FTSE Global Markets by FTSE Global Markets

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DIAMONDS TAKE THE ROUGH WITH THE SMOOTH ISSUE FOUR • NOVEMBER/DECEMBER 2004

So Proper So PRIT Lehman Brothers’ new play Focus on fund of hedge funds

Tellier

tries to lift Bombardier TRANSITION MANAGERS RIDE A RISING TIDE OF BUSINESS

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Outlook EDITORIAL DIRECTOR:

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

Bill Stoneman, David Simons, Ian Williams, Neil O’Hara, Art Detman, David Burrows, Andrew Cavanagh, Angela May Ward, Karen Jones. FTSE EDITORIAL BOARD:

Mark Makepeace [CEO], Peter de Graaf, Paul Hoff, Jerry Moskowitz, Paul McLean, Stuart Ives, Marianne Huve-Allard, Sandra Steel, Carl Beckley, Jamie Perrett, Claire Spraggett, Tim Nicholls SALES DIRECTOR:

Paul Spendiff OVERSEAS REPRESENTATION:

Adil Jilla [Middle East and North Africa], Faredoon Kuka, Ronni Mystry Associates Pvt [India], Ferda Akyürek [Turkey], Harold Leddy & Associates [United States] PUBLISHED BY:

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Air Business Ltd, 4 The Merlin Centre, Acrewood Way, St.Albans, Herts. AL4 OJY FTSE Global Markets is published six times a year. No part of this publication may be reproduced or used in any form of advertising without prior permission of FTSE International Limited or Berlinguer Ltd. FTSE Global Markets is published by Berlinguer Ltd on behalf of FTSE International Limited. [Copyright © Berlinguer Ltd 2004. All rights reserved.] FTSE™ is a trade mark of the London Stock Exchange plc and the Financial Times Limited and is used by FTSE International Limited under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by FTSE International Limited for any errors or omissions or for any loss arising from use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or its licensors. Redistribution of the data comprising the FTSE Indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited or Berlinguer Ltd. ISSN: 1742-6650 Journalistic code set by the Munich Declaration. ADVERTISING AND SUBSCRIPTION ENQUIRIES:

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FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2004

e pride ourselves on our strong programme of institutional profiles and this issue is no exception. Art Detman analyses some of the tough choices facing Charles Schwab in returning to the chief executive’s slot at the Schwab Corporation. We also look at the not at all prim but still rather proper Pensions Reserve Investment Trust Fund [PRIT], which was established to invest the assets of the Massachusetts State Teachers and Retirement System [MASTERS]. David Simons talks to PRIT’s recently incoming executive director, Michael Travaglini about the Fund’s strategy and outlook Karen Jones meanwhile profiles upcoming hedge fund of funds, Focus Investment Group, about its investment strategies at home and strategic alliances abroad. Focus is well-known as an innovative hedge fund. It lays claim to have pioneered the specialist-driven "multi-manager" concept. In these tight days for hedge funds, it also boasts an edge in other areas, such as technology. We find out how and why Focus’s strategy works. Our cover story is all about Montreal-based Bombardier Inc., the world’s third largest transportation and aerospace company. Bombardier has managed a tremendous business turnaround in its transportation division. But can it achieve the same success in its regional jet and business jet markets? The Debt Report dominates this issue. The certainty of higher interest rates on both sides of the Altantic is beginning to cloud the outlook for fixed income investors. We examine the likely impact of a downturn in the market. The prognosis for other collateral classes is better however. Issuance volumes of variable rate instruments; high-yield and emerging market bonds, for example, are set fair to rise. Andrew Cavenagh reports on the reasons for the growing popularity of these asset classes. The report also looks at the reasons why the use of asset-backed securities (ABS) as collateral is still under consideration. Our coverage of the financial services sector in this issue ranges widely. It includes an analysis of the importance of automation in the corporate actions sector, the impact of consolidation in the sub-custody market and key trends in transition management. Enjoy. Four issues into our long term publishing programme we are eager to canvass your opinions on the usefulness and quality of FTSE Global Markets. This magazine is designed for you and we need to know if you are satisfied with its content. Your feedback is valuable and essential. It will help us ensure that we deliver a superior and constructive product to you. At the very back of this magazine is a questionnaire. We would be most grateful if you could kindly spare a few minutes of your time to answer some simple and pertinent questions about the magazine and send them back to us: either in the mail or by fax. We will make full use of your replies and it will help us focus on the issues of real interest to you. Thank you for your time and attention.

Francesca Carnevale, Editorial Director, October 2004

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Contents COVER STORY TELLIER RAISES BOMBARDIER’S GAME ................................Page 33 Bombardier has endured great highs and lows this year. A turnaround in its transportation business was matched by the axing of thousands of jobs as it closed excess capacity in the search for profit. Bombardier fronted both situations with calm aplomb. Francesca Carnevale explains how it was done.

REGULARS MARKET LEADER

WHY INTEREST RATE RISES ARE INEVITABLE ..................Page 6

IN THE MARKETS

..............................Page 12 FMC’s Terry Drewett outlines the shift towards new matching models.

REGIONAL REVIEW

Russia builds up a new issue pipeline........................................................................Page 13 Supersectors debut in new European indices............................................................Page 14 FSC: The emerging face of Taiwan’s new regulator ................................................Page 15 BGI’s new China ETF ....................................................................................................Page 18 The NYSE goes all electronic ........................................................................................Page 20 Toronto’s exchange hits the road ................................................................................Page 24 Why you should locate in the Middle East................................................................Page 25

EQUITY REPORT

................................................................................Page 42 Charles Schwab tries to find new solutions for some gnawing problems.

RBS analyst Lucy O’Caroll on the lingering impact of a soft spot in the global economy.

THE SEARCH FOR CENTRAL MATCHING

THE LION IN WINTER

FIXED INCOME CHARTS A NEW COURSE

..........................Page 63 Andrew Cavenagh reports on the impact of a likely downturn in the market.

DEBT REPORT

EUROPEAN HIGH-YIELD DEBT HEATS UP ..........................Page 67 Andrew Cavenagh explains why this sector is set for growth.

ABS: A NEW COLLATERAL CLASS?

............................................Page 71 Max Illis at JP Morgan explains the benefits of this emerging asset class.

RIDING A SECOND WAVE OF BUSINESS

ALTERNATIVES

..............................Page 78 Karen Jones profiles fund of hedge funds Focus Investment Group.

SECTOR PROFILE

..............................................................Page 38 Neil O’Hara reports on an industry transformation.

DIAMONDS IN THE ROUND

PORTFOLIO DIVERSIFICATION

INDEX REVIEW

........................................................Page 38 Xavier Timmermans at Fortis Investments explains the benefits. Market Reports by FTSE Research ..............................................................................Page 87 Calendar ..........................................................................................................................Page 95

NOVEMBER/DECEMBER 2004 • FTSE GLOBAL MARKETS

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Contents FEATURES SO PRIM, SO PROPER, SO PRIT

......................................................Page 28 Dave Simons reports on the new outlook of Boston’s leading public sector pension fund and talks to incoming executive director Michael Travaglioni about the vagaries of modern day investment theory and practice.

WHY LOCAL CALLS ARE BEST

........................................................Page 46 What is the recipe for success for companies planning to expand into Eastern Europe to take advantage of investment opportunities? Francesca Carnevale reports on some of the answers found in Eastern Europe’s telecommunications sector.

HAVE PORTFOLIO WILL TRAVEL

..................................................Page 50 In the first of a two-part series Francesca Carnevale looks at the changing face of transition management and the emerging benefits for asset owners. In this issue we look at the key trends underlying the provision of transition services.

CORPORATE ACTIONS: THE WAY AHEAD

........................Page 54 The corporate actions sector has been highlighted with monotonous regularity in recent years as an area requiring urgent action to mitigate inherent risks. Is automation the answer? Rekha Menon reports.

LEHMAN BROTHERS COMES TO THE TABLE

......................Page 59 Bill Stoneman rates Lehman Brothers’ bid for recognition beyond its traditional franchise in fixed income.

SUB CUSTODY COMES INTO CHECK

..........................................Page 74 The big players are now trying to take over smaller, local houses. Is this good or bad news for sub-custodians and purchasers of custody services? Stuart Fieldhouse tries to find some answers.

NOVEMBER/DECEMBER 2004 • FTSE GLOBAL MARKETS

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Market Leader MARKET LEADER

The impact of a lingering soft spot in the global economy The global economy has put in its best performance this year since the end of the 1990s’ boom. It is hardly surprising, following an extended period of exceptionally loose fiscal and monetary policy. More recently though, the United States [US] economy has hit a soft patch. Alan Greenspan says this is down to transient factors – primarily high oil prices – and that recovery is already regaining traction. By implication, US interest rates have further to rise. Currency markets appear to believe Greenspan, supporting the dollar in response to anticipated yield differentials. But bond markets have taken a different view, with yields falling during the past few months. Which of the markets is right? Lucy O’Carroll, head of UK macroeconomics, Royal Bank of Scotland Group reports. N THE FIRST half of this year, the global economic recovery appeared to be bedding in. The US was finally generating employment growth to match its gains in real gross domestic product [GDP]. Japan was surprising everyone as it reported upside growth of 1.4% in the first quarter of the year, while the Chinese economy was still growing at a near10% rate. Even the Eurozone showed signs of life, with GDP expanding at its fastest rate in three years.

As is often the way with these things the Fed began raising rates just at the point when the recovery hit a soft patch. US GDP growth slowed to below 3% [annualised] in the second quarter [Q2], well below the peak rate of 7.4% in 2003 Q3, reflecting weaker private consumption on the back of disappointing employment figures. The slowdown was even more pronounced in Japan. Here GDP growth fell to 0.4% from a revised 1.6% in the first quarter of the year. In the Eurozone meantime overall GDP growth eased back to 0.5%.

Do bullish central bankers mean higher rates to come?

Lucy O’Carroll, of the Royal Bank of Scotland Group

Developed-economy central banks began raising interest rates in response to the recovery. The Bank of England was among the first to act over concerns about the impact of narrowing capacity constraints on inflation, and has raised interest rates five times in the past ten months. The US Federal Reserve Bank [the Fed], in contrast, waited until June of this year to make its first rate move, leading to concerns that it was “behind the curve” – raising interest rates too slowly to contain inflationary pressures.

Any soft spot probably owes more to the oil price spike, and one-off factors such as former-president Reagan's funeral, than it does to any fundamental weakness in the global economy. The latest economic data has been positive, although retail sales in the US were disappointing in August. The Fed shares the same view, arguing that the US economy “appears to have regained some traction” in the statement accompanying its decision to raise interest rates for the third time this year, in September. Indeed, Fed chairman Alan Greenspan has made it clear that he will continue raising rates towards more “normal” levels – presumably somewhere between 4-5%, in line with long-run nominal GDP growth [see Chart 1]. The European Central Bank [ECB] has also taken a bullish attitude towards the prospects for recovery,

NOVEMBER/DECEMBER 2004 • FTSE GLOBAL MARKETS

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Market Leader FORECASTING

recently upgrading its forecast for Eurozone growth next year. In its latest statement on interest rates, the ECB has promised to “remain vigilant with regard to all developments which could imply risks to price stability over the medium term”. While this may sound like impenetrable central bank-speak, many analysts – including ourselves – have brought forward their first forecast rise in Eurozone interest rates. We now expect this to happen by March 2005. Japan’s central bank governor has also spoken about the country’s economy gathering momentum. The Bank of England is one of the few exceptions to this bullish, ratetightening outlook. Compared with other central banks, the Bank of England’s Monetary Policy Committee [MPC] is already well advanced in the tightening cycle. Even at the low point for UK interest rates last year, base rates were already significantly higher than in other developed economies. In the minutes of its latest meeting, the MPC noted that the pace of GDP growth appeared to be slowing, recent labour-market data had been

surprisingly weak, and some downside risks had perhaps increased. As a result, though another rise in the United Kingdom’s [UK’s] rates could be on the cards for November. It may well be the last in this cycle.

Currency market responses – the outlook for exchange rates So far, foreign exchange markets seem to have bought the Fed's argument that the soft patch is temporary. Sterling has recently fallen to a seven-month low against the Euro and a three-month low against the US dollar. Markets appear to have concluded that while Eurozone and US interest rates remain on an upward path, UK rates are close to their peak – so narrowing expected interest rate yield differentials with the US and Eurozone economies [see Chart 2]. Yield spreads should continue to underpin exchange rate movements for the immediate future. The dollar is likely to gain some further ground against both the Euro

Chart 1: Long-run nominal GDP growth and outlook 7.0

Forecast 6.0

5.0

GDP Growth Rate

United Kingdom 4.0

3.0

Eurozone

2.0

United States 1.0

Year

06 20

05 20

04 20

03 20

02 20

01 20

0.0

and Sterling during the next few months, provided the US employment and consumer demand data improve and the Fed continues to raise rates. By early 2005, however, yield spreads are likely to be a less dominant factor. We expect the dollar to decline against all the major currencies next year, as uncertainty about the extent and pace of US policy tightening increases and concerns at the size of the US fiscal and current account deficits grow. Our forecast shows the dollar at around $1.86 against Sterling [from around $1.79 at present] and $1.30 against the Euro [from around $1.22 at present] by end-2005.

Bond markets – taking a different view While currency markets have been taking a positive view of the prospects for US activity and interest rates, bond markets have been telling a different story. With the economy growing, the Fed raising interest rates and the price of oil rising, conventional wisdom suggests that US Treasury yields should also be increasing. However, after picking up initially in response to the more positive signs from the US economy, 10-year Treasury bond yields fell back from 4.7% at the end of June to dip briefly below 4% following the Fed’s September rate decision [see Chart 3]. Why are bond markets behaving this way? Recent buying activity may have had an impact, as Asian central banks have intervened in foreign exchange markets to prevent their currencies from rising against the dollar. Although central banks' dollar purchases have slowed, Asian acquisition of Treasuries [by both central banks and the private sector] has continued. The Bank of Japan, for example, stopped purchasing US dollars in March, but Japanese investors still acquired as much as

Source: Datastream/RBS Group Economics

NOVEMBER/DECEMBER 2004 • FTSE GLOBAL MARKETS

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Market Leader FORECASTING

$15bn worth of Treasuries during the summer months. This trend could continue for some time to come, although the sheer size of the bond market suggests that such purchases may have an impact only at the margin. In the past, yields have fallen when rates were increasing, but only when investors have taken the view that rates are unlikely to rise much further. The US bond market has had a confusing time in recent months. The mixed run of macroeconomic data [especially the employment statistics], geopolitical concerns, November's US Presidential election and rising oil prices have all played a part. Furthermore, this is not a normal ratetightening cycle. The Fed usually begins to act when inflationary pressures emerge, with rising rates helping to subdue economic activity. This time around, the Fed has kept interest rates very low for a very long time in order to head off deflationary pressures, but this has had at least two side effects. First, continued strong consumer demand has only widened the US current account deficit. Second, asset prices in several markets

Chart 2: Interest rate differentials: Sterling/Dollar/Euro 1.95 Sterling weaker

1.80

$/£

1.65

1.50 /£

1.35 Sep-02

Nov-02 Feb-03 May-03

Jul-03

[the housing market being one] have risen to what appears to be unsustainable levels. Perhaps these risks to the global recovery have also been weighing on markets’ minds. If, as we think most likely, the “soft patch” is temporary, the bond market should gradually return to more

7.00

6.00

5.00

4.00

Yield on 10 Year US Treasury

04 p-

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02 Se

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Source: Datastream

Jan-04

Mar-04 Jun-04

Sep-04

Source: Datastream

Chart 3: Long term interest rates

3.00

Oct-03

“normal” tightening-cycle behaviour, reflecting the same sentiment as foreign-exchange markets. The 10year US Treasury yield should grind slowly higher, to around 4.5% this year and 5% next.

Conclusion The world economy is on track to grow by around 3.5% this year – its fastest rate since the end of the late 1990s’ boom, despite a 40% rise in oil prices. If, however, the soft patch were to continue, the Fed’s rateraising stance could moderate. After all, this has been a different sort of recovery – one built on borrowing and asset-price [mainly housing market] gains. Questions remain over the impact of rising interest rates, never mind the sizeable uncertainties relating to oil and the US current account deficit. So could current bond-market sentiment about the prospects for the coming months be proved right in the end? We think it is unlikely, but we will have to wait and see.

NOVEMBER/DECEMBER 2004 • FTSE GLOBAL MARKETS

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In the Markets

The search for central matching It is almost the 13th anniversary of the celebrated ‘Fidelity breakfast’ where Electronic Trade Confirmation [ETC] came into being. At the breakfast, the original post-trade process model, that connects broker and investment manager was proposed and drawn out on a table napkin. That napkin still exists today and the design on it is still used as the de-facto model for electronic trade communications. But thirteen years on, things must change. Terry Drewett, business development manager of FMCNet, outlines new efforts to shift the industry towards a new model. N SPITE OF the emergence of the ETC concept some thirteen years ago, it has taken some while for firms to automate the actual post trade process.As a result, all parties continue to remain exposed to operational risk. Even these days, rekeying remains the norm for many firms. According to last year’s Gartner Group report on ETC, 42% of all trades are processed manually and re-keyed at least twice. The need for automation has given rise to a sustainable ‘middleware industry’ and vendors responded by offering routing and matching software to an eager audience throughout the mid-1990s. Post trade systems are still few on the ground. There have been attempts to shift the industry towards a new model; central matching being one suggested alternative. Central matching has many positive attributes. However the demise of the Global Straight-Through Processing Association [GSTPA], combined with the current reluctance of the United Kingdom [UK] buy-side community to commit to new investment to information technology, means an immediate transition is unlikely unless a clear return on investment [ROI] is demonstrated. In the United States [US] meanwhile, there is a proposal by the Securities and Exchange Commission [SEC] for sameday affirmation or matching. In Europe,

a recent paper by the European System of Central Banks and the Committee of European Securities Regulators [ESCBCESR] has tried to reignite the discussion around processing and settlement improvements. The paper covers some 19 standards and proposes that if settlement structures in Europe are to be regulated, rules should cut across function rather than market sector. It is especially important to do so now that settlement cycles have come into line at Trade plus three days [T+3]. It is a very different situation to that of 1989. Then, even though the G30 group of countries had provided operational recommendations, SWIFT, the financial industry-owned cooperative and now guardian of the International Standards Organisation’s 15022 standard [which covers the format of electronic message exchange], was reluctant even to allow buy-side institutions to participate as members. Although the clearing houses and international central securities depositories [ICSDs / CSDs], such as Euroclear and Clearstream, provide some of the answers by offering matching capabilities, the problem is still not entirely resolved. Current practice appears to work well for some domestic and ‘vanilla’ trades. However, the cost of error

repair at the settlement stage is far higher than discovering the mistake upstream when the trade is first struck. Figures vary according to the various surveys consulted, but generally agree that each failed trade at settlement will cost around $50 versus $6 at the block stage. Pre-allocation also works for some areas of the business so many are asking, why match post-trade? Buy-side regulatory rules require the fund manager to know which portfolio is being dealt for at the time of execution. The fact that many allocations are not made or released until market close is another issue. Clearly, the ultimate post-trade solution should not be prescribed but must offer sufficient flexibility. Same-day matching can be encouraged and more easily achieved by removing both the perceived obstacles, [particularly if that is an ROI barrier], as well as removing any dilemma that organisations may have as to which matching model to adopt. Historically it is vendors that have imposed standards. This has created a plethora of proprietary protocols that have done little for either inter-vendor operability or external message connectivity. One thing has become clear over the years. Organisations will only change if they see obvious benefits, or are forced to comply by regulatory pressure. Client demand may help, but feeling coerced by commercial forces will carry little weight and generally hit a brick wall. At the end of the day, the answer is quite simple. Give the user a choice.

NOVEMBER/DECEMBER 2004 • FTSE GLOBAL MARKETS

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Regional Review

USSIA’S MAIN EVENT in September was the $1.98bn purchase by oil major ConocoPhillips of a modest 7.6% share of Lukoil in a government share auction. The final price was only slightly above the $1.95bn base price wanted by Russia but the deal signalled much more. Moody’s Investor Services took up the tone in early October and announced it will give Russia an investment grade rating, creating an immediate price rally in the bond market. While equity markets still remain relative muted, Moody’s decision could be the tipping point for a spate of new private sector bond issues and revitalised investor interest in Russia after a testing spring and summer. The impact of the impending upgrade was immediate in the debt market. Mobile telephone operator Mobile TeleSystem [MTS] and MMK Finance, the captive financing arm of the Magnitorgorsk Iron and Steel Works, reported tightening of spreads on their respective $400m and $300m bond issues. The upgrade will help rebuild confidence in a market that took some battering after the Yukos affair. High oil prices can only reinforce the trend. Russian market analysts in London say the market looks more favourable for specialist investors in Russian bonds: “a significant pipeline of issues is building up,”says Peter Botoucharov, emerging markets strategist at Commerzbank Securities Any new sovereign issues are unlikely however. “Russia enjoys a massive current account and fiscal surplus. There is no

obvious need,”explains Botoucharov. The country’s Paris Club [the informal grouping of countries that agrees to reschedule sovereign debts owed to them in tandem] debt still attracts discussion though. In June, Germany controversially re-packaged €5bn of debt, out of a total €14bn owed to it by Russia, into so-called Aries credit linked notes [CLNs]. The deal took the markets by surprise. Paris Club rules forbid a government from buying back debt, at a discount, from individual Paris Club members. Technically though, the deal was not a buyback. Germany had simply issued Eurobonds securitised by Russian debt. Reportedly Russia was not entirely satisfied with the deal. According to Tim Ash, emerging markets strategist at Bear Stearns, “Russia made it clear that it did not feel adequately involved in the process. Additionally, I think they were surprised at the size of the final deal. They had been thinking along the lines of maybe €2bn.” Nonetheless, Aries invariably set some kind of precedent in Russian thinking and in late August, Finance Minister Alexei Kudrin followed up with an announcement that the government planned to propose converting Paris Club debt into bonds. Speaking at a press conference in Moscow, Kudrin said: “We are ready to prepare such an initiative.” He did not disclose any further details. “I think it was an effort by the Russians to retake the initiative,”says Bear Stearns’ Ash, rather than it being an invitation for other Paris Club members to respond. “It signals the Russians are

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2004

EUROPE

Russia builds up new issue pipeline

Peter Botoucharov, emerging markets strategist at Commerzbank Securities

keen to take control of their liability management,”he adds. In September, Russian negotiators met with the Paris Club, though no details of the talks have emerged. Italy and France, Russia’s other major creditors have not responded. “If they did, like Germany, it would be in the context of the Stability Pact [the European Union’s agreement on budgetary discipline],” says Ash. Germany, for example, faces a potential financing shortfall in the 2004/5 fiscal year. The Russian deal released cash, while some of Germany’s exposure to Russian was transferred to the capital markets. At the corporate level a significant pipeline of issues is building up, across a broad range of sectors, including oil and gas, heavy metals, utilities and finance. Last year Russian banks alone issued Eurobonds worth $2.5bn and so far this year have raised $1.6bn, in spite of a quiet period during the spring and summer months. In early September, MDM, Bank of Moscow and Russian Standard [which recently sold 50% of its shares to BNP Paribas] came to market with modest sized issues around the $200m mark. Private financial institution Ural Siberian Bank [UralSib], Russian diamond monopoly Alrosa, and Uralsvyazinform are among high profile companies with impending bond issues. Permbased telecommunications company Uralsvyazinform moved rapidly to issue a Rub3bn O4 Series bond in early October to help finance the rollout of next generation networks [NGN], optic-fibre networks in Yekaterinburg and ensure on-air coverage in the Urals region.

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Regional Review EUROPE

Russia’s companies still straddle both investment grade and high-yield ratings. Two classes of investors emerge: those who only buy state owned issues, such as Vneshtorgbank; and those that buy riskier, private sector assets such as UralSib. “Invariably these investors are dedicated Emerging Markets funds in America and Europe. Insurance

companies and pension funds tend to have restrictions on the risk they can assume,”says Botoucharov. Bond investors in Russia do not have far to hunt for yield. Russia’s 30 year sovereign bonds, maturing in 2028,“are yielding 270 basis points [bp] over US treasuries with a price around 154 to 155,” says Botoucharov. Some of the longer dated Gazprom [the state owned

energy supplier] are meanwhile yielding 320bp over US treasuries, which is already a 50bp pick-up compared to the yield on the sovereign 20 year bonds. Oil producer Sibneft’s bonds, which mature in 2009, meanwhile offer a yield of 506bp over US treasuries. “It’s a full 200bp differential,” adds Botoucharov. “Similar producers, but different owners and that makes all the difference.”

New Supersector Indices launched in Europe SET OF NEW Supersector indices were added to the FTSEurofirst Index Series in mid-September. The new specialised and liquid indices allow investors to trade a full range of 18 Supersectors across Europe on a real-time basis. From a base universe of some 300 companies, investors can now gain exposure to 93.3% of the FTSE Developed Europe Index. The indices will be traded on Euronext. FTSEurofirst Indices are a set of European indices, launched in the spring of 2003 by Euronext and FTSE Group. The move to launch a new index series based on Supersectors follows various initiatives in the European market to develop a set of effective industrial based indices. FTSE itself, LIFFE and LMX, the derivatives exchanges, have variously attempted to launch specialised industrial indices, with only limited take-up. The Supersector concept, however, promises more. The development is timely, says Gareth Parker, head of index design at FTSE Group. “There’s a lot of interest in the new indices, as previously the indices on offer, at sector level, were

deemed to be too granular. In other words, there were too few companies involved in the make-up of the index. Equally, at the other end of the spectrum, industry level indices can sometimes offer exposure to too many companies and are not as precise as some investors would like. We think the Supersector solution is a happy medium,”explains Parker. The new Supersector indices will utilise the same background stocks selected from the FTSE Eurofirst 300 [previously known as the FTSE Eurotop 300 index]. The Supersector principle is culled from the Industrial Classification Benchmark [ICB], a comprehensive structure for sector analysis, facilitating the comparison of companies across four levels of classification and national boundaries. In February this year, Dow Jones Indexes and FTSE signed a Memorandum of Understanding that governed the merger of their respective industry classification systems to create a single seamless, structure covering both equities and corporate bonds around the world. Supported by the ICB Universe database that contains approximately 45,000 equities

Gareth Parker, head of index design at FTSE Group

worldwide from the Dow Jones Indexes and FTSE Universes, the benchmark is becoming an industry standard. ICB is transparent and rules-based. The new indices nevertheless are competitive with similar Supersector indices offered by other index provider. There are key differences in the make-up of their respective indices. According to Parker, “FTSE use a smaller group of companies in the construction of the index,” he explains.“The companies are carefully checked for liquidity. As a consequence, we maintain our resulting indices are easier to trade.” Supersectors will be used to launch three sets of indices: one for the United Kingdom, one for Europe and another covering the Eurozone, adds Parker.

