US. However, that has not happened in this case, there is still a great deal of choice for the investment side and they can choose more people who can give them a good algo service.

TIM: Will all algo providers give good service though?

RICHARD: The issue is where that liquidity lies, because liquidity will consolidate, and if the exchanges do as Euronext Paris has done and respond to the threat, then that will be less of an issue. However, there is a very significant problem about consolidation if everybody is going to the key three or four liquidity providers. That is a less transparent market and makes the investment community dependent on a much smaller group of players, so I would hope that with the landscape changes it remains competitive.

DEFINING BEST EXECUTION MICHAEL: What is best execution? Best execution has always been covered by a broad range of factors but MiFid has brought a process and some more specific definitions into play.

There are still several various factors to take into account and we also have to include specifics such as likelihood of settling a trade.That is because it is no use getting the best price in the world, whether via an algo or whatever means, if we cannot settle a trade. In all honesty nothing much has really changed and we will continue to do what we have done all along.

TIM: We have seen that MiFiD has given us some guidance.

It has become much more about needing to show or demonstrate a process, than it is about checking three places for a single order and this is the best bit. It is about consistency and it is about how you demonstrate you had a logic to the way you traded.

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SCOTT COWLING, European head of trading, Barclays Global Investors (BGI) CHRIS SIMS: It is a process and we have to demonstrate

that we have followed a clear defensible process.

CHRIS MARSH: Even before MiFiD most firms were

demonstrating best execution. Before it was codified, it was simple cases of letting the market decide. If you gave best execution and you did not feel that between the buy side and the sell side that you did not fulfil best execution then the business would go elsewhere. And largely, in that sense, there are still TCA tools and it is very similar to what we were using, six , ten, twelve months ago: where you look at various benchmarks and whether you are having difficulties in settlement; or whether you are exhaustively looking to find out where the best price is on an individual and micro basis.

It is no good if you say I found the best bid and I found it in the best venue if at the end of the day you have missed VWAP by 15 basis points because you traded fundamentally incorrectly throughout the course of the day. So that for all the discussion around it, it has been similar to the way it has always been.

SCOTT: I completely agree with Chris, nothing has changed. It has always been in everyone’s best interests to achieve best price. Tim alluded to the fact that today it is now a formalisation of the process. I also note that I believe it is a holistic thing, as opposed to applying to every child order. Best execution to me is about maximising the wealth of our clients.

CHRIS SIMS: Again getting best price is what you want to do. However the temptation to label all the buyside organisations of a similar size in the same way, is not the way to go. You can reel off the names of similarly sized

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organisations to as Gartmore, but the way that business is transacted is entirely different. And a lot of the TCA offerings that are pushed towards us are based on a rather traditional approach: investment decision by fund manager, off to the dealer, off to the broker, gets filled and you’re done. It’s too simplistic.

THE IMPACT OF GLOBALISATION TIM: Most of the big sell side are structured to play the

global game. Clearly in those terms, our business has always been global, the largest trading house for global equities in the world, and some of our clients care about that and do business with us in every region because some of our clients are t themselves global consumers if you like.

However, some of our clients are entirely focused on Europe, the UK, the US or wherever it is and they do not care about globalisation. There is a sub set of our client base (and typically they tend to be the ones that pay us the most and have most assets under management) who do care about the global client experience if you like. Certainly, therefore in the algorithmic and DMA space it is a challenge making an offering available in multiple vendors that can be applied to multiple client desktops. Doing that globally adds another level of complexity. It comes back to high fixed costs and how many players will enter the game.

Doing that well is a major, major challenge. To be able to get such a point that you have a common set of algorithms that are available in every market in the world where someone might want to trade algorithms, is another level of difficulty entirely. That is because they work in such a way that you can’t take a copy in America and then paste and run it on some hardware in Asia. Essentially we have to ensure that the customer always experiences a high quality offering. Yes, you get your core ten or twelve algos and maybe you get two or three specific regional ones, which make a load of sense when you are trading in one market but make no sense at all when you are trading in another. Irrespective, the core ten have got to feel, that they are trading the same way wherever they are trading, but for that to happen they have to be built and work in different ways. That is a massively complex piece of work and again, it plays to the fact, highlighted earlier in the discussion, that there are not going to be 60 providers in this space over the long term.

SCOTT: If we start with developed markets, many investors in London will have a UK or perhaps panEuropean universe and if you are using algorithms you would ideally like to access every market in the developed European region. However I can think of several cases where algorithmic providers do not currently offer electronic access to Ireland or Greece. We electronically access cash equity, futures, and foreign exchange markets right now and I would be very confident, commodity markets, this year. I think the concept of true cross asset trading is some way away for the majority of firms.

RICHARD: Asia is interesting; the market structure itself,

does not lend itself to electronic trading anywhere near as much as Europe or the US. So, we have big tick sizes and wide spreads, and that doesn’t go towards algorithmic trading. There are also fewer brokers than Tim said. He thinks five, I would say four. The benchmark that we are using is a percentage of the spread as a way of measuring cost, because the spreads are so wide it is a much more effective measure. If you look at some of the advantages of algo trading there: you have the midday close in Japan; no close in Hong Kong; and you have short selling to take care of. Algos can screen you from that, without having to worry about it, which comes back to the efficiency argument.

However that is where particularly US investors are looking to capture alpha out of the Asian market. This is a hot topic for them and it will really drive the electronic trading industry in Asia even although the market (in terms of its micro structure) might not ready for it yet. Likely, it will be driven as much by workflow as anything else. Coming back to Tim’s points, is that algo providers have to develop specific algos for Asian markets. They all work slightly differently. In India, for example, there is very little algo trading going on with pioneer products currently being launched by the first players. These have to be developed on a local basis, and then kind of packaged up into a global solution.

MIKE: We are all trading globally and we need to make sure the strategy we decide upon is the correct one for that particular market at the time of trading. In terms of Asia, I read the other day that Asians typically save 40% of their earnings, while in the UK it is 2%, so obviously there is a massive untapped market out there and we will look forward to developments with interest.

CHRIS SIMS: We do everything globally on the electronic side and have done so for years. I would agree with Tim, the number of brokers with properly wired up plumbing, never mind the algos, globally, is very, very few.

RICHARD: Is that four or five?

CHRIS MARSH: Not even as many as that. Being fully globally connected even causes us problems on a regular basis. What people think of as just the basics are in fact very complicated when you scale across the planet.

TIM: The whole package is very difficult to put together and global order routing, anyone who says it is easy does not know they are talking about. It is massively complex.

CHRIS MARSH: And getting more so: we are forcing maturity on a lot of markets that you would not have expected to come into play so quickly. For example: DMA and algo trading into Eastern Europe is now a reality, we can access South Africa and it is feasible to see electronic trading next year in Russia, the GCC and Latin America. In multi-asset class trading it is the same thing: FX, futures, and options are a reality today. It is not widely disbursed though- if you think there are four banks that do global routing in equities, this number is even smaller. However the technology will spread a lot faster than people give credit, and it will show up on everyone’s desks altogether sooner than they think.

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IN A BIFURCATED WORLD Photograph kindly supplied by istockphotos.com, April 2008.

Approximately one-third of all institutional equity transactions are dealt via a portfolio trading strategy. As the global investment market has changed in complexion and gained complexity, portfolio trading has entered a bifurcated world.

At one end lies a community of ultra-sophisticated buy side traders who utilise the full breadth of available portfolio trading services and constantly test the limits of the sell side offering. At the other is a community with more vanilla requirements yet requiring as much customised and client-centric care as the first. Even for higher end, high touch clients, the blunt facts are inescapable: the need to trade seamlessly and ever-rapidly in multiple venues, geographies and asset classes means a continued dialogue with the sell side. Where will this burden carry the bulge bracket investment banks going forward? Francesca Carnevale goes in search of some answers.

HE ERA WHEN portfolio trading principally hinged on more or less predictable portfolio rebalances for index or long-only investors is now, for some, the stuff of dim sentimental reminiscences. While trading flow remains buoyant, in fact refulgent, programme trading is increasingly part of a wider service offering by bulge bracket trader/dealers anxious to keep pace with a fragmented and diversified marketplace, cradle to grave

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technology and a growing sophistication and market knowledge among their key clients. As Simon Bird, head of portfolio trading at Bear Stearns in London explains,“The business has always been a mix of rebalances and liquidity plays. In the past index funds were big users, whereas now there are many more pseudo index plays, where an investor might track but not hold all the constituents of an index.”

While rebalances have by no means disappeared from the lexicon of portfolio trading, these days the specialisation encompasses, much more. In particular, it has cemented its role as a cornerstone of the transition management offering; for both high end and more passive players.“ Passive index investing was always a smaller piece, although it remains a key element of the business,” notes Bill Stush, head of transition management at Merrill Lynch in New York.

“However, a significant and growing component are active and quant shops. More and more we are seeing $1bn quant rebalances or portfolio transitions where clients now require a sophisticated set of trading tools.”

Likewise, at BNY ConvergEx, portfolio transitions provide a growing source of business: “with a great deal coming from the transition space,”says Anthony Blumberg, president, BNY ConvergEx Global Markets. As the make up of investment portfolios changes, it is also adding to the changing contours of portfolio trading as a service specialism: says Blumberg “Increasingly, it is part of the overarching trading environment, though it is more diverse and complex, because of the wholesale nature of

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play: “In the US clients are the business.” As Jeremy more apt to use algorithms Baxter, head of portfolio themselves and trade on trading at Instinet, their own, but that may be a explains: “each client has function of the fact that his own strategy, and so algorithms were adopted the service increasingly here first.” Blumberg ranges from high touch concurs:“It is the same with trades to DMA and from dark pools, it is much more ready made algorithms to far-reaching; it appears that bespoke offerings.” more players are accessing Portfolio trading, says them in the US than in Blumberg, like all other Europe,”he says. specialisations in electronic Another key development trading is benefiting from is market concentration. rapid change in the This has two effects.The first overarching trading is the gathering of business market. Lee Morakis, in the hands of key players: managing director, a flight to quality. The portfolio trading at Merrill second, more challenging Lynch, underscores the William Stush, head of transition management at Merrill Lynch in effect, is that the bulge point. “It is a more holistic New York. Stush maintains that a significant and growing bracket sell-side firms now business these days.” component within the portfolio trading service “are active and quant have to provide a farAmong the plethora of shops. More and more we are seeing $1bn quant rebalances or reaching service, from cross trends, stresses portfolio transitions where clients now require a sophisticated set of having to determine how to Morakis, a fundamental trading tools,” he says. Photograph kindly supplied by Merrill attract the largest amount of motor of change is Lynch, April 2008. liquidity at the most technology, “which is increasingly differentiating between so called alpha and beta economic prices, leverage technology investments, provide traders”. Alpha traders (which also includes proprietary competitive decision-making and reporting services, provide trading desks at the large investment banks) are mainly DMA services and still maintain their core buy-side/money statistical arbitrage and quant funds, who look for advantage manager relationships.

To accomplish this, “brokers are increasing their service in individual trades and who require (and sometimes write their own) algorithmic and direct market access (DMA) levels to their best clients and developing value-added tools. For this alpha group, low latency and unfettered access execution technologies,”says Instinet’s Baxter. Trading is not to multiple trading pools are buzz requirements. According an easy task, and “the enormous fixed costs involved now to Ary Khatchikian, president of Portware, this segment will means only a handful of banks can be in the scale business only increase in importance. “The buyside are investing in and are able to stomach the spend,”acknowledges Ken Kane, hiring quant and algo traders. As the buyside demands more managing director, equities at Credit Suisse in London. The control and invests in technology that provides access to a consequences have been dramatic.“It has put a squeeze on multitude of brokers, alpha traders will gain much more the smaller banks who have found it increasingly difficult to compete in the space,”he says, adding that the bank now also flexibility and choice,”he notes.

Beta traders on the other hand, look for low cost trading. has“clients who are in fact small brokers. ”That drive back to the bulge bracket houses continues to On the whole their trades are large, linked to specific portfolio requirements and sometimes take liquidity from refine the role of portfolio or programme traders. Recent market the market. For this group, technology appears to have a volatility, growing demands for best execution, ever lower lower priority, though the sell side might and does argue latency and invisible trades are among the latest requirements differently. According to Richard Hills, head of electronic for portfolio traders. These requirements have resulted in a trading services, Société Générale Corporate & Investment dramatic increase in the interpolation of cradle to grave Banking (SG CIB),“asset managers might say that latency technology into the trading mix; allowing buy and sell side new and ease of access to multiple pools of liquidity doesn’t options in approaches to the market (DMA, DSA, white and matter, but if the ease and quality of service across the black box algo-trading); new and easier access to pan-regional trading venues and stocks, improved reporting and the board is not there, they might soon think differently.”

Morakis outlines the parameters of the franchise: “While development of a complex interdependency between buy and portfolio trading and algorithmic trading are separate desks, sell side as the overarching market evolves to the next stage.

The buy side continues to raise the bar acknowledges they are managed together. Algorithms have become tools for most traders, even those with a strong cash focus.” Kane. The diversity of investment styles and growing However he adds, that there is also a physical element in complexity in the trading market per se requires a superset

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of technology, expertise and reach“that few sell side houses can supply,” he says. There are other considerations also.

The decline in commission rates and growing adoption of commission sharing agreements (CSAs) to consolidate commission dollars has compacted the drive back into the arms of the bulge-bracket brokers. Although pressure on commission rates will not cease, the Boston based TABB Group in a recently issued report predicts this shift from low- to high-touch flow will inevitably drive blended commissions rates up until volatility declines and the markets stabilise once more.

Another no less important driver is provided by regulatory changes (specifically Reg NMS in the United States and the Markets in Financial Instruments Directive [MiFiD] in Europe) which have facilitated the development of new execution venues. In the US they are referred to as electronic communication networks (ECNs).

In Europe meanwhile, the appropriate moniker is multilateral trading facilities (MTFs). Some of these systems have evolved into alternative trading systems (ATS), where liquidity is reported to reside but cannot be seen with the naked eye. A diverse group of more than 30 of these new liquidity points has further complicated the electronic trading playing field for both buy- and sell-side firms. These new dark and/or invisible pools of liquidity have in turn wrought increased choice to both the buy and sell side to help effect best execution.

A number of rapid fire developments clearly illustrate the newly emerging contours of equity trading. In mid-March NYFIX, the financial transactions processes designer, launched Euro-Millennium, a dark pool for pan-European cash equities. The new alternative trading venue went live in early March as its buy and sell side participants that are members of its advisory board began using the system.

Credit Suisse was the first client to match live trades using its Advanced Execution Services (AES) algorithms to communicate with the dark liquidity venue, according to Chris Marsh, head of AES trading at Credit Suisse. EuroMillennium is currently matching UK equities and will be rolling out the other major European markets throughout 2008. While NYFIX works on rolling out matching in the other European stocks, clients can also send pass-through orders into Euro-Millennium via direct market access pipes. The new service draws on the functionality of NYFIX Millennium, a dark liquidity pool for trading US stocks, which has been operating for the past seven years. Just as Millennium in the US has the ability to hold residential orders, but pass orders through Millennium on its way to other market centres such as DOT and NASDAQ, EuroMillennium has the same functionality set. In addition, NYFIX struck a deal with SWX Europe (formerly known as Virt-x) last year to act as the dark pool for Swiss blue chip securities and that is slated to be launched later in the year.

The dark pool will be operated by SWX but powered by NYFIX Euro-Millennium. Buy-side members include: Allianz Global Investors KAG, Baring Asset Management, JPMorgan Asset Management, Schroder Investment

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Ary Khatchikian, president of Portware, the portfolio trading segment will only increase in importance says,“The buyside are investing in hiring quant and algo traders. As the buyside demands more control and invests in technology that provides access to a multitude of brokers, alpha traders will gain much more flexibility and choice.”

Photograph kindly supplied by Portware, April 2008.

Management and Resolution Asset Management, while its sell side advisory board members are BNP Paribas Services, CA Cheuvreux, Citi, Credit Suisse, JPMorgan, Merrill Lynch and UBS. NYFIX now competes with a slew of new trading venues, such as Instinet’s Chi-X, Liquidnet and ITG Posit while the much anticipated Turquoise, is scheduled to become a player later this year. Gearing up for its launch in September this year, Turquoise, is a multi-lateral trading facility set up by nine European investment banks. Most recently, it selected Stockholm-based Neonet's XG Market Data software as a source of real time data form the various European equity markets. Neonet is a direct market access agency broker that has been expanding its memberships to European and Asian exchanges. Neonet will provide public quotes, private equities and bids and asks to Turquoise, while Neonet’s XG Market Data will be used to conduct analysis of transactions as well as detailed trading information.

In early April, Chi-X Europe Limited marked the passage of its inaugural year as the first, pan-European equity MTF. Launched at the end of March last year by trading, clearing and settling the component stocks of the AEX25 (Dutch) and DAX30 (German) indices with the help of Fortis’ European Multilateral Clearing Facility (EMCF), Chi-X Europe has now added the FTSE 100 (British), CAC 40 (French), SMI20 (Swiss) and OMX Stockholm 30 (Swedish) indices, which it says represent Europe’s most significant markets by volume and turnover.“It has been an encouraging first year for Chi-X Europe, as we have established ourselves as a significant alternative execution venue for European equities,” says Tony Mackay, chief executive officer of Chi-X Global, a holding company for Instinet’s Chi-X platforms. Chi-X boasts a year in which its market ratios have steadily climbed, achieving a peak market ratio volume of 13.18%

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providers are moving on to of total trading in the next generation of FTSE100 stocks on the automated strategy 13th of March this year. implementation, brokers are Similarly it achieved racing to develop cross6.82% of DAX30 trading multi-currency asset, the next day. platforms with sophisticated More latterly, BATS execution logic in response Trading has its revealed to market events. plans to enter the European As the industry looks to equities market, having reduce its overall risk formed BATS Trading exposure, portfolio-driven (Europe). The Kansas-Cityalgorithms also will be hot based operator of BATS in 2008, according to ECN said it will target live Morakis: "Algorithms trading on the European looking to aggregate baskets platform this year. BATS of stocks and correlations said has already selected a between them and between data centre in the London sectors will be key.” area and plans to release Moreover,“Most algorithms details shortly. BATS will be are still somewhat singleco-located in the data stock-based," he explains facility with numerous Anthony Blumberg, president, BNY ConvergEx Global Markets, says and though he other trading firms and that as the make up of investment portfolios changes, it is also adding to acknowledges that there are market centres, according the changing contours of portfolio trading as a service specialism: only a few portfolio-based to the release.

“Increasingly, it is part of the overarching trading environment, though algorithms in the market, To this cocktail of it is more diverse and complex, because of the wholesale nature of the “there still is not a critical venues should be added business.” Photograph kindly supplied by BNY ConvergEx, April 2008. mass of successful options the rise of the internal crossing networks provided by the bulge bracket broker in this area”. Moreover, in today’s current market volatility, dealing firms. “Broker-sponsored internalised liquidity we’ve noted substantive changes in investment strategies,”he pools and crossing systems are innovating to aggregate adds. “We are seeing many more defensive plays, small cap order flow and deliver deep, well-diversified matching and a growing trend in emerging markets.”

In addition, the bulge bracket trading firms now need to rates along with high levels of trader control,”notes Credit Suisse’s Marsh. BNY Convergex’s Blumberg, thinks that understand the nature and idiosyncrasies of the different the plethora of new trading venues is likely unsustainable pools of liquidity, so they can formulate strategies that over the long term.“We provide access to over 90 country match their clients’ appetite for stealth trading and help markets and 55 separate electronic markets, DMA in all 55, them take advantage of the optimal mix of liquidity points, for customers in some 60 or so countries. But where will we notes Morakis.

