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ROUNDTABLE: NEW PARAMETERS IN SECURITIES LENDING

ISSUE 50 • APRIL 2011

Is corporate debt the best game in town? Buyers mix it up in the music industry The tussle for market share in equity options The smoothing effect of StableRisk Indices

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OUTLOOK

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FTSE GLOBAL MARKETS • APRIL 2011

ELCOME TO THE 50th edition of FTSE GLOBAL MARKETS. The magazine officially launched in May 2004, a few weeks after the FTSE 100 celebrated its 20th anniversary on January 3rd of the same year. The year began cautiously. The FTSE 100 had lost 25% of its value in 2002 and suffered a third annual loss in 2003 amid fears over war in Iraq, tensions in North Korea, corporate scandals and economic stagnation, and world oil prices were hovering near two-year highs. Redundancy figures and questions over City bonuses filled the financial press. How reassuringly familiar it all sounds. There are important differences nowadays though. Back in 2004 optimists bet on improving economic conditions in the US, then the world's economic growth engine, to lift advanced markets out of the mire. Now, optimists bet on advanced-emerging markets to be the principal drivers of economic growth. In 2004, there was some justification for that optimism; the FTSE 100 had gained 36% after bottoming out in March 2003 and looked to end the year near 5,000. Today, we’d like reassurance that it won’t go back down to that level any time soon. As far as possible over the past seven years we have tried to cover the key topics of the day. It has often resulted in a mixed bag of goodies; and this anniversary edition is no different. Mailed with this issue is The 2011 Global Trading Handbook for you to keep. We hope it provides you with a valuable and comprehensive overview of the principal trends and developments that will affect the trading of equities and other securities through this year and beyond. It is apparent that 2011 is another turning point in the now seemingly constant evolution of the global financial markets. With this in mind, we’ve collated the views and opinions of a selection of market influencers in our special extended Face to Face department to reflect upon some of the most influential changes and developments in their particular business segment. In a market where there is a dearth of IPOs, news comes that Swissheadquartered Glencore is planning to list in London and Hong Kong, with an equity issue variously valued at around $10bn, sometime in May, depending on market conditions. If true, that might tempt back issuers such as French media group Lagardère, which has postponed the listing of its 20% stake in tv channel Canal+, and Danish firm ISS, which has delayed its $2.8bn Copenhagen listing. Vanja Dragomanovich reviews the outlook for Glencore and others in still worrisome market conditions. Enough for now of the past and the pesky problems of today: let us celebrate today and all its hard-won benefits and look with as much optimism as we can muster to the future. We continue to upgrade the quality and breadth of coverage each year. This month we’ve updated the cover and hope you like the simplified design. For ourselves, we are mindful of and thankful for the continuing support of FTSE Group, which has been an exemplary stakeholder in the magazine; our revered and regular advertisers and sponsors, who continue to sustain us via their marketing strategies; our suppliers, who provide us with outstanding service and, not least, of the constancy of our loyal readers. The team in London and our writers and sales representatives, scattered around the globe, would like to thank you for your much-valued support and input. We are truly beholden.

Francesca Carnevale, Editor April 2011 Cover photo: Archive photo of Glencore CEO Ivan Glasenberg seen during the signing of a merger deal, September 2006. Photograph by Alexander Bundin/Photas/Tass/Press Association Images, supplied by Press Association Images, March 2011.

CONTENTS COVER STORY

WAITING FOR GLENCORE ..........................................................................................................Page 56 The impending IPO of Glencore International is tantalising market commentators in London and Hong Kong. The company’s low, low profile ascribes it a certain mystique; and its business model is aggressive and profitable. What should the market expect from the biggest IPO to date this year? Vanya Dragomanovich reports. DEPARTMENTS

MARKET LEADER

ASSET ALLOCATION IN AN AGE OF CHANGE ........................................................Page 6

SPOTLIGHT

EU CONTINUES FINANCIAL CRACKDOWN ..............................................................Page 12

Lynn Strongin Dodds discusses the benefits of diversified asset allocation strategies.

Key stories around the global investment and capital markets.

SOVEREIGN WEALTH FUNDS POWER AHEAD

....................................................Page 18 SWFs neared the $4trn mark in assets under management (AUM) in 2010.

IN THE MARKETS BRICs TAKE THE LEAD ON DRs IN EUROPE ............................................................Page 22 DR pricing and market volatility dampens new issuance. Lynn Strongin Dodd reports.

UPTURN IS OUT OF SIGHT ..................................................................................................Page 26 Simon Denham, MD of spread betting firm Capital Spreads takes the bearish view.

INDEX REVIEW SMOOTHING OUT MARKET VOLATILITY

................................................................Page 27 Dr Elton Babameto explains the appeal of the new FTSE StableRisk Indices.

COUNTRY REPORT COMMODITIES DEBT REPORT

KUWAIT: THE POLITICAL FACTOR ................................................................................Page 30 Kuwait’s parliament slows reform agenda.

FOLLOWING THE SMART MONEY INTO ASIA

....................................................Page 33 Vanya Dragomanovich looks at likely developments in the commodities markets.

THE BEST GAME IN TOWN ................................................................................................Page 38 European corporate bonds remain attractive despite market volatility.

MARRYING SIZE AND PERFORMANCE ......................................................................Page 41 Tim Keaney, chief executive officer, BNY Mellon, discusses trends in asset servicing.

FACE TO FACE

THE RIGHT TIME AND PLACE FOR TM ......................................................................Page 44 Duncan Klein, head of TM Asia at JP Morgan, talks of opportunities in Asia.

INTELLIGENT INDEX INVESTING ......................................................................................Page 47 Ali Toutounchi, MD of LGIM, discusses the outlook for index-based investment strategies.

APRIL 2011 • FTSE GLOBAL MARKETS

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CONTENTS AN APPETITE FOR THE RIGHT KIND OF CHANGE ..............................................Page 50 Kevin Cronin, head of global equity trading, Invesco posits the need for reform.

FACE TO FACE LEVERAGING NEW MARKET DYNAMICS

................................................................Page 52 FTSE Group CEO, Mark Makepeace, describes the evolution of investable indices.

FX VIEWPOINT

WHO SERVES WHO IN FX? ................................................................................................Page 54 Erik Lehtis, president of Dynamic FX Consulting, on liquidity, new portals & Japan.

FEATURES DERIVATIVES:

COMPETITION HEATS UP FOR EQUITY OPTIONS TRADING ....................Page 59 David Simons analyses the main trends in the equity options space.

SECTOR REPORT:

CHANGING BUYER PATTERNS UP END MUSIC SALES ................................Page 62 Joe Morgan takes the down and dirty view of the latest trends in the music business.

ASSET MANAGEMENT:

GERMAN FUNDS MIND THE PENSIONS’ GAP ................................................Page 65 The pension fund industry is in rude health after a decade of reform. Joe Morgan reports.

GCC ASSET MANAGEMENT GROWS IN CONFIDENCE ................................Page 68 Higher oil prices are feeding asset values in the GCC once more.

ISLAMIC FUNDS:

A STEP CHANGE IN SHARI’A COMPLIANT ASSET SERVICING..................Page 72 The growing distinction between Shari’a friendly and Shari’a compliant asset services.

COMMODITIES MURABAHA HELP INVESTORS MANAGE CASH............Page 74 Explaining the rationale behind a new Islamic money market fund.

ETFs:

ETFs PLUNGE INTO DOUBLE DIGIT GROWTH WITH ELAN ......................Page 75 Lynn Strongin Dodds surveys the main trends and players.

ROUNDTABLE:

NEW PARADIGMS IN SECURITIES LENDING ......................................................Page 77 Jeff Petro, head of money market trading at Federated Investors says a securities lending specialist said to him: “We don’t want you to embrace this product because we’re telling you to or the SEC is telling you to. We want you to embrace it because we think it’s the right product for the market.”Did other participants in our US Securities Lending Roundtable agree with him?

DATA PAGES

DTCC Credit Default Swaps analysis ..............................................................................................Page 87 Fidessa Fragmentation Index ........................................................................................................................Page 88 BlackRock ETFs ....................................................................................................................................Page 90 Market Reports by FTSE Research................................................................................................................Page 92 Index Calendar ....................................................................................................................................................Page 96

APRIL 2011 • FTSE GLOBAL MARKETS

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ASSET ALLOCATION: THE BENEFITS OF A DIVERSIFIED GROWTH STRATEGY

Photograph © Sebast1an / Dreamstime.com, March 2011.

Asset allocation in an age of change The crop of crises through the first quarter of 2011 is creating an environment for new asset allocation strategies. Although the immediate crises of this year may have given asset managers a significant jolt, many were already changing their asset allocation blueprints. Balanced models had been confined to history and diversification became the new mantra. Although the strategy unravelled during the crash of 2008, the basic concept has endured. The difference today is that fund managers are taking a much more dynamic approach not only to alleviate the risks that can cause portfolios to suddenly implode but also to exploit any new opportunities in the offing. Are they better prepared to withstand this year’s early storms? Lynn Strongin Dodds reports. HESE DAYS, INSTEAD of adopting a set-and-forget approach, trustees are being much more proactive, says Lloyd Raynor, a senior consultant at Russell Investments. In the past, trustees would conduct a standard asset liability management review in line with their actuarial assumptions. Now, however, he says: “These reviews are done on a much more frequent basis. Also, there is much more of an integrated approach. The funding requirements and investment strategy

discussions today are no longer two separate conversations but are done together with trustees and the company sponsors participating in both.” Things were beginning to change before the financial crisis with institutions moving away from an equity home to international bias and incorporating non-traditional asset classes into the mix. The trend was a natural development in the wake of both pension reform regulations as well as the dotcom crash, explains Jamie Lewin,

head of asset allocation at BNY Mellon Asset Management. He says: “The events in 2008 only accelerated the process and have forced investors to move the pieces of the puzzle around in anticipation of market movements. They do not necessarily have to forecast market conditions but ensure that they can move quickly and aggressively to manage their exposures.” Not surprisingly there is no onesize-fits-all solution and asset allocation models will depend on a scheme’s particular requirements such as maturity, funding levels, corporate sponsor and appetite for risk. The general consensus though is that strong risk-adjusted returns can be generated through diversification across different and uncorrelated asset classes and regions. Even so, rather than relying on purely quantitative evidence, which can have an insignificantly short track record, the approach now combines the statistical with the qualitative. Chris Mansi, senior investment consultant at Towers Watson, believes that “strategic asset allocation should always be the starting point but tactical asset or a more dynamic approach has become much more widely used”. He adds: “Our recent Global Pension Asset Study 2011 also showed that there is more emphasis on scenario risks to complement quantitative risk measures such as tracking error. The principles behind diversification are still important but the level of focus has changed and pension funds are also interested in how they can protect their portfolios from extreme events, as well as managing other risks such as liquidity.” Stephen Hull, director and investment strategist of BlackRock’s multiasset client solutions division, also advocates a much more active, dynamic asset allocation strategy. “One of the reasons why diversification did not work effectively in 2008 is because [although] the sources of return of the alternatives in the portfolio were different, the structures used to access them were bond and equity like and were exposed to the same liquidity and

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MARKET LEADER

ASSET ALLOCATION: THE BENEFITS OF A DIVERSIFIED GROWTH STRATEGY

credit risks. There is now a greater emphasis on portfolio construction and building stronger risk-adjusted returns through uncorrelated independent ideas. It is not just about strategic but also dynamic and tactical asset allocation techniques to access a blend of returns from different asset classes.” Gregor Hirt, head of multi-asset solutions at Schroders, expands the theme: “Diversification became popular after the 2001/2002 dotcom crash with investors starting to look at a wider range of asset classes. The problem was that they all copied each other with the result that everyone in effect was chasing the same goal. This not only increased correlations but the demand also drove up prices in illiquid assets such as private equity. We believe that ‘diversifiers’ play a critical role in portfolios but that you need to look carefully at the different risk premia you are buying, in particular liquidity risk.” Adrian Jarvis, head of investment strategy at Aviva Investors, notes that, actually, “diversification has not been a smooth ride”. He adds: “The credit crunch showed that investments that diversify risk in the long run do not always succeed in doing so in the short term. Despite the bad experience of 2008, putting all your eggs into one basket is still not a good idea, which is why diversification remains important but it is also important to spot shorterterm risks and opportunities.” Jarvis explains: “This is why it is [vital] to have long-term (strategic) asset allocation, to maximize risk-adjusted returns over the long term, as well as short-term (tactical) asset allocation, which looks to exploit market inefficiencies and mitigate tail-risks over the short to medium term. For the latter, option-based strategies are often attractive, allowing portfolios to be protected against extreme events while still benefiting from periods of favourable market conditions.” Market participants are also witnessing funds ratcheting up their use of derivatives such as interest and inflation rate swaps to hedge against rising rates. They are either used as part of an

Chris Mansi, senior investment consultant at Towers Watson. Photograph kindly supplied by Towers Watson, March 2011.

investment-driven liability strategy or as part of the risk-return mix. Chris Paine, associate director, asset allocation at Henderson Global Investors, says: “We are starting to see investors using sophisticated derivative strategies to achieve the target returns of their portfolios as well as exchangelisted derivatives to facilitate asset allocation. For example, if you have a bearish view of the equities market and do not want to sell them, then you can use derivatives to hedge against the equity risk.” However, a cautionary note is sounded by Saker Nusseibeh, head of investment at Hermes Pension Management. He warns against using overly complicated derivatives strategies. “We are great believers in simplicity. Investors should be careful about using complex overlays or risk models. In effect, using derivatives means they are only buying the underlying assets and getting exposure to the same things but in a different way. As for the risk models, there should be much more attention paid to political risk, which was not a factor for the past 50 years but is significant today.” Looking ahead, institutions may follow different investment paths, but alternatives will certainly be featuring more prominently in portfolios. Regulation is one reason. Pension fund reforms have required mark to market valuations which have sharpened corporate sponsors’collective minds on better matching

their assets and liabilities. In addition, Solvency II, the European Union regulatory framework for the insurance and reinsurance industry due to be implemented in January 2013, could have an impact. The jury is out regarding the final outcome but the rules do require a more dynamic asset allocation philosophy for insurance companies in order to limit the financial risk in the proposed stricter solvency regime. The other impetus is that pension schemes today are spoilt for choice. “The fundamental drivers are that the opportunity sets have exploded and investors everywhere are looking across all asset classes to make greater use of those opportunities,” according to Crispin Lace, principal and senior investment manager of Mercer. “It does depend though on the size of the fund. The smaller ones which have less time and resources to spend on governance rely more on mainstream investment classes while the larger ones are more comfortable and able to cast their nets wider.”

Alternative strategies Mercer’s 2010 annual survey of European asset allocation, which canvassed about 1,000 of its pension fund clients with about €500bn under management, reflects this trend. It shows that, in the past, equities, bonds and property dominated with only about 6% to 8% of schemes slotting in alternative investments including funds of hedge funds, funds of private-equity funds, and highyield debt. The picture is changing with continental funds showing the strongest interest in alternatives. About 13.6% are considering funds of hedge funds, 8.6% are looking at private equity, and 8.8% are reviewing their emerging-market debt options. In the UK and Ireland, by comparison, which has seen exposure to alternatives jump to 9% from 6% over the year, the main focus is on hedge funds, global tactical asset allocation (GTAA) and private equity. Alternative bond strategies such as high yield, emerging market and distressed debt are also gaining traction across the board.