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Taiwan’s newly established financial supervisory authority has a timely and rather big agenda. After a series of false starts, the Taiwan authorities now look to be tackling head on important issues, such as financial sector reform and the need to improve and police corporate governance. Will the government finally succeed? Neil O’Hara reports. the less than perfect situation,” explains Huang. “The government and the legislature created this new financial supervisory group that centralised the inspection, the supervision and the monitoring functions over financial institutions.” The FSC oversees four bureaux: Monetary Affairs; Insurance; Securities and Futures and Examination. Steve Champion, president and chief spawning financial executive officer [CEO] of the Taiwan T SEEMS THERE is a change in the mergers, that blurred Greater China Fund, sees the change air in Taipei.“It is not just the same conglomerates bureaucrats moving from one jurisdiction. “There were overlapping as a logical response to consolidation. office to another,” says Jack Huang, a areas, and there were areas that “As financial holding companies have partner at Jones Day in Taipei, “The neither side wanted to claim combined the kinds of companies that atmosphere has changed, and the responsibility over,” says Huang, “It were regulated separately in the past, style has changed.” Huang is talking wasn't the best regulatory regime, in they wanted to bring all these bureaux about Taiwan's new Financial that you had too many people together. The government also has stakes in various Supervisory Commission companies and they [FSC] which assumed TSEC 50 Index vs. FTSE Asia Pacific ex Japan Index 200 wanted to ensure the responsibility for financial independence of the regulation at the beginning 175 regulator,”he says. of July this year. The new 150 The new institution is regulator is a behemoth of 125 meant to have teeth. FSC’s sorts. It brings under a clout is reflected in the single umbrella the Bureau 100 strength of its top of Monetary Affairs, the 75 management. Kong JawDepartment of Insurance, 50 sheng, a veteran in the the Securities and Futures banking sector and former Commission and the chairman of state-run Financial Institutions TSEC 50 Index FTSE Asia Pacific ex Japan Index Taiwan Sugar Corp., and Inspection Bureau. Data as at 31 August 2004. Source: FTSE Group former Credit Suisse First Although young, like many a big creature, the FSC is wanting to supervise the same thing Boston banker is chairman, while the making its presence felt already. "I or the same organisation, or else too FSC Examination Bureau, formerly the think there's a big difference in that few of them.” While discussions about Bank Examination Department of the you have only one commission. The a super-regulator dragged on, Taipei-based Central Bank of China, is mission is very clear. The agenda is entrenched interests prevented any headed by Susan Chang, an ex-deputy action until a rash of corporate minister of finance, who also doubles very clear,”says Huang. The old agencies, which reported to scandals exposed the serious flaws in up as one of two FSC vice chairs. The FSC Banking Bureau is led by Gary either the Ministry of Finance [MoF] Taiwan’s financial sector. “It was partly the change of Tseng, the director of its predecessor, or the central bank, served their purpose until laws passed in 2000 and government and partly the scandals the Bureau of Monetary Affairs of MoF. 2001 permitted cross-industry that brought everybody’s attention to Mark Wei directs the FSC Insurance

FSC rewrites Taiwan’s agenda

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Bureau, previously known as the MoF now estimated to be worth some fund's investment policy to focus on Department of Insurance, which he $23bn [equivalent to around 5% of Taiwan companies that have major also directed. And the FSC Securities total lending]. Consolidation is a business operations in China.“We felt Though hardly any it was a competitive advantage to be and Futures Bureau, successor to the priority. MoF Securities and Futures restructuring or consolidation has dealing with and holding Taiwan Commission, is led by Wu Tang-chieh, taken place among Taiwan's banks, companies as opposed to other ways even though new laws passed in 2000 you get effective exposure to the former MoF secretary-general. An important question emerges and 2001 eased the way for mergers China market,” he says, “The however: just how independent will and foreign investment in the regulatory climate is so good in the new agency be when most staff financial sector. Taiwan still has some Taiwan, the transparency is so good performed similar functions at the old 50 banks and 313 credit cooperatives and the market is run so well.” Kung’s executive mission agencies? “The Ministry of Finance serving a banking market valued at a now becomes a much smaller relatively modest $675bn and a encompasses a number of initiatives. Perhaps the most controversial plan government ministry,” explains population of only 23m. Even so, outsiders have seen steady is to require troubled banks to accept Huang, who points out that the FSC state-funded bailouts, reports directly to the giving the FSC more Executive Yuan, Taiwan’s A platform for growth? FTSE Taiwan Banks Index vs. FTSE leverage perhaps to cabinet.“This is a superAsia Pacific Banks Index 300 encourage further reforms. agency. It is very, very He is also keen on powerful. There are nine 250 promoting Taiwan as a commissioners who venue for incoming have ministerial rank.” 200 foreign banks to take The commissioners are 150 equity in domestic prominent figures from financial institutions. The the securities and 100 FSC is certainly dynamic. insurance industries, or, 50 For instance, it has moved like the chairman, from quickly to draft revisions investment banking. to the Securities At the inauguration FTSE Taiwan Banks Index FTSE Asia Pacific Banks Index Transactions Law and the ceremony, Kong Data as at 30 September 2004. Source: FTSE Group Accounting Law, which explained that the FSC will help Taiwan adjust to improvements and acknowledge the are now before the Executive Yuan, globalisation, improve the country’s efforts in improving financial the Taiwan parliament. The revised competitiveness of the financial sector, market regulation. “Transparency in Securities Transaction Law addresses liberalise outdated financial laws and Taiwan used to be terrible. There were issues of corporate governance, regulations and enhance corporate all kinds of corporate scandals; financial statements and insider governance and its enforcement. companies that would be profitable trading. Proposed revisions will Kong’s inaugural address right up to the day they closed their empower the FSC to demand, under circumstances, that acknowledged the need for Taiwan to doors,”says Champion,“The American certain transform itself into a regional Chamber of Commerce used to offer companies set up auditor committees financial hub. The island’s financial advice in a slightly patronising way. I in addition to their boards of expertise currently provides it with a think we're more humble today, given directors and supervisors. They also critical edge over neighbouring China. the horrid scandals and the lack of require that there must be at least five The island is under pressure to build transparency we have sometimes in members in the board of directors. At on that expertise over the coming this country. But all of this has gotten least a quarter of the board’s directors must be independent, and less than decade if it is not to lose out as China’s hugely, hugely better.” So much better that Champion now half should be relatives. Financial economy burgeons. Taiwan's regulatory statements will have to be signed by The issue is pressing. There are too embraces many banks in the country and many framework as a marketing tool. About a company’s chairperson, general of them carry substantial bad loans, a year ago, the trustees altered his manager and head accountant. If the

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signed financial statement is found to be false, penalties can include imprisonment and even the payment of damages to investors. Moreover, the proposed amendments include provisions that shift the burden of proof from shareholders to company management in the case of litigation. FSC drafted revisions to the Accounting Law meanwhile require certified public accountancy firms to insure their operations and that company auditors must be neutral and independent from the public relations firms that prepare year-end reports. Certified public accountancy firms must also have paid-in capital of at least $750,000 for up to five partners. Each additional partner will require a further $60,000 in capital. Accounting firms will also face fines up to a value of $900,000 and have their licenses suspended in cases of proved infractions. The FSC has also opted to follow the example of financial sector supervisory agencies in the United Kingdom, the United States [US], Canada and Singapore by charging financial institutions a supervision fee, based on the principle that the supervision safeguards not only the public interest but also the private interests of financial institutions. The annual supervision fee is 0.03% of an institution’s business income. These early steps by the FSC have strengthened Champion’s conviction. “We see movement in exactly that direction from the chairman, disciplining accountants, suspending their licences, and talking about a complete removal of the collars on trading,” says Champion. He has a high regard for the staff at the new regulator. “They are bureaucrats, but that's not necessarily a bad word. They're usually very smart, welleducated, experienced people.” Foreign players have enjoyed increasing access to Taiwan's markets,

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a trend that will probably accelerate under the FSC. “I think that this commission is more open to the free market. I think they will try to reduce Kung’s executive red tape and reduce mission restrictions on how encompasses a foreign financial number of initiatives. institutions can operate in Taiwan,” Perhaps the most says Huang. controversial plan is Champion’s to require troubled experience supports banks to accept this view. Last state-funded February, even before the FSC took bailouts. over, his fund changed its status to become a foreign investor instead of being managed by a The FSC’s chairman wants the new local securities investment trust company. “We were taking the first agency to function more like the US mutual fund ever formed in Taiwan Securities and Exchange Commission and changing it into a foreign investor. [SEC], according to Huang, who It could have been controversial if knows him socially.“He would like to somebody wanted to make it that way. see the underwriters, the legal But it was handled crisply, profession, and the accounting take over more intelligently, very easily,” he says, profession “people asked the right questions and responsibilities, and also be given more authority,” Huang says, “He they understood the answers.” Huang expects the commissioners’ wants the industry to be more selfindustry experience will push the regulated. At the same time, he has to FSC toward a less bureaucratic be very careful, because he can not approach. “They speak the same change the world overnight.” The must reassure the language, they are more attentive to chairman your concerns,” he says, though that legislature and the public that he is does not always translate into faster fighting abuses revealed in recent approvals. “In some areas, they may scandals, but practical measures that want to change direction or crack strengthen the regulatory framework down. In the States, you had your don't make headline news. “It remains to be seen whether financial scandals; we had our fair share of that, too. So they’re cleaning he can really stick to and make all up the accounting mess, setting clear the necessary changes to deliver rules on audit standards, and trying what he's been conveying to the to make some of the securities market,” says Huang, “It’s not an easy job.” transactions more transparent.”

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Regional Review CHINA/FTSE

BGI launches first China Only ETF ARCLAYS GLOBAL INVESTORS [BGI], a major provider of exchange traded funds [ETFs] with some $1.1trn under management, announced a new spate of ETFs in early October. High profile is being given to a new China-only ETF for US investors.The FTSE/Xinhua 25 Index has been selected as the underlying benchmark. Traded on the New York Stock Exchange, the iShares FTSE/Xinhua China 25 will track the performance of the largest and most widely traded Chinese stocks. The Index has had a twelve month return of approximately 30% through October 2004. Lee Kranefuss, chief executive officer [CEO] of BGI’s Intermediary and ETF Business says US investors can now enjoy exposure to “pure mainland China iShares to execute and investment strategy that involves one of the world’s largest and most exciting economies.”

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

ETFs are index funds that are bought and sold like ordinary shares on a stock exchange and are a tool to gain diversified exposure to a market. They are liquid investments and are attractive to both retail and institutional investors because of their relatively low cost and trading flexibility. Institutional investors can trade on exchange or over the counter [OTC], directly with a market maker. BGI will also launch four new products in the UK, subject to regulatory approval. The iShares FTSE/Xinhua China 25 [FXC], will be the first ETF to be available in Europe for exposure to the rapidly growing Chinese economy and will begin trading on the London Stock Exchange at the end of October. The FTSE/ Xinhua China 25 Index aims to create real time indices and provides a comprehensive and transparent means for tracking the emerging market in China. The iShares FTSE/Xinhua China 25 will focus on two out of the four types of Chinese shares currently traded, namely red chip and H share securities, which are usually listed on the Hong Kong Stock Exchange. The iShares FTSE/Xinhua China 25, with a Total Expense Ratio [TER] of 0.74%, will provide investors with a transparent and cost effective way of gaining exposure to China. The move follows quickly on from the launch of iShares MSCI Japan [IJPN], earlier in the month. In addition to the new Asian funds, iShares will launch two new ETFs with exposure to European equities: iShares DJ Euro

Lee Kranefuss, managing director of BGI’s Intermediary and Exchange Traded Funds Division

STOXX MidCap [DJMC] and iShares DJ Euro STOXX SmallCap [DJSC]. Both of the new European funds will begin trading on the London Stock Exchange at the beginning of November. Designated exchange market makers for all four of the new ETFs will be Merrill Lynch International and Susquehana International Securities. OTC market makers include Credit Suisse First Boston, Goldman Sachs International, JP Morgan Securities, Merrill Lynch International, Morgan Stanley and Susquehana International Securities. “The launch of these four new funds represents a change of gear in the expansion of ETFs in Europe. We are revolutionising the way investors can get exposure to important market segments such as China, Japan, and the small and mid-cap sectors of the European market,” says Bruce Lavine, Head of iShares in Europe. “ETFs are increasingly being seen as a useful tool that delivers institutional level products and pricing to investors both big and small. As the leading provider globally of these funds, we continue to expand the breadth and depth of our product set to reflect the demands we are seeing from investors,”he adds. iShares is the largest provider of ETFs in the world with over 110 funds listed globally, totalling US$92.27bn. In the UK, iShares already has 10 ETFs listed on the London Stock Exchange.

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Regional Review USA

Thain hastens hybrid NYSE market John Thain, Chief Executive Officer [CEO] of the New York Stock Exchange [NYSE]

ARLIER THIS YEAR, the NYSE’s CEO, John Thain revealed his plans to revamp the current NYSE’s electronic trading platform, Direct+. Launched in 2001 as a fledgling attempt to offer an e-trading option, it has executed only 10% of the exchange’s share volume this year. To complicate matters, Direct+ has been virtually unusable by institutional investors [who had been pressuring the exchange for a faster and more efficient system]. An order limit of 1099 shares and 30-second limitation for consecutive orders proved unworkable. Thain and NYSE were not slow to take on board the issues. Now Thain proposes to eliminate all limits on size, timing and types of orders. In August this year, he also announced a proposal to the United States’ [US’s] Securities and Exchange

Shortly after John Thain, Chief Executive Officer [CEO] of the New York Stock Exchange [NYSE], took office in December 2003, it was clear the 212-year-old Big Board was in for a seismic shift. A strong advocate of using technology to maintain the exchange’s dominance in a rapidly changing marketplace, he has unveiled a series of initiatives designed to propel the NYSE into the 21st century of electronics and fast markets. Karen Jones reports from New York

Commission [SEC] to create a hybrid market, which would include the traditional floor brokers and specialists that manually handle orders along with a new and improved NYSE Direct+. “We are seeking to upgrade significantly our use of technology to execute securities transactions. We want to enable our customers to execute more of their orders quickly and electronically, with certainty and anonymity,” says Thain. As electronic trading increases, he also wants to preserve the “advantages” of NYSE’s auction system. There are several reasons why Thain moved quickly after taking the reins at the NYSE. One is the institutional investment community's increasing ire at the existing trade through, or “best price” rule – a controversial regulation viewed as a clear advantage to the NYSE.“If you are a market and have a customer order to execute, but another market is showing a better

price, you are obligated to send through that order to the better priced market,” says Jodi Burns, analyst at Celent Communications, a research and consulting firm that evaluates how technology supports business and product strategy. According to NYSE data, the Exchange posts the best price of any market for NYSE-listed equities “93% of the time,” and had “the best fill rate” of any market for NYSE-listed equities. Because they tend to have the best prices, orders migrate to the NYSE which wouldn’t otherwise because of the trade-through rule, explains Jodi Burns. “Competitors have been screaming for years at the unfairness of the rule and how it is enforced because it defines best execution in such a singular way, price. Speed is something investors care about as well.” John Wheeler, vice president of domestic equity at American Century

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Investors, one of the biggest mutual funds in the United States [US] trading at 4bn shares and $100bn worth of stock, applauds the NYSE proposal for more automation.“All the data has shown that the more we can eliminate human discretion, the lower transaction costs become.” He offers that trading on an electronic platform could save institutional investors such as American Century “between $200m to $250m a year in costs.” As far as the trade through rule goes, Wheeler says that while no one wants to trade at an inferior price, “people are willing to accept what appears to be an inferior price if it includes certainty of execution, size of execution, or speed of execution as well as anonymity.” Wheeler remains skeptical about manual execution. “While manual exchanges may post what appears to be the best price, many times that price has proved unattainable. While trying to attain that price, you lose all the sure prices and all the inferior prices before you can react,”he says. Thain’s e-trading push is also a move to counter the impending revisions to the trade-through rule listed in National Market System Regulation [Regulation NMS], a wide-ranging market reform initiative now being reviewed by the SEC. So far the SEC has decided to uphold the existing rule, but in a nod to institutional investors, is proposing two key exemptions. One is an “Opt-Out” rule whereby customers can dictate to brokers to opt out of a trade through for a particular order regardless of price, and execute through another market. Not surprisingly, the NYSE strongly opposed this exemption. The other is termed as “fast versus slow”where a fast market can ignore a slow market price, if it remains slow and is hard to access.

“The NYSE is trying to make the best of a bad situation,” says Burns. “They would be classified today as a slow market because only 10% of its orders are executed electronically without human involvement.” She adds that in this new environment you do not want to be a slow market “free to be ignored” or marginalised. “The SEC has said to the NYSE, if you want to enjoy what you have today, you have to be a fast market, so they have been forced to adopt this hybrid model.” Thain says his hybrid system marries the best of the electronic market and the auction market in a way no other market can match and enables the exchange to execute orders more effectively than a “onedimensional electronic platform.” American Century’s Wheeler is not so sure. “When you are taking a hybrid market and setting up rules that allow for human interaction, you set up a system that can be manipulated to investors’ determent,”he explains. As to whether the advent of widespread technology spells the eventual doom of the floor traders and specialists that have been the trademark of the Exchange for over two centuries, no one is sure, but their days at the top of the hill are clearly numbered.“They are not happy,” says Celent’s Burns “this is an alternative to sending your order to a floor broker who walks it over to the specialist to execute manually. It is absolutely the case that they will lose order flow.” Wheeler offers,“When you consider the process of changing money for shares of stock, there is no other transaction in the US economy that is riper for automation than that process. You would think the people making huge New York wages doing nothing more than delivering paper from a post to a specialist can see the writing on the wall.”

John Wheeler, vice president of domestic equity at American Century Investors

Meanwhile Dave Humphreville, President of the NYSE Specialists Association, disagrees. He says NYSE will do what makes sense for both customers and the market while retaining their unique services.“We do have automatic execution at this time and we are just going to be expanding that in a way we feel makes sense for people to use.” Even after the SEC moves forward with its proposed changes to current regulations, change will take time, allowing all sides time to regroup and rethink their business strategies. While automation means gains in efficiency, it always costs intermediaries money. “The strong survive,” says American Century’s Wheeler.“The NYSE has literally been the toll booth standing between buyers and sellers of US stock for far too long. The toll has been too high, the prices too low. The ones that are truly adding value to the process by automating, innovating and meeting customers’ needs will flourish. It has happened in every industry in this country and we are about to see it at the NYSE.”

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Regional Review NORTH AMERICA

TSX spreads its wings It has been a heady ride for Toronto Stock Exchange [TSX] and Barbara Stymiest, its outgoing chief executive officer [CEO] over the last five years. Now TSX is pushing hard to expand abroad. N SEPTEMBER, TSX Group [TSX], which owns Toronto Stock Exchange and TSX Venture Exchange, the public venture market, held a road-show in London’s Savoy Hotel. The event was part of a campaign to raise awareness of the investment opportunities on TSX. The event is part of a three-fold push by TSX to enhance its core business, look further afield for companies to list on Canada’s exchanges and to attract overseas investors to inject cash into the country’s capital markets. TSX is hawking a strong Canadian growth story in Europe. “Caveats notwithstanding, The Economist Intelligence Unit has maintained its prediction that Canada will be the leading industrial economy for the 2004-2008 period. This year’s numbers are at least consistent with that coming about,” says TSX’s straighttalking and upbeat chief executive officer [CEO] Barbara Stymiest. TSX Group has long competed for listings and trading with equity markets in the United States [US]. But as markets become increasingly globalised, TSX Group is now turning its sights to Europe. The London road show was bittersweet. Shortly before the event, Stymiest announced her resignation, effective October 31. TSX’s loss is Royal Bank of Canada’s [RBC’s] gain. Stymiest is joining RBC as chief operating officer [COO], reporting to president and chief executive officer [CEO] Gordon Nixon. Stymiest will be responsible for strategic development and will have all the bank’s corporate

functions reporting to her, including risk management and finance. The exchange is now on fast forward to find her replacement. It has been a heady ride for Stymiest and TSX over the half decade. More than half of the world’s mining companies are now listed on the two exchanges and there are also more oil and gas companies listed on Toronto Stock Exchange and TSX Venture Exchange than elsewhere. The exchanges accounted for 45% of the equity raised worldwide for mining companies so far this year. Stymiest was appointed CEO five years ago armed with a mandate to complete the Exchange’s demutualisation and take the company public in an initial public offering that was completed in November 2002. TSX’s chief financial officer, Michael Ptasznik, explains that the exchange is hoping to capitalise on the perception that European investors regard TSX as “the entry point to a robust Canadian economy and also a vehicle for foreign business building in the United States.” It is a timely development. Canada is bouncing back after a difficult 2003. Last year the Canadian dollar soared against the United States [US] currency, severely affecting export industry; forest fires devastated large parts of British Columbia, the SARS virus discouraged tourism and a single case of mad cow disease shut down the lucrative Canada to US cattle trade. Now the accelerating Canadian economy [with growth currently running at 4.3%] has overtaken US economic growth. The trend looks likely to continue for some

while: “For the next two quarters Canadian profits are projected to rise at 29% and 24% respectively, compared to US profits projected at 14.7% and 15.6%,”says Stymiest. Nonetheless, she sounds a note of caution. “Given the unexpected hits the Canadian economy took last year and some troubling issues in the global economy, caution certainly remains appropriate,”she adds. TSX's European venture is part of a broader trend in corporate Canada, notably in the resource sector, acknowledges Ptasznik. “Our natural mandate is to help promote Canadian companies, mining and oil and gas companies among them. As they are venturing abroad in search of both new mineral wealth and a wider following among overseas investors, so are we.” Dual listings by Canadian companies in London are not nearly as prevalent, as those in the US, says Ptasznik, “but that can soon change. Twenty-seven Canadian companies are already listed on the London Stock Exchange [LSE], including 10 on the main market and 17 on the Alternative Investment Market [AIM].” Nonetheless, there is still some way to go. Of the nearly 1,400 companies listed on TSX, 185 are also listed on the New York Stock Exchange or the Nasdaq Stock Market. “By encouraging this trend, it widens our reach as well,” says Ptasznik. TSX recently launched Team USA, a sales team that encourages US brokers to send more trades in Canadian duallisted companies up to the exchange. TSX is wants to set up a similar team for Europe. Ptasznik holds that the group has broader strategic plans based around its fixed income electronic platform, CanDeal and the development of the natural gas exchange, NGX.“Together with an increased share of trading here and in the US, we look forward to expanding our franchise,”he smiles.

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MIDDLE EAST

Be there, or be square... Photo of the Bahrain Financial Harbour Reproduced with the kind permission of BFH

Despite small concerns about security, with oil prices and production levels riding high and lubricating the regional economy, the Middle East is firmly back on the investment industry’s agenda. Thinking and acting locally is the key to success in the Middle East. But even if you are willing to locate in the Middle East, where should your office be? STIMATES ABOUT THE levels of private wealth in the Gulf vary enormously though $1.7trn to $2trn is widely quoted. What is much clearer is what this huge amount of capital offers financial institutions operating in the region. “Opportunity” claims Dr. Oman Bin Sulaiman, director general of the Dubai International Financial Centre [DIFC]. “Where else in the world is there such a wealthy and untapped potential investment pool?” Jean-Michel Bourgoin, head of international sales, Middle East, at Crédit Agricole Asset Management [CAAM] agrees. “It has always been

an important region to us. It has become even more important following our merger with Indosuez, which had historically been a big regional player. However the recent inflow of capital from high oil prices and the knock-on effects in the local economies have led us to further increase our efforts to intensify funds under management from there in recent years.” Not only international firms have benefited. “We have seen a material increase in assets undermanagement,” claims David Waite, head of asset management at Gulf International Bank [GIB] which has

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Esam Yousif Janahi, CEO, Gulf Finance House and chairman, BFH

$12bn currently under management, all of which is invested internationally. Investing local wealth internationally has long been the norm in a region that had until a few years ago had been restricted by immature local capital markets, supported only by weak legal and support infrastructures. Sulaiman estimates that the Middle East has invested somewhere in the region of

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Regional Review MIDDLE EAST

$1.5trn overseas. This means that as much as 85% of funds raised locally are invested abroad. Competition from United States [US] institutions has declined,“but the field of asset management has always been very competitive, partly because it does not require a physical presence in the region to offer asset management services,” claims GIB’s Waite. However, while GIB’s fund managers are based in London, where they remain close to the markets in which they invest, it is the bank’s marketing team that is based in GIB’s headquarters back in Bahrain, close to its GCC client base that provides the bulk of its funds under management. Even when raising money to invest overseas Ahmed Abubaker Janahi, director, Bahrain Financial Harbour [BFH] thinks that the best way for fund managers to source funds from the

Middle East is through a permanent presence.“The asset pool of the region has been steadily growing, accordingly we think that whether a bank has existing client relationships in the region or is seeking to build new ones, asset managers could grow asset under management more effectively by setting up an on-the-ground presence,”says Janahi. Bourgoin’s experience at CAAM seems to bear out this thinking. “We used to run our sales operation for the region from Paris. Even with regular sales trips we would often arrive for a meeting with a client only to discover that a deal had been struck two weeks before by someone with a presence on the ground. This led us to decide that we had to open an office in the region.” Fortunately for Bourgoin the merger in July of the respective asset management subsidiaries of Crédit

Lyonnais and Crédit Agricole, which created a fund management operation with €287bn in assets under management as of end June 2007, gave the opportunity to base a sales team in what was Crédit Lyonnais’ Abu Dhabi office. Although the majority of the funds raised in the Middle East continue to be invested abroad, there are many, including Esam Yousif Janahi, CEO at Gulf Finance House and Chairman of the BFH, who believe the tide is turning. “The region is on the threshold of a paradigm change. Significantly, some of the Arab money that used to chase Western capital markets and investment avenues are slowly coming back to the region,” says Janahi.“I believe the momentum of this homeward flow is set to grow in the coming years. This is mainly because there is more credibility in the Dubai International Financial Centre Reproduced with the kind permission of DIFC

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regional market place now. Trading volumes in the regional stock markets are on the rise – more companies are getting listed on the bourses, and the risks associated with investing in the region have lessened over the years,” he adds. This view is one held by the coproponent of the BFH, Ahmed Janahi. “The future business opportunity in the region relies on re-developing Middle East wealth into regional direct investment,” he says. This investment seems to be one that is being increasingly felt by the fund managers themselves. Meanwhile, GIB’s Waite has found that although they have traditionally focused on international products promoted to an institutional client base they are “seeing an increased awareness and appetite for investment opportunities locally.” The effects of this increased interest [and one of the driving forces behind it] has been the impressive performance of the Middle East equity markets. According to official figures, the market capitalisation of the largest exchange in the region, Tadawul [the Saudi Stock Exchange], more than doubled last year’s from $75bn to $157bn. Figures released by the Bahrain Stock Exchange show that its market capitalisation rose from $2.7bn to $3.7bn during 2003 and by the end of the second quarter of this year it had risen further and stood at $4.3bn. These figures match or better some of the best performing emerging markets in 2003 and far outstrip the moribund performances of the more developed international markets over the same period. There’s another important change in the region. Local investors, who in the past invested almost exclusively in their own domestic markets, are increasingly willing to invest in other Gulf Co-operation Council [GCC]

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Dr Omar Bin Sulaiman, director general, DIFC

states. However, for this development to be cemented, it will require the creation of a single entity or platform – in other words, a regional exchange. A regional equity and debt market would allow the largest companies in the Middle East to raise much larger sums of equity and debt locally. It would also provide investors, both international and local, with more liquidity and choice than is currently available through the domestic exchanges working today. The two most likely contenders to host the regional exchange are Bahrain and Dubai in the United Arab Emirates [UAE]. The decision to locate the regional exchange in either centre would provide a fillip to either of the big financial centre developments under way in both cities. One of these, the Bahrain Financial Harbour, a waterfront development comprising 250,000 square metres of commercial space, is already earmarked to house the Bahrain Stock Exchange and the Bahrain Insurance Association. The quality of the regulatory environment,

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provided by the Bahrain Monetary Authority [BMA] has contributed to the rise in the number of financial institutions located in the Kingdom, which rose from 310 in 2000 to 360 last year. “Bahrain has continuously been the first and preferred choice of locations for financial institutions who seek to have a presence in the region,” claims Ahmed Janahi. Esam Janahi believes much of this success can be attributed to the BMA. “The BMA is a guiding beacon for the financial and banking industry in Bahrain,” believes Janahi. “It is the most dynamic regulator in the region. It has a high profile and is very active.” The other contender for the location of a GCC regional exchange is the DIFC, which is already the planned location for the Dubai International Financial Exchange [DIFX]. “It is the only international exchange in the region,” claims Sulaiman. The centre also boasts a regulator, the DIFC Financial Services Authority [DFSA], “whose independence has also been guaranteed by our ruler, with a set of laws based on those of the world’s leading jurisdictions,” he adds. The DFSA works under the control of the DFSA Regulatory Council, chaired by Dr Habib Al Mullah. In the eyes of many observers the creation of a regional exchange is not a question of ‘if’ but more likely ‘when’. However in a region where a local presence is so important a structure along similar lines to pan-European exchanges, such as Euronext, where a presence is maintained in each country, looks set to be the most likely result. Even without a regional exchange the ability to offer Middle East and international investors the opportunity to invest locally will be pivotal in winning mandates to manage the region’s burgeoning wealth.

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FUND PROFILE: PRIM

As a lifelong Bostonian, Michael Travaglini, the newly appointed executive director serving Massachusetts’ Pension Reserves Investment Management Board [PRIM], can appreciate the emotional see-saw that is the investment business – perhaps better than most. David Simons explains why Travaglini, in his own way, is becoming a master of sorts – if not of the Universe – then certainly the Commonwealth.

So PRIM So Proper So Boston

...So very PRIT

OSTON IS A city steeped in both triumph and tragedy, home to political legends and losers, football heroes and baseball goats, hi-tech booms and busts. Michael Travaglini, an ardent Red Sox supporter is about to make his way to Fenway Park for the evening after this interview. It is typical of his thoughtfulness that he makes time for the interview, even though he is no doubt anxious to leave. He doesn’t betray impatience. It is a mark of the man and his amiable, though thorough, style. Similarly, Travaglini approaches the business of managing pension funds with an air of open pragmatism typical of any optimistic Red Sox fan. In other words, he is a man of studied caution and care. “You need to keep things in perspective, and try to avoid getting overly excited or overly pessimistic,” says Travaglini, who is directly responsible for the state’s Pension Reserves Investment Trust [PRIT] fund, which currently serves some 80,000 state employees. “My mantra has always been,‘We are in it for the long haul’.” The PRIT Fund is a pooled investment fund established to invest the assets of the Massachusetts State Teachers’ and Employees’ Retirement System [MASTERS] and the assets of local county, authority, district, and municipal retirement systems that have also opted to invest in the Fund. The Fund was created in December 1983 with a

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Michael Travaglini, executive director, Massachusetts’ Pension Reserves Investment Management Board

mandate to accumulate assets, to reduce the Commonwealth’s significant unfunded pension liability, and to help participating retirement systems meet their obligations. The PRIT Fund merged with the MASTERS Trust in 1997 and, as of the end of August this year, the unaudited assets of the fund totalled $32.5bn. The PRIT Fund is actually made up of two separate investment funds: the Capital Fund and the Cash Fund. Cash, deposited and invested on a temporary basis, is transferred monthly from the Cash Fund to the Capital Fund. Once placed in the Capital Fund, funds are invested and reinvested across all asset classes under the PRIM Board’s long-term investment guidelines and asset allocation plan. The Capital Fund serves as the long-term asset portfolio and is made up of nine accounts: Domestic Equity, Fixed Income, High-Yield Debt, International Equity [EAFE], Emerging Markets Equity, Core Real Estate, Non-Core Real Estate, Timber and Alternative Investments. PRIM’s nine-member board is responsible for the management of the PRIT Fund and also acts as trustee for each retirement system that invests in it. It also employs a

professional staff to manage day-to-day operations. The executive director helps the Board and its advisory committees define and implement investment policy and regularly reports on the status of the Fund and the operations of PRIM. Disclosure fever has overtaken the financial world and PRIM is no exception. But accountability is nothing new in Massachusetts, where watchdog groups and oversight committees have long been a part of the social, political and economic fabric. It was in Massachusetts, after all, that the furore over mutual fund late-trading and markettiming gained momentum when state secretary Bill Galvin launched a probe against Boston-based Putnam Investments. In turn, it led to a broader investigation conducted by the United States’ [US’s] Securities and Exchange Commission [SEC]. Putnam, one of several money managers responsible for the investment of the state’s equity holdings, was later dismissed but invited back earlier this year following payment of a $110m federal and state settlement. This past August, the state once again made news when, in response to growing pressure, it made public for the first time the fiveyear results for the 103 venture capital funds that were part of the state’s pension-fund holdings from 1986 through 1998. Keeping the public’s trust while [at the same time] turning a profit is not an easy task, particularly in these trying days. But in 2003, the PRIM fund did just that and more, posting a gain of 26.33%, its highest mark since the fund was formed back in 1985. The figure was more than three points ahead of the median return for public pensions with $1bn in assets or greater, as tracked by Wilshire Associates [the company that also serves as PRIM’s chief consultant, assisting in the selection of fund managers, providing performance evaluation and other such duties]. “It was fun to be the executive director with the best returns in history,” remarks Travaglini’s predecessor, former PRIM executive director James Hearty, who departed earlier this year after accepting a position with a West Coast investment firm. Hearty has a nice line in self-mocking humour. Although Hearty was executive director through the Fund’s good year in 2003, he is modest enough to

PRIT Core Asset Allocation

Domestic Equity Fixed Income High Yield Debt International Equity Emerging Markets Alternative Investments Real Estate Timber Absolute Return

Actual Allocation 30/9/03 %

Interim Allocation Plan %

Long Term Target Allocation Plan %

41.1 18.7 3.3 17.4 5.8 5.6 5.4 2.8 0

33 18 8 15 5 7 7 4 3

26 15 9 15 5 10 10 5 5 Source: PRIM

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FUND PROFILE: PRIM

Equity Manager Roster

Mandate

2001 Allocation % of Portfolio

2003 Allocation % of Portfolio

S&P 500 Index Small value cap Large Cap Value Small Cap Index Small Cap Growth Large Cap Core Large Cap Core/Growth Small Cap Value Small Cap Growth Small Cap Core Small Cap Value Small Cap Growth

58% 6% 6% 5% 5% 5% 4% 3% 2% 2% 2% 1%

63% 0 6 11 0 0 4 4 2 2 2 0

Domestic Equity Managers State Street Global Advisors Putnam Advisory Company Legg Mason Capital Management, Inc. Dimensional Fund Advisors MF Asset Management JP Morgan Investment Management Fidelity Management Trust Company AXA Rosenberg Investment Management Numeric Investors Wellington Management Company Lazard Asset Management Loomis Sayles & Co.

