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GLOBAL CUSTODIANS PROFIT FROM AN ERA OF CHANGE I S S U E 2 7 • J U LY / A U G U S T 2 0 0 8

US Congress stakes out commodity speculators Poverty and profits: the new politics of wheat QFC responds to the competitive challenge Life after Bear Stearns

THE REMAKING OF FANNIE MAE & FREDDIE MAC ASIAN TRANSITION MANAGEMENT: THE NEW GROWTH EQUATION

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F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 8

T IS AN ill wind, goes the old chestnut, that brings no one good fortune.

Given the level of doom and gloom, one might be forgiven if in recent months that the mix of unseasonal weather, the sub prime crisis, continual bank write downs and the scary escalation of commodity prices might lead one to believe that all seven plagues of Egypt were carried in their wake. Eike Batista, chief executive officer of OGX Petroleo e Gas Participacoes (OGX), has however, had rather good reason for joy. OGX’s debut on the Bovespa raised almost BR6.71bn (around $4.1bn), following the decision by Credit Suisse to buy an additional lot of 741,800 shares.

OGX say the record keepers is Brazil’s largest IPO. Trading in the aftermarket has now pushed the company’s value to $23.7bn, and OGX is now Brazil’s second largest oil company after Petrobras by market cap.

Investor interest in OGX was and is preternaturally high, despite obvious risks. For one, the company has not found oil, yet. Nonetheless, investors have gambled on the asset because of sky high oil prices and a promise of success, following several recent major deep-sea oil finds off the Brazilian coast. Issuance in the T-BRIC markets has been patchy so far this year; but of the major deals to come to market, such as Turk Telekom and OGX, demand has been outstandingly healthy. Ironically, in this most challenging of periods for the global capital markets, it may be that the emerging markets really do manage to come into their own this time. Certainly Deutsche Bank’s sixth annual Alternative Investment Survey, conducted during March 2008, by the Bank’s Hedge Fund Capital Group shows that substantial number of investors plan to increase their allocations to emerging markets, with the Middle East predicted to be the top performer in the near term.

Needless to say, we will be following the smart money.

While selected emerging markets reap the benefits of capital markets turmoil, Europe and the North American markets have their own particular sets of issues to face. Though it seems that some of the themes playing out on the custody stage are no different than the trends taking place in the wider, financial arena. Working in a market in which paradigms are in constant shift, custodians are now coming to terms with the impact of consolidation, increasing market fragmentation and complexity, a growing push into alternative asset classes and the rise of a more discerning and sophisticated client set that is equally competent in setting the agenda of change and their expectations of service levels. At one inflection point of change, custodians not only have to keep an eye on technology delivery but also improved and cost efficient service quality in order to stay on top of their game. Lynn Strongin Dodds and Dave Simons report on the key drivers of change in investment services in a challenging market.

We continue to rake over the embers of the sub prime crisis. Dave Simons casts a net over the long term repercussions on the banking sector. “Free markets can only function in a system where a company’s creditworthiness can be assessed independent of a letter grade supplied by a rating agency,”is the acid comment of Jacki Zehner, founding partner of Circle Financial Group, a NewYork-based private wealth management operation. In reality, says Zehner, this is simply no longer the case.“Before one can declare that this financial crisis is over, the markets have to be able to make this kind of assessment.

Unfortunately, we are not there yet.”Moreover, our cover story this month looks at the outlook for both Fannie Mae and Freddie Mac—both in need of a major makeover in the sub prime aftermath. Their situation remains precarious and any meltdown at Fannie and Freddie could cost the US government $420bn to $1.1trn, according to latest figures from Standard & Poors. Freddie Mac’s press office notes that the S&P report is “a scenario analysis, not a prediction.”

Fortunately, he is right. Even so, the markets remain uneasy. Should they be?

Probably not, writes Art Detman. Read his report on page 63 to find out why.

Bringing all the threads of this edition together, one thing is clear.“People have to understand it is a new world,” holds John Perry, project manager, Global Banking and Markets, Basel II at HSBC. According to Perry, the future is it is about managing risk and aligning risk with capital reserves. It involves, use testing, stress testing and scenario analysis and getting back to a prudent banking philosophy, in a nutshell.” Would that were the case.

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Francesca Carnevale, Editorial Director June 2008

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Contents COVER STORY COVER STORY: WHAT NOW FANNIE MAE/FREDDIE MAC? ............Page 63

Fannie Mae and Freddie Mac buy or guarantee four of every five home mortgages made in the US, and their combined portfolios of loans and guarantees exceed $5trn. Reportedly they are losing billions of dollars and need at least $20bn in new capital to survive. Their accounting processes remain murky, and on a fair-value basis their common shareholders have no equity.

Can they go on in their current form. Art Detman asks some uncomfortable questions.

DEPARTMENTS MARKET LEADER

............................................................Page 6 Basel II and the sub prime aftermath by Francesca Carnevale

BALANCING RISK AND REGULATION

THE KNOTTY QUESTION OF BANKING REGULATION ......Page 10 Dave Simons on the long term fallout of the sub prime market

A CLARION CALL FOR INVESTORS..........................................................Page 16 FTSE Group and Silatech promote youth led enterprise

IN THE MARKETS

SALES OF THE CENTURY ................................................................................Page 20 Mark Faithfull on the growing synergy between private equity and real estate

HEDGE FUND OF FUNDS AT FULL CLIP ..............................................Page 24 Dave Simons reports on the flow of money into HFOFs

UNINTENDED CONSEQUENCES ................................................................Page 28 US regulators move to curb speculators

INDEX REVIEW

............................................................................................Page 31 Simon Denham, managing director, Capital Spreads, is more optimistic than usual. Why?

AN END IN SIGHT?

WILL OGX SET A NEW PACE FOR INVESTORS IN BRAZIL ....Page 32

COUNTRY REPORTS FACE TO FACE DEBT REPORT

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

............................Page 36 Simon Watson weighs the risks of investing in Medvedev’s Russia

THE HEAVY HAND OF POLITICS IN POLAND

................................................................................................................Page 38 Lenny Feder, explains why Standard Chartered is the bank to watch

THE FEDER LINE

..............................Page 40 Andrew Cavenagh on the impact of the credit crunch on Europe’s sovereign issuers

VARIED APPETITE FOR EURO SOVEREIGNS

THE QFC BUILDS ON QATARI GROWTH ............................................Page 72

COMPANY PROFILES ETFS DATA PAGES 2

Three years on from launch, what now for the QFC? Dave Simons reports

CHOREN AND THE PERFECT FUEL ..........................................................Page 82 Vanya Dragomanovich on a German firm’s unique approach to alternative energy

..........................................................................Page 84 Neil O’Hara sorts the wheat from the active ETF chaff.

ETFS’ EASTERN PROMISE

Securities Lending Trends by Data Explorer ............................................................Page 87 Market Reports by FTSE Research ..............................................................................Page 88 Index Calendar ..............................................................................................................Page 96

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Contents FEATURES ASSET SERVICING REPORT

MANAGING RISK IN SECURITIES LENDING ................................Page 42

Nadine Chakar, head of EMEA for The Bank of New York Mellon Asset Servicing thinks that in many cases the challenges custodians face are the same, regardless of the geographic location. According to a recent industry report by Oliver Wyman, innovation across all product ranges, client delivery and customisation are key components custodians need to retain and sharpen their edge. Is it all becoming too much? Lynn Strongin Dodds reports.

FUND POOLING: THEY’RE BACK … AND THIS TIME IT’S SERIOUS! ........................................................Page 50

When Unilever debuted its Univest tax-transparent, cross border asset pooling structure at the end of 2005, asset service providers held their breath waiting for an onslaught of business.

It never came. Now however, something is stirring in the woods … Dave Simons reports

A NEW WAVE ......................................................................................................Page 53

As long as markets keep moving, up or down, asset service providers have traditionally been happy, handling the volumes of trades and settlements required and the traditional back office support. Now the game is changing and product is dominating the agenda.

Dave Simons explains why

ASIAN TRANSITION MANAGEMENT

TRAVELLING HOPEFULLY............................................................................Page 58

To travel hopefully, is sometimes better than to arrive, say the sages. Well Asia’s transition managers have been travelling around Asia for quite a while now and are still waiting for the promised upsurge in business. On the surface, everything is smooth sailing, but are those sunny smiles hardening into rictus grins as increasing numbers of transition managers looking for new business opportunities in the region threaten to swamp the market before it has really taken off? Francesca Carnevale goes in search of some answers

TRADING IN EMERGING MARKETS

NEW MARKETS AT FULL TILT..................................................................Page 68

In spite of turmoil in many so-called advanced economies, most developing countries remain in robust health. Moreover, investors have taken note and the demand for exposure to the emerging market growth story, particularly in the energy and commodity sectors is keeping specialist emerging markets trading desks increasingly busy. Asset managers are scrambling to meet the operational challenges posed by record inflows designated for emerging markets and the emerging markets trading operations in the global investment banks is keeping pace with change. By Neil O’Hara, with additional reporting by Francesca Carnevale.

THE AGRICULTURAL COMMODITY REPORT

SORTING THE WHEAT FROM THE CHAFF ....................................Page 76 Speculators, funds and trading houses made some spectacular profits in the wheat market in the last year. Reports of record earnings and massive returns though sit uneasily alongside the world’s poor and hungry. What’s the answer? Vanya Dragomanovich reports

WHAT NOT TO DO WHEN THE PRICE OF STAPLES RISES ..Page 79

Relentless rises in agricultural commodities prices are changing notions of agri-resource management. John Rumsey compares the experience of Argentina and Brazil’s approach to agri-business, highlighting the good, the bad and the downright ugly

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Market Leader BASEL II AND THE SUB PRIME AFTERMATH

Basel II makes detailed recommendations for banks on three main areas or pillars: risks, supervisory review, and market discipline; or as Wellinck describes it, “strong capital cushions, robust liquidity buffers, strong risk management and supervision, and better market discipline through transparency." Photograph © Orlando Florin Rosu/Dreamstime.com, supplied June 2008.

BALANCING RISK & REGULATION With the credit crisis almost a year old, it is still too soon to talk of an upturn in the fortunes of the banking sector. The protracted nature of the crisis is one problem. Another is its timing. The crisis could not have come at a more inopportune time as a series of market changing directives have or will come into play this year; not least Basel II. What does adherence to Basel II and an impending raft of European banking regulation mean for the banking sector as a whole and, in particular, those banks struggling to find a stable footing in the global financial markets? Francesca Carnevale reports.

AKE NO BONES about it, “people have to understand it is a new world,”holds John Perry, project manager, Global Banking and Markets, Basel II at HSBC. Perry holds that Basel II is about “improving the management of banks; improving risk and capital management and tying it up with funding and liquidity. People have misunderstood: it is not about compliance; it is about managing risk and aligning risk with capital reserves.

It involves, use testing, stress testing and scenario analysis and getting back to a prudent banking philosophy, in a nutshell.”

Just how different a world it is was clearly illustrated in May when

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Standard & Poor’s (S&P) downgraded the credit ratings of three major US investment banks (Lehman Brothers, Merrill Lynch and Morgan Stanley), and at the same time put Bank of America, Citi and JPMorgan on negative watch, noting that the outlook on large US financial institutions is “predominantly negative.” In other related developments, Wachovia’s board ousted its CEO and Washington Mutual announced that it will replace its chairman.

Recent market events emphasise the need for a robust and independent assessment of risk on the part of banks. The contraction of liquidity in the structured product and interbank markets, as well as off-balance sheet

commitments coming onto banks’ balance sheets, has led to severe funding strains for some banks and central bank intervention in some cases. Over the longer term, according to Perry the“enhanced risk-sensitivity of Basel II creates positive incentives for banks to price for risk and to recognise the value of collateral, by requiring banks to hold more capital against higher-risk exposures”.

The Basel Committee on Banking Supervision seems to agree with him and in mid April launched a crackdown in response to the global credit crunch, closing loopholes that let banks harbour risks out of regulatory sight, higher capital charges for handling ABS, and raising the costs of holding volatile trading positions.

Justifying the crackdown, Nout Wellinck, chairman of the Basel Committee on Banking Supervision and president of the Netherlands Bank noted in a formal statement that, “Supervisors cannot predict the next crisis but they can carry forward the lessons from recent events to promote a more resilient banking system that can weather shocks.” There does seem

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Market Leader BASEL II AND THE SUB PRIME AFTERMATH

to be a step up in gear, notes Anna Nicholl, head of operational risk management EMEA at The Bank of NewYork Mellon,“and emphasises the need for risk management systems to be effectively embedded in the business framework and underscores a best practice approach.”

Basel II makes detailed recommendations for banks on three main areas or pillars: risks, supervisory review, and market discipline; or as Wellinck describes it, “strong capital cushions, robust liquidity buffers, strong risk management and supervision, and better market discipline through transparency.” The infrastructure provided by these pillars is designed to promote a proactive approach to capital adequacy supervision, one that has the capacity to evolve in line with market conditions. This latest move to modify the application of Basel II should be seen in this light. In particular, according to the Committee, recent market turmoil has revealed significant risk management weaknesses at banking institutions. Pillar 2 (the supervisory review process) provides supervisors with additional tools to assess risk management and internal capital management processes at banks and it appears that the Committee is determined to pursue this responsibility to the fullest extent. According to Anthony Epstein, an independent consultant working with The Bank of New York Mellon on Basel II issues, “Essentially you can no longer leave it to the business line managers to decide what is appropriate risk, the Board now need the to demonstrate engagement.

In contrast to the simple approach of Basel I, in which exposures to obligors of varying creditworthiness were given the same capital treatment, “Basel II rules require banks to distinguish between the credit quality of individual borrowers,” says Perry. For example, under Basel I almost all first-lien

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residential mortgage exposures are subject to the same risk weight regardless of the borrower’s creditworthiness, whereas Basel II provides for a more detailed differentiation of low credit quality versus high credit quality mortgage borrowers. Likewise, Basel I is inadequate for dealing with capital markets transactions, such as highly structured asset-backed securities.

Basel II, on the other hand, requires banks to hold capital commensurate with the actual risks of such transactions. “It comes as a menu of approaches, using a combination of internal and external ratings to determine the capital you need,” explains Perry. The prominent role of External Credit Assessment Institutions (ECAIs) in supporting financial institutions and companies in risk related decision-making has been widely acknowledged by Basel II and the Capital Requirements Directive (CRD), recently adopted by the European Parliament. “The underlying principal is that for the first time there is joined up thinking. There is something of a bandwagon approach, that is true, in the aftermath of the subprime crisis, but the good thing is that the various agencies and regulators are on the same bandwagon,” notes Epstein. “How you go about it then,” adds Nicholl, “is all in the detail and that is where nuances emerge.

The Basel Committee now says it will monitor Basel II minimum requirements and capital buffers over the credit cycle. To the extent that this analysis reveals any shortcomings in capital cushions, the Committee says it will take appropriate measures to help ensure Basel II provides a sound capital framework for addressing changes in the sometimes complex risk profiles in individual banks or in the sector as a whole. In July, the Committee will publish for

consultation global sound practice standards for the management and supervision of liquidity risks. These will address many of the shortcomings evinced in the banking sector over the last year. Among other weaknesses, these relate to stress testing practices, contingency funding plans, and management of on-balance sheet and off-balance sheet activity as well as contingent commitments.

The Committee says it intends to coordinate a system of rigorous follow up by supervisors to ensure banks adhere to fundamental principles. “An interesting question here,” asks Nicholl,“is who owns stress testing in the banks? Is it the finance department: the risk management team or the management team itself?

It is not an easy question to answer because stress testing is required at the joint of change: overlaying any number of credit decisions.”

In particular, the Committee will revise the framework to establish higher capital requirements for selected structured credit products, such as“resecuritisations”or CDOs of asset-backed securities (ABS)—which produced the majority of losses during the recent market turbulence; enhance liquidity facilities to support asset-backed commercial paper (ABCP) conduits, and credit exposures held in the trading book; inevitably with higher charges for some structured credit assets.

The current value-at-risk based treatment for assessing capital for trading book risk, says the Committee statement, does not capture extraordinary events that can affect many such exposures, according to the release. In cooperation with the International Organisation of Securities Commissions (IOSCO), the Basel Committee is therefore extending the scope of its existing proposed guidelines for“incremental default risk”

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to include other potential event risks in the trading book. Until this event risk charge is in place (and it is planned for 2010), an interim treatment will be applied for complex securitisations held in the trading book. “These measures will be introduced in a manner that promotes long-term bank resiliency and strong supervision, while seeking to avoid potentially adverse near-term impacts as the re-pricing of risk and deleveraging process continues in financial markets,” noted the Committee in the statement. The Committee’s actions also are in support of the Financial Stability Forum’s (FSF’s) Working Group on Market and Institutional Resilience, which recently released its report to G7 finance ministers and central bank governors.

Banks have lobbied hard for regulators to take a light approach, saying they aim to put their own houses in order first, but growing pressure from the G7 and the FSF, to improve handling of capital, liquidity and risk management; closing loopholes that let banks perform regulatory arbitrage in ways that put them below the radar screen of regulators, most likely means those pleas have fallen on deaf ears.The UK’s financial watchdog, the FSA has also gotten in on the act and also reviewing its liquidity regime. In a discussion paper issued late last year, the FSA noted that banks should update regulators more regularly on their liquidity position and should also test their liquidity “insurance”, including what assets they hold as treasury and whether promises from other banks can really be called upon. The UK regulator is due to issue its next statement on liquidity next month, including industry comments on its proposals, ahead of a full consultation paper this summer. Adding to the plethora, the European Union launched a public consultation in May

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John Perry, project manager, Global Banking and Markets, Basel II at HSBC. Photograph kindly supplied by HSBC, June 2008.

on some 50 planned changes to the CRD, that will attempt to address issues around the exposure of banks and their counterparties. Issues covered include hybrid capital, supervisory arrangements, large credit exposures and waivers for co-operative banks. The paper also focuses on liquidity facilities attached to securitisation vehicles, particularly conduits and those bête noirs of the recent credit crunch structure investment vehicles (SIVs). Responses will be collated after mid June, with a formal announcement of the new raft of proposals expected in the early autumn.“The EU has adopted Basel II belt and braces”, notes Perry and its tenets are enshrined within the CRD; superimposed on that are local rules.

The question now is whether the emerging raft of requirements will be a hindrance rather than a help. Nicholl for one thinks that invariably the banking system will have to undergo substantive change:“It is back to basics in some respects; though banks will definitely have to rethink their

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approaches to risk allocation, capital adequacy and live with the attendant increase in the cost of capital,”she says.

The reality is that while Basel II sets out sound principles, its introduction at this inflection point in the credit crisis, has probably made life much more difficult for banks seeking to stabilise their balance sheets. “It’s about procyclicality,” says Perry. “at precisely the point when things are getting worse, you are exacerbating the problem. The buffers are negatively impacted; sensitivity is much bigger. Ironically, Basel II has come five years too late. While we all welcome better governance and most banks manage themselves to best standards, countries embracing Basel II have to be applauded. However, the ramifications of the accord are still to be felt.”

Nicholl is more sanguine. “Change has been in the air for some time.

Basel II has been in the pipeline since 2004, so it is not a sudden response.

In my view, there is a lot more buy-in to Basel principles because of what is happening right now.” Is there more to come? Will there be a Basel III? Although the April memorandum from the Basel Committee began to address the liquidity issues in more detail, according to Epstein. “Basel II is very light in this regard and may set of a further round of legislation covering liquidity and large exposure.” Whether in comfort or pain, global banks will invariably have to adapt to a more rigorous regulatory environment over the near term. The good news is that globally, governments, regulators and banks appear to be taking both Basel II and its ramifications seriously. Whatever the pains underway in banks striving to comply with Basel II best practice, they can console themselves with the knowledge that in their efforts to comply, they are not alone.

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In the Markets RE-REGULATION IN THE AFTERMATH OF THE SUB PRIME CRISIS

THE KNOTTY QUESTION OF REGULATION First came the collapse of its hedge funds; then the mammoth losses tied to mortgage-portfolio write downs. In March, dark clouds circling over Bear Stearns’ Manhattan headquarters suddenly collapsed into a vortex that reduced the former investment giant to a near-worthless pile of debris. Were it not for the sudden resourcefulness of the New York Federal Reserve, things may have turned out even worse. Now a chorus of finger-pointing regulators insist that investment banks be held accountable--before another Bear is let loose. From Boston, Dave Simons reports.

N THE WEEKEND of March 14th , the New York Federal Reserve gave its blessing (in the form of a $30bn no-risk financing agreement) to JP Morgan Chase & Co to acquire the remains of the 84-yearold Bear Stearns for a mere $2 per share, later sweetened to $10.The takeover bid was officially approved by shareholders in late May. Speaking shortly after the crisis was resolved, US Treasury Secretary Henry Paulson noted that the Bear Stearns episode “raises significant policy considerations that need to be addressed.”The collapse, said Paulson at the time, underscores the rapidly changing role of non-bank financial institutions as well as the interconnectedness among all financial establishments. These changes “require us all to think more broadly about the regulatory and supervisory framework that is consistent with the promotion and maintenance of financial stability,” he added.

Just as last summer’s illiquidityfueled downdraft prompted calls for universal limits on leveraging, the Bear Stearns experience has critics taking aim at current regulatory standards. These they argue are in need of a substantial overhaul. An important question arising from this

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US Treasury Department secretary Henry M. Paulson, Jr. delivers a speech on Open investment before the US/ UAE Business Council at Emirates Palace, in Abu Dhabi on Monday, June 2nd 2008. Paulson noted that the Bear Stearns episode “raises significant policy considerations that need to be addressed.”The collapse, said Paulson at the time, underscores the rapidly changing role of non-bank financial institutions as well as the interconnectedness among all financial establishments. These changes “require us all to think more broadly about the regulatory and supervisory framework that is consistent with the promotion and maintenance of financial stability,” he added. Photograph by Manuel Salazar, provided by the Associated Press/PA Photos.com, supplied June 2008.

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development is: how best to carry out these measures? Another is: if those measure are a good idea, why have they not been addressed sooner?

US Federal Reserve Bank chairman Ben Bernanke vigorously defends the Bear bailout, noting that “recent events have demonstrated the importance of generous capital cushions for protecting against adverse conditions in financial and credit markets”.

Detractors offer a much less sanguine assessment. One notable handwringer is former St. Louis Fed president William Poole, who thinks that,“It is appalling where we are right now … we’ve become a backstop [sic] for the entire financial system.”

Indeed, by all accounts the Fed checkbook may be in for more plundering in the coming weeks and months. In May, Congress put in an emergency call, imploring the Fed to swap Treasury notes for bonds backed by student loans. And with the peak of the credit crisis still months (or perhaps even years off according to some experts) the Fed may have to contend with many more foundering companies arriving in the dead of night, cap in hand.

Was the Fed correct in intervening on Bear’s behalf? John Halsey, a former

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In the Markets RE-REGULATION IN THE AFTERMATH OF THE SUB PRIME CRISIS

senior managing director at Bear Stearns, says that, given the circumstances, the Fed had to take action. Had Bear failed, says Halsey, “Our financial system would have failed as well. The dollar, already weakened, would have plummeted, and it would have hastened the inevitability of the dollar’s demise as the world’s reserve currency. Stocks would have dropped, markets would have crashed and stopped trading. In effect, Bear shareholders were sacrificed for the good of the system. That said, I do not think it will have much effect on decision making or risk taking.”

The Fed’s willingness to get behind one near disaster after another fails to address some key underlying issues: namely lack of transparency, as well as the enormous complexity of modern financial products, that has rendered normal pricing metrics obsolete.

JPMorgan’s valuation gyration over Bear Stearns’ share price is the latest evidence that all is not right. “Free markets can only function in a system where a company’s creditworthiness can be assessed independent of a letter grade supplied by a rating agency,” remarks Jacki Zehner, founding partner of Circle Financial Group, a New York-based private wealth management operation. In reality, says Zehner, this is simply no longer the case. “Before one can declare that this financial crisis is over, the markets have to be able to make this kind of assessment.

Unfortunately, we are not there yet.”

Though the Fed may have had little choice but to step in on Bear’s behalf given the magnitude of the counterparty risk, other companies in a similar predicament but with a slower bleed rate may not be as fortunate. Says Erik Sirri, director of the Securities and Exchange Commission’s (SEC’s) trading and markets division,“I think when one of

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Christopher Cox, chairman of the US Securities and Exchange Commission, testifies at a hearing of the Senate Banking, Housing and Urban Affairs Committee in Washington, DC, on April 3rd 2008. Cox faced intense scrutiny over his agency's response to Bear Stearns problems, and reportedly said the SEC’s response had succeeded in protecting consumers.

Photographer by Carol T Powers, working for Bloomberg News /Landov. Photograph provided by PA Photos.com, June 2008.

these firms gets into trouble rapidly, liquidity support is needed.” Should that unraveling occur more slowly, however, “that liquidity support may not be needed.”

“Others will fail, though it is not clear what will happen when they do,”says Zehner.“I believe the Fed can and will prevent any sort of systemic collapse which they may have witnessed had they not come to the rescue of Bear. But there will be more problems. Exactly how and where is a difficult bet indeed.”

In the aftermath of Bear, slower client activity, below-normal principal and proprietary trading results and losses from the tightening of structured credit liabilities are just a

few of the factors weighing on the investment-banking industry, notes analyst William F Tanona in a recent research paper. Some have been more generous than others. In contrast to Oppenheimer & Co. analyst Meredith Whitney’s assessment of Citigroup’s “antiquated and disparate systems and technology,” Ladenburg Thalmann’s financial institutions analyst Richard Bove sees a much brighter future for the bank. Bove notes that Citi’s turnaround potential is “so significant, it could carry the stock to multiples of its current price.”

While the longer-term picture may be positive--particularly given the prospect of further Fed interventions nonetheless, US banks are in all likelihood looking at a prolonged period of belt tightening and superscrutiny. “It is truly amazing to see how slow analysts have been in bringing down earnings estimates for the investment banks,” says Halsey.

“Of course, at some point soon the bulls will probably be able to point to some very favourable year-over-year comparisons. But the fact remains that the entire sector is going to have to learn to live with much less leverage-and that many of their biggest earning sectors will never recover.”

Is reform needed?

It was the late economist Hyman Minsky who suggested over 20 years ago that “in a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators.”While it may be impossible to prevent changes in the structure of portfolios from occurring, said Minsky, “if the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to attenuate the disruptive expansionary tendencies of our economy.”

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In the Markets RE-REGULATION IN THE AFTERMATH OF THE SUB PRIME CRISIS

Speaking at a conference held in Minsky’s honour, Paul McCulley, managing director of fixed-income specialist PIMCO, said that recent events demonstrate how little attention has been paid to Minsky’s words over the last two decades. While initiatives such as Basel I and most recently Basel II may be a step in the right direction, “neither of those arrangements fundamentally addresses the explosive growth of the shadow banking system,” thinks McCulley, referencing the radically leveraged, off-balance sheet vehicles that were so successful in helping institutions sidestep imposed limitations.

To make matters worse, regulators have consistently turned a blind eye to the goings-on within the investmentbanking sector, even as the crisis in liquidity was growing more palpable.

Their inaction prior to last summer’s meltdown left the banking system vulnerable to the catastrophic run on liquidity that set the stage for innumerable hedge-fund collapses, and ultimately the fall of Bear Stearns, say observers.

In an effort to deflect further criticism, the SEC has wasted little time getting on the case, and has already made clear its intentions to increase the transparency of liquidity and capital positions held by the likes of Morgan Stanley, Lehman Brothers and Merrill Lynch through its consolidated supervised entities (CSE) program. SEC chairman Christopher Cox said the commission wants the changes to take affect prior to the implementation of the new internationally accepted standards for capital and liquidity as set forth in Basel II. Cox has admitted that insufficient regulatory standards in all likelihood helped foster the conditions that led to the Bear crisis.

“It’s difficult for anyone to say the

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system worked or that the regulatory gap that exists in statute lacks any consequence,” said Cox. Halsey, however, calls the commission’s sudden interest “laughable.”“Where were they when these problems were developing?” he asks. As it relates to the current real estate crisis, “the SEC, banking regulators and especially the Fed were absolutely facilitators to the mess.

Alan Greenspan’s legacy has been destroyed.”

To begin to remedy the situation, all institutions that are given access to the Fed’s discount window “must at the same time have pari passu regulatory oversight,” argues McCulley.

While banks will undoubtedly balk at such an arrangement, they may have little choice but to play ball. After all, offers McCulley, “if you have access to the Fed’s discount window, the Fed should (and will, I strongly believe) have the power to supervise and regulate your business.” Such increased oversight could take the form of raising core capital requirements, while increasing risk and liquidity management, he adds.

Although regulators appear anxious to expand their legal authority over the investment banking sector, it’s up to lawmakers to ensure that it happens. Speaking before a Senate panel in May, former Clinton administration SEC chairman Arthur Levitt said that “Congress must face these conflicts of interest issues head on, or at least empower the SEC with the proper oversight and disciplinary powers that will enable them to do the job.” As for the near-term direction of the investment banking sector as a whole, Halsey believes that a fundamental shift has already occurred, one that favours the likes of JPMorgan over Goldman Sachs and Morgan Stanley. While product

innovation will once again take place and attract new talent and capital, “it will take years for that to happen. In the meantime, the likes of CDOs, CDSs and all mortgage-related trading will deliver a fraction of the profits that stoked Wall Street for so long.” Accordingly, Halsey sees the prospect for a significant brain drain from the various institutions as return on capital founders. “Bright, hungry guys will continue to leave to pursue innovation and profits at hedge funds.

That will hurt banks and investment banks alike.”

Can increased regulation be truly effective so long as institutions are allowed to stay one step ahead through the creation of the kind of product embellishments that helped precipitate the crisis in the first place?

Absolutely not, says Halsey. Wall Street can afford to hire the best and the brightest and spend more on financial innovation than regulatory bodies can budget for, says Halsey, and as a result, no individual or group can effectively anticipate innovation.

Hence, the need for broad, highly flexible guidelines that can compensate for these future product developments.

“As a young guy at Bear, I remember thinking how creative the people who structured collateralised mortgage obligations (CMOs) must have been to come up the concept of interest only strips (IOs) and principal only strips (POs),” recalls Halsey. “By the time they had become commonplace, we were already onto trading inverse floaters. It quickly became apparent that if you could imagine a cash flow of any kind-backed by any kind of credit; then you could create a bond that mimicked such a cash flow. In short, the possibilities of creating new products with unknowable risks when applied to the financial system are endless.”

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In the Markets FTSE & SILATECH PROMOTE YOUTH LED BUSINESS

At the Doha Summit on young people and employment, held in February this year, the issues of chronic youth unemployment, discrimination against women in the job market, lack of skills required for particular jobs among university graduates and the negative perception about private sector jobs were key discussion topics. In a groundbreaking development, involving FTSE Group with youth initiative Silatech, established by Her Highness Sheikha Mozah bint Nasser Al Missned of Qatar, is now leading a regional wide index project to support youth-led small and medium sized enterprises (SMEs) in the Middle East and North African region. Over the medium to long term, the project hopes to encourage sustained private sector institutional investment in seed companies in the region to facilitate equal opportunity and employment. Francesca Carnevale reports.

Photograph © Gines Valera Marin/Dreamstime.com, supplied June 2008.

A CLARION CALL FOR INVESTORS IN YOUTH-LED ENTERPRISE 2007 REPORT by the International Business Leaders Forum (IBLF) puts the scale of the problem in context. In the report, IBLF notes that over 290m people live in the Middle East and North African region (MENA) and the demographic is expected to double over the next thirty years. Out of today’s population, some 60% is under 24. That in turn means that 20m jobs have to be found right now to reduce current levels of unemployment, and over 100m new jobs have to come on stream in the next 20 years to meet supply.

Youth unemployment is chronic in emerging markets and for all its much vaunted riches and resources, the story is the same in the MENA region.

Finding a job is the top priority for 68% of Arab youth and if the means to find work are not there, then the result could be very challenging indeed. The problem has been in mind for some time. A few years ago, at an International Fund for Agricultural Development meeting in Rome, Gulf

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Co-operation Council (GCC) secretary-general Abdul Rahman alAttiyah compared unemployment to a ticking bomb likely to cause a“revolt” should the region fail to act comprehensively and soon. His fears may be justified. IBLF’s report says that 80% of young Arabs do not believe they will find employment easily; while 70% of young Arabs think it is up to the government to solve the unemployment problem.

The private sector can play an important role in tackling the growing crisis of youth unemployment and perhaps for too long governments and aid agencies have been seen as the only solutions to what could be an impending crisis. However, businesses and pressure groups across the Middle East now appear to be picking up cudgels and instigating—albeit in a small way—initiatives to help create new employment and enterprise opportunities for young people. IBLF’s report was published, for instance, with the support of the Young Arab

Leaders, Emirates Environmental Group, Young Entrepreneurs Association, the United Nations Development Programme (UNDP) and a consortium of companies. Now comes a clarion call to action by FTSE Group and Silatech, which together are working to attract global investors into the process of change through the launch of a special index project to support youth led small businesses in the MENA region.

The initiative will promote the creation of small and medium sized enterprise (SME) markets and indices across the MENA region in order to “facilitate their growth and development and thereby increase youth employment opportunities,” notes Imogen Dillon-Hatcher, managing director of Europe, Middle East and Africa at FTSE Group. The initiative will encourage and support individual exchanges “in establishing their junior SME markets, that are lightly regulated and thereby encourage the development of

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In the Markets FTSE & SILATECH PROMOTE YOUTH LED BUSINESS

smaller, entrepreneurial companies.

We know that such companies are more likely to employ and even be run by the 18 to 30 age group,” she adds.

The first initiative will be implemented in Qatar, where local regulator, the Qatar Financial Markets Authority (QFMA) is working with the Doha Securities Market to establish a ”younger market that will attract investors. The next stage is to establish credible investible indices supporting the junior markets that will attract institutional investment,” explains Dillon-Hatcher. Moreover, she adds, the World Bank and the International Labour Organisation (ILO) are also supporting the broader Silatech initiative.