APRIL 2011 • FTSE GLOBAL MARKETS

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MARKET LEADER

ASSET ALLOCATION: THE BENEFITS OF A DIVERSIFIED GROWTH STRATEGY

The recent Russell Investments 2010 Global Survey on Alternatives Investing also confirms that institutional investors are “staying the course” with alternative strategies. The survey questioned 119 firms with a total of $1.3trn of assets under management, finding that they are expecting to increase their allocation to 19% by 2012 from 14% in 2009. Alternatives such as real estate, private equity and hedge funds are top of the list although commodities and infrastructure were gaining ground as hedges against rising inflation. Hedge funds have also come back into favour after the Lehman collapse and the Madoff scandal. Respondents across the board are planning to increase their exposures to 5.7% in 2012 up from 4.2% in 2009. The global industry had a bumper year in 2010 with figures from Hedge Fund Research, the US-based data provider, showing $55bn of new money was pumped into the sector. Overall, at the end of 2010 assets were $1.917trn, which was close to the peak of $1.93trn in the second quarter of 2008. Traditional long-only managers are also refining the way they use hedge fund strategies. For example, State Street Global Advisors (SSgA) is an advocate of combining divergent strategies such as managed futures, CTAs and global macro as well as convergent strategies including spread trading or equity neutral. According to Mike Arone, managing director at SSgA, convergent strategies are based on the notion that the intrinsic value of securities and asset classes can be measured using fundamental data such as a company’s future earnings, dividends and growth rates. The belief is that there are stable price relationships that can be statistically measured and exploited. Deviations from normal relationships can be capitalised upon because prices that are out of line will move back, or converge, to a mean or theoretical value. Most investment strategies fall into the convergent category, including those with hedge funds and alternative asset classes. Divergent strategies, on the other

Chris Paine, associate director, asset allocation at Henderson Global Investors. Photograph kindly supplied by Henderson Global Investors, March 2011.

Crispin Lace, principal and senior investment manager of the pension fund consultancy, Mercer. Photograph kindly supplied by Mercer, March 2011.

hand, seek to identify and exploit serial price movement such as trends and momentum which reflect changing market themes and investor sentiment. There is no inherent belief that markets will move to a stable, long-run equilibrium, rather that the world adjusts over time to new equilibrium prices. Divergent strategies, however, provided non-correlated returns and meaningful alpha while virtually all other strategies were tumbling in tandem. “Corporate sponsors want to lower the volatility of their plan because of uncertain markets and pension fund regulation that has required them to account for their assets on a mark to market valuations basis, “ says Arone. “We believe that combining these two strategies will help smooth out the volatility as well as the returns over the long term.” Another increasingly popular approach, particularly with smaller and medium-sized schemes, is diversified growth funds According to Herold Rohweder, global chief investment officer for RCM, which offers these funds to a wide range of investors, diversified growth funds are intrinsically different from other “balanced” or “absolute return” approaches. “The challenge in portfolio construction is to get the three pieces—strategic, tactical and option strategies—correct. Diversified growth funds aim to generate positive real returns over a market cycle while offering downside protection in times of market stress. They include a

wide range of uncorrelated risk premia as well as ETFs to gain exposures to underlying assets in a more cost-effective way. They are not constrained by maximum or minimum exposures or blended asset benchmarks.” Diversified growth funds are also gaining traction in the UK in the defined contribution (DC) space. Mike Turner, head of global strategy and asset allocation at Aberdeen Asset Management, says: “Most DC assets go into a default fund but we are increasingly seeing diversified growth funds attract more flows on the back of consultants’ advice. Although it depends on the scheme, historically most have a limited number of default funds to choose from and they have traditionally been more like oldfashioned balanced funds divided between equities, bonds and property.” Mansi of Towers Watson also notes that, overall, “defined contribution schemes are becoming more sophisticated about asset allocation”. He adds: “There is a much greater appreciation of appropriate risk metrics for a DC member and more life-time planning of their asset allocation. We are seeing the best practices of the defined benefit world being applied to defined contribution. One of the benefits of using a diversified growth fund is that it offers a one-stop shop and provides daily pricing, which is necessary for the UK DC environment, but challenging if separately investing in a number of asset classes such as real estate and hedge funds.” I

APRIL 2011 • FTSE GLOBAL MARKETS

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SPOTLIGHT

EU continues financial crackdown MEPs vote on banning sovereign debt speculation and naked short selling IN A MILESTONE vote in early March curtailing naked short selling and speculation which policy makers say has exacerbated Europe’s sovereign debt crisis, the EU Economic and Monetary Affairs Committee voted 34 to eight to curtail certain trades in sovereign bonds, and introduced a requirement that traders settle uncovered positions by the end of each trading day. MEPs also inserted a requirement that short sale transactions be reported less often and beefed up rules to ensure that fines are dissuasive. MEPs involved with steering the regulation through Parliament will now sit down with Member States to thrash out a deal which can then be tabled for a plenary vote. Any final regulation resulting from plenary discussions and voting is expected to come into force by early 2012. The European Securities Markets Authority (ESMA) requires permission of the government in question if it wants to ban naked selling of sovereign CDS linked to its debt, thereby potentially undermining the universality of regulation across Europe. The broad, cross-party majority means the assembly is in a strong position to negotiate with EU states, which have a joint say on the final version of the

measure, but EU states are split over the efficacy or wisdom of introducing these measures. Germany, which introduced tough curbs on short selling during the financial crisis, supports a panEuropean stance; the United Kingdom, on the other hand, mindful of its status as a global financial hub, continues to voice its concerns over the efficacy of such moves. Short selling (when speculators bet on a fall rather than a rise in the price of a security to make a profit) and credit default swaps (which allow an investor to insure, in this instance, against a state defaulting on its debt obligations) were both heavily implicated in Europe’s recent sovereign debt crises. The committee’s position prohibits anyone from being involved in credit default swap (CDS) transactions if they do not already own sovereign debt linked to that CDS (in other words, naked CDS trading), or securities whose price depends heavily on the performance of the country, such as shares in a major company based there. The committee is claiming that the initiative: “Therefore innovates, not only by banning CDS naked trading, but also by introducing a correlation that would allow investment firms some room for manoeuvre”, says an EU statement.

Although the committee’s view is that naked short selling should not be completely banned, it does set a very tight deadline for converting a naked short sale into a short sale (by the end of the trading day, in fact). The committee says a seller failing to make the conversion on time would incur fines which “must be sufficiently high to prohibit any profits being made”. The position adopted reflects the European Commission’s tough “locate and reserve rule”, whereby a seller must not only identify where it plans to borrow securities, but must also have a guarantee that it will be able to borrow the securities when the time comes. The committee position imposes further reporting requirements on investment firms, particularly in exceptional circumstances. It also allows national supervisory authorities to require lenders to notify them in exceptional situations. In emergencies, national authorities will be also required to provide more information within 24 hours to the ESMA, when asked to do so. On the other hand, the committee position only requires investment firms to report on their short sale transactions at the end of the trading day, rather than reporting each short sale as it happens, as proposed by the Commission. I

Eurozone stability mechanism should be part of EU, says Constitutional Affairs Committee WHILE THE EU’s Economic and Monetary Affairs Committee is hardening its stance on speculation over European sovereign debt, a limited EU treaty change was mooted in the same week in early March by the confederation’s Constitutional Committee to allow the creation of a permanent European Stability

Mechanism (ESM); in other words to create a permanent bailout fund. One stumbling block is that while a permanent facility is now agreed by 17 votes to four against, MEPs were frustrated by the fact that ESM is an inter-governmental choice, rather than an EU one. The European Parliament will vote on the treaty change in late

March, though any revision will require consultation involving the European Parliament, the European Central Bank and the European Commission. Even then, any change to the treaty will have to be ratified by all 27 Member States. The target date is January 1st 2013 for a fully functional ESM. Watch this space.I

APRIL 2011 • FTSE GLOBAL MARKETS

SPOTLIGHT

A Euro-Med investment bank in mind Union for the Mediterranean Assembly calls for a “Marshall plan” for transition countries A PROPOSAL TO create a EuroMediterranean investment bank to help fund the transition to democracy in countries on the Mediterranean’s southern shore took shape at the Union for the Mediterranean Plenary Assembly in Rome in the first week of March. Delegates also signed a declaration condemning the violence in Libya, calling for international humanitarian assistance on its borders. A proposal by Italian member of the European parliament (MEP) Pier Antonio Panzeri, of the centre-left Progressive Alliance of Socialists and Democrats (S&D), to transform the Facility for EuroMediterranean Investment and Partnership (FEMIP), an official European funding facility into a real Euro-Mediterranean investment bank, was backed by European Investment Bank (EIB) president Philippe Maystadt and other MEPs. “A new Marshall plan should enable us to improve economic relations and development, but also improve security in the region. We cannot open a channel for a huge influx of desperate persons coming to Europe. We call for a new plan for the EIB to invest in the region, as was done by the EU to improve stability in the Western Balkans back in the 1990s”, explains Franco Frattini, Italy’s foreign minister speaking on behalf of the current Italian rotating Presidency of the EU. The EIB’s Maystadt says the prospective bank is ready to provide finance and support for small and medium-sized enterprises in the region, backed by €6bn in finance over the next three years, pending budgetary approval from the EU. I

Fund flows into offshore centres on the rise Guernsey’s fund industry moves past the £250bn mark ACCORDING TO GUERNSEY Financial Services Commission (GFSC), the value of investment fund business in Guernsey grew by 5.9% (equivalent to an injection of new money worth £14.3bn) during the final quarter of last year. The funds industry on the island has grown for six consecutive quarters, taking the net asset value of funds under management and administration to a record of £257.4bn by the end of last year, up 39.7% (equivalent to £73.2bn) over the previous year. Peter Niven, chief executive of Guernsey Finance, the Channel Island’s investment promotion agency notes: “Our funds industry has bounced back very well from the global financial crisis and in recording six consecutive quarters of solid growth we have clearly outstripped some of our closest competitors. These are encouraging signs and we must look to capitalise on this momentum as we move through 2011.” Niven says Guernsey has benefited from the greater certainty provided by the agreement for the framework of the EU’s Alternative Investment Fund Managers (AIFM) Directive, adding that there is much work still to do in relation to the

directive but the continuing efforts of government, industry and regulator mean that “Guernsey is well positioned”. The GFSC says Guernsey domiciled open-ended funds had reached a net asset value of £57.9bn by the end of 2010, up 8.2% during the last quarter and up 14.2% over the year. The closed-ended sector was valued at £109.5bn, up £3.6bn (3.4%) during the final three months of 2010 and rose £24.1bn (28.2%) over the year. Meanwhile nonGuernsey schemes, where some aspect of management, administration or custody is carried out in the island, was valued at £90bn at year end, up 87.1% over the previous year. “A significant increase in the number of these non-Guernsey funds entering into service level agreements with local licensees earlier in 2010 has notably boosted these figures but our Guernsey closed-ended funds also continue to attract a lot of interest, especially from promoters in alternative and niche asset classes and where there may also be a demand to raise money through capital markets by listing on a stock exchange,” explains Niven.I

Photograph © Reshavskyi / Dreamstime.com, March 2011.

APRIL 2011 • FTSE GLOBAL MARKETS

FTSE is proud to host the World Investment Forum 2011. The World Investment Forum brings together the world’s leading financial academics with the world’s largest and most influential asset owners.

15th–18th May, 2011 The Carneros Inn, Napa, California

Speakers at the event include: Edward Altman Rob Arnott George Constantinides Elroy Dimson Charley Ellis William Goetzmann Martin Gruber Jason Hsu Roger Ibbotson Donald Keim Andrew Lo Lionel Martellini Jane Mendillo John Mulvey James Norman Richard Roll Steve Ross William Sharpe Gillian Tett Vijay Vaidyanthan Hal Varian Jiang Wiang

Qualified asset owners can register their interest via:

www.worldinvestmentforum.org

SPOTLIGHT

$814bn of LBOs need refinance by 2016 Europe and the US account for 95% of debts maturing OVER $814BN OF leveraged buyout (LBO) debt, spread over 6,055 deals held by private equity portfolio companies globally, is due to mature over the next six years with more than $80bn (across 752 deals) due for refinancing this year alone. A peak of almost $200bn is expected in 2014, according to a new report by international law firm Freshfields Bruckhaus Deringer. European private equity portfolio companies account for more than half (52% or $424bn) of LBOs maturing by 2016, ahead of North America (43% or $352bn). The positions are reversed this year when North American LBOs will need to refinance a slightly higher amount ($39.2bn) of debt than their European counterparts ($36.6bn). For the sixyear period the refinancing challenge is far less acute for Asia (including Japan), where almost $21bn will need refinancing, and Australasia ($13bn). LBO refinancings are ramping up with “$80bn due for refinancing this year alone and $92bn next year, followed by a whopping $174bn in 2012 and $196bn in 2014. Only by the middle of the decade will pressure start to ease,” says David Trott, head of UK banking at Freshfields. “If the pipeline we are seeing is anything to go by, private equity shareholders are likely to pursue selling down their interest in leveraged [corporations] via an IPO while at the same time prepaying a significant amount of outstanding finance debt,” he adds. Outside of major refinancing exercises, private equity houses are beginning gradually to invest their cash reserves once more, with the value of global leveraged buyouts rising over 204% (to $131.8bn) says Thomson Reuters. Deal volume rose by more than 72% to 923 transactions. These numbers are still well off the peak recorded in 2006 however (when over $600bn of deals spread across 1,460

Volume and value of new LBO deals 2009 and 2010 by region 2009 Target Primary Nation Region

Ranking Value inc. Net Debt of Target ($m)

Mkt. Share

Europe Americas Asia-Pacific (ex Central Asia) Africa/Middle East/Central Asia Japan Industry Total

19,612.73 18,678.71

2010 No. of Deals

Ranking Value inc. Net Debt of Target ($m)

Mkt. Share

No. of Deals

45.3 43.2

228 274

46,197.23 78,844.16

35.1 59.8

472 392

3,712.80

8.6

5,645.16

4.3

142.29 1,128.65 43,275.19

0.3 2.6 100.0

9 9 536

85.91 994.10 131,766.55

0.1 0.8 100.0

3 13 923

*Freshfields Bruckhaus Deringer, March 2011.

transactions were completed). “Orderly fashion refinancing exercises can also be envisaged thanks to more settled lending conditions across markets; the amount of ‘dry powder’ or financial resources accumulated by PE houses before the credit crunch which could be used as junior or senior debt; a growing liquidity in the high yield bond market which last year saw more than $317bn raised globally; more extend-and–amend solutions where lenders get better terms in exchange for extending loan maturities; and evidence of renewed activity in the CLO market,”explains Trott. While the US accelerated past Europe in terms of deal value last year, “the data shows that was based on a smaller number of large deals which would imply that the US is moving ahead with large cap deals while European players are still focused on smaller transactions,”says Chris Bown, head of Freshfields’ London private equity team.“Economic and lending conditions are certainly improving but getting deals off the ground is still proving challenging, not least because past solutions are no longer workable in what has become an even more complex and unpredictable market and where creativity and new techniques, which generally take longer to implement, are needed,”he adds. Looking ahead to 2011, there is cause for optimism as well as caution

says Bown. ‘Private equity houses are starting to deploy their dry powder reserves—estimated at over $1trn by Prequin—and this is causing ripples in the market. High yield is becoming more accepted and in turn this is making some banks more willing to provide debt. On the whole, after a period of waiting and seeing how the economy was going to turn out we are sensing more confidence and seeing the pipeline gradually fill out,” says Brown. In contrast, he points out; there are a number of factors still holding the market back.“There seems to be a lack of enough assets at the right price to generate interest among private equity houses. While retail and technology are proving popular, real estate is still recovering from having gone into virtual hibernation, while consumer staples companies and media and entertainment firms, most vulnerable to contractions in consumer spending, are also less sought after.” “On the financing side, many banks are holding large private equityrelated credits and are under financial pressure to clean up their balance sheets and under political pressure to direct lending towards small-and medium-sized enterprises rather than leveraged deals. New regulations on the largest international banks under the Basel III rules will also curb lending,” concludes Bown. I

APRIL 2011 • FTSE GLOBAL MARKETS

measure it understand it apply it sĂZ ƌĞŵĂŝŶƐ Ăƚ ƚŚĞ ŚĞĂƌƚ ŽĨ ƌŝƐŬ ĞƐƟ ŵĂƟ ŽŶ ĨŽƌ ďĂŶŬƐ ĂŶĚ ĂƐƐĞƚ ŵĂŶĂŐĞƌƐ But a single VaR number is not the whole story D ƉƉůŝĐĂƟ ŽŶƐ Excerpt ĚĞůŝǀĞƌƐ͗ ^ŚŽƌƚͲƚĞƌŵ ĂŶĚ ůŽŶŐͲƚĞƌŵ sĂZ hƐĞƌ ĚĞĮ ŶĞĚ ƌŝƐŬ ĂƩ ƌŝďƵƟ ŽŶ ŽŵƉƌĞŚĞŶƐŝǀĞ ŝŶƐƚƌƵŵĞŶƚ ĐŽǀĞƌĂŐĞ ƌŽďƵƐƚ ƐƚĂƟ ƐƟ ĐĂů ŵŽĚĞů ĂƐǇ ŝŶƚĞŐƌĂƟ ŽŶ ŝŶƚŽ ǇŽƵƌ ŝŶǀĞƐƚŵĞŶƚ ƉƌŽĐĞƐƐ

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ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

IN THE MARKETS

SOVEREIGN WEALTH FUNDS: STEADY PROGRESS WITH $4TRN AUM

Photograph © Ryan Pike / Dreamstime.com, March 2011.