Source: PRIM

acknowledge that: “unfortunately, the year before I was the executive director, with the worst returns in history,”he adds. Indeed, PRIM’s record-setting 2003 numbers followed three consecutive years of negative returns, resulting in a combined 15% loss through the period. But let us be fair to Hearty. The haemorrhage was hardly exclusive to Massachusetts. Having beefed up equity holdings during the irrationally exuberant late 1990s, public pension funds [the majority of which are defined-benefit plans] were subsequently hammered during the bear market that followed. By last year, the rapid depreciation of assets had created an alarming funding shortfall of $366bn overall, according to a recently published Wilshire Associates study. Hardest hit were industrial states such as Illinois, Ohio and Indiana. All of which makes the job of running a public fund in 2004 a most daunting task – but one that many think Michael Travaglini is perfectly suited for. As director of the Boston Retirement Board during the 1990s, Travaglini managed a pool of funds worth around $2bn. With PRIM, he is responsible for more than 10 times that amount. Travaglini, however, isn’t fazed by the extra zeros. “Sure, you get a heck of a lot more attention when it is $33bn,” says Travaglini, who assumed the position as head of PRIM last February, “and PRIM is the leading fund in Massachusetts, and it is nationally recognised as well. But it is just asset size.” Prior to joining PRIM, for at least a year, Travaglini was relationship manager for Putnam Investments. Before that, he was the first deputy treasurer of the Commonwealth of Massachusetts between 1999 and 2003, working under former State Treasurer Shannon P. O’Brien. On O’Brien’s watch, he served as the treasurer’s chief financial advisor with primary responsibility for overseeing cash management, debt management, the Office of General Counsel and the PRIM Board. Even before that, Travaglini worked for the City of Boston, having been appointed as executive officer of the Boston Retirement System in 1994

by Mayor Thomas Menino, thereby managing the city’s defined benefit program. As a consequence: “Michael is very knowledgeable about the industry,” remarks Larry Curran, current chairman of the Boston Retirement Board and a one-time Travaglini associate. “He was right on top of our fund managers at all times, a no-nonsense guy who always led by example. He was very respectful, always willing to listen. PRIM couldn't have made a better choice," he adds.

Shuffling the Deck In an effort to fatten returns over the long haul, last year the PRIM board substantially scaled back its equity position while increasing its exposure to high-yield bonds, timber, real-estate and emerging-markets investments. The board also made the decision to go into an absolute-return strategy for the first time in its history, earmarking 5%, or roughly $1.6bn, of its total assets for hedge-fund investing [PRIM’s hedge-fund approach has been mirrored by other state pension funds, including California’s CalPERS, one of the largest public funds in the US]. “There’s been a lot written about hedge funds, and, unfortunately, the general public’s view is that they are a very risky asset class,”says Travaglini.“I’m not denying that hedge funds in and of themselves are a risky investment – but what I tell people is that a 5% allocation actually reduces the risk profile, because of the funds’ correlation to equity markets and other asset classes. So when people call us and say, ‘Why are you going into hedge funds, I think you’re taking a big risk,’my answer is,‘We are not just going into hedge funds, we have got plenty of other assets at work as well.’” Travaglini says the decision to re-visit PRIM’s asset allocation was “a real sea-change” for the better. “Here in Massachusetts we evaluate our asset allocation every three years by statute,”says Travaglini.“It is not the kind of thing we necessarily need to do year after year – we try to avoid the temptation to be market-timers or tactical asset

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International Equity Portfolio International Equity Portfolio – approx 15.4% of the pension reserve [approx $4bn]. The strategy is investing in a ‘passive’ Europe, Australia, Far East [EAFE] Index Fund and three ‘active’ EAFE portfolios. 33% is allocated to an EAFE Index Fund. Pareto, performs a currency overlay programme on the EAFE Index. The currency overlay strategy is defensive, not speculative.

International Equity Manager Roster Managers

Mandate

Marathon, London Putnam Advisory Company Capital Guardian Trust Co Pareto Partners Baillie Gifford The Boston Company State Street Global Advisors

EAFE Benchmark EAFE Benchmark EAFE Benchmark Currency Overlay EAFE Benchmark EAFE Benchmark EAFE Index

2001 Allocation % of Portfolio

2003 Allocation % of Portfolio

28% 25% 23% 25% 0% 0% 0%

30% 0% 12% 1% 12% 12% 33% Source: PRIM

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-0

M ar

Se p-

ar -

-0

M ar

ar -

Se p-

-0

M ar

allocaters. At that time we began an implementation where Where the money goes we were going to take as much as 15% away from equities Perhaps the single greatest challenge for PRIM and the in general – and not just because we’d had three bad years various other public pension funds over the near term is in the markets.” dealing with the increased scrutiny and suspicion that resulted What drives the decision-making more than anything from Enron, WorldCom and the various other financial storms else is a fund’s risk-return profile. As a state pension fund, of the last ten years. Answering to charges of unethical “we have consultants attempt to tell us what they think the investment practices has become a leading issue in recent domestic-equity market is going to do over the next 10-15 times. A Pittsburgh Tribune-Review story charged years or so,” explains Travaglini. “But as you’re aware, in Pennsylvania’s State Employees’ Retirement System [SERS] recent times the with investing in regimes projections from almost with a history of humanFTSE US vs. FTSE Developed ex North America every single asset class rights violations. As a result & FTSE All-Emerging 160 have been reduced.” of its investment in CACI 140 This isn’t just a stock International, a Californian phenomenon. “If people pension fund’s board 120 believe interest rates are members found themselves 100 going up, we know that on the committee 80 our bond manager’s investigating the Virginiaability to produce a great based defense contractor 60 return is going to be allegedly implicated in the 40 impacted,” continues torture of Iraqi prisoners at Travaglini.“The challenge Abu Ghraib prison. for us is to attempt to In an effort to discourage FTSE US Index FTSE Developed FTSE All-Emerging Index build a total asset any conflict of interest ex North America Index Data as at 30 September 2004. Source: FTSE Group allocation that still allows investment practices us to meet our actuarial among money managers, in investment target, which is 8.25% annualised over a long- 2002 New York State Attorney General Eliot Spitzer term period.”Currently the fund’s annualised return sits at spearheaded the Merrill Lynch Principles on behalf of New a healthy 10.89%. York, California and North Carolina. A similar policy exists Although the jury is still out, for the time being, PRIM’s under Travaglini’s watch. “Every investment-management reshuffling program appears to be paying off. “We are agreement that PRIM has comes with written guidelines certainly pleased that we have been able to take the board’s that our staff monitors on a daily basis with our custodian policy decision and been able to implement it,” says to make sure they are adhered to,”says Travaglini. Travaglini.“It was an enormous amount of work procuring In this new era of openness, not even the secretive world the five hedge funds and fund managers and then actually of private equity investing is sacred. Massachusetts, funding them. We will obviously need to get a little more birthplace of the venture-capital [VC] movement, in a new time under our belts to see if it is progressing according to initiative, sent shockwaves through the private-equity plan, but at least we are up and running.” community last August by revealing the five-year returns of

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FUND PROFILE: PRIM

VC holdings in a list issued by state treasurer Timothy Cahill. Private equity leaders have long opposed making such information to the public, stating that VC firms typically don’t turn the corner until after a 1-5 year gestation period. Ironically, the state’s Republican governor, Mitt Romney, himself a former venture capitalist, opposed efforts to keep the records private. “The issue with private equity was that some of the requests pertained to portfolio-level information,” says Travaglini.“I would argue that all anyone needs to know is the value of our limited partnership and its level of performance. I don’t believe we need to disclose that out of 15 investments that five were bad, 10 were good, and the whole breakdown. Again, people are interested in who we are investing our money with, which has never been an issue. If it is a large cap, we don’t show up at the meetings and say, ‘Fidelity has 100 stocks in this portfolio, and IBM was good but AOL was bad,’ and so forth. No one makes the same case to look at portfolio-level data in the public markets, so we didn’t understand why the same couldn’t hold true for the private markets.” “The bottom line is that PRIM has no problem with disclosure in any way shape or form,”notes Travaglini.“We have had reporters occasionally charge that we do things secretively, but the fact is that our meetings are publicly held. That is where all the investment decisions are made.

Anyone can attend. Obviously, it would be pretty difficult to do anything behind anyone’s back,”he maintains.

Keeping the faith “Before the Enron calamity became public,” reflects Travaglini,“we had one manager who owned the stock. This was a deep-value, large cap manager, who bought Enron at $12, making what looked at the time like a very good value play. I mean, the seventh-largest company in the world was now a screaming buy.”The fact that the purchase was made at $12 was well within the Fund’s existing investment guidelines, and, says Travaglini:“in fact, was exactly what we hired the manager to do! So then the news breaks, someone looks and sees that PRIM is holding Enron – and suddenly, they are violating their fiduciary obligation. Now, we can all watch the football game on Sunday, then Monday morning say,‘He should have passed instead of carried.’ Of course, if everyone only knew then what we know now, things would’ve been a whole lot different.” Although it is a challenging time to be a fiduciary, Travaglini believes that today’s investment environment is much healthier.“Unlike in the 1990s, the party isn’t going to be nearly as lavish, the returns won’t be as fat, you’ve got the SEC changing standards, dealing with accounting issues and so forth,”notes Travaglini.“The whole paradigm has been altered – but I really think it is all for the better.”

Fixed Income Portfolio 2001 As with Emerging Markets, the Fixed Income Portfolio has undergone big changes. The PRIM Board invested some $7.3m in Fixed Income back in 2001. Included in this is an allocation to Treasury Inflation Protected Securities [TIPS] of up to 5%. Now this allocation is 25%. In 2001 PRIM's core fixed income comprises only investment grade bonds and is benchmarked 78% to the Lehman Aggregate Bond Index and 22% to the Lehman Five-plus Year TIPS Index.

2003 Fixed Income Manager Roster Managers Barclays Global Investors PIMCO BlackRock Financial Management Loomis, Sayles & Co.

Mandate Core Index TIPS Active Core Active Core

% of Portfolio 18% 25% 19% 19% 19%

Source: PRIM

Emerging Markets The value of the PRIM Emerging Markets portfolio was around $769m back in 2001 – representing around 2.9% of the Pension Reserves Investment Trust Fund. This allocation has now risen to 5.8% [of $32.5bn]. Investments are focused in the Far East, South America, Central America and Central/Southern/Eastern Europe.

Manager

Style

Capital Guardian Schroder EMI/Emerging Markets Management Grantham, Mayo, Van Otterloo & Co. LLC

Core Growth Value/Frontier Value

Long Term Target 2001

2003 Allocation

40% 40% 20% 0%

21% 0% 38% 40% Source: PRIM

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COVER STORY

Paul M. Tellier, Bombardier president and chief executive officer [CEO]

Bombardier In early September, Canada’s Bombardier Inc. announced that it had successfully renewed C$718m worth of short term [one year] banking lines in North America. It capped a summer of new sales, improved liquidity and sealed the end of the first half of a massive business turnaround for the manufacturer of regional aircraft, business jets and rail transportation equipment. Francesca Carnevale reports.

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NSCONCED IN CHAPTER 11 bankruptcy protection, the plight of United States [US] air carriers US Airways and Delta highlights the challenges facing the transportation sector in general and aircraft manufacturers in particular. Back in August this year US Airways lost the financing for nearly 100 regional jets that were to be a key part of the near-bankrupt airline’s restructuring plan. The Virginia-based airline sought Chapter 11 bankruptcy protection after being pinched by low-cost rivals, higher fuel prices and a failure to win new concessions from its labour force. US Airways efforts were not enough for its aircraft suppliers, Canada’s Bombardier Inc. and Brazil’s Empresa Basiliera de Aeronautica S.A. [Embraer], which decided to terminate their financing contracts on the jets. The carrier had built part of its transformation plan around the increased use of 50-70 seat aircraft during its previous restructuring in 2002. US Airways had hoped to deploy the jets on many of its shorter or less popular routes and use them to expand service to short-haul destinations. The harsh experience is typical for Bombardier which in any case, like many transportation manufacturers, has seen a sharp decline in its order books since 2001. Bombardier is the world’s third largest commercial aircraft maker, after Boeing and Airbus and is ranked just slightly ahead of Embraer. Bombardier’s particular niche is the manufacture of regional aircraft, business jets and rail transportation equipment. In the harsh post 9-11 world, Bombardier is working hard to find new answers to old problems and is using new business strategies to ensure profit growth. The firm is bang in the middle of a three year transformation programme that is radical and which could become a template for other transportation companies to follow. Improvements at Bombardier’s transportation unit have helped the Montreal-based corporation’s second quarter [Q2] revenue grow a modest 1.6% to $3.88bn over the same period last year. Consolidated revenues of the corporation were stable over the period, despite the effect of a lower US dollar, which had a negative impact mainly on the aerospace segment. Notably, the company is back in the black after second quarter [Q2] trading in 2004 – a marked turnaround over the $209m overall loss registered in Q1. Consolidated revenues reached $7.7bn for the fiscal year to date, mainly reflecting higher revenues in the corporation’s transportation segment. Bombardier’s Transportation division saw the largest turnaround in the corporation, having turned a Q1 loss of $196m into $44m in earnings before tax [EBT] in the second quarter. The performance was offset, however, by lower revenues in aerospace, where sales remain challenged, declining 5% to $1.95bn from $2.05bn in the quarter. At the end of September came the news however that Bombardier’s Aerospace division had signed a contract worth a potential C$2.45bn with national carrier, Air Canada, for the firm supply of 15 CRJ700 Series 705 planes and a further 15 CRJ200 for its regional airline, Air

Canada Jazz. Conditional orders of a further 15 CRJ200s and a further 45 planes are under option. There was a catch. The options portion of the contract was contingent upon Air Canada’s emergence from bankruptcy protection under Canada’s Companies Creditors Arrangement Act [CCAA]. Air Canada duly emerged to Bombardier’s relief. According to Robert Faye, senior analyst, transportation and aerospace at Canaccord Capital, Canada’s largest independent investment dealer,“Bombardier’s three largest customers include US Airways, Delta and Atlantic Coast, which is now Independence Air, working out of Washington Dulles. Air Canada’s firm order for 30 aircraft won’t entirely make up for the suspension of purchase orders for 34 aircraft from Atlantic Coast, which Bombardier had on its order logs.” Faye acknowledges that the outlook for Bombardier’s regional aircraft business is challenging.“If Delta files [for Chapter 11 protection] then the production of the regional jet business could decline,”he suggests ominously.“It is an area of risk.” Similarly, Faye points to the fact that the regional jet business has matured. Bombardier is also facing new competition. In the past, the notable opposition was Embraer. “Increasingly you see the Russians and Chinese building their own regional jets, which is redefining the market.” Harry Breach, global aerospace analyst at Banc of America

Bombardier’s urbane vice president, investor relations, Réjean Bourque

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Bombardier’s regional jet, the CRJ200

Securities in London thinks the issue is more complex. “I don’t think that the Russians or the Chinese have any particular edge – except perhaps on price. The more pertinent issue is that the 50-seat regional jet market is maturing faster than expected and in the larger growth 70seat market Embraer is providing powerful competition.” Embraer is competitive on three counts, suggests Breach. It offers a greater seating range from 70-seat craft to 110seat craft, compared with Bombardier’s more limited 70seat to 90-seat craft. Pay-rates are lower in Brazil and the company business model is based on outsourcing, which allows it to be more flexible on margins in a sale. Despite this variable background, Bombardier’s urbane vice president, investor relations, Réjean Bourque cuts a sharper dash these days. “Bombardier has made real and substantial progress in its efforts to restore the corporation's earnings power,” says Bourque.“We are now generating profits and have the impetus for the earnings to grow. We envisage more traction on earnings going forward, backed by a diverse portfolio of products and we will invariably benefit from restructuring.” “Clearly, some of our clients face serious challenges,” notes Bourque. He perhaps retains a more positive view of the regional jet market than some market analysts.“In the broader view, the regional jet market potential remains strong. Regional routes have grown by 33% in the last 18 months. These routes are profitable for the airlines and we are right there with 50% of orders in that market for the last fiscal year.” Bourque says the organisation is leaner and more efficient, and both regional and business aircraft deliveries are up on a year-over-year basis.“During fiscal year 2004, aircraft deliveries totalled 324, compared to 298 last year, representing a 9% improvement,”he maintains. The business aircraft unit took full advantage of a

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recovering market with a strong performance, maintains Bourque. Some 29 business jets were delivered in Q2 – marginally up on the previous quarter. “But there are 53 deliveries this year so far, compared with only 35 in the first half of last year,”he says. Similarly,“firm orders are picking up for a year-to-date total of 60 deliveries, compared to 24 in the same period last year.” “The business jet market is stabilising,” agrees Faye, but he doubts whether the delivery of even a hundred business jets a year will offset the possible decline in the regional jet business. Bourque remains more optimistic. “Regional jet sales sustained the business during the business jet downturn and now it is the other way around. With entries in 96% of the business jet segment, this market recovery means we will deliver a similar number of aircraft for the year,”he says. Signal confidence in Bombardier’s ability to bounce back from difficulty was shown even earlier this year when, in April, the corporation announced that it had successfully closed a mixed term $750m notes offering. The transaction was in two parts: a $500m tranche with a 10 year maturity and a $250m tranche with a longer term maturity of 30 years. It had been two years since the corporation had issued unsecured bonds in the US capital markets. The ease with which Bombardier had arranged both its North American and European banking lines during the summer months confirmed the faith of the corporation’s bankers in its forward order book. Bombardier's order backlog totalled $32.9bn at the end of July, marginally down on January’s total of $34.6bn, mainly due to a decrease in orders in the corporation’s transportation segment. “The turnaround plan and execution of the restructuring are starting to yield improvement in the transportation group's performance. The current EBT level, before special items, represents a good run rate for the next quarters,”

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COVER STORY

Bourque told a group of investors at a Toronto Stock year, Bombardier announced a restructuring plan for the Exchange forum in London in September. “There are also transportation business that addressed excess capacity in signs of a solid recovery in the business aircraft sector; our its industrial operations, pushed performance capital resources remain strong following the renewal of improvements and tried to restore its earnings power. Once fully implemented, the plan is for the restructuring to our bank lines in the US and in Europe and the company is reduce transportation’s costs by approximately $600m a year. liquid,”explains Bourque. One swallow doesn’t make a summer holds the old Bombardier had already begun to replace a large part of the chestnut, but Bourque is quietly confident. “You have to transportation group’s senior management in the early part look at it in context,” he confirms, “our free cash flow of the year and, according to Bourque, the current upturn in performance is significantly improved over what it was last revenue is a direct result of the new team’s efforts to improve year, we have a sound balance sheet, access to strong project management. “The team undertook a rigorous contract review process,” capital resources and explains Bourque. This therefore, strong Manufacturers & assemblers of aircraft vs. Air transport includes a new liquidity.” Bombardier's companies & airport operators 300 organisational structure to free cash flow, defined as improve accountability “and cash flows from operating 250 increase focus on project activities less net management at Bombardier additions to property, 200 Transportation,” he adds. plant and equipment of 150 The company’s Industrial the manufacturing Division has been segments, amounted to a 100 disbanded. Manufacturing use of $164m between 50 facilities and processes will February and July this now form part of the year. This compares to a respective product use of some $1.4bn for the FTSE World Aerospace Index FTSE World Airlines & Airports Index divisions, thereby allowing same period in the 2004 Data as at 30 September 2004. Source: FTSE Group each division to have direct fiscal year. “While our revenues have held and our backlog is good at responsibility for marketing, sales and engineering, as well as Bombardier Transportation, we need to push performance production. "The rail industry is undoubtedly facing improvements forward. Plant efficiency is not adequate, with challenges. We are coping with a difficult economic certain facilities operating at barely 50% capacity. Our goal is environment, while striving to meet the continuously to improve margins,”said Paul M. Tellier, president and chief growing demands for passenger and freight transport, says executive officer [CEO], in late August as the company’s Q2 Bourque: "Bombardier is tackling these challenges by results were announced.“We could no longer delay moving realigning its strategy to address the future demands of the ahead on our restructuring initiative as our competitors have market. In addition, we are strengthening our efforts to not already dealt with industry changes. During the year, we put only deliver high-tech products in a timely fashion, but also in place a rigorous bid review process and we are now to provide them with the service, maintenance and overall back-up that they need," adds Bourque. focusing on project management.” The restructuring of Bombardier Transportation is the In April last year, Tellier announced an aggressive action plan that was designed to restructure the balance sheet, most exhaustive component of the company’s three year restore shareholder confidence, and get Bombardier back programme. It includes a reduction of 6600 rail operations to profitability. That meant an overhaul of the workers [equal to around 18.9% of its workforce], the transportation business and a gradual wind down of closure of seven production sites in five European countries Bombardier Capital, the corporation’s specialist leasing and and the introduction of productivity improvement financing arm.“We have made good on that plan and have initiatives in selected manufacturing sites. Workforce met all of our commitments,” says Bourque. “Overall, we reductions have already begun at some locations. The move are where we expected to be at this most challenging and was significant. Bombardier employed a global workforce of 35,600 people, 78% of which were based in Europe.“The crucial phase of our three year plan.” “Altogether, our continued focus on execution, the excess capacity issue is most acute in Europe,” benefits of restructuring, and our diversified presence in a acknowledges Canaccord Capital’s Robert Faye. Not global transportation market are giving us traction on surprisingly Bombardier reports that 86% of the workforce earnings growth going forward,” he continues. “As for reductions will occur just here. In North America overcapacity has already been Bombardier Capital, results and the winding down of addressed. Four sites including Kingston in Ontario; portfolios are on track.” Underlying the second quarter recovery was a Burnaby in British Columbia; Barre in Vermont; and turnaround at Bombardier Transportation, a leading Pittsburg in California have closed or suspended supplier of equipment to the rail industry. In March this operations. Other sites overseas have either closed or been

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SEDOL 2109712 Country Canada Exchange Canada (Toronto) Economic Group General Industrials (20) Sector Engineering & Machinery (26) Sub Sector Engineering General (267) Full Market Cap (millions local) (CAD) 1,043 Full Market Cap (millions USD) 824

Boeing

l-0

Bombardier A

-0

identified for closure in 2004. Amadora in Portugal and program, launched earlier in 2004, will rationalise the operations in Doncaster in the United Kingdom [UK] have number of suppliers the business utilises, increase parts closed, while Derby Pride Park in the UK will be shut standardisation, and centralise negotiation processes to down at the end of this year. However the firm will achieve economies of scale wherever possible. “The urgency to move at Bombardier Transportation was maintain its operations at Derby Litchurch Lane in the UK. The next phase of European closures will occur in 2005, underscored by disappointing financial results in this affecting Pratteln in Switzerland; Ammendorf in Germany; division in the last two quarters of fiscal year 2004,” acknowledges Bourque. Kalmar in Sweden and Wakefield in the UK. Invariably Bombardier will have to cope with a changing The cost of this restructuring is estimated to be $777m, $457m of which was spent during the fourth quarter of landscape in the transportation sector as well as aerospace. fiscal year 2004 [which ended on January 31st this year], The company makes much of the emphasis that it places on its ability to offer project with remaining costs financing and project being spread over the next Beating back the decline – Bombardier vs. Boeing, management.This is spite of two years. “Although the Embraer & FTSE World Aerospace Index 140 running down its captive cost of these efforts is finance operation, high, these steps are 120 Bombardier Capital. essential to maintain our “Customers are competitive position in 100 increasingly expecting the market,”says Bourque. 80 suppliers such as Since 65% of costs are Bombardier to come in with in materials, this 60 a financing package and initiative also includes 40 life-cycle costs to new arrangements with accompany the sale of suppliers to better capital goods,” explains coordinate materials Bombardier A Boeing Data as at 30 September Canaccord Capital’s Faye. In procurement, he adds. Embraer ON FTSE World Aerospace Index 2004. Source: FTSE Group addition, he says: “they also The upside of the restructuring programme is the improvements being made expect you to maintain services and facilities for up to 10 to 15 to selected sites. Five locations, in Crespin, France; Aachen years. It is very different to the past where plain vanilla lease and Siegen in Germany; Bruges in Belgium; and Crewe in based financing would see you through. Now you are asked the UK will take part in the initial phase of a global to come in on a project financing basis, such as the buildindustrial site improvement program that will, over time, own-operate-transfer [BOOT] model.” “There is a small residual element of doubt that be rolled out to all manufacturing facilities. This program will focus on reducing inventory levels and production Bombardier has fully audited and reserved on its contract overhead, improving project management and increasing portfolio,”says Banc of America’s Harry Breach,“and that it is able to execute its plant closure programme without efficiency in site configuration. “Initiatives launched in the fourth quarter of fiscal year delays or unexpected side-effects. However, for the 2004 will set the stage for the third phase of our strategy – moment it seems under control.” That doubt does not stretch to the Bombardier team. capitalizing on growth opportunities and maximizing shareholder value next year,” he explains. Management is Bourque in particular remains optimistic. “Overall, also targeting procurement and supplier base as areas Bombardier’s strengths are positive cash flow in the fourth offering significant opportunities for cost savings and quarter, a strong backlog, an excellent product portfolio efficiency improvements. The procurement integration and a solid global market position,”he says.

Embraer ON

2108601 2313030 USA Brazil US (New York) Brazil (São Paulo Stock Exchange) General Industrials (20) General Industrials (20) Aerospace & Defence (21) Aerospace & Defence (21) Aerospace (215) Aerospace (215) (USD) 43,522 (BRL) 3,831 43,522 1,342 Data as at 30 September 2004. Source: FTSE Group

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SECTOR REPORT: DIAMONDS

Taking the rough with the

smooth When De Beers adopted its “supplier of choice” strategy four years ago, it triggered an earthquake. The aftershocks are still rocking the diamond industry. Value added is migrating to miners and retailers as the web of middlemen who distribute diamonds unravels. Now De Beers plans to bring its fabled name to the US retail market in partnership with luxury goods powerhouse Louis Vuitton Moet Hennessey [LVMH]. Neil O’Hara reports on an industry transformation.

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OR MORE THAN 65 years, De Beers operated Jerry Ehrenwald, president perhaps the most successful cartel the world has ever and CEO of the seen. It withheld production when demand was weak International Gemological and bought from third parties when necessary to support Institute [IGI] the rough diamond price. While its own mines and an exclusive agreement to market Russian diamonds accounted for 85% of the world market, De Beers could afford to act as the buyer of last resort. When Rio Tinto’s Argyle mine in Australia came on stream in 1985, De Beers secured marketing rights to preserve its dominant position. During the 1990s, De Beers’ grip on Russian output weakened, Rio Tinto set up its own marketing organisation for Argyle diamonds and Canada emerged as an independent producer. By 1999, De Beers’ market share in rough diamonds fell to 65% and its stockpile ballooned. “The $5bn stockpile was the result of stagnant demand,” says Derek Palmer, global communications director of the Oren Sofer, CEO of Tri-Star Worldwide, the largest Diamond Trading Company [DTC], De Beers’ marketing arm. “The industry had only grown faster than GDP once distributor of certified Canadian diamonds in the US is in the previous 10 years. It was not innovative, not focused incisive. “If there is a weakening of a cartel-controlled on the consumer, or on marketing,” he adds. In fact, environment with multiple players, how is it that the price diamond jewellery was losing ground to other luxury goods of rough has not bounced around? Why is it staying the same or increasing as it nothing changed?” Sofer believes and foreign travel. De Beers responded in 2000 with its “supplier of choice” the new players have learned from De Beers.“They all keep strategy, which placed more emphasis on marketing and their prices,”he says,“nobody is giving away any bargains.” According to DTC’s Palmer, the industry spent an distribution. “For the first time we wanted to be demand driven. We needed to change the image to focus on the additional $275m on marketing by the end of 2003. The consumer,” explains Palmer. DTC overhauled its list of incremental cost squeezed a Byzantine distribution system “sight holders”– the privileged dealers invited to buy rough peculiar to the diamond business. De Beers sells to sight diamonds directly from De Beers at 10 annual ‘sightings’. It holders, who keep some stones and sell others to rough cut the number from 105 to 84 and required clients to dealers. Both sell to cutters and polishers, who used to sell commit additional resources to marketing and distribution. some to polished dealers and the rest to jewellery “The supplier of choice arose because we do our manufacturers, who sell to retailers. A stone can change hands seven times, marked marketing, but it is not up at every stage, between effective if the industry does not follow through and “India has emerged as the leading centre mine and consumer. “The first people who contribute,”says Palmer. for cutting and polishing in recent years.” disappeared were the Statistics show that in the polished diamond traders, past “diamonds were under who bought polished branded [and] under promoted, compared to other luxury goods,” says Kowie diamonds from polishers, maintained a stock and sold Strauss, chief commercial officer of BHP Billiton’s diamond them on to jewellers,” says Robert Gannicott. “The and speciality products division.“The industry as a whole, polishers either became jewellery manufacturers or they including ourselves, is making quite a lot of effort to created relationships with manufacturers. The next people compete with other luxury goods and put more money into who are increasingly disappearing are the rough diamond traders. Now we are seeing small polishing companies that promotion. It is becoming more normal.” “De Beers didn’t make the change out of a sense of just cannot maintain their margins because the price of the philanthropy,”says Robert Gannicott, CEO of Aber Diamond. rough has been going up. If you don’t have a premium “They realised this business could be grown much better if outlet for your polished then you are in trouble.” While the middle is under pressure, miners and retailers competitive advertising emerged.” Aber owns 40% of the are moving into each other’s territory. De Beers entered the Diavik mine in Canada’s Northwest Territories. The strategy worked. Growth in demand has outstripped retail market through a joint venture with LVMH that GDP growth in every subsequent year. De Beers reduced its opened a flagship store in London in November 2002 and inventory by $4bn to sustainable working capital levels while three boutiques in Tokyo last year. It plans to open stores in rough diamond prices held steady. Now the company is New York and Beverley Hills now that De Beers has settled a longstanding US antitrust dispute. operating hand-to-mouth and rough prices are moving up.