Portware’s Khatchikian thinks that the real challenges to be in 5 years time? Probably not in as many trading venues, the portfolio trading community are threefold. The first will that’s for sure.”

TABB Group, the Boston based specialist research house, come as“true multi-asset trading develops, where you have also believes that by 2009 the delicate balance between fixed income alongside the trading of equities,” he says. increases in trading volume and revenues paid for sell-side Additionally, he thinks, the future will be increasingly alpha-generating services will stabilise, with fewer players in defined by the buyside, as “it seeks greater control over its the arena and clarity in the true competitive valuation of trading decisions.” The final challenge will be in place services. “Those delivering service, value and liquidity will when the buyside has the same connectivity to exchanges capture the lion's share of an increasingly global execution and the range of dark pools that the sell side currently business. There will not be 40 dark pools in 2009, the number enjoys. That will be interesting,”he smiles.

Société Générale’s Hills summarises the movement: of exchanges worldwide operating as stand-alone businesses will decrease by at least 20% and a number of global platforms “These days it is really about delivery and choice. Our job will emerge. Further, the average number of executing brokers is to see that our client is linked to the right execution will fall by 25% or more and the number of idea and research channel, be that cash equities, emerging markets, algo providers that are able to justify the economics of both an trading; the right pools of assets across x number of time information business and an execution business will drop by zones. It is total service provision, which is all to the good of the client. It is easy to talk about, but not easy to provide 40%,”predicts a recent TABB trading report.

For the time being, portfolio trading providers are living and so it remains to be seen how many of the buy side with the results of current market volatility. While algorithm houses can continue to compete in this space.”

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BACK TO THE FUTURE: The automated trading market would dearly like to break one of the laws of physics governing the time taken for electronic messages to be sent along a wire—the speed of light. Why? The current market focus in automated, black-box trading is on low latency, which effectively can be thought of as the total ‘reaction time’ of automated trading systems to market events. The ability to identify and transact first on an arbitrage opportunity defines the winners and losers in this game. It is a race where first-mover advantage is worth many millions of dollars to the leading institutions, but a race where light speed sets an unbreakable technical limit on how quickly trading can ultimately be done. Brian Sentance, chief executive officer of Xenomorph, looks at ways of expanding accepted definitions of latency.

S WE NOW head from latency levels measured in milliseconds to 100s of microseconds, each improvement becomes more and more expensive to squeeze out. Latency is a key battleground (the only battleground if you listen to many financial system vendors) but automated trading does exhibit other issues that can be crucial determinants of success. The race for ever lower latency is crucial if all institutions are automating exactly the same set of trading strategies. To some degree this is the case, leading to new algorithms being designed to counteract or ‘attack’ other algorithms thought to be used by competitors. Even so, one way of neutralising your competitor’s advantage in reaction/transaction aspects of low latency is to be a first mover with a new trading idea. If nobody else is searching for the type of opportunity you have identified, then the need for low latency is less crucial (other than not capturing the opportunity before it has disappeared!).

Therefore, perhaps another wider definition of latency is the time taken for a new trading idea to be ‘live’, running real trades and positions in the market. The competitive pressure to innovate is endemic within financial markets, and in this way real-time automated trading is not very

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different from its trading cousin in over the counter (OTC) derivatives. New products (new strategies) command higher prices (and earn more money) than commoditised ones, and so there is a real temptation to bring new trading strategies to market as quickly as possible in order to be ahead of the competition. This then begs the question over how best to bring a new trading strategy to market, gaining from innovation but protecting the institution from a‘Wild West’attitude to proper testing and validation of the idea.

Given this pressure to innovate, it can be the case that new trading strategies are released to market without extensive testing. This ‘suck it and see’ approach can only have two outcomes – one that will cost a company money and one that won’t. Obviously constraining position sizes during such live testing will limit losses, but if you are constraining position sizes are you really testing what you would ultimately like to release to market? The obvious answer you would think is to undertake strenuous backtesting of the strategy on historical data, but here we definitely need to go Back to the Future…

The trading paradox You could back-test your algorithm against historic trade and volume data, but if your algorithm was running at the time that the history was recorded, would it not have changed history through the trades your strategy would have made, and hence invalidated the testing you are trying to perform? In an attempt to overcome this paradox, many institutions are paying more attention to order book data (buy and sell requests in the market, some of which become trades, many of which never get executed). By looking at this data, it is possible to getting a better of understanding of how the market may have reacted to the trades your strategy wished to place. But this is still only a model, and it is ultimately impossible to know how the market is changed by the application of your algorithm.

Competitive pressure to innovate will continue to drive new developments in automated trading and its supporting technology, and where this will ultimately take the markets is difficult to predict.

ELECTRONIC TRADING: LATENCY VERSUS MARKET STRATEGY

Photograph © Triggerjoy/Agency: Dreamstime, supplied April 2008.

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Different Strokes The two most immediate casualties of the meltdown in the sub prime credit markets were the UK’s Northern Rock, a mid-sized specialty mortgage lender and Bear Stearns, one of the stars in the US investment banking firmament. The treatment of the two institutions in their hour of need could not have been more different. Lynn Strongin Dodds compares and contrasts their experiences and draws some lessons for the future, should it happen again. It won’t, will it?

Ron Sandler, executive chairman of the Northern Rock in Gosforth, in the British Lake District on the 22nd February 2008. The transfer of Northern Rock to public ownership was completed after Chancellor Alistair Darling signed off its nationalisation.

Photograph Owen Humphreys/PA Wire; supplied by PA Photos, April 2008.

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S 2008 DAWNED, the financial services community was hoping that the impact of the credit crunch would be diminishing. Many expected the government hatchet to drop over Northern Rock but no one predicted that Bear Stearns, the US’ fifth largest bank, would collapse within a matter of days. While the two are different banking species, both were caught in the credit crunch tail lights and the downward spiral of investor confidence. The main difference is that the New York Federal Reserve acted swiftly, while the UK government has been accused of procrastinating.

Jeremy Tigue, head of global equities at F&C Investments, notes,“It took the UK government about six months to find a solution for Northern Rock, which was far too long. I think the Fed learnt lessons from this and it acted quickly before the situation at Bear Stearns deteriorated even further.”

Ralph Silva, senior analyst, European banking and payments at TowerGroup, a global consultancy adds,“One of the problems was that the UK government did not fully understand the severity of the problems at Northern Rock and how to deal with them. The Fed could not afford to let Bear Stearns go under. Unlike Northern Rock, the bank was part of the money supply and when that supply slowed, they had to act quickly. However, loss of confidence was key in both cases. Confidence is critical to the financial system working smoothly and if that disappears, whether it is with counterparties, investment banks, investors or depositors, then there can be painful consequences.”

This was certainly true in both cases although each firm had its own set of specific problems. As Martin Kinsler, financials fund manager at Henderson Global Investors, notes, “Compared to Bear Stearns, Northern Rock is a relatively small, UK deposit based bank. If the bank disappeared it would not have been a total disaster for the country. In fact, if the bank had been sold before the credit crunch, it would have been considered a bite-sized acquisition. However, when people started to take their money out and the queues started to form, the UK government had to do something to stabilise the market.”

Northern Rock ran into trouble when it started to rely on the wholesale markets rather than on retail deposits to finance most of its lending. More than any other large British lender, it relied on securitising its mortgages, which meant it bundled its loans together and packaged them into bonds that it sold to investors around the globe. In January 2007 it raised £6.1bn this way, while a second securitisation in May brought the first-half year total to £10.7bn. At the time it put Northern Rock in the enviable position of being at the top of the securitising chart for a British bank. Then the sub prime crisis blew up last summer and the rest, as they say, is history.

Cracks also appeared at the 85 year old Bear Stearns in July last year when two of its hedge funds nearly collapsed from big positions in securities tied to sub prime mortgages. The investment house had to bail out the funds and take possession of many of their instruments. The firm seemed to regain its composure until this past March when

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British chancellor Alistair Darling answers question in the House of Commons about the Northern Rock crisis on Monday, February 18th 2008. Shares in stricken bank Northern Rock were suspended on the same day after the government moved to nationalise the lender.

Photograph PA Wire, supplied by PA Photos, April 2008.

rumours spread that its coffers were dry. Bear Stearns’ creditors had become progressively becoming concerned about Bear’s exposure to mortgages: not, in fact the sub prime variety, but the highly rated AAA quality homeloans due to a stream of bad news in the US. This included weak economic growth, higher than expected unemployment and a plummeting housing market which led to borrowers finding it increasingly difficult to repay their debts. Although individuals were not clamouring to get their feet into the door, panic ensued and there was a wholesale run on the investment bank.

Neil Dwane, chief investment officer Europe at RCM, part of Allianz Global Investors observes, “What is genuinely terrifying for financial markets is the power of market rumour. Despite being widely quoted in the press and media saying that they [sic] had adequate liquidity and funding, in the space of some 48 hours, many counterparties withdrew their lines of commitment with Bear Stearns, so that by the morning of Friday 14th March, Bear Stearns did have a liquidity and a solvency issue.The most important thing here is the speed with which this all happened. Talking to various contacts within the market, one thing becomes clear; you can get talked into going bust in these financial markets.”

The New York Federal Reserve, which is the largest regional Federal Reserve Bank in the US, could not allow an investment bank the size of Bear Stearns to buckle. At the end of November, the bank had consolidated assets of $385bn. The fear of systemic risk was too great. There would not only have been the losses for those institutions and individuals that had provided $383bn of credit to the different components of Bear Stearns (there was also $12bn of equity supporting all that debt), but the market price for all kinds of financial assets would have collapsed.

This would have caused solvency and liquidity problems at other banks and financial institutions.

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JPMorgan chairman and chief executive officer Jamie Dimon, left, and Bear Stearns president and chief executive officer Alan Schwartz testify on Capitol Hill in Washington, Thursday, April 3rd 2008, before the Senate Banking Committee hearing on the federal bailout of Bear Stearns.

Photograph by Lawrence Jackson, supplied by AP Photo/PA Photos, April 2008.

Equally, as important would have been the psychological impact on an already fragile national psyche. The minute the Ben Bernanke’s Federal Reserve (the Fed) stepped in to provide a temporary lifeline to the ailing brokerage firm, memories of the 1929 crash were evoked. The rescue marked the first time in four decades that the US central bank agreed to provide emergency finance to any financial institution other than a traditional commercial bank.

There had been a precedent however. The US government has, when required, intervened in other high profile cases over the past 30 years. For example, in 1984, the Federal Deposit Insurance Company (FDIC) bailed out Chicago based Continental Illinois, once the seventhlargest US bank, which became insolvent due to bad oil and gas exploration loans bought from the failed Penn Square Bank of Oklahoma. Continental Illinois was also considered "too big to fail," so the FDIC spent $4.5bn to rescue the bank. The government held an 80% stake in the bank until 1994, when it was sold to Bank of America.

During the savings and loans crisis in the 1980s and 1990s, two federal agencies closed or assisted 1,036 institutions hurt by unsound real estate and commercial loans. The FDIC estimated that ending the crisis cost $153bn, with taxpayers paying $124bn. Ten years ago, the Fed organised a $3.6bn bailout of hedge fund Long Term Capital Management (LTCM) because Russian bond defaults panicked markets worldwide. Ironically, Bear Stearns was among the creditors that declined to participate.

Fast forward to today, and the Fed has gone into business with JPMorgan, the country’s third largest commercial bank, to salvage Bear Stearns. While the original deal at $2 a share was widely praised for its speed and simplicity, JPMorgan was forced to raise its bid to $10 a share to help assuage angry shareholders, which includes Bear’s 14,000 employees, who own around a third of the company. The five-fold increase in the offer for Bear Stearns represented a remarkable turnaround for JPMorgan which was reported to have been dead set against raising the stakes. However, the need to close the deal quickly,

avoid shareholder revolt and retain the best and brightest of the employees, were thought to be the key drivers behind the revised bid. In addition, the transaction gained a boost from better than expected February housing sales which showed sales of existing US homes rising for the first time since July.

Under the initial agreement, the Fed agreed to fund up to $30bn of illiquid assets on Bear’s balance sheet. The new deal has JPMorgan being responsible for the first $1bn of these assets with the Fed funding the remaining $29bn. In addition, JPMorgan will guarantee Bear Stearn’s borrowings from the Fed under a new facility extended to investment banks. The firm will also sell l95m newly issued shares to JPMorgan, giving the bank an almost 40% stake, which will more than provide a majority in any shareholder vote.

Not surprisingly, investors are not that enthusiastic with the new terms. Although it has raised Bear Stearn’s value to about $1.2bn from a paltry $236m, the company is still worth significantly less than the $8.3bn market cap it was sitting on in early March. Shareholders at Northern Rock can more than commiserate, but Silva of TowerGroup echoes the sentiments of many when he notes, “Nationalisation for Northern Rock was not a solution, but it was the best solution available. The private bids on the table (Virgin and the Northern Rock management team) did not allow repayment to taxpayers in a reasonable timeframe whereas from a financial point of view the government saw public ownership as the best way to protect taxpayers.”

Under Virgin's bid, Northern Rock's total value would have needed to rise to at least £2.7bn—several times its current level—before taxpayers reaped any benefit. As for the management proposal, the government felt that they would not raise enough new cash to protect taxpayers from the risk of losses. As Dwane of RCM, points out, “the problems with the bids from Virgin and the Northern Rock management teams, were that neither addressed the issue of how they were going to raise sufficient, sustainable capital. Even with government backed guarantees of £33,000, they would still find it difficult to attract deposits.”

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Dwane also believes that the system of banking and financial-market supervision implemented by Gordon Brown when he was chancellor of the UK Exchequer, did not work. “The Bank of England, the Financial Services Authority and the Treasury did not effectively communicate with each other and were unable to act quickly and decisively. If they had, then they would have understood the problems and accepted the offer from Lloyds TSB which already had a strong retail network and access to long term capital flows. The Bank of England, though, did not provide the support Lloyds had asked for, and the result was a public sector solution.”

Lloyds TSB is believed to have offered 200p a share for Northern Rock on condition that the Bank of England provided £30bn of funding. The FSA has already fallen on its sword and published a report, listing its catalogue of failures. This included extraordinarily high turnover of FSA staff directly supervising the bank which partly contributed to the limited contact the regulator had with the bank.

Over the whole period from January 2005 to the crisis in the summer, Northern Rock merited a mere eight meetings, against an average of 74 for each of its peers.

While the FSA is promising to get its regulatory act together, many analysts believe that either the Bank of England or one of the three regulatory bodies should have full control. Alex Potter, an analyst with Collins Stewart, notes, “By creating a tri-party, there was real lack of coordination and accountability among the three regulators.

It is like parents of children, with mum and dad applying different rules. Why would the FSA and Bank of England agree on the right solution? I don't have a particularly strong view on which regulator should take charge as long as one does take primary responsibility.”

In the US, there are discussions as to whether some version of the old Glass-Steagall act, which separated commercial banking and capital-markets activities, should be reintroduced.The Depression-era law was repealed in 1999 and there is a view that this has contributed to banks taking bigger risks. While the wrangling over regulation and supervisory powers will continue to play out, the more pressing question today in the UK is how quickly the government will be able to pay back Northern Rock’s debt and return it to the private sector either via a trade sale or initial public offering.

Under a new restructuring plan, which is geared towards meeting strict European Union rules on state aid, both its mortgage book and workforce will be slashed. The bank, which wrote one in five new mortgages in the first half of 2007, is expected to dramatically reduce its £113bn balance sheet to up to half of its current size while a third of its 6,500 workforce is expected to be cut by 2011. Simon Ward, an economist and strategist with New Star Asset Management, is fairly optimistic that the government will pay back the Bank of England within its three to four year timeframe, if not before. He has estimated that about £13bn of mortgages could be repaid this year and pounds £10bn of retail deposits could be attracted, which would leave Rock only £2bn short of the estimated £25bn Bank

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Ralph Silva, senior analyst, European banking and payments at TowerGroup, a global consultancy, adds,“One of the problems was that the UK government did not fully understand the severity of the problems at Northern Rock and how to deal with them. The Fed could not afford to let Bear Stearns go under. Unlike Northern Rock, the bank was part of the money supply and when that supply slowed, they had to act quickly. However, loss of confidence was key in both cases.

Confidence is critical to the financial system working smoothly and if that disappears, whether it is with counterparties, investment banks, investors or depositors, then there can be painful consequences.”

Photograph kindly supplied by TowerGroup, April 2008.

loan. The caveat, of course, is the direction of the economy and housing problems. If prices plummet, then it will take longer for the government to repair the damage.

Ross Abercromby, vice president-senior analyst for financial institutions group at Moody’s Investor Services, notes, “The government will be walking a fine balance between paying back the Bank of England without being unfairly competitive, which it has promised to do. The biggest challenge is to avoid rocking the EU boat without destroying the franchise.” All agree that the government cannot fail in its mission to return the bank to the private arena. Northern Rock may emerge as a shadow of its former self but the reputational risk of not doing so would be too great. As one market participant put it, “nationalisation goes against the grain of New Labour and the government now risks being tainted with the tag of Old Labour. They want to turnaround Northern Rock as quickly as possible but I think the damage has already been done and as a political issue, this will not go away overnight.”

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President Bush poses for cameras at the conclusion of his meeting with the President's Working Group on Financial Markets, Monday, March 17th 2008, in the Roosevelt Room of the White House in Washington. From left are, Securities and Exchange Commission (SEC) Chairman Christopher Cox, Treasury Secretary Henry Paulson, the president, and Federal Reserve Chairman Ben Bernanke. Photograph by Gerald Herbert, supplied by AP Photos/PA Photos, April 2008.

INEVITABLE REGULATION There are increasing calls from Congress for a reversal of the trend to deregulation that many see as the root cause of the current credit crisis. Ironically, while many academic economists, such as the University of Texas’s James Galbraith, see Federal Reserve (Fed) chairman Ben Bernanke as reaping what his predecessor Alan Greenspan had nurtured, the latter is still publicly revered. For example presidential-hopeful Hillary Clinton has called for him to head the rescue efforts for the crisis that he helped engender. Will investment bankers have to work under new guidelines in future? Ian Williams writes a blistering polemic from New York.

With oil floating above $100 a barrel, the dollar sinking to new (and seemingly persistent) lows, huge fiscal and trade deficits and a seemingly endless war in the Middle East, Fed chairman Bernanke was certain to meet with major storms early in his term. It was clear even that the housing bubble was going to burst, which would at least constrict the torrents of credit being issued against inflated home equity. The precise cause of the shock, collateralised mortgage securities, was a surprise to many. It is not so much the sub prime aspect, it was rather that these securities were so palpably insecure, despite their Triple A ratings and that they had become so ubiquitous a part of the financial system.

Of course, the added risk is that the declining interest rates will accentuate the growing unease of the Asian and oil economies at recycling their trading surpluses into declining dollars. The Chinese central bank, for one, appears tired of losing billions on the transactions and latterly reports a steady drift to other currencies.

However, while investors applaud those bankers astute enough to have kept their money out of mortgagebacked securities, it remains to be seen whether US tax-payers will cheer a central banker who has invested $400bn—almost half of his reserves—in securities that commercial bankers (who originated and sold them) will now not touch.

Thing is: it could just get worse. There is yet much unresolved over those quasi-governmental mortgage loan agencies Fannie Mae and Freddy Mac, for example, which reportedly have some $225bn in sub prime and not so prime loans. There is a risky ambiguity

about the agencies. Technically independent corporations, they are widely assumed to be federallybacked—even though they explicitly disown such backing. The Fed and the Treasury face a dilemma: if they point out the lack of federal guarantees, they might very well end up having to guarantee them if crunch comes to crumb.