“This initiative is about energising SMEs, which are critical to the creation of youth employment opportunities, [which is] our main goal,” says Rick Little, chief executive of Silatech. Silatech, is focused on connecting young people across MENA to encourage employment and provide new business development services, unlocking capital and encouraging new business start-ups.

Moreover, other exchanges in the region have indicated their interest in the project.“We have already had the commitment of the QFMA and expect to make announcements related to other exchanges which are in accord with the project very soon,” adds Dillon Hatcher.

The initiative also has broader connotations. According to DillonHatcher, “it also resonates in markets such as Syria and Yemen, for instance, where there is no formal exchange arrangement, but where we can encourage small firms to list on other exchanges in the wider region to get access to investor funds.” In Syria, for instance, the major issues are lack of skills among the youth and a high preference for the public sector; a

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Imogen Dillon- Hatcher, managing director of Europe, Middle East and Africa at FTSE Group. The initiative will encourage and support individual exchanges “in establishing their junior SME markets, that are lightly regulated and thereby encourage the development of smaller, entrepreneurial companies. We know that such companies are more likely to employ and even be run by the 18 to 30 age group,” she explains. Photograph kindly supplied by FTSE Group, June 2008.

common trend in most countries of the region. In Tunisia, unemployed youth from rural areas are increasingly migrating to the cities. In Yemen, unemployment among women is six times higher compared to that of men.

These dissonances have economic consequences, and it is estimated that MENA countries are losing as much as $25bn in income every year due to unemployment.

Global firms are also investing in the initiative. Cisco Systems is in the process of creating “an incredible web based communications network supporting the project,” notes DillonHatcher, “designed to appeal to 18 to

30 year olds, providing forums, chat rooms and providing advice and access to training and meeting facilities.”

It is important to remember, notes Dillon-Hatcher, that the project has sound business principles behind it.

“Without that it simply would not work. Although our involvement fits neatly with our high standards of corporate citizenship driven by our relationship with UNICEF, we also have a business stake in the project.

What we are creating here sits alongside our day job. That ensures its longevity and our commitment as a business. Unless it fitted in with our strategy, it could wither on the vine.”By way of explanation, she points to the perennial requirement of exchanges in the MENA region to establish national indices and pan regional indices. “Our job is to create appropriate indices for the junior markets, perhaps with different frameworks to suit local market conditions, but with a common methodology.”

Ultimately, “All exchanges in the region are keen to establish new products, such as exchange traded funds (ETFs) and this project should be seen in this regard, as a means of diversifying indices in the MENA region, and offering investors access to the growing prosperity of the region as a whole across the business spectrum. The youth opportunity project in this regard is a very exciting development, which also has significant repercussions for youth employment in the region over the longer term,” highlights DillonHatcher. In other words, its business case is based on the fact that the overall success of the Middle East in increasing prosperity among its population, and in particular, younger members of that population, is of central importance to every business with long-term operations in the region.

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In the Markets REAL ESTATE: PRIVATE EQUITY & RETAIL

Photograph supplied by Istockphoto.com, June 2008.

SALES OF THE CENTURY Private equity money swooped into the retail arena during the last few years, snapping up crown jewels across the world. By last year it had almost become a sport for predatory banks and financial houses. Fronted by hard nosed retail operators with turnaround track records, financiers tried to woo disgruntled shareholders with the promise of a premium price for their stakes in return for the opportunity to take the helm and turn high street under performers into consumer stars. That was then; this is now. Have crashing consumer confidence, woeful high street sales and the cold chill of a debt freeze put an end to the age of the mega-deals? Mark Faithfull reports.

ETAIL IS IN fact a relative newcomer to the private equity portfolio. Traditionally viewed as a high risk sector, open to the vagaries of consumer tastes and with limited international expansion opportunities, the market was left largely to founding families and listed company status. That was until the last few years when, in many markets, consumer spending went unchecked and continued upwards and upwards unabated, regardless of a worsening economic picture in the wider world.

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At the same time retailers began to flex their muscles outside their home markets, brands began to travel dramatically and the Far East began to open up as a fledgling consumer market; and although small it showed a particularly refined (nay obsessive) interest in high end luxury products.

What has followed is a series of mega-deals. Just a few of the high profile highlights include KKR fronting the purchase of US toys retailer Toys‘R’ Us and Texas Pacific Group buying venerable US department store group

Neiman Marcus and Australian household name Myer. In Europe footwear retailer Kurt Geiger was snapped up by Graphite, in the UK Debenhams flipped through the hands of private equity for vast profits, while Cortefiel in Spain has predicated growth on its equity backing.

Moreover, Icelandic predator Baugur has moved in to buy a string of, predominantly British, retailers. Last year private equity finance backed the biggest deal of them all; the purchase of the merged Alliance and Boots operations to create a European pharmaceutical powerhouse. Even Sainsbury’s was circled by equity houses although it managed to repel any and all advances.

There have been many more deals.

The reasoning behind the majority of them has been very similar: despite the consumer boom, at any given time a number of retailers tend to be struggling or underperforming, either as a result of lethargic or unfocused management teams or because the retailer has failed to adapt to declining sales in its traditional retail channel.

That’s the downside. The upside?

Well, retail offers any number of attractive attributes. For one, it is one of the most cash-generating sections of the economy. Two, buyout groups like companies with substantial assets, and most retailers own at least some of their valuable property freeholds. Three, private equity companies like businesses with steady income streams, and (with seasonal peaks and troughs taken into account) retailers’ cash tills ring all year round.

Private equity money has flowed into those businesses where the financial team believes that the company’s woes are in part of their own making, where the retail niche is under-exploited and often where property is part of the play. Get the formula right and fortunes can be

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made. At least, up until the middle of 2007 when consumer spending in several key markets including, notably, the US, the UK and Ireland, and Spain began to fall off a cliff and the cost of debt (when it could be found) began to spiral upwards. “It is only in the past few years that private equity has really had an appetite for retail,” reflects Henry Jackson, chief executive and managing director of London-based Merchant Equity Partners, which he joined from Deutsche Bank where he headed up the German bank’s European consumer and retail group. “Those companies have had some very successful transactions and we have seen a period when companies have been sold at ten or 11 times earnings.

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I think we will now see much less activity from private equity and in broad terms a lot less interest.”

Jackson’s company specialises in the retail field and has continued to invest in retail opportunities. In October 2006 it bought the retail arm of struggling UK kitchens and bedroom furniture retailer and distributor MFI Group and in March of this year it snapped up French furniture retail chain BUT from Kesa Eletricals for €550m. “We target companies with potential, but they need to be of scale. They need to matter,” he says. “Valuation is very difficult in retail. Certainly we look for good returns but there is no doubt that retail is at the high risk end.”

Nowadays, following that extended

bull run of consumer spending in the opening years of this century, that level of risk appears to be putting equity money off any move onto the high street. In the first five months of 2007 over €25bn of private equity money exchanged hands in the retail sector, almost two thirds of the total retail deals for the period. The first five months of this year have seen that total plummet by an order of magnitude to just €2.4bn, representing a paltry 15% of deal totals. In comparative periods the sector fell from the most active for private equity deals to fourth.

In May this year Bridgepoint Capital became the first private equity house to buy back debt from a UK portfolio company when it bought €13m of the

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In the Markets PRIVATE EQUITY & REAL ESTATE

€240m of debt used to finance the €455m management buyout of UK clothing chain Fat Face from Advent International. Nonetheless, others remain positive about the role of private equity, despite the current downturn. Jón Ásgeir Jóhannesson, the controversial executive chairman of Icelandic operator Baugur Group, has snapped up a host of retail names with a focus to date on the United Kingdom. A hybrid company, Baugur started off by running its own grocery retailing operations in Iceland but by using venture capital soon sought bigger markets in which to target retailers it felt were punching below their weight. In a back story, behind the scenes Jóhannesson has been reportedly dogged by financial investigations by the Icelandic authorities for what he claims are politically motivated reasons and to date nothing has stuck.

Like Jackson, Jóhannesson is undeterred by the current downturn and Baugur has been linked with an audacious bid for Saks Fifth Avenue, in which it already has an 8.5% stake.

While he will not be drawn on what would represent the standout deal of 2008, he does admit that the US is of interest but dismisses the notion that the weak US dollar is part of the appeal. However, Jóhannesson says that he sees “some interesting value around” and that “it will be an interesting year”. Jóhannesson typically looks for management teams to invest in their own operations and “to take part in what we are doing”.

Previously Jóhannesson has been drawn to UK retailers, in part because of the thriving UK high street and in part because he felt that the market contained a number of clear underperformers.

Now he says that Baugur is seeking “something that has the potential to travel across markets”.

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Australian retailer Myer’s planned futuristic superstore, projected to open in Melbourne some time in 2009. Photograph kindly supplied by Myers, June 2008.

Spanish high end retailer Cortefiel. Cortefiel in Spain has predicated growth on its equity backing. Last year private equity finance backed the biggest deal of them all; the purchase of the merged Alliance and Boots operations to create a European pharmaceutical powerhouse. Even Sainsbury’s was circled by equity houses although it managed to repel any and all advances. Photograph kindly supplied by Cortefiel, June 2008.

Online sales have held up better than store sales in the opening phases of the consumer slow down and Jóhannesson says that he is increasingly keen on retailers with a strong internet presence.“A lot of our focus is on e-commerce,” he says. “I strongly believe it will be a big part of our business quite soon. We are

researching and spending a lot of money on it and some of our businesses are already doing 45% of their business online.” Jackson concurs and reflects of the previous MFI management team (MEP’s initial purchase): “As the UK market leader, not to own kitchens online was a big mistake. After our first year in charge we have focused on our online activities.”

However, not everyone agrees that e-commerce is the only maxim.

Anselm van der Auwelant, the charismatic Belgian CEO of Spanish retailer Cortefiel Group, asserts that the dramatic expansion of the fashion retailer would have been impossible without private equity money and that physical stores still form the backbone of the company’s future growth.“There are two financial partners plus the retail operation in our agreement and the business plan remains all about growth,”says Auwelant. An instinctive retailer at heart Auwelant believes that growth potential in emerging Europe and Asia remains strong and that physical stores rather than the internet also remain the best route to market.

“To me the internet is the shop window but I still believe nothing can replace the real experience. Ecommerce is a bit like sex, nothing beats the real thing.”

Despite soaring year-on-year internet retail sales, the polarisation in retail performance is also about more than online versus in-store sales. The internet may be holding up better than the high street but the real split in consumer outlook comes in western versus eastern markets.

China, India, Russia, south east and sub-continental Asia and central and eastern Europe are suffering few if any of the consumer crises of their west European and US counterparts and little wonder that the biggest private equity deal of the year to date has

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been the acquisition of Turkish supermarket group Migros Turk by BC Partners and Turkven for €1bn.

However, entry into the emerging markets through the private equity route is increasingly difficult, with no shortage of domestically produced cash waiting in the wings in the emerging market. Consequently, most would-be investors will probably be forced to team up with local, family run businesses and to use their investment to grow the businesses organically and through local acquisitions; making the prospect of a quick in and out remote.

Yet it is not all bad news. Initial skepticism from the retail sector about the motives of private equity buyers, notably whether they would simply be asset strippers or experts at polishing a business up for the short term while damaging it for the longer run, has largely proved unfounded.

Bernie Brookes, CEO of Australian department store stalwart Myer, points out that in a consumer downturn the rigours of private equity can in fact revitalise operations. Brooks heads up one of Australia’s most venerable retail names and his department store group was extracted from conglomerate Coles Myer in June 2006 when Texas Pacific Group led a management and family buyout.

“Myer represented about 10% of Coles Myer Group turnover and got about 10% of the time,” he reflects.

“We introduced a 100-day plan, a turnaround phase from 2006 until 2010 and then a growth phase to 2014. We intend to move from 58 stores to 80-plus and we have reinvested in stores, in our people and in 2009 we will have a state-of-theart flagship in Melbourne.”

Indeed in Australia a report published in May has challenged the view that private equity takeovers will

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Anselm van der Auwelant, the charismatic Belgian CEO of Spanish retailer Cortefiel Group, asserts that the dramatic expansion of the fashion retailer would have been impossible without private equity money and that physical stores still form the backbone of the company’s future growth.“There are two financial partners plus the retail operation in our agreement and the business plan remains all about growth,” says Auwelant. Photograph kindly supplied by the Cortefiel Group, June 2008.

continue to wane in the current climate, after a surge in private equity takeovers of high-profile Australian retailers in recent years, including Myer, Godfreys and Repco. Rather, the report argues that the high cost of credit is pushing private equity firms to restructure their deals rather than miss out altogether.

The PricewaterhouseCoopers (PwC) retail outlook report also predicted that while there would be fewer deals involving companies at the top end of the market in the next 18 months, the focus would shift to mid-cap deals.

“There’s still plenty of equity in the market, with 70% of private equity funds remaining uninvested.

However, due to the credit crunch, new deals need to be structured with 6% more equity,” says PwC corporate

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finance partner Greg Keys.

What retailers also often offer is an attractive real estate portfolio, with the potential to unlock capital through sale and leaseback. John Hoffman, shareholder representative at RREEF Printemps, which owns Italian department store group La Rinascente and French retail group Printemps, reflects: “We wouldn’t look at a deal that didn’t involve a property play.

That is part of what makes it stack up.” Tough times might just be the time to make a foray into the retail arena, reckons Henry Jackson. “In a downturn capital expenditure has to justify the investment against the leverage,” he says. “What private equity does is put discipline back into the business and in the current climate that is no bad thing.

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In the Markets FAST TIMES FOR FUNDS OF FUNDS

Hedge Fund of Funds at Full Clip

Photograph © Marius Antonescu/Dreamstime.com, supplied June 2008.

Once the exclusive domain of high-net worth individual investors, over the past several years the hedge fund of funds sector has attracted a steady stream of both public and private institutional money, as mainstream managers became increasingly acclimated to working within the alternative world.

Even with the persistent threat of turbulence hanging in the air, hedge fund of funds continue to gain ground at an amazing clip.

Dave Simons reports.

F THE CREDIT crunch has provided investors with a healthy dose of cautiousness, it does not appear to have put a dent in the advance of the burgeoning hedge fund-of-funds (HFoF) market. Since 2005, fund-of-funds assets have nearly doubled, reaching some $1.4trn last year, according to Boston-based research and advisory firm Aite Group; equivalent to approximately half of the total hedge-fund asset base. Aite reckons on an average annual growth of 16% for HFoFs through to 2011, as alternative

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strategies continue to exert their influence on the marketplace. With profitability on the rise, HFoFs will build out their operational infrastructure, acquiring enhanced technology solutions from leading vendors, notes Denise Valentine, senior analyst with Aite Group and author of the report.

Continuing a multi-year trend, the pension programmes of corporations, state systems and government organisations, in addition to major foundations, endowments, and sovereign wealth funds in both the US

and Europe, remain among the key drivers of HFoF growth. Allocations range from as much as 25% for large foundations, to around 5% on average for more conservatively biased public pension plans. “The biggest fund-offunds are the ones that are most prepared to take on public money, because they’ve had the institutional build-outs in place for several years now,” says Susan Solovay, founding partner of New York-based Pomegranate Capital LLC and the first HFoF to invest exclusively in hedge funds managed by women.

In the HFoF world, size really does make a difference, says Solovay. “The fund-of-funds that are north of $10bn tend to be invested in the same type of hedge funds--because when you are working with that kind of money, you have to go with the guys who are truly the biggest. That way when you make an allocation of, say, $50m, you

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wont be exceeding 10% of that fund’s total capitalisation.”

The downside, says Solovay, is a potential lack of diversification. “In other words, it is a very select flow of money that basically stays in one small portion of the hedge-fund space; which means that if there are 9000plus hedge funds and the top 300 get 80% of the capital, all of the underlying managers are in the biggest fund of funds.” That particular dynamic, notes Solovay, underscores one of the main advantages of investing with small to mid-sized HFoFs: “The managers are not all from the same small group of funds, which obviously helps increase diversification.”

In the wake of the credit crisis, competing products such as 130/30 funds have received something of a

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boost as newly risk-averse investors opt for long-oriented strategies. At this point, however, Solovay does not believe that the rise in popularity of these so called ‘hedge fund lite’ alternatives pose a serious threat to the viability of HFoFs. “For instance, 130/30 funds are still relatively new, they have had a challenging year, and it remains to be seen how they will fare in the near future,” says Solovay.

“While their fee structure may be more competitive and easier for investors to understand, in opinion, it is really another marketing concept that hasn‘t been properly tested.”

That being the case, HFoF investing still has some issues to address of its own. “The use of alternative assets comes at a price, and in the past few years much of the ‘alpha’ has been

paid away in high fees, which destroys the value proposition,” says Paul Trickett, European head of investment consulting at Watson Wyatt. Critics of HFoFs typically cite the potential downside of the so-called “doublelayer” fee structure associated with fund-of-funds investing. On balance, HFoF managers charge approximately 1% of assets and roughly 10% of investment profits. Additionally, investors must shell out 2% of assets and upwards of 20% of profits for the base of underlying managers. To combat these fees--and as managers become more savvy in the hedge-fund arena--some plans are choosing to bypass funds-of-funds altogether in favour of investing directly through single-manager funds.

The trend appears to be catching

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In the Markets FAST TIMES FOR FUNDS OF FUNDS

Michael Travaglini executive director, Massachusetts Pension Reserve Investment Management (MassPRIM) Board.“Though we have a total of 10% of our fund in HFoFs, at present we have only one person handling all of those fund-of-funds relationships,” says Travaglini.“While I am confident that we can handle a HFoF search on our own, I am not sure I have the capability to go out and identify what makes a good direct hedge fund investment,” he adds. Photograph kindly supplied by Massachusetts Pension Reserve Investment Management, June 2008.

on. A recent survey by Pensions & Investments found that slightly more than half of all pension funds are now going the direct route. Larger pension plans such as NewYork State‘s $155bn retirement program, as well as the $108.5bn Ontario Teachers’ Pension Plan, make up the bulk of directinvested groups, say experts such as Craig Asche, executive director for the Amherst, MA-based Chartered Alternative Investment Analyst Association (CAIA), given the “diversification and capital requirements needed to go it alone”.

However, reducing fees is not always enough to convince plan managers to abandon their HFoFs. With an admirable track record in the alternative

26

sector, the Massachusetts Pension Reserves Investment Management (MassPRIM), which oversees the state‘s $51.8bn retirement fund, continues to invest exclusively through fund of funds. According to MassPRIM head Michael Travaglini, it all comes down to staffing, or rather or lack of staff.

“Though we have a total of 10% of our fund in HFoFs, at present we have only one person handling all of those fundof-funds relationships,” says Travaglini.

“While I am confident that we can handle a HFoF search on our own, I am not sure I have the capability to go out and identify what makes a good direct hedge fund investment.”

“People talk about this double-layer of fees that are associated with HFoFs, as if youare paying money and getting nothing in return,” says Travaglini.

“Well, I for one can tell you that we are getting a lot. When using an HFoF, all of your fees--legal, custodial, consulting--are inclusive. Whereas if you went direct, your back-office obligations might change drastically.”

For example, says Travaglini, PRIM’s payment to its primary hedge-fund consultant, Cliffwater LLC, is based on its usage of HFoFs. “If we started calling on them to help us source direct investments, the expense would increase dramatically. And the reality is when these folks decide to go direct, they do not just do away with HFoFs altogether: so now in addition to paying this ‘double-layer,‘ they’re also having to shell out for the administrative and consulting fees that come with investing directly to hedge funds.”

When Boston-based hedge fund Sowood Capital Management LP collapsed during the credit meltdown of last summer, it took with it the investment capital of numerous educational endowments and public foundations, including $30m of MassPRIM’s money. Diversifying

Susan Solovay, founding partner of New York-based Pomegranate Capital LLC and the first HFoF to invest exclusively in hedge funds managed by women.“The biggest fund-of-funds are the ones that are most prepared to take on public money, because they've had the institutional build-outs in place for several years now,” she explains.

Photograph kindly supplied by Pomegranate Capital LLC, June 2008.

through an HFoF (New York-based Arden Asset Management made the investment on PRIM‘s behalf) undoubtedly helped, yet Travaglini has learned a more important lesson from the Sowood experience.“I think it proved that even with all the resources and knowledge that a HFoF like Arden had at their disposal, they could still wind up investing in a firm like Sowood,”says Travaglini. “Whereas we only have one person covering the same territory. Given that, I’m not so sure I could do a better job. And yes, the diversification factor is a compelling argument--even if there’s one issue that’s getting crushed, theoretically you’ve still got a bunch of others that

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will offset those losses.”

For the time being, Travaglini’s fund of funds approach appears to be working nicely; according to the TUCS Rankings, during 2007 the PRIT fund returned a solid 11.50%, well above its annualised actuarial investment target of 8.25% – even with Sowood and sub prime-related volatility factored in.

“Which is great, because for every basis point above that benchmark is a dollar that the state does not have to appropriate on our behalf,”he adds.

With an increasing number of institutional investors filing into the alternative space, many advisors continue to recommend the fund of funds approach. Because the average pension plan lacks the skill sets necessary to perform due diligence on individual hedge funds, Jim McKee, director of hedge fund research at San Francisco-based Callan Associates, a longtime proponent of HFoFs, says that investors need to keep in mind the many hidden attributes of having a fund-of-funds intermediary. For many institutions, any reduction or elimination of HFoF fees through the direct hiring of individual managers would in all likelihood be offset by the expense of having to provide in-house the due diligence, experience, and fiduciary duties offered by the outgoing HFoF team, says McKee. Furthermore, many HFoFs have the ability to tailor specialised investment programs that can suit the individual needs of the client.

Certainly, it has been a challenging market for alternatives as a whole, as reflected by the HFR fund of funds Composite and HFRX Global Hedge Fund indices, both of which have been in negative territory of late, says K Daniel Libby, senior portfolio manager for Sands Brothers Select Access Management Fund. In the most recent quarter, small-to medium-sized HFoFs underperformed their large-cap peers,

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K Daniel Libby, senior portfolio manager for Sands Brothers Select Access Management Fund. In the most recent quarter, small-to medium-sized HFoFs underperformed their large-cap peers, which trend more toward the big-asset, more liquid type of hedge fund, says Libby.“Illiquid funds have fared the worse, which is very much the opposite of what has happened in the recent past.”

Photograph kindly supplied by Sands Brothers Select Access Management Fund, June 2008.

which trend more toward the bigasset, more liquid type of hedge fund, says Libby. “Illiquid funds have fared worse, which is very much the opposite of what has happened in the recent past.” With spreads tightening some, Libby sees the potential for gradually improving market conditions. “There could always be another leg down, of course,” says Libby, “and we need to be wary of things like commodity and resource inflation that could push its way through. On the other hand if the ratecut trend changes--that is, if the Fed stops cutting every quarter, which could very well be the case--then everything could head in the other direction very quickly.”

Despite their recent successes in the alternative arena, many institutional managers still consider hedge funds a long-term experiment, in which fundof-funds will in all likelihood continue to play a key role. “The question is

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whether [hedge funds] will really put us in a better place over a ten to 20year period, or do they just make us sound more interesting at cocktail parties,”quips Travaglini.“I’ve become a big defender of fund-of-funds, which is sort of an unusual position for me. But the point is, what we are trying to do through fund of funds is to buy the kind of expertise that does not exist in this building. If at some point the board wants me to begin making direct investments, that’s fine-however, before that happens, we’re going to have to build the kind of infrastructure that can replicate the work that our fund-of-funds are currently doing today.”

If Travaglini could be convinced that there is a whole universe of direct funds that PRIM isn’t currently exposed to through its HFoF programme, that might be a different story.“However,” he adds,“I’m not so sure that is really the case.”

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In the Markets US REGULATORS MOVE TO CURB SPECULATORS

Senator Joseph Lieberman, the senator for Connecticut, right, accompanied by Democratic Senator Barbara Boxer, California, gestures during a news conference on Capitol Hill in Washington, Friday, June 6th 2008, to discuss the environment and climate change. Lieberman, who is also the chairman of the Senate Homeland Security and Governmental Affairs Committee, proposes to ban large institutional investors, including index funds, from investing in commodity markets. In election year in the United States, any move against perceived speculation in the commodity markets is hot political currency.

Photograph by Susan Walsh, supplied by Associated Press/PA Photos, June 2008.

UNINTENDED S CONSEQUENCES A sure-fire sign that an issue is a proverbial hot potato is when industry sources otherwise perfectly happy to be quoted on their investment views prefix a conversation with: “you can’t quote me on that.” And this summer’s hot potato is the intense pressure US lawmakers are exerting on domestic regulators to limit investment in commodity markets, aimed ultimately at stopping the rapid rise of oil prices. The investment community feels that politicians are unnecessarily interfering with free markets, by pointing wagging fingers at index and hedge funds; moreover investors say proposed measures curbing speculation will have a negative effect on commodity markets, resulting in funds pulling out of this asset class altogether.

Anecdotal evidence is beginning to bear out the latter contention. By Vanya Dragomanovich

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KY HIGH PETROL prices are putting inflationary pressure on the already strained US economy and are infuriating the heavily car-dependent domestic consumers. This would be bad news at the best of times but with not only presidential elections but also elections for the US House of Representatives and parts of the Senate due this November this agitation is gaining additional political emphasis.

The pressure is spilling into London as an old agreement between the US commodity regulator Commodities Futures Trading Commission (CFTC) and the London-based ICE Futures Europe, part of Intercontinental Exchange (ICE), which allowed for less CFTC oversight is being changed. As of the

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middle of June, ICE will have to report US law makers as manipulation is two other issues called into question by daily positions and impose limits on mainly the result of heavy inflows of Congress were the fact that CFTC the crude oil contracts that are traded money into commodities which classifies swap dealers, which are started with the credit crunch last typically large investment banks, as on both sides of the Atlantic.

In addition to this there is talk of August. “I wouldn’t say that the commercial traders, and that CFTC had margins being raised and the tax market is being manipulated, but no regulatory oversight over trading of treatment of commodity investments then, I am not trying to get myself re- a NYMEX-traded crude oil contract by pension funds altered to make elected,” says a London banker who when it is traded on the ICE in them less attractive. There are also preferred not to be named. He added London. The latter has now been addressed. Most futures some more drastic markets impose limits on proposals on the table. the size of positions that Senator Joseph Lieberman, “Most futures markets impose limits on may be run in both the the chairman of the Senate the size of positions that may be run in prompt month and across Homeland Security and both the prompt month and across all all forward months.

Governmental Affairs forward months. Investors are not free to Investors are not free to Committee, will propose run positions of any size they like, a run positions of any size later this month to ban they like, a recognition that large institutional recognition that large positions can large positions can become investors, including index become problematic whether or not this is problematic whether or funds, from investing in the intention. The CFTC has exempted not this is the intention. commodity markets. commercial users—physical hedgers such The CFTC has For months, the as oil companies and airlines—from these exempted commercial Congress has been trying limitations, and has allowed many banks users (physical hedgers to find ways to regulate the such as oil companies and market more tightly and to and financial institutions to “hedge” their airlines) from these control rampant oil prices. over-the-counter and index exposure in limitations, and has Since the beginning of the the futures markets by classifying them as allowed many banks and year the CFTC testified commercial rather than non-commercial.” financial institutions to twice before the Senate. “hedge” their over-theThe initial hearings focused on market manipulation, but that commodity markets are much counter and index exposure in the the CFTC said none was taking place. thinner than either stocks, bonds or futures markets by classifying them as “To date, CFTC staff economic currencies and a large inflow of commercial rather than nonanalysis indicates that broad-based money has a much stronger effect commercial. It allowed them to make use of the standard hedging manipulative forces are not driving here than in other markets.

In the last five years investment in exemptions to the usual position the recent higher futures prices in commodities across-the-board,” said index funds tied to commodities has limits. If that rule is changed it could Jeffrey Harris, CFTC’s chief economist grown from $13bn to $260bn. The affect a number of US pension funds, in testimony before the Senate in late turnover on commodity derivatives in according to Arturo Rodriguez, chief May. The statement resulted in an the first quarter this year rose by 52% investment officer of Juno Mother angry barrage from members of the compared with the same period last Earth Asset Management, a New Senate, including a letter from the year, according to the Bank of York-based commodities hedge fund chairman of the Senate Energy International Settlements. Measured firm. “Some funds have the kind of Committee Jeff Bingaman in which he in numbers of contracts, global mandate that does not allow them to claimed that CFTC’s discounting of turnover in commodity derivatives speculate and if they are classified at the potential role of speculation in grew from 420m to 489m. On a busy speculators by the CFTC they won’t driving up oil price was “based on a day on the New York Mercantile be able to remain in commodities,” Exchange close to one million crude says Rodriguez. glaringly incomplete data set.”

On the issue of regulatory control, However, market watchers in oil contracts can change hands.

Apart from market manipulation, most of the oil trade happens on the London say that what is perceived by

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In the Markets US REGULATORS MOVE TO CURB SPECULATORS

New York Mercantile Exchange which is fully regulated by the CFTC. Around 75% of the WTI crude oil contracts are traded on NYMEX, which is under US regulation, while the UK regulated ICE Futures Europe has the remaining market share of 25%. On NYMEX the limits are for 3,000 contracts in the last three days of trading.

The ICE has in the past said that, although it was happy to cooperate with the CFTC, more oversight would have no effect on global oil prices. On top of that, although up until the middle of June ICE was not required to report to the CFTC, some form of cooperation between US and UK regulators already existed as the UK Financial Services Authority (FSA) started providing the CFTC with weekly trade information since 2006.

Back home, the CFTC will use its existing ‘Special Call’ authorities to immediately begin to require traders in the energy markets to provide the agency with monthly reports of their index trading. It will routinely require more detailed information from index traders and swaps dealers in the futures markets and review their trading practices in an attempt to quantify its affect on the market overall. Olivier Jacob, managing director at Petromatrix, a Swiss risk management firm specialising in oil, says more transparency will be a positive thing and will help markets.

As for other initiatives, large institutional investors are already assessing their positions against potential new rules. “Our target allocation for commodities is 1.5% of our total portfolio which is currently at $240bn. Even if the rules change we will be within the new limits” says Clark McKinley, spokesman for California Public Employees’ Retirement System (CalPERS) one of the world’s largest pension funds.

CalPERS has $1.5bn invested in

commodities with a heavy stress on energy. McKinley added that although CalPERS supports the CFTC “we do not believe that investments in index funds have created the big price moves in the oil market. We tend to go with people who say that it is about fundamental issues of supply and demand.” Other market sources say that some funds are beginning to reposition themselves out of commodities. “We are already seeing anecdotal evidence of funds pulling out, particularly index fund providers,” said one London source.

“What we will see more of over the summer is funds withdrawing length, going short or reallocating investment which were destined for commodities into other markets.”

The latest Commitment of Traders report published by the CFTC shows that large speculators have been taking off long positions in WTI for the last two weeks in May and the first two weeks in June. Olivier Jakob said that the current level of long positions in the oil market is at its lowest since the corresponding period in 2003. At the time, WTI was trading at $100 a barrel less than now. Crude oil started June at close to $135 a barrel.

Commodity prices and derivatives activity Prices 1

Derivatives activity2 Energy Precious metals Base metals Agriculture

Jan 98 1 2

S

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How efficient any of the new rules will be in terms of price control remains to be seen. Supply and demand fundamentals already indicate that oil prices are in a bubble, demand is flat on the year if not slightly lower, and there is sufficient supply in the market, according to Juno’s Rodriguez. But not all depends on fundamentals, he says. Part of it is perception, and “you can’t argue with perception. The market wants to go higher. We are not getting close to the end of the market. What needs to happen is an exhaustion move like the one we had in wheat earlier this year when prices rose to $13 a bushel.

When that happens in oil, and that exhaustion move will probably be $200, this is when the market will turn,”added Rodriguez.

If there are to be any more legislative changes they will likely happen by late September or early October because members of Congress will aim to return to their states to campaign for elections. If legislation is not passed by then, it won’t likely happen until Congress reassembles in late January next year. Six months is a long time in commodity trading. By then the picture may have changed significantly.

Jan 01

Jan 04

Jan 07

420

100

340

80

260

60

180

40

100

20

20

Jan 98

Jan 01

Jan 04

Jan 07

0

S&P GSCI Commodity Index subindices, monthly averages; 1998–2002 average = 100.

Exchange- traded derivatives; number of contracts traded, in millions.

Sources: Datastream; BIS

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Index Review To those inured to the generally negative sentiment in this column on UK equity markets, this month might come as something of a shock. While I am not turning entirely bullish, it must be recognised that for the long term investor able to ride out the current storms, there are now some outstanding ‘value’ if short term ‘risky’ stocks on the block. Simon Denham, managing director of specialist spread betting firm Capital Spreads, gives us his unique view of the markets.

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

AN END IN SIGHT? N ANALYST WOULD have to believe in a financial tsunami to recommend selling banking stocks at current valuations. If you are not in the bear camp then a small dabble might prove remunerative, as returns are now above 10% in many cases; even though, in general, UK bank debt is still reasonably highly rated. There is one problem; the stickiness of the credit crunch. A lesser reported symptom is visible in the short term interest rate futures markets. In Short Sterling contracts dealers are used to thousands of contracts on each side going well out along the curve. Recently we have seen tiny volumes by comparison, with frequently just twenty to a hundred on even the front month. A bank trying to get away several thousand contracts is often seeing slippage of up to six pips.

After years of watching the futures markets sweep all before them, we are now seeing a return of over the counter (OTC) deals, as traders become ever more wary of matching off against LIBOR, (as happens with futures contracts). If the most liquid arena on the planet is witnessing this type of gridlock then we obviously have some way to go before there is a true end to the crunch. When the credit crunch is finally deemed to have finished, stocks will have already rallied significantly and the small investor will be

A

wondering where the opportunity went.

It is not normal to postulate that rising inflation might be working (for a short time), in the stock pickers favour.

Normally any mention of inflation, or indeed stagflation, is considered an anathema to investors.This time might well be different. There is a good argument that current inflationary pressures are of the‘one off’variety and t once the breaking effect of the surge fades away, then a more accommodating rate stance might be adopted by the European Central Bank (ECB) and the Bank of England (BoE).

Are we worrying unnecessarily?