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SECTOR REPORT: DIAMONDS

Indian cutters helped Argyle develop a market for small, lower-quality diamonds. “It is a market where Argyle has not only been very successful as a mine, but we’ve very successful in collaborating with the Indian cutting industry to create a whole new product segment in diamonds,”Johnson says. Argyle dominates the market for inexpensive [under $500] diamond jewellery sold at Traget or Wal-Mart.“That’s a market that hardly existed 20 years ago, yet now it is an enormous market for which all of those high-volume retailers, including much of Zales, Meanwhile Tiffany bought a 14.7% stake in Aber and really run their business. Rio Tinto produces higher-value diamonds through its negotiated a supply agreement.“Tiffany’s reaction was very straightforward,” says Sober, “Tiffany was indirectly a De 60% stake in Diavik and premium pink diamonds from Beers’ client. They said,‘OK De Beers is competing with us, Argyle, which can fetch $100,000 per carat for a polished we’re going to go ahead and joint venture with Aber.’ Now stone. “We have well over 90% of pink production,” Tiffany can say, ‘we don’t get all our diamonds from De Johnson says, “that gives us genuine and unusual brand value with those pink diamonds, quite different from white Beers, we are just as direct.’” Aber in turn bought prestige jeweller Harry Winston.“We diamonds. We polish them ourselves, in Perth, in our own dedicated facility, and sell diamonds to people only sell polished pink that supply diamonds to Aber Diamond, BHP Billiton, & Rio Tinto vs. FTSE World diamonds.” Rio Tinto sells Winston,” says Gannicott, Mineral Extractors & Mines Index all its other diamonds “they may not be the same 500 rough and has no plans to diamonds, but the strength 450 move downstream. we have as a mine 400 The diamond industry is producer gives us a 350 trying to create more commanding edge in 300 brand image among purchasing the polished 250 consumers, but it faces we need to run the 200 150 an uphill struggle. Winston business.” 100 “Manufacturers are trying Cutters and polishers 50 to brand their diamonds,” are integrating up and says Pamela Danziger, a down the chain too, principal at Unity according to Strauss. Aber Diamond Rio Tinto Marketing. “I see that “Because they are mostly BHP Biliton FTSE World Mineral Extractors & Mines Index happening, but I don’t private companies you Data as at 31 August 2004. Source: FTSE Group know that it is really don’t hear much about them, but they are buying into retail, they are buying into affecting customers. Jewellery is one of the lower brandawareness categories. The other is the store brand and I production,”he adds. Keith Johnson, CEO of Rio Tinto’s diamond division, think that is more important. Do I trust the guy behind the does not see middlemen capturing more value as the counter to have the right thing?” industry evolves.“The economic rent in the value chain still BHP Billiton recently launched its Canada/Mark predominantly accrues to the producers of rough and programme, which identifies and tracks the stone all the retailers,” he says, “The middle of the value chain is still way from the mine to the consumer. “The retailer can put pretty skinny. It is highly competitive. It is relatively his own brand name on it, but it will have CanadaMark in fragmented. It is dominated by very, very low production the background, like an Armani suit will have the cost companies in very low production cost countries.” Woolmark sign,” says Strauss. BHP Billiton has no plan to India has emerged as the leading centre for cutting and enter retail directly. polishing in recent years.“There used to be 2000 cutters in Sofer has taken the approach through to retail with TriNew York, now there are maybe 200,” says Jerry Star’s brand, Canadia. It takes a diamond that is of Canada Ehrenwald, president and CEO of the International origin, tracks it back to the mine from which it came, and Gemological Institute [IGI]. “New York can not compete sells it to the consumer under the brand name Canadia in its with the lower cost of labour overseas,”he adds. jewellery. “The advantage is the consumer knows that the Other traditional centres have suffered too. Gannicott diamond is 100% real, that it is untreated, that it is mined in believes no more than 300-400 cutters survive in Antwerp.“In a way consistent with their own political or social ideas.” the Indian industry, you have some 800,000 people polishing Rio Tinto’s Johnson wonders how many of the diamonds. They are doing it there because there are good proliferating Canadian brands will endure. Although he artisanal skills at very reasonable labour rates,”he says. sees evidence Canadians will pay a premium for Canadian Keith Johnson, CEO of Rio Tinto’s diamond division

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diamonds, he is not convinced consumers elsewhere will. It connotations from the publicity that attended the antitrust suit for so many years.“It is not quite the same as Tiffany, is a view others share. The industry has tried to eliminate the stigma of ‘conflict which is a nice home-grown, Norman Rockwell-type diamonds’ through the Kimberley process.“If you take the name,” he says. “For us, Harry Winston is more Marilyn number of interested parties that had to sit around and get Monroe than Normal Rockwell, but it is still very much an this going, I think it is an amazing achievement,” says American name.” For all the glamour surrounding premium stones, the Strauss. Nobody pretends the system is perfect, but it has curbed the traffic from questionable sources. While the diamond industry’s prospects hinge on mass retailers and topic attracts media attention, Pamela Danziger’s research rough production. De Beers’ market share in rough has at Unity Marketing shows conflict diamonds barely fallen to 50%. Even so, the supplier of choice initiative has register with most US consumers and do not affect revitalised demand for diamond jewellery in the US, which accounts for half the world market. Rapid growth purchasing decisions. in India and China has further In the premium retail boosted demand, which will market, DTC’s Derek exceed mine supply in 2004. Palmer sees “enormous” “While the middle is under What will happen to rough potential in the De Beers pressure, miners and retailers are prices? Although the name. He notes the joint producers were reluctant to venture does not buy moving into each other’s territory.” comment, their capital rough directly from De spending plans speak Beers.“It is up to De Beers volumes. Diamonds account LV to source stones, which may come from our clients as well as others,”he says.“We for 25% of the exploration budget at Rio Tinto and almost are not competing with our clients. It is like us owning 40% at BHP Billiton. “There is no new slug of production, not one single shares in Cartier. There is no direct business relationship.” De Beers/LV’s US stores may siphon business from large world scale green field development under way Cartier, Tiffany and Harry Winston but probably won’t anywhere in the world,” says Johnson, who nevertheless affect the overall market. “The stores will carry prestige,” expects some incremental production from Southern says IGI’s Ehrenwald. “But not even half the diamonds in Africa, Russia and Canada. “You’ve got relatively the US are sold at the premium stores. They do a great job concentrated supply in the hands of responsible selling the larger stones, but the mass merchandisers sell producers, a steep cost curve, you’ve got a well-balanced more volume.”De Beers’diamonds already reach the US so supply and demand equation, and you’ve got strong demand coming from reasonably good economic growth. its stores won’t be tapping unmet demand. Despite the strong association with diamonds, If you ask me to describe an attractive minerals industry, Gannicott thinks the De Beers name may carry other this one’s pretty well got it all.”

De Beers World Production Estimates

Angola Australia Botswana Canada Namibia Others Russia South Africa D.R. Congo Grand Total

US$ bn 2001

2002

2003

0.9 0.3 2.3 0.6 0.5 0.5 1.8 0.9 0.4 8.2

0.9 0.4 1.8 0.6 0.5 0.4 1.5 0.8 0.4 7.3

1.0 0.4 2.2 1.0 0.5 0.5 1.6 1.0 0.7 8.9

These figures are De Beers’ estimates based on: De Beers' own production figures;

11% 4% 25% 11% 6% 6% 18% 11% 8% 100% Source: De Beers 2004

Published 3rd party production figures; De Beers’ internal estimates of 3rd party production. Dollar values cited here are De Beers’ calculations and estimates of the market value of rough production. It should be emphasised that the data reproduced reflect levels of production, and do not constitute "supply" of rough diamonds to the market in the strict sense of the word. For example, in any given year De Beers - as just one producer - may not sell all of its production, and indeed might call on stocks to sell in addition to its intake.

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EQUITY REPORT: SCHWAB

Just what Chuck Schwab thinks of the idea of selling his company, the Charles Schwab Corporation, isn’t known. But the thought must have occurred to him. It certainly has to others. At age 67, Schwab is now trying to rescue his company. It is a daunting challenge, but the man is a revolutionary, a visionary, a magical marketer, and someone consumed by the thought of his legacy. Can he do it? Art Detman reports.

THE IN WINTER Chuck Schwab

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HESE ARE TOUGH days for Chuck Schwab, the discounters such as Ameritrade and E-Trade, to fullpioneer in discount stock brokerage, Internet trading, service firms such as Bear Stearns and Merrill Lynch – and so much more. Granted, Charles Schwab enjoyed robust earnings growth. Clearly, something had Corporation is the fourth-largest financial services firm in gone awry in the company’s comeback strategy and just the United States [US] and, with nearly a trillion dollars in weeks later the board dismissed chief executive officer customer assets, the industry’s undisputed leader in [CEO] David S. Pottruck. Schwab, who had been co-CEO with Pottruck for five gathering assets. Additionally, its subsidiary Charles Schwab & Co. remains years before relinquishing the post in May 2003, was by far the largest discounter, with 7.5m accounts and 285 named sole CEO while also remaining chairman of the offices across America. Moreover, even Schwab Bank, board. This management suite shuffle strikes analyst Ryan Caldwell as odd. “It is not as if Pottruck was making chartered only in April 2003, has grown to $3.8bn in assets. For all that, stormy weather continues to shadow the decisions without Chuck’s knowledge,”says Caldwell, with Schwab organisation. Questions invariably come into play the investment management company of Waddell & Reed. over the corporation’s ability to remain independent over “It is disingenuous to say that Chuck is coming back to fix the long term. Revenues have dipped from a record the problems that were created by Mr. Pottruck. The fact is $5.7bn in 2000 to $4.1bn in 2003. Net income reached that Chuck never really left.” John Kador, author of $718m in 2000, fell to Charles Schwab: How One $109m in 2002, and Company Beat Wall Street and recovered somewhat to In a stroke, Schwab had eliminated Reinvented the Brokerage $472m last year. But is it two major cost centers of a traditional Industry, agrees “I think enough? Opinion varies Chuck bears a great deal of widely. One security analyst brokerage as well as the conflict of responsibility, and I think expects this year’s net interest that exists when a broker’s he’s owned up to it by taking income to be $338m, and of income depends on a customer’s buy over,”he says. the 16 analysts who follow and sell orders. “Things go better when he the company, five have a sell [Schwab] is taking the rating on the stock, which visionary role, acting as the has been sitting at just above $9 for some time. Lehman Brothers says it is worth face of the company and allowing administration to fall to no more than $7, while Morningstar says $6. On the other more capable hands,”he posits. Even so, investors might be willing to give Schwab the hand, Banc of America Securities has a 12-month target of $11.50, and Fox-Pitt, Kelton – the investment banking benefit of the doubt. Remember, when May Day arrived subsidiary of the Swiss Reinsurance Company [Swiss Re] on Wall Street in 1975 and brokers became free to set – sees Charles Schwab Corporation at $14. Make of this commissions, some firms actually raised prices for individual investors. But not Schwab, who headed a small division what you will. Some commentators are brusque in their reading of one-office brokerage firm. He saw a future visible to few Schwab’s situation. “If you can not make money off a others and almost single-handedly invented the deeptrillion dollars in assets,” shrugs Matthew Snowling, an discount brokerage. His great insight was to understand analyst at Friedman Billings Ramsey & Co., who leaves the that low trading fees could not sustain either research or thought unfinished. “Four years ago people argued that advice, and that many small investors wanted neither. So, once Schwab hit a trillion dollars [sic] they will really he eliminated both, hiring instead salaried clerks who achieve economies of scale and it will all fall to the bottom took orders over the phone. In a stroke, Schwab had line. Well, they have not found a way to extract value out of eliminated two major cost centers of a traditional brokerage as well as the conflict of interest that exists those assets.” A grim assessment, to be sure, but earlier this year when a broker’s income depends on a customer’s buy Schwab’s management saw sunny days just ahead. The and sell orders. Schwab continued to defy common wisdom. He collapse of the high-tech bubble was three years past, and the company had new products and two important remained based in San Francisco, even though the acquisitions. The first was US Trust, the country’s oldest industry’s centre was in New York. Blessed with an innate money-management outfit for the very rich, which was sense of marketing, in 1975 he began using his picture in acquired in 2000. The second was SoundView Technology ads [his open face radiated quiet competence and Group, a small research-oriented securities firm that was trustworthiness]. He spent heavily to automate the back purchased in January 2004. “We have never been better office settlement system, and created the world’s first equipped to address our many opportunities,” Charles automated telephone quote system. To the dismay of many, he built a network of branch Schwab informed shareholders. In the second quarter, profits dropped 10% from 2003's offices. Investors loved the idea, and assets skyrocketed. He second quarter [Q2] as other firms – from Internet-only opened regional call centers to handle trading orders,

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EQUITY REPORT: SCHWAB

freeing the branches to focus on new accounts. He gave up mutual fund inflows. This meant the corporation’s earnings $9 m in annual Individual Retirement Account [IRA] fees were more cyclical than those of its Wall Street competitors, and the resulting increase in IRA assets more than made up which also earn a variety of fee income. The corporation’s for the loss. Schwab persuaded no-load funds to pay him a revenues were also declining faster than its overhead. Total small sales fee to offer their funds, and Schwab OneSource employee compensation rose from 37% of revenues in – the first supermarket of mutual funds – was an enormous 1999 to 48% by mid-2004, according to analyst Richard Repetto of Sandler O’Neill & Partners. success. It now offers 1,100 funds. But the biggest problem was that Schwab was no longer the Early on, Schwab embraced the Internet and led the way in low-cost Web transactions [again, assets zoomed low-cost leader it had been in pre-Internet days. Nor, despite upward]. “Schwab was a pioneer in understanding how all the bells and whistles that had been added over time, was Schwab a full-service broker. people use the Web as not Like Sears and JC Penney, two just another way to do “In a 2003 survey, Schwab ranked 27th other iconic retailers, Schwab business but as the way to do is in the middle at a time when business”says Tim Carpenter, out of 38 firms in terms of whether it did market watchers say that more a senior analyst at Watchfire “What’s best for me and my household”. and more customers are GomezPro, which provides seeking either the low end or online business management the high end of the broking business.“Since the bubble burst,” software and services to enable regulatory compliance. When customers began demanding advice, Schwab says Caldwell,“the knock on Schwab has been,‘What are you responded by forming a network of 5,100 independent going to be? Are you going to be full-service or a discounter?’ investment advisors who use Schwab research, trading and There probably isn’t room for much in the middle.” Some opinion says there is. Analyst David Trone of Foxcustodial services, and later by creating Schwab Equity Ratings, which provides investors buy-hold-sell Pitt, Kelton believes the company is highly misunderstood. “Advice light,” he says, “represents the future of mass recommendations on 3,000 stocks. To be sure, there were missteps. Perhaps the most well affluent investing, and Schwab is the only way to play this known of these was Schwab’s decision to sell his firm to paradigm shift. Schwab is our top long-term pick.” It is a gutsy call, for sure. Especially taking into account Bank of America [BofA] in the early 1980s. At BofA, Schwab’s company reckoned it would have access to low- Trone’s supercharged performance targets: 12% annual revenue growth over the cost capital and benefit next decade and a boost in from the halo effect of Falling behind? pretax operating margin being part of the country’s Charles Schwab vs. Ameritrade & E-Trade Financial from the current 18% to largest bank. But Schwab, 500 28%. who became BofA’s 450 400 These numbers look largest individual 350 ambitious considering that shareholder and a 300 Schwab’s vaunted member of its board, ws 250 reputation for putting the reported to be somewhat 200 customer first is perceived disillusioned by reported 150 to have taken a beating. In allegations of supposed 100 a 2003 survey, Schwab incompetence from some 50 ranked 27th out of 38 firms managers and the board’s in terms of whether it did alleged indifference. By Ameritrade E-Trade Financial Charles Schwab “What’s best for me and 1987, he engineered a Data as at 31 August 2004. Source: FTSE Group my household”. Some 40% management-led buyout. of Schwab’s customers The timing was opportune. Just months before the crash of 1987, Schwab gave it high marks, compared with 43% at Merrill, 54% at took his company public with an initial public offering at Morgan Stanley and 61% at leading brokers Edward Jones. The SoundView acquisition was made in part to provide $16.50 a share. By the early 1990s, Schwab was growing rapidly, introducing new products, pulling in assets, and proprietary research to Schwab’s individual and opening new offices. After 1995, everything went into institutional accounts.Yet in August the corporation sold it overdrive. In 1999, Schwab’s stock reached $50 a share, to Swiss bank UBS for $265m – $56m less than it had paid making the company, for a moment, worth $25.5bn, a for it just ten months earlier. The sale was regarded as an shade more than even mighty Merrill Lynch. Offices admission that the corporation’s strategy was off key. SoundView “didn’t fit into Schwab’s discount brokerage peaked out at 430 by the end of 2002. But as the market bubble deflated and daily trading strategy. No one is willing to pay for that research, and with volume declined, some problems came into stark relief. thirty-dollar trades, you’re not charging enough to support Nearly all of Schwab’s income came from stock trades and a competitive in-house research platform,”says Snowling.

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Meanwhile US Trust also had its glitches. One goal was create issues for Schwab, whose company depends on to shift many of Schwab’s customers with m-dollar trading volume. Schwab can not look to mutual funds for accounts to US Trust, which could provide help either. They are under a great deal of pricing pressure comprehensive financial planning services, thereby themselves and are unlikely to accept any fee increases. Meanwhile, Chuck Schwab passionately insists that US generating substantial additional revenues. But fewer than 1,000 of Schwab’s 175,000m dollar accounts made Trust is not for sale, though some analysts believe he is only the switch. “There is very little synergy between the waiting for market conditions to improve. Should it happen, brokerage and US Trust,” says Snowling. “One doesn’t it will likely not happen for some while. As Caldwell of Waddell & Reed notes, if necessarily drive client defections business to the other.” Stuck in the Middle? continue, with each Soon after acquiring US Charles Schwab vs. US Investment Banks 180 passing day US Trust is Trust, Schwab discovered 160 worth less. “Schwab says that US Trust’s record 140 they are not looking at keeping was in shambles. 120 getting rid of it,”Caldwell After US Trust was fined 100 says, though he points $10m by federal and New 80 out that, “it is not a core York state officials, its 60 business.” chief executive was 40 What about the sale of abruptly replaced. 20 Schwab itself? Five years The dissimilar cultures ago, it would have been of Schwab and US Trust a laughable idea. Not have chafed. A number Bear Stearns Merrill Lynch Morgan Stanley today. A prolonged lowof account managers are Bank of America JP Morgan Chase Charles Schwab volume environment reported to have left the FTSE US Investment Banks Index could frustrate the company, taking Data as at 31 August 2004. Source: FTSE Group company’s attempts to customers with them and, apparently, profits. In the second quarter, US Trust’s rebuild profit margins and over time erode Schwab’s profit margin was 6% compared with 37% at Northern market position and value. “I don’t think a sale is imminent,”says Caldwell.“But two Trust and 44% at Citigroup Private Bank. Since returning to the corner office, Schwab has years down the road I don’t think it is crazy at all to think continued the cost-cutting began by Pottruck. Some 145 that this is no longer an independent company. Schwab domestic brokerage offices have been closed over the past would fit very nicely inside of a company like JP Morgan two years, and the headcount has been reduced by more Chase. Even BofA could look at it again. It is a different than 10,000 since 2000. In June a new and complicated fee BofA than when it owned Schwab before.” Richard Bove, stock schedule was introduced, analyst at San Franciscowith trades as low as $9.95 based Hoefer & Arnett, says for investors who pay a Analysts say that Schwab’s costs that many competitors, such quarterly fee or have $1m in remain high and the corporation, as Ameritrade, E-Trade, household assets. A $14.95 like everyone else, cannot depend on Fidelity and others, would rate is offered to those who a revitalised stock market or higher love to buy Schwab’s make 30 or more qualifying customer list. “But Schwab trades a quarter. The new mutual fund fees to generate will want something for its pricing structure has more revenue. systems, name and position stanched the outflow of in the industry,” says Bove. accounts, but it is not likely That means finding a big to solve some of the regional bank or even a national bank that wants to crossproblems facing Schwab Analysts say that Schwab’s costs remain high and the sell its services to Schwab’s customers. Just what Chuck Schwab thinks of selling his company is corporation, like everyone else, cannot depend on a revitalised stock market or higher mutual fund fees to not known outside the company, for he has steadfastly generate more revenue. The Value Line Investment Survey, a refused interviews since becoming CEO. And no one else at proprietary and successful stock ranking system based on the Schwab Corporation is talking At age 67, he is now the collective expertise of 70 independent securities trying to rescue his company. It is a daunting challenge, but analysts, and whose long-term forecasts of market moves Schwab is a revolutionary, a visionary, a magical marketer, have been exceptionally accurate, predicts that stock prices and someone consumed by the thought of his legacy. So four years from now will be only slightly higher than today. don’t count him out. Chuck Schwab may be a lion in That suggests a sluggish trading environment. That could winter, but he is still a lion.

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EASTERN EUROPE Jim Kinsella, executive chairman of pan-European network owner and operator, Interoute

Interoute, one of Europe’s largest and most densely connected fibre-optic network providers, acquired Central European network operator Central European Communications Holdings BV [CECOM] earlier this year. Six months on, the integration of the two companies has been successful, and business volume is growing rapidly. What is the recipe for success for companies planning to expand into Eastern Europe to take advantage of investment opportunities? Francesca Carnevale reports on some of the answers found in Eastern Europe’s telecommunications sector. ITH THE RECENT expansion of the European Union, the Eastern European market is one of the fastest growing and potentially most lucrative telecommunications markets in the world. According to data issued by the International Data Corporation [IDC] this year, the telecommunications market is expected to

WHY LOCAL CALLS ARE BEST grow by almost $20bn over the next five years. Much of that volume will be boosted by the under-penetrated Central and Eastern European markets, adds IDC. Second, new technology, such as the emerging ‘voice over internet protocol’ [VoIP], is now well underway and will spur the take up of new technology within Eastern Europe as the protocol is increasingly adopted and the benefits of it are seen in lower overall transmission costs. Rising business volumes invariably leads to new money. Some estimates have placed potential investment volumes in the sector, in developed and intermediate markets, as high as $85bn over the next few years, according to figures reported by The Yankee Group, the communications and networking research and consulting group, based in Boston, of which a portion will invariably go to Eastern and Central Europe. Telecommunications operators in particular are eager to take advantage of the burgeoning Eastern European market; for at least three reasons. First, technologies such as mobile phones [an already saturated market in Western

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RAIFFEISEN BANK.* FOCUSED ON YOUR NEEDS IN CENTRAL AND EASTERN EUROPE.

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Europe] are only just beginning to take off in the region. European acquisition is one element in a “solid and Second, new internet-based telephony protocols look to aggressive plan” of expanding its network “where and make the cost of communication in Eastern Europe much when it makes the most economic sense,” says chairman cheaper, much faster. Third, low-cost production platforms Kinsella. He sees the acquisition as only the start of a in economies such as Poland and Hungary make them period of intense growth and expansion for the company. The purchase of CECOM follows a series of acquisitions attractive markets for telecommunications companies by Interoute in the rest of Europe. Interoute’s particular striving to remain globally competitive. Investing in Eastern Europe is not easy however, even if strength is in the metro space. “It is where the action is,” you are a cash rich telecommunications company.“Actually, acknowledges Kinsella. The consensus among analysts and it requires a whole new way of doing business,” maintains vendors is that the metro space, where there is deemed to Jim Kinsella, executive chairman of pan-European network be more of a bandwidth bottleneck, will be the strongest owner and operator, Interoute. On-the-ground optical growth area in the short to medium term. Interoute is well placed to take advantage of this trend. representation is, for example, an imperative; as is hiring local managers, he says. Foreign companies also find that It had already rolled out its fibre-optic backbone across business relationships take quite a long time to establish. Europe, connecting 61 cities in 12 countries using “The need to understand the local language, culture and 23,500km of cable over the previous few years. Rather than work customs sounds simplistic. But in this part of the work with third parties to provide its customers [primarily world adherence to these issues is paramount. Business other carriers, such as British Telecom; Telecom Italia and deals are more solid, but relationships do take more time to AT&T] with “end-to-end connections” and so risk what industry specialists refer to as quality of service [QoS] build, and expectations are vastly different,”says Kinsella. Interoute is one of the first major European degradation, Interoute launched a series of metropolitan telecommunications network providers to establish a area networks [known as MANs] in key capitals, such as strong presence in Eastern Europe. The acquisition of Amsterdam, Madrid, Frankfurt, London, Paris and Vienna. CECOM from America’s Zephyr Communications Inc., in The latest addition is a new MAN in Rome. The company May this year has extended Interoute’s network into seven has full operating licences and interconnect agreements in markets, including the Czech Republic, Slovakia, Hungary, most major European countries, while Interoute’s network Austria, Germany, Poland and Romania. “Having been an is the largest in Europe today. “The development of further metropolitan area services Interoute customer for more than 18 months prior to the is pivotal to Interoute’s acquisition, CECOM was strategy of becoming the an ideal extension to Globally competitive? FTSE Poland & Hungary Telecom. most advanced and Interoute’s business,” says Services Index vs. FTSE Developed Europe Telecom. densely connected Vladimir Hendrych, Services Index European network,” says director for Central & 175 Kinsella.“Since we control Eastern Europe [and 150 the network, Interoute has formerly one of the the flexibility to expand, founding directors of 125 develop and tap into its CECOM]. network to meet customer Jim Kinsella is at pains 100 demand. We are in a to point out that 75 unique position to be able Hendrych’s continuing to offer truly competitive presence in the business is 50 pricing without important for Interoute’s compromising quality of long term business service. Invariably, we will strategy in the region.“You FTSE Hungary Telecom. Services Index FTSE Poland Telecom. Services Index continue to explore simply cannot run a FTSE Europe Telecom. Services Index opportunities for business in Eastern Data as at 31 August 2004. Source: FTSE Group expansion and growth.” Europe with the decision The significance of Interoute’s acquisition of CECOM making based at headquarters in the United States [US]. You need people on the ground, who understand salient works on a number of levels. First, with extensive networks issues and can respond accordingly.” The acquisition, of its own across Eastern and Central Europe, CECOM explains Hendrych, allowed Interoute to drive its physical provides complimentary services that fit easily within the network to Bratislava, Romania and Poland thereby: Interoute portfolio. It adds eleven new cities to Interoute’s “bringing us our Eastern European customer base,”he says. networks and has allowed the company to provide The marriage of the two companies had an immediate seamless delivery almost immediately, as both companies impact:“a couple of deals came in through the door, as they shared so-called ‘points of presence’ in Austria and Germany – two centres of information and telephony saw the capability we could offer,”continues Hendrych. Interoute holds firm to the view that its Eastern traffic between central and Eastern Europe and western

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Europe’s financial centres. That should result in better liquidation only two weeks later following an undisclosed connectivity and more reliable services. “We now offer a agreement between Alcatel and Interoute’s shareholders. single connected network that stretches right to New York,” There remains an active vendor relationship in place, though Alcatel is no longer claims Kinsella. “Few can involved in the financing offer that consistency of Fall from grace – FTSE Developed Europe Wireless vs. of Interoute’s growth. service provision.” Fixed Line Telecom. Services Index (Aug 99-Sep 02) Kinsella joined in 2002, Second, is the 250 and in August was advantage that Interoute 200 promoted to executive will enjoy once new chairman, with Alan Lowe technology comes on 150 as chief executive officer stream. “The internet is 100 [CEO]. Soon after his changing the very way in promotion, he was armed which people make a 50 with a mandate to phone call,” says Kinsella. consolidate Interoute’s “Voice calls are 0 pan-European assets, add increasingly being made new assets and put the over the internet, rather FTSE Developed Europe Wireless Telecom. Services Index Data as at 31 August 2004. company at the forefront of than traditional phone FTSE Developed Europe Fixed Line Telecom. Services Index Source: FTSE Group European network service lines. It means that the provision. Previously, as cost of calling will be upturned. In the US, for instance, you can now pay $50 a chairman of World Online, Kinsella had helped drive the month for unlimited calls through North America and consolidation of Europe’s internet industry, having been Western Europe. It will be hard to offer that kind of service the driver behind the merger of World Online with Tiscali, without the kind of long distance connectivity that we can to create Europe’s largest internet service provider. Almost provide. It will revolutionise the cost of telephony overnight, admits Kinsella, the company had gone from throughout Europe and benefit Eastern Europe being in difficulty to “looking for useful assets to acquire.” Kinsella is up-front and direct on the strategy that enormously in the process.” Interoute has adopted in directly benefiting from “It is a unique asset in Europe,”chimes Hendrych. consolidation within the Third, the acquisition wider pan-European marks another milestone A happy ending? FTSE Developed Europe Wireless vs. carrier market. “We have in the efforts of Kinsella Fixed Line Telecom. Services Index (Sep 02-Aug 04) gained from the difficulties and his management 180 of others. Let us be frank. It team to grow and 160 has been a good time to revitalise a company that build up assets and we had gone from boom to 140 have acquired on good dust in the 120 terms at very good prices.” telecommunications Among the assets now fallout at the turn of the 100 incorporated into Interoute century. Interoute is a is KPN Quest’s Ebone privately held pan80 network, which it acquired European carrier and is in the middle of 2002. one of the survivors of the FTSE Developed Europe Wireless Telecom. Services Index Data as at 31 August 2004. Under the terms of the telecommunications FTSE Developed Europe Fixed Line Telecom. Services Index Source: FTSE Group acquisition agreement sector boom in the late with KPNQwest’s Dublin1990s. Interoute is owned by a number of internationally based shareholders, with based receivers, McStay Luby, Interoute assumed full the largest being the Sandoz Family Foundation. ownership and control of the high-capacity MANs in eight According to historical press reports, the Foundation European cities including Paris, Frankfurt, and London. The downturn in the carrier market and the present state invested some €1.2bn in the firm in 1997 and has sporadically injected more cash as required. It has provided of the industry has played into Interoute’s hands.“Because the firm with access to secure finance – useful when the of this, you could argue, we are one of a small band of firm underwent restructuring in 2002 and 2003. It also players left and are well placed to achieve dominance of the helped during and an extremely difficult period when European market. Our Eastern European footprint is a key Alcatel, which had financed much of Interoute’s I-2I component of this strategy,”concludes Kinsella. It might be network build out, decided it wanted to look for an exit a successful one at that. The move dramatically increases strategy. Alcatel reportedly forced Interoute into liquidation Interoute’s network reach, and propels Interoute into the in November 2002, but the company emerged from first rank of European telecommunication providers.

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TRANSITION MANAGEMENT

Have portfolio will travel Paul Marchington, managing director of the transition management group at Lehman Brothers

Asset owners feel more comfortable about switching investments in their portfolios on a regular basis. This is grist to the mill of transition managers, which have flourished over the decade. Transition managers come in many guises and sizes. Investors have more choice than ever before, but can the flurry of new houses offering transition management services survive once the market starts to mature. In the first of a two-part series Francesca Carnevale looks at the changing face of this service market and the emerging benefits for asset owners.

HEN PAUL MARCHINGTON left Deutsche Bank to become managing director of the transition management group at Lehman Brothers, the market was stunned. While at Deutsche Bank, Marchington and his colleagues had built up one of the world’s biggest reputations and volumes in the transition management sector, competing only with other leading houses, such as State Street, and Swiss investment bank UBS Securities. Lehman Brothers was not deemed to have

been in the same league. That, at least, is what the market thought. Marchington thinks differently. Transition management groups in investment banks have traditionally emerged from equities portfolio trading desks, he explains “with fixed income capabilities being tacked on as an after thought. This no longer fulfils the needs of sophisticated multi-asset clients.” He maintains that the move to Lehman Brothers was precipitated by the view that the bank has “a true cross-asset culture. The top down structure created within the transition management group here, provides an ideal platform to fully leverage this strength.” It is a bold assertion. Nonetheless, Marchington maintains that it is the template needed in future, if transition managers are to effectively meet the increasingly sophisticated demands of their clients. It is an interesting take on a market which has been in flux for some years and which many believe is still looking for a cohesive identity. Looking at it from the point of view of a loose, unofficial ranking of the market, Marchington’s move from Deutsche Bank to Lehman Brothers appears brave. Even through five years of year-on-year growth, the transition management business continues to be dominated by only a handful of banks. These include Deutsche Bank, State Street, Russell Investment Group and UBS Securities.