Bernanke moved into new territory with his bailout of Bear Sterns through a trade sale, expanding the remit of the Federal Reserve from banks to brokerages. While the resulting quintupling of Bear Stern’s stock price may be good news for stockholders, the rest of the country may wonder why they should pick up the tab for recidivist mismanagement. After all, Bear Sterns was already sending warning signals nine months ago with its investments in hedge funds. Its recent disclosures showed that most of its $46bn in assets were in home mortgages and securities based on them. They were higher paying (what some would call predatory) loans, most liable to fail, which the brokerage had funded with short-term loans. Its fall might have been deserved, but its rescue was a collateral benefit of the Fed’s fear of the economic unraveling that would follow its collapse.

Politically there will be fallout. Many voters will want to know why people who cannot pay ballooning mortgage interest rates should be thrown out off their homes, while investment bankers who engage in foreseeable and reckless policies should get $30bn from the government. Bernanke’s reappointment comes up during the next presidential term, so he has an added imperative for political sensitivity. So far the

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somewhat confused political calls have mostly been to maintain or boost home prices which is, on the face of it, illogical. Cheaper homes are more affordable for more people. However, homes are no longer for housing. For a decade or more, they have been piggy banks which American consumers have been rifling to keep buying foreign oil and Chinese merchandise. What needs to be addressed is that dependence on bubble-credit.

Bernanke has two tasks. In the short term, he has to rescue the US financial system and indeed of much of the rest of the world in these globalised days. Over the longer term, the Fed, together with the SEC, and the Treasury, might need to redesign the regulatory system to protect the economy from the excessive exuberance of financial engineers. His short-term response is in line with his predecessor’s bail out of Long Term Capital Management (LTCM) although with considerably more brio than Alan Greenspan who mostly stood at the helm saying, “Steady as she goes.” Bernanke has been shoveling money at the wobbly institutions.

For decades, certainly under the reign of Alan Greenspan, the Fed Chair’s job was to persuade the market that he could indeed command the waves of the economic cycle. Greenspan realised that and was consciously gnomic in his pronouncements so that there would be no panic. Bernanke is cursed with interesting times and a more lucid line in discourse, but his purpose is the same: reassurance. He has been taking increasingly desperate and imaginative measures, but has been doing so in a measured way that some shows signs of reassuring the markets. Despite that outward calm, he is in effect shooting out the loophole calling on his colleagues to pass the ammunition. Once he started accepting dubious securities as the equivalent of treasury bonds and cash, the banks and brokerages will grow increasingly eager to dump their paper.

Fair’s fair: up to now, he has lived up to his own speeches. In 2002, for example, when he earned his nicknames “helicopter Ben” and “printing-press Ben” for his robustly Keynesian strategy. He said, “The US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost.”

The context in which he spoke also anticipated the dilemma now facing the Fed. By reducing interest rates progressively, the traditional Fed formula warned that it risked reducing unemployment below a level that contained inflation. That formula has, empirically, been repeatedly disproved, but Central Banks have held to it with theological fervour.

In fact, with the credit crunch and plummeting interest rates, a more realistic fear is of deflation, and Bernanke anticipated that in a recent speech, “By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services,

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which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a papermoney system, a determined government can always generate higher spending and hence positive inflation.”

His current tactics are certainly living up to his plan for injecting liquidity, “To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities.”

Ironically, however, in that same speech he addressed the question of the persistence of Japanese deflation. He said its economy “faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, privatesector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies … Fortunately, the US economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan.” One might suspect that the American and Japanese models have converged since he spoke, and ominously it was a real estate bubble that also brought the Japanese banks into question.

Bernanke’s long-term reactions should be different from Greenspan’s benign indifference to irrational exuberance and failure to anticipate the consequences of the housing bubble. Like the Savings & Loans scandal of a decade ago, which also cost the tax-payers billions, and indeed the tech bubble, the housing bubble was well predicted by many whose concerns were, however, overridden by the push for de-regulation. Mortgage-backed securities were presented as triumphs of financial ingenuity fuelling American growth, rather than as the opaque schemes that many have turned out to be.

In the long term, the Fed needs to address those rating agencies that gave triple A ratings to securities such as those from Countrywide. Countrywide’s foreclosure rate went up 900% last year, and reportedly had $24bn worth of mortgages made out to clients with “low or no stated income documentation,” over two thirds of whom are not, allegedly, even meeting their full interest repayments.

Bernanke in his latest speech to Congress did actually acknowledge that the Fed had a dual mandate, to control unemployment as well as inflation. Greenspan rarely, if ever, mentioned the former part of his dual mandate. With an election year looming, and from his own predilections, it would appear that Bernanke is going to keep on throwing money at the banks, brokerages and any other financial institutions for as long as he can to stave off recession.

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ABS: IT’S LIFE Jim, BUT NOT AS WE KNOW IT Credit spreads have blown out across the board among asset-backed securities (ABS), an asset class dominated by repackaged credit card, automobile and student loans often considered a sensitive barometer for the economy. Current prices imply that consumers are in deep trouble and unlikely to recover soon. Nonetheless, while delinquencies and charge-offs have ticked up they are nowhere near historic highs. ABS have traded down: not only in sympathy with other non-government fixed income markets, but also because major ABS holders include the off balance sheet entities created by the banks known as structured investment vehicles (SIVs)—most of which are now liquidating their portfolios. In today’s market, ABS are either dirt cheap, or the world as we know it is about to end.

Neil O’Hara reports.

Photograph © Gofer/Dreamstime.com, supplied April 2008.

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S SECURITISED DEBT instruments, ABS share some basic attributes with their cousins, private label mortgage-backed securities (MBS). The underlying loans are pooled and the cash flows are allocated to different tranches protected by varying degrees of subordination. ABS deals are less complex, however. The overwhelming majority of paper sold to the public carries a AAA rating, and although modest quantities of lower-rated investment grade bonds do see the light of day the originator/issuers almost always retain the lower tiers of the capital structure. That promotes a common interest between issuers and investors notably absent in the private label MBS market where issuers who sell down even the equity tranche that bears the first credit losses have no skin in the game. It limits capital structure arbitrage opportunities, too, as does the absence of a tradable index equivalent to the ABX for MBS. Credit card and auto loans have long been popular with banks, insurance companies and some fixed income money managers, according to Joseph Astorina, director of securitisation research at Barclays Capital in New York. In recent years, SIVs emerged as big buyers, too, but after the meltdown last summer they are gone, probably for good.

“We need to find additional investors to replace them,” says Astorina, “This could be the year of the real money account in consumer ABS.” Money managers elbowed aside by the SIVs will find consumer ABS much more attractive now that spreads are at record premiums to the London Interbank Offered Rate (LIBOR).

Macroeconomic trends play a critical role in the performance of ABS. As long as people stay employed all but a handful will make credit card and car payments on time; while a strong job market encourages new graduates to join the labor force and start paying off their student loans. Astorina says an uptick in bankruptcy filings tends to foreshadow a rise in charge-offs that eat into the credit protection embedded in credit card ABS, while automobile deals depend more on the recovery rate on defaulted loans.

“You have to repossess the vehicles and sell them,”Astorina says, “In a strong economy high used car prices mitigate losses but when prices are falling as they are now it is hard to recover as much.”

The margin between interest received from borrowers and the amount paid out to bondholders provides credit support throughout the life of every ABS deal. For example, if credit card borrowers pay 18%, charge-offs run at 7% and investors receive 5%, the remainder—the excess spread of 6%—provides a cushion against higher charge-offs in the future and a profit margin to the security issuer. It is an additional buffer on top of the subordination and any other credit support the structure may have at the outset.

ABS deals have to take account of the characteristics of the underlying loans, of course. Credit card structures employ a master trust in which payments of principal from a revolving pool of receivables are reinvested until shortly before the designated maturity date. Based on historical repayment rates, the servicer and the trustee determine how

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Joseph Astorina, director of securitisation research at Barclays Capital in New York. In recent years, SIVs emerged as big buyers, too, but after the meltdown last summer they are gone, probably for good.“We need to find additional investors to replace them,” says Astorina,“This could be the year of the real money account in consumer ABS.” Money managers elbowed aside by the SIVs will find consumer ABS much more attractive now that spreads are at record premiums to the London Interbank Offered Rate (LIBOR). Photograph kindly supplied

by Barclays Capital, April 2008.

many months it will take to accumulate enough principal to repay the maturing bonds and stop reinvesting at that point. The principal is either paid out to investors month by month or accumulated toward a single bullet payment at maturity (most often 3 or 5 years from the issue date). It is a soft bullet, though: Failure to make payment on time and in full is not an event of default, which protects the trustee against the possibility that repayments fall below expectations (in practice, issuers rarely miss the date).

Automobile loans amortise over their life (typically 48 or 60 months) so ABS holders receive both interest and principal throughout the life of their bonds. The top tier in the structure is often eligible to be held by money market funds (i.e. less than thirteen months to final maturity) while other tranches have average lives from one to three years. Payments of principal, either sequential (the shortest dated tranches get paid off first) or pro-rata, include regular payments and prepayments but are offset by any defaults, which have to be made up from the excess spread.

Student loans are quite different. ABS deals have a longer average life and the vast majority—around 90%—of them enjoy the benefit of a government guarantee under the Federal Family Education Loan Program (FFELP).

Students get a waiver of principal payments while they are at school—they have no income, after all—and for a six month grace period after graduation; the loans then amortise over fixed periods of up to 20 years. Depending

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on their financial circumstances, borrowers can defer their risk we have not seen a deterioration in excess payments or apply for forbearance even after principal spreads yet.”

Credit card rates are sticky, too, so when a weak repayments begin. The government guarantee covers 97% of the outstanding principal, so bondholders have only 3% economy prompts the Federal Reserve Board to cut short at risk and the historical loss experience in this category is term interest rates the gross spread in an ABS deal may actually increase if funding costs fall faster than the chargeminiscule (less than 10 basis points per annum).

The whirlwind that blew through the auction rate off rate rises. Bavely points out that both credit card and securities market has created havoc among state student loan automobile loan ABS have stood the test of time through programs financed by these instruments.“The cost of funding past recessions.“We know how bad these stresses can be,” has increased and liquidity has dried up,” says Sean Davy, a she says “The rating agencies incorporate them in their managing director in the mortgage-backed securities and models.”The agencies have a robust track record in rating securitized products division at the Securities Industry and ABS, unlike sub prime MBS for which their models proved Financial Markets Association (SIFMA), a global trade woefully inadequate.

The housing debacle has shaken up traditional organisation dedicated to the expansion and improvement of capital markets through policies and practices that reinforce assumptions about how consumers prioritise their debt payments. The idea that the public’s trust.“There people will always pay has been great concern the mortgage first no that when students are longer holds sway if looking to lock their they owe more than funding in place they Ron D’Vari, managing director and head their house is worth. will have fewer options.” of structured finance and CDO products at “People need their car The turmoil won’t New York-based money manager to get to work so it is the necessarily impair Blackrock, uses consumer ABS in short, auto loan that has top student loan ABS, priority,” Bavely says, however. Fitch Ratings medium and long term bond funds to park “They may be more announced in March money and pick up some yield while he delinquent on credit that despite record waits for other investment opportunities. cards because they numbers of failed He does not treat ABS as cash substitutes, already have the object auctions it did not but short durations keep volatility low and they bought in hand.” anticipate any near term From a portfolio rating action on student liquid markets make them easy to buy and standpoint, Bavely used loan ABS trusts funded sell. D’Vari sees the shift in consumer to view consumer ABS by auction rate debt. payment priorities as an unexpected bonus (she does not buy Of course, the rating because people who are no longer able to student loan deals) as agencies no longer draw on a home equity loan are staying stable high quality enjoy the same current on their credit cards in order to short term investments confidence among that paid a premium to investors they had retain access to instant credit. the equivalent Treasury before the credit crunch. securities. Now that Davy points out that spreads have blown instead of doing their out, she sees an own due diligence some investors put too much faith in the rating agencies. Ratings opportunity to make some real money when the market have assumed greater importance not only under the risk- turns. “Consumer ABS have been thrown out with the based Basel II capital framework for financial institutions but bathwater,”Bavely says,“We’re buying top tier AAA names also in investment guidelines for insurance companies and at very attractive yields.”At one time she expected spreads asset managers. Davy notes that ABS ratings have held up to snap back quickly but as the credit crisis unfolded she has pushed back her time horizon. Meanwhile, she is being much better than those for MBS, however.

Credit losses per se do not necessarily impair ABS. Credit well paid to wait.

Ron D’Vari, managing director and head of structured card issuers keep a close eye on borrower behaviour and have the right to cancel cards at any time if they experience finance and CDO products at New York-based money payment problems. Issuers can also raise the interest rate manager Blackrock, uses consumer ABS in short, medium charged on unpaid balances, explains Connie Bavely, vice and long term bond funds to park money and pick up some president and head of mortgages and structured products yield while he waits for other investment opportunities. He at Baltimore, Maryland based money manager T Rowe does not treat ABS as cash substitutes, but short durations Price. “We have seen charge-offs and delinquencies tick keep volatility low and liquid markets make them easy to buy up,”she says,“But because they have the ability to re-price and sell. D’Vari sees the shift in consumer payment priorities

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Connie Bavely, vice president and head of mortgages and structured products at Baltimore, Maryland based money manager T Rowe Price, says that credit card issuers keep a close eye on borrower behaviour and have the right to cancel cards at any time if they experience payment problems. Issuers can also raise the interest rate charged on unpaid balances, explains.“We have seen charge-offs and delinquencies tick up,” she adds,“However, because they have the ability to re-price their risk we have not seen a deterioration in excess spreads yet.” Photograph kindly supplied by T Rowe Price, April 2008.

as an unexpected bonus because people who are no longer able to draw on a home equity loan are staying current on their credit cards in order to retain access to instant credit.

The questionable or fraudulent data that has plagued the MBS market is less prevalent in the ABS world where credit card issuers actively manage their loan portfolios. Lower average loan balances reduce the potential losses, too.

There are still pitfalls, however. If a credit card issuer speeds up lending a growing receivables balance may mask rising delinquencies. “You can always add fresh water to dirty water and make it look as if things are ok,” says D’Vari, “Delinquencies as a percentage of current balances may appear low, but over time it will catch up with you.”

Lisa Reed, a portfolio manager and head of ABS trading in the Louisville office of money manager Invesco, believes the economy is sliding into a recession so she is keeping portfolio spread durations short. Invesco manages about $20bn in structured assets, including MBS and ABS. Reed has been focusing on fixed rate consumer ABS, which have outperformed floating rate instruments while short term interest rates have fallen because the coupon does not reset.

She notes that ABS spreads blew out before any

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Lisa Reed, a portfolio manager and head of ABS trading in the Louisville office of money manager Invesco, believes the economy is sliding into a recession so she is keeping portfolio spread durations short. Invesco manages about $20bn in structured assets, including MBS and ABS. Reed has been focusing on fixed rate consumer ABS, which have outperformed floating rate instruments while short term interest rates have fallen because the coupon does not reset.

Photograph kindly supplied by Lisa Reed, April 2008.

evidence of deterioration in credit quality, although delinquencies and charge-offs have since ticked up. For example, fixed rate credit card and automobile loan ABS that once traded at or even under LIBOR now trade 100150 basis points over LIBOR depending on the average life. “The widening we have seen so far is mostly attributable to less demand for the sector,” Reed says, “Many entities that were buying these instruments were putting them in structured vehicles that are now in an unwind process.”

The slump in house prices has curbed debt consolidation refinancing in which consumers used the proceeds of a home equity loan to pay down high cost consumer debt.

Reed says refinancing disguised the underlying performance of consumer ABS during the housing boom because what appeared to be principal prepayments were in fact rolled over into home equity loans. Now the game is over, ABS delinquency rates have increased and are headed higher.“If the economy continues to slide, credit performance will get worse,” Reed says, “non-housing ABS spreads could go wider still even though they are already at record levels.”

The jury is still out on whether current ABS spreads represent the sale of the century or a harbinger of doom.

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COMBATING FRAUD Frank McKenna, chief fraud strategist at BasePoint Analytics says the mortgage industry can do more to curb insider fraud, such as altering compensation incentives to keep brokers and loan officers accountable for the credit quality of loans they originate.“We need to get underwriting and risk away from sales and production so underwriters can make decisions that are independent,” he says.

Photograph kindly supplied by BasePoint Analytics, March 2008.

During the sub prime mortgage boom, some lenders appeared to throw their usual caution to the wind. Instances have been reported where some lenders appear to have approved loans without full and proper verification of the borrower’s employment or income or in some cases their social security numbers. Not surprisingly, where credit checks were lax, misrepresentation and fraud flourished. So has the industry’s efforts to combat them. Neil O’Hara reports.

NVESTOR CONFIDENCE IN sub prime mortgagebacked securities (MBS) will not return until the industry has reliable data to quantify the likely delinquency and default rates on the most troubled vintages. Until then, pricing of sub prime MBS and collateralised debt obligations (CDOs) that include them will be little more than guesses, bid-offer spreads will remain wide and liquidity poor. Wall Street has spent untold millions on models that purport to predict mortgage default rates. However, no matter how robust the models are, their predictions are only as good as the data fed into them. During the sub prime mortgage boom, some lenders appeared to throw often stringent credit checks to the wind. In some instances, loans were approved without proper or accurate verification of the borrower’s employment or income. In others, there are alleged incidents of lenders failing to check whether a social security number matched the borrower’s name and address. Not surprisingly, misrepresentation and fraud flourished. More latterly so has the mortgage industry’s efforts to combat fraud.

There is no single source that collects information about mortgage fraud. However, recent analysis by the United States’ Federal Bureau of Investigation (FBI) suggests it is a pervasive problem and one that is growing fast. The FBI’s view is supported by ChoicePoint’s Mortgage Asset

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Research Institute (MARI), which noted in its 2007 annual report to the Mortgage Bankers Association (MBA) that the number of suspicious activity reports (SARs) filed by financial institutions pertaining to mortgage fraud jumped from 5,387 in 2002 to more than 28,000 in 2006. Moreover, for every fraud reported many more were not.

Although federally chartered institutions have to file SARs, state chartered institutions—which are responsible for the lion’s share of mortgage lending—do not. Mortgage brokers do not have to file, either. Therefore it is quite difficult to pinpoint how much fraud takes place. MBA’s wide-ranging 2006 estimate shows just how much uncertainty there is about the actual level of fraud. The Association’s range for 2006 veers between $946m and $4.2bn.

For years, soaring house prices disguised the effect of lax underwriting standards; but now the piper has presented his bill.“People throughout the industry turned a blind eye to questionable practices because everything seemed so good,” says Richard Girgenti, national practice leader for forensic accounting at global accounting major KPMG. Profligate sub prime mortgage lending reminds Girgenti of the excesses that preceded the financial reporting scandals in the early 2000s. Mortgage lenders will never eliminate fraud entirely no matter how hard they try. Unscrupulous lenders have little incentive to strive for a goal that would deprive them of profitable lending opportunities, either.

Although most software vendors now claim to offer comprehensive screening capability their products take different approaches to fraud detection. Interthinx, Data Verify and Digital Risk focus on data verification: they match declarations in the loan application against publicly available sources. Does the social security number belong to the borrower? Does the borrower’s address match the one associated with that social security number? The software can verify phone numbers, confirm employer information and compare the current appraisal to past appraisals on the same property or others in the area. It will also check whether the broker, loan officer, appraiser or anyone else involved shows up on any list of miscreants either shared by the industry or compiled by the software vendor.