Central banks are expected to raise rates by 75bps or so up to March 2009, but it is difficult to see them doing much more than keep a watching brief. Unless underlying increases in commodity prices filters through into raised wage expectations (and awards) the inflationary spiral is unlikely to get going.

With growth now looking to be a concern the ECB and the BoE would come under intense political pressure if they decided to fight a heavy-handed inflation battle at this juncture. Mr Trichet cautions there may be an ECB hike next month. We must take him at his word, but to extrapolate this into two, three or even four moves (at the time of writing euro three month Libor rates next March are at 5.5%) for the euro, sterling and dollars might stretch the correlation.

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Over-exuberant mortgage lending s may have dealt the UK a nasty blow, with a serious dragging effect caused by a weakening housing market.

Property is unlikely to recover for some time and the question is: how far might prices slip? However, the slowing economy has not (yet) led to serious employment but this must surely just be a matter of time. Even though property valuations have fallen marginally, they are still absurdly high from an investment return point of view. Remember that retrenchments of the past have generally only ended when the other extreme has been reached and property becomes ridiculously cheap.

Unfortunately if we look at a modestly rising wage environment— of perhaps 3% per annum— it is not unreasonable to postulate a sinking property market for three to four years before inflation and wages catch up and pass housing affordability. In eyeing up the shell-shocked house building and financial sectors is not hard to argue that the Armageddon scenario has almost been written in to valuations already. This leaves precious little room for an unexpected shift to a more positive outlook. At the moment the downside risk, just for once, looks a good deal smaller than the upside. As ever Ladies and Gentlemen, place your bets!

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Country Report BRAZIL’S CAPITAL MARKETS’ OUTLOOK

WILL OGX SET A NEW PACE FOR INVESTORS IN BRAZIL?

S&P’s move also means the Brazilian central bank should be able to change tack and cut interest rates increases, which in turn should trigger a large increase in corporate issuance, he says. The achievement of investment grade underlines the diversification of the Brazilian economy away from the staple of commodities, says James Quigley, chairman of Merrill Lynch International and head of the firm’s Latin America business.“This [upgrade] mitigates risks for the country and creates a platform for bringing in further foreign direct investment,” he says.

Photograph supplied by istockphoto.com, June 2008.

As the second quarter got underway, the Brazilian equity market appears to be doing the splits. The primary equity market remained sullen with two key test deals providing a lukewarm experience for investment bankers. Meanwhile, the secondary market continued to clamber back to all-time highs and Brazil finally reached investment grade, at least with one agency. Then came the sidewinder that was OGX, marking an IPO benchmark.

What is next for this key market?

IRST THE GOOD news. Eike Batista, CEO of OGX Petroleo e Gas Participacoes (OGX), has had good reason for merriment in June. The launch of OGX on the Bovespa raised almost BR6.71bn (around $4.1bn), following the decision by Credit Suisse to buy an additional lot of 741,800 shares; its Brazil’s largest IPO. Trading in the aftermarket has now pushed the company’s value to $23.7bn, and OGX is now Brazil’s second largest oil company after Petrobras by market cap. Interest in OGX has been preternaturally high, despite the

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obvious risks involved (it has not found oil yet). Investors have gambled on the asset because of sky high oil prices and the future of the Brazilian oil industry following several major deep-sea oil finds off the coast in the past year. OGX plans to drill wells this year and report discoveries next year; with first production from the wells expected some time in 2012. OGX surged to prominence in November 2007, when it won the right to explore some 7,000km² worth of high potential blocs estimated to hold some 4.83bn barrels worth of oil, according to a study conducted by the

DeGolyer and MacNaughton consultancy, which has been working for OGX. The thing about OGX’s initial public offering (IPO) is that it is not entirely clear how much of its appeal rests on the fact that it is an oil story at a time when oil prices and supply are at a premium; or whether it is a bellwether for Brazil through the rest of 2008 and beyond.

For the ‘glass is half full’ contingent, the decision by rating agency Standard & Poor’s to upgrade Brazil from BB+ to BBB- is an important feather in the cap for the country and is set to usher in another wave of investment. The upgrade is bringing in investors that had been sitting on the sidelines.

Institutional clients, particularly pension funds, endowments and insurance funds, now are actively looking to invest in the country directly, says Zeca Oliveira, chief executive officer (CEO) of BNY Mellon Asset Management in Rio de Janeiro.

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Moreover, “interest from overseas razor-thin 2%. Additionally debt significantly cheaper than BRIC rivals fixed-income funds should be markets have continued to post gains China or India.

And now for the bad news. Still, enormous. After all, we have some of with Brazilian dollar bonds narrowing the highest interest rates in the world,” nine basis points against US Treasuries there are downsides to the upgrade. adds Joaquim Patto, principal at Mercer to 219 basis points on the day, bringing One possible negative side-effect of in São Paulo. The benchmark Selic rate the fall over comparable US Treasuries the upgrade is to put further upward pressure on the already strong real, is 11.5%. S&P’s move also means the to more than 22% since late 2002.

S&P gave further reasons for pats on which is up 6% this year and was Brazilian central bank should be able to change tack and cut interest rates the back. “The upgrades reflect the trading at 1.67 against the US dollar. increases, which in turn should trigger maturation of Brazil’s institutions and That is already hurting the balance of a large increase in corporate issuance, policy framework,”says Lisa Schineller, payments. Despite all the hullabaloo he says. The achievement of primary analyst for the sovereign. She in the secondary markets in the last investment grade underlines the added a note of caution, pointing out couple of months, the primary markets diversification of the Brazilian that: “Net general government debt have remained in the doldrums. The economy away from the staple of remains higher than that in many first two months of 2007 saw a virtual commodities, says James Quigley, ‘triple B’ peers, but a fairly predictable drought in the equity markets. Nine chairman of Merrill Lynch track record of pragmatic fiscal and companies raised money on the International and head of the firm’s debt management policies mitigates exchange in the first two months of 2007, achieving R$6,794bn in funding Latin America business. “This this risk”. with large, liquid deals The [upgrade] mitigates risks for first two months of 2008, by the country and creates a contrast, saw just two deals platform for bringing in “The currency, already the world’s that raised a paltry further foreign direct best performing against the lacklustre R$387.5m, or less than 6% investment,”he says. dollar, was up 2.46% on the day, of the 2007 number. March Quigley reasons that the possibly helped by the Federal evened up the score first in will be non-traditional Reserve’s decision to cut US rates to a somewhat but that was and nimble investors such as mostly thanks to one sovereign wealth funds, high razor-thin 2%. Additionally debt markets jumbo secondary offering net worth individuals and have continued to post gains with that raised R$1.2bn, and private equity funds. He Brazilian dollar bonds narrowing nine even with that deal, 2008 argues that the upgrade also basis points against US Treasuries to miserably failed to reach reflects the emergence of São 219 basis points on the day, bringing last March’s level. April had Paulo as Latin America’s the fall over comparable US Treasuries been seen as a key test for financial hub, the low level of the primary markets and credit exposure enjoyed by to more than 22% since late 2002.” one that Bovespa flunked in Brazilian banks and the the second quarter.The IPO strength of the small and The upgrade follows the surprising of consumer goods firm Hypermarcas, medium SME sector in the country.

The upgrade helped push the already news that in late February, Brazil led by Citibank, was seen as a safe bet. buoyant equity market up to still snatched the crown of largest free- The deal was from a company in a giddier heights. The Ibovespa, the float cap from China in the MSCI popular sector, with a decent amount principal index, surged more than 6% Global Emerging Market Index on offer (over R$600m) and with a rankings.

Brazil proven management team. Even so, to a record high on the day of the capitalisation announcement, the biggest single-day achieved a free-float cap of $509.1 bn the deal priced well below the initial gain since November 2001. The (14.95% of the index) against giant range of R$20.50-24.50 at R$17 per currency, already the world’s best China, which had slumped to $481.8 share and glided downwards after the performing against the lacklustre bn (14.15%). In 2002, Brazil accounted IPO. Also, the much-awaited IPO of dollar, was up 2.46% on the day, for just 5.3% of the index. Moreover, the more capricious Le Lis Blanc was possibly helped by the Federal with trading multiples of about 12.5 weaker. Admittedly, the company was Reserve’s decision to cut US rates to a times 2008 earnings, Brazil remained seen as a difficult sell even in regular

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Country Report BRAZIL’S CAPITAL MARKETS’ OUTLOOK

markets. First off, the firm is involved in the fashion sector and was the debut such company to seek a listing on Bovespa. Second, the deal was small at a time when investors are clamouring for liquidity. Finally, the majority owner, private equity firm Artesia, which held an 85% stake, was seen to be selling its investment hastily, having kept it just a couple of years. The bankers behind the deal, Merrill Lynch and Morgan Stanley, were compelled to chop and change the deal size and conditions several times in the run-up to the launch.

Then on its debut, Le Lis Blanc dropped 20%. The firm raised less than half the amount it had sought.

What happened?

The key deciding factors for the nearterm future of the Bovespa markets are the global appetite for equity risk as well as how quickly the more mundane work of re-building trust in investment banks after last year saw some deals get too puffed up. Investment bankers agree on one thing: that their competitors rushed many companies to market to exploit investors who were interested in just about anything Brazilian. “The Brazilian markets experienced irrational exuberance which can be seen in the quality of stories that came to market. They have not delivered in terms of news flow and growth. They may be high quality companies, but they were not at the right stage [for a public market launch],” says Ricardo Lacerda, managing director and head of investment banking Brazil & co-head of investment banking Latin America at Citigroup. He expects to see around 1020 IPOs this year, most of which will be larger than the deals that squeaked through last year, with OGX setting the pace for the remainder of the year. That lack of responsibility in presenting companies to the market left many

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investors resentful and companies frustrated by their limited access to international markets, says Bernardo Parnes, CEO of Banco Bradesco BBI, the investment arm of the private bank.

This more cautious stance from investors has meant that deals coming out of Brazil, even after OGX, need to tick more check-boxes and there will be less fancy footwork from investment bankers. José Olympio, managing director and head of Brazilian investment banking, at Credit Suisse, sees investors as selective, but by no means refusing to consider new opportunities.“Any story that has the combination of a good sized free float, quality management and business plan and a track record will get done successfully,” he says.

Sonia Dula, head of Latin American investment banking at Merrill Lynch in New York, sees investors asking: “Why are you issuing? Is my money funding growth? Is the management good quality?” She expects volume to return in quantity in the second half.

This moment of fussiness by investors begs the question of just how many Brazilian firms are ready to come to market after the recent generous bout of fund raising as well as how qualified the last bunch were.

Rodolfo Riechert, head of investment banking for Brazil at UBS, thinks the gloom is overdone and that most companies that came to market have not performed so badly.

“Many of the companies recently brought to market are making good sales and seeing positive return on equity that are beating expectations,” Riechert says. He argues that the vast majority were solid stories and are matching up to their earnings promises.There are just a small number of outliers that turned out to be disappointments, weakening investor appetite, he says. UBS held the number one spot in IPO book-running last year.

Private equity and more In the absence of any window for IPOs in the public equity markets, investment bankers are having to earn their spurs by thinking creatively about fund raising in other formats. That is being facilitated by the emergence of new pools of interested investment money. These include family offices, private equity firms, hedge funds (which run multiple funds with many different mandates in Brazil), sovereign wealth funds and others. The timely move up to investment grade will ensure that these and other sources of funds become significant in catalyzing investments in Brazil. The wave of capital raising by private equity firms means that they are cash rich. Brazil’s home grown GP Investments has successfully raised multiple funds and increasingly foreign firms are looking to supply intermediate-tenor financing. US private equity firms and hedge funds are increasingly coming to the region and scouting out opportunities for private placements, especially for small deals, says Dula.

Credit Suisse’s Olympio is already working on deals of this kind and notes that Brazilian firms that are looking to raise cash include can still do so, if by alternate routes. He points to the example of Goiânia-based MB Engenharia, a real estate firm that had filed for an IPO but opted in March for a sale to Brascan Residential Properties.

Citigroup is unusual in also watching the debenture market for signs of a revival. That comes in despite a recent increase in interest rates by the Central Bank of Brazil.“It is a high interest rate environment, but local debenture investors are looking for private names and non-government risk and prefer local markets to avoid foreign exchange risk,”Citi’s Lacerda notes.

In addition to acting as middle-man between clubs of investors, bankers continue to operate aggressively in the

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merger and acquisitions arena.

Brazilian M&A activity was close to $27bn in the first quarter, 140% more than the previous year, compared to a 24% fall worldwide. The deals come in all shapes and sizes and continue to include the very largest firms.

Indeed, the jumbo merger of the two exchanges BM&F, the futures exchange, and Bovespa, the cash exchange, has already been factored into the league tables. The big deals won’t stop there.

The tie-up between Brasil Telecom and Tele Norte Leste Participacoes SA(Oi) is crawling ever nearer. A rule change allowing fixed-line telecoms to operate in more than one region of Brazil will spark competition by creating a major new continental player. Ronaldo Sardenberg, president of Brazilian regulator Anatel, told local press in mid June that the rule change would allow telecom Oi to buy Brasil Telecom, Brazil’s number three fixed-line carrier.

The new company would then compete against foreign players that dominate the market: Spain’s Telefonica SA and Mexico’s America Movil, which is owned by billionaire Carlos Slim. Oi has signed a deal that will see it stump up R$5.9bn to acquire a controlling share in the telecom operator.

BNDES, too, has confirmed its intent to sell energy company Brasiliana, with its stake thought to be worth in the region of $1.1bn.

The renewed optimism surrounding M&A and the revival of IPOs as the mid year point approaches depends heavily on a reduction in market volatility. With markets see-sawing, it has become increasingly difficult to put a value on a company that both seller and buyer – or buyers -- are happy with. “The hit ratio in M&A is suffering,” acknowledges Lacerda, whose Citi is a leader in the market.“It’s going to be a tricky year that could go either way. Firms are not abandoning plans and looking very actively at opportunities, but the

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OGX surged to prominence in November 2007, when it won the right to explore some 7,000km² worth of high potential blocs estimated to hold some 4.83bn barrels worth of oil, according to a study conducted by the DeGolyer and MacNaughton consultancy, which has been working for OGX. The thing about OGX’s initial public offering (IPO) is that it is not entirely clear how much of its appeal rests on the fact that it is an oil story at a time when oil prices and supply are at a premium; or whether it is a bellwether for Brazil through the rest of 2008 and beyond. Photograph © Denis Thompson/Dreamstime.com, supplied June 2008.

challenge is to complete the process and this has become much more challenging,”he says.

It is this volatility rather than the overall direction of the markets that has proved such a cold shower for investors’ ardour in Brazil. They have hardly been hit by some results that were weaker than expected.

Other consolations are in play however. The key indices have recovered from dips earlier in the year and the outlook for Brazil’s economy is on the up. As S&P points out, foreign direct investment (FDI) is diverse in terms of size and destination and is drawn to Brazil, given its maturing growth outlook. After reaching a record of $34.6bn last year, FDI

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continues at a robust pace in 2008 and is expected to cover the $20bn current account deficit forecast for 2008.

The sticky question remains: when will volatility in the market subside?

With the recent pipeline of good news, a pick-up in the primary market must be expected sooner rather than later. return to form with OGX and large IPOs from companies with a proven track record in the pipeline, interest from investors will at worst be piqued and at best will focus on what looks to be one of the year’s most active markets globally. The greater danger is perhaps that investor pickiness will be shortlived as the usual determination not to miss out on the good times returns to Brazil, putting the froth back in.

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Country Report POLISH BANKS IN THE POLITICAL SPOTLIGHT

THE HEAVY POLITICAL HAND ON POLISH BANKS Finally, after almost three years of political jockeying, Unicredit has bowed to pressure and allowed GE Money to buy and walk off with approximately 20% of Bank BPH and its brand name. The break up of Bank BPH has been long and protracted, with significant implications for both Unicredit’s holdings in Poland and the image of the country as a free market. Julia Grindell reports.

HEN UNICREDIT BOUGHT HVB back in 2005 it thought it was a key move in establishing dominance in the Polish banking market (albeit Unicredit’s original purpose in buying the German bank involved a much broader regional strategy). HVB owned Bank BPH. Unicredit owned Bank Pekao; and a merger of Poland’s third and second largest banks (respectively) in terms of assets looked to be a sine qua non.

Instead it was the beginning of a long, protracted battle between the government, which felt that the deal would compromise the country’s antimonopoly laws and Unicredit, whose aspirations to dominate the Eastern European banking landscape found that it had hit a proverbial Polish brick wall. The government dug in its heels: wanting to keep the BPH brand in the market and perhaps even curb Unicredit’s ambition. In the end a compromise of sorts was reached and a deal was finally inked in June.

Unicredit could merge Bank Pekao with approximately 80% of Bank BPH’s assets. The balance would have to be sold off, and in the end it was, to GE subsidiary GE Money, which would also be able to utilise the longstanding BPH brand. Unicredit was left with the Bank Pekao moniker, with which to market its wares.“Unicredit now owns a 59.28 % stake in Pekao with the state

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treasury holding around a 5% stake and the remaining shares are widely spread between minority shareholders such as pension and investment funds, as well as numerous private individuals,” reveals Luigi Lovaglio, general manager and first vice president of Bank Pekao SA. For now, it looks like a proverbial win/win result. “The acquisition of BPH by Unicredit marks the final stage in its overall merger with HVB,” says Lovaglio with some relief. Pekao is now the top ranking bank in the country in terms of total savings (now standing at PNL108.5bn; about $49.7bn). “The merger also gives scaled operations and better geographical coverage,”says Lovaglio.

“We integrated about 80% of Bank BPH including 285 of its 485 outlets, the entire corporate banking division and respective headquarters, and most of its subsidiaries,” he adds, while Pekao’s net profits jumped 23% alone in the first quarter of this year.

Unicredit is not the only player with an eye on the potential of the Polish market. Majority foreign ownership is now a common theme in Poland’s banking sector, where over 40 of Poland’s 58 commercial banks are now controlled by foreign banks, which together control just over 60% of the country’s total banking assets. Slawomir Sikora, president and chief executive

Photograph © Paul Cowan/Dreamstime.com, supplied June 2008.

officer (CEO) of Citi Handlowy, the result of a merger between Poland’s Bank Handlowy w Warszawie SA and Citibank (Poland) back in 2001, explains why the market is so appealing.

“Mortgage lending, personal and consumer lending and credit operations have been showing strong growth as the number of bankable clients are growing in line with Poland’s development.”

Additionally, in keeping with other central and eastern European countries, lending to the small and medium sized enterprise (SME) sector has shown robust growth. “The SME sector now generates nearly 50% of GDP in Poland,” explains Sikora.

“Revenues from SMEs constitute almost 26% of total enterprise revenues here at Citi Handlowy,” he says, adding that higher spreads on SME lending compared with those on loans to larger corporates adds to the sector’s popularity. However, assistant vice president analyst of financial institutions group at Moody’s, Irakli Pipia, notes, “Intensifying competition between banks and in particular the leading banks is now apparent, especially in the larger cities.

Competition to attract deposits is equally as stiff as for lending products.”

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“Fierce competition is putting pressure on margins,”acknowledges Sikora.

Even so, the good might just outweigh the bad. Pipia, for instance, points out that, “The abundance of foreign ownership has helped the market in terms of streamlining the restructuring process of regional banks and implementing best practices such as risk management tools and Basel II, as well as the quality of service and product diversification.” Pipia believes there is still a lot of room for the market to grow and develop, even though competition for business is hot.

Even so, banking penetration in Poland is approximately 50% and the ratio of banking assets to GDP stand around 60%, significantly below the EU average of 240% of GDP. As a result there is still a significant opportunity to utilise the wider market in growth strategies through regional expansions as well as increasing product offerings.

PKO Bank Polski, now Poland’s second largest bank in terms of assets but the number one bank in terms of its branch network, hopes to tap into this opportunity going forwards.“We predict that PKO BP’s revenues will continue to grow strongly this year on the back of expanding volumes,” says Marcin Piatkowski, chief economist at the bank.

“We want to leverage our largest branch network to maximise penetration of SME and consumer markets throughout the country.” PKO BP is one of the few remaining Polish banks where the state treasury holds a majority 51.49% share with a remaining portion floated on the Warsaw Stock Exchange (WSE).

More pronounced market segmentation opportunities on the back of a growing wealthy class, boosted by fast domestic growth and a strong stock market performance over recent years is also encouraging new entrants. “It is striking that within Poland there are still banks being set up from scratch,” says Piatkowski. One such example is Noble

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Bank, a greenfield operation incepted in 2006 with a mere PLN4.0bn in start-up capital. Noble has now become one of the biggest financial advisory firm’s in the country and the 25th largest bank.

Noble’s vice president Krzysztof Spyra explains that the company has found a niche in the market by differentiating away from the large universal banks to provide tailored services to predominantly wealthy clients. “Given Poland’s strong stock market performance and growing wealth we have worked hard to capture some of this ‘new money’ so to speak. A few years ago, it made no sense to talk about market segmentation in Poland. Now however it makes sense for the niche players to come in and capture some business from the universal high street players” says Spyra. “The company’s success has really been a matter of good timing as well a bit of luck,”he jokes.

Key to a continuation of the opportunity within the Polish banking sector is a helping hand from the government. Some market watchers worry however, that the administration sometimes applies medicine with an overly heavy hand. For instance, a number of analysts contend growth in the banking sector has to some extent been overshadowed by recent regulatory developments implemented by the government. “Political developments in Poland will always be welcomed,” says one banker with a touch of irony. Most worry however about the political overlay of the sector.

Its most recent form is a comprehensive market review, which resulted in key regulatory changes earlier this year.

In January this year, the Commission for Banking Supervision (CBS), was merged into the Polish Financial Supervision Authority (PFSA) in order to address the evolution of Polish financial markets such as the increase in multinational financial groups and cross-sector financial products. Prior to

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this CBS had the limited objective of ensuring the safety of deposits held by banks. The government contends the new move will allow the banking system to be governed by a body with a much wider remit. Nevertheless, the obvious complexities that transpired as a result of government intervention over the recent Pekao-Bank BPH merger only highlight the need for a far more independent regulatory environment within the sector. “The inception of a more independent banking supervisory body would be welcomed,”argues Pipia adding,“we observe that well regulated financial systems have their supervisory authorities independent from government influence and any step in this direction in Poland will be considered a positive development.”

For the time being liquidity is Poland’s ace.“Most bank funding has come from deposits and until recently there has been less reliance on funding from external sources,” says Pipia. Liquidity in the domestic market has helped minimise the impact of the credit crunch felt elsewhere in Europe. However, Sikora explains, “Our credit cycle peaked between 2006 and 2007 and as a result liquidity could now become an issue.

There have been some concerns that loans could go bad further down the line. And although we have not seen this trend yet, given the stage in the credit cycle, tightening could follow.”

PKO’s Piatkowski thinks Poland will enjoy a benign market for some time.“This year, Poland’s GDP will be close to $600bn which is larger than western European countries such as Belgium, Sweden or Switzerland. In addition, household incomes are rising fast and creditworthiness is continuing to improve. Demand for credit finance is rising in line with the trend.

Given poor financial penetration, growth opportunities abound,”says Piatkowski.

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Face to Face STANDARD CHARTERED GEARS UP FOR THE NEW WORLD ORDER

The Feder Line The appointment of Lenny Feder as group head of Financial Markets for Standard Chartered’s wholesale banking business in July last year marked a new modulation in the both the remit and pitch of the bank. It was a signal that the bank was breaking out of its traditional emerging markets franchise and was now serious about a global footprint. One year on FTSE Global Markets talked to Feder about the bank’s ambitions and its delivery of global services.

Lenny Feder, group head of Financial Markets, Standard Chartered. Photograph kindly supplied by Standard Chartered, June 2008.

remains brisk.” Feder explains that the bank’s footprint across Asia, Africa and the Middle East “is unrivalled.

Most competitors try to play up their commitment to a region after being in it for a decade or so; Standard Chartered has been in many of these markets for over a century. I have also been impressed with senior management’s deep and personal knowledge of so many geographies. I think we are now uniquely positioned as the bank with the best opportunity in markets that offer the fastest growth.”

To best leverage its strengths, it invested in key areas. Early this year, it completed the acquisition of American Express Bank (AEB) for $823m. The purchase provides an opportunity to add capability, scale and momentum in the strategically important financial institutions and private banking businesses and adds 19 more markets to the Standard Chartered footprint; deepening its presence in some core markets and providing access to several new growth markets, adding capability in trust, fiduciary services, margin trading, wraps, and extend geographic reach with new booking centres in Geneva, Monaco, Miami. It also accelerates Standard Chartered’s financial institutions business, enhancing its capabilities in a core

customer segment and doubling the bank’s US dollar clearing operations and providing it with a direct euro and yen clearing capability.

Another element is people.

Following an internal reorganisation of the bank’s financial markets division to encourage specialisation and drive product sophistication and value-add to clients, Feder brought in a raft of new talent in key strategic roles. Three principal hires came from Lehman Brothers in Asia. Among them was Remy Klammers, who took up the role of global head of fixed income trading, a new position with responsibility for FX, rates, credit and structured products trading. Alexis Suzat was appointed as the new global head of structured products trading, working “hand in hand with the FX, rates, credit, equity and commodity trading teams to ensure we provide one, competitive offering to our clients,” says Feder. Marten Agren was enjoined as global head of modelling and analytics, in a group that encompasses Standard Chartered’s existing quantitative development team. “In Remy, Alexis and Marten we hired the key manager, trader and quant/IT specialist who will form the backbone of the structured trading team. This cutting edge model has been used regionally, but never on a global basis

HEN HE JOINED Standard Chartered from Bear Stearns, Lenny Feder’s main brief was to provide strategic oversight around the bank’s financial markets products and services. He worked closely with the heads of wholesale banking’s, capital markets business, rates and foreign exchange business, regional markets operations and asset and liability management (ALM) for the bank’s consolidated balance sheet, to determine a forward strategy. The subsequent decision to deliver better end-to-end coordination of the bank’s financial markets offering was “driven by the increasingly sophisticated and integrated solutions required by clients wanting seamless delivery of capital raising, loan syndication and asset securitisation services, in line with rates and foreign exchange and derivatives risk management services.

It made sense to have one person provide strategic coordination and service delivery oversight to our infrastructure,”notes Feder.

It has paid off in spades. While most other global banks have been on the write off trail, Standard Chartered has remained immune.“We certainly have benefited from the bank’s commitment to strong liquidity. We’ve had no large write offs and have enjoyed the space to focus on our core markets and clients, where business

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and will fundamentally change the rate at which we build scale and sophistication in our product offering.” says Feder. A number of elements are driving the strategy.

“Globalisation is irreversible,”stresses Feder, “and no one of our offices is more than 20% of the whole. We are building an international network of business that is closely aligned with our clients and which enables the bank as a whole to leverage its position in high growth markets.”

It is a level of commitment that has sometimes had the bank under fire (literally). In places such as Africa, Standard Chartered has long had a reputation for taking a “last out” approach to doing business in striferidden nations. Tales of the company still undertaking retail banking in the midst of national conflict in West Africa are the stuff of legend and yet are true. “We do not take leaving a country lightly,” smiles Feder. Right now, the bank is focusing on more sophisticated activity, involving the establishment of specialist platforms, including structured trading, equity derivatives, commodities and convertibles.

“We have a Straight2Bank platform in this regard,” notes Feder, “we have different electronic platforms, we can manage cash, deal with numerous countries, transact FX. The one thing you have to figure out is how you interact with the client and that the solutions you offer are the exact solutions the client needs. That means complexity and sophistication; hence our investment in people and technology.”

Standard Chartered has more room for manoeuvre than most. “As the effects of the sub prime contagion has been pretty limited for us, and we are doing more business than before,” says Feder: “the iTRAXX index is tighter, ABS prices have stabilised and

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funds are buying distressed asset.

We’ve not had to slow down, so we’ve been around for clients when others couldn’t be.” In part that is the result of the bank’s strict compliance with “the advanced version of Basel II,” says Feder. “We know the return on assets by business and by client. It has allowed us to understand our return on capital very precisely.. Ultimately, your clients want to know that you are stable.” It is also the bank’s commitment to a multi-tiered client approach, which means it is relied upon as much by other global banks as global asset managers and/or commercial firms. The bank’s “on the ground credentials in that regard count for a lot. It gives us a different perspective. For instance: we don’t think it is crazy to think that within a decade the largest stock market in the world might be India or China; it will completely change the face of finance – and we are preparing for that eventuality.”

The bank is establishing its global credentials and that means an extension of its network into key developed markets. Most recently it opened an office in Paris. The establishment of a physical presence in France. Revenue from French corporates and financial institutions is showing significant growth in 2008 and France now accounts for approximately 10% of all the bank’s European client revenue.

Feder thinks that one key to taking the bank forward is understanding the complex and multi-faceted nature of Standard Chartered. He admits it is not always easy to define in simpe terms. “We are, I guess, something of an enigma. What makes us different from other banks is our deep client franchise. We are more local than an international bank and more international than a local bank; it colours our relations at every level,”he

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notes. As an example, he cites a recent agreement with the International Finance Corporation (IFC), the private sector funding arm of the World Bank, with whom Standard Chartered recently collaborated on the launch of the first-ever issuance of notes backed by loans to microfinance institutions in Africa and Asia. The transaction creates new product to provide investors with access to microfinance as an asset class, and enables Standard Chartered to expand its lending to the sector.

IFC is investing $45m in creditlinked notes to be issued by Microfinance Institutional Loans for Asia and Africa, a special purpose vehicle set up by Standard Chartered to facilitate microfinance lending. On the other side of the coin, the bank has acquired a further 6.16% of the ordinary shares in Vietnam’s Asia Commercial Bank (ACB) and a further 7.1% of the convertible bonds of ACB, a leading joint-stock bank in Vietnam.

Standard Chartered has been a shareholder and strategic partner since July 2005. The investment both strengthens Standard Chartered’s relationship with ACB, and helps the bank benefit from the Vietnam growth story.

Ultimately Feder is optimistic about the opportunities embedded in Standard Chartered’s rich tapestry.“In the past banking was more about Western arrogance,” says Feder. “But that is disappearing and the future is much more about global standards being applied across the board in the banking context; from local to regional through to the global level. It is not easy to move from local to global and I would venture only a handful of banks can really do it successfully. Moreover, as the world goes East, the bank increasingly stands out in terms of service offering.

We are committed to improving it.”

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Debt Report SOVEREIGN DEBT: THE INEVITABILITY OF WIDENING DEFICATES

Varied Appetite for Euro Sovereigns Philippe Mills, the chief executive of French debt-management agency AFT. Photograph kindly supplied by AFT, June 2008.

In mid-2008, as the cycle of cheap credit was reaching its zenith— spread differentials between issuers in OECD countries had eroded almost to the point of inconsequence. At the same time, increasing numbers of emerging countries were coming forward to tap what appeared to be a bottomless reservoir of cheap capital-market funding. Things could hardly be more different now. Andrew Cavenagh reports.

UROPE HAS SEEN the most dramatic change in the sovereign space, as it becomes clear that the fall-out from the credit crisis will hit some countries worse than others. As a result, this year sovereign investors make clear distinctions between issuers in the Eurozone. Secondary market spreads between Spanish and Portuguese government bonds and benchmark German bunds are around 50 basis points (bps)—their highest levels since 1999—on concerns about the meltdown of the property markets in both countries.

Tighter conditions have also led investors to shun the sovereign debt of countries such as Italy and Greece, whose national debts stand at over 100% of their GDP versus the 60% limit laid down in the Maastricht Treaty. In the first week of March, for instance, yields on both Italian and Greek 10-year bonds soared to a record premium of 52bp over comparable German bunds, as investors apparently sold off half the holdings they had built up over the previous four years.“The danger is that they will struggle in an environment where there is a heightened sense of risk aversion,” says a non-sterling sovereign fund manager in London.

Spreads will likely widen, as southern European countries seem certain to incur larger fiscal deficits as their economies retrench (and government revenues fall). “Deficits everywhere are going to rise as the economy slows, unemployment rises and tax receipts fall,”predicts Meyrick Chapman, head of Eurozone fixedincome strategy at UBS in London.

“We anticipate a breach of the Growth and Stability Pact limits [3% of GDP]

by Greece, Portugal, Italy, France and possibly Spain.” Each will, of course, have to issue further debt to finance ballooning deficits, thereby exacerbating the spread differentials against bunds. “The widening could be quite prolonged, but I would anticipate that Italian bonds (BTPs) could reach 85bp over bunds by end 2008,” says Chapman. The problem will be magnified given that the Eurozone is heading into a period of higher issuance anyway, after a period of low bond replacement, as a result of the cycle of long-dated issuance that accompanied the introduction of the single currency.

Chapman says six factors will determine the extent to which spreads between Eurozone sovereigns will widen this year: current fiscal position;

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outstanding ratio of debt to GDP; housing debt; house prices; currentaccount position and the level of nonresident debt holdings. He says investors should be particularly wary of exposure to housing risk and debt risk, as well as the impact of an economic slowdown on issuers’ fiscal position.

On this basis, Germany and Finland emerge as the strongest credits in the Eurozone, while some of the other traditional “core” European issuers (including France and Ireland) are among those at risk of spread widening as their scores across these six parameters are close to that of Portugal. The European Central Bank’s recent signal that it will raise interest rates this year to combat inflation will maintain the pressure on spreads.

Although as long as no one breaks ranks from the euro they should not exceed double digits. “The notion that you are going to see Spain and Italy at 100bps over Germany is highly unlikely,” says the fund manager. The last time this limit was exceeded, he says, was when Italy and the UK opted out of the Exchange Rate Mechanism in 1992.

As issuance is set to rise, capacity on the buy side has shrunk. Losses in the credit markets have constrained the

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balance sheets of banks, so they cannot participate in bond auctions to the same extent as before. The failure of several recent bund auctions (where bids did not match the volume of bonds on offer) should serve as a warning. If possibly the most soughtafter financial instrument in the world at present can struggle in this way, what are prospects for less-favoured sovereigns? Philippe Mills, the chief executive of French debtmanagement agency AFT, stresses the importance of preparing auctions thoroughly in advance with primary dealers to match investor demand. He points out that since the market turmoil began, all AFT’s auctions had seen a“bid-to-cover”ratio of between two and three times. Mills would not be drawn, however, on AFT’s probable levels of issuance over the next two years. “It is too early to answer this question.”He says there were no plans at present to increase issuance of median and long-term debt this year over the €116bn figure published at the end of 2007 and points out that the Sarkozy government is committed to deliver a zero deficit in 2012.