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Typically, these houses have enjoyed two to three times the volume of business that has flowed through second-tier transition management houses, such as Goldman Sachs, Crédit Suisse First Boston, Bank of New York, Merrill Lynch, and Morgan Stanley. The first rank of transition managers would expect to transit some $300bn worth and above of portfolios in a single year. The second tier would expect to handle between $100bn to $200bn worth of volume a year. Below that is another tier of emerging houses such as Lehman Brothers, JP Morgan, Instinet and others, which are establishing a long term stake in the business and whose business volumes range widely from $50bn to $100bn a year. All tiers have reported good growth this year. On the one hand, Marchington’s move was not surprising. His move is only one of many such moves in the market over the last three years. It now appears obvious that investment banks with any pretensions of offering a full programme of services to investors need to have transition management in their armoury and importing experienced talent is the best way to kick-start the process. “In the current performance and accounting environment, effective asset/liability management is at the fore of all assets owners’ minds. Transition management provides a cost and risk-efficient platform of implementing the required changes.

Subsequently, transition management is a key product for any investment bank looking to provide comprehensive coverage to asset owners,”explains Marchington. On the other hand, because of where he moved from it also signalled a new mood in the ranks of transition managers. The old guard would, in future, have to look more carefully at the rising houses. “The transition management landscape is constantly evolving. Dominant players today had yet to gain momentum three years ago, and without question the dominant names will change in the coming years. Success will be governed by adaptability to change,” says Marchington. How fast established houses will be forced to change is still debated. Even assuming that the demand for transitions falls off, “which, obviously, it must do at some point,” says Daniel Wiener, State Street Global Markets in London, “a flight to quality is an important feature of any maturing market. We believe we must still garner market position whatever happens.” Wiener acknowledges that the market is still far from maturing. “We are probably at an intermediate growth stage,” he concedes. Even so, he is ruthlessly candid on the prognosis for the young pretenders in the business.“There’s not enough space for the 25 or so firms that are in this space.

A member of RBC Financial Group

www.rbcglobalservices.com/iis This advertisement is issued and approved in the U.K. by Royal Trust Corporation of Canada, London Branch, which is authorised by the FSA. ™Trademarks of Royal Bank of Canada. RBC Financial Group is a trademark of Royal Bank of Canada. Used under licence.

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Invariably there will come a point where there will be a slow Lehman Brothers’ Marchington, believes that the future down in growth and that may or may not be far off. Many of belongs to liquidity providers.“Transition management has come a long way from basket trading,” says Nash. “It is an the newcomers will simply have to pull out.” Tony Nash, head of transition management at Deutsche increasingly sophisticated means to a sophisticated end. Bank agrees. “If you are serious about this business, the There are market volatility issues, liquidity concerns, and the ability to execute trades barriers to entry are without moving markets. It is enormous. We have a top a huge undertaking without ranked Global Markets and some serious backing behind Equities product. Our fixed Transition management is a key you.” income and equities product for any investment bank RBC’s Proszek thinks that businesses are well looking to provide comprehensive the market is too hung up on integrated and within our definitions. “I think everyone group the transition coverage to asset owners will agree that each transition management team is well is unique and uniqueness integrated with other parts of may require a different the business. You don’t capability and provider to suit achieve that overnight and at small cost,”says Nash.Then again, Nash also thinks that size appropriate situations. As investors themselves become is not the heart of the matter. More importantly it is the more knowledgeable about the transition process they contribution to the market that will be the key to success. increasingly prefer to zero in on certain approaches,”he says. Proszek takes his lead from the client.“No one should be too “This business is not just about execution,”he maintains. Transition management itself is struggling to define itself concerned about fitting into a particular slot, as long as they as a cohesive entity. According to John Minderides, the can provide a fitting solution for clients. They are the vibrant head of transition management at JP Morgan, principle drivers in this business.” RBC’s focus is making clients and prospects aware of the different providers offer varying services. “Among the myriad of new players, it is sometimes difficult to alternatives before them. Proszek concedes that increasing distinguish just what is on offer. These days transition complexity in the market means that it is no longer easy to management covers a lot of activity that is, in fact, not all the distinguish between service institutions.“We help decipher same,” he says. He distinguishes between custodian banks that. It is a challenge,”he says. It is this increasing complexity in the market that is that are “trying to leverage off their custody business, investment banks that are essentially trading venues, causing established houses to fight hard to reinforce their investment managers such as Barclays Global Investors respective market positioning. Some, such as Deutsche [BGI] which sells a fund management model of transition Bank’s Nash think the answers and advantages available management and the integrated houses such as JP Morgan. from the market’s liquidity providers are self-evident. Nash Then there are consultants, such as Frank Russell that sell believes that the advantage of houses such as Deutsche transition management services on the back of project Bank is its ability to call on its own balance sheet. It provides flexibility in transiting a portfolio, particularly management expertise.” JP Morgan’s business niche, maintains Minderides is regarding timelines. “The ability to use the firm’s balance clear. “It is clearly an integrated offering, comprising the sheet allows enormous flexibility for the customer,” services of bank, brokerage and custodian.” It’s a depth of explains Nash.“Customers with illiquid tails are difficult to service that few can offer. Some so-called transition unwind in a few days.” Property is a good example of a portfolio asset that cannot managers claim to be grander than they are, he submits. “You should not confuse the ability to trade out of a be unwound quickly. Keeping property assets is a feat that portfolio with the ability to provide serious transition few can compete with, acknowledges JP Morgan’s management services,” he adds. Other houses however Minderides.“We are certainly in a position to take on stocks claim to have few pretensions to grandeur. “We are a and bonds and have done so regularly in recent times. We consultant more than anything else,” says Stan Proszek, have bought a book of business and managed out of it, it is director, trade management services at Royal Bank of part and parcel of the type of service we can offer. I honestly Canada [RBC]. “As a consultant we separate transition doubt however that we would want to take a few floors of Canary Wharf though!” management, from execution which we outsource.” For the moment, it is a view that few need to share, with Deutsche Bank’s Nash, however, sees the market dividing neatly into two halves: liquidity providers, such as Deutsche transition managers seeing new growth opportunities in Bank, Lehman Brothers and JP Morgan, which have the North America, Europe and Asia as a reason to invest in capability to execute directly themselves and utilise their building the business. “It is still an evolving product,” says own balance sheet; and liquidity resellers, such as Russell Deutsche’s Nash. Equally, the recent history of negative Investment Group, [BGI] and State Street, which utilise returns by many pension and investment funds means that brokers to help execute a portfolio transition. Nash, like for the time being transition managers are being kept very

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John Minderides, head of transition management at JP Morgan

“Among the myriad of new players, it is sometimes difficult to distinguish just what is on offer. These days transition management covers a lot of activity that is, in fact, not all the same”.

busy indeed as pension funds and other institutional investors move to alternate investment strategies. “There’s no doubt that asset owners are looking at transition management more seriously as a way to manage change,” says RBC’s Procjeck. State Street’s Wiener explains that structural changes in the way asset owners and asset managers approach their portfolios means that, “people are focusing on returns; moving from balanced to more specialist portfolios and taking an outsourcing approach. This dynamic has meant more acceptance of using the process of transition management. It is very unlikely for anyone to transit a significant pool of resources without a transition manager,”he says. The transition business is not new to institutional investors, but it has been used with increased frequency in recent years.Transition managers are usually hired to change securities holdings in legacy accounts to create either single or customised target portfolios.There is no single category of transition managers.They come in all shapes and sizes. Asset owners call on transition managers, brokerage firms and/or master custodian banks to handle account transfers or liquidations. “The realignment of asset / liability imbalances and the more aggressive pursuit of alpha continue to be key catalysts for transition opportunities, so although the frequency of transitions continues to grow so does the average size,”says Lehman’s Marchington. Deutsche Bank’s Nash, meanwhile, is more specific. He notes an growing incidence of switches from actively managed portfolios to passively managed portfolios.

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Cost is an important variable in determining which transition manager is right for which customer, maintains RBC’s Proszek.“Cost is naturally an important issue, but is only one of the key measures of success,” says Paul Marchington.“At Lehman, we believe that the success of a transition should be measured against a number of qualitative and quantitative benchmarks including: objective fulfilment, the quality of service provided, implementation shortfall (cost), benchmark deviation and operational success.”It is a hefty definition of an optimum outcome and one that will increasingly challenge providers of transition management services. Lachlan French, head of transition management at State Street Global Markets agrees. “The unique nature of a transition means that it is hard for invstors to make direct comparisons. It is extremely difficult to come to objective measurements describing the success of a transition.”French is interested in developing standards by which transition managers can be compared, “not just to provide objective measurements, but to bring some kind of order to the market. But, he acknowledges that it would only make sense if it was a standard adopted by everyone. The development of these standards, he believes is still some way off in the future. Present business volumes and market traits carry some compensation however. “At the end of the day, transition management is offering our clients a way of makin glow cost changes to their funds. We know they are getting the benefit bu we need to continue to improve the measurement process so that the benefits are increasingly understood,”says French.

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When international financial pressure groups, such as the Giovannini Group, specialist advisors to the European Commission on financial market issues, and the Group of Thirty Consultative Group on International Economic and Monetary Affairs, begin to push for change in the corporate actions sector, then market professionals sit up and listen. This is particularly true when the groups recommend that action be quick and remedial. In fact, the corporate actions sector has been highlighted with monotonous regularity in recent years, as an area requiring urgent action to mitigate inherent risks. That urgency seems well founded, writes Rekha Menon.

Automation: a cure or R

case for

risk? 54

ISK EXPOSURE HANGS heavy in the corporate actions sector. That was the key finding in a recent research report published earlier this year by United Kingdom [UK] based economic consultants Oxera. The report, which was sponsored by The United State’s [US’s] Depository Trust & Clearing Corporation [DTCC], the world’s largest processor of corporate actions, attempted to quantify risks [or costs] associated with corporate actions processing. The report concludes that the global securities industry is exposed to billions of Euros worth of risks. Importantly, individual securities firms are exposed to potential risks that could run into tens of millions of Euros from just one complex corporate action event. To appreciate the findings it is important to get down to basics and understand the key drivers in processing corporate actions. When a publicly traded company initiates a process that brings actual change to its stock, the company is said to have issued a corporate action. Alternatively, corporate actions can be defined as any event

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initiated by a corporation that affects its capital structure or grown our capacity to process an increasing number of financial conditions [such as mergers, spin-offs, stock corporate actions without increasing our cost base, buybacks and stock splits]. It is estimated that close to one factoring volumes across all event types. Whilst many million corporate actions take place every year. The voluntary events are still semi automated, our operational processing of each corporate action, from data capture and efficiency has grown by a further 27%," he adds. While Citigroup’s aim is cleansing to settlement to automate the chain from and reconciliation, is a the issuer right through to complicated affair. It also the investor, reaching the involves several market Holy Grail of 100% participants: from the automation has not proved issuer to intermediaries that easy to achieve in such as custodians, fund practice. "We have already managers, brokers and achieved over 99% depositories, and finally automation for some of the the end investor. The standard, mandatory process is largely manual, events and that was with phones, faxes and achieved a long time back. telexes still often used to Where the problem arises transmit instructions. is with voluntary events Lack of standardisation such as tender offers and only adds to the woes. rights issues. Here the There is absolutely no process becomes complex standardisation in the way and automation takes in which a corporate place in bits and pieces. We action is reported or have achieved nearly 60% subsequently processed. It automation in this area," boils down to conforming Charles Banister, business manager for Global Custody at Citigroup, explains Banister. to local regulatory or Global Transaction Services EMEA Citigroup began market practices, whichever prevails. Invariably, these can change automating corporate actions processing in the late 1990s, along with several other large custodians. Affected the most significantly between jurisdictions. Not surprisingly then, the chances of failure are by the lack of automation, large custodians have taken a extremely high and, potentially, can affect each market natural lead in the drive towards corporate actions participant. “The whole area of corporate actions is a automation. Other intermediaries, such as asset managers jumble, a hotchpotch of communications. And every and broker/dealers, are only now beginning to accept the connection point is a potential point of failure. Everyone is need to automate. Beginning with a simple global events worried about missing a corporate action, missing a part of repository in the late 1990s, Citigroup now has two core a corporate action or misrepresenting a corporate action,” corporate actions processing applications. One of these is a warns Jim Femia, managing director in-charge of asset vendor solution that automates its European operations and the other is proprietary and automates operations servicing and corporate actions at the DTCC in New York. With issuers trying to come up with more innovative around the rest of the world. Banister says, in the long term, events, and an increase in global and cross-border the bank intends to have a single global corporate actions activities, where securities have to be listed on multiple processing solution for all of Citigroup’s custody operations. JP Morgan Investor Services [JPMIS], the global exchanges and settled in different regions, the risks involved in processing corporate actions continue to custodian arm of JP Morgan Chase, uses a proprietary increase. The main motivator in automating corporate automation solution at its global corporate actions actions processing is invariably the requirement to reduce operations centre in Bournemouth in the UK. Along with processing corporate actions for JP Morgan’s custody operational risk and, where possible, to reduce costs. “Undoubtedly, corporate actions is the greatest risk area operations, JPMIS also operates a corporate action solution in the custody business,” acknowledges Charles Banister, for institutional investors that covers 84 markets. While the business manager for Global Custody at Citigroup, Global custodian regularly looks at alternative vendor solutions, it Transaction Services EMEA. Banister explains that has not found an external system that fully satisfies its Citigroup adopted an automated approach in order to requirements. One of the biggest challenges in finding the reduce risk, receive more timely information and increase right product, according to Clyde Piercy, vice president and customer service response times. In addition, it also helped custody product manager at JPMIS, is how to deploy an to lower the custodian’s unit cost of processing. "We have application so that it interacts with all its existing achieved significant cost benefits,” says Banister.“We have automated systems [for example its trading systems,

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CORPORATE ACTIONS AUTOMATION

foreign exchange systems and so on]. The total cost of deploying and maintaining a third party corporate actions solution is also a key consideration. The market for third party vendor solution of corporate actions automation is still maturing. Seeing the interest generated by the subject in recent times, several software vendors have announced their own automated corporate action solutions. In fact, a survey done last year by Londonbased consultants, CityCompass, evaluating corporate action vendor solutions in the UK and European markets, identified nearly 30 vendors and products. However, industry practitioners state that there are essentially only a handful of serious contenders in the marketplace that can meet the specific requirements of the various intermediaries, such as custodians, asset managers and broker/dealers. “While corporate actions announcements are the same for all intermediaries, how they process entitlements differs. The workflow differs and our solution has to be customised accordingly. For instance, fund managers have a small downstream notification process, while custodians have an extensive one. And while fund managers have a very large custodian network, large custodians themselves have a small defined set,” says Brendan P. Farrell, Jr., managing partner of corporate actions solutions vendors, XcitekSolutionsPlus. With over forty clients already using its corporate action solution, XcitekSolutionsPlus claims that it has gained ten new clients in the last year alone, a majority of which are in Europe. For other vendors, it is a very different story. CheckFree [formerly Heliograph], which launched its corporate actions solution two years ago and a new version earlier this year, admits the market is tougher than it expected. Gert Raeves, business development director at Checkfree suggests this is a legacy issue. He says that a flurry of new, and perhaps in some cases immature, product launches in the corporate actions sector that were based on projections of an upsurge in demand for vendor products, has left the market in a kind of limbo. Combined with continued

Clyde Piercy, vice president and custody product manager at JPMIS

budgetary constraints in many financial institutions, this has resulted in a somewhat lethargic mood among potential buyers. There is a marked attitude of ‘let’s wait and see’ among financial institutions, he suggests. “The market is a much more conservative place compared to [sic] two years ago. And a lot of our effort is spent in convincing that the product is right for them,”says Raeves. However, he remains optimistic about the potential of CheckFree’s new product, referring to it as a secondgeneration solution, which he claims significantly reduces project implementation time due to pre-configured workflow features. Other than in the world’s major financial centres, the level of awareness among financial institutions about the lack of corporate actions automation, is still rather low, continues Raeves. Industry experts echo his view. “Awareness about corporate actions and need for automation is still growing. In addition, there is also a mindset prevailing in several institutions that corporate actions are so complex and manual that they just cannot be automated. So the education process is still continuing,”

Corporate Action Life Cycle

ANNOUNCEMENT COLLECTION

ELECTION PROCESSING

Collect corporate action announcement information ■ Consolidate data and prepare for comparison ■

(FOR VOLUNTARIES) ■ Reconcile elections

Communicate elections through financial intermediaries ■ Submit instructions before deadline ■

ANNOUNCEMENT VALIDATION

Normalize, reconcile and enrich data ■ Validate for accuracy and completeness ■ Produce scrubbed announcement record ■

EVENT SETTLEMENT

Deliver securities, if necessary ■ Receive securities and/or money payment ■

IDENTIFICATION & NOTIFICATION

RECONCILIATION

Determine investors impacted by event and calculate entitlements ■ Notify investors of announcement information ■

Allocate entitlements to investors ■ Notify investors of final transactions ■ Close-out event ■

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says Pamela Brewster, senior analyst at research firm, Celent Communications, and author of two reports on corporate actions automation. According to Brewster a notable obstacle to achieving full corporate action automation is the basic corporate actions data itself, which is non-standardised without any uniform way of representing information. She is not alone in her thinking. “There is not consistency in data format [sic]. The biggest challenge is in getting data in a timely manner and managing change,” says Sandra Harris, director business services, in the Securities Valuation Division of Financial Models Company Inc., the investment management systems and services provider. Additionally,“there are problems of accuracy and having an incomplete set of data. Different countries have different ways to representing data and that creates issues for cross-border activity. You can have automation but if the core data is bad and faulty, then the benefits are very limited,”states Brewster. “The biggest challenge in the corporate actions industry is that corporate actions are not announced in a harmonised fashion from the various sources. The barriers to complete automation are lack of uniformity around terminologies and the often unique way in which events are managed in individual markets,” says Piercy of JP Morgan.“Recently Nokia had to announce a corporate action is ten different styles and formats,”says Piercy citing an example on how different country regulations impact corporate actions announcements. While Swift’s ISO 15022 messaging standard for corporate actions notifications and instructions is considered the defacto standard and has been around for sometime, the initial take up was slow. And it is only of late that financial institutions have started adopting the format for corporate action messages – with tangible results. At JPMIS, the adoption of ISO 15022 by institutional investors is one of the main reasons for the increase in STP rates for investment instructions on voluntary events from 10% three years ago to 60% at present. Industry experts suggest that one key to resolving this issue is by standardising corporate actions data when it is being disseminated by the issuer itself. A noble aim, but extremely difficult to achieve, contend others. “Issuers are not too concerned about operational issues because they are not stakeholders in the operational process. One option would be to put the onus on standardisation on stock exchanges. However, this is a very long term goal,” comments Raeves of Checkfree.“With investment bankers getting paid to come up with radical and innovative events, it will be difficult to achieve issuer event announcement without regulatory reform," adds Piercy of JP Morgan. Bodies such as the Securities Industry Association [SIA] and International Securities Services Association [ISSA] in the US and the European Central Securities Depositories Association {ECSDA] in Europe,“are working on a variety of event announcement harmonisation initiatives which will help downstream processes in time. However, we

Gert Raeves, business development director at Checkfree

should be realistic with our short to medium term expectations of wholesale standardisation and automation,”he adds. While several observers remain sceptical, nobody can complain about dearth of action related to corporate actions. There are several threads of activity being carried simultaneously, all aimed at ensuring standardisation of corporate actions. The London Stock Exchange’s [LSE’s] recent announcement to offer all its corporate action announcements using the ISO 15022 format is an example of an increased momentum in the adoption of standards in the marketplace. The LSE is the first stock exchange to implement this standard and industry reports suggest that other stock exchanges will follow suit. Market data vendors are also working towards implementing the 15022 standard. In addition, keeping corporate actions as one of its key focus areas, the Security Market Practice Group [SMPG], along with its associated National Market Practice Groups, are working to create globally harmonised market practices. The DTCC too is working on several initiatives such as the Global Corporate Action [GCA] Validation service that is used by financial institutions, such as UBS, to automate the receipt, compilation and validation of corporate action announcement information, and the Global Corporate Action Messaging service, which standardises and automates corporate action information between investment managers and custodians. Indeed, going by the number of ongoing initiatives [over fourteen] to resolve issues related to corporate actions standardisation, it seems the securities industry is working with a vengeance to make up for the inertia of the past. With all the stakeholders working in collaboration, finally the corporate actions industry seems to be moving in the right direction.

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comes

into play

PROFILE: LEHMAN BROTHERS

Lehmans

Bill Stoneman rates Lehman Brothers’ bid for recognition beyond its traditional franchise in fixed income. Steadily building infrastructure to support increased stock and bond trading, capital raising and business restructuring, Lehman Brothers is also making a serious commitment to research – even while other Wall Street firms question whether it is still a business generator. And now it is taking on the cost of offering high-end trading services to institutional investors who are invariably unwilling to pay up for premium service. Brave or what?

OR SHEER DRAMA, few deals are likely to top Cingular Wireless’s $47bn offer last February for AT&T Wireless. The winning bid was made hours after both a deadline for proposals had passed and AT&T Wireless executives had all but assured Britain’s Vodafone Group that it was the winner of an attractive business in the United States [US]. Among the advisors at Cingular’s side were telecommunications bankers from Lehman Brothers, a Wall Street firm that is regularly typecast as a big player in fixedincome markets, but hardly a leader outside of the bond business. The deal could serve as an announcement of sorts. Ten years after gaining its independence from American Express Co., Lehman Brothers Holdings Inc. is making a serious run for recognition well beyond its fixedincome stronghold.“Lehman Brothers is a different animal than three, even two, years ago,” says Jeffery Harte, an analyst for Sandler O’Neill & Partners LLP. “They have improved their franchise in equity origination, in mergers and acquisitions and in research. They have upgraded across the board.” Lehman executives have been talking about diversifying for some not inconsiderable time. They have made strides in the last several years and especially since the US economy

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PROFILE: LEHMAN BROTHERS hit the skids in 2001 and big Wall Street competitors slashed their overhead. Although Lehman cut its workforce between 2001 and 2002, it also kept hiring securities industry veterans in a bid to expand business line and geographic capabilities. Of course, dislodging Merrill Lynch & Co., Goldman Sachs & Co., or Morgan Stanley from their respective mergers and acquisitions and initial public offering perches isn’t going to be easy. And competition from commercial banks, which have far greater lending capacity than traditional securities firms, is heating up in the US. Just the same, Lehman Brothers is well worth watching as it guns for more high-profile assignments such as Cingular’s, say analysts. “You usually lose money betting against Dick Fuld,” posits Brad Hintz, a New York-based analyst with Sanford C. Bernstein & Co. LLC, a unit of Alliance Capital Management LP. Hintz is referring to Richard S. Fuld Jr., Lehman’s chairman and chief executive officer since it was spun off by American Express in 1994. Indeed, Lehman’s stock has turned in a compound annual growth rate of nearly 30% since its initial public offering. In addition, its 29% annual return, including growth and dividends, from 1999 through 2003, was the best among the 50 largest financial companies worldwide, according to Boston Consulting Group research published last spring. Lehman Brothers still has more of its eggs in the fixedincome sales and trading basket than anywhere else. The segment accounted for about half of all revenue last year and in the first half of this year. But the firm is making headway in other businesses. It ranks sixth in global

mergers and acquisitions advisory business in the seven months of 2004, rising gradually from 11th place in 1999, according to data compiled by Thomson Financial. Lehman Brothers also ranks third in US mergers and acquisitions [M&A] business between January and August this year, up from seventh in 1999. Meanwhile, the firm ranked fourth globally in equity underwriting in the first quarter of 2004 and reached the fifth slot in initial public offering underwriting. Its share of New York Stock Exchange and NASDAQ trading has grown, reaching 7.0% and 3.8%, respectively, last year. Lehman Brothers should be especially interesting to watch, says Hintz [who served as the firm’s chief financial officer in 1996 and 1997] and other analysts, because it is gambling on several fronts as it seeks to establish itself in equities and investment banking. Not only is it building infrastructure to support an increased level of stock and bond trading, capital raising and business restructuring, it paid what many analysts says was a steep price for a midsized asset manager last year. It is making a serious commitment to research at the same time that its competitors are beginning to question whether that research brings in business the way it used to. And it is taking on the cost of offering high-end trading services to institutional investors who appear increasingly unwilling to pay up for premium service. “They have to making a bet that by having high-quality research and distribution capability, they will attract initial public offerings [IPOs],” maintains Hintz. A Lehman spokeswoman says executives with the firm were not available to comment. Investors remain cautious, paying just 1.9 times tangible equity for Lehman’s at the end of August, according to Morningstar Inc. analyst Mike Ford-Taggert. By comparison, price-to-equity multiples were 2.1 for Merrill Lynch, 2.3 for Morgan Stanley and 2.8 for Goldman Sachs. The difference might reflect the difficulty in gaining market share in high-margin M&A work or underwriting of initial public offerings. M&A and equity underwriting leaders tend to stay on top, Hintz says, because reputation counts with corporate executives at least as much as actual expertise does. “People will choose a Goldman, Morgan or Merrill because their boards will never criticise them,”he says. Nonetheless, Lehman has had a host of high-profile assignments lately. In addition to its hand in the Cingular bid for AT&T Wireless, Lehman was co-manager of a €3.3bn IPO in March by Belgacom, Belgium’s largest telephone company, in what was the largest European IPO in three years. It advised Fujisawa Pharmaceutical Co. in Japan in negotiating a merger with Yamanouchi Pharmaceutical Co. that was announced in April. The pending deal was valued at $7.3bn. It advised Teva Pharmaceutical Industries in Israel last year on its $3.4bn acquisition of California-based Sicor Inc. And while Lehman is especially eager to attract equity-related business, it continues to handle big debt

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origination jobs. It is the lead underwriter for the state of Lehman’s volatile earnings, which totaled $1.775bn in 2000, California, which is selling $15bn in bonds to refinance before plummeting 29% to $1.255bn in 2001, dropping an state obligations. Lehman describes the deal as the largest additional 22% to $975m in 2002, and then bouncing back 74% to $1.699bn last year. Lehman’s total headcount, now fixed-rate municipal bond sale ever. Founded in 1850, the modern Lehman Brothers story dates 17,300, is nearly double the 8,900 it had at the end of 1999. back perhaps to 1984, when bitter feuds over the firm’s In comparison Merrill Lynch [which - unlike Lehman - has direction between traders and investment bankers led to its an army of retail stock brokers] has 49,300 employees. Rates have risen in the acquisition by American US this year, which would Express [AmEx]. AmEx Defying the herd mentality? be expected to dampen a acquired the Shearson retail Lehman Brothers vs. US Investment Banks bond firm’s profitability. brokerage around the same 350 So far, however, revenue time and it sought to 300 and earnings have held combine Shearson, Lehman 250 up just fine. In fact, the and other acquisitions into a firm appears well on its diversified brokerage200 way to its best year ever in investment banking 150 revenue, earnings and company. The businesses 100 earnings per share, based never meshed successfully on results for the six and AmEx reversed its 50 months ended May 31. course after 10 years of Net income was $1.2bn trying. Unable to find a FTSE US Investment Lehman Brothers Merrill Lynch for the first half of the buyer for Lehman, it spun Banks Index Goldman Sachs Group Morgan Stanley year, or $4.23 a share, on the firm off in a public revenue of $6.0bn. offering. But by most Data as at 31 August 2004. Source: FTSE Group Although nothing accounts, Lehman’s investment banking capabilities withered under AmEx would boost its profile like investment banking business, ownership and it had little strength outside of bond trading is still far more important. Nearly 69% of the firm’s first half revenue was produced by its capital markets underwriting and trading when it regained its independence. Critics have focused on its reliance on the bond business business, which includes trading stocks and bonds for ever since. But it was unquestionably a lucrative business as institutional investors, compared with 17% from interest rates plummeted in the last few years – and one investment banking and 14% from asset management and that enabled Lehman to post better earnings than most of brokerage services to affluent individual investors. Within its Wall Street peers in 2001 and 2002. “The market we’ve the capital markets business segment, fixed income had during the last three years played to their strength,” revenue was nearly three times as great as equity revenue. Even as it remains heavily dependent on trading bonds, says Wayne Bopp, an equity analyst with Fifth Third the profitability and improving rankings among dealmakers Investment Advisors in Cincinnati, Ohio. And its concentration in the bond business enabled are making believers out of doubters within the Wall Street Lehman to staff up when its competitors were trimming fraternity.“There were a number of times I thought Lehman down. “Times got tough and a lot of Wall Street players wouldn’t survive,”says Gary Goldstein, president and chief started downsizing,”says Jeffrey Harte of Sandler O’Neill & executive officer of Whitney Group, a securities industry Partners. “Lehman Brothers took advantage of that by headhunter.“Now, I’ve got to tell you, they’re the model.” More than most firms in the business, Lehman nurtures hiring some quality people at the bottom of the cycle at reasonable costs.” The firm, which calls its New York, its culture, he says, which can be best characterised by London and Tokyo offices headquarters but generated 69% teamwork, rather than superstars fighting for the spotlight. of its revenue in the US alone last year, added investment Underlying its culture, he says, are top executives who have bankers, institutional equity sales and trading veterans and worked together for years. Fuld joined the firm in 1969. Joseph M. Gregory, president and chief operating officer, analysts in Europe, Asia, and the US. Then, in a move that ran counter to its usual preference came aboard in 1974, followed by Stephen M. Lessing, for internal growth and that received lukewarm response head of client relationship management, in 1980. Herbert from analysts, it paid $2.8bn in 2003 for New York-based H. McDade, head of global fixed income, joined in 1983; asset manager Neuberger Berman. That, along with two and Bradley H. Jack, a member of the office of the smaller asset manager deals, boosted assets under chairman, in came on board in 1984. Contributing to the esprit de corps and its ability to keep management from a miniscule $9bn in 2002 to a modest $124bn. Even though Lehman might squeeze more compensation costs below 50% of total revenue, Lehman profitability out of Neuberger Berman, analysts say its would likely add, 30% of the firm is owned by employees. biggest contribution will likely be providing a relatively Lehman is widely credited by analysts with keeping its consistent stream of income. That would help smooth out costs in firm control.