SWFs power ahead Slated before the financial crisis, foreign government influence and intervention via sovereign wealth funds is now seen as a steadying influence, and the funds are growing, boosted by their size and long-term investment scope. Widely diversified, in general they were not forced into fire sales by the crisis. Also, SWFs do not have the concerns of other institutional investors. For instance, they do not have to draw down funds to meet pension obligations. According to The 2011 Preqin Sovereign Wealth Fund Review, by the end of 2010 SWFs were approaching $4trn in assets under management (AUM), and by now may well have exceeded that figure. SWFs are set to continue their expansion. URING THE FINANCIAL crisis even the most devoted free marketeer countenanced the aid of OECD governments with equanimity. Less remarked upon is the change in attitude to foreign government intervention via sovereign wealth funds (SWFs), which before the crisis had provoked equal measures of expedient xenophobia and neo-liberal concern. SWFs are growing in size and number even more than when they were being vilified before the crisis. Karl Sauvant, of the Vale Columbia Center on Sustainable International Investment, recalls that with all the criticism, “just before the crisis, the IMF raced through an agreement on transparency and the EU, Germany, OECD

came up with guidelines, but during the crisis all this subsided, and since the SWFs have been regarded almost as white knights”. While, as Sauvant points out, some of the funds, from Singapore to China, came under criticism from their own countries for poor investment, in general, the SWFs’ steadying influence, ranging from simply not selling in panic to rescue purchases, meant that they did good—while doing well. According to the 2011 Preqin Sovereign Wealth Fund Review, by the end of last year the world’s SWFs had approached $4trn in assets under management (AUM), and might well have gone past that now as hydrocarbon prices rise and stock markets recover. In fact, they grew by

almost a $1trn over the period of the financial crisis, from $3.05trn to $3.98trn. The review’s editor, Sam Meakin, says that while continued high hydrocarbon prices helped the growth, they only accounted for 30% of the amount. He points out that even with hydrocarbonbased funds such as Norway’s Government Pension Fund Global: “Its reports show that in the year up to the end of September 2010, the majority of its growth was from returns on investment”, even though Moscow, in December, pulled out $15bn, and the fund diminished from $60.5bn to $25.4bn over the year. That might look bad, but not nearly as bad as it would have done if the Russian Treasury had no cash. It also seems to be the exception. Meakin points out the SWFs benefitted from their size and long-term investment scope. Widely diversified, in general they were not forced into fire sales in the trough of the crisis. The three biggest— Abu Dhabi, Norway’s Global and China’s Safe—account for a quarter of total AUM, but even on the other end of the scale there is considerable activity. One of the world’s newest nations, Timor-Leste, only recently began a fund to cope with the oil revenues from the Timor Straits and it grew by a quarter last year to almost $8bn. Elsewhere, Meakin notes, new funds are being started, such as in Nigeria and Angola. That could begin to remedy a “fund gap” for sub-Saharan Africa, which the report states holds only 0.2% of SWFs’AUM. Even Israel is setting up a fund to deal with the expected revenue from the offshore gas fields it has discovered and there were even whispers Japan was considering a fund, but while a more timely launch might have helped reconstruction after the tsunami, its launch is believed to have been postponed. However, the report was completed too early to take account of the unrest in the Islamic oil world, which, for example, saw much of the Libyan $70bn fund frozen. Sam Meakin says: “It is too early to tell what effects the political unrest in MENA, and any resulting

APRIL 2011 • FTSE GLOBAL MARKETS

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IN THE MARKETS

SOVEREIGN WEALTH FUNDS: STEADY PROGRESS WITH $4TRN AUM

measures, will have on SWFs’ willingness to invest.” However, he is open to the possibility that governments might well be tempted to spend more at home to keep voters contented. The Eurasia Group’s Ian Bremner asserts: “Repatriation is already happening and it will continue in the MENA region.” He envisages a continued stream of revenue into the oil-based funds, since India, China and other growing economies are “entering their energy intensive phase”. He adds: “It gives them the opportunity to engage in political and economic reforms.” So Oman looks serious in its reforms and Saudi Arabia is carrying out some significant reforms, Meakin warns. “Altogether, the MENA-based SWFs have hundreds of billions of dollars in assets and so changes in their investment policies would be widely felt,” he says. Political vicissitudes apart, SWFs do not have the concerns of other institutional investors, since they do not have to draw down funds to meet say, pension obligations, Meakin points out that this outlook is currently being shown in increased SWF interest in alternative investments and infrastructure. Apart from the sources of the fund revenues, their targets are also changing. During 2010 the percentage of the funds investing in public equities rose from 79% to 85%. In addition, they were becoming more adventurous. Meakin says: “Last year we predicted that the proportion of SWFs involved in private equity (PE) would increase— and that has already come true to some extent with more of them getting into PE and hedge funds, making the SWFs some of the largest PE investors in the world.” The review found an increase from 55% to 59% of those investing in private equity, 47% via funds and 12% on their own account, with an additional 8%, including Norway’s Global, considering it. Some 40% are interested in distressed and turnaround funds, which of course have had much scope in recent years. Meakin comments: “It’s an ideal profile since it involves ample reserves and a long-term perspective,

able to tolerate illiquidity. SWFs did not ditch assets, and did not withdraw from private equity for example.” However, Eurasia Group’s Bremner cautions that it is not free money. “Of course private equity and hedge funds were going to SWFs because they had deep pockets and were seeking alpha everywhere, so it was a great pitch. Yet if you want to go to Abu Dhabi or Saudi Arabia now you’d better be talking to them about projects and investments in their own region. You need to be much more aware of the political background of those governments than the requirements of portfolio managers. These SWFs have become much more government directed, not just for profit generation, but for delivery on strategic plans, which involve the stability of the population and sustainability of the government.”

Inflationary risks In line with that, Meakin reports: “At the time of last year’s report, 47% of SWFs were investing in infrastructure, while the figure now stands at 61%. SWFs’ size makes them well suited to making such investments with high minimum commitment levels.” He speculates: “They might consider that there might be inflationary risks around the world and infrastructure is a good way to hedge against that.” Allaying fears of a bubble effect from the movement of such large resources, he points out that SWFs are still only a minority source for such investments and that “the increasing proportion investing in infrastructure will not fully meet the increasing need of many countries around the world for infrastructure investment and renewal”. Some of the funds are not living up to the IMF guidelines on transparency, and Meakin confesses: “We don’t have definitive statistics for how involved SWFs are in emerging markets, given the opacity of many of them in revealing AUM and allocation figures, but the general feeling is that their focus is moving from the developed market to developing markets, particularly large

SWFs in Asia. For example, China Investment Corporation is shifting its focus towards emerging markets for future investments, as well as focusing more on alternative investments over the next five to ten years, as it believes return opportunities will be greater in emerging markets.” He also cites the Government of Singapore Investment Corporation increasing its exposure to emerging markets, “particularly in Asia, as it believes that the developed economies will have slower growth in the next ten years”. He adds: “It expects expanding domestic demand to drive the continued high growth rates in the emerging economies, offsetting slower growth in export demand.” Indeed, some of the funds are predicating their strategy on local economies. Preqin finds that 26% have a local target. Indonesia and Malaysia, for example, both concentrate on their own economic development, which presumably enhances future values in the same way. Bremner ties the emerging markets with “infrastructure investment, which is going to be a huge piece of this, and of course it’s going to be commodities heavy. It’s been neglected and the intention is to make the population in these countries involved in development rather than as beneficiaries of government largesse. It’s a different strategy in the social contract many of these governments, monarchies, have had with their people.” Geopolitics is also reflected globally in the SWFs investment strategies. These decisions have political motives and equally political outcomes, and Sauvant suggests: “I would expect a resurgence of discussions about SWFs to reach a pre-crisis level of heat and concerns.” However, Bremner considers it will be more measured, comparing them to Hillary Clinton’s comments on muting human rights criticism of China: “You don’t argue with your banker.” The US, in particular running on empty, will want investments from the SWFs—but it is not going to love them for it. I

APRIL 2011 • FTSE GLOBAL MARKETS

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FIND OUT HOW TO GET INVOLVED:

Michala Kocurova +44 (0)20 7743 9337 michala.kocurova@afme.eu

Fleurise Luder +44 (0)20 7743 9361 fleurise.luder@afme.eu

www.afme.eu/isla2011

IN THE MARKETS

EUROPEAN DRs: DR PRICING & MARKET VOLATILITY DAMPENS NEW ISSUANCE

Although the European depositary receipt market may pale in comparison to its emerging markets counterpart, there is still life left in this well established part of the industry. Trading volumes and value jumped in 2010 and while markets are currently unpredictable in the wake of the Japanese earthquake tragedy and Middle East crisis, this year’s equity capital raising pipeline looks healthy. Lynn Strongin Dodds reports. Photograph © Dan Collier / Dreamstime.com, supplied March 2011.

BRICs take the lead on DRs in Europe HE EUROPEAN DEPOSITARY receipts market saw resurgence last year,” notes Alex Hickson, executive director and regional head of depositary receipts (DRs) in the EMEA region at JP Morgan. “Markets were volatile and there were headwinds in terms of the sovereign debt crisis but we saw strong issuance particularly from Russia. We believe this will continue in 2011 because of the government’s major privatisation initiative.” Chris Hanley, managing director and UK & Ireland team leader within BNY Mellon’s depositary receipt division, adds: “Overall, 151 new sponsored DR programmes were established last year, 48 more than 2009. Although the focus

has been on the emerging markets, the developed markets including Western Europe attracted a great deal of interest from investors particularly in the US. There were 18 new programmes last year and issuers in the region saw nearly 50bn DRs valued at $1.17trn. This was split between $1.12trn on NASDAQ and the New York Stock Exchange and $47bn traded over-the-counter.” The most actively-traded programmes, according to BNY Mellon’s 2010 report, continue to be the stalwarts with the most established programmes. Oil giant BP is out in front, trading more than 5.8bn DRs valued at over $225bn, followed by telecommunication giant Nokia at 6.6bn DRs

valued at nearly $74bn. Food manufacturer Nestlé made its mark as the most actively over-the-counter (OTC) traded programme with more than 141m DRs valued at above $7.1bn trading by year-end. Overall, the BNY Mellon report showed that 2010 enjoyed record trading volumes of 147bn DRs, a 9% hike from 2009, while trading value came in at $3.5trn, a 30% year-over-year increase. The major US stock exchanges continue to capture the lion’s share, accounting for 89% of total DR trading value. The London Stock Exchange seems to have lost its lustre for European DRs with only four new companies listing. These include Ukraine’s leading egg producer, Avangard, Russia’s supermarket chain O’Key, technology company Mail.ru and a transportation company, Transcontainer, a subsidiary of Russian Railways. BNY Mellon’s report reveals that the emerging markets continue to be the

APRIL 2011 • FTSE GLOBAL MARKETS

Send a strong signal to the global capital markets. Who’s helping you? Connecting issuers to investors is critical to the success of every depositary receipt program. BNY Mellon’s unparalleled expertise and outreach initiatives are central to this connection. Operating in 74 countries, we have opened a world of opportunities for issuers and investors — making us the world’s leading depositary bank. Working together, we can help reach your strategic goals.

For more information on Depositary Receipts, please contact: Asia-Pacific: Gregory Roath +852 2840 9821 Central Eastern Europe & Africa: Anthony Moro +1 212 815 5838 Latin America: Nuno da Silva +1 212 815 2233 Middle East: Mahmoud Salem +1 212 815 2248 Western Europe: Marianne Erlandsen +1 212 815 4747 bnymellon.com/dr

Products and services are provided in various countries by subsidiaries, affiliates, and joint ventures of The Bank of New York Mellon Corporation, including The Bank of New York Mellon, and in some instances by third party providers. Each is authorised and regulated as required within each jurisdiction. Products and services may be provided under various brand names, including BNY Mellon. This document and information contained herein is for general information and reference purposes only and does not constitute legal, tax, accounting or other professional advice nor is it an offer or solicitation of securities or services or an endorsement thereof in any jurisdiction or in any circumstance that is otherwise unlawful or not authorised. Depositary Receipts: NOT FDIC, STATE OR FEDERAL AGENCY INSURED; MAY LOSE VALUE; NO BANK, STATE OR FEDERAL AGENCY GUARANTEE. ©2011 The Bank of New York Mellon Corporation. All rights reserved.

IN THE MARKETS

EUROPEAN DRs: DR PRICING & MARKET VOLATILITY DAMPENS NEW ISSUANCE

leading players with issuers from these countries comprising 99% of all capital raising transactions, 58% of DR trading value, 61% of trading volume, and 74% of new sponsored programmes. Issuers from China, India and Brazil took centre stage, accounting for 83—worth a total of $17bn—of the 104 DR capitalraising transactions. This is an increase from last year when issuers from emerging markets accounted for 69% of capital raisings, 55% of trading value and trading volume, and 50% of new sponsored programmes This reflects the wider investment trend of institutional investors’ seemingly insatiable appetite for the emerging market growth story. According to figures from data provider EPFR Global, net inflows into emerging markets equity funds reached $92.5bn in 2010 by December 22nd, which was $10.5bn more than the whole of 2009, the previous record year for inflows. At the same time, developed market equity funds saw outflow of $6bn, including $36bn from US equity funds. Akbar Poonawala, managing director of global equity services at Deutsche Bank, says: “If you look at the market for the past three years, there has been a fairly robust amount of capital raising with a concentration of issuers from the emerging markets particularly within the BRIC countries. Our figures for 2010 show that Brazil accounted for 48%, followed by China at 25% with India and Russia accounting for 10% each. Europe has not seen much new capital raising other than in 2009 when there were two megadeals—Arcelor Mittal and ING, which skewed the figures.” According to BNY Mellon figures for 2009, Western European issuers established 22 new sponsored DR programmes and completed four capital-raising transactions valued at nearly $15.1bn. The respective $11bn and $3.2bn follow on offerings from ING Group’s and Arcelor Mittal comprised the bulk of the activity two years ago. Looking ahead, Brazil, Indian and China are expected to continue to dominate while Russia, which is part of

Akbar Poonawala, managing director of global equity services at Deutsche Bank. “If you look at the market for the past three years, there has been a fairly robust amount of capital raising with a concentration of issuers from the emerging markets, particularly within the BRIC countries,” he says. Photograph kindly supplied by Deutsche Bank, March 2011.