Widening budget deficits in the US and the UK will also lead to higher issuance of Treasuries and gilts over the next two years. Flattening yield curves as the central banks become more hawkish on interest rates will drive issuance to the long end. Yields on 2-year Treasury bonds climbed 160bp in the two months up to June.

Yields on comparable Japanese bonds also rose from 0.5% to 0.9% since March, as inflation finally began to increase—driven by fuel and food prices—despite the apparent slowing of Japan’s economy. “It will be interesting to see how that changes the dynamics of the country’s bond market,” notes the fund manager. As increasing numbers of emerging countries gain access to the

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international capital markets, the overall rating profile of sovereign debt continues to decline. Moody’s recently confirmed that while triple-A or double-A issuers accounted for 100% of the issuers it rated in 1983, the percentage had dropped to just over 60% by 2007.

Yet incidence of default remains remarkably low. Having experienced no defaults among its rated issuers until 1998, there were seven (largely on the back of the Russian financial crisis) over the next three years.

However, there was then just one a year up to 2006.

The agency further pointed out that there had been no sovereign defaults in 2007 and that it had upgraded the ratings of 18 countries during the year against and downgraded just two.

Given that its sovereign ratings have historically proved to be an accurate predictor of relative default risk - and that all defaulters have had a rating of Ba2 (double-B) or lower within a year of ahead of default – the outlook for investors on that score appears reasonably encouraging.

The UK’s promise to issue its first sovereign Sukuk came a step closer in early June when economic secretary and city minister Kitty Ussher said the government favoured a ‘bill-like’ Sukuk programme which could be

fully integrated with the conventional Treasury bill programme. Chairing the third meeting of the Islamic Finance Experts Group, Usher noted that any remaining barriers were surmountable, and “a rolling programme of up to around £2bn of ‘bill-like’ Sukuk issuance would be achievable over time” she said, most likely utilising a ‘plain vanilla’ Ijarabased structure to facilitate sukuk issuance.

Even so, Ussher acknowledged number of outstanding issues that need to be addressed before the UK government will make a final decision on whether or not it will issue Sukuk. A progress report on answers to these issues will be contained in the 2008 Pre-Budget Report (PBR), says Ussher.

In the meantime, the UK Debt Management Office (DMO) has recently issued its second quarter gilt auction calendar. “In terms of the number of gilt auctions scheduled, the next quarter is the busiest ever undertaken by the DMO,” notes Robert Stheeman, chief executive (CEO) of the DMO.“We are planning to launch two new conventional gilts, a new long-dated gilt, which we hope will help in supplying duration to the market and a new 2019 maturity which we will want to build up as the next 10-year benchmark gilt.”

Uk Debt Management Office July To September 2008 Auction Dates AUCTION DATE

GILT

Wednesday 2nd July Tuesday 8th July Thursday 17th July Thursday 24th July Tuesday 29th July Tuesday 5th August Thursday 14th August Tuesday 2nd September Wednesday 10th September Tuesday 23rd September Thursday 25th September

4½% Treasury Gilt 2042 1⅛% Index-linked Treasury Gilt 2037 5% Treasury Stock 2012 1¼% Index-linked Treasury Gilt 2027 5% Treasury Gilt 2018 4¾% Treasury Gilt 2030 1⅛% Index-linked Treasury Gilt 203 New conventional gilt maturing on 7th December 2049 4½% Treasury Gilt 2013 1¼% Index-linked Treasury Gilt 2055 New conventional gilt maturing on 7th March 2019

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 8

Table reproduced with the kind permission of the UK Debt Management Office, June 2008.

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THE CUSTODY REPORT: EUROPE

While Europe has its own particular sets of issues, the major themes playing out on its custody stage are no different than the trends taking place on the global arena. Working in a market in which paradigms are in constant shift, custodians are now coming to terms with the impact of consolidation, increasing market fragmentation and complexity, a growing push into alternative asset classes and the rise of a more discerning and sophisticated client set that is equally competent in setting the agenda of change and their expectations of service levels.

At one inflection point of change, custodians not only have to keep an eye on technology delivery but also improved and cost efficient service quality in order to stay on top of their game. Lynn Strongin Dodds reports.

Photograph © Svetlin Rusev/Dreamstime.com, supplied June 2008.

ALL EYES ON CHANGE ADINE CHAKAR, HEAD of Europe, the Middle East and Africa (EMEA) for The Bank of New York Mellon Asset Servicing, thinks that in many cases, the challenges custodians face are the same regardless of geographical location. “The industry has gone through various cycles of value added to commoditisation. With the credit and current climate, asset owners are looking to custodians to put the value back into the ‘value added’ equation through the provision of the sophisticated tools that will help them in these volatile market conditions.“For us, that has not only meant strengthening our core offerings such as investment accounting, performance measurement and investment analytics but also enhancing our specialist services such as derivatives clearing and transaction cost analysis,”she adds.

According to a recent industry report by Oliver Wyman, innovation across all product ranges, client delivery and customisation are the key components custodians need to retain and sharpen their edge. More specifically, the management consultancy firm projects that over the next

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five years, the battle lines will be drawn over the ability to clear across all asset classes, the strength of middle office operations and over-the-counter (OTC) derivatives processing, which is a particularly thorny issue given that many of the processes are still manually driven. Mark Schoen, head of product management for Europe Middle East and Africa at Northern Trust, says,“One of the biggest problems with derivatives is that there is no standard methodology. Custodians [such as] Northern Trust have put a great deal of effort into the valuation process to ensure that institutions have the correct information.

Although a template has emerged for the plain vanilla derivatives, the challenge is that when more esoteric instruments such as property swaps are introduced, we are back to base camp and have to develop new processes.”

Derivatives has also become a hot topic in Europe, thanks to legislative changes such as the Undertakings for Collective Investment in Transferable Securities’ (UCITs III) as well as new accounting regulation which has led pension funds, especially in the UK, Netherlands and

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©2008 Northern Trust Corporation. Northern Trust is authorised and regulated in the UK by the Financial Services Authority.

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Scandinavian countries, to look at the investment world through a liability driven prism. They have sought to better match their assets and liabilities by expanding their asset class remit to alternatives such as hedge funds, private equity, commodities, real estate and currencies to generate extra returns.

The other major change in Europe, of course, has been the arrival of The Markets in Financial Instruments Directive (MiFID) last November.

Richard Fodder, senior vice president and London managing director at Brown Brothers Harriman, says,“Due to the requirements of MiFID, we have seen an increasing demand for more detailed reporting. We have made significant investments in our systems and have spent a great deal of time working with our clients to facilitate their efforts to ensure that their structures are MiFID compliant.”

MiFID has also prompted custodians to branch out and develop post trade solutions for a new breed of client – the multilateral trading facilities (MTFs). In most European countries, trades are cleared and settled through a central counterparty (CCP), which then links with the national central securities depository (CSD), where the securities are held, to arrange the physical settlement of the trade. Currently there are six CCP and 23 CSDs littered across the European landscape. This is expected to change as MiFID allows MTFs to choose their own clearing provider.

Those providing a faster, cheaper and more efficient service will have the edge and in the past year, several deals have been struck.

For example, Chi-X Europe, the MTF which was the first to launch, has partnered with Fortis to use its European multilateral clearing facility (EMCF), Turquoise has opted for EuroCCP, the subsidiary of Depository Trust & Clearing Corp. while the newly launched NYFIX Euro Millennium has chosen the posttrade services of BNP Paribas Securities Services. The French based firm has developed a dedicated range of post trade services for MTFs, which

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Sébastien Danloy, global head of sales for investor services at Société Générale Securities Services (SGSS), says,“Although T2S is not expected to be launched for another five years, it is already having an impact in terms of the initiatives we have seen from Clearstream and Euroclear. However, there is still a great deal of uncertainty and it is difficult to predict what will happen in terms of European infrastructure. For custodians, the different regulations pose opportunities particularly in the MTF area. It will be those players that move quickly, upgrade their business and make strategic acquisitions that will benefit.

Photograph kindly supplied by Société Générale Securities Services, June 2008.

Mark Schoen, head of product management for Europe Middle East and Africa at Northern Trust, says,“One of the biggest problems with derivatives is that there is no standard methodology. Custodians [such as] Northern Trust have put a great deal of effort into the valuation process to ensure that institutions have the correct information. Although a template has emerged for the plain vanilla derivatives, the challenge is that when more esoteric instruments such as property swaps are introduced, we are back to base camp and have to develop new processes.” Photograph kindly supplied by Northern Trust, June 2008.

it sees as an important new client segment in the post MiFID environment, according to Simon Walker, deputy head of global custody product at BNP Paribas Securities Services.

“We were ahead of the game in terms of servicing the MTFs,” says Walker. “We have been able to leverage off our relationships with local custody clearing networks and build a single, coordinated clearing offering called Clear Suite. “Our objective is to be a leader in the post trade services and be ready on day one for our clients who want to access these liquidity pools. So far, we have been successful in winning mandates from the broker/dealers.”

Walker notes that another potentially important development on the clearing and settlement horizon is the European Central Bank’s Target 2 Securities, which is slated for 2013. The aim to create a single settlement layer for crossborder securities transactions in Europe sounds ideal but the proposals have not been universally cheered. While all want to see operating costs and cross-border fees cut, the central securities depositories are not keen to relinquish their settlement revenues.

Currently, an industry consultation is taking place and a decision on whether to go ahead will be made later this year.

In the meantime, CSDs have been spurred into action to head off the competition with a project called Link-Up Markets due to go live in the first quarter of 2009. Participants include Germany’s Clearstream (the driving force behind the project) the Hellenic Exchanges Group of Greece, the Swiss group SIS, Denmark’s VP Securities Services, Norway’s VPS, OeKB of Austria and the Spanish company Iberclear. The plan is that partners will develop an ‘adaptor’ for the clearing links between the CSDs, so rather than maintaining six separate connections, they instead will have one, to the central translator, Link Up Markets. Euroclear, on the other

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coverage, utilising our hand, is consolidating the custody, fund accounting platforms of the French, and transfer agency Belgian, Irish, Dutch and platforms that work in a UK CSDs, and has adopted global or domestic a wait and see attitude to environment. While we its membership of Link Up certainly deliver high tech Market. If successful these solutions, I think one of projects could tread on the key differentiating custodians’ cross border factors is our personalised servicing capabilities turf. level of service, which is Sébastien Danloy, global always highly ranked in head of sales for investor industry surveys.” Schoen services at Société of Northern Trust Générale Securities comments, “We want to Services, says, “Although look different from the big T2S is not expected to be Nadine Chakar, head of Europe, the Middle East and Africa (EMEA) four. We are smaller and launched for another five for The Bank of New York Mellon Asset Servicing, thinks that in many much more focused but years, it is already having cases, the challenges custodians face are the same regardless of we also offer the same full an impact in terms of the geographical location.“The industry has gone through various cycles of product range. I think initiatives we have seen value added to commoditisation. With the credit and current climate, what you will see is more from Clearstream and asset owners are looking to custodians to put the value back into the acquisitions among the Euroclear. However, there ‘value added’ equation through the provision of the sophisticated tools specialist players. The is still a great deal of that will help them in these volatile market conditions. Photograph biggest challenge for them uncertainty and it is kindly supplied by The Bank of New York Mellon, June 2008. will be whether they have difficult to predict what will the capacity to deal with happen in terms of the increasing demands European infrastructure.

“BNP Paribas’ Walker notes that another and I do not think many For custodians, the potentially important development on the will have the resources to different regulations pose clearing and settlement horizon is the sustain their competitive opportunities particularly edge.” in the MTF area. It will be European Central Bank's Target 2 Just how competitive those players that move Securities, which is slated for 2013. The Northern Trust has quickly, upgrade their aim to create a single settlement layer for become of late is marked business and make cross-border securities transactions in by the appointment of the strategic acquisitions that Europe sounds ideal but the proposals bank by investment will benefit. manager, Hermes Fund Overall, merger and have not been universally cheered. While Managers Limited acquisitions have been an all want to see operating costs and cross(Hermes), to provide overarching theme in border fees cut, the central securities outsourcing services for custodial circles with the depositories are not keen to relinquish middle office investment past five years having been their settlement revenues. Currently, an operations, fund a hive of activity. The most industry consultation is taking place and a administration and notable deal has been the custody. The deal is link up between Bank of decision on whether to go ahead will be Northern Trust’s biggest to New York and Mellon, made later this year.” date, with anticipated which dominates the middle office assets under playing field with three other US giants - JPMorgan Securities Services, Citi and administration £23bn (about $45bn) while assets under State Street. Global specialist players such as BBH and RBC custody services, which will include the BT Pension Dexia have also carved out substantial footholds, as have Scheme (BTPS) – the UK’s largest – will be in excess of the smaller niche players particularly in the alternatives £45bn (approximately $88bn). As part of the arrangement space. While there is always talk of the middle sized players Northern Trust will also support the launch of Hermes’new such as North American based Northern Trust and RBC range of Dublin-based funds providing trustee, custody, Dexia, being squeezed, they have so far been successful in fund accounting and transfer agency services. The holding their own against the US giants and European appointment, which is subject to contract negotiations, is players. Rob Wright, chief operating officer at RBC Dexia, expected to be completed in the third quarter this year. says,“We provide multi-jurisdictional clients with seamless Rupert Clarke, chief executive of Hermes explains that:

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THE CUSTODY REPORT: EUROPE 48

Francis Jackson, head of new business development and client management in Europe, Middle East and Africa for JPMorgan Investor Services echoes the sentiment of many when he says,“Everyone is waiting for the big US custodians to consolidate, but I think we will see more activity in Europe in the next 12 to 18 months because there are several mid-sized players who may not have the resources to build out the processes and systems needed to meet the needs of today’s fund managers. Photograph kindly supplied by JP Morgan, June 2008.

Rob Wright, chief operating officer at RBC Dexia, says, “We provide multi-jurisdictional clients with seamless coverage, utilising our custody, fund accounting and transfer agency platforms that work in a global or domestic environment. While we certainly deliver high tech solutions, I think one of the key differentiating factors is our personalised level of service, which is always highly ranked in industry surveys.” Photograph kindly supplied by RBC Dexia, June 2008.

“Northern Trust distinguished themselves with their understanding of Hermes’ business needs and their transition capabilities. Outsourcing these functions is consistent with our strategy of focusing on growing a specialist investment management business. Building a robust and progressive business platform to support our development is a key part of this.”

However difficult the larger mandates are to secure, there is no shortage of investment in expanding the service offering from the competition. Recently, BNY Mellon bought the fund of hedge funds administrative services business of LAMP Technologies, a US based alternatives investment administrator. Last February, State Street acquired Boston-based Investors Financial Services, which boosted its offshore hedge fund capabilities as well as middle-office outsourcing and private equity accounting.”

As for the European custodians, they may not have the

girth of their US counterparts, but they firmly believe their cultural nuances, product ranges and service enable them to be just as competitive. As Danloy says,“We see ourselves as a European provider. We have our own strategy. Our goal is to provide pan-European clients with panEuropean services, especially cross-border services. It is not the size that gives global custodians scale in terms of price or capacity to deliver quality services. When we are competing, for example, in France, Spain, Germany or Italy, the key is to be able to be domestic and understand the local markets.”

BNP Paribas is intent on giving the US custodians a run for their money. Walker says,“You could say that Europe is divided between the mega global US providers and the Europeans, and we are definitely leading in the European table. We ourselves as a local as well as global player that offers the full suite of services and products for all asset

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classes.”Both BNP Paribas and SSGS will be keeping their eyes open for tactical acquisitions to fill the gaps and bolster their operations. In the past two years, SSGS bought the custody and fund administration arm of UniCredit, the Italian bank, for €548m, while BNP Paribas purchased RBS International Securities Services, previously a 70/30 joint venture between the Royal Bank of Scotland and the Bank of NewYork.This gave the French based bank a sizeable chunk of business in the Channel Islands, covering a range of specialist funds, such as hedge funds and real estate vehicles. The US custodians are also expanding their tentacles on the continent with JPMorgan recently snapping up the institutional global custody portfolio of Nordea, which has approximately €200bn in assets. The purchase will enable the firm to offer local depository services to in-country mutual funds through the establishment of new branches in Denmark, Finland and Norway, together with an expanded presence in Sweden.

Francis Jackson, head of new business development and client management in Europe, Middle East and Africa for JPMorgan Investor Services echoes the sentiment of many when he says,“Everyone is waiting for the big US custodians to consolidate, but I think we will see more activity in Europe in the next 12 to 18 months because there are several midsized players who may not have the resources to build out the processes and systems needed to meet the needs of today’s fund managers. We would be interested in potentially buying businesses if they made strategic and economic sense. One of the reasons we bought the Nordea business is because it opened up a new pool of opportunities and revenue streams, and because it met our strategy to align ourselves more closely with clients in-region.”

Looking ahead, Tim Caverly, executive vice president of State Street’s investor services business in continental Europe, believes that “the two greatest challenges will be the growing complexity of investments and the convergence between hedge funds and mainstream fund managers, which has produced strategies such as 130/30 funds. In Europe, our objective is to be a traditional full service provider who can also cater to local needs such as the greater use of derivatives under UCITs. We work not only with clients but also industry trade bodies such as on the development of standardisation and automation in an attempt to reduce risk.”

Chakar of BNY Mellon believes that flexibility is another key to success. “Today there are two approaches open to clients; they can either bring together disparate best of breed solutions or they can leverage our expertise and capabilities to build and run an architecture on their behalf. We can identify the issues they face, determine where the precise problems lie and then mobilise all our resources to tailor a solution that meets their individual needs. We act as their partner, handling the vast bulk of what needs to be done and then engaging third parties on the client’s behalf to fill in the gaps by bringing in very specific skills and capabilities and packaging it all up to provide a seamless experience.”

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 8

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49

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WILL PENSION FUND POOLING MAKE A COMEBACK?

When Unilever debuted its Univest taxtransparent, cross-border asset pooling structure at the end of 2005, asset servicing providers held their breadth in anticipation. Instead, only a smattering of companies followed suit and the buzz seemingly fizzled out. Activity, though, has been bubbling behind the scenes and industry participants expect to see some announcements rolling off the presses over the next few months.

Lynn Strongin Dodds reports.

THEY’RE BACK! …AND THIS TIME, IT’S SERIOUS! TILL WATERS RUN deep they say. As with life; so with pension pooling say market specialists. The lack of obvious movement decries an imminent return of momentum in the sector emphasises Kerry White, first vice president, global product management at The Bank of New York Mellon Asset Servicing. “On the surface, it may look like things have gone quiet but there are a number of discussions taking place that are not public. One of the reasons is that the business model is still unique, and as pooling gains greater acceptance new processes are getting bedded down.”Sean M Tuffy, European accounting product manager at Brown Brothers Harriman agrees and adds,“As with any product innovation, there is always a burst of activity in the beginning and then there is a lag between the product innovation and market acceptance. Pension pooling is no different. The drivers have not changed but it takes time for new things to be implemented.”

The reasons for pooling are easy to understand. Bundling an international corporate pension fund’s myriad assets together under one umbrella not only creates greater economies of scale but it also leads to lower transaction, custody, administration and investment management expenses. Equally as important are the enhanced risk management practices, a unified corporate governance structure and a more consistent approach to asset allocation.

While there are variations on the pooling theme, the two basic techniques are entity pooling and virtual pooling. The latter combines assets with the same investment management

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be a cultural bias to the selection mandate, while continuing to of the vehicle.“Pension pooling is enable these assets to be legally, a non-mature market and we are beneficially and directly owned by in the extension of the innovative the pension fund participants in the phase. There is not that much asset pool. It employs a difference between the structures information sophisticated and I think location is one of the technology package which main drivers. The US and UK aggregates the assets of pension funds seem to prefer the participating funds as if there was CCF, while the continental funds an underlying pool without actually look towards the Luxembourg combining the pool as a legal entity. product. The Dutch may prefer According to Paul Kelly, principal the FRG while the OFP is likely at investment consultant firm to generate interest in Belgium Towers Perrin, virtual pooling is and perhaps France.” typically geared to investment To date, entity pooling is the managers with multiple funds. It most popular route for the differs from multinational entity household multinational names. pooling in that the efficiencies Unilever was one of the pioneers emanate from technology, when, in conjunction with compared to pension funds looking Kerry White, first vice president, global product Northern Trust, it broke ground to create a more efficient tax management at The Bank of New York Mellon Asset with Univest, a vehicle to pool arrangement and fund governance Servicing.“On the surface, it may look like things have some of the assets of its 48 separate through a specific fund structure. gone quiet but there are a number of discussions taking pension funds using the FCP. So Entity pooling uses fiscally place that are not public. Photograph kindly supplied by far 11 of the company’s pension transparent, open-ended, unitised The Bank of New York Mellon, June 2008. funds have signed up, and while vehicles like Luxembourg’s Fonds commun de placement (FCP), Ireland’s Common Contractual the lion’s share of the assets is held in equities, last year the Fund (CCF) and the Netherland’s Fons voor Gemene consumer giant announced it would add fixed income Rekening (FGR). Last year, Belgium entered into the fray with products to Univest’s €4bn portfolio. Other notable corporate the Organisation for Financing Pensions (OFP), which is developments include IBM which also took the plunge in based on the European Union’s Institutions for Occupational 2005, but opted for the CCF while 2006 saw Shell setting up a cross border asset pooling structure using the FGR. Retirement Provision Directive (IORP).

Despite the hype, though, industry experts estimate that The OFP is being pitched as a genuine pan-European pension plan. It differs from the CCF, FCP and FGR in that overall, there are only around 50 cross border pension it allows for the cross border assets and liabilities of a schemes in existence. One of the main stumbling blocks is pension fund to be brought within a single legal entity for the cost of setting up the structures, which is an expensive the first time. Also, the OFP is not tax transparent, and it proposition, even with the advent of new technological relies upon Belgian corporation tax rates whereas the platforms. The general consensus today is that asset pooling others, when used for multinational pension pooling will is only worth doing if the fund exceeds €1bn. While this is look through to the tax rates of the investors which will down from the previous figure of €3bn three years ago, it still vary by jurisdiction. It is thought that Nestle, the Swiss requires a massive undertaking in terms of reorganising based food group is considering using the OFP framework. internal processes, changing attitudes and smoothing out tax While these tax transparent structures are typically used by issues.“One of the main problems,“according to The Bank of the corporate behemoths, Matt Tomb, a tax partner at New York Mellon’s White,“is that while the structures [such Deloitte, notes that smaller pension schemes are increasingly as] the FCP, CCF and FRG are available, each pension fund turning to their fund managers to develop pension pooling still has to develop its own solutions. There are no off the solutions using these vehicles.“One trend that we are seeing shelf products that offer a standardised solution. It is still is that asset managers are setting up these vehicles for quite an investment in time and infrastructure to make it all institutional clients who are interested in combining their work. This is why only the largest of multinationals are able assets to take advantage of the benefits of pooling via tax to set up these types of pooling vehicles.”

Tuffy expands on the theme. “Setting up these pooling transparent funds. Although there are new structures such as the FRG and OFP, we are finding that clients prefer using the structures can be a labour and capital intensive process. tried and tested FCP and CCF because custodians and other One of the main challenges continues to be tax and while providers have built up experience in dealing with the tax and progress has been made it is still time consuming to get approval in the various jurisdictions,” he notes. For other regulatory issues within these structures.”

Georg Lasch, head of institutional investors Luxembourg example, harmonisation may be one of the long standing at BNP Paribas Securities Services, believes there could also themes in European Union circles, but the eurozone

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Others such as Tuffy are remains a medley of different tax sceptical, claiming that the ERISA regimes, pension scheme ruling simply summarises structures, social security Department of Labour arrangements and regulations. regulations that have been on the The pool must be considered books for several decades. “I do transparent for fiscally not expect a wave of new business withholding tax purposes and from the combination of ERISA this means getting double tax and non-ERISA funds because treaties not just from the EU but the DOL ruling did not break any internationally. new ground.” While views may Witholding tax is governed by diverge regarding the pace and double tax agreements between development of pension pooling, the country where the the main custodian contenders investment is made and the have been busy over the past country of the investor receiving Benjie Fraser head of UK pensions and charities for three years developing pension the dividend or interest payment.

JPMorgan Worldwide Securities Services’ Securities, says pooling products and services.

If the tax authorities in the gaining local trustee support should not be Northern Trust, which provides country of residence of the underestimated.“Trustees have to be comfortable, and the custodial and fund dividend paying company do not more jurisdictions there are the more challenging it can administration services for $24bn recognise the pooling vehicle as be.” Photograph kindly supplied by JPMorgan, June 2008. of pooled assets—over half of transparent, or the vehicle itself it not recognised by the treaty, the underlying funds would which is for multinationals—has been one of the leaders in lose their entitlement to tax relief. Another challenge is the field and has applied for patents to protect the methods winning support form the local trustees. Most of the major and systems it uses. Campbell says,“It is important to have custodians have implemented platforms to support this a truly specialised fund administration service to support tax type of business, but navigating the relationship between transparent vehicles. Whether it is for a multinational or the pension funds and the local boards of trustees for each asset manager, the fund administrator has to provide of these countries, can be tricky. Many trustees have trouble accounting and financial reporting, strike the net asset value plus be able to track the underlying securities held by each loosening the reins and relinquishing control.

Benjie Fraser head of UK pensions and charities for of the investors” Kerry White meantime, notes that The JPMorgan Worldwide Securities Services’ Securities, says Bank of New York Mellon has“a specialist service team and gaining local trustee support should not be tailored products to pension pooling. It is not just about underestimated.“Trustees have to be comfortable, and the custody, performance measurement, compliance, reporting more jurisdictions there are the more challenging it can be. and management company services, but you also need a Most are looking at entity pooling versus virtual and they unique series of operational protocols as each fund has have to be confident that whatever tax transparent different requirements.”

Tim Caverly, executive vice president of State Street’s structures they choose will be more efficient and effective, and justify the control that they are giving up. It can take a investor services business in continental Europe, believes lot of work to convince trustees to go down this road and that technology is only one part of the equation. “One of the main questions pension funds ask is whether there will custodians have to act as internal consultants.”

Despite these hurdles, there have been a few be enough savings from the economies of scale of pooling. developments that some custodians believe will move the This is why the top tier firms [such as] State Street not only industry forward to the next stage. One is the recent ruling have to invest heavily in the infrastructure, but also in by the US Department of Labor to allow multinationals to developing global tax expertise to support these tax commingle Employee Retirement Income Security Act transparent products. These are complicated issues and you (ERISA) and non-US pension assets into a single fund. The need to be able to offer the best advice.”

A custodian should also have the ability to offer customised ruling was in response to a request by Northern Trust in 2005 on behalf of unnamed ERISA clients. Martin solutions as well as the ability to cover all asset classes, Campbell, pooling product manager at Northern Trust says, according to Fraser of JPMorgan.“Two to three years ago, it “I expect that the Department of Labor ruling will lead to was just equities and bonds, but we are seeing a massive move an increase in the number of companies pooling their into alternatives and not all custodians have geared up. We see ERISA and non ERISA funds. One of the main reasons is our role as a central project manager which has a dedicated the trend towards enhanced governance and the need to team that can work closely with companies to build a bespoke have better control over the different plans. However, in product. It is also increasingly important to be able to offer order for it to be successful, though, I think there needs to services such as accounting, valuation, compliance monitoring be a pooling champion within the organisation who and performance measurement for asset classes such as hedge funds and strategies that use derivatives.” highlights the benefits and gets everyone on side.”

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In the world of asset servicing, it does not always matter which way the markets are moving, as long as they keep moving. With volatility supplying the volume, so far so good for the field of US custody providers. But is there a point where the instability becomes more of a challenge? Dave Simons reports.

T SEEMS THERE is never a dull moment for today’s field of custody players. The ever-expanding global marketplace compels providers to polish up their clearance, settlement and safekeeping credentials, while supplementing these services with on-the-ground support so that clients can quickly and efficiently move into local and intra-regional flows. At the same time, custodians must stay in step with an entire realm of emerging investment vehicles and distribution capabilities that are essential for locally domiciled global products.

In fact, the business of custody has evolved to the point where many top players feel that the term custody no longer paints the whole picture. For instance, to drive the point home, JPMorgan now refers to its custody base of operations as investor services. “It is an important statement, because what we offer is a whole spectrum of services that investors and investment companies like pension funds and hedge funds are looking for,”says Rajen Shah, JPMorgan’s global head of custody. While the core of the division is still centered around traditional global custody, “as the markets develop further, people want to

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A NEW WAVE The current period of instability has been marked by dramatically increased volume, which has been very good for custody, says Jim Palermo, co-chief executive officer of BNY Mellon Asset Servicing. Such volatility has led to widening spreads, which in turn has raised deposit levels, increased foreignexchange activity and also greatly improved the market for securities lending, he adds.“In short, all of our various revenue sources have been quite positive since the volatility began in earnest late last summer,” says Palermo.“We are seeing a definite trend in terms of flight to quality, while at the same time there’s been some moderation in alternative-asset growth. People are moving into products that they understand better, where there is more structural transparency, including a flight to more exchange-traded activity.” Photograph © Marilyn Volan/Dreamstime.com, supplied June 2008.

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Peter Cherecwich, head make their assets work of institutional strategy harder,”says Shah. and product development As investors become at Chicago-based increasingly sophisticated, Northern Trust, concurs they are in turn much that custodians are faring more open-minded about well in the current their asset allocations, says environment. While lower Shah. “Asset classes are market values continue to growing and there are have an impact on overall more new asset classes, revenues, increased such as derivatives and marketplace volatility private equity, [that] are means more transactions clearly more complex in for the custody area to terms of being able to lend process and better support. Rising fees has opportunity for the capital more to do with the fact markets areas, says that with more complex Cherecwich.

“New services there are more products are also being costs, and clients are developed and deployed. willing to pay these For example the interest because of the importance market instability has of proper risk created an increased management.

Clients interest in NT’s risk realise that as complexity Timothy J Connelly, partner, Brown Brothers Harriman & Co. “When management offerings,” increases, they want to you examine the financial results of pure-play custodians, for he adds. focus on more capability instance, one finds that the basic health and welfare of the industry Those whose business which is using these has been extremely strong. Market volatility, with its associated models have had the least various different asset trading activity and foreign exchange business, has created a sound exposure to the harmful classes to generate alpha environment in which custodians continue to operate,” says Connelly. affects of the credit crisis [sic].”

Non-pure play institutions, in contrast, have been rocked by write-offs have fared particularly The current period of related to their balance sheets or emanating from investment well, claims Timothy J instability has been marked management and/or investment banking arms surrounding the subConnelly, partner, Brown by dramatically increased prime crisis. Photograph kindly supplied by Brown Brothers Brothers Harriman & Co. volume, which has been Harriman & Co., June 2008.

“When you examine the very good for custody, says financial results of pureJim Palermo, co-chief play custodians, for executive officer of BNY “While lower market values continue to instance, one finds that the Mellon Asset Servicing. basic health and welfare of Such volatility has led to have an impact on overall revenues, the industry has been widening spreads, which in increased marketplace volatility means extremely strong. Market turn has raised deposit more transactions for the custody area to volatility, with its levels, increased foreignprocess and better opportunity for the associated trading activity exchange activity and also capital markets areas, says Cherecwich. and foreign exchange greatly improved the business, has created a market for securities “New products are also being developed sound environment in lending, he adds.“In short, and deployed. For example the interest which custodians continue all of our various revenue market instability has created an to operate.”Non-pure play sources have been quite increased interest in NT’s risk institutions, in contrast, positive since the volatility management offerings,” he adds. have been rocked by began in earnest late last write-offs related to their summer,” says Palermo. balance sheets or “We are seeing a definite trend in terms of flight to quality, while at the same time emanating from investment management and/or there’s been some moderation in alternative-asset growth. investment banking arms surrounding the sub-prime crisis.

People are moving into products that they understand better, Which, says Connelly, “has had the affect of shielding the where there is more structural transparency, including a solid underlying fundamentals of the investor-services component of their businesses.” flight to more exchange-traded activity.”

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space, says Connelly. “Offshore, we A significant measure of the see fund domiciles, such as Dublin market’s caution has been an increase and Luxembourg, actively marketing in risk management and governance their investment vehicles to activity, thinks Palermo. With periodic retirement systems around the temblors such as the Bear Stearns world, and in the US, we see a greater crisis exaggerating moves to the utilization of non-registered products downside, such precautions are as a means to offer lower cost particularly crucial.“You really have to products to retirees.” be on top of your game in order to Emerging markets are increasingly ensure that you have all of the becoming more attractive as source appropriate controls, practices and markets, says Craig Dudsak, managing procedures in place,”says Palermo. director, global custody North America Having an infrastructure that is for Citi.“This shift is supported by the already engaged in compliance and changing regulatory framework, as one performance- measurement practices of the primary drivers tends to be for the non-hedge fund marketplace pension and retirement strategies in is an invaluable resource, suggests these countries which are allowing JPMorgan’s Shah. “In other words, larger percentages of investments to be when it comes to hedge funds cross-border.”As the reforms continue, potentially becoming more regulated Craig Dudsak, managing director, global a much different set of capabilities and and requiring things like compliance, custody North America for Citi. Emerging a more diverse set of products will be we already have the experience in markets are increasingly becoming more required in order for custodians to tap terms of people, technology, and attractive as source markets, he says.“This into these global opportunities, says knowledge to call upon.” Looking shift is supported by the changing regulatory Dudsak. abroad, demand for custody services framework, as one of the primary drivers Domestically, retirement assets in numerous foreign markets tends to be pension and retirement strategies grew 7% to $1.1trn during 2007, and continues to eclipse domestic growth in these countries which are allowing larger over the next 10 years, the number of rates, the result of improved crosspercentages of investments to be cross-border.” baby boomers approaching border activity, ongoing pension As the reforms continue, a much different set retirement will reach its peak. It is reforms, as well as greater of capabilities and a more diverse set of during this period that these “preparticipation in the Qualified products will be required in order for retirees” will be setting aside their Domestic Institutional Investor custodians to tap into these global greatest allotments of retirement program (QDII). “Europe and the opportunities, says Dudsak. Photograph capital, notes Palermo. “As such, the Middle East are seeing significant kindly supplied by Citi, June 2008. demographics remain strong, growth,”says Shah,“so we are taking a broader look at these areas and developing more of a particularly within the US market.”