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The firm’s overarching goal is to move away from reliance on low-margin and capital-intensive sales and trading business, especially in fixed income products, by building equity sales and trading and by establishing itself as a leader in higher-margin investment banking. It is also attempting to build a prime brokerage business, which provides technology, securities lending, short-selling and other services to hedge funds. The prime brokerage business is currently dominated by Goldman Sachs, Morgan Stanley and Bear Stearns. For their part, Lehman executives say the firm garners an increasing share of its corporate and institutional investor clients’ business when the same bankers and sales representatives call on them over time. That, in part, drives decisions about managing the firm’s headcount.“We didn’t act the same as other firms in the downturn,”says Bradley H. Jack, the office of the chairman member and now head of Lehman’s investment banking, at an investor conference in London last May.“In 2001, 2002 and 2003, we kept the team together. And that’s really helped us be consistent with our clients.” Securities firms cut their collective US workforce by 66,000 in 2001 and 2002, according to the Securities Industry Association, with layoffs reaching into the senior ranks at many of the big firms. Lehman is poised to benefit from corporate restructuring in Europe and securitisation of distressed debt in Japan, Jack said. Furthermore, he says that debt underwriters like Lehman have a big opportunity in Europe, where securities firms provide about 20% of debt capital, compared with 80% that’s provided by banks. The market will swing toward securities issuers, he added, asserting that securities firms are more efficient than bank lenders. Securities firms have 80% of the US market, he says, compared with 20% for banks. Within its existing fixed income business, Jack told investors that Lehman is broadly diversified across 12 different product lines, none of which accounts for more than 20% of fixed income revenue. Product lines include residential mortgages, derivatives and risk management, municipal finance, corporate finance and junk bonds.Hintz says Lehman is trying to leverage its relationship with debt issuers to pry open the doors for M&A business. Although

Lehman Bros SEDOL 2510723 Country USA Exchange US (New York) Economic Group Financials (80) Sector Speciality & Other Finance (87) Sub Sector Investment Banks (875) Full Market Cap 22,103 (millions USD)

commercial banks are trying to do the same thing from their position as lenders, Lehman’s prospects may be better, he says, if only because it is typically calling on more senior-level officers than lending officers do. Its best M&A prospects, he says, may be with so-called financial sponsors, private equity firms such as Kohlberg Kravis Roberts & Co., which may understand better than other corporate executives that mergers expertise is widely available. Lehman is taking a contrarian approach to building its equity sales and trading business, Hintz says, bolstering the research that it offers to institutional investors and providing high-quality service. In fact, Lehman executives rank high among their accomplishments that the firm placed first in the 2003 Institutional Investor magazine’s “All America Research Team” survey in both fixed income and equity. One problem with this is that highly regarded research isn’t necessarily going to produce revenue, Hintz says. He explained that institutional sales and trading margins are under enormous pressure and that it therefore isn’t clear that Lehman will be able to charge any more for its service than competitors that are taking a low-cost-provider approach. Lehman’s approach will pay off, Hintz says, if expanding relationships with pension funds and other institutions improves its stature as an underwriter of initial public offerings, a business where margins are much wider then they are in trading. There’s no guarantee, however, that Lehman’s distribution capabilities will make much impression with executives of companies that are ready to go public, he says. And new rules in the US barring analysts from helping to sell investment banking services may make it more difficult than ever to convince corporate executives to look beyond firms like Merrill Lynch, Morgan Stanley and Goldman Sachs, he says. “You usually see the Street moving together as a heard, always chasing the same thing,” Hintz says “Lehman is going very different than the rest of the Street at this point.” Chances are that a year from now, when the results of Lehman’s bets are clearer, either other big securities firms will be emulating Lehman or Lehman will be cutting back on its research and white-glove service to institutional investors, he concludes.

Goldman Sachs Group

Merrill Lynch

Morgan Stanley

2407966 USA US (New York) Financials (80) Speciality & Other Finance (87) Investment Banks (875) 45,064

2580986 USA US (New York) Financials (80) Speciality & Other Finance (87) Investment Banks (875) 46,568

2262314 USA US (New York) Financials (80) Speciality & Other Finance (87) Investment Banks (875) 53,885

Data as at 30 September 2004. Source: FTSE Group

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FIXED INCOME

Chartinga new course

The outlook for fixed-income investors is clouding over as the certainty of higher interest rates on both sides of the Atlantic threatens to curtail the strong run that the bond markets have enjoyed so far in the 21st century. Andrew Cavenagh reports on the likely impact of a downturn in the market. NY DOWNTURN IN the bond markets seems likely to catch a lot of investors out, as poorly performing stock markets have induced a massive exodus from shares over the past three years that is still in progress. Regulatory intervention, notably the Financial Services Authority’s [FSA’s] new risk-based capital regime for insurance companies in the United Kingdom [UK], is partly responsible for the size and continuation of the trend. Other insurers seem certain to follow the example of Standard Life, which was obliged to unload £7.4bn of shares at the beginning of the year to meet the FSA requirements. “My suspicion is that investors are still going through transition trades, with some pension funds exiting some of their equity positions,”says Stephan Michel, who co-leads the credit research team for the UK and Europe at Barclays Capital. Many pension funds, which are under huge

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2004

pressure to redress the widening gap between assets and liabilities [largely as a result of depressed share values] are a notable group of investors that are currently transferring money out of equities. “There may also be a shift to products that have equity as an underlying asset,” notes Markus Sgouridis, European legal counsel at the Bond Market Association [BMA]. “This is not an irrational response to poorly performing equity markets,”says Roger Bartley, head of fixed income at Gartmore Investment Management. However, some market watchers believe these institutional investors are in for severe disappointment, as rising interest rates will sharply reduce the returns from bonds compared with the levels seen over the past five years. “You’ve got investors with substantial investments in fixed income who are expecting returns that they’re never going to get,” asserts Graham Colbourne, director of relationship management at the FTSE Group. “People are investing in asset classes that give them no hope of meeting their forecasts – or covering their liabilities,” he adds.“Why would anyone in the right mind want to invest in fixed income at this time in the market?” Indeed, there is broad consensus that bond yields will rise in the months ahead as higher rates reduce the market

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value of the instruments. “Overall yields are likely to be higher rather than lower over the course of the next year,” says Bartley at Gartmore. The severity of the impact on fixed-income returns will depend on how large and sustained the rate rises turn out to be. While the United State’s [US’s] Federal Reserve Bank [the Fed] is expected to raise rates by a further 0.25% before the end of the year, most economists see this move as an “unloosening” of monetary policy to normalise interest rates, rather than the start of a sustained effort to put the brakes on the economy. The pundits point out that growth in the US economy is panning out broadly in line with projections, while inflationary pressures are still moderate. Much the same applies to the UK, while the Bank of Japan still needs to keep monetary policy as loose as it possibly can. It is the European Central Bank [ECB] that is giving some cause for concern, having seemingly adopted a more hawkish stance since its summer recess. While the ECB did not express any concerns about inflation and growth in its most recent monthly bulletin in September, it did draw attention to the risks of rising asset prices – property values are increasing quite rapidly in some parts of the euro-zone. The bulletin notes that ‘boom and bust’cycles in asset prices could be damaging to national economies and the wider community, and it concludes: “The rapid pace of residential price increases in some euro area countries warrants a close monitoring of housing market developments in these countries, given the potential implications for these economies and for the euro area as a whole.” This language has led many in the market to believe there is at least a significant faction in the bank pressing for higher rates across euro-land and that the change in tone could mark the beginning of a more interventionist strategy. “It is obviously the start of a less neutral rhetoric,” observes Lawrence Mutkin, head of bond strategy at Threadneedle Investments. “I would suggest that the people who are monetarist within the ECB are getting concerned that interest rates should rise.” The size and frequency of future rate rises will obviously depend on how much influence these monetarist thinkers can exert on the ECB’s 17-strong board, but the market has certainly taken note. Within minutes of the bulletin’s release, yields on two-year government bonds in the euro zone went up by 20 basis points. Faced with diminishing returns on government bonds, one option for fixed-income investors is to assume the higher risk of corporate instruments. “Credit obligations are going to be more attractive,” says Michel at Barclays. “They offer a little more than government obligations and a little less risk than equities.” “On the corporate side they also have the yield factor,” agrees Sgouridis at the BMA. He adds that financial institutions may be inclined to rebalance the weighting of their bond investments, although it might not directly involve their sovereign operations. “It is a different strategy,” he concedes. “The desks that trade government

Markus Sgouridis, European legal counsel at the Bond Market Association [BMA]

bonds won’t switch to corporate bonds, or trade less government bonds, but the corporate desks may increase their investments in corporate bonds.” There are, of course, risks to this approach. Colbourne at FTSE Group points out that it only requires a single default in a portfolio of corporate instruments to more than wipe out any gains that would have been made over a sovereign investment.“I think you have got to be very careful if you start to play with corporate bonds,”he cautions. Bartley at Gartmore maintains, however, that the market for corporate credit has become sufficiently sophisticated for investors to protect themselves against such risks.“The whole structure of the credit markets has changed dramatically over the last two years. Investments exist now to hedge your underlying investment, and one of the key developments in the European credit market has been the development of the structured credit market.” He adds that the increased sophistication of fixedincome trading over the last five years also means that declining bond values do not necessarily spell the end of investment opportunities. Whereas that might have been the case for a traditional “long” fund manager five years ago, he says it no longer applies to the “long” and “short” manager of today, who can use a whole range of derivatives to exploit market volatility in either direction.“The market has become very much more complex – which makes it very much more interesting,”he says. Another option for fixed-income investors looking for improved returns are investments in emerging markets, a sector that has grown over the last decade to rival the US high-yield market in size. US dollar-denominated issuance from more than 30 sovereign issuers currently exceeds US$230bn and now includes Eurobonds and globals as well as the original Brady bonds. Local-currency and corporate

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Main features of net issuance in international debt securities markets [in billions of US dollars] Year

2002

Total net issues 1,011.40 Money market instruments* 1.70 Commercial paper 23.70 Bonds and notes* 1,009.70 Floating rates issues 198.80 Straight fixed rate issues 800.80 Equity related issues 10.20 Developed countries 945.50 United States 330.70 Euro area 479.10 Japan -22.70 Offshore centres 8.10 Emerging Markets 36.90 Financial Institutions 833.20 Private 697.90 Public 135.40 Corporate Issuers 55.30 Private 44.50 Public 10.80 Governments 102.00 International Organisations 20.90 Domestic Commercial Paper# -99.10 Of which the US: -99.40

2003

1,472.40 75.40 83.30 1,397.00 392.40 983.70 20.90 1,365.90 275.60 768.80 -1.00 16.30 66.90 1,888.60 984.80 203.80 113.30 95.30 18.00 147.30 23.20 -41.70 -81.30

Second Quarter

2003 Third Quarter

Fourth Quarter

2004 First Quarter

Stocks at Second end June Quarter 2004

351.40 3.70 13.30 347.70 74.10 273.00 0.60 318.10 30.50 208.70 -1.80 4.00 13.90 248.20 199.50 48.70 33.90 31.10 2.80 54.00 15.30 -26.60 -41.90

303.90 -32.90 -25.40 336.80 98.00 234.50 4.30 281.60 91.20 124.80 -3.70 0.40 19.50 256.40 209.80 46.60 22.00 18.30 3.70 23.00 2.40 -36.60 -22.30

458.90 49.20 48.70 409.70 153.40 240.60 15.70 435.20 98.20 223.40 7.90 9.10 18.80 409.80 349.50 60.40 40.90 37.20 3.70 12.30 -4.20 7.50 -1.50

521.00 35.00 9.00 486.00 154.40 338.50 -6.90 486.00 126.40 232.70 6.30 0.90 24.10 417.30 339.80 77.50 7.40 0.00 7.50 86.20 10.00 58.40 47.80

347.50 12,332.00 2.60 596.00 -3.40 414.90 344.90 11,736.00 167.90 3,112.70 169.50 8,267.40 7.50 355.90 316.70 11,002.00 6.90 3,200.30 214.80 5,306.00 11.00 283.10 5.00 137.40 18.70 676.20 282.10 9,082.40 234.60 7,675.40 47.50 1,407.00 10.80 1,495.90 7.20 1,249.10 3.50 246.80 47.60 1,237.20 7.00 516.50 -10.60 1,928.40 -26.80 1,309.70

Notes * Excluding notes issued by non-residents in the domestic market # Data for the second quarter of 2004 are partly estimated SOURCES: The Bank for International Settlements, September 2004; Quarterly Review Dealogic, Euroclear, ISMA, Thomson Financial Securities Data, National Authorities.

Net Issuance of international debt securities by region and currency* [in billions of US dollars] Year Region North America

European Union

Others

Total

2002

2003

Currency US dollar Euro Yen Other US dollar Euro Yen Other US dollar Euro Yen Other US dollar Euro Yen Other

297.20 40.30 -7.00 12.30 68.80 463.60 -26.60 86.70 53.30 18.90 -9.60 13.60 419.30 522.80 -43.30 112.50

220.30 52.00 -1.90 25.10 149.50 749.40 -8.90 117.20 98.20 32.90 6.60 32.20 467.90 834.30 -4.30 174.50

Second Quarter

2003 Third Quarter

Fourth Quarter

2004 First Quarter

Second Quarter

27.20 6.30 -1.80 7.60 29.90 212.90 -3.20 27.40 21.00 14.50 1.90 7.70 78.00 233.80 -3.10 42.80

80.70 14.60 0.60 9.60 37.60 211.40 2.20 43.70 31.00 6.20 9.10 12.30 142.4 140.3 -6.9 28.1

99.30 14.30 1.30 12.00 42.00 224.90 1.00 34.00 33.10 37.80 2.70 18.70 149.40 232.20 11.80 65.50

99.30 14.30 1.30 12.00 42.00 224.90 1.00 34.00 33.10 37.80 2.70 18.70 174.40 277.00 5.00 64.70

-26.50 20.50 1.60 12.60 56.00 184.40 4.30 36.20 23.30 16.30 9.00 9.70 52.90 221.30 14.90 58.50

Notes * Based on the nationality of the borrower SOURCES: The Bank for International Settlements, September 2004; Quarterly Review Dealogic, Euroclear, ISMA, Thomson Financial Securities Data, National Authorities.

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FIXED INCOME Stephan Michel, co-leader of the credit research team for the UK and Europe at Barclays Capital

issues are also proliferating. According to September’s Bank for International Settlement’s [BIS’s] Quarterly Review, “despite turbulence in emerging market credit spreads, issuance by emerging market economies maintained a healthy pace in the second quarter.”According to the review, net issuance by emerging economies fell from $24bn in the first quarter of this year to $19bn in the second, though it remained significantly above the average $17bn worth of quarterly issuance in 2003. Furthermore, the overall credit quality in emerging markets has improved significantly. The average rating is up from BB- to BB+ over the period, and almost 50% of the current issuers are now investment grade compared with less than 5% in 1994. As emerging countries continue to develop stronger economic policies and financial institutions they are becoming less vulnerable to external events such as economic downturns in the developed economies and credit crises elsewhere, such as the defaults by Russia and Argentina in 1998 and 2001. Despite those high-profile events, JP Morgan’s Emerging Market Bond Index calculated that the asset class made annualised returns of 15.4% over the five years to 31 December 2003. Such returns from countries whose credit ratings are continuing to improve understandably attract considerable interest from fixed-income buyers who are looking at a downturn in their principal markets. “Some of the opportunities look pretty attractive - at least superficially,” says Colbourne at FTSE Group. The flow of investment may not be one way either, as several Chinese insurance companies are looking at the international fixed-income markets to invest their large –

mostly dollar – foreign currency holdings under the qualified domestic institutional investor (QDII) licence scheme that the government is expected to introduce next year. Janus Capital Group, the ninth largest US fund manager with assets of US$129bn, confirmed at the end of September that it was interested in helping QDII-licensed institutions to invest overseas. In Asia however,“most of the action has been from the private sector,”says an analyst in Basel, Switzerland,“most of the governments are in pretty good shape and have not needed to come to the market.” The BIS Quarterly Review reports a divergence in market views about the strength of the global economic recovery during July and August, with an attendant impact on issuance. Bond and equity prices fell though corporate credit spreads remained more or less the same.“There was a point where rate rises from the Fed caused a slowdown in some markets [high yield was hit, for example, as were less creditworthy emerging markets]; but what this meant in practice was that issuance fell off somewhat,” says the analyst. “But by June/July most of that scare had gone away.” Even so, new issuance slowed somewhat in the second quarter of 2004 compared to the first. Nonetheless it has remained at a strong pace overall this year, and in spite of concerns over the outlook for interest rates, will continue strong relative to 2003. The outlook for the third quarter of this year is one where the market will once again see a rapid pick up of issuance. Although, if the figures reported in the latest BIS review are extrapolated – issuance by emerging market issuers and the high yield sector will continue to be strong.

Graham Colbourne, director of relationship management at the FTSE Group

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HE PERFORMANCE OF high-yield bonds in Europe this year contrasts starkly with that of the more mature high-yield bond market in the United States [US]. Investment bank JP Morgan reported in September that high-yield issuance in the US during the first eight months of 2004 had risen only marginally from $94bn last year to $95bn this year. In Europe, it is a different story however and analysts expect the volume of business to double this year over the unseasonably low level of issuance in 2003. Fitch Ratings pointed out recently that the $21.9bn [dollar equivalent] of high-yield bonds issued in the first half of 2004 was not far short of the $23.6bn achieved in the whole of last year.“It certainly looks likely to be one and a half times, maybe even twice the level of last year,” says Daragh Murphy, high-yield analyst at Fitch. “Demand is outstripping supply. You have a lot of investors chasing high-yield paper.”

DEBT REPORT

The European market for high-yield bonds has escalated strongly this year. As spreads on investment-grade products have tightened, investor appetite for risk has picked up. There are even sound reasons to believe this developing sector is in for a period of sustained growth. Andrew Cavenagh explains.

European High-Yield Debt

Heats Up FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2004

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DEBT REPORT

Investor enthusiasm is fuelled by the improving credit sheets. This usually obliges them to sell to private equity profiles of existing issuers and an extraordinarily low level of houses rather than trade buyers. Two significant LBO related issues came to market in defaults in 2004 to date. Fitch says that in the first half of the September. The first was a €185m year downgrades [in dollar terms] bond priced at par for a yield of 8%. were only marginally higher than The bond part financed private equity upgrades with a ratio of 1.25:1 – a vast firm Clayton Dubilier & Rice’s improvement on the 9:1 ratio [CD&R’s] acquisition of the US water experienced in the first half of 2003. treatment and services company There was also just one issuer default – Culligan International from France’s that of Avon Energy Partners Holding Veolia Environnement. This was in the utility sector. This means that CD&R’s second acquisition this year European high-yield bonds had a of a division of a European-based default rate of just half a percent over parent with significant North the six months, compared with rates of American operations. The earlier deal 6.3% and 20.9% for the same periods was a £1.65bn acquisition of VWR in 2003 and 2002 respectively. International, a global distributor of Moreover, the Avon instance was laboratory supplies from Merck KGaA regarded as a technical rather than a in Germany. financial default. It appears the issuer Daragh Murphy, The second LBO related issue is a was entangled in a protracted takeover high-yield analyst at Fitch €150m floating-rate instrument battle for Midland Electricity and the bondholders were obliged to incur a minimal loss after priced at par to yield 725 basis points [bp] over threePowerGen acquired $515m of bonds back from the issuer’s month Euribor. This deal part financed the secondary buyout in June of German car repair group ATU by US parent at a discount. There are other important trends at work. For instance, Kohlberg Kravis Roberts [KKR], one of the world’s largest the improvement in credit outlook has enabled companies buyout firms. KKR reportedly paid Doughty Hanson, the in the cable and telecommunications sectors to return to German LBO specialist, €1.45bn for the Auto-Teile-Unger the market. Murphy acknowledges the trend as “one of the Group [ATU Group]. The acquisition marks a belated big drivers” in the recovery in issuance volumes. He says victory for KKR, which had tried to buy ATU in 2000 and that after the extensive shake-out in the was beaten to the acquisition by Doughty Hanson, which telecommunications and cable sectors over the past three is believed to have raked in some $850m from the deal for years, only now are new or reformed corporations the limited partners that had invested in the firm’s emerging that can raise money on the capital markets Doughty Hanson & Co Fund III. LBO related transactions are expected to account for again. “The companies that have come through have most of the remaining repaired their balance deals this year. One sheets and reduced debt,” FTSE Euro Corporates BBB Index vs. FTSE Eurozone Index syndicate banker even explains Murphy. 150 140 claims that some 75% of It is a notable turnaround 130 the transactions in his for sectors that were 120 forward calendar fall into previously out of favour. 110 this category. “We are The reasons for their lack of 100 90 extremely busy at the popularity are stark. They 80 moment on many buyout were responsible for a 70 situations,”adds Tanneguy substantial portion of the 60 de Carne, deputy head of losses incurred by investors 50 high-yield capital markets in collateralised debt at BNP Paribas. obligations [CDOs] during FTSE Euro Corporates BBB Index FTSE Eurobloc Index And the market is 2001 and 2002. The unlikely to abate in the sectors now make up 21% Data as at 30 September 2004. Source: FTSE Group near future, as European of the issuance in the first half of this year, while fallen angels account for a companies have some way to go to complete the corporate “de-sizing” that has taken place in the US. Neil Parekh, further 17%. Another cyclical factor that has boosted the level of global head of high-yield at SG Corporate and Investment issuance this year is the increasing number of leveraged Banking [SG CIB] in New York, says he expects the stream of buyouts [LBOs], as large corporations – some of them business from LBOs to go on for at least the next two years. However, Parekh also says that the fallen angel market, fallen angels such as Vivendi – look to raise cash from the disposal of non-core assets to strengthen their balance by contrast, has probably reached the end of its current

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cycle.“Do not expect a lot of issuance in the next two years in the high-yield market [from that source].” Even so, other trends fuelling the high-yield recovery are more stable. The significant surge in issuance from mid-sized [or Mittelstand] German companies, for example, should not be so vulnerable to business cycles. Heckler & Koch, Gildemeister, SGL Carbon, Schefenacker, and Celanse and Duerr are among the leading names that refinanced themselves in the highyield markets in 2004. The tendency seems certain to continue as German companies will no longer be able to count on cheap finance from their traditional relationship banks. The requirements of the Basel II capital accords and the removal of German state guarantees will oblige the country’s regional Landesbanks to increase their margins on corporate lending significantly. Invariably these midrange companies will, in future, tap the high-yield [and other capital] markets for finance on a permanent rather than a cyclical basis. “You have had a host of mid-cap companies financing themselves in the capital markets,” says de Carne at BNP Paribas. “While the LBO market is certainly a favourable and lasting trend, I think the corporate market is the deeper one in the long term.” He adds that companies elsewhere in Europe are likely to follow this lead in 2005, with Italy probably next. “This year FIAT might very well do something.” “I think it will be a permanent shift,” agrees Murphy at Fitch. “Certain companies are taking proactive steps to secure alternative means of finance before the changes [Basel II and loss of state guarantees] come in.” Parekh at SG CIB meanwhile says that there has also been an important cultural change in attitudes towards high-yield bonds.“High-yield bonds are understood as an acceptable financing compared with five years ago.” One sure indication that a market is seen to have good long-term prospects is the arrival of new participants, and SG CIB announced at the end of September that it was going to expand its US high-yield finance business into Europe. “As demand for high-yield financing increases in Europe, it has become of strategic importance that SG CIB continues to extend its product offer to include high-yield in the region,”explained Marc Breillout, the global head of SG CIB’s debt finance division. The investment banking arm of Société Générale says the new European team would be based in London and report to Parekh. The bank will recruit high-yield sales, trading and research professionals for the London operation over the next few months. Parekh says the new team will be the final piece of the “very strong”European leveraged finance platform that SG CIB had developed for both financial sponsors and corporate issuers in Europe – predominantly in the loan market.“High-yield was really the only missing element,” he adds. SG CIB intends to offer high-yield origination to this client base, with particular focus on the telecom and

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2004

Tanneguy de Carne, deputy head of high yield capital markets at BNP Paribas

media sectors. It also expects the initiative to expand its “investor franchise”for all debt products. More competition among arranging banks and burgeoning investor demand should normally produce some downward pressure on pricing. However, the coupons on high-yield issues are likely to remain towards the upper of the range from 6.25% to 11% seen so far this year, as further interest-rate rises seem inevitable. Most expect the Federal Reserve, for example, to raise US rates by a further 0.25% before the year end. While some higher quality issuers may be able to issue below the 8-11% level – particularly if the supply of highyield paper slows temporarily – most bonds will consequently have to pay comparable coupons to those issued in 2003. “I would say that although spreads have tightened, the fact that interest rates have started to go up again has offset that to some degree and issuers are

Non-Dollar Denominated High-Yield Bonds Managing bank Deutsche Bank CSFB Citigroup JP Morgan Morgan Stanley BNP Paribas Goldman Sachs RBS Barclays Capital Merrill Lynch

Issues 20 13 9 8 8 7 6 2 2 4

Value [Em] Share [%] 2,546.9 2,334.4 1,241.8 1,031.7 816.0 689.9 652.6 446.4 381.7 342.3

21.9 20.1 10.7 8.9 7.0 5.9 5.6 3.9 3.3 3.0

Source: Thomson Financial

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DEBT REPORT

and chemical sectors, but it also reflects more aggressive structuring.“It is a little bit concerning that leveraged levels are reaching such heights,”said Murphy at Fitch.“The kind of structures we’re seeing at the moment means that maybe two years down the road we will see higher default rates again.” He added that historically companies that were going to default usually did so in the first two or three years of a deal. “There are some slightly worrying aspects of the current cycle,” agrees de Carne at BNP Paribas. He identifies the recent use of high-yield issues to pay dividends to equity holders as a particular cause for concern. Parekh at SG CIB observed that it was important not to lose sight of the fundamentals in a demand-driven market, such as the present one. “I strongly believe this is an environment where you have to maintain strict credit and cost control.” Another recent development that could check the expansion of the European high-yield market is a worsening conflict between US and non-US banks over the value of pre-sale research. As American institutions are prevented from publishing such research under Securities Exchange Commission [SEC] rules designed to protect investors, they do not like European banks on joint Neil Parekh, global head of high-yield at SG Corporate and mandates doing so.“They think the institution that is able Investment Banking [SG CIB] in New York to publish will gain visibility and that its name will feature probably paying about the same as they were 12 months more prominently with the investors,”explains de Carne at BNP Paribas.“We’ve had several instances this year where ago,”commented Murphy at Fitch. Despite the overall sense of optimism, there are some they’ve tried – from various angles – to stop us publishing.” In addition, de Carne says that while pre-deal research inklings of concern that increasingly aggressive levels of gearing in transactions – notably LBOs – could lead to a might no longer be necessary in the US market, where there sharp increase in defaults further down the line. The recently is a strong base of experienced high-yield investors with their arranged €900m debt package to refinance the acquisition of own research capabilities, in the younger and smaller Grohe [formerly Grohe Holding GmbH] in Germany by European sector it still provides a valuable service. Particularly when an issue involves Saphir 45. W GmbH, a relatively unknown company formed by Texas Increase in the appetite for risk? – FTSE Euro companies or sectors, says Pacific Group and DLJ Corporates BBB Index vs. FTSE Eurozone Index de Carne.“When the market Merchant Banking 108 is three to four times larger, Partners was the first 106 maybe we’ll review the need industrial LBO with a 104 for pre-sale research.” gearing of over six times. He cites an instance in €335m of the purchase 102 July where BNP Paribas was package will come from a 100 joint book runner together high-yield bond. 98 with a US bank on an issue It is a situation that will for a Hungarian fixed-line have echoes for some of 96 telephone operator, and the the US junk bond debacle American bank persuaded in the 1980s. They will FTSE Euro Corporates BBB Index FTSE Eurobloc Index the client not to allow the recall that former junk Data as at 30 September 2004. Source: FTSE Group French bank to issue prebond king Michael Milken sale research. While the based his original and highly successful investment strategy on the premise that triple-C plus transaction was sold successfully, de Carne lowly rated bonds tended to experience lower default rates said that “in the end, many investors turned down the deal”. The head of credit research at one of the big US than expected. While the concentration of BB-rated bonds in the first half investment banks questions the value of reports that are of the year remained constant with the same period of 2003 not allowed to describe details of a transaction, make at 38.5%, there was a noticeable increase in the level of CCC- future projections or give an opinion. “If as a research rated bonds to C-rated instruments from 8.5% to 12.6%. analyst you cannot give an opinion, what use are you?”she Some of this was attributable to new issues from the cable pertinently asks.

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Emerges as a new collateral class

The use of Asset Backed Securities [ABS] as collateral has been discussed for years by various specialist groups in Europe, without any significant success at improving its acceptability. Even today this asset class is still under consideration. Industry players are asking why it cannot be used as collateral and what role it might play in larger strategies. Recent discussions with groups as diverse as Fund Managers, Collateralised Debt Obligation [CDO], and Special Purpose Vehicle [SPV] administrators and brokers have indicated that all are looking to leverage their positions in this peculiar asset class. Max Illis at JP Morgan explains. HE EUROPEAN SECURITISATION market has been growing at an extraordinary rate over the last few years. According to the European Securitisation Forum’s Securitisation Data Report, new issuance in the European securitisation market increased to €125.6bn in the first half of 2004, up 32.2% from the same period one year ago. According to the Financial Times’ Interactive Data European Bond Evaluation team, the current outstanding European ABS Market is approximately €540bn, excluding any CDOs or Pfandbriefe, which are both significant market segments. Given that the existing market in ABS repo is effectively

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2004

zero, the potential for growth in this market segment is enormous. The data is compelling. European mortgagebacked securities issuance totalled €70.1bn in the first half of the year, 17.4 % higher than the €59.7bn issued in the first six months in 2003. Non mortgage ABS issuance rose substantially to €55.5bn through June, an increase of 56.8 % from the same time a year ago. In the more traditional debt market you would expect in the region of 60% of the outstanding issues to be traded as repos within Europe. This figure is based upon International Securities Market Association [ISMA] figures on 2003 European debt outstanding of $7,377bn and 2003 outstanding European repo contracts of $4,772bn [according to the European Repo Council]. This ratio provides an indication of the potential repo market within Europe when compared to the more traditional debt market. Using this ratio to give an approximate value of the potential market size of a mature European ABS repo market we arrive at a figure of €345bn in outstanding repo contracts – both bi-lateral and tri-party. The market for repo-ing these securities could be huge. There are many different reasons why the use of ABS as collateral is becoming increasingly attractive. With the growing abundance of these securities in Europe, there is a corresponding need to finance positions in them. As with other asset types, the repo market is an attractive source of funding and it is expected that when ABS becomes eligible collateral class this will become a significant segment of the market.

EUROPEAN ASSET BACKED SECURITIES

ABS

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there is the expectation that there will be a dramatic move from unsecured lending to secured or collateralised loans, which are less penalised under Basel II – all good news for the repo business. As the capital costs associated with unsecured lending increase there will be a greater requirement to secure the loans through any number of possible methods. The expected result is an increase in the amount of securitised debt and a corresponding need to finance it – probably through SPVs of one form or another. Many potential cash lenders are eyeing this market with great interest. The acceptance of asset backed securities as collateral is not without its own concerns. Credit quality, exposure [through opaque collateral pools] to unknown industries or businesses, and the collateral value or pricing are all pertinent areas.