In contrast, First American Corelogic built its software around a massive database of home sale transactions that allows a lender to compare the appraised value on a loan application to other properties nearby in granular detail.

Walter Allen, a senior vice president at First American Corelogic, points out that lenders cannot afford to rely on a single approach.“One system may be good for identifying a certain type of fraud,”he says,“But when you are looking at risk layering you need to have multiple systems covering all aspects to identify where fraud occurs.”

First American Corelogic’s software generates a risk score for each loan. In back tests run for one potential customer on a $2.5bn mortgage pool, the 73% of loans identified as low risk accounted for just 17% of credit losses, while the 5% of loans flagged as high risk generated 50% of the losses. While not infallible, the screen nevertheless helps lenders allocate scarce resources to zero in on the riskiest

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loans. First American Corelogic constantly upgrades its fraud detection capabilities, too. In January, the company introduced the first tool designed to thwart the latest scam: fraudsters who submit multiple loan applications on the same property and try to close as many as possible on the same day to compound their ill-gotten gains.

It’s a game of cat and mouse, of course. No sooner does the industry clamp down on one scheme than the fraudsters concoct another. “These people have to earn a crust,” says Bart Patrick, head of United Kingdom risk intelligence in the London office of SAS Institute, based in a Cary, North Carolina,“They will adapt their strategies and go for another weak link in the chain.”The more sophisticated fraudsters take their time and keep probing until they find a weakness.

Even then, they may not commit fraud right away. It’s an endless battle to keep fraud detection models up to date.

“The fundamental weakness in many systems is that model renewal is very slow, laborious and costly,”says Patrick,“The second weakness is the ability to cope with enormous data volumes.” SAS’ software has the capacity to analyse every loan application, but Patrick says some systems depend on sampling techniques to cut data processing demands.

Merle Sharick, vice president of business development at MARI, says the organisation’s latest research indicates that the industry’s historical ambivalence toward fraud for housing may be misplaced because borrowers no longer treat their home merely as a place to live.“People have begun looking at their house as if it’s an automated teller machine,” Sharick says,“It is an investment they can get money out of.”

While house prices were spiralling upward, borrowers were able to refinance their mortgage for a higher loan amount or take out a home equity loan to free up cash for current consumption. Falling prices have shut down the ATM but not the borrowers’ appetite for cash, which leaves them vulnerable to fraudulent refinancing solicitations and other schemes that promise cash back at closing.

Fraud schemes often depend on the complicity of industry insiders, if not their active participation. Frank McKenna, chief fraud strategist at BasePoint Analytics says the mortgage industry can do more to curb insider fraud, such as altering compensation incentives to keep brokers and loan officers accountable for the credit quality of loans they originate.“We need to get underwriting and risk away from sales and production so underwriters can make decisions that are independent,” he says. Lenders must go back to basics and revive credit review concepts that vanished under the “originate and distribute” mortgage banking model.

Meanwhile, the market awaits clarification on how much fraud contributed to the sub prime mortgage debacle.

McKenna says that although fraud frequently shows up in the first six months as early payment defaults, it may not completely wash through the system until three years after the origination date. Although more data will come to light in 2008, investors may not know the final cost of fraud for the troubled 2006 vintage sub prime mortgages until the end of 2009.

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Besides inflated appraisals, other common borrower misrepresentations include overstated income, false employment history, inflated assets, false occupancy intent and identity theft.

Photograph © Darknightly; Agency: Dreamstime.com, supplied March 2007.

WHAT TO WATCH FOR: COMMON TYPES OF MORTGAGE FRAUD Connie Wilson, executive vice president at Interthinx, a Los Angeles, California-based provider of fraud detection software, says downpayment fraud has been around “ever since the first mortgage loan”, but in most cases it does not cause credit losses. Legitimate borrowers who stretch the truth about the size of their downpayment, or where the money came from, usually stay current on payments.

Lenders tend to think minor misrepresentations in the application do not matter as long as the loan stays current. No harm, no foul. Fraud for profit though is another matter entirely and lies at the heart of today’s mortgage-backed sub prime lending crisis. By Neil O’Hara In simple downpayment fraud, the borrower does want the property either for its own use or to rent out. It is an example of fraud for housing, which Wilson says has historically generated far smaller losses than fraud for profit schemes intended from the outset to steal money from the lender. As a result, the industry tends to concentrate on fraud for profit, which often surfaces soon after a loan closes.

The perpetrators never intend to keep payments current: they just take the money and run. That is why early payment default—in the first three to six months after closing—is a red flag that fraud may have occurred in the origination.

Wilson says fraud for profit schemes typically affect multiple loans so lender losses can be severe.

Fraudsters often recruit industry insiders, including mortgage brokers, real estate agents, property appraisers, attorneys and title examiners. Inflated appraisals play a critical role, of course. In a simple example, a fraudster may buy a house worth $300,000, get a false appraisal for $400,000 and tell the lender he will put up $40,000. After a little sleight of hand with the documentation, the fraudster gets a loan for $360,000, pays $300,000 for the house, and walks away with $60,000 in cash. Fraud for profit schemes typically involve more then one type of fraud, too. “In most fraudulent transactions the downpayment has been manipulated,” says Wilson. No matter how much cash the fraudster gets, the lender takes a bigger hit because the house will fetch a fraction of its fair market value at a foreclosure auction.

Chameleon-like fraudsters quickly adapt their tactics to market conditions, according to Interthinx’s Wilson. Many sub prime borrowers who expected to refinance before introductory teaser interest rates expired now face big increases in monthly payments they cannot afford. They have become prime targets for fraud schemes that promise to provide cash and save the borrowers from foreclosure.

Suppose a borrower is struggling to make payments on a $280,000 mortgage on a house worth $300,000. The fraudster recruits a straw buyer with good credit who purports to buy the house for $400,000, applies for a $350,000 loan based on a phoney appraisal and then deeds the property back to the original owner along with responsibility for the new loan. The transaction frees up $70,000 in cash, of which the homeowner might receive $20,000 while the fraudster and the straw buyer abscond with the rest. A few months later the cash is gone and the homeowner is worse off than before. “Foreclosure bailout scams are a huge issue right now,” says

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Connie Wilson, executive vice president at Interthinx, a Los Angeles, California-based provider of fraud detection software, says downpayment fraud has been around “ever since the first mortgage loan”, but in most cases it does not cause credit losses. Legitimate borrowers who stretch the truth about the size of their downpayment, or where the money came from, usually stay current on payments.

Photograph kindly supplied by Interthinx, March 2008.

Wilson, “People who were in foreclosure on a $280,000 loan surely can’t handle a $350,000 loan.”

Besides inflated appraisals, other common borrower misrepresentations include overstated income, false employment history, inflated assets, false occupancy intent and identity theft. Frank McKenna, chief fraud strategist at BasePoint Analytics, a fraud detection software firm based in Carlsbad, California says these account for about 95% of all mortgage fraud. BasePoint estimates that about 40% of loans that go into early payment default include material misrepresentations, while the average fraud loss amounts to at least $35,000 on a $165,000 loan balance. McKenna says an industry that generated lending volume of $2.5trn during 2007 from almost 20m new loans cannot afford to have fraud investigators conduct a detailed review of every loan application. Instead, mortgage lenders rely on software to screen for the highest risk loans that warrant further investigation.

Bart Patrick, head of United Kingdom risk intelligence in the London office of SAS Institute, a Cary, North Carolina-based leader in enterprise intelligence software and services, says first line data validation systems are a good start rather than a complete solution. They will catch obvious fraud, which may be only 20% of the total, but are vulnerable to high rates of false positives due to discrepancies and

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Bart Patrick, head of United Kingdom risk intelligence in the London office of SAS Institute, a Cary, North Carolina-based leader in enterprise intelligence software and services, says first line data validation systems are a good start rather than a complete solution. They will catch obvious fraud, which may be only 20% of the total, but are vulnerable to high rates of false positives due to discrepancies and errors in public databases.

Photograph kindly supplied by the SAS Institute, March 2008.

errors in public databases. For another 40% of known frauds that are harder to detect, many companies employ rules-based fraud detection. False positives bedevil this approach, too, because rules tight enough to catch fraud often flag too many legitimate borrowers. None of these systems tackle the estimated 40% of fraud where the lender doesn’t even know what the scam is or how to detect it.

Patrick says SAS’ software tries to identify potential fraud based on the performance of past loans. It searches for patterns of fraud on applications for loans that later became delinquent or fell into default. It also analyses borrower behaviour in an effort to catch fraudsters who, for example, open a bank account, take out a small loan and repay it on time, repeat the process with a larger loan and only then go for the big score on a fraudulent mortgage.

Fraudsters often work in networks that cross state lines or national borders, but software can pick up a trail of bad loans and reveal connections a human investigator might never find. Patrick says SAS’ latest predictive models apply advanced mathematical concepts like neural network analysis to calculate the probability that a transaction is fraudulent in an effort to catch the elusive 40% of undiscovered fraud.

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THE NOT SO LITTLE COMPANY THAT DID

The Not So

LITTLE COMPANY that Did

As a profitable niche business in the Ohio Rustbelt, with an ironic speciality in rust-proofing, it could have been swallowed up like the fictional New England Wire & Cable Company in the noted play Other People’s Money, (you know, the one which epitomised the “greed is good” era of the 1990s). RPM’s sometimes unprepossessing moniker has little or no brand equity except for the investors who have done rather well out of RPM over the decades. From a $50,000 start up, it is now global company, with $3.3bn in sales worldwide, including $600m in Europe and footholds in India and Latin America.

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“Streetwise” is often the wisdom of the lemmings on Wall Street: follow the crowds even if they end deep under the Hudson River. Waves of mergers and conglomeration follow with equal certainty on waves of disposals and de-mergers, initial public offerings alternate with leveraged buyouts, to the applause of analysts who will enthusiastically hail lay-offs and downsizings as often as they plaudit investment and expansion. For all of this time RPM Inc, which began life in Cleveland as Republic Powdered Metals in 1947, has almost consciously been marching out of step. Ian Williams reports on a small to large success story.

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PM INTERNATIONAL INC. announced in early equity except for the investors who have done rather well March that one of its wholly owned subsidiaries in out of RPM over the decades. From a $50,000 start up, it is Europe, Tremco illbruck International, has purchased now a global company, RPM International Inc, with $3.3bn Prosytec SAS from a subsidiary of Goodrich Corporation. With in sales worldwide, including $600m in Europe and sales of approximately $39m, Prosytec is a leading provider of footholds in India and Latin America. The company plans sealants for the construction and window assembly markets in to raise sales revenue to $5bn by 2010.

RPM’s particular selling point is that the holding Southern and Eastern Europe. The company has been a longtime partner of Tremco and has served major European company owns subsidiaries that are world leaders in markets under a licensing arrangement since 1997. Prosytec is specialty coatings and sealants serving both industrial and headquartered in Paris and has a manufacturing plant in consumer markets. RPM’s industrial products include roofing systems, sealants, Dijon, France. Prosytec will corrosion control coatings, become part of the Tremco flooring coatings and illbruck International specialty chemicals. It’s organisation, the European industrial brands include operating platform for Instead of bottom feeding, looking Stonhard, Tremco illbruck, Tremco. RPM’s president for failing companies, RPM took what Carboline, Day-Glo, Euco and chief executive officer Tom Sullivan calls “the lazy approach. and Dryvit.

RPM’s (CEO), Frank C Sullivan says consumer products are the deal will “grow our We did not really think ourselves used by professionals and construction and window smart enough to do turnarounds, we do-it- yourselfers for home sealants presence thought ourselves smart enough to maintenance and dramatically in Southern do good things, and create the improvement, boat repair and Eastern Europe … [and] atmosphere to get good people to and maintenance, and by enhance our already strong stay, and let them. You should buy hobbyists. Its consumer sealants business in brands include Zinsser, Europe.” Then, later the the best companies you can, with the Rust-Oleum, DAP, same month the company best people in charge of them, and Varathane, and Testors. announced that another of sit back and enjoy yourself.” That Although the company its subsidiaries, The Euclid entailed paying premium prices for has an aggressive accretion Chemical Company of quality. Sullivan reminisces, “When programme, it has Cleveland acquired Increte maintained the Systems of Odessa, Florida. we bought Rust-Oleum we paid entrepreneurial drive of a With sales of approximately $176m for a company with a tangible small family business, and $15m, Increte is a maker of net worth of around $50m. We were has in fact contrived to decorative concrete systems paying for name and distribution. For harness others so that it that economically recreate us to push the name of RPM on functions almost as a the look of natural stone, Rust-Oleum would be about the cooperative of family wood, tile, brick and pavers enterprises. The company using concrete. The existing dumbest thing I could think of, but has achieved 60 Increte management team there are companies that do just consecutive years of will remain in place and the that, take all the pride away from the increasing results, issued 11 company will operate as a people there.” stock splits. While the Wall stand alone business unit of St fashion was to eschew Euclid Chemical reporting to dividends for stock Moorman Scott, Euclid buybacks and “growth,” Chemical’s executive vice RPM holders have now had both steady growth and 34 president.

The two examples cited above are clear indications of years of increasing annual dividends. Chief Operating RPM International’s particular buy and hold approach to Officer (COO) Kelly Tompkins thinks that, “Investors acquisitions, which has underpinned the company’s realised after Enron and the Internet bubble that accretive growth strategy. As a profitable niche business in companies can do a lot to manipulate GAAP earnings, but the Ohio Rustbelt, with an ironic speciality in rust- cash is cash, and a very significant proxy for the health of a proofing, it could have been swallowed up like the fictional company—and what better proxy for cash than a steady New England Wire & Cable Company in the noted play and increasing dividend?”

Although management is still in the hands of the Other People’s Money, (you know, the one which epitomised the “greed is good” era of the 1990s). RPM’s founding Sullivan family, whose numerous progeny ensure sometimes unprepossessing moniker has little or no brand future continuity, less than 10% of the stock is in the hands

R

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RPM nonetheless stuck to its business and its own brand of ethics and principles even while steadily expanding through its niche―actually protective coverings―across the globe. Its stable of brands, including Rust-Oleum and Day-Glo, are all leaders in their fields, but purchasers would have to squint at the small print to see RPM almost hiding behind them. Photograph © Marco Poli/Agency: Dreamstime.com, April 2008.

of family and management. President Tom Sullivan, son of the founder and father of the current CEO Frank Sullivan, is proud that the family’s philosophy still dominates. “I learnt principles from my father, and when you begin with $11m and grow to $2bn, the good thing is your attitude doesn’t change, you don’t take yourself too seriously.”

RPM is also people oriented. The firm introduced a 35hour working week forty years before France did, and Sullivan senior recalls,“We were one of the first companies to provide a free lunch everyday in the region. We thought things like that were terribly important, because happy employees are likelier to work harder to take pride in their work.” They continued to do so even as the Street applauded“Chainsaw Al”Dunlap for his ruthless dismissal of employees of the companies he was turning around.

RPM nonetheless stuck to its business and its own brand of ethics and principles even while steadily expanding through its niche—actually protective coverings—across the globe. Its stable of brands, including Rust-Oleum and Day-Glo, are all leaders in their fields, but purchasers would have to squint at the small print to see RPM almost hiding behind them. “Not a monolith, but a mosaic, of superior products, services, technologies, companies and people,”the company claims. The company has maintained the entrepreneurial drive of a small family business, and has, in fact, contrived to harness others so that it functions almost as a cooperative of family enterprises. The dozens of operating companies now owned by the firm still have their pre-acquisition owners or management running them. Sullivan says “It is like an extended family, all of us have been with together for such a long time so they can grow at their own pace—but grow they must, they understand that.”

Overall, RPM has a very shallow management structure.

Still based near Cleveland, it is a holding company which contrives to be hands on; but with a very light hand, with its constituent companies. Tompkins compares it with“one end of the spectrum of pure Berkshire Hathaway but certainly not closely managed and integrated.” It is an unusual mix of the hard headed, the concerned, the visionary and the principled.

The company has long anticipated much of the recent pressure on corporate governance issues, for instance. It has had a majority of independent directors for thirty years, and only independents on the audit and compensation committee. An annual meeting of executives from the component companies reports back with new product ideas, marketing initiatives, and even acquisition policy.

“Sometimes a company president comes up with a really good idea, but we decide another company is better equipped to handle it,”Tompkins says, “But in general we leave them with a lot of initiative.”A basic RPM principle is that the operating companies are best equipped to know their own markets, so there is no central marketing function at all, but Tompkins adds, “We do coordinate purchasing. We spend almost a billion dollars a year in raw materials, so it makes sense to use our power to make joint purchases of titanium dioxide, acrylic and epoxy resins for example. Our corporate level handles insurance and benefits, medical coverage and 401Ks for our 9,000 employees. We share R&D.” Sullivan explains,“We are the only one in our industry that runs its operations on a holding company basis. Someone looking at us would say, you are a conglomerate, but we’re not, we are in the same industry, specialist chemicals and building materials. When I talk about synergies, I talk about

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intellectual synergies, our presidents have great knowledge of their markets and they get together to share with one another the experiences of their sister companies.”

The family, in the industry for over a century, maintains a corporate memory that recalls recessions and Depressions, and their product mix and acquisitions take account of them. Tompkins points out, “we have a balanced portfolio, three and half billion company revenues from sales, and some 60% of that is tied to industrial markets whether it’s maintenance or repair spending, certain niche building activities, roofs for school buildings, public buildings, coatings for petrochemical plants and similar industrial activities. Then, on the consumer side we have home improvement products that sell at Loews, Home Depot, Wal-Mart and so on. They operate on a different cycle from the industrial and even within the industrial side there’s balance between early and late cycle products.”

Instead of bottom feeding, looking for failing companies, RPM took what Tom Sullivan calls “the lazy approach. We did not really think ourselves smart enough to do turnarounds, we thought ourselves smart enough to do good things, and create the atmosphere to get good people to stay, and let them. You should buy the Overall, RPM has a very shallow management structure. Still based near Cleveland, best companies you can, with the best it is a holding company which contrives to be hands on; but with a very light hand, people in charge of them, and sit back and with its constituent companies. Tompkins compares it with “one end of the spectrum enjoy yourself.” That entailed paying of pure Berkshire Hathaway but certainly not closely managed and integrated.” It is premium prices for quality. Sullivan an unusual mix of the hard headed, the concerned, the visionary and the principled. reminisces,“When we bought Rust-Oleum Photograph supplied by istockphoto.com, April 2008 we paid $176m for a company with a tangible net worth of around $50m. We were paying for $100m to $600m in five years. “There are a lot of smaller name and distribution. For us to push the name of RPM companies that do not want to be gobbled up by huge on Rust-Oleum would be about the dumbest thing I companies and have someone telling them what to do. could think of, but there are companies that do just that, While we do have planning conferences, and manage where necessary, if people are doing good things, we take all the pride away from the people there.”

Apart from recession-proofing, Tompkins describes the generally leave them alone.”

Their defence against the Barbarians is the complexity of pattern of expansion, usually from current cash flow,“Our history was built on entrepreneurial acquisitions, based on the operating company structure on the one hand, but Tom acquiring solid management teams who can carry on and Sullivan adds that in recent years the best defence has been expand what they are doing as part of a larger organization “sadly, the asbestos law suits, and no one wants to buy into with more resources and more capital. The second type has that. Bondex, a product for sealing concrete, contained been where a company is having succession problems, asbestos. It never sold more than half a million dollars a year, where its founder, say, does not have a family member who “and I am sure never caused anyone any harm,”Sullivan says, wants to take on the management. We can fill the gap.” but it was enough to entangle the group in the mammoth More common now is “filling the white space, where we class tort action.“The only beneficiaries are the tort lawyers, look for companies that have product lines that mesh with Europe has social costs and we have tort costs, greed and fraud perpetrated by a bunch of lawyers who became very ours, that we can co-market.”