With the markets changing, clients have responded by local presence. In China, we have recently opened up six branches and in India we’re establishing our own sub- shifting asset classes. Says Dudsak,“In addition, we are seeing an acceleration in changing investment strategies such as custodian presence.”

Through its Fund Solutions practice, BBH has been able 130/30, alternative investments, and exchange-traded funds to integrate a range of services including fund execution, (ETFs), which the custodian community needs to support.” custody, compliance, administration of distribution fees, Through 2007, (ETFs) approached $800bn in total assets and fund messaging, allowing the company to establish worldwide, and with good reason, say their proponents. They and advance relationships with significant global asset are tax efficient, trade throughout the day, and their indexgatherers, says Connelly.“A number of investment firms are oriented strategies are easy for investors to digest. The tools seeking distribution advice that includes support of cross and strategies needed to handle settlement, valuation and border product targeting this growth dynamic. We believe accounting procedures for this ever-expanding world of that firms that can easily service investment vehicles across product innovations, however, represents a particularly the globe and support the distribution of the vehicles that significant challenge for custodians going forward.“The ETF an investment manager chooses to focus on will be marketplace is one that is quickly expanding and shifting with winners going forward.” the evolution of new products,” explains Citi’s Dudsak. The advent of thematically-based ETFs, actively managed ETFs, exchange traded notes (ETNs) and hedging requires that fund Pension Prospects Given the varied nature of retirement schemes and managers keep pace with client demand. As such, custodians systems, servicing firms that can support investment must have access to global networks, integrated systems and vehicles that can easily be adapted to the widest array of innovative client facing tools, says Dudsak.

As ETFs continue to grow and their models become country-specific retirement systems will be winners in this

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more popular, a greater number of managers are looking at investing in them across multiple asset classes. In consequence, manufacturers are pushing the boundaries of these first and second generation ETF products ever further. Tim Keaney, co-chief executive officer of BNY Mellon Asset Servicing says the trend challenges investment service providers to make sure their factory floor is able to meet the production line.“It is like if we were manufacturing cars--if one month we are producing Fords and the next it is Ferraris. It doesn’t matter; you still have to deliver the same number of automobiles each day of the production cycle. [Moreover] if you cannot keep up, your clients— which have very elaborate production schedules—just won’t stick around for very long.” Additionally, with demand growing overseas, support for like products also needs include multiRajen Shah, JPMorgan’s global head of custody.“What we offer is a whole spectrum of services currency, multi-tax and multithat investors and investment companies like pension funds and hedge funds are looking for,” he jurisdictional components, says Keaney. says. While the core of the division is still centered around traditional global custody,“as the Unlike standard open-ended mutual markets develop further, people want to make their assets work harder …. As investors become funds, servicing ETFs requires that increasingly sophisticated, they are in turn much more open-minded about their asset custodians develop a specific skill set allocations, he adds. Photograph kindly supplied by JPMorgan, June 2008. that includes maintaining “in-kind” security cost basis, proper GAAP tax reporting, transfer Nipping at the Niches agency functionality, and the necessary connectivity with In March, JPMorgan’s Worldwide Securities Services exchanges. “In addition, one should not discount division (WSS) announced its intentions to procure the complementing technological capabilities in supporting $315bn institutional global custody operations of Nordea, exchange-traded products,”adds Connelly. the Nordic region’s leading local custody provider. It is the While corporate actions remains one of the highest risk latest in a series of selective acquisitions aimed at areas in the industry, a number of firms have made great broadening JPMorgan’s global reach--and yet another strides incorporating technology to assist in areas such as example of a niche player taking the bait.“I think that there notification and response. One sticking point, however, is will always be a place for niche providers,” says Shah,“but responding effectively to corporate action notices in the increasingly, that number will diminish, as this is an institutional arena for money managers who are often increasingly complex business that requires scale and dealing with between ten and 50 custodian entities not of substantial investment. Nordea is a great example--they their own choosing.“The establishment of a ‘golden notice’ asked themselves, ‘do we really want to be in the asset and aggregating responses and notification is an area that servicing business?’ And the answer was, no, we just don’t needs continued development,” he says. Supplementing its have that kind of appetite. [Moreover,] there are many corporate-actions tools with its Infomediary connectivity players out there right now who are asking themselves the solution, BBH continues to address such issues“in a unique same question.” and thoughtful way” for the benefit of their clients, says The future is for organisations that more than adequate Connelly. scale, asserts Shah, repeating the oft-spoken mantra of the Citi’s Dudsak agrees that corporate action processing major players. It is those with the strongest balance sheets continues to be a major challenge for the industry. “The and ability to devote energy and resources to the kinds of most prevalent challenge is that complexity and risk investments clients now demand that will ultimately rule surrounding the processing of corporate action remains the roost. In short, says Shah,“you have to be the kind of high because the industry does not use a standard method bank that has broad enough capabilities to provide a of communication. The solution here requires automation, combination of derivatives services and investment and a change in behavior of various market participants services. These things are all part of the armory that you including issuers, underwriters, legal counsel, agent banks.” really need to service clients effectively.”

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TRANSITION MANAGEMENT: ASIAN OPPORTUNITY

Transition management in the context of the Asian market has been one of gradual introduction of the service on a top-down basis.

Without a doubt, the Asian market will one day be key for transition managers; history is moving their way as more asset gatherers, manufacturers and asset managers come into play. The question is how long before that all important tipping point is reached? Francesca Carnevale reports.

Betting On The Long Game

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NE MIGHT BE forgiven for being reminded of the old proverb: he who laughs last, laughs best when it comes to reporting on the emergence of the Asian transition management theatre. In some ways, its application is unfair. Transition management has in the wider Australasian region been a buoyant business.

Australia and New Zealand, are highly competitive markets fuelled by substantial and still growing transition volumes. Japan too, Asia’s most mature market is a natural source of supply, though take up has been disappointingly slow for many transition managers. Andy Maynard, head of portfolio trading for Merrill Lynch in the Pacific Rim, notes that,“Regulation has yet to keep pace with globalisation in some markets, which has limited the take-up of transition management. In India, for instance, there are still rules hampering local funds wanting to invest overseas. We are beginning to see more Australian, Korean, Japanese and Chinese funds coming out of their home markets into the international arena, but frankly, Asia is still in its infancy in the context of transition management.” In transition management, Merrill Lynch works in joint venture with BlackRock, combining “the investment bank’s trading and execution skills with BlackRock’s fiduciary strengths in the region,”notes Maynard. “Right now, the business remains skewed towards Australia, where the biggest bulk of business emanates from the large superannuation funds in Melbourne and Sydney. Equally, much of the transition management talent still resides in Australia, though there are signs that is changing.”

Elsewhere in Asia business remains patchy and in large part confined to Asia’s key financial hubs and again, for the most part confined to state-run institutions: be they pension funds, sovereign wealth funds, or central bank funds. To this peculiar cocktail is gradually being added new ingredients: incoming hedge funds, private sector mutual funds, insurance funds and specialist QDII funds out of China. However, the spread of these incomers is still slow; albeit picking up at a gentle trot. That means for those transition managers willing and able to play a waiting game, Asia promises to be a gold mine—it is simply a question of when.

Duncan Klein, executive director, transition management at JP Morgan describes the geographic dynamic in more detail.“There are three different rhythms in play. First the sophisticated clients already using transition management

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business and investment. in Singapore, Australia Third, the big, global fund and Hong Kong; then firms are now setting up in there are what we call ‘ Singapore, Hong Kong receptives’, these are and establishing joint beneficial owners and ventures in China, which asset managers in Taiwan, bodes well for future Malaysia and the transition volume.”

Philippines to name three, To take account of these who are showing active developments, transition and promising interest in managers are on the move. the product offering. Then, State Street’s Justin finally, there are the Ballogh, senior managing countries where we are director of State Street’s actively pushing the Global Markets operation product, and where the in the Asia Pacific for some emphasis is on client time located in Japan, has education, and those are now moved to Singapore. markets such as Vietnam, Tom Clapham, director of Indonesia and Thailand.” transition management at That infrastructure is Deutsche Bank is based increasingly placing out of Hong Kong. important investment Transition managers, it demands on transition seems are beginning to management providers if hug opportunity ever they are to keep up with tighter, as the end of the the pace of potential tunnel looks in sight. “It growth in the region. has been an interesting JPMorgan, for instance, year, with the growing works out of multiple ascendancy of the centres in the region. “It John Minderides, managing director and global head of transition sovereign wealth funds makes sense to stay close management, JPMorgan. Photograph kindly supplied by JPMorgan, and larger Asian pension to the ground in terms of June 2008. funds adopting new asset service provision to help deepen the market,”notes John Minderides, global head of allocation strategies,” notes Clapham. For established transition management at the bank. “Australia is a good players, such as Citi, Credit Suisse, JPMorgan, State Street nine hours away from Hong Kong and Singapore, and is and Deutsche Bank, Asia currently offers a steady stream of not ideal for servicing clients across southeast Asia, business, built up over years and often combined with therefore we work closely with our in country teams complementary service offerings. According to Clapham: working out of Hong Kong, Singapore, Sydney and Tokyo.” “counterparty risk is always a concern in Asia and the That distribution has historically defined the location of global banks will have to face that fact going forward. It will transition management teams in the region. Australia has be interesting to see how it impacts on the allocation of been the tempering pot: a transition management mandates going forward.” Maynard at Merrill Lynch hints hothouse where regional experience has been honed and that, as is happening in Europe, transition management for houses such as UBS, Goldman Sachs, Citi, Morgan operations will become more specialised in Asia, and as Stanley and others, been a starting point for a wider Asian equity allocations take a higher profile, then those houses push. Michael Jackett-Simpson, Asia Pacific head, offering global trading capability will come to the fore. It’s transition management, at Citi in Sydney, which has to a view endorsed, indirectly by Credit Suisse’s Achuthan: date dominated the Australasian transition management “transition manager selection will focus on strong track business notes that, “Transition management is gaining records in managing complex, non-linear transitions, as traction in the region for a number of reasons. One is the transition sizes out of the region become larger and natural emergence of the business out of the Australian straddle across asset classes. Transition Managers that are market, where expertise has been honed to a exceptional leaders in best execution and possess strong track records degree and which still dominates the broader regional in risk management potentially stand to gain” For Minderides and Jackett-Simpson, the equation in space in terms of volume. Second, Asian asset managers are moving from domestic equity to international equity Asia is about multi-service JPMorgan’s Minderides notes allocations, be that regional or global to gain diversity in that transition management is invariably accompanied in their portfolios and this is having an obvious impact on the region by a wider service brief. “Often you will see

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Some think client service.

We think client success.

We are totally focused on our clients’ success. Because of our transition management team’s depth, stability, global perspective and risk management consistency, we don’t simply provide answers. We provide clients with unique, innovative and transparent solutions to their complex transaction challenges.

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130/30 strategies. It is still requests for proposals that niche, but growing in encompass custody as well volume.” Citi’s Jackettas transition Simpson concurs:“There is management,” he says. not a pension fund that “They are looking for one doesn’t have a 130/30 in stop shop solutions.” He the mix.; though most of also notes the rise of those reside in Australia.” transition management Transition management panels, as a way of in Europe has undergone working with transition something of a radical managers: “either because transformation over the they are keen to see what last six months; and the differentiates transition future face of the service in managers, or because they Europe has yet to take are using a transition shape. In Asia, there has management team for the been limited fallout up to first time. We find clients now and it may be that the are honing in on those structure and service of the operational efficiencies, its product offering, will over particularly keen in the time, evolve in a different large public institutions.” way to the service Hari Achuthan, director elsewhere. In the good old of Transition Management days of only a couple of at Credit Suisse concurs. years ago, the long “As there are fewer running debate in providers in the Asian transition management space, there’s more was whether a buyside or ‘stickiness’; clients are sell side approach was keen to ensure that they best. It has gone way are provided Best in Class beyond that in Asia. What service, Increasingly has come to the fore over clients are telling us that the last half year is that the product has to carry Michael Jackett-Simpson, Asia Pacific head, transition management, clients are viewing global itself with strong risk Citi. Photograph supplied by Berlinguer Ltd, June 2008. banks with different management and execution quality key factors” Maynard at Merrill Lynch lenses. According to Clapham:“counterparty risk is always says the pressure is on, with clients still focusing on fees a concern in Asia and the global banks will have to face that and driving down cost, while Minderides thinks that it is a fact going forward. It will be interesting to see how it question of market maturity. “In Europe, clients now impacts on the allocation of mandates going forward.” understand that knocking off a few points on fees is Maynard at Merrill Lynch hints that, as is happening in ultimately useless, if the overall transition doesn’t do the Europe, transition management operations will become more specialised in Asia, and as equity allocations take a job. That still has to filter through in Asia.”

Going forward, transition managers in Asia rest on the higher profile, then those houses offering global trading fact that they have a future of powerful consolation before capability will come to the fore. It’s a view endorsed, them. New markets are opening up yearly and the indirectly by Credit Suisse’s Achuthan: “it will be about behemoths of India and China have really yet to come on strong track records in managing complex, non-linear stream. Moreover, opportunity still abounds in “frontier transitions, as transition sizes out of the region become markets. It’s a long process, notes Clapham,“but it is the larger. It has to play into the hands of houses that provide established way that transition management enters the best execution.”

For Minderides and Jackett-Simpson, the equation in space. First comes education, then comes help along a Asia is about multi-service solutions, of which transition spectrum of business and then comes the transition.”

Even so, on a general level exposure to derivatives and management is one element in a wider product set. “It’s alternative asset classes is a rising trend. Says Lachlan strength in depth,”says Jackett-Simpson,“going forward it French, head of transition management at Barclays Global will be about the houses that have all asset classes covered, Investors (BGI) [which has a team of four building up the along a broad spectrum of product. The business will firm’s transition franchise in the region].“We are beginning invariably become more competitive and complex, so it is to see more transitions into specialist hedge funds, and about expertise and support in depth that counts.”

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THE REMAKING OF FANNIE MAE & FREDDIE MAC

Fannie Mae and Freddie Mac, America’s two giant mortgage companies, were created by Congress to help people buy homes. Today, they buy or guarantee four of every five home mortgages made in the US, and their combined portfolios of loans and guarantees exceed $5trn.

Reportedly they are losing billions of dollars and need at least $20bn in new capital to survive.

Their accounting processes remain murky, and on a fair-value basis their common shareholders have no equity. Oh, yes, then there’s that question of leverage. Is it 20 to 1, 34 to 1, or 60 to 1? Art Detman explains why Fannie and Freddie will survive; but perhaps not in their current form.

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ANIEL MUDD, PRESIDENT and chief executive officer (CEO) of Fannie Mae, has a public face that is relentlessly optimistic. After his company— formally, the Federal National Mortgage Association (FNM)— announced a first quarter loss of $2.2bn, a loss that would have been higher had it not been for some accounting adjustments, he assured analysts on a conference call,“As the market recovers, we will be a prime beneficiary.”The forecast was eerily reminiscent of Angelo Mozilo’s prediction in September 2006 that his Countrywide Financial Corporation would emerge from the mortgage industry’s meltdown stronger than ever. One year on and Countrywide was in desperate straits, and today it is in the final stages of being acquired by Bank of America, even as its loan-documentation practices are being investigated by the Federal Bureau of Investigation (FBI). That Countrywide is the largest seller of home mortgages to Fannie Mae only made Mudd’s proclamation more unnerving.

D

CAN THE US’S GSES SURVIVE IN THEIR CURRENT FORM?

The fact is that the US housing market remains in a downward spiral not seen since the 1920s.Yale economics professor Robert J. Shiller, who helped devise the Case-Shiller indices of house prices and for years has warned of a housing bubble, reckons that home prices fell 30% between 1925 and 1933. That housing boom-and-bust overlapped the stock market’s boom-and-bust, and then came the Great Depression. In the recent housing boom, prices rose 85% from 1997 through the summer of 2006, an unprecedented gain according to Shiller. Since then they have fallen 15%, and are still falling—tracing a pattern unsettling similar to that which brought on Japan’s lost decade after its residential real estate bubble popped in 1991. Photograph © Melanie Taylor/Dreamstime.com, supplied June 2008.

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For all that, barring an extremely severe recession no one actually expects Fannie to go bankrupt. The same holds true for its younger, smaller and perhaps even more troubled sibling, the Federal Home Loan Mortgage Corporation (FRE, or Freddie Mac). Freddie’s chairman and CEO, Richard Syron, is not as exuberant as Mudd, but at the company’s annual meeting in early June he said that this year’s results will be better than last year’s. Considering that Freddie reported a record loss of $3.1bn and a 42% drop in book value for 2007, shareholders probably found only mild comfort in Syron’s carefully chosen words.

The fact is that the US housing market remains in a downward spiral not seen since the 1920s. Yale economics professor Robert J. Shiller, who helped devise the CaseShiller indices of house prices and for years has warned of a housing bubble, reckons that home prices fell 30% between 1925 and 1933. That housing boom-and-bust overlapped the stock market’s boom-and-bust, and then came the Great Depression. In the recent housing boom, prices rose 85% from 1997 through the summer of 2006, an unprecedented gain according to Shiller. Since then they have fallen 15%, and are still falling—tracing a pattern unsettling similar to that which brought on Japan’s lost decade after its residential real estate bubble popped in 1991.

Jack Malvey, Lehman Brothers’ chief global fixed-income strategist, believes the housing downturn will continue through 2009 and possibly even 2010, making it the worst housing correction since the Great Depression. One sign of its severity is the sub prime loss pattern. In the past, these losses peaked two years after the origination of the loans.

However two years after the origination of sub prime loans in 2005, losses on those loans were still rising. No one knows what might be the total loss on residential mortgages of all kinds will be, but the estimates are breathtaking. Last December the economists at Lehman said losses could total $250bn to $300bn over the lifetime of the securities. Days later their counterparts at Merrill projected losses of as much as $500bn; $100bn from option-pay adjustable rate mortgages and an additional $400bn from other loans.

Since then, estimates have gone only higher.

By April, as losses mounted at Fannie and Freddie, number-crunchers at Standard & Poor’s (S&P’s) were thinking the unthinkable. What if both companies failed?

Like everyone else, S&P assumed that the federal government would step in to resolve the crisis, just as it did back in the late 1980s and early 1990s when America’s savings and loan (S&L) industry imploded, in part because it was financing long-term, low-interest-rate home loans with short-term, high-interest-rate deposits.

The government made whole all depositors; the ailing S&Ls were auctioned off at fire sale prices, and their shareholders got little or nothing. All told, S&P calculates that the rescue cost American taxpayers $250bn in today’s money, which is a positive bargain compared with what it might cost if Fannie and Freddie founder.

A meltdown at Fannie and Freddie could cost the government $420bn to $1.1trn, according to S&P. The latter

figure might even put at risk the Treasury Department’s triple-A credit rating and bring into disrepute the timehonoured promise that a Treasury security is backed by“the full faith and credit of the United States Government.” A press officer at Freddie notes that the S&P report is “a scenario analysis, not a prediction.”Fortunately, he is right.

Even so, the markets are uneasy. The premium paid on Fannie and Freddie debt over Treasury debt soared from 1.7 percentage points at the start of the year to 3.5 percentage points by March. Meanwhile, the cost of buying credit protection against a Fannie or Freddie default had risen to a record high of 95 basis points (bps), up from 10 bps in July of 2007. Clearly, investors were nervous.

Should they be? Probably not. At least not that much.

After all, Fannie and Freddie are government-sponsored enterprises (GSEs), chartered and in key ways controlled by the US Congress. “To a large extent they are arms of the Treasury,” explains Yaron Brook, who is president and executive director of the Ayn Rand Institute and has a doctorate in finance and an masters of business administration. “Everyone knows that the government will not let them fail, that there is an implicit guarantee of the debt that Fannie and Freddie take on. If they do get into financial trouble, the Treasury will step in and bail them out.” Actually, by many measures Fannie and Freddie are already in financial trouble. Their combined losses in 2007 and 2008 may reach $20bn; which is surely a reasonable definition of financial trouble. Yet they continue to raise new capital through the sale of common and preferred stock, continue to sell debt more cheaply than companies that aren’t GSEs, continue to guarantee mortgage-backed securities, and continue to buy mortgages for their own portfolios. In short, they stay in business because of the implicit guarantee of the federal government. “If they lost the implied guarantee of the US government, their cost of debt would rise appreciably, particularly since they have had so many accounting problems,” says Richard Bove of Ladenburg Thalmann.

“That would be one difficulty of losing the implied guarantee.The other would be that, if Fannie and Freddie did not have the federal government behind them, their debt would simply be mortgage-backed paper. Therefore all the institutions that hold their securities because they have the implied guarantee of the government would have to sell them. They have legal requirements to own only a certain type of financial instrument, and if all of a sudden Fannie and Freddie were no longer government-sponsored enterprises, they would be legally required to sell all Fannie and Freddie paper because now these are just mortgage companies.”

Not only are Fannie and Freddie not “just mortgage companies,” they are vehicles for furthering government housing policy, which is to encourage home ownership.

Fannie was set up as a New Deal government agency in 1933. It was not until 1968 that it was spun off as a publicly owned corporation. “President Johnson did not want to have the debt of Fannie on the federal budget,” explains Bove.“When the decision was made to build 26m housing

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Daniel Mudd, chief executive officer of Fannie Mae, speaks at a housing conference at the National Press Club in Washington, DC and the picture is dated December 3rd 2007. On the day, Fannie Mae’s business of guaranteeing mortgage bonds is going “gangbusters,” Mudd claimed. Photograph by Carol T Powers for Bloomberg News /Landov; supplied by PA Photos, June 2008.

units over a 10-year period, which was a mandate of the 1968 Omnibus Housing Act, it became evident that not only would the debt of Fannie Mae be on the Federal budget but that this debt would increase dramatically in order to facilitate reaching that goal. So the government wanted to get Fannie off its books, and the way to do that was to make it go public.”

Two years later, in 1970, Congress chartered Freddie to provide competition for Fannie. Although both were forprofit, shareholder-owned corporations whose stock was traded on the NewYork Stock Exchange (NYSE), both were also creations of Congress, which set certain limits, such as how much capital they may raise and the maximum size of loans they may buy or guarantee (the so-called “conforming” loans). Not only was their corporate structure unique, so was their mix of constituencies.

Liberal Democrats and free-enterprise Republicans alike championed the two GSEs because Fannie and Freddie held the promise of increasing the number of Americans who would become homeowners.

Not-for-profit community organisations likewise supported Fannie and Freddie, and so did politically conservative groups such as homebuilders, real estate agents, mortgage brokers and bankers, all of whom have powerful lobbyist. Just about

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everyone loved Fannie and Freddie: some because of the good Fannie and Freddie could do for others; others because of the good Fannie and Freddie could do for them.

There was, of course, a built-in conflict of interest between the GSEs’ public policy mandate of increasing home ownership and its public company responsibility of increasing shareholder wealth. In good times, the two goals were compatible. Though not in bad times, such as when credit markets began freezing up after the collapse of Bear Stearns’ two hedge funds in July 2007. By early 2008, Wall Street was virtually out of the business of buying, packaging and reselling mortgages. Meanwhile, more than 250 US mortgage lenders across the country have disappeared since late 2006. The housing boom was dead.

Brokerages had elbowed their way into the business a decade ago, benefitting from the run up in housing prices and helping drive up those prices. Their aggressive and innovative sales tactics pushed down to 40% the market share of Fannie and Freddie. Both had to loosen their standards in order to compete, taking on some sub prime mortgages as well as Alt-A mortgages (which went typically to people with good credit scores but whose incomes were variable or hard to document). Even as the market share of Fannie and Freddie rebounded last year,

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Florida, Nevada, Arizona and California, all of which had enjoyed steep rises in home prices. Michigan, too, was badly hurt even without having had a housing bubble. As manufacturing jobs at auto makers vanished, For Sale signed sprouted like mushrooms after a rain. Late in 2007, as it became clear that losses at Fannie and Freddie for the year would be very big, their stock fell off a cliff. From a high of 70.57 just last year, Fannie fell to 25 by mid-June.

Freddie went from 67.20 to 23.

Most of the decline was caused by the big losses the two companies suffered. Some may be attributable to the dividend reductions (Fannie cut its quarterly dividend from 35 cents to 25 cents this year, while last year Freddie halved its dividend to 25 cents). But fear of dilution was also a factor. Members of Congress and the head of the Office of Federal Housing Enterprise Oversight (Ofheo, which regulates Fannie and Freddie) urged GSEs to raise more capital. Mudd and Syron resisted. In fact, Syron angered many supporters when in March he closed the door on new capital, saying, “This company will bow to no one on our responsibilities to shareholders.” Members of Congress, the regulators at Ofheo, and many others were upset. What about Freddie’s responsibilities to homebuyers (and homebuilders, home sellers, home lenders)? In the end both Mudd and Syron reluctantly agreed, once again, to increase capital.

Richard Syron, chairman and chief executive officer (CEO) of Freddie Mac, talks about the subHowever, neither of them agreed prime lending crisis and its effect on the housing market in Boston in this April 27th 2007 file to be interviewed for this article photo. At the time, Freddie Mac set aside $1.2bn in the third quarter to account for bad home (although their press officers were loans and posted a $2bn loss on Tuesday, November 20th 2007, prompting the nation’s secondhelpful), and little wonder why. In largest guarantor of home mortgages to seek additional sources of capital. Photograph by Stephan the last half of 2007 and the first Savoia, for Associated Press, supplied by PA Photos, June 2008. quarter of 2008, Fannie and Freddie the two found themselves suffering the same losses that reported combined losses totaling $11.1bn, and both are were bedeviling Bear Stearns, Citigroup, Merrill Lynch, UBS expected to lose billions more during the rest of this year. and others. Packages of triple-A rated mortgages were not What’s more (and what’s worse) is that Fannie and Freddie performing as projected. At first it was mainly sub primes made accounting changes that will ease the pain on both and Alt-A’s that were failing; but later mortgages to prime- their income statements and balance sheets for 2008. No rated borrowers began failing, too, especially those with companies better illustrate the idea that profits and net adjustable rates. The housing markets that were the hottest worth are accounting concepts, not physical facts. Take, as for the past five years suddenly turned cold, as the an example, first-quarter results. Fannie’s reported loss of delinquency rate on loans soared and the number of $2.2bn came to $2.57 a share versus a profit of $961m or houses in foreclosure skyrocketed. Hardest hit were $0.85 a share for 2007’s first quarter. Using generally

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accepted accounting principles (GAAP), shareholders’ equity was $38.8bn, down nearly 12% from $44bn on December 31st. But if fair-value accounting were used, in which assets are marked to market, the December 31 figure becomes $35.8bn, which shrinks to only $12.2bn at March 31st. Some $14bn in net worth is attributable to preferred shareholders, which means that the equity of common shareholders was a negative $1.8bn. Fannie’s position here is that GAAP is GAAP, which is true enough. Clearly though GAAP did not anticipate a nationwide meltdown in housing prices and the consequent plunge in value of housing-related securities.

Another practice that vexes analysts is Fannie’s inclusion in its net worth of $45.4bn of $13bn in deferred tax credits.

These were generated by losses and can be used only to reduce taxes on future earnings. Most analysts expect they will expire before Fannie earns $36bn to use them. If Fannie were a commercial bank, it would have by now cancelled this “asset.” Freddie’s accounting magic was even more blatant, according to Moshe Orenbuch, a managing director at Credit Suisse. He expected a per share loss of $2.15, but Freddie reported a loss of only $0.66. Good news? Not really.

Orenbuch notes that two accounting changes reduced losses by about $2.3bn, down to $151m. One was the selective revaluation of assets on both its balance sheet and profitand-loss statement. This, Orenbuch says, will raise Freddie’s cost of credit over the longer term. In the other change, Freddie no longer recognises loan losses until they have been delinquent two years instead of 120 days. This pushes $700m in losses from 2007’s first quarter to 2009’s first quarter.

Joshua Rosner, an analyst at Graham Fisher & Co., says Freddie’s accounting changes“put a lot of lipstick on a pig.”

The first quarter accounting changes and other financial reporting practices make it difficult for analysts and all but impossible for ordinary investors to determine the true financial results and net worth of the two companies. Even so, both Fannie and Freddie have improved their behaviour in recent years. Alleged financial scandals involved managed earnings and other problems came to light in 2004, triggering a change of management at Fannie and Freddie, restatements of past years’ results, and delayed reporting of current results. It was not until this year that they caught up and began filing timely reports.

Fannie is now seeking $6bn and Freddie $5.5bn in new capital, both mainly through the sale of common and preferred shares. Ofheo was encouraged enough by this to reduce a surcharge it had imposed on the minimum capital that Fannie and Freddie must maintain to support their lending and guaranteeing portfolios. It had been 30% since 2004, the year the accounting scandal surfaced, and now goes to 20%. This reduces Fannie’s capital requirement by $3.2bn and Freddie’s by $2.6bn, enough to allow the two to fund up to $200bn more in home mortgages. The extra cushion should also help now that Congress has increased the maximum Fannie or Freddie loan to $729,750, in certain markets, up from $417,000. By September, Mudd and Syron hope to have the surcharge further reduced to 15%.

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To be sure, Ofheo’s capital requirements are hardly onerous. Basically, Fannie and Freddie need to have a capital base equal to 4% of their assets. They’re GSEs, you know. Given their low capital requirements, what kind of leverage do Fannie and Freddie have? Well, that depends on how their net worth and potential liabilities are calculated. At year’s end Fannie and Freddie had a combined net worth of $85bn, which supported $5trn in debt and loan guarantees. This is a 60 to 1 ratio. A different method yielded a 50 to 1 ratio for Freddie at March 31st but only 21.7 to 1 for Fannie. Still another method showed that, even after the surcharge reduction to 20%, Fannie and Freddie can borrow up to $33 for each dollar of their own capital, a 33 to 1 ratio. By comparison, Bear Stearns’ leverage was 34 to 1 at the end of 2007.

Then there was the Congressional testimony of James B. Lockhart III, head of Ofheo. Using fair value accounting, he told his incredulous audience, Fannie’s leverage at year end was 81 to 1. Freddie’s was an eye-popping 167 to 1.

Not to worry though. Under GAAP, Fannie’s leverage is only 20 to 1, Freddie’s only 30 to 1, and the average of nation’s 20 largest banks is 11 to 1. Last December Fannie and Freddie raised $13bn in new capital, and this year they’ve promised to raise an additional $12bn. Then what should they do? Why, raise more capital, of course. That is the virtually unanimous opinion of analysts and others who follow the stock. “The point is that if they keep burning through $5bn worth of capital every quarter, they are going to be in nosebleed territory in terms of leverage,” says Peter S Cohan, head of his own consulting firm.“They need to replenish their capital.”

Meanwhile, Congress is working on a new bill that will create a new oversight agency that will assume many if not all of Congress’s duties in setting capital requirements, loan limits and other parameters. Lockhart, Ofheo’s director, is the frontrunner to head this new agency. For Fannie and Freddie, it will mean both tougher regulation but also more flexible and responsive oversight. One goal will be to get Fannie and Freddie to operate counter-cyclically by building capital in good times and lowering lending requirements in down markets.

Can more capital and a new federal regulator change Fannie and Freddie; and save them? If the economy doesn’t collapse, the answer is yes. But there are two other possible solutions. As a libertarian, Brook believes Fannie and Freddie should be fully privatised. Alex Pollock, a resident fellow at the right-of-center American Enterprise Institute, used to favour privatisation. Now he believes Fannie and Freddie are too important to the housing market and too financially fragile to be set free. Instead, he advocates nationalising both and making them true government agencies. It is unlikely that either Brook or Pollock will get his way. Moreover, it is unlikely that any material changes to Fannie and Freddie will occur prior to the Presidential elections on November 4th. But this time next year, Fannie and Freddie are likely to be well on their way to a major make-over.

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TRADING IN EMERGING MARKETS STOCKS

EMERGING MARKETS TRADING AT FULL TILT In spite of turmoil in many so-called advanced economies, most developing countries remain in robust health. Moreover, investors have taken note and the demand for exposure to the emerging market growth story, particularly in the energy and commodity sectors is keeping specialist emerging markets trading desks increasingly busy. Asset managers are scrambling to meet the operational challenges posed by record inflows designated for emerging markets and the emerging markets trading operations in the global investment banks is keeping pace with change. By Neil O’Hara, with additional reporting by Francesca Carnevale.

NVESTING AND TRADING in emerging markets is a rising asset class. Access to emerging market high growth stocks is facilitated by healthy listings numbers on major exchanges; there are almost 70 stocks from Brazil, Russia, India and China (BRIC) listed on the London Stock Exchange (LSE) for instance; with a further 123 on its Alternative Investment Market (AIM). Similar numbers abound on the New York Stock Exchange, NYSE Euronext and Luxembourg. The trend is upward. Investors plan to increase their allocations to emerging markets, with the Middle East predicted to be the top performer amongst all regions, according to a recently released Deutsche Bank survey. Deutsche Bank’s sixth annual Alternative Investment Survey, conducted during March 2008, by the Bank’s Hedge Fund Capital Group found that “Hedge fund investors’ prediction that the Middle East and North Africa will be the top performing region in 2008 indicates a clear redistribution of capital towards emerging markets.” Backing up its findings this year the bank

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Photograph supplied by istockphoto.com, June 2008.

established a specialist Middle East platform, backed by a detailed research capability based in Dubai and headed up

by Pascal Moura, head of CEEMA & Latin America company research. The research facility focuses on 80 leading blue-chip regional stocks across all sectors as well as supporting the bank’s global research capability. In addition, Deutsche Bank provides a wide range of e-trading offerings to capture clients’ needs globally. “It is part of the bank’s commitment to having a full range of products across the trading spectrum. Nowadays it is about bundling any set of services to meet our client’s precise needs and right now one of those needs is ease of access to emerging markets,” says Rhomaois Ram, head of global trading at Deutsche Bank. The emerging market challenges are created by huge differences in regulation, market structure, currency, trade order types and exchange systems, says Ram.“Traders now face more decisions about where, when and how to trade,”he says.