BRIC but also categorised as part of the Europe, Middle East and Africa camp, is also poised to be the EMEA’s most prolific in terms of new listings. Last year, the country raised more than $2.1bn, which accounted for over 90% of initial public offerings out of EMEA. The reason for the optimism is the government’s plans to sell off $32bn in state assets over the next three years, including a 15% chunk in Rosneft, the state oil company, and a 7% slice of Sberbank, the 60% state-owned bank which is the country’s largest. This could lead to more issuance in the form of DRs such as the recent 10% stake in VTB, which was listed as a DR on the London Stock Exchange earlier in the year. However, pricing will remain an issue as well as volatile market conditions. The Middle East crisis combined with lower than expected returns already saw companies such as Russian

coal miner Koks pull its $500m IPO. This was followed by pipe producer Chelyabinsk Tube Rolling Plant, also known as Chelpipe, with its $828m listing and Severstal unit Nord Gold, which cancelled its $1.1bn deal. Meanwhile pump manufacturer Hydraulic Machines & Systems Group cut the price range and the size of its listing in a $360m deal. Hickson says: “In the current environment we have seen investors sitting on the sidelines and deals being pulled. However, I do think Russia will continue to be the big story in the EMEA region because of the privatisation programme. We also note the increase in the number of reverse DR structures globally, and were delighted to assist Sberbank in Russia with the establishment of the first Russian depositary receipts (RDRs) for Rusal (the world’s largest aluminium company). Continued capital raising through DR programmes this year will depend on how companies will want to raise money, according to Poonawala. “The question remains to be seen whether companies will use the equities or debt markets for a lower cost. They may also at this point in time wait and use internal cash that is sitting on their balance sheets. It will depend on the sector and the need for capital.” Market participants also believe that trading could become more active in DRs against the current climate of uncertainty. The general consensus is that DRs are extremely liquid and they do not take away the liquidity from the shares listed on the home exchanges. In fact, in some cases, they can prove to be an alternative in illiquid markets or those that have to temporarily close as was the case in Egypt during the protests. The exchange was closed for a month but investors were actively trading the DR shares of companies such as Orascom Telecom, Orascom Construction, EFG-Hermes and Commercial International Bank (CIB)—four of the ten largest Egyptian companies on the Egypt Stock Exchange—on the London Stock Exchange. I

APRIL 2011 • FTSE GLOBAL MARKETS

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INDEX REVIEW

RECOVERY ON HOLD AS GLOBAL EVENTS PUSH UK INFLATION

Upturn is out of sight Interest rates in the UK were held steady at the last MPC meeting, which cannot have come as much of a surprise as the economy is hardly in a state where the added burden of higher rates would make much difference to the prospects for inflation going through 2011 and into 2012. Job prospects and growth remain in the doldrums and it is this more than anything else that is helping to hold down pay awards even in the face of February’s 4.4% inflation figure. Even so, if there is any move in interest rates, this is likely to lead to higher wage demands as mortgage/debt payments and so forth are a considerable (and non-discretionary) factor in many peoples’ lives. Simon Denham, managing director of spread betting firm Capital Spreads, takes the bearish view. HE UNDERLYING FUNDAMENTAL is that, for once, it is not an unreasonable assumption to state that the UK’s inflation problems are little to do with internal events but everything to do with global pressures. Raising interest rates in the UK is unlikely to impact Chinese oil demand or the price of corn in Russia. Moreover, the events of the past month may well be driving the last nail in the coffin of companies that have been teetering on the edge. Many companies retained staff through the downturn arguing that they would be needed when the upturn arrived. The upturn seems just as far away as ever and even in my own stomping ground—well-insulated, suburban Chelmsford—the “business closed” boards continue to sprout around the town. In this environment it is hard to recommend domestically-exposed stock, especially retail, property or leisure. With the government’s belt tightening yet to really kick in and various tax rises beginning to affect wage packets, the prospects of a consumer-led recovery are getting dimmer by the day. Of course, the point about the FTSE 350 is that the bulk of the constituent parts is nonUK revenue, so we must look further

afield to try to estimate overall prospects. With the senior index down to 5700 at one point in March, it is tempting to argue that the value caused by unrest in the Middle East and North African regions and the tsunami which devastated Japan have created a strong buying opportunity as these events will, by their nature, be temporary. Yet there is the continuing problem of commodity-induced inflation, which seems to present no realistic solution right now; the prospect of steeply rising producer input prices with a squeezed global consumer base would generally add up to a tightening of profit margins. The prevailing pattern is one of uncertainty and sensible investing decisions are always tough to take in this environment. Gold seems to be the obvious hedge but even that is struggling to reach new highs. At the time of writing this column, we are seeing a bounce from the nuclear fallout lows, though I worry that the optimism of January and February may be hard to regain any time soon. Any rallies appear to being driven by short-term measures—such as the decision of the G7 to intervene in the currency markets to help weaken the yen.

Simon Denham, managing director of spread betting firm Capital Spreads. Photograph kindly supplied by Capital Spreads.

Longer-term issues also continue to pose threats to global economic stability. Apart from the situation in Japan, Libya is also unpredictable, at best, especially in light of the UN’s interventionist vote for a no-fly zone over the country. If Bahrain’s troubles do overflow into Saudi Arabia (one of the world’s largest oil producers,) the impact on any investment class you can think of could be spectacular. Elsewhere, European banking stress tests are due to start in the very near term and this has put the microscope, once again, on sovereign debt despite the EU agreement to raise the bailout fund. The EC is also proposing the creation of a $6bn Euro-Mediterranean investment bank to help fund the transition to democracy in countries on the Mediterranean’s southern shore over the next three years. It is being called a 21st century Marshall Plan for the region, which is supposed to mirror the EU’s efforts to bring peace to the Balkans through economic investment and prosperity. Let us hope the EU has the opportunity to invest it. The next few weeks (perhaps months) look to be characterised by unpredictability. As ever, ladies and gentlemen, “place your bets”. I

APRIL 2011 • FTSE GLOBAL MARKETS

FTSE GROUP: NEW INDICES ADDRESS INVESTOR CONCERNS

Photograph © Leigh Prather / Dreamstime.com, March 2011.

Smoothing out market volatility The FTSE StableRisk Index Series, designed in association with AlphaSimplex Group, is a new family of risk-controlled multiasset indices which seek to capture long-term risk premia with less extreme shifts in short-term risk levels. This is achieved by using a portfolio of liquid futures contracts representing asset classes, rebalanced as often as daily, with the objective of maintaining constituent and index volatility at longer-term historical levels. This new index series aims to capture returns and, at the same time, tackle heightened market volatility regimes during various points of the market cycle. The indices offer exposure to equities, commodities, currency and interest rates. Francesca Carnevale spoke to Dr Elton Babameto, associate director, quantitative research at FTSE Group, about the implications of the launch of the new indices. NVESTOR DON’T LIKE uncertainty. Ensuing market volatility following events such as the fall of Lehman Brothers, the eurozone sovereign debt crisis and more recently the catastrophic earthquake which devastated Japan and political ructions in North Africa, highlight the trend. The new investible index series from FTSE Group is intended to address investors’ natural concerns in the wake of either natural, political or market events while helping them to protect longer-term returns. The FTSE StableRisk Index Series family of indices is targeting investors who are trying to capture the longterm risk premia of major asset classes while controlling shorter-term spikes in asset risk levels. There are two sepa-

FTSE GLOBAL MARKETS • APRIL 2011

rate families of indices available, the FTSE StableRisk Trend and FTSE StableRisk Indices. FTSE StableRisk series is a family of long-only, risk-controlled indices for each major asset class plus a multi-asset class composite index, while the FTSE StableRisk Trend series is a family of momentum-based, longshort risk-controlled indices for each major asset class plus a multi-asset class composite index. FTSE Group worked with the Cambridge, Massachusetts-based, Alpha Simplex Group (owned by Natixis Global Asset Management) which specialises in absolute-return investment strategies that are implemented primarily with futures and forward contracts, on developing the new index series.

The group is led by Professor Andrew Lo, who has “established a risk-controlled, multi-asset methodology which will provide innovative new indices for the market place which increase the range of strategic index solutions offered,” explains Elton Babameto, associate director, quantitative research, at FTSE. “It is worth emphasising that investors are becoming increasingly sophisticated and FTSE is getting more demand from the market. We’ve seen a trend in taking once-active strategies passive. Such increasingly sophisticated passive vehicles are a cost-efficient way to get access to returns provided by these types of investment strategies. Moreover, the underlying index methodology is an innovative strategy within a passive vehicle which is transparent, intuitive and investable,” he adds. According to Babameto, the new indices are more than merely a basket of futures contracts. “They combine momentum signals (FTSE StableRisk Trend) with a disciplined risk-controlling framework (FTSE StableRisk Trend and FTSE StableRisk indices). Such indices provide a transparent and rules-based framework that a typical active fund manager would employ in this space. The beauty of such indices is that they are wrapped up into a passive and transparent framework as opposed to the traditional

INDEX REVIEW

FTSE GROUP: NEW INDICES ADDRESS INVESTOR CONCERNS

‘black-box’ approach,” he explains. In addition, he says, they are fundamentally different to a basket of futures where there are no controls on short-term volatility levels and no views about short-term market performance. Importantly, the new index series are investable and replicable and can easily serve as the basis for creating high-capacity, low-cost investment vehicles to gain exposure to asset classes at stable risk levels and have multiple application possibilities, says Babameto. These include utilisation as risk-controlled benchmarks for manager evaluation, usage as an asset allocation benchmark based on risk budgeting and the creation of riskcontrolled investment products.

Dynamically risk controlled Babameto explains that heightened volatility regimes and their negative impact on returns have left many investors bruised. “The year 2008 is clearly a case in point. As a result, it is easy to see why investors would like to have exposure to this particular type of index series which are dynamically risk controlled; transparent and rules-based. The targeted volatility levels of each asset class are calibrated to their long-term average values. Consequently, the shortterm volatility of each index is stabilised at the target (long-term) level by adjusting the market exposure of each index. For example, if short-term market volatility was to double in a particular asset class, the market exposure of such asset class would be halved,” he says. Having said that, Babameto notes it is worth emphasising that this particular product should be attractive to investors at all times. “Naturally, periods of heightened market volatility help highlight the benefits of being exposed to such indices. However, volatility is a permanent feature of financial markets and investors would always have the need to tackle volatility shifts in their continuous fight of capturing the longer-term risk premia,” he explains. Short-term volatility is estimated using a methodology which provides

Dr Elton Babameto, associate director, quantitative research, at FTSE Group. Photograph kindly supplied by FTSE Group, March 2011.

more weight to the latest asset returns. “Practitioners frequently refer to this approach as the Exponentially Weighted Moving Average method (EWMA) method. To illustrate, when the EWMA estimate for a particular index constituent is higher or lower relative to the ten-year average volatility value, then the weight of the constituent is either decreased or increased in the index,” says Babameto. In the case of the FTSE StableRisk Trend Indices, momentum signals, which are generated by comparing trailing 21-day moving-average prices relative to 252-day movingaverage prices, are employed to generate both long and short positions. Once those signals are generated, then final allocations are worked out relative to well-defined risk targets. The constituents of the index series are futures contracts, which are chosen as a proxy for respective markets and asset classes. The indices utilise benchmark derivatives contracts only, such as The Bursa Malaysia Crude Palm Oil futures contract (FCPO), which is the benchmark for international trade in crude palm oil and reflects the fact, says Babamento, that “our indices choose contracts which are representative of respective markets”. He adds: “In addition, futures contracts are selected on the basis of their liquidity, so that indices are investible in volume and on the basis of regulatory restrictions; in

other words they are approved by the US Commodity Futures Trading Commission.” There is also a threshold of $1bn in terms of average aggregate daily trading volume on each future contract. A contract is excluded from participating into the index if its average aggregate daily trading volume falls below $500m. Even though the indices utilise derivates to smooth out volatility spikes, the calculation of index constituents is relatively straightforward, explains Babameto. “As long as there is a clear and transparent set of rules upon which you construct an index, the use of index constituents is straightforward. In other words, it makes no technical difference whether we are talking about cash or derivative instruments used as constituents for the purpose of constructing an index.” Futures are used to construct the FTSE StableRisk Trend and FTSE StableRisk Index series for a number of reasons. Transacting in futures contracts implies (on average) lower transaction costs and high levels of liquidity. Unlike stocks and bonds, taking short positions via futures contracts is, says Babameto: “Logistically simple. A futures market participant can take a short position in a futures contract without borrowing a long contract. In addition, as futures contracts have no dividends, the complications and costs of shorting a stock which pays dividends are avoided.” Moreover, unlike cash instruments, a futures contract holder only needs to hold a fraction of the notional value of the underlying contracts in the investor’s exchange account.

Equal risk allocations The guiding compass behind the new indices is, nevertheless, the long-term volatility of a particular asset class. Long-term volatility is defined as the average value of volatility over the last ten years for any particular asset class. Also, adds Babameto: “When shortterm volatilities are forecast to be higher/lower relative to respective

APRIL 2011 • FTSE GLOBAL MARKETS

Historical performance and volatility: FTSE All World versus the new FTSE StableRisk Indices FTSE All World Cumulative Return Annualised Return (Geometric) Volatility Sharpe Ratio

Index rebased (31 December 1999 = 100)

FTSE All World 800

FTSE StableRisk Composite Index 617.14% 19.61% 15.43% 1.11

15.88% 1.35% 16.63% -0.07

FTSE StableRisk Composite Index

FTSE StableRisk Trend Composite Index 541.35% 18.41% 15.74% 1.01

FTSE StableRisk Trend Composite Index

700 600 500 400 300 200 100 0

Dec 1999

Dec 2000

Dec 2001

Dec 2002

Dec 2003

Dec 2004

FTSE All World Cumulative Return Annualised Return (Geometric) Volatility Sharpe Ratio

Dec 2006

Dec 2007

FTSE StableRisk Equity Index 35.82% 2.82% 14.78% 0.02

15.88% 1.35% 16.63% -0.07

FTSE All World

Dec 2005

FTSE StableRisk Equity Index

Dec 2008

Dec 2009

Dec 2010

FTSE StableRisk Trend Equity Index 302.90% 13.51% 14.94% 0.70

FTSE StableRisk Trend Equity Index

Index rebased (31 December 1999 = 100)

500

400

300

200

100

Dec 1999

Dec 2000

Dec 2001

Dec 2002

Dec 2003

Dec 2004

Dec 2005

Dec 2006

Dec 2007

Dec 2008

Dec 2009

Dec 2010

Source: FTSE as at 31/12/2010, supplied March 2011.

long-term values, positions are scaled down or up, relative to respective longterm values, in order to achieve equal risk allocations across asset classes and within each particular asset class.”

FTSE GLOBAL MARKETS • APRIL 2011

Nonetheless, the index series are based on a sophisticated set of rules. Given the underlying constituents of the index are derivates, the indices will have to be rebalanced frequently. “Rebalanc-

ing could take place daily if need be. Naturally, there is recognition of the fact that frequent rebalancing also leads to reduced returns over time through higher transaction costs,” says Babameto. To minimize this possibility, FTSE Group is employing rebalancing thresholds to minimize turnover. To this end, index rebalancing takes place only if position changes are at least 25% larger or smaller than the immediate previous positions. “In addition, all index calculations are carried out taking into account transaction and market impact costs which are available in the published methodology. This way, index calculations aim to mirror the performance that investors would get in practice via investable indices as opposed to non-investable benchmarks,” he adds.

Quantitative investment strategies The field of indexation is expanding rapidly and indices are no longer confined to providing a low-cost, lowturnover means of obtaining access to the world’s equity markets using a capitalisation weighted scheme. There are now indices that use alternative weighting schemes which seek to overcome some of the problems of excessive concentration that cap-weighted indices can exhibit, particularly during bubbles, and there are indices that seek to emulate quantitative investment strategies but at considerably lower cost. The new indices are an example of the latter and are tailored to those investors who want to capture the long-run risk premium associated with a risky asset but without suffering the short-term negative returns often associated with periods of elevated volatility. As such, holds Babameto, the indices are suitable for all investors with a long-term horizon. “Asset owners may choose to ask sophisticated investment managers to implement the index strategy on their behalf. However, the indices are also suitable bases for investment funds and structured products that should appeal to retail investors.” I

COUNTRY REPORT

KUWAIT: AMBITIOUS REFORMS IN STASIS AS POLITICIANS TUSSLE

Kuwait's cabinet submitted its resignation at the end of March, largely as local commentators had predicted it would, to avoid rigorous questioning from its assertive parliaments. It is likely that the prime minister will reassemble another cabinet shortly; however growing dissent among the country’s political groups could undermine economic reforms and undo the efforts by local financial institutions to get back to business as usual in the wake of the financial crisis.

British Prime Minister David Cameron meets with Speaker Jassem Al-Kharafi at the Kuwait National Assembly in Kuwait City. Photograph by Tim Ireland/PA Wire/Press Association Images, supplied by Press Association Images, March 2011.