Overseas expansion is now important and Sullivan rich. I would take the social costs,” he says bitterly, but sees reports that the management method works equally light at the end of the tunnel. “Once that’s gone, though, abroad, particularly in Europe where they have grown from you’ll see the stock rise rapidly,”he concludes confidently.

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INVESTMENT: ETFs: THE NEXT STAGE OF EVOLUTION

THE APPEAL OF ACTIVELY MANAGED

ETFs

Photograph of an active nuerone © Photographer Sebastian Kaulitzki; agency Dreamstime.com, March 2008.

The rapid evolution of exchange traded funds (ETFs) took another twist in March when the United States’ Securities and Exchange Commission (SEC) approved the first actively managed ETF. Until then, all US ETFs tracked an index, which meant that investors always knew exactly what securities the fund held. ETF sponsors have laboured to overcome the obstacles to active management for years, but although active ETFs have made their long-awaited debut a critical question remains unanswered: Who will buy them? Neil O’Hara reports.

HE BOUNDARY BETWEEN active and passive management is no longer a bright line, of course. The advent of “intelligent” indices, which apply quantitative screens to exclude from a chosen population components that are expected to underperform their peers, introduced an element of active management to ETFs several years ago.“You do not have a person using their full discretion to decide what we will be in the portfolio, how much of it and how long it will stay,” says Jeffery Ptak, an ETF analyst Morningstar, the Chicago-based fund research and data provider,“But it is a form of active management.”

T

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the portfolio that may or In some cases, sponsors may not include the actual fueled new product holdings. The approach launches by creating may serve well enough indices that served little under normal market purpose except to provide conditions, but statistical a benchmark for an ETF to models suffer from a fatal track. Nevertheless, the flaw. They break down umbilical cord that tied during market ETFs to an index has dislocations. That will contributed to their cause bid-offer spreads to popularity among widen just when investors professional traders and are most likely to make enabled the authorised adjustments to their participants who create portfolios. “Active equity and redeem units to hedge ETFs may not disclose their exposure precisely. their holdings each day Active management and if they do the basket undermines the may not be a full transparency that keeps representation of what the passive ETFs trading close fund owns at that time,” to their net asset value says Richard Genoni, (NAV). Even a rulesmanager of ETF products based quantitative active at The Vanguard Group, strategy that is only one the Valley Forge-based step beyond an index fund management introduces a small degree powerhouse, “You could of uncertainty. If the see fairly wide bid-offer sponsor posts the spreads as a result.” portfolio every morning Transparency—or the on the Web, investors lack of it—could affect the know what the fund holds Jeffery Ptak, an ETF analyst Morningstar, the Chicago-based fund performance of active when the market opens research and data provider. The boundary between active and passive ETFs, too. Genoni points but not how those management is no longer a bright line. The advent of “intelligent” out that index providers holdings change during indices, which apply quantitative screens to exclude from a chosen publicise changes to the the day. So while an active population components that are expected to underperform their peers, constituents in advance, ETF may be transparent, it introduced an element of active management to ETFs several years which attracts hedge funds will not be as predictable ago.“You don’t have a person using their full discretion to decide what and other institutional as an indexed ETF. The we will be in the portfolio, how much of it and how long it will stay,” investors who take the only way dealers can he says,“But it is a form of active management.” Photograph kindly other side of the trade and protect themselves supplied by Morningstar, March 2008. lessen the market impact against any divergence between the theoretical and actual NAV is to widen the when index funds—including ETFs—make the required portfolio adjustments. An active equity manager who bid-offer spread.

At the opposite end of the active spectrum, sponsors of dumps a position in an illiquid stock gets no such help.“If active ETFs based on fundamental research must balance the trade takes place over several days, the price may be the managers’ need for secrecy—if they publish the driven down by the manager’s own trading,” says Genoni, portfolio every day third parties have an opportunity to “It can hurt the performance of the fund.”

Experienced managers try to minimise the market front run their trades—and the authorised participants’ need for transparency to keep market prices close to NAV. impact of their trades but some sponsors who plan to “ETFs depend on transparency to the market in order to launch active ETFs have little or no track record in active function, but that disclosure is anathema to active management. Genoni expects investors will be reluctant to commit money to a product until it has proved it can managers who do not want to tip their hand,”says Ptak.

The active equity ETFs now in registration at the SEC all generate excess return, or alpha. Although Vanguard has provide near real-time transparency, but as sponsors edge overcome the obstacle because its ETFs constitute a toward products that offer active management of less liquid separate share class of existing mutual funds that have equities they will have to sacrifice full disclosure. Among well-established track records Genoni does not see the alternatives proposed is a basket back-tested to track much demand for active equity ETFs from either

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James Ross, senior managing director responsible for ETFs and intermediary businesses at State Street Global Advisors (SSGA headquarters in Boston, Massachusetts. In another variant that defuses the transparency problem, SSGA plans to launch a series of a series of target date retirement funds structured as active ETFs. The active funds will own passive ETFs, but SSGA will overlay an asset allocation strategy tailored to the target date that calls for periodic rebalancing among the underlying ETFs.“They will not be the most active of active ETFs,” says Ross,“But they are not based on a benchmark.” Disclosure will offer traders little opportunity if the underlying portfolios change infrequently and consist of nothing but index funds. Photograph kindly supplied by SSGA, March 2008.

institutional investors or financial planners.“Our advisor clients are looking to achieve alpha through management of index funds,” he says, “They would rather over- or underweight sectors or size or styles through beta [index] products to achieve alpha rather than use an unproven equity alpha product.”

If Genoni is right, the demand for active equity ETFs will have to come primarily from direct retail investors.

“Active ETFs will be a sold product,” he says, “I do not expect early adoption on the equity front without a proven track record.” Other market participants share Genoni’s reservations. Bruce Lavine, president and chief operating office at New York-based WisdomTree Investments, says sponsors must prove to potentially sceptical investors that active ETFs will trade at fair value with ample liquidity, tax efficiency and—most important of all—investment merit.“The most successful active ETFs will retain the benefits that investors get from passive

ETFs while adding something else not available today,”he says. Compared to actively managed mutual funds, index ETFs offer greater transparency, intraday liquidity, lower fees and—in the U.S., at least—superior tax management, not to mention a long term record of higher returns than most active managers deliver. As Lavine says,“Index ETFs have already raised the bar quite high on the merits of investment products.”

Transparency is no threat to an active manager if the instruments the fund holds are highly liquid, of course.

WisdomTree has filed applications at the SEC to launch several currency ETFs that will trade money market instruments in foreign markets, while Vanguard has applications for four funds that trade only US treasuries.

Regulators have already recognised that a portfolio of actively traded short term debt offers little opportunity for front running even if it is fully disclosed. Although the launch date was postponed in the wake of Bear Stearns’ financial difficulties, the first active ETF the SEC approved for trading, the Bear Stearns Active ETF Trust, was to have been an ultra-short US dollar bond fund in which duration was expected to average 180 days and the final maturity of any instrument it owned had to be three years or less. It planned to post its portfolio on the Web every day, but Scott Pavlak, the senior portfolio manager at Bear Stearns Asset Management who would have run the fund, says transparency poses no threat to performance. “Investors have the advantage of knowing what is in the portfolio,”he says,“It would be difficult for someone to arbitrage against such a high quality short duration portfolio.”

Pavlak notes that the value added from his team’s investment process derives not only from security selection but also from the maturity profile, duration and sector allocation.

Bear Stearns has delivered returns consistently higher than competing retail money market funds for more than 10 years using the same strategy to manage surplus cash for institutional clients and separately managed accounts. At 35 basis points (bps), the proposed management fee of the ETF was almost half the average for retail money market funds.

“It is a good value proposition,” Pavlak says, “It levels the playing field between institutional and retail investors.” At certain times in the credit cycle, Pavlak sees potential interest in the ETF from institutional cash managers, too. The target duration is about twice that of most money market funds so when short term rates tumble the return on the ETF will ratchet down more slowly. He expects the core market to be retail investors and financial advisors, however.

In another variant that defuses the transparency problem, State Street Global Advisors (SSGA) plans to launch a series of target date retirement funds structured as active ETFs. The active funds will own passive ETFs, but SSGA will overlay an asset allocation strategy tailored to the target date that calls for periodic rebalancing among the underlying ETFs.“They will not be the most active of active ETFs,” says James Ross, senior managing director responsible for ETFs and intermediary businesses at SSGA’s

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they can reverse headquarters in Boston, engineer an active ETF’s Mass., “But they are not secret sauce then odds based on a benchmark.” are that the ability to Disclosure will offer generate alpha will traders little opportunity evaporate quickly and it the underlying if will end up as a closet portfolios change index fund,” Archard infrequently and consist says. of nothing but index The ETF industry needs funds. to focus on where the Although target date structure can add value funds may seem tailorrather than churning out made for 401(k) ill-considered products retirement plans, ETFs that may be of little still face two major benefit to investors, hurdles in the 401(k) according to Archard. In world. Their low fees fully transparent active leave no room to pay for ETFs, he sees an recordkeeping or opportunity in short term commission tails to the fixed income and current brokerage community, products (BGI already has and an information two in registration) and technology infrastructure “slow moving asset geared toward mutual allocation products” funds that price only Richard Genoni, manager of ETF products at The Vanguard Group, the within a fund of funds— once a day cannot handle Valley Forge, Pennsylvania-based fund management powerhouse.“Active whether target-dated like continuously traded equity ETFs may not disclose their holdings each day and if they do the those of SSGA or not—in instruments like ETFs. basket may not be a full representation of what the fund owns at that which secrecy is not Ross sees a bigger time,” he says,“You could see fairly wide bid-offer spreads as a result.” critical to the portfolio opportunity in the Photograph kindly supplied by The Vanguard Group, March 2008. manager’s success. emerging market for Archard sees little employees who switch interest in active ETFs jobs and roll over their The active equity ETFs now in registration among institutions, 401(k) balance into an at the SEC all provide near real-time most of which can get a individual retirement transparency, but as sponsors edge toward mandate customised to account (IRA). The their needs at lower cost money is still earmarked products that offer active management of through a separately to fund future retirement, less liquid equities they will have to managed account. He but now it resides in a sacrifice full disclosure. Among the expects active ETFs to brokerage account. “That alternatives proposed is a basket backhave a slower growth is where the target date tested to track the portfolio that may or trajectory than their ETF comes in really may not include the actual holdings. The index cousins as a result. handy,” Ross says, “It’s In the long run, though, one trade.You hold it and approach may serve well enough under if sponsors keep active the sponsor optimises the normal market conditions, but statistical ETF fees lower than for asset allocation for you.” models suffer from a fatal flaw. They break equivalent mutual funds Noel Archard, head of down during market dislocations. That will and portfolio managers US iShares Product cause bid-offer spreads to widen just when can deliver tax efficiency Development at Barclays comparable to index Global Investors (BGI), investors are most likely to make ETFs, Archard sees a the leading sponsor of adjustments to their portfolios. significant portion of ETFs, says full retail assets flowing into transparency could undermine the performance even of an active ETF that active ETFs.“Once we get the structure right and broaden holds only the most liquid large capitalisation stocks. If a out the mandates, the opportunity for us to deliver a fund consistently delivers excess returns it won’t be long valuable product to the marketplace is huge,”he says.

It just won’t happen tomorrow. before other investors try to figure out how it does so. “If

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ETF Listings as of End February 2008

Ireland P Listings: T Listings: Managers: AUM:

Germany P Listings: T Listings: Managers: AUM:

Spain P Listings: T Listings: Managers: AUM:

Iceland

1 1 1 US$0.07 Bn

175 304 8 US$54.21 Bn

12 26 3 US$2.79 Bn

92 194 4 US$22.60 Bn

United Kingdom P Listings: T Listings: Managers: AUM:

Belgium P Listings: T Listings: Managers: AUM:

1 1 1 US$0.05 Bn

1 1 1 US$0.19 Bn

2 58 2 US$0.40 Bn

Netherlands P Listings: T Listings: Managers: AUM:

Italy 7 213 3 US$1.09 Bn

Norway P Listings: T Listings: Managers: AUM:

Turkey

21 139 4 US$8.78 Bn

119 179 6 US$42.11Bn

59 59 3 US$18.21 Bn

5 89 2 US$4.27 Bn

6 6 2 US$0.21 Bn

4 4 2 US$0.30 Bn

P Listings: T Listings: Managers: AUM:

Sweden P Listings: T Listings: Managers: AUM:

India P Listings: T Listings: Managers: AUM:

Australia P Listings: T Listings: Managers: AUM:

7 7 1 US$2.34 Bn

8 8 4 US$1.61 Bn

Finland P Listings: T Listings: Managers: AUM:

2 2 2 US$0.21 Bn

New Zealand P Listings: T Listings: Managers: AUM:

6 6 2 US$0.54 Bn

Hungary

P Listings: T Listings: Managers: AUM:

Austria

P Listings: T Listings: Managers: AUM:

Japan

P Listings: T Listings: Managers: AUM:

1 1 1 US$0.03 Bn

1 17 1 US$0.06 Bn

15 16 4 US$33.01 Bn

3 3 2 US$0.41 Bn

4 4 3 US$4.39 Bn

22 22 4 US$2.65 Bn

South Korea

P Listings: T Listings: Managers: AUM:

Malaysia

P Listings: T Listings: Managers: AUM:

5 16 5 US$1.64 Bn

Singapore

P Listings: T Listings: Managers: AUM:

1 1 1 US$0.04 Bn

10 10 2 US$1.70 Bn

10 19 5 US$11.33 Bn

Hong Kong

P Listings: T Listings: Managers: AUM:

Taiwan

P Listings: T Listings: Managers: AUM:

Thailand

P Listings: T Listings: Managers: AUM:

P Listings = # Primary Listings, T Listings = # Total Listings. Source: Morgan Stanley Investment Strategies, Bloomberg

1 1 1 US$0.01 Bn

P Listings: T Listings: Managers: AUM:

P Listings: T Listings: Managers: AUM:

Indonesia 11 11 4 US$2.01 Bn

South Africa P Listings: T Listings: Managers: AUM:

4 18 2 US$1.43 Bn

P Listings: T Listings: Managers: AUM:

1 1 1 US$0.11 Bn

Greece P Listings: T Listings: Managers: AUM:

P Listings: T Listings: Managers: AUM:

1 1 1 US$0.01 Bn

China

Slovenia P Listings: T Listings: Managers: AUM:

Switzerland P Listings: T Listings: Managers: AUM:

France P Listings: T Listings: Managers: AUM:

Canada P Listings: T Listings: Managers: AUM:

Mexico P Listings: T Listings: Managers: AUM:

1 1 1 US$2.27 Bn

604 604 18 US$521.5 Bn

United States P Listings: T Listings: Managers: AUM:

Brazil P Listings: T Listings: Managers: AUM:

EXCHANGE TRADED FUNDS: LISTING & DISTRIBUTION AS OF FEB 2008

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Worldwide ETF and ETP Growth 800

1400

700

1200

1000

500 800 400 600

# ETFs

Assets USD Billions

600

300 400

200

200

100

0

1993

1994

1995

1996

1997

1998

1999

2000

2001

$0.81

$1.12

$2.30

$5.26

$8.23

$17.60

$39.61

$74.34

$104.80

ETF Assets USD Billions ETF Commodity Assets USD Billions ETF Fixed Income Assets USD Billions

$0.81

$1.12

$2.30

$5.26

$8.23

$17.60

$39.61

2002

2003

$141.62 $212.02

2004

2005

2006

2007

Feb 08

$309.80

$412.09

$412.09

$796.60

$742.63

$0.04

$0.11

$0.32

$0.46

$1.20

$1.20

$6.32

$9.17

$0.12

$0.10

$3.97

$5.83

$23.05

$21.32

$21.32

$59.93

$71.63

$74.34

$104.66

$286.28

$389.57

$389.57

$730.28

$661.83

$15.58

$15.58

$45.87

$57.38

461

714

1171

1,222

23

70

134

171

$137.54 $205.87

ETF Equity Assets USD Billions # ETFs

3

3

4

21

21

31

33

92

202

280

282

336

# ETPs

0

Source: Morgan Stanley Investment Strategies, Bloomberg

Top 20 ETFs Around the World by AUM, as of End February 2008

20 Day 20 Day ADV (000) ADV Shares (USDMM)

Ticker

20 Day ADV (USDMM)

SPY US

$27,780

207,591

$67,027

PowerShares QQQ Nasdaq 100 QQQQ US

$6,487

151,030

$16,630

$3,103

iShares Russell 2000

IWM US

$5,822

84,546

$8,349

$375.8

iShares MSCI Emerging Markets

EEM US

$3,103

22,226

$25,655

Ticker

AUM (USDMM)

SPDR S&P 500

SPY US

$67,027

207,591

$27,780

iShares MSCI EAFE

EFA US

$46,139

12,715

$910

iShares MSCI Emerging Markets

EEM US

$25,655

22,226

IVV US

$17,575

2,810

ETF

iShares S&P 500 PowerShares QQQ Nasdaq 100

Top 20 ETFs Around the World by Average Daily US$ Trading Volume, as of End February 2008

ETF

SPDR S&P 500

20 Day ADV (000) AUM Shares (USDMM)

QQQQ US

$16,630

151,030

$6,487

Financial Select Sector SPDR Fund XLF US

$2,854

110,488

$5,605

iShares Russell 1000 Growth

IWF US

$13,209

3,669

$202.0

UltraShort QQQ® ProShares

QID US

$1,825

34,660

$1,596

iShares Lehman 1-3 Yr Treasury

$8,163

SHY US

$9,901

1,239

$104.3

DIAMONDS

DIA US

$1,717

13,955

Vanguard Total Stock Market ETF

VTI US

$9,742

609

$80.8

Energy Select Sector SPDR Fund

XLE US

$1,697

22,320

$5,743

iShares S&P/TSX 60 Index Fund

XIU CN

$9,523

3,106

$253.4

UltraShort S&P500® ProShares

SDS US

$1,497

23,220

$2,916

iShares MSCI-Brazil

$7,514

iShares Russell 1000 Value

IWD US

$8,653

2,534

$187.6

iShares Lehman Aggregate Bond

AGG US

$8,523

602

$62.0

iShares Russell 2000

IWM US

$8,349

84,546

DIAMONDS

EWZ US

$1,306

15,634

iShares FTSE/XINHUA China 25

FXI US

$1,004

6,916

$5,882

$5,822

iShares MSCI EAFE

EFA US

$910

12,715

$46,139

UltraShort Financials ProShares

SKF US

$769

6,447

$1,923

Ultra QQQ ProShares

QLD US

$703

10,223

$954

UltraShort Russell 2000 ProShares TWM US

$657

7,799

$1,062

S&P 400 MidCap SPDR

MDY US

$644

4,467

$7,989

IYR US

$582

9,232

$1,815 $1,540

DIA US

$8,163

13,955

$1,717

S&P 400 MidCap SPDR

MDY US

$7,989

4,467

$644

iShares MSCI Japan

EWJ US

$7,969

21,354

$267.6

OSE NIKKEI 225 ETF

1321 JP

$7,612

500

$63.8

iShares MSCI-Brazil

EWZ US

$7,514

15,634

$1,306

TSE TOPIX ETF

1306 JP

$7,383

3,793

$47.3

Materials Select Sector SPDR Trust XLB US

$533

13,052

Lyxor DJ Euro STOXX 50

MSE FP

$7,239

1,734

$98.3

Ultra S&P500 ProShares

SSO US

$471

6,907

$809

TIP US

$6,402

586

$64.8

iShares S&P 500

IVV US

$376

2,810

$17,575

iShares Lehman US TIPS Fund

Source: Morgan Stanley Investment Strategies, Bloomberg

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Source: Morgan Stanley Investment Strategies, Bloomberg