Increasingly global fund managers and specialist emerging markets fund managers are keen to achieve direct access to stocks listed on emerging markets exchanges; lifting the pressure on emerging markets issuers to have to deliver equity via global depositary receipts (GDRs) and listing on foreign exchanges. Most recently, Turk Telekom limited its share offering to the Istanbul Stock Exchange (IsSE),“these days you can reach global fund managers as readily out of Istanbul as you can out of London,” notes Metin Ar, Cheif Executive Officer and managing director of Garanti Securities, which together with Deutsche Bank led te deal. Some 60% of Turk Telekom was sold to international institutional investors (50% of that to European investors, 25% to the US market and a further 25% to Middle East

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investors). “GDRs and ADRs do not function well in the Turkish context, notes Ar, “the IsSE is efficient, the conversion of Turkish lira is efficient, so institutional buyers tend to prefer to trade in the stock directly.”

A number of investment options are available: country focused, individual stock focused; in the main though the major trading houses report a strong sector bias. Outside of Asia “where individual country strategies dominate, elsewhere energy and commodities are natural foci,” notes Richard McKay, Global Emerging Markets equity trader at Nomura in London. Reflecting that emphasis, core markets for Nomura include Russia and the CIS states, Central and Eastern Europe, Turkey, Brazil and South Africa. “The mantra is truly global,” notes Funda Ayhan, co head of Global Emerging Markets (GEMs) equity trading at Nomura,“but the emphasis is on sectors with a global reach.”

Foreign asset managers still face obstacles to investing in some emerging markets, of course. Jervis Smith, the Londonbased head of managed funds in the financial institutions group of Citi’s corporate bank, notes that direct investment in China is still restricted by quota through the qualified foreign institutional investor (QFII) regime, and similar rules apply in India. Local tax laws come into play, too: Turkey and Brazil levy withholding tax on certain types of foreign investor. The right legal structure may allow asset managers to mitigate any incremental costs, however. Funds based in Luxembourg can take advantage of a double taxation treaty with Mauritius to escape capital gains tax on investments in India, for example.“The asset manager needs to know who its clients are and what tax problems or benefits there may be,” says Smith,“It requires a lot of work and research which does not apply in more developed countries.”

Henry Hall, head of EMEA equities at Merrill Lynch says much more than research is involved.“Now it is about making markets available for people.”The bank is taking a multi-route approach. The first is direct access, with seats on the ground.

“Last year we pushed into the Gulf Cooperation Council (GCC) countries, ex Saudi and established a fully functioning trading desk in the Dubai International Financial Centre (DIFC). The second is via its specialist indices. Most recently the bank launched its frontier market index,“that was a natural build on last year’s African Lions index,”notes Hall.“Third is a focus on product and mechanisms,”he explains,“clients buy a Merrill Lynch certificate that gives access to a particular market, denominated in euros and US dollars. It cuts out a lot of problems for the client and eases the investment process.”

Bond managers typically have easier access to emerging markets than their equity counterparts. Claudia Calich, portfolio manager and head of the emerging markets group at Invesco, points out that many countries tap the international capital markets for dollar denominated bonds, which are accessible to all and settle through Euroclear or Clearstream just like other international bonds. For most local currency bonds, managers have to set up an account in the country of origin, and while the paperwork may take time settlement problems rarely crop up.

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Jervis Smith, the London-based head of managed funds in the financial institutions group of Citi’s corporate bank, notes that direct investment in China is still restricted by quota through the qualified foreign institutional investor (QFII) regime, and similar rules apply in India. Local tax laws come into play, too: Turkey and Brazil levy withholding tax on certain types of foreign investor. Photograph kindly supplied by Citi, June 2008.

The biggest risks arise in countries that have entrenched capital controls, such as India and China. Calich says many investors use pass-through instruments to evade the regulations, such as a structured note issued by a major broker that delivers the economic return on the underlying bond in exchange for a modest fee. Although technically an obligation of the broker, the note is really a conduit so if liquidity dries up in the underlying instrument during a financial crisis the investor may be unable to close out the position.

It makes little difference whether the counterparty is a local broker or a global securities house, as Calich discovered the hard way. Several years ago at another firm, a fund she managed held Turkish treasury bills through a structured note issued by a major international bank.

Although she tried to bail out when the currency came under pressure the bank could not find anyone willing to take the other side. Stuck holding Turkish lira through a significant devaluation, the fund took a painful loss.“Using a large US or European institution doesn’t mean you will escape systemic problems,”Calich cautions.

For regular cash trades settled against payment or delivery the operational risk is minimal. If the broker (whether local or global) goes bust the trade fails, no money changes hands and the investor bears only mark to market risk until it can reinstate the trade. Besides the major global houses, some smaller banks, including ING and ABN Amro, have developed a particular specialty in emerging markets, while

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exposure to the 50 largest and most in countries such as Russia and Brazil liquid stocks from the local brokers have captured a underdeveloped frontier markets. As significant market share. In every case, Hall explains “Frontier markets have the credit crunch has curbed the outperformed both emerging and brokers’ appetite for balance sheet developed equity markets going right exposure and driven up costs for back to January 2000.”Between investors who rely on them for January 2000 and January 2008, structured notes and other derivatives. frontier markets had an annualised Market access is not the only obstacle, capital return of 20% compared with of course. Settlement delays were once 12% in emerging markets and 1% in the bane of investors in emerging developed markets. Moreover, a chief markets, but Citi’s Smith says they have advantage is the lack of correlation improved to the point where trade with developed, and even other processing in some countries is even emerging markets, in terms of more automated than in developed George Hoguet, emerging markets portfolio performance. Frontier markets hold markets. It is still a patchwork, however. manager and global investment strategist at significant potential for growth, “The South Korean stock market is a State Street Global Advisors (SSgA). however, cautions Hall “Corporate straight through processing Photograph kindly supplied by State Street transparency can be poor; trading environment, but most former Global Advisors, June 2008. and settlement is challenging and Commonwealth of Independent States (CIS) countries in central Asia are not,”Smith explains,“You still liquidity is low. Investors in frontier markets must have have settlement issues, but not in all countries.” We have long horizons and high risk tolerance,”he adds.

The explosive expansion of investment capital in the recently experienced a significant increase in clients, both buyand sell-sides, expressing interest for Emerging Markets Middle East and other emerging markets has spawned a connectivity, in order to expand their market coverage. Every growing community of local brokers as well as local asset single electronic trading manager at a bank or strategist at a managers. Foreign asset managers who wish to expand hedge fund now has a shopping list containing the new‘must- their geographic coverage can now hire local sub-advisors, haves’, the‘very eager to talk about’and the‘hmm, interesting’. which may be faster and less expensive than developing inThe first category includes Warsaw, Athens, Istanbul, Moscow, house research and trading capability. “However,” notes Tel Aviv in EMEA, Brazil, Mexico & Argentina in the Americas, Nomura’s McKay,“it does depend on the market. In Turkey, China & India in APAC” says Philippe Carré, global head of for example, it is cheap to use a local broker, we are talking connectivity at GL Trade. “Institutions are nevertheless in the range of 5 basis points (bps); if you are talking interested to hear about the opportunities out there even if Palestine, on the other hand, you are looking at a full 100 current obstacles such as clearing, liquidity and fiscal rules may bps.”It’s an attractive alternative to using an index-tracking ETF sponsored by a competitor, and anyway the major ETF prove insurmountable in the short term.

The rising tide of investor enthusiasm threatens to sponsors have not yet launched products that track many swamp the available market capitalisation in some frontier markets.“You don’t find much passive management emerging markets. Capacity constraints affect markets in the smaller markets,” says Smith, “Managers want to such as China and India that restrict foreign participation, charge a premium for scarce local expertise.”

Citi’s footprint for clearing and settlement services but the weight of money alone can overwhelm smaller markets even if they don’t curb access. A case in point: the around the world gives the bank unusual insight into which Middle East, where Citi’s local individual and institutional countries investors favour. Among frontier markets, Smith clients who prefer to invest in other regional markets find sees particular interest in certain former CIS countries— it hard to buy as much as they want without pushing prices Kazakhstan, for instance, where Citi Global Transaction beyond fair value. “The markets just aren’t big enough,” Services opened an office in May—the Middle East and Smith says,“They can’t absorb the tsunami of money that sub-Saharan Africa, where China’s thirst for natural the oil price and other commodity prices have generated.” resources has generated incremental trade revenue that is Another is Latin America, where the paucity of global financing much-needed improvements in infrastructure.

In the decade since a devaluation of the Thai baht stocks is concentrating demand into major name investments. According to Nomura’s Ayhan, “the key is triggered a collapse in both equity markets and currencies all guiding the client to value. We explain that on a valuation across Asia the public finances of many developing countries basis Petrobras, for instance, is trading at a multiple of 14 to have undergone a transformation. Propelled by higher 15, whereas Rosneft, which shares many of the commodity prices, the resource economies are running fiscal characteristics of Petrobras and has a similar reserve as well as current account surpluses and their currencies are appreciating. In the BRIC countries (Brazil, Russia, India and outlook, is trading at a multiple of 11 times earnings.”

Merrill Lynch has not stopped there; having launched its China), new-found wealth has swollen the ranks of the ML Frontier Index earlier this year, providing investors with middle classes, whose burgeoning consumption has created

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endemic growth and diminished their erstwhile dependence on exports to developed economies.

Sovereign wealth funds (SWFs) have become a powerful symbol of developing countries’ unprecedented financial strength. Once the exclusive preserve of oil-rich states in the Persian Gulf, SWFs have become a force to be reckoned with all over the world. Russia, which devalued the rouble and defaulted on its sovereign debt as recently as 1998, has accumulated a $157bn investment fund thanks to soaring oil revenues; in February, it announced plans to allocate $32bn to a new SWF. Brazil has joined the ranks of capital exporters for the first time in its history and has announced plans to launch a $20bn SWF. Global Insight, a financial research and consulting firm based in Waltham, Mass., estimates that total SWF assets today amount to a staggering $3.5trn.

Globalisation was supposed to draw the world’s developed and underdeveloped economies closer together, but proponents of that theory made no allowance for increasing trade flows among developing economies. James Upton, senior portfolio specialist and chief administrative officer for the emerging markets equity team at Morgan Stanley Investment Management (MSIM), notes that the proportion of exports from the emerging markets to the US hit a peak in 2000 at 26% but declined in subsequent years to just 18% in 2007. Exports to other emerging markets have taken up the slack; they now represent almost half the total.

“The knee-jerk reaction in the West was that if the US is slowing it’s all over because exports out of China and India will fall,” Upton says, “That is not the case. For example, China is increasingly the producer of capital goods—cars, tractors and other durables—going to Vietnam, Thailand, Malaysia and Africa.”

For the last two years, MSIM’s flagship $18bn emerging markets fund has earned about half its excess return (alpha) from successful country allocations and the other half from canny stock selection. In a prescient call, MSIM stayed overweight China well into 2007, a period when nosebleed valuations drove others to cut back their exposure. “We still saw tremendous demand and productivity gains,” Upton says, “China was increasing exports to other emerging markets even as the U.S. slowed down.” Only in the fourth quarter of 2007, when central banks in developing countries began to tighten monetary policy in response to the inflationary spike in food prices, did emerging markets equities take a dive.

Upton, who has focused on emerging markets equities since the early 1990s, says better corporate governance, improved transparency and the adoption of international accounting standards have bolstered valuations in recent years. In many cases, price-earnings multiples in emerging markets no longer reflect a discount to developed markets, a significant departure from the historical pattern.

Nevertheless, Upton stresses that investors cannot take a blanket approach to the emerging markets; they have to understand what drives growth in individual countries.

It has become a formidable task as the number of emerging markets open to foreign investors has expanded. Last year,

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MSIM expanded its emerging markets strategy to include some 32 frontier markets that are not represented in the MSCI Emerging Markets Index. In addition to high real GDP growth—in excess of 6%—the strategy looks for countries in which economic reforms have opened up capital markets to foreign investors, cut capital gains taxes or permitted domestic pension funds to invest in equities (rather than just bonds) for the first time. It’s an active investment approach. “Alpha generation opportunities are larger in emerging markets than in developed markets,”says Upton,“We have total flexibility as to which countries we are in or out of.”

Managers who are able to trade in and out of specific markets have to keep an eye on costs, however.

Commissions remain high in most emerging markets—as much as 80 basis points (bps) each way for benchmark stocks, according to George Hoguet, emerging markets portfolio manager and global investment strategist at State Street Global Advisors (SSgA). Liquidity is often limited in smaller markets like Jordan and Morocco, so dealing spreads can be wide. Investors must watch out for practices long frowned upon in developed markets, too: Hoguet says front-running is a fact of life in some emerging markets. It all adds up to significant round trip trading costs.

In total, SSgA handles about $30bn in the emerging markets, of which more than $17bn is actively managed by Hoguet and his colleagues. They use a quantitative screen to rank countries in order of attractiveness, then load up on the best and pare down the worst relative to the benchmark weightings. Right now, high commodity prices are generating robust earnings growth in Brazil, which Hoguet expects to continue. SSgA is overweight Russia, too, where budget and balance of payments surpluses could push the rouble higher against other currencies. Among smaller markets, Hoguet favours Indonesia, which is enjoying strong growth in domestic demand, and Egypt, whose proximity to the cash- rich Gulf States has created opportunities for local construction and telecommunication companies.

Hoguet and the team cut back their exposure to India when valuations became stretched last year—a smart move given that the benchmark index has dropped 25% so far in 2008. While he still believes in China’s long term growth story, fears of inflation, uncertainty over Tibet and the undervalued renminbi have caused him to underweight that market, too. It’s a case by case analysis, of course.“One does not want to be exposed to countries which are heavily exposed to the US consumer or have close links to the US economy [such as] Mexico,”Hoguet says.

Emerging markets have always been more volatile than developed markets and Hoguet doesn’t see that changing.

Investors need to keep their return expectations in check, however. Although fortuitous market timing can create outsize returns, Hoguet suggests a reasonable medium term real return target one or two percentage points higher than for developed markets.“If you hit the right market you can double your money in a year or two,”he says,“But people should try to think about these markets systematically.They are a call option on world growth and a manifestation of ongoing globalisation.

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QFC TURNS THREE

The QFC Builds on Qatari Growth Backed by a preternaturally buoyant domestic economy, in just three years the Qatar Financial Centre (QFC), which encourages foreign firms to come to Doha in order to take part in Qatar’s booming financial services industry, has managed to secure enough big-name business to position itself as a viable alternative to the wellestablished centers in neighbouring Dubai and Bahrain. Can they keep up the pace?

Dave Simons reports.

ITUATED IN A REGION that is now a major magnet for both direct and indirect investment, Qatar is one of the jewels in the Gulf Cooperation Council (GCC) countries crown. In a region where big numbers abound, as is the case with the Emirate of Abu Dhabi, some of the bigger numbers in the GCC countries are also found in Qatar. The world’s largest exporter of liquefied natural gas (its vast gas reserves places it third behind Russia and Iran), Qatar is also oil-rich as well, with reserves estimates ranging as high as 26bn barrels. Energy accounts for nearly two-thirds of the country’s booming gross domestic product, which has seen a 10-fold increase since the start of the decade, making Qatar second only to Luxemburg in terms of GDP percentage growth. A recent S&P report on Qatar estimated GDP per capita at $75,800, up from $27,000 seven years ago, while real economic growth is expected to maintain its current 14% clip through 2009.

Not content to rest on its laurels, Qatar has been busy putting its riches to good use at home. A series of economic and social reforms helped give Qatar a

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Stuart Pearce, chief executive officer of the Qatar Financial Centre. A series of forthcoming initiatives will be integral to the next phase of the QFC’s development, says Pearce. Leading the list will be the creation of an integrated regulatory body modeled after the UK’s own Financial Services Authority (FSA) and covering the whole of the Qatar market. Photograph kindly supplied by the QFC, June 2008.

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temporary seat on the United Nations Security Council.

Meanwhile, Qatar’s government has pledged to spend the equivalent of $500,000 per citizen through 2012 in an effort to boost its profile as a centre for cultural and academic achievement. Qatar believes such investments in its domestic infrastructure will help attract not only the best and the brightest, but some of the biggest business names the world has to offer. In the process, the upstart GCC nation is aiming to give its nearby neighbours some serious competition.

In fact, it hasn’t taken much to convince many leading foreign firms to bypass Dubai in favour of Doha, particularly since the advent of the Qatar Financial Centre (QFC), established in mid-2005 by the government of Qatar with headquarters in the capital city. The QFC, whose overall goal is to encourage global financial-services institutions and multi-national corporations to participate in Qatar’s regional financial services industry, consists of two main bodies: the QFC Authority (QFCA), charged with developing commercial strategy and securing relationships with global financial firms; and the QFC Regulatory Authority (QFCRA), which oversees companies licensed by the QFC. The QFC’s mandate is first and foremost to build Qatar’s own fledgling financial services sector, and then to offer a regional hub to financial services companies for their GCC operations.

Business has been good across the board right from the get-go. Enduring a pronounced regional market sell-off, within months of its official opening in September 2005 the Centre had already attracted top names such as Credit Suisse and AXA Investment Managers, on its way to securing 21 global and regional firms by the end of 2006.

Now less than three years later, the QFC sports a staff of 106 employees covering 23 different nationalities, as well as a packed roster of 82 licensed firms that includes such investment banking names as Deutsche Bank, ABN Amro, Barclays, Citigroup, Goldman Sachs, Morgan Stanley and Lehman Brothers, with another 20 firms set to join the ranks over the next several months. In the field of insurance, the Centre has also attracted a number of new entrants in the form of AIG, with large brokers Marsh and AON declaring their intentions to set up in the QFC as well. The introduction of these new entrants has virtually doubled the existing number of Qatari insurers, and looks set to start up what has been until now a virtually nonexistent local brokers’ market.“To date, the GCC insurance industry has only a 0.17% share (valued at $6.2bn in 2006, the most recent reliable figure) of the world insurance market. Recent research shows that the regional growth of demand for insurance is higher than the growth rates seen in most large insurance markets across the world and the QFC is keen to leverage that fact.

The QFC has had a profound impact on the Qatar region as a whole, says Stuart Pearce, the former HSBC executive who signed on as CEO of the QFCA in July 2005. Pearce is flanked by the QFC Regulatory Authority (QFCRA) head Philip Thorpe, who formerly served with competitor Dubai

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It hasn’t taken much to convince many leading foreign firms to bypass Dubai in favour of Doha, particularly since the advent of the Qatar Financial Centre (QFC), established in mid-2005 by the government of Qatar with headquarters in the capital city. The QFC, whose overall goal is to encourage global financial-services institutions and multinational corporations to participate in Qatar’s regional financial services industry, consists of two main bodies: the QFC Authority (QFCA), charged with developing commercial strategy and securing relationships with global financial firms; and the QFC Regulatory Authority (QFCRA), which oversees companies licensed by the QFC. The QFC’s mandate is first and foremost to build Qatar’s own fledgling financial services sector, and then to offer a regional hub to financial services companies for their GCC operations. Photograph kindly supplied by the QFC, June 2008.

International Financial Centre (DIFC); Yousef Kamal, also Qatar’s minister of finance, serves as QFC chairman. As Pearce explains, the Centre has come a long way since its humble beginnings when, during those first few months, Pearce and his comrades camped out in the Ministry of Economy and Commerce. “There was no building back then,” says Pearce, “we had no branding or marketing materials, no HR policies or IT systems, not even a

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lucrative. Following a corporate plan of any market correction in early note.” Things are much “A series of forthcoming initiatives will 2006 correction, which different today, remarks be integral to the next phase of the QFC’s resulted in major losses for QFC chairman Kamal. development, says Pearce. Leading the investors who had Many of the world’s top overdrawn to support the banks, asset rated list will be the creation of an integrated bull market, DSM prices managers, insurance regulatory body modeled after the UK’s have levelled out. Today, companies, accountancy own Financial Services Authority (FSA) the market is holding and legal firms have and covering the whole of the Qatar steady and investment chosen to come to Qatar, market. The QFCRA, the all-in-one continues to grow, albeit he says, “because of the regulatory platform will combine the slowly.

Initial public opportunity to participate offerings still make up the in our rapidly increasing current QFC Regulatory Authority with the majority of this new outlay. market for financial Qatar Financial Markets Authority (QFMA), As if to underscore the services, and because of which is the regulator of the Doha fact that the regulator has the quality of the legal and Securities Market (DSM), as well as the teeth, in April the QFCRA business infrastructure regulatory arm of the Qatar Central Bank.” moved to introduce a that the QFC has created. substantive set of Moreover, an increasing amending rules designed number of firms now see to ensure that the risk of money laundering activity Qatar as their regional centre of choice.”

Adds Pearce, “At this point the platform is quite well continues to be minimised in the QFC.“Whilst evidence of known, so far this year we have had about 130 prospective money laundering is not an issue we have had to confront firms come to talk to us, and the message concerning what in the QFC we are nevertheless determined to ensure that we are, what we are not, and why we are the way we are, is robust and effective AML measures are always up to date obviously becoming much clearer.” At a recent meeting and in operation,”notes Thorpe.“We have seen a significant held in Qatar, the country’s prime minister, His Excellency, increase in the number and range of banks and other Sheikh Hamad bin Jassim Bin Jaber Al Thani, went to great financial institutions in the Qatar Financial Centre, and a lengths to extol the virtues of the QFC, including how the rapid expansion in financial services more generally as a QFC has helped raise the performance standards of the consequence of Qatar’s position as one of the world’s regional financial-services industry. “That sort of public fastest growing economies. Against this background our objective is to ensure that we continually monitor the endorsement is obviously very nice to hear,”says Pearce.

A series of forthcoming initiatives will be integral to the effectiveness of existing measures and introduce timely next phase of the QFC’s development, says Pearce. Leading amendments where necessary.”

As part of the consolidation, all financial services in Qatar the list will be the creation of an integrated regulatory body modeled after the UK’s own Financial Services Authority will be required to step up to international standards by (FSA) and covering the whole of the Qatar market. The 2010, says Pearce.“Among other things, it will certainly make QFCRA, the all-in-one regulatory platform will combine this market more competitive than, say, the UAE, which the current QFC Regulatory Authority with the Qatar continues to operate using three or four different regulators.

Financial Markets Authority (QFMA), which is the So we believe it will enhance the attraction of Qatar not only regulator of the Doha Securities Market (DSM), as well as as a market to operate in, but also to operate from.” the regulatory arm of the Qatar Central Bank. Like the QFCRA, the new integrated regulator will operate Doha Differences independent of the QFCA and have a broader remit. Chief Pearce relishes the idea of adding a competitive element to regulator Thorpe sees the transitional process for QFC the GCC region. “There’s nothing wrong with competing, firms extending through next year or possible into the we believe the element of competition brings out the best beginning of 2010, though evidence of the new single in most circumstances. And the fact that there are three regulator will be palpable sooner, he adds. Says chairman different financial centres is good for the industry because Kamal, “With one authority we believe we will be able to it means that the general level of standards is being raised achieve greater efficiency and higher standards of across the GCC. And it also gives both the regulated and regulation. We also feel that Qatar can be a viable financial unregulated financial-services businesses in the region a centre only if the business climate in its entirety is greater choice.” modernised and placed under an overall authority.”Key to Though similar in some respects to the higher profile DIFC that will also be the growth of the DSM. Launched in 1997 or the increasingly competitive Bahrain Financial Harbour, the Doha Securities Market began to grow five years ago the QFC is marked by some very distinct differences, says when oil income was just starting to buoy investor’s Pearce. For one, the DIFC is a financial free zone that imposes portfolios. The resulting market was fast growing and a number of restrictions on firms that are licensed by the

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DIFC authority, including dealing, lending or deposit-taking in the dirham, thereby making it impossible to transact business on a domestic basis. By contrast, because it is an onshore centre, none of these restrictions apply to firms licensed with the QFC. Hence, the benefit for companies doing business in Doha—as opposed to merely doing business with Doha—is the potentially significant advantage of gaining exposure to Qatar’s fertile economy and burgeoning marketplace. “We have a very different model with a much different purpose; we were specifically designed to develop the market for the state of Qatar,”says Pearce.“As such, any licensed QFC company is afforded full access to the domestic financial markets.”

Also, because the QFC is not a property development (QFC law permits Doha buildings to be used as QFC sites) licensed firms do not have set up shop on the QFC premises itself. Furthermore, foreign companies are allowed to maintain 100% ownership, and all profits may be remitted outside of Qatar.

In addition to its leverage as an onshore entity, Pearce says there are other ways that the Centre is able to distinguish itself.“As a regional destination, Qatar is extremely attractive-since 2000, the GDP of Qatar has expanded from around $8bn to close to $80bn today. So the economy is unusually strong, is growing quickly and has massive sustainability.”

From a real-estate perspective, Qatar represents a good bang for the buck, at least for the time being. According to government figures, property values in Qatar, though rising steadily, are still substantially lower than in many other regional markets, including Dubai’s. However, the country’s 14% rate of inflation (the result of substantial increases in public-sector wages), along with rapid population growth, has put continued pressure on the housing market while driving up the cost of building materials and construction services, according to an S&P report. As such, property values may not stay discounted for very long. Hence, global businesses currently considering a piece of Qatar’s action may wish to act sooner than later, say observers.

Of course, even with a potential 100 firms or more licensed by year’s end, the QFC is still a long ways from the

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A view of the Doha skyline. Qatar has a future of powerful consolation before it. With the GCC’s account surplus touching $750bn by the end of 2007, economists agree the region is more or less isolated from a world recession shock. Moreover, with $150bn worth of infrastructure projects in the pipeline, the outlook remains largely rosy. Photograph © Paul Cowan/Dreamstime.com, June 2008.

400-odd companies currently doing business in Dubai.

What those figures don’t show, says Pearce, is a steady flow of Dubai-based businesses that are pulling “double-duty” by securing a place in Doha as well. Additionally, the criteria that global companies have traditional used when considering Gulf-region residency are rapidly changing, and the new direction favors the likes of the QFC.“I think the international financial services firms are now looking at the Middle East in a completely different way,”says Pearce.

“The countries in the region have been investing heavily in their domestic infrastructure, diversifying their economies and creating programs that will make their economies sustainable over the longer term. Which is a markedly different economic environment from what we saw just four or five years ago. And that environment is very attractive to financial services firms today.”

Qatar has a future of powerful consolation before it. With the GCC’s account surplus touching $750bn by the end of 2007, economists agree the region is more or less isolated from a world recession shock. Moreover, with $150bn worth of infrastructure projects in the pipeline, the outlook remains largely rosy.

Inflation remains something of a bugbear, as higher food and building material costs offset a fall in rental inflation.

Inflation in Qatar rose slightly to 13.74% at the end of December, its second-fastest pace on record, as rents and food prices surged. A 30% rise in global food prices in 2008 and 2009 and an increase in building material costs would keep inflation at about 13.7%, according to recent government statements. However, with double digit annual growth expected for the foreseeable future, the QFC has a solid foundation on which to build.

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COMMODITY PROFILE: WHEAT

SORTING THE WHEAT FROM THE CHAFF Speculators, funds and trading houses made some spectacular profits in the wheat market in the last year. Reports of record earnings and massive returns however sit somewhat uneasily alongside television pictures of Egypt’s poor fighting for loaves of bread or tortilla riots in Mexico. What’s the answer?

Vanya Dragomanovich reports.

A key question right now is whether wheat is likely to continue to be a good investment. Most analysts believe that prices will move either slightly lower for the rest of the year or, at best, sideways. Going forward, they say, it becomes increasingly difficult to assess what the market will do, as farmers tend to respond quickly to changes in crop prices and alternate planting between corn, soybeans and wheat.

Photograph © Kim D French/Dreamstime.com, supplied June 2008.

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N WHAT IS becoming a highly political market it is even more difficult than usual to sort the wheat from the chaff. Depending on who is taking the pulpit, either the drought in Australia, Russia and Ukraine’s electionmotivated export restrictions, biofuels, speculative fund investment, trade houses monopolising the market or China’s demand for meat is the main reason behind today’s high prices. A close look, however, reveals that all these factors remain in play and together have contributed to higher prices and that, except for Australia’s drought, most will continue to play a role for years to come. As a result the face of the wheat market will change irrevocably.

Having traded between $3 and $4 a bushel for years, wheat prices rose to a record high of $13.5 at the end of February. By the end of May, however, wheat fell back by more than 40% to $7.6. Most analysts say that the grain is not likely to pick up steam for the rest of the year. Further ahead, however, the picture is far less clear. Some analysts believe that demand from developing countries such as India and China will continue to support higher prices, while others say that the outlook will depend on the oil price and the interplay between wheat, corn and soybeans.

The fact that the price of wheat is quoted in dollars per bushel is indicative of the dynamic of the global wheat trade. The US, although not the biggest producer, plays a massive role as the top grain exporter. All the prices quoted above are Chicago Board of Trade (CBOT) wheat futures prices. Most of the wheat futures traded globally are traded on four North American Exchanges – CBOT, now part of the Chicago Mercantile Exchange (CME), the world’s largest commodities exchange; the Kansas City Board of Trade; the Minneapolis Grain Exchange and the Winnipeg Commodities Exchange in Canada. In Europe meantime,

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Pakistani house wives chant slogans against the government to condemn the recent wave of inflation in Lahore, Pakistan on Wednesday, May 14th 2008. The prices of food items have been raised to almost double and a shortage of wheat, rice and other items is making the situation worse for ordinary people in Pakistan. The Pakistani government plans to import 2.5 million tons of wheat to meet the domestic shortfall of wheat crop, which stood at around 22 million tons for the current year. Photograph by K M Chaudary, supplied by Associated Press/PA Photos, June 2008.

the largest flows go through Liffe, which is now part of the NYSE Euronext group, followed by the Hannover Risk Management Exchange. Wheat is also traded on exchanges in China, India, South Africa and Argentina.

Even larger volumes are traded off exchanges, directly between producers and buyers. In Europe the main flows are from the Black Sea region, including Ukraine, Russia and Kazakhstan, into the Middle East and all of North Africa. Odessa, once Europe’s largest grain port, is regaining importance as a key point for wheat sales. In Asia, Japan buys most of its wheat from Canada and the US, while Australia supplies most of the rest of the South Pacific.

For years, wheat was a rather less than exciting investment; trading, for the most part, within a one dollar range. However, the recent credit crunch and the confluence of a number of supply factors has put paid to all that. Nowadays both funds and speculators have discovered wheat as a rather dynamic investment. Once prices began to move higher, the rally fed itself, attracting further investors. John Thompson, analyst at Investec Asset Management, estimates that currently between 25% and 30% of the wheat futures trade is fund and speculator related. He attributes the remaining 70% to producer hedging, either directly, or through big trade houses, such as Cargill, which in the last quarter reported an earnings increase of 86% to $1.03bn.

On the fund front, Investec launched The Investec Enhanced Natural Resources fund in May planning to invest in commodities futures and related equities.

Meanwhile, New York-based Castlestone Management recently launched its Aliquot Agriculture Fund, a fund with a significant allocation in wheat. And ex-Odey hedge fund manager Hugh Hendry is also known to be planning the

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launch of an agricultural fund this summer. A number of other new funds are skirting the grain area, such as Sarasin’s AgriSar fund, which invests in agri-companies such as seed makers, fertilizer producers and tractor companies.

The increasingly popular exchange traded commodities (ETCs)—financial products traded on stock markets like shares—are also seeing higher inflows. ETF Securities in London, one of the biggest providers of ETCs, says that ETFS Wheat is its most popular individual agricultural ETC this year. In the week of May 23rd the inflow into ETFS Wheat was $29.7m, bringing the total in the product for year to date to $97.7m, according to Nicholas Brooks, ETF Securities’ Head of Research. On the structured product front, commodities structured products specialist Dawney Day Quantum launched two commodity products in May after two similar products opened in March this year proved a sell-out. Both new products will include allocations in agricultural commodities and wheat.

A key question right now is whether wheat is likely to continue to be a good investment. Most analysts believe that prices will move either slightly lower for the rest of the year or, at best, sideways. Going forward, they say, it becomes increasingly difficult to assess what the market will do, as farmers tend to respond quickly to changes in crop prices and alternate planting between corn, soybeans and wheat.

While the high demand last year has meant that global stocks were depleted to the lowest level seen in 30 odd years, the amount of wheat planted in the crop year 2008/2009 will result in record harvests, according to Sudakshina Unnikrishnan, a commodity analyst at Barclays Capital.“The big fall in prices was in line with our expectations. High prices (in 2007) provided an incentive for farmers to plant more and we now expect record harvests,”she says.

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Another factor contributing to a sharp price decline this year was Ukraine’s decision in April to lift its export ban on wheat.

Mehdi Chaouky, analyst at Diapason Commodities Management, says there are signs that Russia will also soon lift its export ban. Despite the export restriction still being technically in place, it recently sold wheat for shipment in August at €280 to €290 a tonne free on board (FOB), meaning the buyer is paying on delivery. With one tonne equivalent to 36.7 bushels and the euro at $1.55 this translates into $8.5/bushel. Kazakhstan also said recently that it will no longer restrict exports from this September. Chaouky adds that world wide supply this year is expected to increase by 5.2%.

Even so, he says, “at present I would be long on wheat rather than selling it,”adding that his forecast for this year is for wheat prices between $7.50 and $8 a bushel. High oil prices will affect wheat in more ways than one. The most obvious will be demand for the cheaper alternatives in the shape of biofuels. Although wheat, like corn and sugar, is used to produce bio-ethanol, it is used on a much smaller scale than the other two crops. Only about 2% of the wheat planted in 2007 was used for biofuels. This compares to around 1% in 2005.