The Practicalities The credit quality of asset backed securities is, probably unfairly, often perceived as poor. It is a notion not necessarily without foundation. There is a wide variety of tranches available, especially in Real Estate Mortgage Investment Conduits [REMIC] or CMO issues. These tranches vary widely in their credit quality – lower tranches, down to so-called z-bonds, will only repay interest and Regulatory Drivers There are a number of changes to the European regulatory principle after all other tranches have been repaid to the landscape over the coming months that are expected to investor. The senior tranche may well be rated as AAA, but increase the levels of securitisation and drive forward the the lower tranches may often be sub-investment grade. need for securities’ financing products such as ABS repo. Understandably these lower or subordinated tranches When the German Landesbanks lose their government would not be considered quality collateral. However, the reality of dealing with these issues and guarantees in July 2005 many of them are expected to lose their triple-A rating and start issuing Residential Mortgage tranches is somewhat different. The credit rating agencies typically rate each tranche Backed Securities [RMBS] separately and given the through special purpose definition of these ratings, vehicles [SPVs]. At the “The ability to repay interest moment German RMBS One thing that all cash lenders have and principal”, the credit contributes only about 6% to in common is a requirement that the quality can be quantified. the outstanding European collateral is marked to market – as It may come as a bit of a RMBS. Pfandbriefe frequently as possible. surprise, but the incidence of outstanding, however, is in downgrades of asset backed excess of €1trn. securities is far lower than The changes in the that of corporate bonds. German market are already having an effect. SPVs have been set up to provide a According to Moody’s Investor Services’ average one-year funding mechanism independent of the credit rating of the transition rates of 1983 through 2002, an average of 98.9% originating bank. Traditionally, these entities have issued of all AAA rated ABS paper remained unchanged, only United States [US] Asset Backed Commercial Paper 0.04% were downgraded below A and 0.03% below [ABCP] as a source of funding; however, the rates are investment grade in special cases. ABS ratings in comparison have been far more stable. An becoming less attractive. This has led at least some of these entities to look at repo-ing their ABS as an alternative average of 89.3% of all AAA rated corporate issuers remained source of funding – not to replace the ABCP market but to unchanged, whilst 1.00% were downgraded below AA3. supplement it. Indications are that once the intermediary costs of the commercial paper market are considered the Exposure cost of financing is equivalent. Clearly the rating of a particular issue is only one of the key In addition to the changes to the German state requirements for eligibility or acceptance as collateral. guarantees there is also the issue of Basel II. Simply put, Although it can be argued that the credit rating covers many

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Billions

other characteristics of the security, more detail is required. a while in the US but have only recently penetrated the Most existing collateral management systems and service European market to any great degree. Companies, such as providers limit their European Securitisation Issuance 2000:Q1-2004:Q2 Financial Times Interactive eligibility criteria to certain Data, analyse the terms and key data elements – asset 90 conditions of each issue and type, industry, geography, 80 create an accurate indication issuer, etc. Asset backed 70 of the value of the security. securities have two 60 50 By looking at the additional characteristics 40 components of the that need to be considered: 30 underlying collateral, the collateral pool type and 20 principal and income redemption characteristics. 10 characteristics and other The collateral pool 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 criteria, they can arrive at a information will indicate 2000 2001 2002 2003 2004 value of the security. This is the exposure to either a then checked with various particular industry, for Sources: Dealogic Bondware, Thomson Financial Securities Data, JP Morgan brokers who can give example residential Securities, Inc., SR further information and mortgages, or to the collateral type, for example receivables. Asset backed apply a market view of the valuation. This gives an indication securities can be subject to variations in repayment. The of the price of the security where no direct market information principal payments can repay or extend which can leave is available. These types of prices have been accepted in the additional unwanted balances that need to be ‘soaked up’ at United States for years through companies such as Interactive maturity. This has led to wide variations in how these Data and JJ Kenny [now part of Standard & Poor’s], but their usage in Europe has been less securities mature. Varieties of accepted until recently. call options exist allowing the As might be expected; issuer to retire the bond early. reference data is central to the Although this is not limited to One of the main differences effective management of ABS the asset backed securities between more traditional debt as collateral. The differences class the volatility in ABS securities and ABS is the way between ABS and more repayments can lead to the they mature. traditional debt securities can bond maturing unexpectedly, be managed with access to which is obviously not ideal the right sources of data. At for the collateral taker. the end of the day it is the One of the main differences between more traditional debt securities and collateral taker that assumes the risk and this can only be ABS is the way they mature. ABS typically repay the managed effectively with sufficient information. principal monthly, over the life of the security. Each month a new ‘pool-factor’ is calculated based upon the Going Tri-Party repayments of the underlying collateral pool and this is It is clear that asset backed securities are more complex than passed on through a variety of mechanisms to the final traditional debt securities and require more attention to investor. This information is often hard to come by and the detail in their use as collateral. The additional information reality of the market means that occasionally these required to fully describe these securities, the scarcity of securities repay significant portions of the outstanding pricing information and the fact that the collateral value of nominal with little notice. When used as collateral, this can these securities decreases monthly as they amortise, only result in sudden drops in the value of the collateral held. increases the burden of settling such repos through biOne thing that all cash lenders have in common is a lateral mechanisms. For all of these reasons, a dedicated trirequirement that the collateral is marked to market – as party repo service is probably the only viable method for frequently as possible. This is far from easy and has managing these trades cost effectively. probably been the single biggest cause for the lack of an The sixth ISMA Repo Market Survey indicated a large ABS collateral market in Europe. increase in the amount of repos settled through Tri-party repo arrangements. This was for a number of reasons; including cost savings versus bi-lateral settlement, ease of Pricing Asset backed securities are not liquid securities. While execution and settlement, improved risk management by there is secondary market activity, it is not widely reported using auto-allocation functionality. It would seem that the and there is little price transparency. Obtaining an idea of addition of Asset Backed Securities as eligible collateral their current value is very difficult. Enter the specialist can only increase this trend to the benefit of the industry pricing companies. These companies have been around for as a whole.

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SUB CUSTODY

Staying in the sub-custody game is getting harder all the time. And sub-custodians have had to ask themselves some serious questions. Is custody as we used to know it dead? Is subcustody simply outsourcing by another name? Is the cost of providing sub-custody services worth it? The big players are now trying to take over smaller, local houses. Is this good or bad news for sub-custodians and purchasers of custody services? Stuart Fieldhouse tries to find some answers.

F CUSTODY’S HIGH-ROLLERS, Citigroup, JP Morgan Chase, Bank of New York, and State Street Corp. between them enjoy in excess of $8trn worth of cross-border assets under custody. Around half of that comes under the control of Citigroup. However, in order to function efficiently in the world of cross-border trading American, European, and major Asian banks, such as HSBC and Standard Chartered, still rely on networks of sub-custodians to give them the global coverage they need. In fact, in reality, there is no such thing as a true global custodian, one that can provide 100% coverage of the world’s diverse securities markets. The argument proposed by claimants to this title is that their presence on the ground in individual markets gives them a pricing advantage, as well as confidence in their personnel and systems that comes with inside knowledge of their operation. In strategically important markets, most banks certainly seem to want their own subsidiary handling their clients’assets. It makes sense to have your own employees in position in the high volume markets that are traded by the majority of your clients. In less liquid and more specialist markets however,

Custody comes into Check this is not always the case. In these instances, a sub-custody relationship is often the best way forward, even for larger institutions such as Citigroup and State Street. Sub-custodians provide global custodians and brokerdealers with access to the local securities market infrastructure. They have links to a given market’s central securities depository, as well as the central bank and the payments system. Good sub-custodians have to be customer-focused and have the necessary critical mass to keep them in the tough pricing environment that exists today. Value-added services, such as corporate actions reporting, investment accounting, and tax reclamation are becoming increasingly important as a result. “The client comes first,” says Andrew Rand, vice president at Brown Brothers Harriman [BBH]. “We may be an old bank, but we’re certainly not staid. We have excellent systems, and we tackle tough problems for our clients.” Consolidation is the current watchword in the industry, as major international custodians acquire smaller businesses, including more specialised enterprises that help them to add value to their core services. Recent dealmaking activity has seen strategic transactions that bring the major custodians new products, services, technology, and talent. For the larger houses, the absorption of local services and expertise is fast becoming an imperative. For example, JP Morgan Chase merged with Bank One earlier this year, and HSBC famously acquired Bank of

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Bermuda, which has helped to boost its sub-custody business in the Caribbean region as well as adding a specialist fund administration capability to its portfolio. Bank of New York even bought a stake in Netik, a specialist data warehouse used by fund managers. Moreover, there is a subsidiary trend that sees custodians diversifying their product offerings and broadening their services to include fund administration, in order to offer clients bundled backoffice services at cost-effective rates. Partly this is driven by increasingly sophisticated and extensive demand on the part of clients. In other areas, it is simply driven by competition and the desire to monopolise a regional niche. HSBC’s acquisition of Bank of Bermuda is another piece of the consolidation of regional empires in the sub-custody world. Apart from the Caribbean, HSBC is more powerful in its traditional stamping ground in Asia, where it has the most extensive sub-custody network of any financial institution [and where the Bank of Bermuda had a big slice of the fund administration market]. The bank is widely represented in the Middle East, where it has helped to open up local markets to foreign investors. It was the first foreign bank to sign a custodial agreement with the Dubai Financial Market in 2001, and is the only provider of custody and clearing services in the Palestinian Autonomous Area. Similarly, Citigroup has built up a regional specialisation in Latin America. Its representatives sit on the boards of all the local clearing houses and serve on technical committees. It maintains a regional operations centre in Florida that is linked to depositories and exchanges throughout the region. Banamex in Mexico, a noted provider of custody services to foreign investors in the country [with an 88% market share], is also owned by Citigroup. In Western Europe BNP Paribas has emerged with a widely-praised sub-custody network. It covers the major markets itself, and uses sub-custodian banks in other countries. Overall, it holds over $2trn in assets in its network, and handles 26m transactions per year. It acquired JP Morgan’s clearing network in 1996, and started up its own global custody operation in 2000.“Our hearts beat in Europe,” says Tony Solway, head of BNP Paribas Securities Services in the UK.“Using our own branches gives us both a cost and risk advantage. We can manage the value chain all the way down to local levels, and the risk besides.” “We would not describe ourselves as a regional player as we have a global offer,” Solway adds. “Where we manufacture [custody services] ourselves, we do it in Europe.” But does he subscribe to the acquisitive strategy that has helped the big banks build up their impressive custody networks? Aside from the initial 1996 acquisition, BNP Paribas built its UK custody business from scratch. Recently, in Turkey for example, it has built up a partnership agreement with Garanti Bank. “We worked to establish market share, and have found this to be a successful way of doing business in the local market,”Solway says. There has been a lot of focus on BNP Paribas’ backyard recently as the central securities depositories and the European Commission seek to provide a more closely

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Tony Solway, head of BNP Paribas Securities Services in the UK

harmonised securities processing market within the EU. “Euroclear and Clearstream are moving into the field of custodians,” says Rand at BBH. “They are commoditising what global custodians have been doing; it is pushing down the costs. Prices and margins are coming down as a result.” The other major theme affecting the sub-custody business in Europe has been the expansion of the EU to cover 10 additional markets. Overall, those banks that have not established a permanent presence in Eastern Europe are viewing it with caution. Others have been there a while, like Austria’s Raiffeisen Zentralbank, and have played a role in building the local securities infrastructure since the end of the Cold War. “The key is to be able to make an impact,” says Solway. “There are still barriers to that, and we will be taking a cautious approach.” Managing an efficient sub-custody network is an art in itself. Credit ratings are one of the key criteria global custodians use when making their choices in local markets. Sometimes there is little choice to make, due to the limited nature of the banking system in some developing markets. Choices can even become too narrow, as the exit of custodians from the markets in Bolivia and Ecuador recently demonstrates. When faced with a choice of institutions that cannot provide a single non-junk rating between them, custodians have to ask the client to assume the risk before they can provide any clearing facilities, something most clients are unlikely to accede to. BBH has built up an impressive network of subcustodians based on a best-of-breed approach, and prides itself on the quality of the banks it uses.“Sixty per cent of our revenue comes from our investor services group, so we have to take it very seriously,” Rand says.“The size of this firm allows us to change with the market much more rapidly. We are small in assets compared with the Bank of New York, but our partners are on the ground floor, and this differentiates us over other larger competitors.” Apart from credit ratings BBH also focuses on the standards of the technology being used in sub-custodian

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banks. Like in many other areas of the securities services amount of accounting and reporting, as well as performance business, technology spend has become a benchmark for an measurement,”says Solway at BNP Paribas.“They are coping institution’s level of commitment to this service area.“I look with an increasingly multi-manager world. It would be very at technology as a statement of commitment,”says Rand.“If unusual for a pension fund to get accounting done in one a bank is decreasing its spend on custody systems a red flag place and custody in another.” Risk management and proper reporting are also high on goes up with us. We are extremely demanding of our subthe shopping list for major custodians. There are more custody clients. The culture than just minimum The big hitters – Global Custodians vs. FTSE Financials in the US market has requirements.” For Index 150 become increasingly example, when one of demanding for custodians, BBH’s recently-replaced 125 as concerns about sub-custodians started to corporate governance, reduce its technology 100 transparency, and risk budget in the custody area, 75 management have raised BBH was forewarned that the bar for service the bank was likely to pull 50 providers. out of custody provision. “Technology is as “We were asking them 25 important as having a good for more automation, and client relationship team,” this has a high cost base,” Citigroup JP Morgan Chase & Co. Bank of New York says Northern Trust’s Gout Rand explains. “They just State Street FTSE Financials Index of his own clients’ weren’t spending.” Data as at 30 September 2004. Source: FTSE Group demands. “If clients use Banks like BBH and Northern Trust will review their sub-custody multiple custodians, we need to tailor that information. arrangements on a regular basis, on top of reviews Clients are driving us to offer them as automated a solution prompted by other indicators like a change in credit rating, as possible. We have a single system technology platform, or a decrease in technology spend. “We tend to be very and customised reporting.” Global custody is not the cash cow it used to be. Those conservative,” Rand says. “Under normal market conditions we will make four or five changes per year in a banks still in this space are here because they’ve made sufficient investment in terms of people, infrastructure, network covering nearly 100 markets.” This year BBH looks set to make six changes in its sub- and networks to continue to compete. With the custody network, two because of banks leaving the business. increasing sophistication of assets, the stringent At Northern Trust sub-custodians receive a similar level demands of regulators, and the enhanced speed of the of scrutiny. “We rely totally on our custody services,” says global trading infrastructure, it is not surprising that John Gout, responsible for the bank’s European business those still in the game are either giants like Citigroup and development. “We conduct extensive reviews throughout HSBC, or avowed specialists in this field who have made the year. We will also review the situation whenever a sub- it a core competency. The size of a sub-custody network will make little real difference for most institutional custodian is not meeting its target.” For investors seeking a custodian that can give them a clients, so long as the markets they trade in are efficiently global service that is both efficient, and cost-effective, the covered. Service standards and pricing will always be a choice is getting narrower all the time. But service levels are far more critical factor than whether a bank can offer creeping up, and pricing is coming down. Value-added custody of assets in Bolivia or Morocco, hence the services are coming to the fore in negotiations with emphasis now on added value services. For those institutional investors, as banks are seeing them as potential shopping around for a custodian, there has never been a deal-makers.“Pension funds tend to look for an increasing better time to look for one.

Citigroup

JP Morgan Chase & Co Bank of New York

State Street

2297907 USA US (New York) Financials (80) Banks (81)

2190385 USA US (New York) Financials (80) Banks (81)

2076021 USA US (New York) Financials (80) Banks (81)

Banks (810) 141,801

Banks (810) 22,536

2842040 USA US (New York) Financials (80) Speciality & Other Finance (87) Other Financial (879) 14,324

Sub Sector Banks (810) Full Market Cap (millions USD) 227,061

Data as at 30 September 2004. Source: FTSE Group

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To find out more about how you and your company can help UNICEF when an emergency occurs, please go to: www.unicef.org.uk/emergencyrelief if you are in the UK or www.supportunicef.org if youÂ´re outside of the UK. Thank you for your support

AP/Wide World Photos

The earthquake that hit Iran in December 2003 left more than 40,000 dead and injured tens of thousands more. Images like the one you see right are now unfortunately a regular feature not only in Iran but in many countries affected each year by humanitarian disaster. With a presence in over 190 countries, UNICEF (The United Nations Childrens Fund) is uniquely positioned to react quickly to these emergency situations by providing clean water and sanitation, healthcare, nutritional and emergency education supplies. As we receive no funding from the UN, we desperately need the help of individuals and companies to support this work. FTSE already support UNICEF (nearly ÂŁ1,000,000 donated through FTSE4Good so far) and in doing so help us to alleviate the distress and hardship caused to children who find themselves suffering in the aftermath of emergencies such as the recent earthquake in Iran.

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ALTERNATIVES

Mazen Jabban chief executive officer [CEO] and co-founder of Focus Investment Group

Riding the second The Focus Investment Group is known as an innovative hedge fund and claims to have pioneered the specialist-driven “multi-manager” concept. In these tight days for hedge funds, it also claims the edge in other areas. For instance, a topical goal for institutional investors is achieving economies of scale. Another is implementing technology that allows accurate, transparent and contemporary reporting. Unusually, in a market that has tended to rely on prime brokers for achieving all or just some part of these goals, Focus has done it alone and actively promotes and capitalises on its technological strengths. While 2004 has been a challenging year for hedge funds Focus remains optimistic. Karen Jones explains why.

wave of

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ECHNOLOGY AND TRANSPARENCY are keystones is a steady and slow burner. It has spent the last 10 years at Focus Investment Group, an independent, growing assets gradually, alongside its clients and manager, employee-owned, asset management company explains Eugenio Verzili, managing director and head of specializing in fund of hedge funds. With $1bn currently business development at Focus Investment Group. “We under management Focus plans to grow assets to $3bn to built the business from the bottom up, meaning we spent a lot of time and resources $5bn over the next three on building teams and years. Focus’management FTSE Hedge Management Style Indices vs. FTSE Hedge Index 300 technology. Where we considers the fund are today is in a leading perfectly positioned to 250 position on both ends, ride what they call “the particularly technology.” second wave” of 200 Focus, like many allocation from the 150 hedge funds, is readying institutional marketplace. itself to take on board Founded in 1994 as 100 new money as large asset Focus Group, it changed 50 owners begin to accept its name in March last hedge fund investments year to Focus Investment as a measurable portion Group Ltd. Based in FTSE Hedge Index FTSE Hedge Directional Index of their overall portfolios. Bermuda, its asset FTSE Hedge Event Driven Index FTSE Hedge Non-Directional Index Celent’s Valentine is clear management group, Data as at 30 September 2004. Source: FTSE Group about the trend. In 2004 Focus Asset Management (FAM), works out of New York and is a fund of hedge funds. “we see a lot of public plans making announcements about Funds of hedge funds allocate capital to several hedge funds allocations to hedge funds or fund of fund communities. and investors buy shares in them in order to gain exposure The Pennsylvania State Employees’ Retirement System, for to several highly specialised hedge funds in specific regions example, actually doubled their allocation, which is and strategies. Investors in fund of hedge funds will tend phenomenal,” she says. As if to emphasise the point: acquire a proportionate share of ownership in a collective “traditional equity investments will be 5-7%,” says Valentine.“That’s the lowest we have seen in a decade and portfolio of [typically] 12-20 managers. The Focus Investment Group is notable for a number of that means a lot of pension and investment goals are in reasons. One of them is that it is one of the first fund of jeopardy… We are also seeing a lot of activity in fund of hedge funds to register with the US Securities and Exchange funds because of this new environment where more Commission [SEC] and the Financial Services Authority pension plans want to get involved.” As well, ultra-high-net[FSA]. In an industry built worth wealth managers and largely on secrecy, Focus FTSE Hedge Directional Strategies family offices in the United Investment Group tries to 300 States [US] are accelerating maintain transparency. their adoption of hedgeAlthough the SEC will 250 fund-of-fund investments, eventually require 200 according to a recent Prince registration for all hedge & Associates survey of 653 funds, those that are 150 family offices representing currently registered offer 100 more than 34,000 families institutional investors with $1.2trn in investable “more credibility” claims 50 assets. According to the Denise Valentine, survey at present some securities and investments 45% of family offices invest analyst at Celent FTSE Hedge Directional Index FTSE Hedge CTA/Managed Futures Index in funds of funds though, Communications, a FTSE Hedge Equity Hedge Index FTSE Hedge Global Macro Index notably, a significant 84% research and consulting Data as at 31 August 2004. Source: FTSE Group expect to do so over the firm that evaluates and next three years. measures the ways in On the institutional side, if a pension fund’s board of which technology supports business and product strategy. “The investment community is accustomed to dealing with directors is considering allocating money to alternative firms that have disclosure and transparency. The old modus investments, a fund of funds is generally regarded as a “less operandi of hedge funds was to hold your cards close to the risky” option over single hedge funds. The reason is vest [sic]. … If you are registered with the SEC you want straightforward. From a fund of funds point of view, “the more managers I have within my investment pool, the more your name to get out,”says Valentine. Rare in an industry noted for its near term outlook, Focus likely I am going to try to coordinate those managers for n04

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of funds popping up, we different correlations,” will have to segment them explains Valentine. out,” says Valentine. Some “Therefore they will behave ‘specialists’ are “just prime differently in markets and brokers who know a lot of hopefully compliment each managers and think they other to produce an overall have a handle on who are return that is good.” the best. Then you have Because of the investment consultants underlying trend, Celent’s who are purely in the Valentine believes [and business of picking stated in a recent hedge managers. I would go for fund report] that the latter,”she adds. alternative investments The issue does not worry [and hedge funds in Focus. As far as raising particular] “will experience capital Verzili says Focus significant growth in the can not complain.“It hasn’t coming years.” It is a fact been where we would like that Focus is keen to it to be, but there are leverage. Even so, pension various reasons for that. fund investors need to First we have always factor in the costs as well. catered to financial “The hedge fund managers institutions and traditional already make aggressive asset management firms. performance fees and the The recent inflow of assets fund of fund is going to put have come into fund of another fee over that,” funds through institutional cautions Valentine. investors. We have only The hedge fund Eugenio Verzili, managing director and head of business development now really been tapping community then has hit the at Focus Investment Group into that lucrative market.” mainstream market with all of its traditional investment expectations. By its insistence on He adds that they have only been present in the US transparency, full reporting and client access, Focus then institutional race for the last 12 months and actively becomes a spearhead of a movement within the hedge fund marketing to US pension plans.“That’s one reason why we sector that is keen to establish its credibility and credentials weren’t really on the radar screen. We were always catering to ride this crest.“Only the details of implementation are in to a different profile.” But that position is dynamic. “I would say we are in a flux as the market shakes out which actions may impose on the investment process, client requirements and which sweet spot,” says Verzili.“We are in a position to grow. We technology best supports investments, operations and client have the capacity and can double our assets in a short period of time without suffering any consequences. We are servicing,”explains Valentine. Looking towards the future,Verzili is optimistic.“We have now ready for the second wave of allocations going to a niche. We have a process and product that will not smaller fund of funds with a lot of experience and perhaps correlate with most fund of funds products and that other not the mainstream names. We are in a position to reap the fund of funds may find hard to replicate. A lot of investors benefit in the near future.” Mazen Jabban chief executive officer [CEO] and cothinking of investing in single managers will quickly realise how difficult it is to monitor and select these managers. founder of Focus Investment Group agrees and proceeds to They will revert back to outsourcing to specialists.” When asked what criteria investors should use when considering in a fund of funds, Verzili says that there are a Table 1: Focus Investment Group 2004 lot of “misconceptions” about what differentiates one fund of fund from another. He adds that the investment part of Geographic exposure the industry tends to equate fund of funds with mutual % of portfolio Region funds, believing bigger is better. 60% Europe Celent’s Valentine spreads a note of caution. The issue is 18% North America not that there aren’t good hedge funds, or funds of hedge 17% Middle East funds. The issue is being able to distinguish between them. 3% Latin America She certainly does not think all fund of funds advisory 2% Asia companies can be called experts.“There are so many fund

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explain why. Jabban says he lists the firm’s proprietary web- of 1994, 1997 and 2000 through to 2002. As far as the based technology platform as one of four cornerstones in investments Focus specialises in, he offers,“We cover equity Focus’s business approach.“We have built a platform where Long/Short, Event Driven, Relative Value and Macro. every single piece of information from the beginning of the Distressed, Special Situation, credit arbitrage and Japan process, manager qualification to manager due diligence and Long/Short have given us the best return this year and we anticipate that to continue going through the over the next six months.” monitoring of the FTSE Hedge Non-Directional Strategies 200 “Principal protected managers, portfolio structures have come a construction, investment, 180 long way and we feel that execution and reporting are 160 our … approach truly all on a single integrated 140 offers the opportunity for platform,”he says. investors to profit over the “Focus has a clear and 120 long term regardless of concise picture of the 100 equity market direction, exposure of our portfolios 80 while also benefiting from on an ongoing basis. This a guaranteed rate of return picture is created from through a coupon,” said reliable information that FTSE Hedge Non-Directional Index FTSE Hedge Convertible Arbitrage Index Eugenio Verzili, Managing comes right from the FTSE Hedge Equity Arbitrage Index FTSE Hedge Fixed Income Relative Value Index Director of Focus source,” explains Jabban. It Data as at 31 August 2004. Source: FTSE Group Investment Group. also ensure the firm enjoys It has not all been plain economies of scale. “The firm’s proprietary technology-based infrastructure is cost- sailing for the firm. Focus’s management acknowledges effective. Focus employs global staff of 40 employees but, that market conditions through 2004 continue to be without the technology, that number could be as high as difficult. Jabban thinks that it is an issue of market 100 to 120,” says Jabban. He explains that the firm’s confidence – not the result of overcrowding in the hedge technology allows Focus to “streamline” the investment fund sector. Not everyone is chasing the same deals. process and save its research teams from “repetitive tasks”. “Obviously in a year like this when performance is lower, It also means the firm can concentrate on risk management and we make money based on performance, you would see and the efficient monitoring of its managers. “Ultimately revenue go down but that was the same as we had in 1998 this enables us to build strong relationships with our and 1994. So it is really nothing new. The bottom line has managers, which is of paramount importance to Focus,”he to do with the market and it is been a difficult year,” says explains. Focus manages over 20 proprietary multi-manager Jabban. Even so, he claims to be “very happy with what we have achieved and we have done it based on a very simple funds and offers the option of portfolio customisation. “For fund of funds, it is better to be well focused and on the principle, the fact that you are looking at absolute return smaller side,” explains Verzili. With experience a leading versus relative returns.” It is an approach that criterion, Verzili cites Focus’s 10 years of expertise in early identification of hedge fund managers and the ability to work has governed Focus’s of its with more niche managers, particularly those who“can afford development to stay small and not grow to $50bn.They can stay in the $250 international investment In Canada, m to $2bn range. Those are the types of managers that will policy. for example, Focus eventually be able to give you the best returns over time.” By diversifying capital among its specialised managers, has developed a strategic with Focus believes investors can benefit from investment partnership professionals who leverage their capabilities by ‘focusing’ Montrusco Bolton, a their efforts on what they do best. It is a mainstay of the C a n a d i a n - b a s e d money Focus Investment Group approach, and one that it claims to institutional running have pioneered. At the same time, this diversification manager in both ensures that selected strategies tend to have a relatively low C$5.5bn and correlation to each other, thereby reducing both manager traditional and strategy risks. “If the multi-manager approach is to alternative investments. deliver a superior product,”says the firm’s website,“working “We both have a relatively conservative with the world’s best managers is critical.” The other cornerstones are asset management, investment philosophy investment and client advisory says Jabban. Over the last 10 suited to institutions, Frank Belvedere, vice president of years Focus has achieved about 10% return with a downside particularly hedge funds. alternative investments at volatility of less than 5%, even including the difficult years We are both focused on Montrusco Bolton

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capital preservation and risk management,” says Frank Belvedere, vice president of alternative investments at Montrusco Bolton. According to Belvedere, in 2001 Montrusco realised the need for “absolute returns” and started the search for a hedge funds partner. Coincidentally, at that time Focus was looking for a partner in Canada. “Their investment philosophy is very suited to institutions,” says Belvedere. They are not a fund of funds that combines a lot of highly volatile managers together in the hopes that the risk becomes low. They build fund of funds with managers who themselves are focused on preserving capital. They have critical mass at $1bn and a tremendous infrastructure based on their IT platform. It is really superior to a lot of fund of funds.” It is high praise. Belvedere is careful though and adds that while it would be “very self-serving”to say that Focus’s technology platform is “state-of-the-art”, they have had many large pension prospects go to New York to Focus’s office to check out the system. Upon returning to Montrusco’s Canadian office, “they invariably say it is the best they have ever seen.” Aside from basic portfolio information, it allows the client to perform analytics, both at fund of funds level and at the level of the underlying manager. As a result, Belvedere says Focus’s proprietary system provides a “tremendous comfort level [sic] at how the fund is invested.” Focus’s management remain bullish about the prospects for the Canadian market. Currently Montrusco has C$160m invested in fund of funds and Belvedere is very confident this will “double” in the next six to twelve months. He says that the Canadian marketplace is an evolving market but has progressed at a relatively slow

rate. “It is going in the right direction, but there has not been the stampede of assets we have seen in Europe. Still he feels that they have made an “excellent footprint”in the Canadian marketplace and expects to see the Montrusco Bolton Focus Return Global Fund “going to C$1bn in three to four years.” Focus’s Canadian strategy is just one element in a global outlook. Focus does the bulk of their business overseas, according to managing director Verzili.“We have always been an international company. It is very important to have our options open globally, not only with clients but with managers.” “We are always on the lookout for highly skilled and experienced managers branching out and starting their own businesses,”says Verzili.“Invariably we look for people with 20 years of experience in large hedge funds or on the sales side, or in large institutions who are in the process of setting up their own funds.” Meanwhile, Jabban says one of the biggest challenges for Focus over the next three years will be identifying talented managers in their early stages as more and more money flows into hedge funds. He is confident, however, that they are “well positioned for this, as we have gained the respect and credibility within the hedge fund community as being long term players.” As far as the 2004 market goes, Celent’s Valentine has the last word.“Just because hedge funds are down now, it doesn’t mean that anyone will run away from them. The institutional community will not because they are longterm investors. What is happening today is only a question of implementation. It is a question of when [not if] they choose to go in [to this market].” FAM certainly hopes so. FTSE Hedge Event Driven Strategies 150 140 130 120 110 100 90

-0 3

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FTSE Hedge Event Driven Index

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FTSE Hedge Merger Arbitrage Index

FTSE Hedge Distressed & Opportunities Index

Data as at 31 August 2004. Source: FTSE Group

Denise Valentine, securities and investments analyst at Celent Communications

The FTSE Hedge Index provides a broad asset class representation of trading strategies and reflects the aggregate risk and return characteristics of the open, investable hedge fund universe. Each eligible fund must have a minimum of $50m of un-leveraged assets under management, independent audited financial statements, a minimum two-year track record and monthly reporting with a minimum of quarterly liquidity screening. The index comprises three Management Style Indices and eight Trading Strategy Indices with Net Asset Value (NAV) and Gross Asset Value (GAV) for each. The base value for the FTSE Hedge Index is US dollars. The FTSE Hedge Index is also calculated in GBP, Euro and Yen.

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PORTFOLIO DIVERSIFICATION:

a key to better returns Diversification to a broader range of asset classes must be a core strategy for funds that are pursuing increased returns. A broader range of assets increases the scope for achieving value from tactical allocation. But exploiting the potential of diversification also requires close monitoring of the evolution of the volatility of assets and their correlation. Xavier Timmermans, head product specialist asset allocation at Fortis Investments in Brussels, explains why smart benchmarks are the best way to ensure that higher returns are captured without paying the penalties of higher portfolio risk.