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Global ETF Assets by Region of Exposure, as of End February 2008 Region of Exposure

Total Listings

# ETFS

AUM (US$bn)

Commodities Global (ex-US)

% TOTAL

Global

1%

1%

Currency

0%

8%

Americas Emerging Markets Europe/Africa Asia Pacific Fixed Income Global Commodities Global (ex-US) Currency Total

453 160 260 69 135 62 37 43 4 1,223

579 333 521 131 234 135 59 47 4 2,043

$338.44 $99.04 $92.60 $64.81 $71.64 $58.46 $9.43 $8.19 $0.02 $742.63

45.6% 13.3% 12.5% 8.7% 9.6% 7.9% 1.3% 1.1% 0.0% 100.0%

Fixed Income

12%

Americas

46%

Asia Pacific

12%

Europe/Africa

12%

Emerging Markets

46%

Top 20 ETF Managers Around the World ranked by AUM, as of End February 2008 Year End 2007 Manager

AUM # ETFs (USD Bn)

Barclays Global Investors State Street Global Advisors Vanguard Lyxor Asset Management PowerShares Nomura Asset Management ProFunds DB X-Trackers Nikko Asset Management Daiwa Asset Management Bank of New York AXA / BNP Van Eck Associates Corp Credit Suisse WisdomTree Hang Seng Investment Management Ltd Nacional Financiera SNC China Asset Management BBVA Gestion Credit Agricole Structured Asset Management

321 83 37 88 114 7 58 49 2 5 1 30 8 8 39 3 1 2 7 3

$402.61 $152.39 $41.97 $31.50 $38.02 $17.44 $9.70 $10.66 $9.08 $7.63 $10.15 $6.69 $3.49 $4.97 $4.52 $4.71 $3.74 $3.09 $1.18 $3.02

% Total

50.5% 19.1% 5.3% 4.0% 4.8% 2.2% 1.2% 1.3% 1.1% 1.0% 1.3% 0.8% 0.4% 0.6% 0.6% 0.6% 0.5% 0.4% 0.1% 0.4%

End February 2008

YTD Change

AUM # # ETFs (USD Bn) % Total Planned

323 $375.97 84 $118.47 37 $43.07 94 $34.63 116 $30.87 7 $16.36 58 $15.53 67 $14.84 2 $8.62 5 $7.99 1 $7.99 30 $7.08 12 $5.38 8 $5.23 40 $4.22 3 $4.02 1 $3.93 2 $2.90 7 $2.58 3 $2.54

50.6% 16.0% 5.8% 4.7% 4.2% 2.2% 2.1% 2.0% 1.2% 1.1% 1.1% 1.0% 0.7% 0.7% 0.6% 0.5% 0.5% 0.4% 0.3% 0.3%

12 20 3 2 51 0 69 22 1 1 0 8 12 0 29 0 0 1 0 0

AUM # ETFs % ETFs (USD Bn)

2 1 0 6 2 0 0 18 0 0 0 0 4 0 1 0 0 0 0 0

0.6% 1.2% 0.0% 6.8% 1.8% 0.0% 0.0% 36.7% 0.0% 0.0% 0.0% 0.0% 50.0% 0.0% 2.6% 0.0% 0.0% 0.0% 0.0% 0.0%

-$26.64 -$33.92 $1.09 $3.12 -$7.14 -$1.09 $5.84 $4.18 -$0.46 $0.36 -$2.16 $0.40 $1.88 $0.26 -$0.31 -$0.69 $0.19 -$0.19 $1.40 -$0.48

AUM % Market % Share

-6.6% -22.3% 2.6% 9.9% -18.8% -6.2% 60.2% 39.3% -5.1% 4.7% -21.3% 5.9% 53.9% 5.3% -6.8% -14.6% 5.0% -6.1% 118.2% -15.9%

0.1% -3.2% 0.5% 0.7% -0.6% 0.0% 0.9% 0.7% 0.0% 0.1% -0.2% 0.1% 0.3% 0.1% 0.0% 0.0% 0.1% 0.0% 0.2% 0.0%

Source: Morgan Stanley Investment Strategies, Bloomberg

NOTES The Number of ETFs increased in February 2008.

At the end of February 2008, 63 ETFs have been launched. There are plans to launch a further 497 ETFs: 61 in Europe, 393 in the US and 43 in the rest of the world.

ETF AUM is expected to exceed $2trn in 2011.

• The forecast that ETF AUM will exceed $2trn in 2011 is based on a number of factors driving the growth such as; 1.continuing increase in the number of institutional and retail investors who use ETFs and view them as useful tools for tactical and strategic exposure, 2.funds making larger allocations to ETFs based on recent regulatory changes in the US, Europe and in many emerging markets, 3.the expansion in asset classes and the number and types of equity, fixed income, commodity and other indices covered, 4.development and growth of investment products that employ ETFs and other low cost beta products 5.many exchanges plan to launch new ETF trading segments and 6.the expectation that there will be a number of new issuers/managers of ETFs.

Disclaimer: This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. This material was not prepared by the Morgan Stanley Research Department, and you should not regard it as a research report. Morgan Stanley may deal as principal in or own or act as market maker for securities/instruments mentioned or may advise the issuers.

We do not represent this is accurate or complete and we may not update this. © 2008 Morgan Stanley Contact info: Comments/suggestions are always appreciated and Morgan Stanley can provide customized modeling analysis or implementation strategies where appropriate. Please contact Deborah Fuhr on +44 20 7425 5598 or email Deborah.Fuhr@morganstanley.com.

M AY 2 0 0 8 • F T S E G L O B A L M A R K E T S

GM EDITORIAL 25.qxd:Issue 25

12/4/08

15:13

Page 95

Top 10 Equities By Daily Total Return

Top 10 Corp Bonds By Daily Total Return

Rank Stock description

Rank Stock description

1

Wartsila Oyj Abp

1

Archer-Daniels-Midland Co (0.875% 15-Feb-2014)

2

Sponda Oyj

2

American General Finance Corp (6.9% 15-Dec-2017)

3

Groupe Eurotunnel Sa

3

Quiksilver Inc (6.875% 15-Apr-2015)

4

Imergent Inc

4

Affinia Group Inc (9% 30-Nov-2014)

5

InterOil Corp

5

Sally Holdings Llc (10.5% 15-Nov-2016)

6

Wci Communities Inc

6

Burlington Coat Factory Warehouse Corp (11.125% 15-Apr-2014)

7

Nutrisystem Inc

7

Domtar Corp (7.125% 15-Aug-2015)

8

Orion Corporation

8

Dean Foods Co (7% 01-Jun-2016)

9

Medis Technologies Ltd

9

Freescale Semiconductor Inc (10.125% 15-Dec-2016)

10

Conn’s Inc

10

Yankee Acquisition Corp/MA (9.75% 15-Feb-2017)

Equity by Fee > 10 < 100 Mln

Equity by Fee > 100 Mln

Rank Stock description

Rank Stock description

1

Groupe Eurotunnel Sa

1

Wartsila Oyj Abp

2

Imergent Inc

2

Sponda Oyj

3

InterOil Corp

3

Nutrisystem Inc

4

Wci Communities Inc

4

Orion Corporation

5

Medis Technologies Ltd

5

Corus Bankshares Inc

6

Conn's Inc

6

Abitibibowater Inc

7

Osiris Therapeutics Inc

7

Stora Enso Oyj

8

Globalstar Inc

8

Upm-kymmene Oyj

9

Conergy Ag

9

USANA Health Sciences Inc

10

Sulphco Inc

10

Indymac Bancorp Inc

Corp by Fee > 10 < 100 Mln

Corp by Fee > 100 Mln

Rank Stock description

Rank Stock description

1

Sally Holdings Llc (10.5% 15-Nov-2016)

1

Freescale Semiconductor Inc (10.125% 15-Dec-2016)

2

Burlington Coat Factory Warehouse Corp (11.125% 15-Apr-2014)

2

Countrywide Home Loans Inc (3.25% 21-May-2008)

3

Yankee Acquisition Corp/MA (9.75% 15-Feb-2017)

3

Neiman Marcus Group Inc (10.375% 15-Oct-2015)

4

Beazer Homes Corp (8.125% 15-Jun-2016)

4

General Motors Corp (8.375% 15-Jul-2033)

5

Michaels Stores Inc (11.375% 01-Nov-2016)

5

Spectrum Brands Inc (11.25% 02-Oct-2013)

6

Cch I Holdings Llc (13.5% 15-Jan-2014)

6

Countrywide Financial Corp (3.345% 05-May-2008)

7

General Motors Corp (7.25% 03-Jul-2013)

7

United States Treasury Strip Coupon (0% 15-May-2024)

8

K Hovnanian Enterprises Inc (8.625% 15-Jan-2017)

8

Cit Group Inc (5% 24-Nov-2008)

9

Bon Ton Stores Inc (10.25% 15-Mar-2014)

9

General Motors Corp (7.125% 15-Jul-2013)

10

Ply Gem Industries Inc (9% 15-Feb-2012)

10

Gaz Capital Sa (8.625% 28-Apr-2034)

Govt by Fee > 10 < 100 Mln

Govt by Fee > 100 Mln

Rank Stock description

Rank Stock description

1

Italy, Republic Of (Government) (2.05% 01-Feb-2010)

1

United States Treasury (4.75% 15-May-2014)

2

Italy, Republic Of (Government) (0% 14-Nov-2008)

2

United States Treasury (3.375% 30-Nov-2012)

3

Resolution Funding Corp (0% 15-Jul-2019)

3

United States Treasury (3.625% 31-Dec-2012)

4

United States Treasury (0% 15-Aug-2021)

4

United States Treasury (2.875% 31-Jan-2013)

5

United States Treasury (0% 15-Feb-2009)

5

United States Treasury (4.25% 30-Sep-2012)

6

United States Treasury (0% 15-Aug-2027)

6

United States Treasury (0% 26-Jun-2008)

7

United States Treasury (0% 15-Aug-2017)

7

United States Treasury (4.25% 15-Jan-2011)

8

United States Treasury (0% 15-Nov-2011)

8

United States Treasury (3.5% 15-Dec-2009)

9

United States Treasury (0% 15-Aug-2023)

9

United States Treasury (4.125% 31-Aug-2012)

10

United States Treasury (0% 15-Aug-2015)

10

United States Treasury (0% 03-Apr-2008)

SECURITIES LENDING DATA

A SNAPSHOT VIEW OF THE SECURITIES LENDING MARKET AS OF FEBRUARY 2008

Source: Data Explorers, 2008. All figures kindly compiled by Data Explorers, February 2008.

F T S E G L O B A L M A R K E T S • M AY 2 0 0 8

95

lF Wo FT TSE rld SE W Ind FT or D ex SE FT eve ld I S A FT dv E lop nde SE Em ed x a In e Se nce co d E rgin de x nd g m FT ary erg Ind ex in FT SE E g SE G me In FT D lob rgin de SE x FT eve al g In Ad SE lo All va Em ped Cap dex nc In ed erg All F Ca de FT TSE Em ing x p SE In Se erg All c Ca de Gl i x ob ond ng p A FT al G ary ll C Ind F ov Em ap ex FT TSE SE EP ern er SE In E EP PRA RA me gin dex RA /N /N nt g I A nd A / B F R FT TSE NAR REI EIT ond ex SE In EP EIT T G Gl d o EP lo R RA A/N Glo ba bal ex /N AR bal l RE Ind AR D ex E IT M M acq EIT IT G ivid s I ac n Gl lob end de qu uar x o + i al e ar In G ba R ie Gl lob l No ent de x a ob al n In -R l In al In fra ent de x fra st a st ruc l In ru de F tu x FT TSE ctu re In SE 4G re FT SE FT 4G oo 100 dex RA SE ood d G In FI GW G lob de x De A lob al In ve De al d 1 lo v pe elo 00 ex FT d In p de SE ex me RA US nt I x FI 10 nd Em 00 ex I er gi nde ng x In de x

Al % Change

Al lF Wo FT TSE rld SE W Ind FT or D ex SE FT eve ld FT Ad SE lop Ind SE va Em ed ex In e Se nce co d E rgin de x nd g m FT ary erg Ind FT SE Em ing ex SE G In e FT De lob rgin de al SE x F g v In Ad TSE elo All de C va E pe x nc me d A ap In ed rg ll F Ca de FT TSE Em ing x p SE In Se erg All c Ca de Gl i x ob ond ng p A FT al G ary ll C Ind F ov Em ap ex FT TSE SE e E SE In rn er E P EP PRA RA me gin dex RA /N /N nt g I AR nd A / B F FT TSE NAR REI EIT ond ex SE In EP EIT T G Gl d o EP lo R RA A/N Glo ba bal ex In /N A ba l R AR RE l D EIT de M x M acq EIT IT G ivid s I ac lo en nde G qu uar ba d+ x ar ie lob lR In a G ie Gl lob l No ent de x ob al n- al In In R al In fra ent de x fra st al st ruc In ru de F tu x FT TSE ctu re In SE 4G re FT SE FT 4G oo 100 dex RA SE ood d G In FI GW G lob de x De A lob al In ve De al d 1 lo v pe elo 00 ex FT d In p de SE ex me RA US nt I x FI 10 nd Em 00 ex I er gi nde ng x In de x

FT SE

96 % Change

p05

p07 M ar -0 8

Se

M ar -0 7

p07

18:13

Se

Index Level Rebased (31 Mar 03=100)

9/4/08

M ar -0 6

Se

M ar -0 5

Se p04

M ar -0 4

Se p03

M ar -0 3

MARKET DATA BY FTSE RESEARCH

FT SE

MARKET REPORTS 25.qxd:MARKET REPORTS 25.qxd Page 96

Global Market Indices

5-Year Total Return Performance Graph 800

700

FTSE All-World Index

600

FTSE Emerging Index

500

FTSE Global Government Bond Index

400

300

FTSE EPRA/NAREIT Global Index

200

FTSE4Good Global Index

100

Macquarie Global Infrastructure Index

0

FTSE GWA Developed Index

-4

-6

0

-10

FTSE RAFI Emerging Index

2-Month Performance

6

4

2

-2 0

Capital return

Total return

-10 -8

-12

1-Year Performance

30

20

10

Capital return

Total return

-20

-30

M AY 2 0 0 8 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

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Table of Capital Returns Index Name FTSE All-World Indices FTSE All-World Index FTSE World Index FTSE Developed Index FTSE Emerging Index FTSE Advanced Emerging Index FTSE Secondary Emerging Index FTSE Global Equity Indices FTSE Global All Cap Index FTSE Developed All Cap Index FTSE Emerging All Cap Index FTSE Advanced Emerging All Cap Index FTSE Secondary Emerging Fixed Income FTSE Global Government Bond Index Real Estate FTSE EPRA/NAREIT Global Index FTSE EPRA/NAREIT Global REITs Index FTSE EPRA/NAREIT Global Dividend+ Index FTSE EPRA/NAREIT Global Rental Index FTSE EPRA/NAREIT Global Non-Rental Index Infrastructure Macquarie Global Infrastructure Index Macquarie Global Infrastructure 100 Index SRI FTSE4Good Global Index FTSE4Good Global 100 Index Investment Strategy FTSE GWA Developed Index FTSE RAFI Developed ex US 1000 Index FTSE RAFI Emerging Index

Currency Constituents

Value 2 M (%) 6 M (%) 12 M (%) YTD (%) Actual Div Yld (%)

USD USD USD USD USD USD

2915 2453 2012 903 441 462

238.02 416.52 224.28 547.03 498.88 659.78

-1.6 -1.6 -2.0 1.4 4.3 -2.5

-11.3 -11.4 -11.8 -7.3 -5.8 -9.3

-2.4 -3.3 -4.6 19.7 18.1 22.0

-9.7 -9.4 -9.6 -10.7 -6.1 -16.4

2.64 2.67 2.68 2.29 2.52 1.97

USD USD USD USD USD

8009 6188 1821 939 882

399.02 378.55 772.85 715.71 899.90

-1.5 -1.8 1.3 5.1 -3.6

-11.5 -11.9 -8.0 -6.8 -9.6

-3.0 -5.2 19.8 18.1 22.2

-9.7 -9.5 -11.2 -6.0 -17.6

2.55 2.59 2.25 2.49 1.92

USD

723

120.50

2.8

11.5

13.4

3.6

3.04

USD USD USD USD USD

291 189 226 236 55

2201.44 998.99 2046.56 1120.45 1273.39

-2.2 1.1 -1.2 1.5 -10.6

-16.9 -14.7 -14.7 -14.3 -22.8

-20.3 -20.2 -15.9 -21.7 -15.9

-6.5 -2.1 -5.4 -1.5 -17.5

4.19 5.10 4.95 4.91 2.31

USD USD

241 10070.81 100 9923.95

-1.5 -1.3

-3.2 -2.4

3.3 3.0

-9.0 -8.5

3.24 3.26

USD USD

708 105

6136.27 5208.37

-2.9 -3.9

-13.8 -14.7

-7.8 -8.4

-10.8 -12.1

3.23 3.51

USD USD USD

2012 1022 360

3762.08 6538.22 6462.21

-2.8 -0.2 2.3

-13.4 -10.7 -7.2

-7.1 -3.4 24.2

-9.9 -9.5 -10.8

3.17 3.82 2.90

Table of Total Returns Index Name FTSE All-World Indices FTSE All-World Index FTSE World Index FTSE Developed Index FTSE Emerging Index FTSE Advanced Emerging Index FTSE Secondary Emerging Index FTSE Global Equity Indices FTSE Global All Cap Index FTSE Developed All Cap Index FTSE Emerging All Cap Index FTSE Advanced Emerging All Cap Index FTSE Secondary Emerging Fixed Income FTSE Global Government Bond Index Real Estate FTSE EPRA/NAREIT Global Index FTSE EPRA/NAREIT Global REITs Index FTSE EPRA/NAREIT Global Dividend+ Index FTSE EPRA/NAREIT Global Rental Index FTSE EPRA/NAREIT Global Non-Rental Index Infrastructure Macquarie Global Infrastructure Index Macquarie Global Infrastructure 100 Index SRI FTSE4Good Global Index FTSE4Good Global 100 Index Investment Strategy FTSE GWA Developed Index FTSE RAFI Developed ex US 1000 Index FTSE RAFI Emerging Index

F T S E G L O B A L M A R K E T S â&#x20AC;˘ M AY 2 0 0 8

Currency Constituents

Value 2 M (%) 6 M (%) 12 M (%) YTD (%) Actual Div Yld (%)