Nonetheless, Gabriel Didham, manager of Objective Capital, an independent research company, says that in the current environment “bio-fuel producers making fuel out of crop will find it difficult to continue as they are.”They will continue to face criticism from environmental groups and possibly new political measures over using crops for fuel at times when food supplies are becoming tighter around the globe. One UK bio-fuel consultant says he recently took part in meetings in which government officials found it difficult to continue supporting bio-fuel projects in the UK because of intense media pressure, which he described as unreasonable and uninformed. Objective Capital’s Didham says that in addition, if the global credit crunch persists bio-fuel producers will find it hard to source financing for large scale projects. A number of technologies currently used for biofuels are financially feasible only with subsidies. If that changes, or what is already happening, the crops become too expensive, producers will find it impossible to remain financially viable.

In the US, where the government subsidises corn-based bioethanol producers at least one plant had to close down recently because corn prices overtook ethanol prices on the way up. Similarly, in 2007, most US bio-diesel plants using soybeans found that they could not cover their operating expenses. Soybean futures are trading at around $13.60 a bushel, about twice as much as at the beginning of 2007.

In terms of wheat production, by far the biggest producer world wide is Europe, accounting for 20% of global output, most of which is consumed within the EU. The next biggest producer is China with 17%, also self-sufficient, with a mild bias toward exports, according to Barclays Capital’s Sudakshina Unnikrishnan. India produces 12% of world wheat and consumes about 13%, importing the difference.

America and Russia are almost on a par in terms of production, with Canada, Australia and Ukraine following closely behind. Both the European Union and the US

subsidise their farmers, while Russia, Ukraine, Kazakhstan and a number of other countries restrict exports to make sure that domestic food prices don’t go up.

If the potential easing of these restrictions by CIS countries signifies lower wheat prices, what might prevent them from falling too far is the explosion in demand from the developing world for protein food. Less than half of the world’s grain production is directly eaten by people. In China and India, where local consumers are earning more and living better, food choices are moving away from traditional grain-based staples towards meat. However, to produce one pound of beef requires several pounds of wheat or corn. As all the forecasts indicate that China’s and India’s gross domestic product (GDP) will continue to rise at a much faster clip than that of Europe and the US, food demand in those countries will only continue to grow.

Corn and soybeans are grown on the same land as wheat and depending on the price, farmers rotate between the three. Sometimes they sow one crop earlier in the year and then another later. At $6 a bushel, corn is currently the cheaper option for cattle feed, but that may change if wheat prices continue to decline. This also means that there will be a natural floor in prices below which wheat is not likely to fall. Diapason’s Chaouky argues that high oil prices will also contribute to wheat prices as they affect fertiliser prices, seed prices and transport costs. In 2007 fertiliser prices have more than doubled, cutting into the margins of large farmers and in some cases resulting in lower use.“Farmers are much more careful about how much fertilizers they use, but this could lead to a whole host of new problems like reappearance of viruses and yields going down,” says Chaouky. Some big companies bundle together fertiliser sales with seed sales, another contentious issue.

In the US large amounts of crops are genetically modified. On the upside, they produce higher yields than conventional crops and need less pesticides because the strains are usually insect resistant. However, they require large amounts of fertilizer to sustain them, and, as their seed dies after a season, they engender the additional expense for seed. Farmers who don’t use GM grains typically leave some crop behind for seeds. Most US farmers do not find this an issue but there is huge resistance to it in Japan, and to a lesser extent in Europe.

Reflecting this sensitivity, Diapason, which manages $8.5bn in a range of commodities, offers a series of different funds including a Non-GM Agro Commodity Index Fund that only invests in European and Japanese crops. Wheat is shipped in the same cargo ships that transport coal and iron ore from Australia to China. The cost of hiring large vessels went through the roof last year as Chinese demand has sucked up all the available ships to bring in raw materials into the country. Taken together this means that wheat is not likely to fall back to its long term average price. Although a short term pullback is likely, the next decade is set to see higher average prices compared to the last ten years. Whether this is good or bad depends on which side your bread is buttered on.

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Relentless rises in agricultural commodities prices are changing notions of agri-resource management. Staples such as rice, wheat and animal feed are in short supply; hiking prices and leading, in cases, to riots and the imposition of trade barriers. How to make the best of it?

John Rumsey compares Argentina and Brazil’s approach to agri-business, highlighting the good, bad and the downright ugly in their respective management of agricultural production and resources.

Argentina’s president Cristina Fernandez Kirchner, right, arrives with her husband Nestor Kirchner to a rally at Plaza de Mayo in Buenos Aires on Tuesday, April 1st 2008. Fernandez Kirchner called on striking farmers to end a 20-day old nationwide strike. Photograph by: Natacha Pisarenko; supplied by Associated Press/PA Photos, May 2008.

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BRAZIL/ARGENTINA: HOW TO MAKE HAY WHILE THE SUN SHINES

WHAT NOT TO DO WHEN THE PRICE OF STAPLES RISES

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N THEORY, HUGE price increases should benefit Argentina and Brazil; two of the world’s largest and most competitive soft commodity producers of size.

Brazil has seen its agro-industrial sector thrive as foreign investors rush in to key sectors such as sugar and local companies use the new-found power of local capital markets to leverage up their low cost business models. They have now become internationallyrecognised names and that should stand them in good stead if commodity performance from now on out is more moderate. However, while Brazil has seen money pour into key sectors, Argentina appears to have botched its agribusiness policy. So much so that analysts now predict a reduction in the planting of key crops this season. The contrast between Argentina and Brazil could hardly be starker. Buenos Aires was struggling with food shortages earlier in the year. Moreover, individual farmers and agri-companies appear to be slashing investment as the government seeks to prevent grain exports and micromanage the sector.

Increases in agricultural commodity prices have been unprecedented and fairly universal. By early May corn for July delivery had gained 60% over the year, based on demand for livestock feed, food and biofuels, reaching a record $6.24 per bushel on April 29th. Soy beans are also up; close to 80% over 12 months after reaching a record $15.86 on March 3rd and after farmers in the United States last year planted the lowest crop area in more than a decade. Price increases have been massive and swift; even though in some cases there has been some easing of top line prices. Wheat is a good example. Its price per bushel reached an all-time high of $13.49 on February 27th, but by early May had already fallen by 42%. Even so, the price per bushel is still up 65% on the same time last year. As a result, farmers are rushing to plant more (particularly in efficient markets such as the US).

Moreover, some countries are slapping on trade barriers, holding off buying commodities until prices reach either equilibrium or a significant discount to recent highs.

Obviously and despite some cross trends, this is a highly attractive time for farmers and agro-industrial companies to sweat output.

Argentina is the world’s second largest exporter of corn; is the number three producer of soya and the sixth largest producer of wheat. The fertile pampas and sheer extent of arable country give it unrivalled advantages for growing temperate crops. Not surprisingly, the sector accounts for over 40% of exports.

Brazil on the other hand is the largest exporter and producer of sugar and sugar-alcohol and of beef and chicken, selling to 147 different countries. Both countries are strong in soya and corn, while Brazil majors in sugar: with Brazil’s tropical and sub-tropical climate making it a more suitable grower. Argentina’s temperate climate means it favours wheat and indeed, until recently, Brazil was importing 70% of its wheat from Argentina. Excepting the overlap of soya production, the differences between the

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countries means that a hike in agro production in both should affect prices overly much.

Argentina has not managed to harness the recent price boom in its key exports however; through no fault of its farmers. Thanks to distortive government policies, farmers have actually reduced planting. The Argentine government was one of the first among the leading commodities producers to use export tariffs to try to insulate its domestic market from the impact of surging world prices. Argentine farmers went on strike when the government announced that it would hike the tax rate on exports and introduce a sliding scale that depends on prices and amounts to some 40% at current levels. Later, the government announced temporary export bans, including on wheat.

Farmers announced a truce in early April to allow a breathing space to negotiate. Since then, the government has agreed to meet some of the farmers’ demands but has baulked at others. That raises the prospect of further strikes, exacerbating the chronic lack of investment in the sector at a critical time. The policies of Cristina Kirchner have lead to a worrying drop in spending on investments with sales of tractors and other agricultural equipment down; they slumped 70% in April from a year earlier.

Now, with local wheat prices commanding about half the price of wheat on the international market, Argentina’s farmers are reluctant to sow for this harvest.

Consequently, while the country produced 15.8m tonnes of wheat in the 2007/2008 season, a 15% drop in crops planted is possible this year. Moreover, the double whammy of policy uncertainties and export duties is exacerbated by rising prices for diesel, fertiliser and seeds.

In a sign of just how bad things have become, Bunge (the second-largest exporter of grains in Argentina behind Cargill) declared force majeure on shipments from the country on March 26th in a time of unprecedented prices for agricultural goods.

Brazil has suffered badly from the actions of its southern neighbor and fellow member of Mercosul; the supposed common market of South America. Brazil has been forced to look to North American suppliers to make up a huge wheat shortfall and compelled it to reduce import taxes from Canada and the US. If the reduction of wheat supplies from Argentina proves long-lasting, it will hurt Argentine farmers even more. When (and if) policy is normalised, the country may no longer be considered a reliable supplier.

Although the drop in wheat is certainly causing headaches for Brazilian consumers and contributing to consumer price inflation and a move up in interest rates, the Brazilian government is not replicating the policy mistakes of Argentina. Instead, the Ministry of Agriculture, Livestock and Supply is proudly touting Brazil’s agricultural exports. Exports of agricultural produce rose from $24.8bn to $49.4bn between the beginning of 2002 and the end of 2006, an increase of 99%. Additionally, the 2007/2008 harvest should produce records crops of corn, cotton and soybeans because of a felicitous combination of an increase in areas under plantation and favourable weather.

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Soybeans are forecast at a record 61m tonnes and with record yield levels, for example. Exports of soya were already worth $9.3bn in 2006, while coffee production is up by 143%, cereals and cereal preparations by 123%, and fruit by 91%.

Brazil’s own boom sector is sugar and sugar-ethanol; which is the country’s best performer. Sales are up by 243% over the last five years, with plenty more scope for growth.

Brazil’s sugar exports were valued at $6.2bn in 2006 while sugar-ethanol exports reached $1.6bn, more than twice the value of sugar ethanol exports in 2005.

The massive interest in sugar and sugar-based ethanol has been drawing in private equity firms and leading to a slew of IPOs. Still, it has not been an easy ride for these companies. In 2006, market leader Cosan listed its shares (please refer to FTSE Global Markets, Issue 25, page 30).

Initially, they performed spectacularly. Kicking off at R$18.54, they more than tripled in six months, hitting a high of just over R$63 by May before entering a tail-spin. In 2007, there were a further two listings of sugar companies.

First up was São Martinho which came to market in February raising R$424m and Açúcar Guarani which listed in July raising R$666m. These shares have struggled to find liquidity. Indeed, São Martinho has asked Credit Suisse to investigate ways to stimulate trading. Still, this year signs are more promising and there has been a recovery in the price of sugar.

Other firms interested in biofuels have listed in London on the AIM market. That has been the case with Infinity Bio-Energy. The firm raised $516m through its London initial public offering back in May 2006 and has been on a buying spree since. Clean Energy Brasil pursued a similar path, with a London listing to fund acquisitions in the sector. In addition to the volatile price of sugar, the country had had to grapple with the poor reputation that ethanol has garnered in some quarters, mostly thanks to erroneous comparisons with the highly inefficient US corn-toethanol programme, and criticism that working conditions for sugar cane cutters are dismal. An office has been opened in Brussels to lobby the European Union and attempt to present Brazil’s case that the industry is not leading to deforestation and is improving working practices.

A recent survey by the government farm-date agency Conab gave support to those that say sugar will not lead to mass deforestation. The report shows that about 653,000 hectares of land were turned over to sugar cane last year.

Of this, 65% was taken from pasture, mostly as a result of higher-intensity ranching. Angelo Bressan of Conab says the impact of last year’s expansion of crops is irrelevant.

Brazil has more than 200 million hectares of pasture.

Meaty Returns Brazil has also become the world’s biggest exporter of beef and chicken, selling to 147 different countries with exports rising by 170% over five years. This constitutes a remarkable degree of expansion given the fact that Brazil

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had a trade deficit in meats as recently as the early 1990s.

One of the most remarkable Brazilian success stories in this area has been Grupo JBS Friboi. The São Pauloheadquartered group emerged from nowhere to report $1.8bn in 2006 revenues, a figure that should rise to around $13bn this year with acquisitions.

JBS Friboi was started in 1953 in deeply rural Goiás state in central Brazil. It only started foreign acquisitions in 2001, which were initially confined to Argentina but is now the largest meat producer and exporter in Latin America. The firm has managed to exploit a niche in the giant Brazilian beef industry, which has the cheapest costs in the world and plenty of room for growth thanks to under-utilised pastureland. It has cannily grown both organically and through massive acquisitions as beef consumption rises worldwide. Take-overs include key firms in the US, the world’s top consumer of beef, and in Asian markets such as Japan, which currently bans imports from Brazil. The 2005 purchase of Argentina’s Swift Armour for $200m was followed by the purchase of Swift of the US for $1.46bn last year, giving it production and distribution operations in Brazil, Argentina, the US and Australia. Even so, the firm has a short track record.

That has seen the European Union restrict imports from Brazil on grounds of quality control while concerns continue to swirl over exports that are sourced from companies reportedly encroaching on Amazon basin lands to rear cattle.

Other firms in the meat-processing industry, including the arch-rivals Sadia and Perdigão, are increasingly attracting foreign investors. Nonetheless, the injection of foreign shareholding has not helped Sadia in its efforts to take over Perdigão, and both firms are reportedly thriving.

The strategy for both has been to rapidly expand exports and even open up plants overseas, with the Middle East and other emerging countries seen as prime targets.

Sadia’s results for Q1 2008 saw gross revenues rise 20.3% to R$2.6bn with exports accounting for a whopping 46.7% the revenues. Sadia is embarked on an aggressive plan to become more international and has just opened its first plant in Russia and is expanding in the Middle East. Moreover, countrywide governance issues remain: so much so that the European Union (EU) continues to restrict imports from Brazil on grounds of quality control, while concerns continue to swirl over exports based on meat production out of the Amazon basin lands. Beginning to attracting foreign investors as despite the failure of Sadia’s attempt to take over Perdigão, both firms have been thriving. The strategy for both has been to rapidly expand exports and even open up plants overseas, with the Middle East and other emerging countries seen as prime targets. Perdigão, Brazil’s largest food company, has seen sales increase 11fold since 2003 as demand for Brazilian poultry in Japan, Saudi Arabia and Russia boosted prices. Analysts are expecting the São Paulo-based company to boost profit as much as 83% in 2008.

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Photograph © Jesse-lee Lang/Dreamstime.com, June 2008.

CHOREN & THE

PERFECT FUEL

Bio-fuel makers using sugar, corn and wheat are facing a serious conundrum. While their technologies are meant to help save the planet some of them contribute indirectly to losses of forest to farmland and to higher food prices.

Every cloud has a silver lining, goes the old chestnut, and now it looks like a technology developed before World War II, perfected in East Germany and fine-tuned by German company Choren Industries, could provide an interesting solution. Vanya Dragomanovich reports.

HOREN, AN EXPANDED acronym for Carbon, Hydrogen, Oxygen and Renewable, claims to have managed to circumvent both the problem of rising food prices and the issue of irresponsible land use, two byproducts of the current environmental management debate, by using as a starting point raw material for fuel which has little other purpose. It takes recycled wood, wood chips, sawdust, and straw, and turns this detritus into what it cheerfully describes as “the perfect fuel. If you asked a car manufacturer what would be his perfect fuel he would describe our fuel,”claims Choren chief executive Tom Blades, a British-born former engineer. “It has no sulphur and no aromatic component.The soot that comes out of a diesel car as it drives up the hill comes from such aromatics. Fuel combustion is more efficient enabling the car to drive with more power,”says Blades. On top of that, it reduces harmful emissions by 30% to 40% compared to traditional diesel.

It sounds too good to be true, but in a time of growing stress over available oil supplies Choren claims to have found a sustainable and environmental friendly resource. It has its roots (no pun intended) in the scarcity racked economies of the Iron Curtain countries of the 1940s and 1950s. Living in semi-isolation and trying to avoid ending up dependent on oil imports, East Germany, or DDR as it was called at the time, developed a way of producing fuel out of brown coal; a resource which it had in abundance. The research work underlying the technology was done in the late 1970s by a group of engineers in an institute in the coal mining town of

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Freiberg. As a starting point they used what is called a FischerTropsch process, which facilitates the turning of synthetic gas into fuel. The process had been mooted in the 1930s by two German scientists after which the process is named.

When the Berlin Wall came down and East and West Germany were reunited, the head of the Freiberg institute, Dr Bodo Wolf, left for the private sector. He took some of his brighter colleagues with him and subsequently launched Choren Industries. Since launch, Choren has tested various ways of producing fuel out of bio mass—typically left-over wood or plant material. This April it completed work on its Freiberg plant and has begun what is known in the industry as commissioning; the testing of systems to see if they work as they were designed to.

Initially, inert liquid is put through the pipes and then gradually bio mass is introduced. For a plant of this complexity commissioning can take the best part of a year.

Choren is still months away from pumping out its first drops of fuel. However, it is the first among the so-called second generation of bio-diesel producers that is up and running (well, almost). Blades claims that his company is about five years ahead of any meaningful competitor. World wide, there are a large number of projects, either in planning or construction. There are however only two other second generation plants already producing fuel; both of them bio-ethanol rather then bio-diesel, according to the UK National Non-Food Crop Centre (NNFCC). One is run

by Iogen in Canada and the other by Abengoa in Spain.

In the UK there is at least one second-generation project in the pipeline, but it is still years away from completion.

What some second generation producers, including Choren, will have to grapple with is the fact that there is only limited availability of wood waste in Europe. One solution would be to grow fast-growing wood such as poplar for raw material. Although the land that is used for such wood typically does not compete for the same land as crops, it does however still leave some open questions about possible environmental side-effects.

“Second generation bio-fuels could have a land-usechange impact but we do not know enough about it yet,”

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acknowledges Ian Waller at FiveBarGate Consultants, an expert on biodiesel and renewable energy. He posits that the image of all bio-fuel producers has been unnecessarily tarnished in the media, with producers using crops being lumped into the same category as those using biomass, algae or other raw material. However, the Renewable Fuels Agency, a UK government body, recently published the Gallagher review on the precise impact of bio-fuel use, which should go a long way in establishing hard facts about the environmental effect of such producers.

Choren’s Blades says the Freiberg plant will use around 65,000 tonnes of biomass per year to produce 18m litres of diesel. One third of the raw material will come from waste wood, one third will be recycled wood and one third will be forest residue such as fallen branches.

The whole of Choren’s first year production of 18m litres will be bought and distributed by Shell. Shell’s spokesperson Martin von Arronet says his company will evaluate Choren’s efficiency once the production is up and running and before the next plant is built. “You need a good business case in place, that is very important,”von Arronet adds.

Aviation fuel In the future, the real breakthrough for Choren could happen if it cracks the lucrative aviation fuel market. So far, none of the new batch of alternative fuel producers has succeeded in this segment as aviation fuel has very specific requirements. It must stay liquid at low temperatures and have high energy content by volume, for instance. Despite Richard Branson’s brief excursion into palm oil as plane fuel, which has since been abandoned, there is no ‘bio’ equivalent of kerosene, the petroleum-derived fuel currently used by the aviation industry. Blades maintains however that Choren’s fuel could work.“Aviation is waiting with bated breath because this is the only thing that could make them fly more cleanly,”he says, adding that Choren’s main buyer, Shell, already supplies the aviation industry and is talking to a number of companies who are interested in Choren fuel. Shell’s von Arronet says that a team of Shell’s technicians is working on developing new fuels with Choren and that Choren’s patented biomass gasification technology has the potential for aviation application. But actual bio-kerosene is still several years away as the Freiberg plant is currently not configured for this type of fuel.

Choren is owned by ten private individuals with minority stakes held byVolkswagen, DaimlerChrysler and Shell.Three principal investors put €180m into the company of which €100m went into the Freiberg plant and €80m was spent on developing technologies and salaries. The initial 18m litres will only be a drop in the ocean of European demand, which is constantly being ramped upwards. According to UK government targets set in 2005, for instance, the UK is obliged to include at least 5% of bio-fuels in transport fuels by 2010, explains the NNFCC. In Europe, this target is at 10% and there are plans for it to be even higher.

Choren is banking on higher projected demand and has invested time and effort in developing two large processing

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plants that could produce about 270m litres of bio-fuel per year. Each requires a high level of capital expenditure, requiring investment in excess of €800m.“We are probably beyond the venture capital stage now. We are exploring a number of options,”says Blades.“Raising equity through an IPO could be one of them,” but he acknowledges it is unlikely. He concedes that for the company to go ahead with a listing the Freiberg plant would need to be in full production, and the firm would need to be seen to be making significant progress on engineering a second plant.

According to the company’s official statements, a second plant is in the pipeline and will likely be built in Schwedt, a town 80km east of Berlin. Both plans are likely to be achieved by late 2009 or early 2010, Blades estimates.

The preferred choice of location for Choren’s third plant, however, is not Europe but the US where the company can get hold of much cheaper biomass—estimated at one quarter of the price in Germany—and where the US Department of Energy offers to guarantee 90% of a loan needed to build it. The location will likely be somewhere in the Southern states, says Blades.“The US is very proactive on such projects particularly on the loan front and if things are agreed they tend to move quicker than in Europe,” he explains, adding that getting government approval in Germany took 20 months. Family homes in the US are mainly built of wood which, when houses are demolished, ends up in landfills. If the landfill is within city limits the wood cannot be burned because it affects air quality.

However, Choren’s gasification process can convert wood into synthetic gas and use it either to drive engines or power a turbine and produce electricity. The US produces 60m tons of waste wood a year that could create 12m tons of fuel. On top of that Choren’s technology can use hurricane waste wood, which also ends up in landfills.“The idea is to close the loop [on waste],”says Blades.

Plymouth-born Blades, who has over 20 years of experience in the oil and gas upstream industry and has worked in the Middle East, Nigeria, Borneo and Texas, says that when he got the call to join Choren and when a former colleague explained what the company did, “I was caught hook, line and sinker. I was fascinated by the idea of producing something superior. I thought it would be a challenge not to build a new company but to build a whole new industry,”Blades says.

Whether he made the right move or not is moot. If high oil prices persist, and analysts are currently calling possible prices as high as $200 a barrel, explaining that supply tightness is likely to persist for years, there will be increasing calls for cheaper alternatives. However, if oil prices turn, the environment will become harder for bio-fuel producers as their product will have to compete with regular oil. In either case, Choren is in a fairly good position with production on line several years ahead of nearest competitors. Should prices turn, which seems unlikely in the immediate future, by that stage Choren should have the economies of scale to see them through any downturn. Even with that outcome, calls for cleaner fuels are not likely to abate.

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ASIAN ETFs: READY FOR LIFT OFF?

ETFS’ EASTERN PROMISE Exchange traded funds (ETFs) came to Asia way back in 1999, the year before they reached Europe. Yet today, Europe has 400 ETFs with more than $150bn in assets, while Asian ETFs have attracted only $64bn into about 80 funds. Fragmented markets, multiple regulatory regimes and protectionism have all hampered ETF development in Asia, although changing attitudes are paving the way for faster growth to come. Asia is unique, however, and the market will continue to blaze its own trail, one different from either Europe or the United States. Neil O’Hara reports.

Sammy Yip, vice president and head of ETFs in Asia Pacific at State Street Global Advisors (SSgA).“We act as a sub advisor,” he says,“We help local managers launch the product. We lobby the government and tell them how the ETF should be structured.” Most countries have to change their laws to permit the tax-free exchange of ETF units for baskets of shares in the underlying portfolio, which is critical to the arbitrage trading that keeps an ETF share price tied to its net asset value. Photograph kindly supplied by SSgA, June 2008.

TFS WERE INVENTED in the US, a huge homogeneous equity market that offers deep liquidity no other country can match. However much Asian and European investors craved pan-regional investment vehicles, multiple currencies, incompatible settlement terms and different regulatory regimes on the various stock exchanges presented almost insuperable obstacles. ETFs took off in Europe only after the creation of the euro and the EU’s UCITS directive opened up the cross-border market for mutual funds. ETF sponsors can now organize a fund under the laws of a single jurisdiction and distribute or cross-list it on exchanges throughout the EU. It still is not as seamless as the US, of course. European sponsors have to find local market makers in each country where the ETF trades, so the price in Amsterdam can trade at a premium or discount to either Paris or Frankfurt. European banks still have strong captive distribution channels, too, which means multiple sponsors can attract assets to ETFs that track the same index. Lyxor, iShares and db x-trackers all

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have successful ETFs based on the Dow Jones EURO STOXX 50 Index, for example. In contrast, the first sponsor to market in the US typically grabs virtually all the assets that track a particular index. State Street Global Advisors (SSgA) had the market to itself for years after it launched the original SPDR ETF that tracks the Standard & Poor’s 500 Index in 1993, and although iShares introduced a competing product in 2002 it remains a distant second with a market share of less than 20% despite the strong brand recognition iShares enjoys.

Little wonder that ETFs have been slow to pick up momentum in Asia, which has no equivalent to UCITs and no common currency.“You have ten markets but you do not have one set of regulations that govern the set up and marketing of ETFs,”says Joseph Ho, a managing director and head of ETF sales and marketing in Asia at Lyxor, a leading ETF sponsor and a subsidiary of French bank Société Générale,“Each country requires different qualifications. We have to do it one market at a time.” Ho is leading Lyxor’s push into Asia from his office in Hong Kong.

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version still accounts for the lion’s The major international ETF share of assets), while in Hong Kong sponsors face other regulatory HSBC has used its strong distribution obstacles, too. Ho points out that, with among mandatory pension schemes the notable exception of Hong Kong to raise assets for its own ETF that and Singapore, Asian countries insist tracks the Hang Seng Index in direct that mutual funds and ETFs be competition with the Hong Kong domiciled locally and managed by Tracker Fund, the original Asian ETF domestic firms. Hong Kong and launched by SSgA and the Hong Singapore have long permitted foreign Kong government in 1999. funds to tap local investors, which is Yip has noticed a shift in the why Lyxor has obtained authorisations landscape over the past year or so as in those markets and cross-listed some regulators have softened their of its European ETFs: 12 in Hong Kong opposition to cross-listing. In part, it and eight in Singapore so far, with reflects a recognition that small more to come by the end of this year. markets cannot support the Ho says Lyxor and its international proliferation of ETFs seen in the US, competitors are typically not present Joseph Ho, a managing director and head of ETF where funds now track individual in markets where capital controls sales and marketing in Asia at Lyxor, a leading sectors or narrow style categories. “In restrict access by foreign asset ETF sponsor and a subsidiary of French bank Asia, after you launch the basic large managers. In consequence, local asset Société Générale, says,“You have ten markets cap equity ETF you run out of options,” management firms offering products but you do not have one set of regulations that saysYip,“A mid-cap sector ETF may not based on domestic indices have come govern the set up and marketing of ETFs,”says be well diversified, or if it is the to dominate the market for ETFs in Each country requires different qualifications. underlying stocks may not be liquid countries like China, Malaysia, We have to do it one market at a time.”Ho is enough for you to structure an ETF.” Taiwan and South Korea. Even if local leading Lyxor’s push into Asia from his office in The limitations have encouraged the regulations permit the sale of ETFs Hong Kong. Photograph kindly supplied by development of ETFs for other asset based on foreign indices, a separate Société Générale, June 2008. classes, including foreign currencies, fund for each country isn’t economic.

“I cannot imagine that anyone wants to build an ETF based commodities and bonds. Jane Leung, head of ETF product for on the Standard & Poor’s 500 in China, and then do Asia ex-Japan at BGI, also sees demand for ETFs that cover another fund for Korea, another in Taiwan and another in investments in infrastructure, water and clean energy.“ETFs provide instant access to a diversified basket of securities Malaysia,”Ho says,“That’s not going to happen.”

Although the economics of cross-listing are compelling representing the market, in a very low cost, liquid, and for international ETF sponsors, regulators in each country transparent manner,” Leung says. She expects rapid growth face pressure to protect domestic asset managers. As a result, in the number of ETFs launched in Asia ex-Japan, where and SSgA chose to build its business in Asia in the first instance assets under management shot up 52% in 2007 from $17bn through partnerships with local firms that manage the to almost $26bn.

Asia offers opportunities for specialised products that flagship large cap ETF in each country, according to Sammy Yip, vice president and head of ETFs in Asia Pacific at SSgA. meet local investors’ needs, too. In late May, for example, “We act as a sub advisor,”he says,“We help local managers Daiwa launched an ETF based on the FTSE Shariah Japan launch the product. We lobby the government and tell them 100 Index, which, as its name implies, tracks the 100 largest how the ETF should be structured.” Most countries have to Shariah-compliant companies in Japan. Paul Hoff, the change their laws to permit the tax-free exchange of ETF Tokyo-based managing director of FTSE Asia Pacific, notes units for baskets of shares in the underlying portfolio, which that Daiwa did not list the new ETF in Japan; instead, it is critical to the arbitrage trading that keeps an ETF share chose Singapore, where the local stock exchange is trying to create a regional trading platform for ETFs similar to its price tied to its net asset value.

Even though its name does not appear on the products, already successful effort in futures on Asian markets.

SSgA has played a role in bringing the first ETF to every Singapore also wants to maintain its edge over the Hong major market in Asia. The strategy has given SSgA a strong Kong stock exchange, which has long been the gateway to position in the market because the large cap ETF in each China but is keen to expand its role in the region.

Unlike stock exchanges in the US and Europe, which are country usually attracts the most assets and has the highest trading volume. Flagship ETFs have first-mover advantage, happy to list ETFs but agnostic about their success, Hoff says too; other sponsors have little incentive to offer an ETF based Asian exchanges often play a role in promoting ETFs. “The on the same large cap index. There are exceptions, of course. exchanges see it as part of their national interest to get the ETF Korean regulators worried about Samsung’s dominant markets going,”he says,“It is a way to advertise the nation.” position encouraged another sponsor to launch a duplicate The Singapore stock exchange will be actively involved in ETF based on the KOSPI 100 Index (although Samsung’s marketing Daiwa’s Shariah Japan ETF, for example. Located

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between two large Muslim populations in Malaysia and Indonesia, Singapore sees an opportunity to become the market of choice for Islamic investments. Hoff says Daiwa plans to sell the new ETF through its office in Dubai to Middle East institutions that need Shariah-compliant products, too, and he sees another potential market among Muslims in India’s burgeoning middle class.

A benign regulatory environment is essential but not sufficient to ensure the successful launch of ETFs, according to Hoff. Legacy software developed by local stock exchanges to handle traditional trading in stocks often cannot handle the creation and redemption transactions so crucial to the ETF mechanism. It takes time and money for exchanges to install new software or rebuild the old. On a recent visit to the Philippines, Hoff found the president of the local stock exchange working flat out to get everything in place. “The stock exchange board signed off in April,” says Hoff, “He’s hoping the government will take the necessary action in time to have an ETF run by a Philippine fund manager launched by the end of the year.”

In a broader context, the fragmented market structure in Asia inhibits the development of panAsian ETFs. Each market has different trading hours, settlement periods vary from T+1 to T+4 and the terms of settlement differ. Hoff believes that Asian nations need to harmonise their market practices, which will boost trading volumes even if they cannot do anything about the plethora of currencies. “The investment banks don’t like pan-Asian products because of these issues,” Hoff says, “Investors need pan-Asian products but it’s very difficult to manage the risk in all these different markets.”

Multi-country risk management may be difficult, but it is not impossible—particularly for an investment bank. Fergus Lynch, head of index development at Deutsche Bank in London, sees ETFs as just another distribution channel for products the bank is already selling through its structured finance or

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Fergus Lynch, head of index development at Deutsche Bank in London, sees ETFs as just another distribution channel for products the bank is already selling through its structured finance or program trading desks.“We take those ideas, wrap them up into an index and make them available as an ETF,” says Lynch, who is responsible for devising the new indices. Photograph kindly supplied by Deutsche Bank, June 2008.

Manooj Mistry, head of equity ETF structuring at Deutsche Bank, says anecdotal evidence suggests that institutions still dominate the ETF market in Asia. He points out that retail interest in ETFs came late even in the US, propelled by a switch to fee-based financial advice that has yet to make significant inroads in Asia. Photograph kindly supplied by Deutsche Bank, June 2008.

program trading desks. “We take those ideas, wrap them up into an index and make them available as an ETF,” says Lynch, who is responsible for devising the new indices.

Once a bank has the infrastructure to support ETF creation (including risk controls, links to the exchanges, familiarity with listing procedures, regulations and compliance) it can turn out new products much faster than traditional ETF sponsors who do not have in-house traders available to act as market makers. In Europe, for example, Deutsche Bank’s db x-tracker ETFs accounted for more than half the 150 or so new products launched in the past 12 months, including ETFs based on commodities, the iTraxx credit default swaps index, currencies and the first short index. Lynch expects the pace of innovation to pick up in Asia, too.

Deutsche has the advantage of knowing in advance that products it launches have a natural market among institutions that already use bespoke versions of the investment strategy as clients of the structured finance group.

Although it is always hard for ETF sponsors to track who owns their products, Manooj Mistry, head of equity ETF structuring at Deutsche Bank, says anecdotal evidence suggests that institutions still dominate the ETF market in Asia. He points out that retail interest in ETFs came late even in the US, propelled by a switch to fee-based financial advice that has yet to make significant inroads in Asia.

Mistry sees enormous potential for ETFs in Asia, where both institutional and retail investors have historically had a strong home country bias.

Countries that relax regulations and permit local investors to invest more abroad will be prime targets for ETFs, which offer a cheap and convenient way to get diversified international exposure. “A lot of QDIIs [qualified domestic institutional investors] in China have applied for licenses to invest overseas,” says Mistry, “The easiest way to do it is through an ETF. It is a listed equity on an exchange. It ticks all the boxes regulators care about.” After a slow start, Asian ETFs may be ready for lift-off at last.

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The market reported 2,538,986 transactions in the month, with 207,063 securities available for lending, worth $14,286bn; while 39,246 securities were out on loan, worth $3,747bn.

Group Results (USD): The following table details the aggregated group results for all Performance Explorer participants and provides a high level summary of the activity in particular assets. This table represents a summary of the 309 separate asset classes in the data set.