Politics undercut improving fundamentals HERE IS A growing sense of wellbeing in the Kuwait’s banking segment which generally has reported positive results for the 2010 financial year. NBK, the country’s largest bank reported net profits of a tad over $1bn, up 14% on 2009 from assets worth $46bn at year end. Ibrahim Dabdoub, NBK’s Group chief executive officer, explains that the bank has sustained asset quality levels. Moreover, he explains:“Our strategy in Kuwait and the MENA region was complemented in 2010 by receiving a license to start operations in Syria,

another large market with significant potential. In addition we increased our stake in Boubyan Bank to 47%, strengthening our market position in the Islamic banking segment in Kuwait,”Dabdoub added. NBK’s operations outside Kuwait remained very strong in 2010 contributing more than 20% of the bank’s profits. NBK launched a heavily oversubscribed rights issue last year which was partly aimed at funding expansion plans in Kuwait and abroad. However, current political unrest in North Africa, the eastern Mediterranean and in some

Gulf Cooperation Council countries has raised risk levels. Given NBK’s regional focus, and conservative policies, it is no surprise that any immediate expansion plans have been put on hold. Gulf Bank today announced a net profit of $68m (KD19m) for 2010, compared to a loss of KD28m a year earlier. The 2010 operating profits included non-recurring items worth KD40m, however, the bank used a substantial slug of funds to increase specific and excess general loan provisions. Ali AlRashaid Al-Bader, Gulf Bank’s chairman notes the results reflect improvements resulting from its new strategy of focusing on core banking activities and “the growth in the bank’s credit facilities to productive economic sectors, as well as the expansion in banking services in general.” The general improvement in the national economic conditions, and the commencement of the five-year development plan projects, “had an obvious effect on attaining these results,” continues Al-Bader. Even Global Investment House narrowed its fourth-quarter net loss by almost $97.4m, as the firm cut operating and interest costs by a massive 35% and 32% respectively through the last year. Global is one of Kuwait's biggest investment firms, and as such was regarded as a bellwether of the investment climate (outside of the national investment behemoth, the Kuwait Investment Authority of course) and reported a net losses worth of KD73.2m for the 2010 operating year, just under half the value of its losses in 2009, according to a company statement. Global also paid back $178.3m in debt repayments to banks through the year, following an agreement with creditors, signed in December 2009, which encompassed the rescheduling of more than $1.7bn in liabilities.

APRIL 2011 • FTSE GLOBAL MARKETS

COUNTRY REPORT

KUWAIT: AMBITIOUS REFORMS IN STASIS AS POLITICIANS TUSSLE

The central bank reports that capital adequacy levels among the country’s banks increased in aggregate by over 2%, however non-performing loans remain troublesome at 7.4%, however the latter figure is well down on the 10% plus registered in 2009, when the economy shrank by an unprecedented 20+% due to weak oil prices and a depressed global economy. The country now faces two challenges: one whether it can continue uninterrupted on its $104bn infrastructure investment programme unimpeded by either internal political ructions or external ones. Two: whether any new incoming cabinet can continue to implement a sustainable economic reform programme in the face of fractious internal support. The most democratically advanced of all Middle East countries, Kuwait’s parliament is rather more powerful than most. The announcement that the country’s governing cabinet had resigned would not have come as a surprise to Kuwaitis. Intense questioning of ministers is regarded as a direct challenge to their authority; and on occasion is regarded as an indirect challenge to the country’s ruler Sheikh Sabah al-Ahmad al-Sabah. Dissent has been brewing for the best part of this year. Parliamentarians had asked for the right to question three ministers, all members of the ruling al-Sabah family, the latest in a series of challenges that have marred the first quarter of this year as the prime minister and his cabinet tried to introduce significant economic reforms.

The impact of political unrest While political ructions have rocked neighbouring GCC states, by comparison Kuwait appears to have remained calm relatively; not least because any dissent has a natural outlet in the country’s often truculent and outspoken parliament. However parliamentary freedom has cost the country dear as the country’s lawmakers have consistently stymied efforts by the government to modernise the economy. In

consequence of the stalemate between ministers and parliament, the country has done little to diversify and reform the economy this year and the inward investment regime remains patchy. The government announced back in 2009 that it wanted to spend some $104bn to spur both private sector growth and modernise the economy, though its plans have largely come to nought. Last year looked to be an important turning point for the country as the government’s current four-year plan (the first of six consecutive development plans that it is hoped will achieve Kuwait’s vision of becoming the region’s financial and trade center by 2035) began implementation. However, the plan calls for the issue or revision of 21 economic laws and regulations in areas such as privatisation, public-private partnerships, competition, and corporate governance over the near term. It also requires the establishment of several market authorities which will supervise the stock market, privatisation and sectors such as transport and telecommunications. So far only a handful of laws have been passed, the most salient being the privatisation law, which involves the sell-off of up to as much as 80% of state held assets in non-carbon business sectors and a law which calls for the setting up of a capital markets authority to supervise financial products and markets. A rapid return to a smoother political debate is now required to set the country on the fast track once more. Over the short term this looks unlikely. Moreover, there are also other tensions in play. Over the past few weeks, parliamentarians have been split along sectarian lines; with Shiite MPs voicing support for the plight of fellow Shiites in Bahrain; while Sunni activists and MPs have backed the Bahraini government and the Sunni community. Moreover, the DRB party is planning to launch a campaign within the next six months to gather support for constitutional amendment proposals, which it plans to formally

present to parliament at the beginning of the next parliamentary term in an effort to expand the parliament's legislative and supervisory authority. Kuwait has been able to afford to remain a relatively open economy, backed by an estimated 9% of the world’s oil reserves. Petroleum continues to account for nearly half of GDP and by far the bulk of the country’s exports (topping 95%) and the country consistently reports a budget surplus. According to the Kuwait central bank, the country should achieve nominal GDP growth of up to 8.3% this year and more or less the same in 2012. At a recent press conference, central bank governor Sheikh Salem Al-Sabah noted that investment levels remained positive and that while inflation projections ranged from 5% to 6% levels remained with target expectations. According to local bankers, continuation of the government’s investment programme is essential for the continued health of the country’s financial segment.“Additional improvements in [Gulf Bank’s] business and results are expected for 2011, especially if active implementation of the five-year plan continues, including the role of citizens and their institutions in owning and managing the various national economic projects. This will entail a tangible improvement in the levels of economic activity, and will promote confidence of investors and businessmen, thus positively reflecting on the national economy and the profitability of national institutions operating in the economy,” adds Al-Bader. In the meantime, Kuwait’s sovereign wealth fund intends to launch a real estate portfolio worth almost $3.6bn, it claimed in an official release. Kuwait Finance House, the country's biggest Islamic lender, will initially manage the portfolio KIA said, adding that the portfolio would not invest in residential properties."The real estate portfolio aims to achieve good returns on midterm and long-term, and will benefit from the steep plunge in real estate," KIA said its statement. I

APRIL 2011 • FTSE GLOBAL MARKETS

COMMODITIES

COMMODITY MARKETS: A WORK IN PROGRESS

Following the smart money into Asia RICES FOR MOST commodities are at or close to historic highs and there is no doubt that commodities are in vogue. The arguments in favour of raw materials and food are solid. The global economy is recovering and industrial production is on the rise, emerging markets are becoming wealthier and their populations are spending more on food. The domestic expansion in China continues to drive demand for all things commodity. Colin P Fenton, analyst at JPMorgan Chase, contributes to the general feeling of wellbeing in the sector. “Our analysis of how strategic commodity allocations in 51 countries fared in 2006 to 2010 concluded that the asset class provided significant benefit in protecting investment performance exactly when it was needed. Commodities worked,” he says. A significant theme over the next two to three years is that more trading is moving to Asia, particularly on the retail front. Banks and exchanges, for instance, are beginning to introduce new types of contracts, generally in the form of swaps rather than futures. Another trend to look to is that gold is becoming established as collateral for investment on a par with financial deposits. Moreover, high-frequency trading, though not likely to replace traditional trading, could potentially consolidate its foothold in the commodities market. “The demand from investors will still be there over the coming years, the diversification element of the portfolio will still be there, but trading strategies are likely to change,” confirms Koen Straetmans, commodities strategist for ING Investment Management. The shift towards Asia as a major trading hub is already under way. In 2009 the volume of commodity contracts traded on the Shanghai Futures Exchange surpassed those traded in either NewYork or London. A list of restrictions

FTSE GLOBAL MARKETS • APRIL 2011

The investment space is already well populated with a wide variety of commodities-based financial instruments and more of these will continue to come to market, but looking at a two to three-year time horizon, the investment options are likely to change. Vanya Dragomanovich looks at the possible developments in the commodities markets over the next two years.

Photograph © Ka Ho Leung / Dreamstime.com, March 2011.

on what local residents and companies can trade might prevent western exchanges from establishing a foothold in China but not in the region as a whole. The London Metal Exchange (LME), for example, which accounts for some 90% of the world’s metals futures and options trade, in February began positioning itself in Asia by launching copper, aluminium and zinc futures traded through the Singapore Exchange.

The futures contracts have already attracted strong interest with three market makers and 20 active traders signed up to the initiative; market markers include GS Energy Partners, of the USA, and Susquehanna Pacific, of Sydney, Australia. The futures have 12 consecutive contract months listed for trading and are cash settled at expiry based on the LME Official Cash Settlement Price for the relevant metal. Liz

COMMODITIES

COMMODITY MARKETS: A WORK IN PROGRESS

Milan, managing director, LME Asia, noted at the launch: “The growth in trading of metals has been exceptional in Asia at industry and institutional levels. However, there is also a high level of interest from retail investors and funds looking for more accessible products that give them exposure to metals prices and help them broaden their investment portfolio.” “If you take into account that one lot of aluminium costs around $110,000, it is clear that we are not a retail market but a wholesale market,” explains Martin Abbott, LME chief executive. “We have a strong global presence with operations in Tokyo, South Korea and Singapore, but then you have got the Shanghai market which has huge volumes and low open interest.” “This tells us there is a large retail market in China and the rest of Asia and although we are not a retail operator we did not want somebody to enter the retail market in Asia and to use this to build a wholesale platform,” Abbott explains. In the first days of the LME-SGX, contracts traded represented 1,500 lots of metal per day but going forward, he adds: “This could be a drop in the ocean.” Another driver that could see more trade move to Asia is the expected tightening of the derivatives trade regulation. In July of last year, the US Congress passed the Dodd-Frank Act, which, among other issues, aims to bring over-the-counter (OTC) derivatives, particularly swaps, under comprehensive regulation. The Commodity Futures Trading Commission (CFTC) is in the middle of the rule-writing process to fulfill congress’s direction. Kamal Naqvi, head of global commodity sales at Credit Suisse, says that, depending on how strict the regulatory changes are, “some products will migrate into the Asian time zone”. This would have major implications for the liquidity of commodity markets as far more commodities are traded over-thecounter than on exchange. The CFTC will have to walk a tight line between trying to keep politicians

Martin Abbott, London Metal Exchange (LME) chief executive. “We have a strong global presence with operations in Tokyo, South Korea and Singapore, but then you have got the Shanghai market which has huge volumes and low open interest,” he says. Photograph kindly supplied by LME, March 2011.

happy with more oversight of commodities markets and trying not to constrict trade to the point that volume and income is lost in western markets. One of the expected changes is that all OTC derivatives will have to be cleared through either clearing houses or exchanges and the players in question are already making preparations. CME Clearing Europe, the London subsidiary of CME Group, will start clearing more than 150 over the counter energy and commodity derivative products from the beginning of May. “While the initial focus of our product expansion will be on commodity products— energy, metals and agricultural—we aim to introduce clearing for OTC financial derivatives, beginning with interest rate swaps, in parallel with the deepening of the commodity clearing,”

says Andrew Lamb, chief executive of CME Clearing Europe. BNP Paribas, HSBC, MF Global UK, Newedge Group, Citigroup and Deutsche Bank will be among the initial clearing members. “There is political and regulatory pressure to go into clearing. We already have OTC systems in place to accommodate that,” adds Abbott of the LME. In terms of new products coming onto the market there is a steady stream of new offerings being made public almost on a weekly basis. Those are now more in the ETF space than in the form of new futures contracts. Two of the biggest new products in the pipeline are US-based copper ETFs that will be launched by JP Morgan and BlackRock Asset Management. The two companies filed applications with the SEC in November 2010 and with the process likely to take up to a year; the two ETFs could be available by the end of 2011. Both financial institutions plan an offering that will dwarf base metal ETFs currently in the market. While gold, metals and energy ETFs proved very popular with investors, agricultural ETFs had a patchier record. Deutsche Bank for instance, in February suspended new issuance of its PowerShares agriculture double long ETF. One of the downsides with ETFs is that for commodities that are in contango (where the current price is lower than the price in the future) investors lose out on the roll yield. ETFs are typically tied to an underlying futures contract one or three months long and when they come to expiry they have to be rolled over by selling the nearby contract and buying a contract for the following month. “Investors are looking for ways to overcome negative characteristics such as a roll yield. This is already possible with some enhanced ETF products. What you are likely to see is that even classic pension funds will start adopting strategies that are more hedge-fund like, that are more quant driven irrespective of their strategic view and that take into account volatility,” says ING’s Straetmans.

APRIL 2011 • FTSE GLOBAL MARKETS

COMMODITIES

COMMODITY MARKETS: A WORK IN PROGRESS

One issue that will affect all commodities is the proliferation of high-frequency trading. Although it has not taken as much hold in commodities as it did in bonds and equities, high-frequency trading has started playing an increasing role. On the futures and options front, offerings for completely new commodities are a rare occurrence. “It still takes a long time for a new contract to take off,” says the LME’s Abbott. The exchange introduced a steel contract three years ago and although the contract is “growing nicely,” outright volumes are still low, he adds. “For a contract like steel to be fully established we need to see a full economic cycle for participants to see and understand missed opportunities in terms of hedging. You also need a big outside event. For instance, the event that established the aluminium contract was the collapse of the Eastern European bloc. Up until then there was a certain level of supply in Western Europe but then suddenly all this Russian aluminium hit the market and western producers no longer set the prices,” says Abbott. The LME is keeping “a watching brief” on a number of commodities such as iron ore and coal but the exchange does not expect to launch a contract for a new metal any time soon. “It is much easier to start a new market with swaps then with futures. If you start with OTC swaps you can have a broking community and see if you have enough liquidity to move on,” says Credit Suisse’s Naqvi. Credit Suisse, alongside Deutsche Bank, was one of the first banks to offer iron ore swaps. “What we have seen with futures is that people try to get there too quickly. The problem with futures is the transparency shows that there is insufficient liquidity. People don’t want to trade in that kind of environment. If you are holding a swap then you are in the position to wait for enough liquidity to trade it,” says Naqvi, adding that iron ore swaps were a good way of introducing a new contract into the market. He notes that there are a number of

other raw materials, such as alumina, thermal coal, coking coal and uranium, for which there is already an active physical market and which could lend themselves for a swap-type paper market. “In our view coking coal and alumina are the two markets that are closest to be launched. They are almost there but we need a little bit more, some form of critical mass,” says Naqvi. That “little bit more” is likely to be an outside event, as in the case of iron ore where the launch of swaps was prompted by the breakdown of the long-term pricing agreements between miners and steel mills.