USD USD USD USD USD USD

2915 2453 2012 903 441 462

278.95 655.06 262.41 664.90 611.24 792.73

-1.1 -1.1 -1.5 1.8 4.7 -2.2

-10.5 -10.5 -10.9 -6.6 -4.9 -8.8

-0.1 -1.0 -2.3 22.3 20.9 24.4

-9.2 -8.8 -9.1 -10.2 -5.5 -16.1

2.64 2.67 2.68 2.29 2.52 1.97

USD USD USD USD USD

8009 6188 1821 939 882

446.29 422.84 884.76 826.95 1014.81

-1.0 -1.3 1.7 5.6 -3.3

-10.7 -11.1 -7.3 -5.9 -9.1

-0.8 -3.0 22.3 20.9 24.5

-9.1 -8.9 -10.8 -5.4 -17.3

2.55 2.59 2.25 2.49 1.92

USD

723

164.61

3.4

13.4

17.5

4.0

3.04

USD USD USD USD USD

291 189 226 236 55

3151.02 1094.12 2191.99 1225.31 1328.29

-1.4 2.1 -0.2 2.4 -10.3

-15.3 -12.7 -12.7 -12.4 -22.0

-17.3 -16.5 -12.2 -18.2 -14.3

-5.6 -0.9 -4.4 -0.3 -17.2

4.19 5.10 4.95 4.91 2.31

USD USD

241 11577.74 100 11439.22

-1.1 -0.9

-2.1 -1.4

6.4 6.1

-8.6 -8.1

3.24 3.26

USD USD

708 105

7120.91 6091.14

-2.3 -3.2

-12.8 -13.6

-5.3 -5.6

-10.2 -11.4

3.23 3.51

USD USD USD

2012 1022 360

4010.40 6966.42 6633.69

-2.3 0.4 2.7

-12.4 -9.8 -6.4

-4.7 -0.6 27.4

-9.2 -8.9 -10.3

3.17 3.82 2.90

97

% Change

F FT TS SE E A m N FT ort eric h a Am s I F T SE La n FT S SE E A tin eric dex a m A N FT ort eri me Ind ca r ex SE h s ica A La Am I tin eri ll C nde ap ca FT x SE Am A In LA eric ll Ca de x TI a p A B I FT FT EX ll C nde SE ap S A x In Am F E LA ll-S er TSE TI har dex B e ic In FT FTS as LAT EX Go IB TO de SE E x EP US ver EX P I F FT RA A G nm Br nd FT TS a e S / o s x SE E E E E NA ve ent il PR RE rn B In EP P R IT me ond dex RA A/N A/ n N N /N AR A I t AR E RE orth Bo nde n I x EI I T No T U Am d In T er No rt S d rth h A Div ica ex In A m ide M FT me eric nd dex ac + SE ric a qu I R a ar FT NA No en nde S ie t No E N REI n-R al I x rth AR T C en nd E t o a ex I A M ac me T E mp l In os qu q d r ar ica uity ite ex ie I I US nfra REI nde T s x A In tru s In fra ctu d e FT stru re I x FT SE ctu nde SE 4G re x 4G oo In oo d U de x d S FT U F In SE FT TS S d RA SE E G 100 ex W FI R In US AFI A U de x US S M I id n Sm 100 dex 0 al l 1 Ind 50 ex 0 In de x

98 % Change

p05

p07 M ar -0 8

Se

M ar -0 7

p07

18:13

Se

Index Level Rebased (31 Mar 03=100)

9/4/08

M ar -0 6

Se

M ar -0 5

Se p04

M ar -0 4

Se p03

M ar -0 3

MARKET DATA BY FTSE RESEARCH

F FT TS SE E A m N FT ort eric h a Am s I F T SE La n FT S SE E A tin eric dex m Am a I No e nd FT ric e r ex SE t h as ric Al a In La Am l e t d FT in A rica Cap ex SE m Al In LA eric l Ca de x TI a p A B I FT FT EX ll C nde SE a S A x p In Am F E LA ll-S er TSE TI har dex BE e i c L In A X FT FTS as Go TIB TO de SE E x EP US ver EX P I FT A B FT nm RA ra nde G FT S S x SE E E E E /NA ove ent sil EP PR PR RE rnm Bo Ind IT RA A/N A/ en nd ex N /N AR NA I t AR E RE orth Bo nde n IT x EI IT No U Am d In T er No rt S d rth h A Div ica ex A m ide In M FT me eric nd dex ac + SE ric a qu ar FT NA a N Ren Ind S ie e o t No E N REI n-R al I x rth AR T C en nd e E ta o x I A M ac me T E mp l In os qu q d r ar ica uity ite ex ie I I US nfra REI nde T s x A In tru s In fra ctu d ex r s e t FT ru I FT SE ctu nde SE 4G re x 4G oo In oo d U de x d FT U S In F SE FT TS S d RA SE E G 100 ex FI RA W In A US FI US dex U M id S 1 Ind Sm 00 ex 0 al l 1 Ind 50 ex 0 In de x

MARKET REPORTS 25.qxd:MARKET REPORTS 25.qxd Page 98

Americas Market Indices

5-Year Total Return Performance Graph 350

FTSE Americas Index

300

250

FTSE Americas Government Bond Index

200

FTSE EPRA/NAREIT North America Index

150

FTSE EPRA/NAREIT US Dividend+ Index

100

FTSE4Good USIndex

50

FTSE GWA US Index

0

FTSE RAFI US 1000 Index

2-Month Performance

6

4

2

0

-2

-4

10

0

Capital return

Total return

-6

-8

1-Year Performance

50

40

30

20

Capital return

-10

Total return

-20

-30

M AY 2 0 0 8 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

MARKET REPORTS 25.qxd:MARKET REPORTS 25.qxd

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Table of Capital Returns Index Name

Currency Constituents

FTSE All-World Indices FTSE Americas Index FTSE North America Index FTSE Latin America Index FTSE Global Equity Indices FTSE Americas All Cap Index FTSE North America All Cap Index FTSE Latin America All Cap Index Region Specific FTSE LATIBEX All-Share Index FTSE LATIBEX TOP Index FTSE LATIBEX Brasil Index Fixed Income FTSE Americas Government Bond Index FTSE USA Government Bond Index Real Estate FTSE EPRA/NAREIT North America Index FTSE EPRA/NAREIT US Dividend+ Index FTSE EPRA/NAREIT North America Rental Index FTSE EPRA/NAREIT North America Non-Rental Index FTSE NAREIT Composite Index FTSE NAREIT Equity REITs Index Infrastructure Macquarie North America Infrastructure Index Macquarie USA Infrastructure Index SRI FTSE4Good US Index FTSE4Good US 100 Index Investment Strategy FTSE GWA US Index FTSE RAFI US 1000 Index FTSE RAFI US Mid Small 1500 Index

Value 2 M (%) 6 M (%) 12 M (%) YTD (%) Actual Div Yld (%)

USD USD USD

862 725 137

541.41 558.55 922.91

-3.5 -3.9 4.3

-12.0 -12.7 4.7

-3.7 -5.3 36.3

-9.4 -9.7 -1.8

2.10 2.09 2.26

USD USD USD

2801 2601 200

343.82 330.05 1381.26

-3.4 -3.8 4.3

-12.0 -12.8 4.0

-4.2 -5.7 35.2

-9.3 -9.7 -2.0

2.02 2.00 2.23

36 3272.30 15 4740.30 13 12535.60

-0.5 4.2 1.7

-2.0 -4.3 -4.7

33.2 17.9 36.7

-10.5 -6.2 -11.2

na na na

USD USD USD USD USD

155 135

116.26 113.77

2.1 2.2

7.2 6.9

8.1 7.4

2.1 2.4

3.33 3.30

USD USD USD USD USD USD

119 95 115 4 137 110

2298.44 1830.64 1057.70 1123.12 152.76 486.39

1.1 1.7 1.5 -2.7 -1.1 1.6

-14.3 -13.7 -14.0 -16.3 -14.9 -13.5

-21.2 -21.7 -21.5 -18.0 -23.8 -20.9

-0.6 0.8 -0.2 -4.4 -1.8 0.2

4.92 5.01 5.03 3.92 5.6 5.0

USD USD

97 90

8262.31 8153.98

-3.3 -3.4

-4.8 -5.4

-3.3 -4.9

-10.1 -10.5

3.07 3.04

USD USD

147 101

4718.76 4531.97

-6.1 -6.1

-16.7 -16.5

-11.1 -10.7

-12.6 -12.6

2.41 2.44

USD USD USD

669 1009 1503

3264.81 5347.20 4748.15

-6.2 -5.7 -3.0

-15.3 -14.8 -14.0

-10.0 -10.6 -13.2

-10.5 -10.3 -9.1

2.45 2.68 2.19

Table of Total Returns Index Name

Currency Constituents

FTSE All-World Indices FTSE Americas Index FTSE North America Index FTSE Latin America Index FTSE Global Equity Indices FTSE Americas All Cap Index FTSE North America All Cap Index FTSE Latin America All Cap Index Region Specific FTSE LATIBEX All-Share Index FTSE LATIBEX TOP Index FTSE LATIBEX Brasil Index Fixed Income FTSE Americas Government Bond Index FTSE USA Government Bond Index Real Estate FTSE EPRA/NAREIT North America Index FTSE EPRA/NAREIT US Dividend+ Index FTSE EPRA/NAREIT North America Rental Index FTSE EPRA/NAREIT North America Non-Rental Index FTSE NAREIT Composite Index FTSE NAREIT Equity REITs Index Infrastructure Macquarie North America Infrastructure Index Macquarie USA Infrastructure Index SRI FTSE4Good US Index FTSE4Good US 100 Index Investment Strategy FTSE GWA US Index FTSE RAFI US 1000 Index FTSE RAFI US Mid Small 1500 Index

F T S E G L O B A L M A R K E T S • M AY 2 0 0 8

Value 2 M (%) 6 M (%) 12 M (%) YTD (%) Actual Div Yld (%)

USD USD USD

862 725 137

826.93 904.22 1158.58

-3.1 -3.5 4.7

-11.1 -11.9 5.8

-1.9 -3.5 39.6

-8.9 -9.3 -1.3

2.10 2.09 2.26

USD USD USD

2801 2601 200

376.89 361.26 1621.23

-3.0 -3.5 4.7

-11.2 -11.9 5.1

-2.4 -4.0 38.4

-8.9 -9.3 -1.5

2.02 2.00 2.23

EUR EUR EUR

36 15 13

na na na

na na na

na na na

na na na

na na na

na na na

USD USD

155 135

174.11 169.71

2.9 3.0

9.6 9.3

13.1 12.3

2.5 2.8

3.33 3.30

USD USD USD USD USD USD

119 95 115 4 137 110

3549.10 1963.27 1161.24 1212.91 3366.68 8300.40

1.9 2.6 2.4 -2.2 -0.2 2.5

-12.2 -11.6 -11.9 -14.8 -12.6 -11.5

-17.7 -18.1 -18.0 -15.2 -20.0 -17.4

0.6 2.0 1.0 -3.4 -0.6 1.4

4.92 5.01 5.03 3.92 5.62 4.99

USD USD

97 90

9488.24 9354.96

-2.7 -2.8

-3.4 -4.1

-0.5 -2.2

-9.4 -9.8

3.07 3.04

USD USD

147 101

5295.22 5103.68

-5.8 -5.7

-15.8 -15.6

-9.2 -8.8

-12.1 -12.1

2.41 2.44

USD USD USD

669 1009 1503

3453.54 5644.29 4879.65

-5.8 -5.2 -2.7

-14.3 -13.8 -13.3

-8.1 -8.7 -12.0

-10.0 -9.8 -8.7

2.45 2.68 2.19

99

FT ve S l F E FT ope TS Eu SE d E E rop FT E De ur uro e I SE De FT vel ope blo nde SE op ex c I x ve F n e FT lope TS Eu d E UK de x E r SE d E op ur In De Eur uro e A ope de x ve op blo ll I lo e A c Ca nde pe l A p x d l C ll C In Eu ap a de ro e p I x x FT pe U nde SE All S I x Al Ca nde l-S p x FT FT ha Ind S S re ex FT Eu E 1 In SE rof 00 de x FT uro irst In SE fir 80 de x st u I F FT T ro 1 nd SE FT SE/ firs 00 ex SE JS t 3 In Eu 0 de / E ro zo F JSE Top 0 In x ne TS A 4 d Go E R ll-S 0 I ex FT ve us har nd FT SE rn sia e ex S EP FT FT E G FT me IO Ind RA SE SE ilt SE nt B ex /N EP E s F Pf Bo Ind AR R PR ixe an nd ex A A d d FT FTS EIT /NA /N Al bri Ind SE E E RE AR l-S ef ex ur E EP PR o IT EIT toc Ind RA A pe Eu E ks ex I / /N e r u M NA AR x U ope rop nde ac R E K e x qu EI IT D RE In T I i ar E v T d ie Eu uro ide s I ex r n n Eu op pe d d + e ro e pe No Ren In x n- ta de I F n FT F TS fr Re l I x SE TS E4 ast nt nd GW E4 Go ruc al I ex G o n A oo d E ture de x De d u ve Eu rop Ind FT lop rop e I ex SE ed e 5 nd RA Eu 0 I ex FI rop nd Eu e ex ro Ind pe e In x de x

De

% Change

De

FT ve S l F E FT ope TS Eu E ro S d FT E E p De Eur uro e I SE De FT vel ope blo nde SE op ex c I x ve F n e FT lope TS Eu d E UK de SE d E E rop ur In x o E u e p De ur ro A e de ve op blo ll I x lo e A c Ca nde pe l A p l l I x l d Eu Cap Ca nde ro e p I x x n p FT e U d SE All S I ex Al Ca nde l-S p x FT FT ha Ind SE SE re ex In FT u 1 SE rof 00 de x FT uro irst In SE fir 80 de FT uro st 1 In x FT d SE FT SE/ firs 00 ex SE JS t 3 In Eu /J E T 00 de ro S zo F E op In x ne TS A 4 d Go E R ll-S 0 I ex FT ve us har nd FT s SE r n ia e ex S EP FT FT E G FT me IO Ind RA SE SE ilt SE nt B ex s /N EP E F Pf Bo Ind AR RA PR ixe an nd ex A d d FT FTS EIT /NA /N Al bri Ind SE E E RE AR l-S ef ex u EP EPR ro IT EIT toc Ind RA A pe Eu E ks ex I / /N e r u M NA AR x U ope rop nde ac R E K e x qu EI IT D RE In ar T E Eu ivi ITs de x ie u ro de I Eu rop pe nd nd + e ro e pe No Ren In x I n t de FT F FTS nfr -Re al I x SE TS E4 ast nt nd E GW 4 Go ruc al I ex G o n A oo d E ture de x De d u ve Eu rop Ind ex r l e F T op op I SE ed e 5 nd RA Eu 0 I ex FI rop nd Eu e ex ro Ind pe e In x de x

FT SE

100 % Change

p05

p07 M ar -0 8

Se

M ar -0 7

p07

18:13

Se

Index Level Rebased (31 Mar 03=100)

9/4/08

M ar -0 6

Se

M ar -0 5

Se p04

M ar -0 4

Se p03

M ar -0 3

MARKET DATA BY FTSE RESEARCH

FT SE

MARKET REPORTS 25.qxd:MARKET REPORTS 25.qxd Page 100

Europe, Middle East & Africa Indices

5-Year Total Return Performance Graph 400

350

FTSE Europe Index

300

FTSE All-Share Index

250

FTSEurofirst 80 Index

200

FTSE/JSE Top 40 Index

150

FTSE Gilts Fixed All-Stocks Index

100

FTSE EPRA/NAREIT Europe Index

50

0

FTSE4Good Europe Index

FTSE GWA Developed Europe Index

-30

FTSE RAFI Europe Index

2-Month Performance

20

15

10

5

Capital return

0

Total return

-5

-10

1-Year Performance

20

10

0

-10

-20

Capital return

Total return

-40

-50

M AY 2 0 0 8 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

MARKET REPORTS 25.qxd:MARKET REPORTS 25.qxd

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Table of Capital Returns Index Name

Currency Constituents

FTSE All-World Indices FTSE Europe Index FTSE Eurobloc Index FTSE Developed Europe ex UK Index FTSE Developed Europe Index FTSE Global Equity Indices FTSE Europe All Cap Index FTSE Eurobloc All Cap Index FTSE Developed Europe All Cap ex UK Index FTSE Developed Europe All Cap Index Region Specific FTSE All-Share Index FTSE 100 Index FTSEurofirst 80 Index FTSEurofirst 100 Index FTSEurofirst 300 Index FTSE/JSE Top 40 Index FTSE/JSE All-Share Index FTSE Russia IOB Index Fixed Income FTSE Eurozone Government Bond Index FTSE Pfandbrief Index FTSE Gilts Fixed All-Stocks Index Real Estate FTSE EPRA/NAREIT Europe Index FTSE EPRA/NAREIT Europe REITs Index FTSE EPRA/NAREIT Europe ex UK Dividend+ Index FTSE EPRA/NAREIT Europe Rental Index FTSE EPRA/NAREIT Europe Non-Rental Index Infrastructure Macquarie Europe Infrastructure Index SRI FTSE4Good Europe Index FTSE4Good Europe 50 Index Investment Strategy FTSE GWA Developed Europe Index FTSE RAFI Europe Index

Value 2 M (%) 6 M (%) 12 M (%) YTD (%) Actual Div Yld (%)

EUR EUR EUR EUR

584 2053 385 517

208.12 115.77 214.89 203.34

-4.8 -3.7 -3.1 -5.0

-18.5 -17.0 -17.0 -18.8

-17.1 -14.4 -14.9 -17.5

-16.2 -16.2 -15.0 -16.1

3.55 3.11 3.50 3.64

EUR EUR EUR EUR

1722 837 1149 1602

346.31 376.60 379.65 340.96

-4.5 -3.3 -2.6 -4.6

-18.7 -17.3 -17.2 -18.9

-18.0 -15.4 -15.8 -18.4

-15.8 -15.8 -14.7 -15.7

3.44 3.51 3.40 3.52

GBP GBP EUR EUR EUR ZAR ZAR USD

669 2927.05 102 5702.11 78 4661.47 98 3997.91 313 1262.14 41 27409.99 239 29587.51 416 1344.04

-2.4 -3.0 -4.5 -6.1 -5.1 9.1 8.3 14.6

-11.8 -11.8 -16.8 -19.0 -18.6 0.5 -1.2 4.4

-10.8 -9.6 -12.9 -16.1 -16.7 11.5 8.5 11.8

-10.9 -11.7 -17.1 -17.7 -16.2 4.4 2.2 -6.3

3.76 3.90 3.89 3.99 3.68 2.37 4.28 4.60

EUR EUR GBP

239 416 29

99.39 106.91 150.25

1.1 1.1 2.0

2.3 1.7 3.7

0.2 -0.3 1.8

1.9 1.8 0.3

4.28 4.60 4.41

EUR EUR EUR EUR EUR

95 38 47 81 14

1937.48 823.34 2375.92 934.53 932.07

-2.5 -3.2 3.2 -2.4 -4.6

-17.7 -15.3 -9.4 -16.9 -29.3

-36.5 -33.9 -25.9 -36.1 -41.7

-2.4 -0.9 2.7 -1.6 -14.4

3.80 3.84 4.57 3.93 1.59

USD

55 13468.71

0.1

-1.0

12.4

-9.1

3.40

EUR EUR

296 55

4070.02 3486.57

-6.0 -7.0

-20.3 -21.2

-19.8 -20.0

-16.8 -18.0

4.02 4.35

EUR EUR

517 527

3280.65 5077.45

-5.1 -5.3

-14.1 -19.3

-13.2 -17.7

-9.6 -16.6

4.22 4.31

Table of Total Returns Index Name

Currency Constituents

FTSE All-World Indices FTSE Europe Index FTSE Eurobloc Index FTSE Developed Europe ex UK Index FTSE Developed Europe Index FTSE Global Equity Indices FTSE Europe All Cap Index FTSE Eurobloc All Cap Index FTSE Developed Europe ex UK All Cap Index FTSE Developed Europe All Cap Index Region Specific FTSE All-Share Index FTSE 100 Index FTSEurofirst 80 Index FTSEurofirst 100 Index FTSEurofirst 300 Index FTSE/JSE Top 40 Index FTSE/JSE All-Share Index FTSE Russia IOB Index Fixed Income FTSE Eurozone Government Bond Index FTSE Pfandbrief Index FTSE Gilts Fixed All-Stocks Index Real Estate FTSE EPRA/NAREIT Europe Index FTSE EPRA/NAREIT Europe REITs Index FTSE EPRA/NAREIT Europe ex UK Dividend+ Index FTSE EPRA/NAREIT Europe Rental Index FTSE EPRA/NAREIT Europe Non-Rental Index Infrastructure Macquarie Europe Infrastructure Index SRI FTSE4Good Europe Index FTSE4Good Europe 50 Index Investment Strategy FTSE GWA Developed Europe Index FTSE RAFI Europe Index