Security Type

Lendable Assets (M)

All Securities

Balance vs Cash (M)

Balance vs Non Cash (M)

Total Balance (M)

Utilisation (%)

SL Fee (Bp)

Revenue SL Return to Share f rom Lendable SL (%) Assets (Bp)

Total Return Lendable Assets (Bp)

SL Tenure (days) 116

14,282,237

2,153,856

1,593,001

3,746,857

20.73

61.35

74.34

8.98

14.53

All Bonds

6,086,539

1,170,748

769,361

1,940,109

29.37

6.59

19.55

1.98

10.62

130

Corporate Bonds

3,318,380

239,598

139,803

379,401

10.03

-10.33

-54.12

-1.19

2.18

147

Government Bonds

2,656,604

922,082

625,832

1,547,914

54.32

10.73

28.78

6.00

21.47

125

All Equities

8,191,919

983,082

823,628

1,806,711

14.33

120.16

89.04

14.18

17.44

102

Americas Equities

4,581,188

568,070

128,308

696,378

11.93

59.61

70.02

5.51

9.39

126 114

Asian Equities European Equities

830,050

60,017

98,087

158,103

13.94

65.94

85.12

7.50

9.70

2,377,397

265,223

576,277

841,500

19.29

187.00

96.78

34.34

36.54

85

239,897

49,268

6,539

55,807

13.11

93.90

84.08

7.51

11.64

61

72,153

37,245

8,518

45,762

22.84

45.08

72.64

13.94

24.71

43

Depository Receipts Exchange Traded Funds

The following tables show the largest utilisations with the largest balance against securities held by Performance Explorer Lenders:

Equities:

Corporate Bonds:

Top 10 By Utilisation and Lenders Balance

Top 10 by Utilisation and Lenders Balance

Rank

Stock description

Rank

Stock description

1

Handelsbanken XACT OBX

1

Landesbank Baden-Wurttemberg (2.629% 10-Dec-2015)

2

Idera Pharmaceuticals Inc

2

FN 0715A GM

3

iPath ETN MSCI India A

3

Bayerische Landesbank (Lon) (4.785% 23-Jun-2009)

4

Thomson Reuters Corp

4

Pfandbriefbank schw eiz Hypo (2.03% 01-Mar-2012)

5

Bh Macro Ltd

5

Enel Spa (5.04% 18-Sep-2009)

6

Gtx Inc

6

Pfandbriefzentrale Schw eizKantonal (2.75% 20-Jun-2014)

7

Air Berlin Plc

7

Royal Bank Of Canada Europe Ltd (2.18% 01-Jul-2008)

8

Crow n Media Holdings Inc

8

Pfandbriefbank schw eiz Hypo (2.87% 20-Jan-2014)

9

Icahn Enterprises Unt

9

CWHL 0346 4A1 Sr Vari

10

Emcore Corp

10

Programa Independiente Hipotecarias (5.125% 20-Jul-2022)

The Total Income generated by lending a security can be split in two; the amount generated from the fee charged, and the amount generated by reinvesting any cash which is received back as collateral. The following tables detail the securities generating the largest income through a combination of these two components:

Equities:

Corporate Bonds:

Top 10 Securities by Total Return

Top 10 Securities by Total Return

Rank

Stock description

Rank

Stock description

1

InterOil Corp

1

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

2

Thornburg Mortgage Inc

2

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

3

Conn’S Inc

3

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

4

Groupe Eurotunnel Sa

4

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

5

Imergent Inc

5

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

6

Wci Communities Inc

6

Freeport-Mcmoran Copper & Gold Inc (5.5% Undated)

7

Osiris Therapeutics Inc

7

St Jude Medical Inc (1.22% 15-Dec-2008)

8

Nutrisystem Inc

8

RAIT Financial Trust (6.875% 15-Apr-2027)

9

Medis Technologies Ltd

9

Rambus Inc (0% 01-Feb-2010)

10

Corus Bankshares Inc

10

Chesapeake Energy Corp (2.5% 15-May-2037)

SECURITIES LENDING DATA by DATA EXPLORERS

KEY PERFORMANCE EXPLORER STATISTICS as of 7th May 2008

Disclaimer and copyright notice The above data is provided by Data Explorers Limited and is underpinned by source data provided by Performance Explorer participants and also market data. However, because of the possibility of human or mechanical errors, neither Data Explorers Limited nor the providers of the source or market data can guarantee the accuracy, adequacy, or completeness of the information. This summary contains information that is confidential, and is the property of Data Explorers Limited. It may not be copied, published or used, in whole or in part, for any purpose other than expressly authorised by the owners. info@performanceexplorer.com www.performanceexplorer.com

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 8

© Copyright Data Explorers Limited May 2008

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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

88 % Change

-0 3

-0 4

-0 5

-0 7

M ay

-0 8

No v07

M ay

17:16

No v07

-0 6

Index Level Rebased (30 May 03=100)

20/6/08

M ay

No v05

M ay

No v04

M ay

No v03

M ay

MARKET DATA BY FTSE RESEARCH

FT SE

MARKET REPORTS 27.qxd:MARKET REPORTS 27.qxd Page 88

Global Market Indices

5-Year Total Return Performance Graph 700

FTSE All-World Index

600

500

FTSE Emerging Index

400

FTSE Global Government Bond Index

300

FTSE EPRA/NAREIT Global Index

200

FTSE4Good Global Index

100

Macquarie Global Infrastructure Index

0

FTSE GWA Developed Index

6

4

0

-10

FTSE RAFI Emerging Index

2-Month Performance

14

12

10

8

Capital return

2

Total return

0

-2

1-Year Performance

30

20

10

Capital return

Total return

-20

-30

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Table of Capital Returns Index Name

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

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

USD USD USD USD USD USD

2,910 2,448 2,007 903 441 462

253.44 443.31 237.86 599.78 555.39 708.27

6.5 6.4 6.1 9.6 11.3 7.3

-5.1 -4.9 -5.5 -1.5 4.0 -8.5

-3.0 -3.9 -5.3 18.6 18.0 19.8

-3.9 -3.5 -4.1 -2.0 4.5 -10.2

2.56 2.60 2.62 2.15 2.35 1.87

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

USD USD USD USD USD

7,970 6,153 1,817 937 880

425.01 402.12 840.46 791.17 956.81

6.5 6.2 8.7 10.5 6.3

-5.0 -5.2 -2.9 3.0 -10.2

-3.6 -5.7 16.9 16.6 17.6

-3.8 -3.8 -3.5 3.9 -12.4

2.48 2.53 2.13 2.34 1.85

Fixed Income FTSE Global Government Bond Index

USD

717

123.15

-0.5

8.1

13.2

5.9

3.55

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

USD USD USD USD USD

291 189 226 235 56

2264.36 1014.68 2092.01 1131.96 1370.37

2.9 1.6 2.2 1.0 7.6

-9.2 -5.7 -7.7 -5.9 -16.6

-18.8 -19.6 -15.3 -21.1 -12.2

-3.8 -0.5 -3.3 -0.5 -11.2

4.17 5.14 4.94 4.95 2.26

Infrastructure Macquarie Global Infrastructure Index Macquarie Global Infrastructure 100 Index

USD USD

241 100

10730.99 10567.36

6.6 6.5

-3.3 -3.1

3.7 3.6

-3.1 -2.6

3.11 3.12

SRI FTSE4Good Global Index FTSE4Good Global 100 Index

USD USD

706 105

6486.31 5505.53

5.7 5.7

-7.4 -8.8

-8.3 -9.1

-5.7 -7.1

3.17 3.44

Investment Strategy FTSE GWA Developed Index FTSE RAFI Developed ex US 1000 Index FTSE RAFI Emerging Index

USD USD USD

2,007 1,016 362

3949.42 6816.79 7148.98

5.0 4.3 10.6

-7.1 -7.3 -1.7

-8.9 -4.8 23.1

-5.4 -5.6 -1.4

3.10 3.79 2.71

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

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

USD USD USD USD USD USD

2,910 2,448 2,007 903 441 462

299.50 703.09 280.76 732.59 683.12 856.37

7.4 7.3 7.0 10.2 11.8 8.0

-3.6 -3.4 -4.0 -0.4 5.2 -7.6

-0.6 -1.5 -2.9 21.2 20.9 22.0

-2.5 -2.1 -2.7 -1.0 5.6 -9.3

2.56 2.60 2.62 2.15 2.35 1.87

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

USD USD USD USD USD

7,970 6,153 1,817 937 880

479.16 452.94 966.79 917.53 1085.79

7.4 7.1 9.3 11.0 7.0

-3.6 -3.8 -1.8 4.2 -9.3

-1.3 -3.4 19.4 19.4 19.7

-2.5 -2.5 -2.5 5.0 -11.5

2.48 2.53 2.13 2.34 1.85

Fixed Income FTSE Global Government Bond Index

USD

717

169.64

0.1

9.8

17.6

7.1

3.55

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

USD USD USD USD USD

291 189 226 235 56

3265.97 1120.57 2259.77 1248.98 1435.97

3.6 2.4 3.1 1.9 8.1

-7.3 -3.2 -5.3 -3.4 -15.6

-15.7 -15.6 -11.4 -17.4 -10.4

-2.2 1.5 -1.4 1.6 -10.4

4.17 5.14 4.94 4.95 2.26

Infrastructure Macquarie Global Infrastructure Index Macquarie Global Infrastructure 100 Index

USD USD

241 100

12474.33 12317.52

7.7 7.7

-1.5 -1.4

7.0 7.0

-1.5 -1.0

3.11 3.12

SRI FTSE4Good Global Index FTSE4Good Global 100 Index

USD USD

706 105

7616.21 6516.69

7.0 7.0

-5.6 -6.8

-5.5 -6.0

-3.9 -5.2

3.17 3.44

Investment Strategy FTSE GWA Developed Index FTSE RAFI Developed ex US 1000 Index FTSE RAFI Emerging Index

USD USD USD

2,007 1,016 362

4256.06 7382.55 7385.74

6.1 6.0 11.3

-5.3 -5.1 -0.3

-6.2 -1.5 26.3

-3.7 -3.4 -0.2

3.10 3.79 2.71

Table of Total Returns Index Name

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89

% Change

F FT TS SE E A m N FT ort eric h a Am s I FT SE La n FT S SE E A tin eric dex a m A N FT ort eri me Ind ca ric ex SE h s A aI La Am 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 PR 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 IT 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 ta e x o A EI 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 In id Sm 100 dex 0 al l 1 Ind 50 ex 0 In de x

90 % Change

-0 3

-0 4

-0 5

-0 6

M ay

-0 8

No v07

-0 7

17:16

M ay

Index Level Rebased (30 May 03=100)

20/6/08

No v07

M ay

No v05

M ay

No v04

M ay

No v03

M ay

MARKET DATA BY FTSE RESEARCH

F FT TS SE E A m N FT ort eric h a Am s I FT SE La n FT S SE E A tin eric dex m Am a I No e nd FT ric e r ex SE th 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 F T E X l l C nd e 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 nd ex RA A/N A/ e nt N /N AR NA I AR E RE orth Bo nde n I x EI IT No T U Am d In T er No r t 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 27.qxd:MARKET REPORTS 27.qxd Page 90

Americas Market Indices

5-Year Total Return Performance Graph 300

FTSE Americas Index

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

40

35

30

25

20

15

Capital return

10

5

Total return

0

-5

1-Year Performance

60

50

40

30

20

10

Capital return

0

-10

Total return

-20

-30

J U LY / A U G U S T 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 27.qxd:MARKET REPORTS 27.qxd

20/6/08

17:16

Page 91

Table of Capital Returns Index Name

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Indices FTSE Americas Index FTSE North America Index FTSE Latin America Index

USD USD USD

861 725 136

582.46 596.78 1099.27

7.6 6.8 19.1

-3.0 -4.2 18.3

-4.4 -6.3 39.8

-2.5 -3.6 17.0

1.99 1.98 2.10

FTSE Global Equity Indices FTSE Americas All Cap Index FTSE North America All Cap Index FTSE Latin America All Cap Index

USD USD USD

2,785 2,586 199

371.29 354.42 1640.79

8.0 7.4 18.8

-2.6 -3.6 17.5

-4.5 -6.3 38.1

-2.1 -3.1 16.4

1.90 1.89 2.09

Region Specific FTSE LATIBEX All-Share Index FTSE LATIBEX TOP Index FTSE LATIBEX Brasil Index

USD USD USD

36 15 13

4092.30 6052.90 16838.10

25.1 27.7 34.3

17.2 20.2 20.6

40.6 28.3 54.7

11.9 19.8 19.3

na na na

Fixed Income FTSE Americas Government Bond Index FTSE USA Government Bond Index

USD USD

155 135

114.88 112.28

-1.9 -1.8

2.8 3.1

5.4 4.8

0.9 1.1

3.99 3.99

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

USD USD USD USD USD USD

119 95 114 5 134 109

2427.22 1932.38 1114.10 1213.15 162.50 515.42

5.6 5.6 5.3 8.0 6.4 6.0

-0.9 0.1 -1.0 0.3 -1.0 0.2

-16.8 -16.8 -17.3 -12.4 -18.7 -15.8

5.0 6.4 5.2 3.3 4.4 6.2

4.69 4.77 4.79 3.82 5.2 4.7

Infrastructure Macquarie North America Infrastructure Index Macquarie USA Infrastructure Index

USD USD

97 90

9034.82 8936.38

9.3 9.6

-1.2 -1.7

0.4 -0.6

-1.7 -1.9

2.82 2.78

SRI FTSE4Good US Index FTSE4Good US 100 Index

USD USD

148 101

4967.51 4758.90

5.3 5.0

-9.3 -9.5

-13.1 -12.7

-8.0 -8.3

2.29 2.32

Investment Strategy FTSE GWA US Index FTSE RAFI US 1000 Index FTSE RAFI US Mid Small 1500 Index

USD USD USD

669 1,006 1,481

3435.57 5591.32 5591.32

5.2 4.6 17.8

-6.9 -7.6 6.5

-12.2 -12.9 -3.9

-5.8 -6.2 7.1

2.32 2.52 1.81

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Indices FTSE Americas Index FTSE North America Index FTSE Latin America Index

USD USD USD

861 725 136

892.68 969.23 1389.79

8.0 7.2 20.0

-2.0 -3.2 20.0

-2.5 -4.5 43.1

-1.7 -2.8 18.5

1.99 1.98 2.10

FTSE Global Equity Indices FTSE Americas All Cap Index FTSE North America All Cap Index FTSE Latin America All Cap Index

USD USD USD

2,785 2,586 199

408.33 389.10 1939.61

8.3 7.7 19.6

-1.6 -2.7 19.2

-2.7 -4.6 41.3

-1.3 -2.3 17.9

1.90 1.89 2.09

Region Specific FTSE LATIBEX All-Share Index FTSE LATIBEX TOP Index FTSE LATIBEX Brasil Index

EUR EUR EUR

36 15 13

na na na

na na na

na na na

na na na

na na na

na na na

Fixed Income FTSE Americas Government Bond Index FTSE USA Government Bond Index

USD USD

155 135

173.88 169.26

-1.1 -1.0

4.9 5.3

10.2 9.6

2.4 2.5

3.99 3.99

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

USD USD USD USD USD USD

119 95 114 5 134 109

3773.39 2086.34 1231.07 1322.83 3605.50 8854.47

6.3 6.3 6.0 9.1 7.1 6.7

1.6 2.7 1.5 2.3 1.7 2.7

-13.0 -12.9 -13.4 -9.2 -14.6 -11.9

6.9 8.4 7.1 5.3 6.5 8.2

4.69 4.77 4.79 3.82 5.21 4.70

Infrastructure Macquarie North America Infrastructure Index Macquarie USA Infrastructure Index

USD USD

97 90

10424.69 10301.34

9.9 10.1

0.2 -0.3

3.3 2.2

-0.5 -0.7

2.82 2.78

SRI FTSE4Good US Index FTSE4Good US 100 Index

USD USD

148 101

5597.50 5381.89

5.7 5.5

-8.2 -8.5

-11.2 -10.8

-7.1 -7.3

2.29 2.32

Investment Strategy FTSE GWA US Index FTSE RAFI US 1000 Index FTSE RAFI US Mid Small 1500 Index

USD USD USD

669 1,006 1,481

3647.94 5925.76 5925.76

5.6 5.0 21.4

-5.8 -6.5 10.4

-10.3 -11.0 0.3

-4.9 -5.3 10.8

2.32 2.52 1.81

Table of Total Returns Index Name

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 8

91

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

92 % Change

-0 3

-0 4

-0 5

-0 7

M ay

-0 8

No v07

M ay

17:16

No v07

-0 6

Index Level Rebased (30 May 03=100)

20/6/08

M ay

No v05

M ay

No v04

M ay

No v03

M ay

MARKET DATA BY FTSE RESEARCH

FT SE

MARKET REPORTS 27.qxd:MARKET REPORTS 27.qxd Page 92

Europe, Middle East & Africa Indices

5-Year Total Return Performance Graph 500

FTSE Europe Index

400

FTSE All-Share Index

300

FTSEurofirst 80 Index

FTSE/JSE Top 40 Index

200

FTSE Gilts Fixed All-Stocks Index

100

FTSE EPRA/NAREIT Europe Index

0

FTSE4Good Europe Index

FTSE GWA Developed Europe Index

10

5

0

-20

FTSE RAFI Europe Index

2-Month Performance

30

25

20

15

Capital return

0

Total return

-5

-10

1-Year Performance

60

40

20

Capital return

Total return

-40

-60

J U LY / A U G U S T 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 27.qxd:MARKET REPORTS 27.qxd

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Page 93

Table of Capital Returns Index Name

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Indices FTSE Europe Index FTSE Eurobloc Index FTSE Developed Europe ex UK Index FTSE Developed Europe Index

EUR EUR EUR EUR

581 2,049 382 514

220.78 121.52 225.11 214.56

6.1 5.0 4.8 5.5

-12.2 -12.5 -11.9 -12.7

-16.9 -16.3 -16.6 -18.0

-11.1 -12.1 -11.0 -11.4

3.60 3.08 3.61 3.71

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

EUR EUR EUR EUR

1,706 828 1,138 1,587

366.32 394.78 397.41 358.94

5.8 4.8 4.7 5.3

-12.2 -12.4 -11.7 -12.6

-17.9 -17.2 -17.3 -18.9

-11.0 -11.8 -10.7 -11.3

3.51 3.64 3.52 3.60

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

GBP GBP EUR EUR EUR ZAR ZAR USD

665 104 78 100 315 41 167 15

3082.26 6053.50 4876.03 4243.28 1334.39 29939.96 31841.27 1647.01

5.3 6.2 4.6 6.1 5.7 9.2 7.6 22.5

-6.1 -5.9 -13.3 -13.3 -12.6 8.4 5.1 19.5

-10.4 -8.6 -15.4 -16.5 -17.2 16.5 11.2 53.1

-6.2 -6.2 -13.3 -12.6 -11.4 14.1 10.0 14.8

3.73 3.86 4.02 4.04 3.74 2.21 2.42 1.18

EUR EUR GBP

235 411 29

97.81 104.98 147.76

-1.9 -2.0 -0.9

-0.1 -0.6 0.8

-0.8 -1.6 1.0

0.3 -0.1 -1.3

4.72 5.14 4.97

EUR EUR EUR EUR EUR

95 38 47 81 14

1809.96 770.08 2277.72 873.34 865.35

-6.6 -6.5 -4.1 -6.5 -7.2

-12.9 -10.7 -5.6 -12.0 -25.0

-38.0 -34.8 -27.1 -37.6 -43.7

-8.8 -7.3 -1.6 -8.0 -20.5

4.31 4.44 5.02 4.46 1.73

USD

55

14325.42

6.4

-3.7

9.7

-3.3

3.32

EUR EUR

294 55

4288.40 3698.85

5.4 6.1

-13.5 -14.5

-19.9 -19.4

-12.3 -13.0

4.08 4.38

EUR EUR

514 522

3413.84 5274.24

4.1 3.9

-14.4 -14.4

-21.5 -19.6

-13.0 -13.3

4.34 4.41

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Indices FTSE Europe Index FTSE Eurobloc Index FTSE Developed Europe ex UK Index FTSE Developed Europe Index

EUR EUR EUR EUR

581 2,049 382 514

278.45 158.94 280.33 271.24

8.1 7.7 7.4 7.6

-9.9 -10.0 -9.3 -10.4

-13.9 -13.1 -13.6 -15.0

-8.8 -9.5 -8.4 -9.1

3.60 3.08 3.61 3.71

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

EUR EUR EUR EUR

1,706 828 1,138 1,587

434.18 468.95 467.95 426.18

7.7 7.5 7.2 7.3

-10.0 -9.9 -9.2 -10.4

-15.1 -14.2 -14.5 -16.0

-8.8 -9.3 -8.2 -9.0

3.51 3.64 3.52 3.60

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

GBP GBP EUR EUR EUR SAR SAR USD

665 104 78 100 315 41 167 15

3764.83 3587.58 5884.58 5149.03 1785.76 3235.37 3411.19 1678.14

6.0 6.9 7.6 8.2 7.8 9.7 8.1 22.6

-4.2 -3.9 -10.6 -10.9 -10.3 9.6 6.4 20.2

-7.1 -5.1 -11.9 -13.1 -14.1 19.3 14.1 55.7

-4.4 -4.3 -10.6 -10.3 -9.1 15.3 11.2 15.4

3.73 3.86 4.02 4.04 3.74 2.21 2.42 1.18

EUR EUR GBP

235 411 29

160.22 182.53 2049.20

-1.2 -1.2 -0.8

2.1 1.4 3.3

3.6 2.5 6.2

1.7 1.3 -0.1

4.72 5.14 4.97

EUR EUR EUR EUR EUR

95 38 47 81 14

2452.36 848.43 2556.98 947.68 895.94

-4.9 -4.8 -1.6 -4.8 -6.1

-10.6 -8.3 -2.3 -9.7 -24.1

-35.5 -32.0 -23.6 -35.0 -42.9

-6.6 -5.0 1.9 -5.7 -19.7

4.31 4.44 5.02 4.46 1.73

USD

55

16959.40

8.3

-1.7

13.6

-1.3

3.32

EUR EUR

294 55

5327.19 4643.34

7.5 8.2

-11.1 -12.0

-16.7 -16.0

-9.9 -10.5

4.08 4.38

EUR EUR

514 522

3774.70 5770.83

6.4 6.2

-11.7 -12.0

-18.2 -16.4

-10.3 -10.9

4.34 4.41

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

Table of Total Returns Index Name

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;˘ J U LY / A U G U S T 2 0 0 8

93

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

94 % Change

-0 3

-0 4

-0 5

-0 7

M ay

-0 8

No v07

M ay

17:16

No v07

-0 6

Index Level Rebased (30 May 03=100)

20/6/08

M ay

No v05

M ay

No v04

M ay

No v03

M ay

MARKET DATA BY FTSE RESEARCH

FT SE

MARKET REPORTS 27.qxd:MARKET REPORTS 27.qxd Page 94

Asia Pacific Market Indices

5-Year Total Return Performance Graph 2000

1800

FTSE Asia Pacific Index

1600

1400

FTSE/ASEAN 40 Index

1200

1000

FTSE/Xinhua China 25 Index

800

FTSE Asia Pacific Government Bond Index

600

400

FTSE IDFC India Infrastructure Index

200

0

2-Month Performance

20

15

10

5

Capital return

0

Total return

-5

-10

1-Year Performance

50

40

30

20

10

0

Capital return

-10

Total return

-20

-30

J U LY / A U G U S T 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 27.qxd:MARKET REPORTS 27.qxd

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Page 95

Table of Capital Returns Index Name

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

USD USD USD USD USD USD USD

1,327 859 468

283.52 485.86 96.82

7.5 5.9 16.5

-7.0 -9.7 -8.0

1.4 9.5 -19.6

-4.8 -8.9 -4.6

2.25 2.73 1.60

3,285 1,983 1,302

497.66 647.54 341.34

7.1 5.6 15.9

-7.5 -10.3 -8.2

1.0 8.5 -19.8

-5.4 -9.7 -4.7

2.25 2.72 1.61

USD USD MYR TWD CNY HKD

156 40 100 50 1,032 25

466.00 9450.39 8269.02 6173.39 8257.47 22287.23

1.8 2.7 0.6 1.5 -6.4 11.9

-3.1 -0.2 -9.2 -0.7 -21.0 -17.3

7.6 7.3 -6.7 5.2 -11.5 32.3

-5.5 -3.2 -13.0 0.2 -30.8 -12.6

3.12 3.14 3.01 3.63 0.70 1.70

USD

255

100.05

-0.8

13.5

19.9

9.4

1.75

USD USD USD USD USD

77 38 51 40 37

2024.53 1554.19 2437.46 1167.52 1407.18

6.2 6.8 2.4 3.0 8.4

-17.2 -14.8 -18.7 -14.8 -18.8

-15.3 -14.5 -10.0 -21.4 -10.6

-12.0 -8.8 -16.2 -10.1 -13.2

3.55 6.5 5.06 5.87 2.00

IRP IRP

85 30

1210.82 1281.85

-3.7 -4.8

-27.0 -29.2

15.9 20.9

-33.2 -34.9

0.50 0.57

JPY

194

5348.16

18.0

-6.2

-17.9

-3.2

1.58

USD MYR JPY

100 30 100

6144.19 10329.14 1475.93

8.0 2.7 16.1

-3.8 -5.9 -8.5

3.7 9.7 -18.0

-1.2 -11.4 -6.5

1.99 2.29 1.69

JPY AUD AUD SGD JPY JPY HKD

468 112 57 16 298 1,028 50

3788.87 3863.41 5849.94 7476.10 5310.29 5230.57 7265.17

17.6 3.6 3.1 4.7 16.9 9.7 11.1

-6.8 -16.6 -14.4 -4.2 -6.2 -13.1 -15.2

-18.8 -14.3 -13.2 -7.3 -17.4 -21.0 29.1

-3.6 -13.3 -12.2 -4.4 -3.8 -12.4 -11.3

1.64 5.42 5.39 3.79 1.67 3.46 2.37

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

USD USD USD USD USD USD USD

1,327 859 468

328.25 611.85 116.82

7.9 6.5 16.6

-5.9 -8.5 -7.1

3.7 12.5 -18.3

-3.8 -7.8 -3.7

1.86 2.45 1.17

3,285 1,983 1,302

555.30 762.27 364.43

7.5 6.1 16.0

-6.4 -9.1 -7.3

3.2 11.4 -18.5

-4.4 -8.6 -3.8

1.84 2.37 1.17

USD USD MYR TWD CNY CNY

156 40 100 50 1,032 25

579.60 10518.56 8818.82 7368.60 8941.68 27382.24

2.8 3.7 1.1 1.5 -6.1 12.8

-1.5 1.4 -7.9 -0.7 -20.7 -16.6

11.1 10.9 -4.0 8.8 -10.9 34.4

-4.1 -1.9 -12.0 0.2 -30.6 -11.9

2.71 2.81 2.50 3.38 0.55 1.49

USD

255

117.72

-0.6

14.4

22.5

10.0

1.75

USD USD USD USD USD

77 38 51 40 37

2699.47 1727.34 2630.74 1311.61 1463.64

6.5 7.0 2.8 3.3 8.8

-15.8 -13.4 -16.9 -12.4 -18.0

-12.6 -11.6 -6.1 -17.2 -9.0

-10.9 -7.7 -14.9 -8.2 -12.5

2.85 5.0 3.86 4.66 1.53

IRP IRP

85 30

1216.63 1289.05

-3.7 -4.8

-26.8 -29.0

16.5 21.5

-33.1 -34.8

0.51 0.66

JPY

194

5760.77

18.0

-5.3

-16.6

-2.3

1.24

USD MYR JPY

100 30 100

6429.46 11081.61 1541.33

8.3 3.3 14.5

-2.8 -4.9 -8.9

5.8 12.4 -17.8

-0.3 -10.6 -7.0

1.73 2.59 1.24

JPY AUD AUD SGD JPY JPY HKD

468 112 57 16 298 1,028 50

3939.37 4368.89 6614.35 8153.54 5505.70 5589.59 7524.42

17.7 4.3 4.0 6.6 17.0 11.0 12.2

-5.9 -14.7 -12.2 -2.1 -5.2 -11.4 -14.2

-17.5 -10.4 -8.7 -3.4 -16.0 -18.6 31.9

-2.6 -11.5 -10.1 -2.7 -2.9 -10.8 -10.3

1.23 3.77 4.14 2.96 1.26 2.65 2.05

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

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 • J U LY / A U G U S T 2 0 0 8

95

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Page 96

CALENDAR

Index Reviews July – October 2008 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

1-Jul 8-Jul 10-Jul Mid Jul Mid Jul

TOPIX FTSE Xinhua Index Series TSEC Taiwan 50 PSI 20 OMX H25

30-Jul 18-Jul 18-Jul 31-Jul

23-Jun 30-Jun 30-May

Mid Jul 8-Aug 15-Aug 2-Sep

31-Jul 19-Sep 5-Sep 29-Aug

30-Jun 30-Jun 30-Jun 31-Jul

Early Sep Early Sep

SMI Family Index Hang Seng MSCI Standard Index Series FTSE Global Equity Index Series (incl. FTSE All-World) ATX CAC 40

Free float weight periodic review Annual Review Quarterly & annual review Semi-annual review Semi-annual review - consituents, Quarterly review - shares in issue Annual review Quarterly review Quarterly review

19-Sep 30-Sep

30-Jun 31-Aug

19-Sep

29-Aug

Early Sep

S&P / TSX

3-Sep 5-Sep

DAX S&P / ASX Indices

19-Sep 19-Sep

29-Aug 31-Aug

7-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep

S&P MIB NZSX 50 FTSE UK Index Series FTSE / JSE Africa Index Series FTSE Asiatop / Asian Sectors FTSE Global Equity Index Series (incl. FTSE All-World) FTSE techMARK 100 FTSEurofirst 80 & 100 FTSEurofirst 300 FTSE Euromid FTSE eTX Index Series FTSE Multinational FTSE Global 100 FTSE EPRA/NAREIT Global Real Estate Index Series FTSE4Good Index Series NASDAQ 100 S&P US Indices S&P Europe 350 / S&P Euro S&P Topix 150 S&P Latin 40 S&P Asia 50 S&P Global 1200 S&P Global 100 FTSE NAREIT US Real Estate Index Series FTSE NASDAQ Index Series S&P MIB DJ STOXX DJ STOXX DJ STOXX Blue-Chip Russell US Indices TOPIX TSEC Taiwan 50

Annual Review / Japan Semi-annual review / number of shares Annual review of free float & Quarterly Review Quarterly review - constiuents, shares & IWF Quarterly review/ Ordinary adjustment Quarterly review - shares, S&P / ASX 300 consituents Semi-annual constiuents review Quarterly review Quarterly review Quarterly review Semi-annual review

19-Sep 24-Sep 30-Sep 19-Sep 19-Sep 19-Sep

29-Aug 17-Sep 31-Aug 11-Sep 3-Sep 31-Aug

Annual review / Developed Europe Quarterly review Annual Review Quarterly review Quarterly review Quarterly review Annual review Quarterly review

19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep

29-Jun 31-Aug 29-Aug 29-Aug 29-Aug 29-Aug 30-Jun 29-Aug

Quarterly review Semi-annual review Quarterly review / Shares adjustment Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review Quarterly review Quarterly review - shares & IWF Quarterly review Style Review Annual review Quarterly review - IPO additions only Free float weight periodic review Quarterly review

19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 24-Sep 19-Sep 19-Sep 19-Sep 30-Sep 30-Oct 17-Oct

27-Mar 29-Aug 31-Aug 5-Sep 5-Sep 5-Sep 5-Sep 5-Sep 5-Sep 5-Sep 29-Aug 29-Aug 17-Sep 19-Aug 1-Sep 1-Sep 31-Aug

10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 12-Sep 13-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 14-Sep 14-Sep 17-Sep 17-Sep 17-Sep 17-Sep 19-Sep 1-Oct 9-Oct

30-Sep

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

96

J U LY / A U G U S T 2 0 0 8 • F T S E G L O B A L M A R K E T S

GM EDITORIAL 27.qxd:Issue 27

20/6/08

15:57

Page IBC1

Daiwa FTSE Shariah Japan 100 Daiwa FTSE Shariah Japan 100 (the "Daiwa ETF") seeks to track the performance of the FTSE Shariah Japan 100 Index that measures the investment return of the largest and most liquid Shariah compliant listed companies in Japan.

The Daiwa ETF allows both Islamic and conventional investors an instant access to the top 100 Shariah compliant Japanese companies, by market capitalisation.

Shariah screening is undertaken by the leading global Yasaar Limited.

For more information please visit

www.daiwa-am.com.sg

email: etf@daiwa-am.com.sg

tel: 65 6223 6712

Daiwa Asset Management(Singapore)Ltd. (Company Registration Number : 199400016R)

A full description of the Daiwa FTSE Shariah Japan 100 (the "DaiwaETF") is set out in its Prospectus issued by Daiwa Asset Management (Singapore) Ltd. (Company Registration No. 199400016R), the manager of the DaiwaETF (the "Manager"). A copy of the Prospectus of the DaiwaETF may be obtained from the Manager or any of its appointed participating dealers and is available from the Manager's website at www.daiwa-am.com.sg . The value of the Units and the income accruing to the Units, if any, may rise or fall. Potential investors should read the Prospectus of the DaiwaETF before deciding whether to invest in the Units and should seek advice from a financial adviser regarding the suitability of the DaiwaETF, taking into account the specific investment objective, financial situation or particular needs of each person before making a commitment to purchase the Units. Investors may only redeem units with the Manager under certain specified conditions. The listing of the Units does not guarantee a liquid market for the Units. The information on this page does not constitute the distribution of any information or making of any offer of solicitation by anyone in any jurisdiction in which such distribution or offer is not authorised or to any persons whom it is unlawful to distribute such document as or any offer of solicitation.

The Manager has been licensed by FTSE International Limited to use the FTSE SHARIAH JAPAN 100 Index in relation to this product.

20/6/08

15:57

Page OBC1

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GM EDITORIAL 27.qxd:Issue 27