Radical change Gold, meantime, which has a special status among all commodities is about to see a more radical change as it takes up the role of a pseudo-currency. While commodity prices are almost directly related to economic growth, gold tends to benefit from both the economy doing badly and the economy doing well. If the global economy is growing, gold benefits because more people buy jewellery and more of the metal is used for industrial purposes such as in electronics. On the other hand, at times when equities slide, when there is geopolitical instability such as there is now in the Middle East, and when other financial instruments are under pressure, investors turn to gold as the go-to safe haven investment. “In an inflationary environment, commodities are not necessarily a good bet but gold is,” explains Koen Straetmans, commodities strategist for ING Investment Management. Having followed that investment logic, banks and investment funds ended up with significant holdings of gold, which they are now looking to put

to better use. CME and ICE Clear Europe already allow the use of gold as a collateral—in ICE Clear’s case for energy and credit default swaps and in CME’s on all its markets—but the fundamental shift really happened this spring when JP Morgan became the first bank to accept gold to “satisfy securities lending and repo obligations”. This sends a clear signal that banks see gold as a safe enough store of value, which is likely to maintain a stable price. One issue that will affect all commodities is the proliferation of highfrequency trading. Although it has not taken as much hold in commodities as it did in bonds and equities, high-frequency trading nevertheless has started playing an increasing role. High-frequency trading in commodities has risen sharply over the past few years but in addition to it, “the amount of trading that is no longer going through a bank or a broker is much higher and there is much more volatility in the system,” says Naqvi. The LME, for instance, has already seen the average size of transaction fall to four lots from between 20 and 25 lots a few years ago, according to chief executive Abbott, who expects this trend to continue. There is a limit to it, however, as 50% of LME trade happens over the phone, 15% in open outcry and 35% electronically. Also, Abbott notes that the current volumes of highfrequency trade can only go up fourfold from here because the smallest contract that can be traded is one lot. He adds that the exchange is ready for it. “We had to stay ahead with building extra memory and building up infrastructure. We have substantially rebuilt our SMART system, all trades are netted through the system, registered, and go to clearing from there.” Commodities are likely to stay the flavour not just of the month but a good 24 months ahead. JPMorgan’s Fenton forecasts 19% 12-month return for the JPM CCI index and 22% for the S&P GSCI commodity energy sub index. If he is right, this is definitely an asset class worth paying attention to. I

APRIL 2011 • FTSE GLOBAL MARKETS

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DEBT REPORT

INVESTMENTS: THE COMPELLING CASE FOR CORPORATE BONDS

The best game in town? No market was immune from the natural catastrophes that struck Japan in March, and the debt of investment-grade European companies with potential exposures to these events took a predictable hit. As with earlier movements on the bond spreads of those that are deemed vulnerable to the growing political unrest in the Middle East, the reaction was limited in scope—as spreads widened by around ten to 20 basis points— and were short lived. This reflected the current strength of high-grade European corporate bonds, as the market’s combination of improving credit fundamentals, decent yields (certainly relative to cash deposits), and limited supply should ensure it remains highly attractive to fixed-income investors throughout 2011 and beyond. Andrew Cavenagh reports. HILE FEW EXPECT the market to perform as strongly as it did last year—when the top-performing funds in the sector achieved returns of 10% or more—investments in non-junk corporate bonds should deliver a return of at least 5% over the next 12 months. Given the risks that still plague much of the financial sector and the sovereign debt of the beleaguered eurozone countries, the volatility in the equity markets, and the pitiful returns on cash held at the bank, it is not hard to see why the case for corporate credit has become so compelling for many. “My sense is that 2011 will be a challenging environment for all risk assets, but especially equities and property,” explains Chris Bowie, head of credit at Ignis Asset Management. “With cash yielding next to nothing, and risks of capital losses from riskier assets, a 5% return from corporate bonds is the best game in town. That is why all of my money continues to be invested in credit.” The Ignis fixed-income credit team has £14bn invested in high-grade corporate debt, the vast bulk of it in sterling-denominated bonds, and Bowie says the industry sectors that he was favouring in 2011 included telecommunications, media and technology (TMT), supermarkets (secured paper) and utilities. Limited primary issuance this year

should ensure that, in general, the spreads on investment-grade corporate debt, apart from the sort of temporary blips that have arisen from the recent events in Japan and the Middle East, remain stable. The credit team at SG Corporate and Investment Banking (SG CIB) forecast at the start of the year that non-financial European corporations with investment-grade ratings would issue around €120bn of further debt in 2011, compared with €110bn last year and €250bn in 2009. However, the level of issuance up to the second half of March is just €23bn versus €43bn for the first quarter of 2010, and may lead them to lower this estimate. There is certainly little reason for most large companies to raise a lot of cash this year. Management focus remains on deleveraging, conserving cash, cost control, and cautious reviews of capital expenditure and little prospect of significant mergers and acquisitions activity on the horizon raising large amounts on the bond markets just creates a negative-carry headache. “Non-financial corporations do not need the cash, and issuance will be fairly light this year,” says Suki Mann, a credit analyst at SG CIB. Given the demand for the paper, it should remain very much an issuer’s market through 2011 that companies will be able to tap it as and when it

suits them. The reception for the €1bn two-tranche bond that the Dutch electricity grid operator TenneT launched in the second half of February was clear evidence of the strength of investor appetite. With the seven-year tranche of €500m offering a coupon of 3.875% and the 12-year tranche one of 4.625% (and the bonds pricing at 99.8% and 99.4% of par respectively), the deal was oversubscribed by a factor of seven. Utilities are perhaps the one group of European corporations that are likely to issue significantly more debt this year than they did in 2010, when they collectively placed just €36bn of bonds after tapping the market for €89bn in 2009. Last year’s relative lack of activity was a direct result of the previous year’s excess, when all the big companies took advantage of the low levels of interest rates at the time to pre-fund their financing needs through to the end of 2011. Much of their issuance in 2010 was driven by cost-of-debt considerations, as the utilities offered to exchange older (more expansive) bonds for cheaper new debt and often combined this exercise with cash buybacks to make the most efficient use of all the cash they had raised in 2009. This year will be a different story, however, as the sector needs to refinance €28bn of outstanding bonds that are due to mature over the next two

APRIL 2011 • FTSE GLOBAL MARKETS

Photograph © Norebbo / Dreamstime.com, March 2011.

years (€11.4bn in 2011 and €16.6bn in 2012) and also has more than €200bn of capital expenditure to finance over the next five years [please see table below]. The companies will be keen to secure as much of their requirements as they can, within the allowances of their leverage targets and credit ratings, while the cost of funding is still relatively low. Analysts consequently expect Europe’s utilities to issue a further €45bn to €50bn before the year end. Ironically, the utilities will be looking to

step-up their levels of issuance just as the sector is hit with fresh uncertainties after a two-year period of consolidation, in which most of the companies have improved their credit standing through prudent financial management—focused on debt reduction, efficiency improvements, cash conservation and careful reviews of capital expenditure programmes. The problems at the Fukushima nuclear plant in Japan, after the tsunami took out the emergency power generation, have inevitably cast a shadow over the big European utility companies that have significant nuclear assets and future development plans, such as Electricité de France and Germany’s E.ON. The impact on E.ON has been particularly bad given the German government’s snap decision to shut down the country’s seven oldest nuclear plants for the time being and to announce a “measured exit” from the technology. Spreads on the debt of those utilities firms with big nuclear exposures widened by 10bps to 15bps soon after the announcement, although they soon started to creep back. The other major uncertainty facing the sector is the near-term outlook for oil and gas prices, which has become

considerably more uncertain as a result of the spreading political turbulence in the Middle East. The widening divergence between spot gas prices and forward contract prices over the past year has already caused difficulties for the gas businesses of E.ON and RWE in Germany, GDF Suez of France, and particularly Italy’s Edison, as the fall in the former, primarily due to shale-gas developments in the US, has left them with expensive—and loss-making— forward purchase contracts. Significant as both developments are potentially for the utility businesses in the longer term, neither seems likely to have much impact on their debt issuance plans for 2011, although the pricing may be marginally more expensive in some cases. On the nuclear issue, delays to the planned new-build programmes in the UK and elsewhere, which now seem inevitable, will not have real implications for utility funding needs until 2013/2014, which is the earliest point at which they would have started to make large investments in the programmes anyway. Vincent de Rivaz, head of EDF’s UK subsidiary, has also since maintained that the company’s two initial plants will go ahead virtually to schedule.

Investment plans of the major European utilities Company E.ON RWE EnBW Vattenfall Fortum Enel Edison Endesa Iberdrola Gas Natural EDP EDF GDF Suez Veolia Env. Suez Env. Centrica SSE Nat Frid

Capex

€20bn + €7.5bn (€28bn) (€7.9bn) €17.9bn €4bn €29.7bn (€7.1bn) €10.5bn €16bn €9bn €4.2bn (€12.4bn) €20bn €3bn €1.9bn €6.5bn €8.8bn-€10bn €25.9bn

Time period 2010-2013 (2010-2013) (2010-2012) 2011-2015 2011-2013 2010-2014 (2009-2014) 2010-2014 2010-2012 2010-2014 2011-2012 (2009) 2010-2011 2011 2010 2010-2012 2011-2015 2011-2015

Date 10-Nov-10 12-Aug-10 12-Nov-10 22-Sep-10 16-Sep-10 18-Mar-10 08-Feb-10 18-Mar-11 24-Feb-10 27-Jul-10 05-Nov-10 15-Nov-10 10-Aug-10 22-Oct-08 25-Feb-10 12-Mar-10 10-Nov-10 20-May-10

Comments

€7.5bn is extra capex from €15bn disposal programme Under review, expect update at FY10 results Under review, expect update at FY10 results SEK €165bn (down from SEK 201bn 2010-14) €1.6bn in 2011, then above upper end of €0.8bn-€1.2bn pa range €3bn of flexibility starting from 2011. Includes Endesa Under review, expect update at FY10 results Included in consolidated Enel investment plan Net capex after grants but before planned divestments (€2.5bn) €5.3bn for 2010-12 with some later flexibility up or down Capex reduced due to lack of US wind PPA visibility Under review, expect update at 1Q11. FY10 capex ~€12bn ~€10bn pa is GDF Suez plan, will increase to 11bn pa with IPR No explicit capex guidance but expects positive FCF after divs Includes €600m for Agbar acquisition Only about €1.8bn currently committed. High optionality £1.5bn-£1.7bn pa to March 2015, but flexibility post 2012 Investments upgraded and capital increase in May 2010

Note: Where plans are under review the previous plan is bracketed and the date corresponds to when the review was announced. SEK/EURO at 9.23, £/EUR at 0.85. Source: Company presentations, CreditSights. Supplied March 2011.

FTSE GLOBAL MARKETS • APRIL 2011

DEBT REPORT

INVESTMENTS: THE COMPELLING CASE FOR CORPORATE BONDS

Meanwhile, the probable hike in gas prices should not be a credit negative for the utilities because it is gas-fired plants that tend to set electricity prices throughout Europe. Any increase in the price of gas-fired power will consequently increase margins on utilities’ non-gas power generation and potentially boost their profitability in 2012; virtually all of this year’s output has already been sold forward. Higher gas prices should also reduce the exposure of those that have been caught out with expensive forward gas-purchase contracts. Otherwise, the outlook for the utilities remains strong. For on top of the credit-enhancing measures they have adopted at home, they have also shown an increased willingness, over the past year in particular, to chase better returns in high-growth regions such as Latin America and Asia. Iberdrola’s announcement in January that it was acquiring the Brazilian power distribution company Elektro for €1.78bn was a recent example of such expansion, and the Spanish company has indicated that it will extend its presence in Brazil further still. The debt of companies based in the struggling eurozone countries, such as Iberdrola’s and Electricidade de Portugal, will of course continue to suffer a measure of contagion from their sovereign debt situations. This will oblige them to continue paying a premium to the rest of the sector through the remainder of 2011 and beyond, but barring any sudden and/or drastic deterioration in their governments’ finances, they should still be able to access the bond markets at an acceptable cost. Both utilities took advantage of an improvement in the market’s perception of Spanish and Portuguese sovereign risk in the second half of January, for example, to issue bonds at tighter prices than they were able to achieve last year. Iberdrola placed a €750m three-year bond at 175bps over the mid-swaps benchmark, while EDP sold a €500m five-year instrument at 340bps. Outside of the beleaguered peripheral eurozone countries, analysts expect

the spreads on utility debt to remain largely unmoved, with yields in the range of 4.7% to 5.9%, which looks attractive for a relatively low-risk investment in the current rate environment. “We expect spreads in most of the names to be relatively stable and trade in line with the market,” says Andrew Moulder, senior utilities analyst at the international research firm CreditSights. “While we are maintaining this view and are ‘market weight’ on most individual names, we do see some buy and sell opportunities.” He identifies Italy’s Enel as one of the buy prospects, notwithstanding its heavy exposure to two of the more stressed European countries. “Despite the sovereign risk of Italy and Spain, we believe Italy’s Enel spreads should tighten over the year as it continues on its plans and the tariff deficit problem in Spain is addressed.”

Financials divide opinion Opinion is more divided on the prospects for the senior unsecured debt of the financial sector, which will continue to dominate investment-grade corporate issuance in 2011. According to SG CIB’s figures, financials had issued €53bn of further debt up to March 21st, and the bank expects a total of around €150bn for the year. Bowie at Ignis Asset Management remains “underweight” on the sector, which he believes still has significant problems to resolve. “We think there are a lot of banks that are telling the market they are higher quality credits than they actually are,” he says. Bowie highlights the sector’s exposure to commercial-property lending, which he says would soon force many banks to mark down such loans more appropriately than they had to date. He said many institutions were also still under-capitalised which, together with the impending regulatory changes, would inhibit their ability to lend to businesses and consumers in the long term. Another big risk for investors in senior unsecured bank debt this year,

Chris Bowie, head of credit at Ignis Asset Management. Photograph kindly supplied by Ignis Asset Management, March 2011.

he thinks, is the real prospect that the Irish government might prove unable to support the bonds of the country’s beleaguered banks as it had undertaken to do, and that such failure could then spread elsewhere in the eurozone. “There could be a read-across to the other PIIG countries,” he warned. Others seem convinced, however, that there are considerable opportunities in a sector where valuations of corporate bonds have yet to return to their precrisis levels. “We see good value in European financial-sector bonds, especially when compared to their non-financial investment-grade counterparts,” notes Roger Doig, a credit analyst at Schroders. Doig explains that in his view the efforts that banks had already made to increase regulatory capital levels ahead of the Basel III accords will force them to maintain significantly higher levels and should insulate most institutions from any further shocks in the near term. “I think we are pretty comfortable that balance sheets are strong enough to withstand any further volatility that arises this year.” He adds the caveat, that this analysis did not embrace most of the banks in the troubled eurozone countries and even some of the names outside them. “There are names that are still vulnerable to a double-dip recession.” In the longer term, Doig thinks Basel III will strengthen the credit of the sector on a permanent basis. “Our view is that Basel III changes bring in a regime where you have a large amount of equity capital in the banking system and that is supportive of credit.” I

APRIL 2011 • FTSE GLOBAL MARKETS

FACE TO FACE

GLOBAL CUSTODY: TIM KEANEY, CEO, BANK OF NEW YORK MELLON ASSET SERVICING

Marrying size and performance When the Bank of New York and Mellon joined forces four years ago in a $16.5bn merger, critics doubted whether such a large organisation could deliver quality products and services while clients worried they would be usurped in the pecking order by shareholders. Fast forward to today and the world’s largest custody bank has not only reaped several accolades but has also become a case study in how to successfully integrate two large organisations. Lynn Strongin Dodds talked to chief executive Tim Keaney about the strategic considerations underlying BNY Mellon’s approach to asset services provision. HE STATISTICS SAY it all. BNY Mellon is today high up the global asset servicing league tables with $25trn of assets under custody and a 20% market share, according to the latest Global Custodian rankings. In addition and equally important for the firm, it has consistently ranked number one on several client satisfaction polls. The secret to its success, according to Tim Keaney, chief executive officer of BNY Mellon Asset Servicing and chairman of Europe at BNY Mellon, “is not to become complacent”. He adds: “The trick is not to live on last year’s results but to focus on the ultimate goal, which in our case is to provide undisputable quality and innovative products, services and solutions that can help clients in their decision-making processes.” Although it may sound trite, the old adage of putting the customer first also helped win over the biggest critics of the merger. Keaney says: “We definitely had our sceptics, the biggest ones being the clients sitting on the client advisory board that we established to get their feedback and show them how the merger was going to work. We presented them with our blueprint of how we planned to integrate the best practices, products and service from both organisations in as seamless a way as possible. We also told them that compensation was going to be linked to quality and client satisfaction, and not the cross selling of products.” Keaney acknowledges the 80/20 rule in managing client accounts and the importance of retaining key clients. “Although it may seem simple, I firmly believe that if the client is happy and

FTSE GLOBAL MARKETS • APRIL 2011

Photograph © Bauroise / Dreamstime.com, March 2011.

we are doing our job right, then it will become a self-fulfilling prophecy in that clients will buy more products and services from us. It worked in that our client retention was 98% after the merger. Also our internal surveys show that 80% of new business comes from existing clients.” As for its employees, it was an equally hard sell especially as with any merger fears of job cuts loomed overhead. “Just as we were transparent with our clients about what we were doing, we were totally honest with our employees from the start,” explains Keaney. “The merger was one of equals and at the

end of the day, asset servicing only had to cut 500 jobs due to the inevitable overlap. That said, because we were growing market share, we were still creating roles. So headcount has actually grown. If this had not been the case, there might have been difficult decisions to be made.” Tough decisions today revolve around the volatile operating environment and regulatory challenges that the bank’s clients—investment managers, insurance companies, banks and other financial institutions—are operating under. It is also not that easy to make money as a custodian. Firms have