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2004

TRONG RETURNS OVER the past year have gone some way to reviving pension funds’ fortunes – even though many investors still have uncovered liabilities. There is only small hope however that, over the short to medium term, markets will be able to deliver levels of sustainable growth needed to restore funds to their pre2000 positions. The exceptional returns of the 1980s and 1990s were made possible by low starting valuations and a benign set of circumstances that fuelled extended bull markets in both equities and bonds. That model, however, was turned on its head by the recent bear market. The balance of risk now weighs against bonds.Yields on government bonds are at historically low levels and are more likely to rise than to fall in coming years. Such a rise could further hurt the capital value of pension funds. Hope of a decline in long bond yields, which would certainly help investors, seems increasingly remote given the Federal Reserve’s determination to fight deflation and the historically low starting point of yields. Equity markets also seem likely to disappoint. History shows markets do not recover quickly from long or deep

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bear markets. Instead immediate post-bear market periods typically are marked by high volatility [the yearly performance of markets after protracted losses can be as high as +/- 40%]. Much of the recent US growth is fuelled by tax cuts and the willingness of US homeowners to spend money gained from re-mortgaging homes at lower rates of interest. Once these stimuli run their course, long term problems [low savings rates, high indebtedness of both retail and corporate borrowers, the output gap and the US current account deficit] will begin to bite. Traditionally a pension fund’s strategic asset allocation tried to match an allocation to bonds with forthcoming liabilities, while using a further allocation to equities to add capital growth. This worked because liabilities were well covered. So it did not matter that the tactical asset allocation – and the excess performance generated from bonds and equities – was trivial compared to the total return needed. This model is not sufficient these days to meet the required returns as returns from traditional bond equity products are lower than in the 1980s and 1990s [see Graph 1: Traditional strategic asset allocation models no longer work].

of only asset A and then adding a small percentage of the more risky asset B results in a decrease in the total risk of this portfolio. Case 3: There is no correlation between A and B [0.00] Case 4: The correlation between A and B is negative [-0.25] The same portfolio with a small percentage of the more risky asset now has a risk profile that is much lower than that of the less risky asset.

Monitoring volatility and correlation

Return

Adding new asset classes adds complexity to a fund. The volatility of asset classes and the correlation between them changes over time. In turn, it also changes the risk/return profile of the fund as a whole. Without proper controls a fund could move beyond its acceptable risk adjusted return profile. Exploiting these new diversification opportunities to the full therefore demands new tools for the management of risk. The correlation of different assets, no matter how beneficial they may usually be, can be subject to rare events that can suddenly increase the risk of a portfolio. Of particular concern is that this risk becomes most acute during bear markets when both volatility and correlation between assets tend to increase. Where markets have Diversification – the theory Diversification is a powerful risk reduction strategy. fallen rapidly, history has shown that the increase is Exploiting the potential of diversification necessitates close sharper still. A good example of this is the correlation between US monitoring of the evolution of the volatility of assets and their correlation. To make this possible fund managers high yield and US treasuries. Historically, the correlation should consider risk control systems that can accurately between these two asset classes has been low. Between measure the risk relationships of a complex balanced January 1985 and October 2003, the correlation between monthly returns was portfolio and offer 14%. On a 12-month smarter benchmarks Graph 1: Traditional strategic asset allocation models no rolling basis, the that are properly longer work average was 19% and aligned with their Traditional strategic Asset Allocation cannot achieve the median 25%. client’s new objectives. required return 100% equities 1 Yet, in September In the example below Active management Lower expected 1987, correlation you can clearly see how Total 1 return 100% equities Strategic between the asset the inclusion of an asset 2 1 Active management AA classes reached 80% can improve risk 2 when Treasury yields adjusted returns – even 2 rose before the stock when the new asset has … particularly as for some plans risk reduction also market crash. At the a higher risk than the required 2 1 other end of the scale, established portfolio. 2 1 100%bonds the liquidity crisis of Asset A has an August and September expected return of 4% Risk Strategic AA Total 1998 saw the asset and a risk of 10% [with volatility measured by the standard deviation]. Asset B has classes’ correlation plummet to -62%. This is an extreme example but the lesson is clear. The a higher expected return of 14%, but also a higher risk [20%]. The following chart shows the risk/return trade-offs correlation of different asset classes, no matter how [or efficient frontiers] of Assets A and B, based on four beneficial they may usually be, can be subject to rare events that can suddenly increase the risk of a portfolio. The different correlation hypotheses: Case 1: The correlation between A and B is perfect implementation of a strategy that seeks to exploit the [1.00]. With the two assets perfectly correlated an increased potential of diversification to the maximum requires the exposure to the more risky asset results in a simple linear implementation of a system that closely monitors the evolution of assets’ volatility and correlation. In addition, increase in portfolio risk [along the red line on Graph 1]. Case 2: The correlation between A and B is low [0.25] any investment process that utilises an enhanced As the two assets begin to decouple, the benefits of diversification strategy must incorporate mechanisms to diversification become apparent. Starting with a portfolio preserve gains and to stop losses.

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Power in diversification The benefits gained by additional asset classes in a bond/equity portfolio are best explained by an example. We start with a 50-50 split between European equities and euro government bonds. The risk of this initial portfolio is expressed as 100%. By sequentially adding diversification asset classes the risk profile of the portfolio can also be reduced. This benefit comes at no cost to expected returns, which are held constant for the sake of the example and remain the same as that of the initial 50-50 portfolio. For the risk component [standard deviation] and the correlations we have used five years of monthly returns from market indices. The following graph, Graph 2: Risk reduction through diversification into new asset classes, clearly shows that broad diversification of the initial portfolio leads to a substantial reduction [30% of the volatility of the portfolio returns without a change in the total expected return, leading to a substantial improvement of the risk return profile of the portfolio.

another important implication for investors looking to determine an optimal allocation to hedge funds. Databases that track the performance of hedge funds as a class have a survivorship bias that occurs because the performance of failed funds is not counted. This results in an overestimation of historical returns and an underestimation of risk. A recent study by Amin Gauray and Kat Harry M, published in the Journal of Alternative Investments, in the summer of last year, quantified the well-known survivorship bias in hedge fund databases. The attrition rate from hedge fund databases ranges from 2% for the average fund to 4% to 5% for younger, smaller, leveraged funds. The results are similar, although less pronounced, for fund of funds.

Risk allocation not asset allocation

Return %

Because correlations and volatility of asset classes are changeable, and regularly do change, there must be a fundamental shift in the concept of how balanced portfolios should be managed. Balanced portfolio managers should no longer think in terms of allocating Hedge funds The huge diversifying effect that hedge funds have on a funds between assets, but must now allocate them balanced portfolio justifies special attention. In the example between risks. Risk budgeting should be one of the key features that below we added the CSFB/Tremont index to create an eighth portfolio, incorporating a 10% exposure to hedge funds. The dictate the asset allocation process. This process is the remaining 90% of the portfolio has the same composition as allocation of absolute and relative risk across asset classes. the seventh portfolio. Overall, the risk level of the portfolio To this end managers should agree a risk budget with a client as a first step in any falls significantly. relationship. The absolute The beneficial effect of Graph 2: Risk reduction through diversification into new risk budget, the absolute a fund’s risk/return profile asset classes volatility or value at risk, of adding hedge funds is 16 100% B should be the crucial so great that if an 14 driver for the strategic optimiser were to be used correlation = -0.25 asset allocation. The to allocate weights freely, 12 correlation = 0.00 relative risk budget is hedge funds could defined as the total constitute as much as 10 tracking error relative to 50% of the portfolio. 8 the benchmark agreed by While this might correlation = 1.00 the client and is a function optimise the portfolio’s 6 of the outperformance relationship between risk correlation = 0.25 target. and return it would not 4 100% A Once a risk budget has necessarily be beneficial 2 been agreed, risk can be for the overall health of allocated to those areas the fund. The problem is 0 where it can be used most that at this level of 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 effectively to add value. exposure a balanced Risk % This allocation is arrived portfolio would start to be affected by other types of risk that are inherent in many at through analysis of where managers believe they have the greatest potential to deliver excess returns per unit of hedge funds. For example, hedge funds are not very liquid. Fund risk, where they find the most promising risk/reward redemptions are typically allowed only monthly or ratios, and where their strongest convictions of market quarterly with a required notice period of several weeks. performance lie. At the same time, the overall risk of the portfolio can be The funds are also very opaque, making monitoring of their underlying investments, investment processes and reduced by optimising the diversification effect between risk controls difficult. Finally, they have proven different asset classes and with lowly correlated active risk themselves highly subject to operational risks [some 50% [tracking errors within those asset classes]. To do this successfully, managers need to have a system of hedge close within three years of launch]. This fact has

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capable of measuring absolute and relative risks. Traditional asset allocation processes cannot achieve this because their top-down approach precludes a comprehensive assessment of a manager’s alpha generating capability. Funds of hedge funds attempt to capture the manager ‘talent’ factor, but the opaque nature of hedge funds’ investment processes rarely gives access to the underlying portfolio of securities, and therefore it does not allow a proper measurement of risk. We believe that risk is a good thing, because it offers an opportunity for returns. What is bad is risk that is mispriced, misunderstood or unintended.

Smart benchmarks This new model of risk allocation poses another question. What should the new portfolio’s benchmark be? As laid out above, the strategic benchmark should meet client specific needs in relation to value at risk or volatility. This volatility can however be distributed in different ways, over a few assets classes [such as traditional allocation to equities and bonds] or over a broader range of asset classes. Asset managers should provide their clients with optimised solution to ensure that the absolute risk budget is used most effectively. A good benchmark for a balanced portfolio is, by definition, a composite of the indices form which its investments are drawn. This composite is the best passive

portfolio that the fund could adopt as an alternative to active management and thus the best benchmark against which active management can be measured. Adding new asset classes in a composite benchmark complicates this concept of benchmarking. Indeed, in recognising that asset class allocations need to be changed to maximise performance in changing market conditions, the traditional approach to benchmarking becomes obsolete. Adopting a smart benchmark that includes the new multiple asset categories increases the probability that a tactical asset allocator will take them into account. Of course, there may be circumstances where it might be prudent to underweight significantly or even not hold some of those assets. But on average, if they can be taken into account in the benchmark, the propensity to include those assets in a portfolio will be higher than if they were simply in a manager’s opportunity set. As correlation, volatility and long term return expectations change over time, the most sophisticated the benchmark, the more frequently periodic revisions may be needed. Our smart benchmarking concept is therefore a dynamic one that provides optimal diversification over time and asset classes run temporarily in and out of favour. But we do not believe this to be a major constraint, particularly for pension funds, which are subject to regular benchmark reviews for a variety of reasons – most notably because of changes in their liabilities.

IT’S NOT A HARD CHOICE FTSE Global Markets gives you immediate access to 20,000 issuers, fund managers, pension plan sponsors, investment bankers, brokers, consultants, stock exchanges, and specialist data providers. To discuss advertising insertions, tip-ons, supplements, sponsored sections, bookmarks or your own special requirements Contact: Paul Spendiff Tel: 44 [0] 20 7074 0021 Fax: 44 [0] 20 7074 0022 Email: paul.spendiff@berlinguer.com

NOVEMBER/DECEMBER 2004 • FTSE GLOBAL MARKETS

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31st December 2003 - 31st August 2004

FTSE Regional Indices Performance 130

FTSE Global AC (US$)

120

FTSE Developed Europe AC (US$) FTSE Japan AC (US$)

110

FTSE Asia Pacific AC ex Japan (US$) 100

FTSE Middle East & Africa AC (US$)

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80 n04

FTSE Emerging Europe AC (US$)

FTSE North America AC (US$)

FTSE Regional Indices Capital Returns [USD] 10 8 6 4 2 0 -2

MARKET REPORTS BY FTSE RESEARCH

FTSE Global Equity Index Series – Global YTD 2004

pe ro

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FTSE Developed Country Indices Capital Returns [USD] 30

Dollar Value 0

Local Currency Value

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-10

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

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50 40 30 20 10

Dollar Value

Local Currency Value -10 -20

Ar ge nt in FT a SE AC Br az FT SE il A Ch C FT SE ile A F C FT TSE Chi na SE C AC Cz olu m ec b h Re ia A C p FT ubl ic SE AC FT Eg SE yp tA Hu C ng ar FT y AC FT SE In SE In dia do A ne C FT s SE ia A C I FT sra SE el FT K o AC SE re a M AC a FT lay sia SE FT Me AC xi SE co M AC or FT SE occ Pa o A C ki st an F FT TS SE E P AC Ph eru ilip AC FT pin es SE AC Po la F FT TSE nd A SE R C So uss ia ut AC h FT Afr ica SE AC FT Tai w SE a Th n A a ila C FT nd SE AC Tu rk ey AC

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FTSE Global All Cap Sector Indices Capital Returns [USD] 20 15 10 5 0

Capital

-5

Total Return

-10 -15

O inin il Bu & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap e c e & rs e & Me r En Ele ified D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n b Fo Go ile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca s ev ile ar re & e s m & Pr rag ac H oc e eu o es s tic use so al ho s H rs l & d ea P Bi r lth ot od ec uc hn ts Ge o ne To log M r b y ed Lei al R acc ia su e o & re tai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt v m & m Dr Tra ice un u ns s ica g R po tio et rt n aile Se rs r Ut El vic ilit ec es ie tric s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e a cia om ran So tion lity c ftw T & Re pan e e ar ch Ot al ies e no he Es & t r Co logy Fin ate m H an pu ar c te dw e rS a er re vi ce s

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MARKET REPORTS BY FTSE RESEARCH

FTSE All-Emerging Country Indices Capital Returns [USD]

Stock Performance Best Performing FTSE All-World Index Stocks [USD] Aristocrat Leisure 283.1% Hylsamex 178.0% LG Corp 134.2% Nishi-Nippon Bank 105.6% Sammy Corporation 101.2%

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

Worst Performing FTSE All-World Index Stocks [USD] LG Card -86.8% Natural Park Co -81.7% Viad Corp -76.2% CIENA Corp -72.3% PSC Industries -69.8%

No. of Consts

Value

YTD

Actual Div Yld

7,122 1,012 1,790 4,320 2,802 1,617 177 84 1,422 174 2,424 1,224

266.44 266.97 333.06 299.74 160.45 286.91 358.96 349.39 269.75 308.58 257.74 288.72

0.4% 0.5% 0.3% 0.0% 0.5% 3.8% 4.6% 5.8% -0.2% 0.6% 0.2% 0.5%

-1.1% -1.1% -1.2% -1.8% -1.1% 0.7% 11.7% 5.1% -1.9% 1.8% -1.4% -0.2%

-0.1% -0.9% 2.3% 1.9% -0.3% -0.5% 7.0% 9.3% -1.4% 4.9% -0.5% 5.7%

2.05% 2.19% 1.80% 1.67% 2.10% 3.02% 3.24% 2.68% 2.83% 2.95% 1.70% 0.97%

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

NOVEMBER/DECEMBER 2004 â&#x20AC;˘ FTSE GLOBAL MARKETS

O inin & il Bu & g ild Ch G in em as g F St or M ica ee es at ls El Ae l & try eria ec ro O & ls tr on Di sp the Pa ic ve ace r M pe & rsi & e r En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n Fo Go bile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca e i s ar re & ve les m & Pr rag ac H oc e eu o es s tic use so al h s ol He rs & d Bi Pr alth ot od ec u hn cts Ge o n To log M L era ba y ed ei l R cc ia su e o & re tai En & ler Su ter Ho s pp ta tel or inm s Te F tS e le oo co d er nt v m & m Dr Tra ice un u ns s g p ic at Re or io ta t n ile Se rs r Ut El vic ili ec es tie tr s icit -O y th In B er ve L In an s s i tm fe ur ks In fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw T & Re pan e e ar ch Ot al ies e no he Es & lo r ta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

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FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2004 SE

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FTSE Global Equity Index Series – Developed ex US YTD 2004

31st December 2003 - 31st August 2004

FTSE Developed Regional Indices Performance [USD]

115

FTSE Developed (LC/MC)

110

FTSE Developed Europe (LC/MC)

105

FTSE Developed Asia Pacific (LC/MC)

100

FTSE All-Emerging (LC/MC)

FTSE Developed ex US (LC/MC)

FTSE Developed Regional Indices Capital Returns [USD] 8

-2

-4

-6

FTSE Developed ex-US Indices Sector Capital Returns [USD]

-5

Capital

-10

Total Return

-15

-20

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

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MARKET REPORTS BY FTSE RESEARCH

Stock Performance Best Performing FTSE Developed ex US Index Stocks [USD] Aristocrat Leisure 283.1% Nishi-Nippon Bank 105.6% Sammy 101.2% Caltex Australia 85.6% Hokugin Financial 83.9%

Overall Index Return FTSE Developed ex US (LC/MC) FTSE USA (LC/MC) FTSE Developed (LC/MC) FTSE All-Emerging (LC/MC) FTSE Developed Europe (LC/MC) FTSE Developed Asia Pacific (LC/MC) FTSE Developed Asia Pacific ex Japan (LC/MC) FTSE Developed AC ex US (LC/MC) FTSE Developed LC ex US FTSE Developed MC ex US FTSE Developed SC ex US

Worst Performing FTSE Developed ex US Index Stocks [USD] Interchina Holdings -64.4% Converium Holding AG -62.2% Seat-Pagine Gialle -60.3% Brilliance China Automative Holdings -58.8% Mitsubishi Motors -58.1%

No. of Consts

Value

YTD

Actual Div Yld

1,279 637 1,916 886 478 730 296 3,369 484 1,790 4,320

166.40 451.16 158.68 212.56 164.06 162.05 241.10 277.60 265.13 307.43 325.76

0.2% 0.3% 0.3% 4.4% -0.2% 1.1% 2.7% 0.2% 0.2% 0.5% 0.1%

-0.8% -1.5% -1.2% 1.2% -1.9% 0.6% 3.7% -0.8% -1.0% 0.1% -0.2%

-0.2% -0.6% -0.4% 0.6% -2.0% 3.9% 2.8% 0.5% -1.0% 3.3% 6.6%

2.46% 1.74% 2.06% 2.78% 2.87% 1.67% 3.38% 2.41% 2.53% 1.80% 1.67%

FTSE Global Equity Index Series – Asia Pacific YTD 2004 31st December 2003 - 31st August 2004

FTSE Asia Pacific Regional Indices Performance 120

FTSE Global AC

115

FTSE Developed Asia Pacific (LC/MC)

110

FTSE Developed Asia Pacific ex Japan (LC/MC)

105 100

FTSE Asia Pacific (LC/MC)

95 90

FTSE All-Emerging Asia Pacific AC

FTSE Japan (LC/MC) 04 ug 30 -A

l-0 4 -Ju 27

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

NOVEMBER/DECEMBER 2004 • FTSE GLOBAL MARKETS

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FTSE Asia Pacific Regional Indices Capital Returns [USD] 10 8 6 4 2 0 -2

Gl o

ba lA C As FT ia S Pa E D ci e v fic e (L lop De C/ ed ve M lo C) p ex ed Ja A s pa ia n P (L a c C/ ifi FT M c C) SE Al As lE ia m Pa er ci gin fic g AC FT SE As D FT ia e v SE Pa elo ci pe Ja fic d pa AC n In de x (L FT C/ SE M C) As ia Pa ci fic (L C/ M FT C) SE As ia Pa ci fic M FT C SE As ia Pa ci fic SC FT SE As ia Pa ci fic LC

FT SE

As ia

FT SE

fic

-4

FTSE Asia Pacific All Cap Sector Indices Capital Returns [USD] 20 15 10 5

Capital

Total Return

-5

tru

O inin il & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap e c e & rs e & Me r En Ele ified D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n b Fo Go ile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca s ev ile ar re & e s m & Pr rag ac H oc e eu o es s u tic se so al ho s H rs l & d ea P Bi r lth ot od ec uc hn ts Ge o ne To log M r b y ed Lei al R acc ia su e o & re tai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d e nt m & Tr rvic D m un ru ans es ica g R po tio et rt n aile Se rs r Ut El vic ilit ec es ie tric s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e a cia om ran So tion lity c p ftw T & Re an e ar ech Ot al ies e no he Es & r t Co logy Fin ate m H an pu ar c te dw e rS a er re vi ce s

-10

Stock Performance Best Performing FTSE Asia Pacific Index Stocks [USD] Aristocrat Leisure 283.1% LG Corp 134.2% Nishi-Nippon Bank 105.6% Sammy 101.2% Hynix Semiconductor 93.0%

Worst Performing FTSE Asia Pacific Index Stocks [USD] LG Card -86.8% PSC Industries -69.8% Quanta Storage -69.7% Interchina Holdings -64.4% Elitegroup Computer Systems -61.2%

Overall Index Return FTSE Global AC FTSE Asia Pacific AC Index FTSE Asia Pacific (LC/MC) FTSE Asia Pacific LC FTSE Asia Pacific MC FTSE Asia Pacific SC FTSE Developed Asia Pacific ex Japan Index (LC/MC) FTSE Developed Asia Pacific Index (LC/MC) FTSE All-Emerging Asia-Pacific (LC/MC) FTSE Japan Index (LC/MC)

No. of Consts

Value

YTD

Actual Div Yld

7122 2841 1304 463 841 1537 296 730 574 434

266.44 287.59 163.24 277.01 313.92 325.82 241.10 162.05 169.20 107.74

0.44% 1.90% 1.91% 1.78% 2.44% 1.79% 2.74% 1.12% 5.22% 0.46%

-1.14% 0.17% 0.07% -0.13% 0.88% 1.11% 3.65% 0.63% -2.34% -0.58%

-0.07% 3.02% 2.41% 2.02% 3.99% 9.03% 2.82% 3.88% -3.35% 4.29%

2.05% 1.84% 1.85% 1.90% 1.66% 1.72% 3.38% 1.67% 2.59% 0.95%

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

FTSE GLOBAL MARKETS â&#x20AC;˘ NOVEMBER/DECEMBER 2004

ct io

O inin il Bu & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap c er e M er & si & e En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n b Fo Go ile chin t od od s & er Pe y Pr s rs P o & on du Te arts a ce Ph l Ca rs Be xtil ar re e v & e s m & Pr rag ac H oc e eu o es s tic use so al ho s H rs & ld ea Bi Pr lth ot od ec u hn cts Ge o ne To log M r b y ed Lei al R acc ia su e o & re tai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt v m & m Dr Tra ice un u ns s ica g R po tio et rt n aile Se rs r Ut El vic ilit ec es ie tric s - O ity th In B er ve L In an st ife su ks In m A ra fo S en s nc rm pe t C su e at cia om ran So ion lity c ftw T & Re pan e ar ech Ot al ies e no he Es & lo r ta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

tru

FT AC

pe d ex Eu UK rop SE AC e Eu ro fir st 30 0 FT SE ur of irs t8 0 FT SE ur of irs t1 00

l-E

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Page 92

FTSE Global Equity Index Series – Europe YTD 2004

31st December 2003 - 31st August 2004

FTSE European Regional Indices Performance [EUR]

115

FTSE Global AC (EUR)

110

FTSE Developed Europe ex UK LC/MC (EUR)

105

FTSEurofirst 300 (EUR)

100

FTSE Developed Europe AC (EUR)

FTSEurofirst 100 (EUR)

FTSE Eurozone LC/MC (EUR)

FTSEurofirst 80 (EUR)

FTSE European Regional Indices Capital Return [EUR] 15

-5

FTSE Developed Europe Sector Indices Capital Returns [EUR]

Capital

-5

Total Return

-10

-15

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

NOVEMBER/DECEMBER 2004 • FTSE GLOBAL MARKETS

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Stock Performance Best Performing FTSE Developed Europe Index Stocks [EUR] Verbund Oesterreich Elektrizitats 60.9% OMV 59.2% Ericsson B 55.7% EMI Group 46.2% Nobel Biocare Holding 44.7%

Worst Performing FTSE Developed Europe Index Stocks [EUR] Converium Holding AG -60.7% Seat-Pagine Gialle -58.8% Terra Networks -40.2% Ryanair Holdings -35.4% ST Microelectronics -35.3%

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

No. of Consts

Value

YTD

Actual Div Yld

7122 1506 200 334 972 1422 84 681 939 300 80 100

266.44 256.44 291.95 298.79 300.47 255.58 331.03 259.07 261 970.06 3354.32 3266.84

0.44% -1.02% -1.18% -0.85% -0.90% -1.10% 4.78% -1.25% -1.15% -1.21% -1.51% -1.25%

-1.14% -1.29% -1.52% -1.16% -0.71% -1.39% 5.60% -1.70% -1.70% -1.66% -2.36% -1.79%

-0.07% 2.47% 0.75% 5.94% 8.24% 2.32% 13.39% -0.10% 1.03% 1.27% -2.49% -0.58%

2.05% 2.83% 2.91% 2.68% 2.44% 2.83% 2.68% 2.76% 2.58% 2.88% 2.85% 3.08%

FTSE Research Team contact details Carl Beckley Director, Research & Development carl.beckley@ftse.com +44 20 7448 1820

Bin Wu Senior Index Design Executive bin.wu@ftse.com +44 20 7448 8986

Gareth Parker Head of Index Design gareth.parker@ftse.com +44 20 7448 1805

Oliver Whittle Index Analyst oliver.whittle@ftse.com +44 20 7448 1887

Jamie Perrett Senior Index Design Executive jamie.perrett@ftse.com +44 20 7448 1817

Andreas Elia Research Analyst andreas.elia@ftse.com +44 20 7448 8013

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

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31st December 2003 - 31st August 2004

FTSE UK Index Series Performance [GBP] 130

FTSE 100

125

FTSE 250

120

FTSE 350

115 110

FTSE SmallCap

105

FTSE All-Share

100 95

FTSE AIM 4 30

-Ju 27

FTSE techMARK

-A

l-0

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pr -0 -A

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FTSE All-Share Sector Indices Capital Returns [GBP] 50 40 30 20 10

Capital

Total Return

-10 -20

M O inin il Bu & g ild Ch Ga i e Fo ng mi s El c S ec te res Ma als t e tr on Ae l & try eria ic ro O & ls & sp th Pa En Ele ace er M per gi ctr & e ne ic D ta er al ef ls Ho in E e us Au g & qui nce pm eh to ol mo Ma en d c Fo Go bile hin t od od s & ery Pe Pr s rs & Pa od on Te rts uc al e Ph Ca rs Be xtil ar re & ve es m & Pr rag ac H oc e eu ou es s tic se so al ho H rs s & ld ea Bi Pr lth ot od ec uc hn ts Ge o ne To log M L ra ba y ed ei l R c ia su et co & re ail En & ers Su ter Ho pp tai tel or nm s Te F tS e le ood er nt co m & Tr vic D m e un ru ans s ic g R po at e r io ta t n ile Se rs r Ut El vice ili ec s tie tr s icit -O y th e B r In ve L Ins ank st ife ur s In m A a en ss nc fo Sp rm e t C ur e at cia om an So ion lity p ce ftw T & Re an e O ar ch t al E ies e no he s & lo r ta Co gy Fin te m H an pu ar ce te dw rS a er re vi ce s

-30

tio

MARKET REPORTS BY FTSE RESEARCH

FTSE UK Index Series – YTD 2004

Stock Performance Best Performing FTSE All-Share Index Stocks [GBP] Cairn Energy Ashtead Group Charter Ashley(Laura)Hldgs Pendragon

273.8% 211.3% 97.4% 90.7% 66.1%

Worst Performing FTSE All-Share Index Stocks [GBP] Jarvis -80.9% Ultraframe -71.2% Bookham Technology -70.5% Courts -68.8% Antisoma -65.4%

Overall Index Return FTSE 100 FTSE 250 FTSE 350 FTSE Smallcap FTSE All-Share FTSE Fledgling FTSE AIM FTSE techMARK 100

No. of Consts

Value

YTD

Actual Div Yld

Net Cover

P/E Ratio

100 250 350 337 687 394 813 100

4459.32 6087.26 2255.79 2469.94 2214.19 2778.07 868.45 1034.75

1.0% 1.1% 1.0% -0.4% 1.0% 0.4% 0.3% -2.7%

0.6% 0.6% 0.6% -1.5% 0.6% 1.7% 0.9% -9.5%

-0.4% 4.9% 0.3% -0.2% 0.3% 5.9% 4.0% 1.9%

3.34% 2.82% 3.26% 2.39% 3.24% 2.63% 0.61% 1.54%

2.01 1.72 1.97 1.05 1.95 -2.26 -1.05 –

14.94 20.68 15.53 39.79 15.84 -16.84 -156.44 –

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

NOVEMBER/DECEMBER 2004 • FTSE GLOBAL MARKETS

8% 6%

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Date

Index Series

Review Type

Effective [Close of business]

Oct/Nov

Hang Seng

Semi annual review

30-Nov

Data Cut-off

Oct/Nov

CAC 40

Quarterly review

Nov/Dec

Early Nov

DAX 30

Quarterly share / FF Adjustment

17-Dec

29-Oct 29-Oct

10-Nov

FTSE Med 100 Index

Semi annual review

19-Nov

17-Nov

MSCI

Quarterly review

30-Nov

16-Nov

STOXX

Quarterly review (components)

17-Dec

29-Oct

30-Nov

FTSE Goldmines Index Series

Quarterly review

17-Dec

26-Nov

Early Dec

KFX

Semi-annual review

17-Dec

30-Nov

Early Dec

IBEX 35

Semi-annual review

31-Dec

30-Nov

Early Dec

OBX

Semi-annual review

16-Dec

30-Nov

Early Dec

ATX

Quarterly review of number of shares

31-Dec

Early Dec

NASDAQ 100

Annual review

17-Dec

29-Oct

8-Dec

FTSE JSE Africa Index Series

Quarterly review

17-Dec

3-Dec

8-Dec

FTSE All-Share

Annual review

17-Dec

7-Dec

8-Dec

FTSE UK Index Series

Annual review

17-Dec

7-Dec

9-Dec

FTSEurofirst 300

Quarterly review

17-Dec

3-Dec

9-Dec

FTSE Euromid

Quarterly review

17-Dec

3-Dec

9-Dec

FTSE Global Equity Index Series

Annual review North America

17-Dec

30-Sep

13-Dec

FTSE exUK 100 Index

Quarterly review

17-Dec

3-Dec

13-Dec

FTSE Global 100

Quarterly review

17-Dec

30-Nov

13-Dec

S&P/ASX 200

Annual/Quarterly review

17-Dec

30-Nov

13-Dec

NASDAQ 100

Quarterly share adjustment

17-Dec

29-Oct

13-Dec

FTSE techMark 100

Annual review

17-Dec

30-Nov

13-Dec

FTSE eTX

Quarterly review

17-Dec

3-Dec

15-Dec

STOXX

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P 500

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P/TSX 60

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P MidCap 400

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P Asia 50

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P Europe 350

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P/Topix 150

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P Global 100

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P/CITIC

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P Small Cap 600

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P/MIB

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P Latin America 40

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P 1,200

Quarterly share adjustment

17-Dec

30-Nov

15-Dec

S&P 1,500

Quarterly share adjustment

17-Dec

30-Nov

Mid Dec

OMX

Semi-annual review

31-Dec

30-Nov

Mid Dec

PSI 20

Semi-annual review

31-Dec

30-Nov

CALENDAR

Index Reviews November-December 2004

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

FTSE GLOBAL MARKETS â&#x20AC;˘ NOVEMBER/DECEMBER 2004

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