F T S E G L O B A L M A R K E T S â&#x20AC;˘ M AY 2 0 0 8

Value 2 M (%) 6 M (%) 12 M (%) YTD (%) Actual Div Yld (%)

EUR EUR EUR EUR

584 2053 385 517

257.59 147.55 261.09 252.14

-4.3 -3.6 -2.9 -4.5

-17.7 -16.5 -16.5 -18.0

-14.5 -11.8 -12.5 -14.9

-15.7 -16.0 -14.7 -15.5

3.55 3.11 3.50 3.64

EUR EUR EUR EUR

1722 837 1149 1602

403.05 436.43 436.56 397.34

-4.0 -3.2 -2.4 -4.1

-18.0 -16.8 -16.7 -18.1

-15.6 -13.0 -13.4 -15.9

-15.3 -15.6 -14.4 -15.2

3.44 3.51 3.40 3.52

GBP GBP EUR EUR EUR SAR SAR USD

669 102 78 98 313 41 239 416

3550.21 3357.10 5467.99 4758.97 1656.74 2948.87 3156.36 1368.72

-1.3 -1.7 -4.4 -5.5 -4.5 9.8 9.0 14.9

-10.2 -10.1 -16.4 -18.0 -17.8 1.5 -0.1 5.0

-7.7 -6.3 -10.0 -13.1 -14.1 14.0 11.1 13.7

-9.9 -10.5 -16.9 -17.1 -15.7 5.1 2.9 -5.9

3.76 3.90 3.89 3.99 3.68 2.37 4.28 4.60

EUR EUR GBP

239 416 29

161.07 183.98 2059.64

1.9 1.8 2.1

4.5 3.9 6.3

4.6 3.9 7.1

2.3 2.1 0.4

4.28 4.60 4.41

EUR EUR EUR EUR EUR

95 38 47 81 14

2578.51 890.81 2599.41 995.66 954.56

-2.1 -2.9 3.8 -1.9 -4.6

-16.6 -14.1 -8.1 -15.7 -29.2

-34.4 -31.4 -22.9 -34.0 -41.1

-1.8 -0.2 3.5 -0.9 -14.4

3.80 3.84 4.57 3.93 1.59

USD

55 15665.38

0.2

-0.3

16.0

-8.9

3.40

EUR EUR

296 55

4955.41 4293.41

-5.3 -6.2

-19.4 -20.1

-17.1 -17.0

-16.2 -17.3

4.02 4.35

EUR EUR

517 527

3547.10 5434.92

-4.4 -4.8

-19.7 -18.5

-17.0 -15.0

-15.7 -16.1

4.22 4.31

101

F As TS ia E Pa As cif ia F As TS ic Pa E ia e c A Pa s F x J ific i cif a TS ap In P ic a E an de ex cif Ja I x FT Ja ic A pan nde SE pa ll I x Ja n A Cap nde pa ll In x C n FT a d SE F FTS All p I ex Bu TS E/A Cap nde rs E/A SE I x n a FT M SE A d FT T al AN N I ex SE SE SE ays 4 nd As e ia FT Xi C T ia 0 In x Pa SE nh aiw 10 de cif /X ua a 0 I x n n i F ic G nh All 5 de FT SE FT TSE ov ua -Sh 0 In x EP SE EP ern Chi are de R E R m n I x FT FT A/ PR A/ en a 2 nd SE SE NA A/N NA t B 5 I ex R R o EP EP EI AR EI n nde R RA T E T d x FT A/N /N As IT A As Ind FT SE AR AR ia s ia ex SE I E EI Div ia 3 Ind ID DFC IT A T A ide 3 I ex FC I si sia nd nd In ndia a N Re + I ex o di n FT a In n-R nta de In fra e l I x SE fra st nt nd Bu a r F e s rs FTS TS tru uct l In x u E a M E S 4G ctu re dex al G o re In FT ays X S od 30 de SE ia ha Jap In x Sh Hijr ria an de ar ah h 1 In x ia 0 d FT h J Sha 0 I ex FT SE ap ria nd SE G an h I ex FT G WA 10 nd S W 0 e FT E R A Jap In x SE AF Au an de RA I A stra In x d FT FT FI iust lia I ex SE SE Sin ra nd lia e g R R a x FT AFI AF por Ind SE K I J e ex a RA aiga pa Ind FI i 1 n I ex Ch 00 nd in 0 I ex a n 50 de In x de x

FT SE

% Change

F As TS ia E Pa As cif ia F As TS ic Pa ia E e c Pa As F x J ific cif ia TS ap In ic Pa E an de e cif Ja I x FT x Ja ic A pan nde SE pa ll I x Ja n A Cap nde pa l l x I n Ca nd FT SE F FTS All p I ex n C T E Bu S /A ap de rs E/A SE I x n a FT M SE A d FT T al AN N I ex SE n a S S y As E E s 4 de ia FT Xi C T ia 0 In x Pa SE nh aiw 10 de cif /X ua a 0 I x n n i FT ic G nhu All- 50 de FT F SE T SE ov a Sh In x C e EP SE EP rn hi are de R E R m n I x FT FT A/ PR A/ en a 2 nd SE SE NA A/N NA t B 5 I ex EP EP REI AR REI on nde R RA T E T d x F A/ /N As IT As Ind FT TSE NAR AR ia Asi ia ex SE I E EI Div a 3 Ind ID DFC IT A T A ide 3 I ex FC I si sia nd nd In ndia a N Re + I ex o di n FT a In n-R nta de In fra e l I x SE fra st nt nd Bu a r F e s u l rs FTS TS tru ct In x u E a M E S 4G ctu re dex al G oo re In FT ays X S d 30 de SE ia ha Jap In x Sh Hijr ria an de ar ah h 1 In x ia 0 d F h Sha 0 ex FT TSE Jap ria Ind SE G an h I ex FT G WA 10 nd S W 0 e FT E R A Jap In x SE AF Au an de RA I A stra In x d FT FT FI iust lia I ex SE SE Sin ral nd RA R ga ia I ex FT FI AF por nd SE K I J e ex a RA aiga pa Ind FI i 1 n I e x Ch 00 nd in 0 I ex a n 50 de In x de x FT SE

FT SE

102 % Change

p05

p07 M ar -0 8

Se

M ar -0 7

p07

18:13

Se

Index Level Rebased (31 Mar 03=100)

9/4/08

M ar -0 6

Se

M ar -0 5

Se p04

M ar -0 4

Se p03

M ar -0 3

MARKET DATA BY FTSE RESEARCH

FT SE

MARKET REPORTS 25.qxd:MARKET REPORTS 25.qxd Page 102

Asia Pacific Market Indices

5-Year Total Return Performance Graph 2400

2100

FTSE Asia Pacific Index

1800

FTSE/ASEAN 40 Index

1500

1200

FTSE/Xinhua China 25 Index

900

FTSE Asia Pacific Government Bond Index

600

FTSE IDFC India Infrastructure Index

300

0

2-Month Performance

15

10

5

0

-5

Capital return

-10

Total return

-15

-20

1-Year Performance

80

60

40

20

Capital return

0

Total return

-20

-40

M AY 2 0 0 8 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

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Table of Capital Returns Index Name FTSE All-World Indices FTSE Asia Pacific Index FTSE Asia Pacific ex Japan Index FTSE Japan Index FTSE Global Equity Indices FTSE Asia Pacific All Cap Index FTSE Asia Pacific ex Japan All Cap Index FTSE Japan All Cap Index Region Specific FTSE/ASEAN Index FTSE/ASEAN 40 Index FTSE Bursa Malaysia 100 Index TSEC Taiwan 50 Index FTSE Xinhua All-Share Index FTSE/Xinhua China 25 Index Fixed Income FTSE Asia Pacific Government Bond Index Real Estate FTSE EPRA/NAREIT Asia Index FTSE EPRA/NAREIT Asia 33 Index FTSE EPRA/NAREIT Asia Dividend+ Index FTSE EPRA/NAREIT Asia Rental Index FTSE EPRA/NAREIT Asia Non-Rental Index Infrastructure FTSE IDFC India Infrastructure Index FTSE IDFC India Infrastructure 30 Index SRI FTSE4Good Japan Index Shariah FTSE SGX Shariah 100 Index FTSE Bursa Malaysia Hijrah Shariah Index FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index FTSE GWA Australia Index FTSE RAFI Australia Index FTSE RAFI Singapore Index FTSE RAFI Japan Index FTSE RAFI Kaigai 1000 Index FTSE RAFI China 50 Index

Currency Constituents

Value 2 M (%) 6 M (%) 12 M (%) YTD (%) Actual Div Yld (%)

USD USD USD

1328 858 470

263.65 458.79 83.14

-2.8 -1.9 -10.2

-13.6 -13.8 -25.0

-1.2 13.5 -28.8

-11.5 -14.0 -18.1

2.37 2.82 1.74

USD USD USD

3292 1987 1305

464.62 613.40 294.40

-2.5 -1.7 -9.8

-13.7 -14.1 -24.9

-0.9 13.7 -29.0

-11.7 -14.4 -17.8

2.37 2.81 1.74

USD USD MYR TWD CNY HKD

156 457.70 40 9202.33 100 8217.21 50 6080.96 1019 8822.73 25 19911.54

-0.3 0.4 -10.7 10.4 -16.8 -2.5

-2.0 0.2 -5.5 -8.5 -29.4 -23.8

16.4 15.6 0.3 7.7 33.8 27.4

-7.2 -5.8 -13.5 -1.3 -26.1 -21.9

3.10 3.21 3.05 3.70 0.59 1.82

USD

257

96.56

5.0

16.5

17.1

5.6

1.28

USD USD USD USD USD

77 38 51 40 37

1906.64 1454.57 2379.35 1133.80 1297.74

-8.5 -7.7 -8.0 -2.2 -12.4

-23.4 -21.8 -20.4 -22.5 -24.0

-16.2 -16.6 -5.9 -18.7 -14.4

-17.1 -14.7 -18.2 -12.7 -19.9

3.63 6.3 5.01 5.87 2.07

IRP IRP

85 30

1257.12 1346.91

-15.0 -15.8

-5.9 -3.9

51.6 61.3

-30.6 -31.6

0.51 0.57

JPY

195

4532.40

-10.2

-23.7

-27.9

-17.9

1.75

100 5688.45 30 10053.91 100 1271.46

-0.9 -11.3 -10.2

-13.1 2.8 -27.5

-2.1 21.0 -28.4

-8.6 -13.8 -19.4

2.10 2.58 1.77

-10.6 -6.5 -5.7 4.6 -9.8 -8.9 -3.2

-24.4 -20.9 -17.0 -15.1 -23.9 -24.4 -19.3

-29.3 -12.5 -11.5 -1.6 -28.3 -20.1 25.1

-18.0 -16.3 -14.9 -8.7 -17.7 -20.2 -20.2

1.81 5.47 5.42 3.73 1.86 3.52 2.79

USD MYR JPY JPY AUD AUD SGD JPY JPY HKD

470 112 57 16 299 1029 50

3222.74 3730.36 5672.02 7140.43 4542.44 4769.06 6537.29

Table of Total Returns Index Name FTSE All-World Indices FTSE Asia Pacific Index FTSE Asia Pacific ex Japan Index FTSE Japan Index FTSE Global Equity Indices FTSE Asia Pacific All Cap Index FTSE Asia Pacific ex Japan All Cap Index FTSE Japan All Cap Index Region Specific FTSE/ASEAN Index FTSE/ASEAN 40 Index FTSE Bursa Malaysia 100 Index TSEC Taiwan 50 Index FTSE Xinhua All-Share Index FTSE/Xinhua China 25 Index Fixed Income FTSE Asia Pacific Government Bond Index Real Estate FTSE EPRA/NAREIT Asia Index FTSE EPRA/NAREIT Asia 33 Index FTSE EPRA/NAREIT Asia Dividend+ Index FTSE EPRA/NAREIT Asia Rental Index FTSE EPRA/NAREIT Asia Non-Rental Index Infrastructure FTSE IDFC India Infrastructure Index FTSE IDFC India Infrastructure 30 Index SRI FTSE4Good Japan Index Shariah FTSE SGX Shariah 100 Index FTSE Bursa Malaysia Hijrah Shariah Index FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index FTSE GWA Australia Index FTSE RAFI Australia Index FTSE RAFI Singapore Index FTSE RAFI Japan Index FTSE RAFI Kaigai 1000 Index FTSE RAFI China 50 Index

F T S E G L O B A L M A R K E T S • M AY 2 0 0 8

Currency Constituents USD USD USD

1328 858 470

Value 2 M (%) 6 M (%) 12 M (%) YTD (%) Actual Div Yld (%) 304.20 -2.1 -12.7 1.0 -10.9 1.86 574.73 -1.3 -12.9 16.6 -13.4 2.45 100.22 -9.5 -24.3 -27.7 -17.4 1.17

USD USD USD

3292 1987 1305

516.69 718.41 314.04

-1.8 -1.1 -9.0

-12.9 -13.3 -24.2

1.2 16.6 -27.9

-11.1 -13.9 -17.1

1.84 2.37 1.17

USD USD MYR TWD CNY CNY

156 563.73 40 10141.35 100 8718.94 50 7258.27 1019 9524.22 25 24312.44

0.1 0.8 -10.2 10.4 -16.8 -2.3

-1.0 1.1 -4.3 -8.5 -29.4 -23.6

20.2 19.6 3.4 11.4 34.7 29.9

-6.7 -5.4 -13.0 -1.3 -26.1 -21.8

2.71 2.81 2.50 3.38 0.55 1.49

USD

257

113.20

5.2

17.4

19.6

5.7

1.28

USD USD USD USD USD

77 38 51 40 37

2533.64 1614.00 2559.76 1269.29 1345.25

-7.7 -6.8 -6.9 -0.6 -12.1

-22.1 -20.3 -18.5 -20.4 -23.2

-13.6 -13.7 -1.9 -14.5 -12.9

-16.3 -13.8 -17.2 -11.2 -19.6

2.85 5.0 3.86 4.66 1.53

IRP IRP

85 30

1262.75 1354.16

-14.9 -15.7

-5.7 -3.7

52.3 62.2

-30.5 -31.5

0.51 0.66

JPY

195

4999.64

-7.3

-21.1

-25.0

-15.2

1.24

100 5935.73 30 10730.00 100 1345.61

-0.4 -11.0 -9.5

-12.3 3.4 -26.8

-0.2 24.2 -27.2

-7.9 -13.4 -18.8

1.73 2.59 1.24

-9.9 -5.3 -4.3 4.7 -9.0 -8.4 -3.1

-23.7 -19.2 -15.1 -14.5 -23.1 -23.5 -19.0

-28.1 -8.9 -7.4 1.8 -27.2 -17.8 28.2

-17.3 -15.1 -13.6 -8.7 -17.0 -19.7 -20.0

1.23 3.77 4.14 2.96 1.26 2.65 2.05

USD MYR JPY JPY AUD AUD SGD JPY JPY HKD

470 112 57 16 299 1029 50

3347.49 4188.97 6358.04 7651.47 4705.58 5035.43 6705.08

103

GM EDITORIAL 25.qxd:Issue 25

12/4/08

15:14

Page 104

CALENDAR

Index Reviews May – August 2008 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

9-May Mid-May 16-May Early Jun Early Jun Early Jun Early Jun Early Jun Early Jun 1-Jun 2-Jun 5-Jun 10-Jun 10-Jun 11-Jun 11-Jun

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

2-Jun 18-May 30-May 30-Jun 9-Jun 1-Jul 20-Jun 20-Jun 20-Jun 20-Jun 20-Jun 20-Jun 30-Jun 30-Jun 20-Jun

31-Mar 27-Apr 30-Apr 31-May 31-May 31-May 31-May 31-May 30-May 30-May 30-Apr 31-May 31-May 31-May 10-Jun

20-Jun 20-Jun 20-Jun 20-Jun 20-Jun

31-Mar 30-May 30-May 30-May 6-Jun

12-Jun 13-Jun 13-Jun 13-Jun 13-Jun 13-Jun 13-Jun 13-Jun 13-Jun 13-Jun Mid Jun Mid Jun Mid Jun Mid Jun Mid Jun 17-Jun 18-Jun 20-Jun 8-Jul 10-Jul Mid Jul Mid Jul

Hang Seng FTSE Med 100 Index MSCI Standard Index Series ATX KOSPI 200 IBEX 35 CAC 40 OBX S&P / TSX S&P / ASX Indices DJ Global Titans 50 DAX NZSX 50 OMX I15 FTSE UK Index Series FTSE Global Equity Index Series (incl. FTSE All-World) FTSE techMARK 100 FTSEurofirst 300 FTSE eTX FTSE/JSE Africa Index Series FTSE EPRA/NAREIT Global Real Estate Index Series S&P MIB NASDAQ 100 S&P BRIC 40 S&P US Indices S&P Europe 350 / S&P Euro S&P Topix 150 S&P Asia 50 S&P Global 1200 S&P Global 100 S&P Latin 40 VINX 30 OMX S30 Baltic 10 OMX C20 OMX N40 FTSE Bursa Malaysia Index Series DJ STOXX Russell US Indices FTSE Xinhua Index Series TSEC Taiwan 50 PSI 20 OMX H25

20-Jun 15-Jun 20-Jun 20-Jun 20-Jun 20-Jun 20-Jun 20-Jun 20-Jun 20-Jun 20-Jun 30-Jun 30-Jun 30-Jun 20-Jun 20-Jun 20-Jun 20-Jun 27-Jun 18-Jul 18-Jul 31-Jul

6-Jun 8-Jun 31-May 16-May 6-Jun 6-Jun 6-Jun 6-Jun 6-Jun 6-Jun 6-Jun 31-May 30-May 31-May 30-May 31-May 30-May 20-May 31-May 23-Jun 30-Jun 30-May

Mid Jul 8-Aug 15-Aug

SMI Family Index Hang Seng MSCI Standard Index Series

31-Jul 19-Sep 5-Sep 29-Aug

30-Jun 30-Jun 30-Jun 31-Jul

11-Jun 11-Jun 11-Jun 11-Jun 11-Jun

Quarterly review Quarterly review - IWF Quarterly review/ shares adjustment Semi-annual review - constituents Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Semi-annual review Semi-annual review Semi-annual review Semi-annual review Semi-annual review Semi-annual review Quarterly review Annual / Quarterly review Annual Review Quarterly & annual review Semi-annual review Semi-annual review - consituents, Quarterly review - shares in issue Annual review Quarterly review Quarterly review

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

104

M AY 2 0 0 8 • F T S E G L O B A L M A R K E T S

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