FACE TO FACE

GLOBAL CUSTODY: TIM KEANEY, CEO, BANK OF NEW YORK MELLON ASSET SERVICING

been squeezed over the past two years by record-low interest rates, which reduce the profit margins they earn when investing or lending cash deposited by fund clients as well as on lending securities. Clients have also become more demanding and are looking at doing business with fewer providers that have strong balance sheets and can offer comprehensive solutions. BNY Mellon’s strategy has been to continue to hit the acquisition trail in strategic geographical locations, leverage opportunities with financial institutions as well as aggressively manage costs. Keaney says: “The drivers of asset servicing, such as capital market-related revenues, are down while interest rates are low. You

depress net asset value (NAV) below $1 during redemptions, a condition commonly called breaking the buck. In response and within three weeks, BNY Mellon Asset Servicing through its strategic alliance with Investor Analytics, developed a suite of stress tests that examines changes in fund NAV resulting from parallel and non-linear shifts in yield curves, changes in credit spreads, increasing redemption requests, downgrade/default simulations and combinations of these stresses. As for acquisitions, the $2.3bn purchase last year of the global asset servicing unit of PNC Financial Services Group has had a significant impact. The group now called PNC-GIS (Global investor Services) has pro-

pelled BNY Mellon to the number two spot in fund accounting, administration and transfer agency plus added $855bn in assets under administration, including $460bn in assets under custody, as well as doubling the number of funds serviced for accounting and administration. Last year also saw the company expand its geographical reach with the €253m purchase of Germany’s BHF Asset Servicing. As a result, BNY Mellon, which was not even in the top five, now ranks second in fund administration in the country. The combined German business has €569bn in assets under custody and an administration depot banking volume of €122bn. “About 40% of our revenues are generated outside the US and although we have a strong presence in the US, Canada and UK, we realised were under represented in some geographical areas. We decided we needed to be better represented in countries that had stronger growth

prospects and our acquisition of BHF Asset Servicing in Germany is an example of that,” says Keaney. “We had a capability in Germany but it was too small to compete for the very big mandates. While we made a series of bolt-on acquisitions, they take a longer time to integrate. BHF Asset Servicing has made a big difference. It not only enabled us to expand our offering in the world’s fourthlargest economy, but allowed us to provide a full range of tailored solutions to investment companies, financial institutions and institutional investors,” he continues. Amalgamating PNC-GIS and BHF Asset Servicing will keep the firm busy this year, however it is also looking to further expand its existing businesses in countries such as Australia, China, South Korea, India, Brazil and the Middle East. As Keaney notes: “Our focus today is organic growth. It took us three years to merge BNY and Mellon,

APRIL 2011 • FTSE GLOBAL MARKETS

Tim Keaney, chief executive officer of BNY Mellon Asset Servicing and chairman of Europe at BNY Mellon. “The trick is not to live on last year’s results but to focus on the ultimate goal, which in our case is to provide undisputable quality and innovative products, services and solutions that can help clients in their decision making processes,” he says. Photograph kindly supplied by BNY Mellon, March 2011.

and it will not take anywhere as long to integrate PNC and BHF. That said, should the right opportunity present itself, we would consider potential jointventure partnership or acquisition.” The group has been eyeing the Middle East to capitalise on the burgeoning investments in Shari’a compliant funds. Keaney says: “We have been looking at different ways to crack this market. We have a good name and brand and do not like doing green field things. I would like to do something here but we will have to be patient and wait for the right opportunity.” In the meantime, since its launch in 2008, the company has continued to enhance its Islamic Fund Services for European collective investment funds, which bundles investment-restriction monitoring, custody, trustee, fund accounting and transfer agency services into a comprehensive service offering for investment managers launching and running Shari’a compliant funds.

FTSE GLOBAL MARKETS • APRIL 2011

While it may take time to find the right opportunity, the firm has perfected the model of blending local and global ambitions. As Keaney notes: “The recipe that we have perfected at BNY Mellon is to leverage the local presence of a company with our global reach and capabilities. It is very important though to have people on the ground who understand the language and customs. You cannot assume that everyone has the same interpretations.” Looking ahead and, not surprisingly, the plethora of regulation coming down the UK, European and US pipelines is expected to generate more existing business as well as open the doors to new avenues. Back office functions such as custody and safekeeping remain paramount particularly after the Lehman collapse, but the middle office functions—such as collateral management, independent valuation, reconciliations, compliance monitoring, performance measurement and risk management systems—have taken centre stage. The cost of complying with the new rules combined with the squeeze on margins and the sharpened focus on cost has prompted many fund managers to look to their providers to help share the burden. This has led to an increase in outsourcing although there is no one-size-fits-all model. Some clients prefer to keep a tighter grip and only outsource certain components while others will hand over their entire back and middle offices. In response, BNY Mellon has built in customisation as well as flexibility its outsourcing model, but there is also greater standardisation. The platform allows clients to take functional blocks such as trade communication, record keeping, reference data, pricing and valuation, and move them between providers. New rules in the clearing space in the US and Europe, which is pushing

as many over-the-counter derivatives to be centrally cleared or traded through exchanges, have also prompted custodians to explore their post-trade options. BNY Mellon recently launched BNY Clearing, which plans to become a clearing member on major exchanges and central clearinghouses globally. The division will clear customer transactions in both listed futures on exchanges and the more customised swap transactions, which are arranged between dealers and investors and traded over the counter. Also, the group has recently become a clearing member as well as taken a minority stake in the International Derivatives Clearing Group (IDCG), a subsidiary of NASDAQ OMX Group, which clears and settles interest rate swap contracts and other fixed-income derivatives contracts. The deal will provide buy side and sell side clients with a platform for their derivatives trading, clearing and servicing, while IDCG will tap into BNY Mellon’s securities servicing products, including margin and collateral management. Despite the ever changing needs of its clients and the uncertain economic climate, two of BNY Mellon’ asset servicing challenges have not changed: the need for significant investments in technology and hiring people with the right skill set. “You cannot stop investing in technology which is why our business accounted for $600bn of the overall company’s $1bn spend. The importance of people though should not be underestimated. Experience and continuity matter. One of the reasons we were able to manage the financial crisis is that we had a good senior management team who had seen both good and bad cycles. If you just have good technology but not highly-motivated and skilled people in the organisation then you will fail.” I

FACE TO FACE

ASIAN TRANSITION MANAGEMENT: OPPORTUNITY STILL BECKONS

Transition management continues to evolve as a service set, not only in terms of depth of service, but also geographic reach. For some years, transition management specialists trod a lonely path in the Asia-Pacific region. Business focused out of selected markets, such as Australia, which in reality were often too competitive to offer succour to transition managers keen on spreading their business reach, with the inevitable impact on the profitability of Asian-based transition management teams. It all seems so different now. Transition managers in Asia these days are leveraging favourable investment trends, a deepening of the local asset management industry and the rise in the value and range of assets held by beneficial owners, such as sovereign wealth funds and central banks. Is Asia finally delivering on its promise? Francesca Carnevale talks over the most important developments with Duncan Klein, head of transition management Asia, at JP Morgan.

The right time and place for TM rancesca Carnevale (FC): Transition management has been in flux in both the US and Asia over the past 18 months. The Asian market appears to be more consistent and stable. Is that true? Duncan Klein, head of transition management Asia, JP Morgan Worldwide Securities Services (DK): With the global economic recovery still taking shape amid continued headwinds, the Asia-Pacific region has emerged from the crisis in a comparatively healthy state. Money is still moving, plan sponsors are still investing and the financial community is largely optimistic about the region’s future. From a transition management (TM) perspective, generally, the industry in Asia is growing, although demand remains dependent on each individual market. For example, South Korea, Taiwan and Malaysia are becoming increasingly active within the TM space, while countries such as Indonesia, Thailand and Vietnam are generally more passive. While TM activity in Asia is on an upward trend, it is clear that there are now many opportunities for growth. Asia is still behind the curve with regard to continuous activity and absolute volume of flows when compared with the business in the US and Europe, and even Australia, for example. However, one country we are all keeping our eyes on is China. It is an increasingly sophisticated market that is gradually moving towards a more open market infrastruc-

ture. Overall, from a TM perspective, we expect to see some sizeable mandates materialise over the next 18 months from the region. FC: The transition management service set has deepened considerably: project management, risk management, interim management and advisory are now part and parcel of the TM package. How has this helped expand the business set in Asia? DK: As we saw through the financial crisis and more recently through Europe’s sovereign debt concerns, institutions are placing a significantly higher premium on risk management, which plays strongly to the strengths of the TM practice. In general terms, a firm’s ability to manage risk during the transition process has emerged as a major element in delivering a successful transition, in conjunction with that firm’s capabilities in liquidity analysis, particularly within the fixed income sector. Over the last 12 months in particular, TM practitioners are also seeing higher client demand for solutions such as interim management as they disassociate the timing factor between removing a legacy manager and hiring a new manager. Clients are also looking to leverage future overlays or ETFs to maintain their exposure to their relative benchmarks. FC: In the past, transition management found it hard to gain traction in the Asian market. The last time we met, you spoke about a meaningful

uptick in business volumes. What has changed in the Asian market? What unique selling points are Asian beneficial owners looking for from their transition manager? DK: It has been an interesting 12 months but, by and large, 2010 was a year of opportunity for TM in Asia Pacific. During the depths of the financial crisis in 2008 and 2009, many transition managers exited the Asia-Pacific region or simply shut up shop completely. Those firms left standing are now inevitably well placed to capitalise on the re-emerging TM opportunities. Driven by a rapid return of positive sentiment across the region, institutions spent much of 2010 getting back into the market, re-evaluating the panels formed pre-financial crisis, and sending out a swathe of TM requests for proposals. A high number of sizeable mandates is the result. Given Asia Pacific’s relative well-being post-financial crisis, we are seeing a greater realisation that the region represents the future of the global financial sector, and so the many players within each market are ramping up their efforts to build a more sophisticated approach to TM. In addition, as this sophistication improves, we have become aware that Asian beneficial owners are looking to establish longterm relationships with their TM provider based on that provider’s ability to preserve the client’s asset values during the transition phase. Equally, requiring commitments to protect client

APRIL 2011 • FTSE GLOBAL MARKETS

Duncan Klein, head of transition management Asia, at JP Morgan. Photograph kindly supplied by JP Morgan, March 2011.

confidentiality and avoiding conflict of interests is high on their agenda. FC: Where in Asia do you source most business these days? Why and what is it about the JP Morgan service set that is winning you business in these markets? DK: A few years ago, the vast majority of our business was centered on just one or two markets. It was still very much a nascent industry in the region. Fast forward to the end of 2010 and the beginning of this year, and we have seen considerable success in expanding our business to cover six markets, with Taiwan and South Korea the two most active markets for TM. Looking forward into next year, we expect to add China and Thailand to that list. While we continue to have an extremely strong penetration with our existing custody clients, our strength as a universal bank, which combines the operational efficiency of a custodian with the risk management of an investment bank, is also seeing us secure mandates from clients

FTSE GLOBAL MARKETS • APRIL 2011

which are using third-party custodians. For example, over the last year we have secured mandates from third-party custody clients as they reshuffled their TM panels in line with Asia’s strong economic footing following the crisis. We are able to leverage the benefits of risk management and access to global market liquidity from our investment banking business, and couple that with the strong external dealer relationships, operational knowledge and robust infrastructure that come from being a leading custodian bank. FC: What defines a perfect transition management service set these days? What should clients be asking for? What should clients expect as a minimum? DK: The ideal TM platform is one which is able to deliver on a client’s expectations and objectives, without compromising the client’s trading strategy on the basis of the transition manager’s ability to trade. The financial crisis underlined just how important it

is for a transition manager to be able to handle illiquid assets in a manner which aligns with that particular client’s best interests. While some TM providers have solutions, at JP Morgan we are able to partner with our asset management team, drawing on the strengths of our universal banking model to bring the firm to the table. Clients traditionally associate a transition manager’s role with changing a fund manager or asset allocation, however the industry is yet to embrace a dedicated transition manager for one-sided trades when it comes to building portfolios from cash, as a result of a legacy approach with their fund managers. Even so, this is slowly swinging in favour of the TM side of the business. Through constant education and client outreach across the region, clients are beginning to understand the value of disassociating the costs of building the portfolio from the continuing performance of the portfolio itself. In this regard, the benefits of providing full transparency, risk and cost control management intensify and become even more relevant as clients increasingly take a multi-asset manager approach. Moreover, the transition manager is best placed to consolidate and streamline costs and risks across the client’s overall investment needs, compared to, say, asset managers, which tend to focus on their own portfolio of assets. This highlights the difference between a holistic, consolidated client trading strategy versus an uncoordinated, multi-trading strategy approach. FC: Transparency and risk management are vital elements/requirements in the post-recessionary period. How is the JP Morgan TM service set meeting these regulatory requirements? DK: Following the financial crisis and the ensuing global regulatory review, it is clear that we are going to be operating in a significantly different world, going forward. While some of these regulations will pose challenges, we are supportive of government efforts to

FACE TO FACE

ASIAN TRANSITION MANAGEMENT: OPPORTUNITY STILL BECKONS

build into the system higher levels of risk awareness and mitigation. In that regard, we think the industry becomes ultimately stronger and more sustainable. Actually, providing transparency and managing risk to and for our clients are fundamentally central to what we do. To highlight just a few elements: our TM business contracts are under the Market in Financial instrument Directive (MiFID), which came into effect in 2007. We are also committed to delivering best execution and full transparency through the transition from pre-trade to posttrade, and we adhere to the T-Charter, which is a voluntary code of conduct for the TM industry. FC: Where do you see new business opportunities opening up in Asia and why? DK: While the majority of markets in Asia Pacific offer significant growth prospects, it is fair to say that we are focusing heavily on China as the next significant country contributor. It is a dynamic and exciting market, and one which is evolving into a more sophisticated global player. By virtue of its size and economic heft, it is also home to some of the world’s largest institutional players. In that regard, the possibilities are endless. As part of our China strategy, we are working closely with our custody colleagues to identify new business opportunities, and we are doing a

tremendous amount of work in educating our clients and prospects in China about TM and how it can benefit their business through a wide range of channels, including the media, industry forums, seminars and one-on-one client education sessions. As recently as midMarch for example, we sponsored an industry TM forum, the second annual Transition Management Forum Asia 2011, one of the region’s leading thought forums covering the buy side, models of TM, and the outlook for the industry in Asia Pacific, among others. FC: How have transition management teams been able to take on the service expertise involved in specialist areas such as interim management? Does JP Morgan leverage synergies with JPM Asset Management? DK: We partner closely with our asset management colleagues to engineer solutions for our TM clients when they are holding illiquid assets in their restructured portfolios. Through the recent credit market freeze, liquidity was impaired, and price discovery significantly deteriorated. Accordingly, many fixed income transitions were left with an illiquid tail for which total liquidation would have been overly difficult. This collaborative approach gives our clients the added benefit of support from our asset management team, particularly in

terms of monitoring the asset in question over a longer period of time than the actual transition period. A key benefit in this approach is that clients can avoid having to sell assets at opportunistic dealer bids, with dealers often looking to capitalise on short periods of illiquidity. It is about taking a longer-term solution for what has historically been a short-term exercise. FC: How do you envision TM evolving over the coming three years? What elements will encourage or force these changes? How will clients benefit? DK: We are extremely optimistic about the TM industry’s prospects in the AsiaPacific region. Markets are becoming increasing sophisticated and, as such, prospective clients in the region’s various markets are increasingly accustomed to incorporating TM into their thinking when they are looking at a restructure. Continuing education will remain absolutely critical going forward, to ensure that clients have the information, knowledge and tools to hand to be able to make an informed decision on bringing in a transition manager to handle what are often complex, costly and risky movements of funds. At the heart of this lies risk management, which at the end of the day is what TM is all about. By managing risk, clients reduce their costs and make a more efficient transition to their manager of choice. I

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Intelligent index investing Let’s hear it for the index investor. Ali Toutounchi, managing director of Legal and General Investment Management (LGIM), is a dedicated adherent to the market capitalisation weighted index investment approach; and why not? It has served him and LGIM’s clients exceedingly well over the past two decades. While other asset gatherers talk of reducing the space between fund manager and the buy side trading desk, LGIM does it as standard, every day, in the drive for cost and trading efficiency. There are two touchstones for LGIM’s index investment desk, namely minimizing tracking error and maximizing returns for the client. Francesca Carnevale spoke to Toutounchi about his ideological lodestones and the outlook for index-based investment strategies over the near term. GIM DELIVERED UPWARD performance in 2010, with growth across all of its core business areas. Gross new business inflows for the year totalled £33.1bn (compared with £31.5bn in 2009) and assets under management at year-end rose to £354bn (from £315bn at the end of 2009). Moreover, LGIM’s international diversification strategy continues to gather pace. LGIM America (LGIMA) now manages over $18bn of assets, and has established an upward three-year track record with performance across all the fund range. Additionally, LGIM has also developed distribution capability in the Gulf and mainland Europe where the

FTSE GLOBAL MARKETS • APRIL 2011

firm says it expects to increase penetration over the next few years. In accounting terms, IFRS profit was up 20% to £206m (compared to £172m in 2009). This increase is attributed to a combination of higher funds under management, a higher fee to fund ratio and a continued focus on costs. Segmenting LGIM’s results, it appears that continued corporate appetite for pension fund “de-risking through strategies designed to match asset and liability cash flows have resulted in strong growth in liability driven investment (LDI) funds under management to £41bn, an increase of 36% on the 2009 figure of £30bn,”

INVESTMENT STRATEGIES: THE LGIM OUTLOOK

Ali Toutounchi, managing director of Legal and General Investment Management (LGIM). Photograph kindly supplied by LGIM, March 2011.

noted the asset manager’s 2010 official results release in early March this year. Index funds, a traditional area of strength for LGIM, continued to grow with gross inflows of £25.7bn helping drive an increase in assets under management of 10% up to £229bn (compared to £208bn in 2009). Three factors underscore LGIM’s appeal to investors, suggests Ali Toutounchi, managing director of LGIM’s index funds. “We have built our business on the premise that clients always come first. To ensure that we don’t compromise on this principle, we have created a working environment which is free of conflicts of interest; we have no affiliates involved in broking, custody, investment banking or any related activity.” Moreover, the firm claims to have a value-enhancing approach to managing index funds. “We deliver to clients what they are entitled to as passive holders of securities rather than just index returns,” explains Toutounchi as a second pillar, adding: “Index funds are core to our business, the bulk of our revenue comes from this source. They are not yet another product on the shelf; we live on them, so we must ensure that we keep clients entirely satisfied at all times, not only in terms of performance but also in terms of client servicing.” Toutounchi joined LGIM in September 1995 from NatWest Securities, where he spent a number of years leading the firm’s global programme and basket trading unit. It is this cross functional expertise and the proximity of the firm’s trading capability to its fund managers that provides the firm’s added value for implementing index changes. “It is a strength of LGIM that all the trading is effectively off the same extended desk: trading strategies are devised by fund managers, taking into account the advice and wisdom of the trading desk, while the actual trade execution will remain the responsibility of the skilful dealers on the trading desk. In this regard, implementation of index changes is a joint effort. We tend to favour a spreading strategy rather than execution at a single point in time;

FACE TO FACE

INVESTMENT STRATEGIES: THE LGIM OUTLOOK

once the strategy is drawn up, we review it first thing every morning and take it stock by stock, day by day, all the time aiming to minimize transaction cost. Just how fast we go is driven by market conditions and liquidity,” he explains. “Minimization of transaction costs is at the heart of our index fund management activities.” All things being equal, if you manage an index fund and you take out the cost of all the transactions in and out of the index, you will underperform: therefore adopting an intelligent approach will gain you significant returns.” To avoid any issue with liquidity when managing index funds, the important element to remember, says Toutounchi, is introducing a note of common sense into the investment process. In fact, liquidity can be more of a concern for active strategies than index strategies, even though an index portfolio may handle a larger number of stocks. “Tickets are much smaller,” he acknowledges. The heart of the matter about market liquidity post credit crunch is that investment banks’ appetite for risk“has deteriorated,”adds Toutounchi. “If, for instance, you want to do a principal programme trade. Nonetheless, he concedes that things are getting back to normal”.

Merits of passive investing However, it is not only internal processes that have helped grow the value of assets under management. “Effective risk management, cost minimization and discipline are essential for successful investing. For these reasons, long-term investors should allocate a significant portion of their investment to passive and diversified strategies. Investment style should not be a question of ‘active’ or ‘passive’ but what combination of the two is most compatible with the investor’s risk/return objective while also always remaining mindful of the painful compounding effect of costs on hardearned returns,” he says. Toutounchi’s adherence to indexbased investment is grounded on the

basic fact that an indexation strategy is viable in all market conditions for most conventional asset classes. Moreover, while index calculations and benchmarks have undergone substantive changes and now offer multiple approaches, he remains an adherent of the market capitalisation weighted indices if the objective is to achieve market returns and this for a number of reasons. “Market cap-weighted equity indices represent the market; the true worth of a stock is determined by supply and demand. in other words, the price that satisfies most buyers and sellers at any point in time. This price may be deemed value for money or outrageously expensive, but it is what the stock is worth at that point in time.”

Market cap-weighted indices: the argument for It is often argued that tracking market capitalisation-weighted indices forces investors to overweight more expensive stocks; but, says Toutounchi: “It all depends on how you define ‘expensive’. All we know is that there is strong empirical evidence that, net of fees, the median active manager tends to underperform the market cap weighted market indices. One further advantage of cap weighted indices is that they are self rebalancing, hence minimizing transaction costs”. Market cap weighted indices will remain the best proxy for the equity market as a whole, he believes, noting however that “other methods, such a fundamental, low volatility or equally weighted indices as we have seen in recent years, will be produced for creating a diversified portfolio and doing away with active stock selection and allocation”. Accordingly, he regards many of these indices as effectively active strategies with an index framework. They enable investors to access a diverse opportunity set in a systematic way, but they neither provide market returns nor are necessarily more diversified than cap weighted indices. He does not believe that alternativelyweighted indices (e.g. fundamentally

weighted) will replace market cap weighted indices as the benchmark: “They will be used by some investors for a relatively small portion of their assets. They are actually seen by some investors as a kind of enhanced index!” Nor is he entirely convinced by the emergence of equally weighted indices. “As a method of constructing a benchmark index, the main issue is the fact that they are not scalable because of liquidity issues with mid and small caps. One should also bear in mind that such an index is not a good proxy for the market as a whole and is handicapped by relatively large turnover and hence transaction costs.” Nonetheless, he acknowledges that they can provide benefits for particular types of investors: active managers with a strong conviction in their ability to pick winners and those who are passive at heart but do not subscribe to the efficient market theory.“Such investors can then spread their investments equally across the available opportunity set,” he explains. No surprise then that non-cap weighted index funds represent a very small portion of LGIM’s business as is the case with other major index fund providers. However, concedes Toutounchi: “We are probably the biggest provider of these products in the United Kingdom.” LGIM’s client driven approach implies no small degree of flexibility in adopting different investment strategies and Toutounchi is not averse to a substantial slab of customisation in the client’s interests. In this regard, he holds: “We are in the business of providing value for money solutions for client needs. So our approach will change to match that of the clients. Transparency, the timely availability of reliable data and its representativeness of the investible universe are ultimately the strengths of market cap-based index investing. Even so, in terms of index approach, it all depends on the client and investment objectives. At the moment, customisation requests are still relatively small but are growing fast.” Toutounchi is mindful of the risks inherent in a securities lending pro-

APRIL 2011 • FTSE GLOBAL MARKETS

Growth of assets under management at LGIM 400,000

Index Funds 350,000

228,537 Active Funds 208,304

300,000

214,115 175,576

£m

250,000

161,966 200,000

137,647 111,197

150,000

92,047 100,000

67,817

74,913

78,255

124,983

76,855

106,797

44,533 50,000 0

15,767 19,866 1995

30,941

21,308 22,135

31,894

35,891

34,860

37,137

43,290

26,323

36,378

51,282

1996

1997

1998

1999

2000

2001

2002

2003

2004

66,681

71,003

2005

2006

82,534

88,652

2007

2008

2009

2010

Source: LGIM, supplied March 2011.

gramme.“As long as there is no conflict of interest with the client, we will undertake securities lending in certain markets and in a very controlled way,” he explains. LGIM does not however lend in many emerging markets and neither does it lend in the United Kingdom. In the UK, he explains: “What you can add is very little if you are not willing to compromise on collateral and the counterparties. If you want to lend responsibly and make more than a couple of basis points a year, it is not really a feasible activity. Additionally, you also lose entitlement to scrip dividends, which can be worth as much as two or three basis points. Losing all that to make one or two basis points doesn’t really make sense.” Additionally, the firm will not accept cash as collateral, taking instead G7 government bonds and AAA issues by supranationals and has always insisted on a 105% over-collateralisation against securities lent.

Considerations in the emerging markets The rise of the emerging markets has posed few challenges for either LGIM or Toutounchi. Approaches to emerging markets are undertaken in exactly the same way as investments in advanced market, but with a wider target tracking error. Theoretically, active managers should be able to outperform emerging market indices because emerging

FTSE GLOBAL MARKETS • APRIL 2011

markets are deemed to be inefficient. However, empirical results do not support this; BNY Mellon CAPS Pension Fund Survey suggests that the median manager, net of fees, has failed to beat the index over one, three, five and tenyear periods. The three and five year numbers in particular look pretty grim (-3% and -1.8%),” he says. The problem which active managers face is that, for practical reasons, he continues, they confine themselves to a subset of the universe of available stocks, hence they miss out on the wider opportunity set. “Following a fundamentally weighted index fund may be a good substitute for active management in emerging markets,”he suggests. He continues: “As far as we are concerned, we regard ourselves as pragmatic replicators. We aim to hold each stock within the index in a similar proportion to its index weight but we also apply common sense. For example, If we cannot find a natural source of liquidity for a small-cap stock we will replace it with a basket of stocks of similar characteristics. However, in the emerging markets, where transaction costs can be high and liquidity poor, it may be more appropriate to consider sampling, in which case we would apply our proven stratified sampling technique. There is a choice then of sampling or replication, and the efficacy of either depends on the structure of the index, the size of the

investment, the frequency of cash flow, target tracking error and above all what satisfies client’s specific requirements All in all, it is an upbeat approach to index investing and one which Toutounchi says has long legs. “The growth of index funds will continue and spread to investor bases beyond the main developed markets. In addition, the conceptual interest in alternatively weighted indices will translate into actual investment for some clients. We are well positioned to accommodate this demand,”he avers, adding that:“Clients’ investments are becoming more internationally focused at the expense of their local markets. This in addition creates passive currency management opportunities for us.” Nevertheless, he sounds a guarded note.“For index investors one of the biggest challenges is the limited choice of passive management firms which can operate globally,”he says. Moreover, he stresses:“It is important to remember that passive investing should not imply that one has to be a passive shareholder. As an index fund manager we take our corporate responsibility very seriously; we vote on every resolution and engage with company management on important issues.” It is a signal indication of LGIM’s pivotal role in the UK equity market (it holds 4% of the UK equities market). In that context, he says:“Our clients expect us to be responsible as well as smart.”I

FACE TO FACE

BUY SIDE TRADING: KEVIN CRONIN, HEAD OF GLOBAL EQUITY TRADING, INVESCO

An appetite for the right kind of change The May 6th 2010 flash crash may have only lasted minutes but the debate it has kicked off over market infrastructure continues to reverberate through the equity trading market. Competition has been a double-edged sword and the almost 1,000-point plunge exacerbated concerns of many long-only fund managers over the weaknesses in the market infrastructure as well as exposure to some of the more predatory tactics of the high-frequency traders. Lynn Strongin Dodds spoke with Kevin Cronin, head of global equity trading at Invesco, about the need for reform. EVIN CRONIN, HEAD of global equity trading at Invesco, the global investment manager with $616.5bn in assets under management, spoke for many in his industry when giving testimony in front of the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) Joint Advisory Committee on Emerging Regulatory Issues last year. “The large and sudden price dislocations on May 6th were, in large measure, the result of flaws and inefficiencies in the current United States’ market structure,” he noted. Cronin, along with others on the buy side, is calling for a more fundamental review than the one undertaken by the SEC and CFTC. He believes that the advisory committee should not lose sight of the broader market structure issues raised by the SEC’s concept release examining the structure of the US equity markets. These include the adequacy of information provided to investors about their orders, the impact of high-frequency trading as well as undisplayed liquidity. Instead the report included 14 sets of recommendations including new circuit breakers for stocks and activelytraded exchange-traded funds (ETFs); extending the length of current fivesecond circuit breakers in stock

markets, expanding trading pause rules plus new liquidity and market imbalance reporting requirements for large trading venues. Much to the chagrin of some industry participants, it avoided detailed recommendations on high-frequency trading, stating that while it was “a significantly profitable activity” , the “benefits from making markets in good times do not come with any corresponding obligations to support markets in bad times”. The regulators’ report into the crash, which erased $862bn from the value of US equities in less than 20 minutes, also singled out a $4.1bn sale in E-Mini S&P 500 futures contracts by a mutual fund—identified as Waddell & Reed Financial—as being the catalyst. The large sale allegedly triggered a liquidity imbalance as high-frequency traders that had bought the contracts from the firm and accumulated an excessive long position also began to sell off the contracts. The declines in index futures convinced traders a “cataclysmic event” was pushing down equities on May 6th 2010, leading them to abandon the market, triggering the biggest crash in a quarter century. Views are divided over the cause. For example, research from Nanex, which runs a data-feed platform of all quotes on the exchanges, showed that the fault was with one trader who bought 3,000 of

Waddell & Reed’s contracts and within 50 milliseconds sold them all, breaking through the ten levels of bid prices that an e-mini contract has. Other market participants also argued that the report should have commented on the fragmented US trading marketplace and the impact it has on trading.

Structural weaknesses Cronin says: “The report pointed to a mutual fund company but I do not think anyone was at fault. There are structural weaknesses in the market that need to be addressed because the markets have changed dramatically over the past five years. Technology has enabled more choice—there are over 40 trading venues in the US but fragmentation has had unintended consequences. For example, trading blocks of shares is much more problematic and, as the flash crash demonstrated, trading in this type of environment becomes much more difficult in times of extreme stress. He is also keen on increased transparency, particularly “around market participants such as high-frequency traders and their practices. Many of us have concerns about this type of trading. Efficient markets are made through the participation of all kinds of participants; we are not trying to suggest otherwise. Indeed some of these high-frequency traders do provide valuable liquidity and efficiencies to the markets. However, we also believe there are some high-frequency trading strategies that could be considered as improper or manipulative activity.” That is not his only concern. Cronin believes: “The industry is too focused on the speed of execution over all other factors. To be clear, we do think that speed is an important consideration in trading, but we believe the most important variable to investors is price. Exchanges need to be reminded of this concept.” Although the fallout from the flash crash highlighted the dangers of competition, it is ironic that the headlines are now being dominated by consoli-

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Kevin Cronin, head of global equity trading at Invesco. Photograph kindly supplied by Invesco, March 2011.

dation. The outcome is still uncertain but the past few months have seen a rash of proposals between the London and Toronto Stock exchanges, Deutsche Börse and NYSE Euronext and Singapore and Australia on the exchange side. BATS and Chi-X Europe are so far the only MTFs that are planning to join forces but others are expected to follow on. Bigger, though, is not necessarily better, however, and Cronin is not necessarily convinced of the supposed merits that these deals will bring. “We have some concerns about the rush of mergers we are seeing in the industry at the moment, “he says. “We understand that these exchanges are publicly-traded companies and as such will undertake activity which is designed to maximize their shareholders’ value. At the same time we want to ensure that this goal is not inconsistent with the primary objective of the exchanges, which is to provide investors with efficient and fair trading markets to facilitate long-term investing and ultimately the capital formation process.”

Providing value add Against this ever-changing trading backdrop, Invesco itself has taken on some of the feel and characteristics of a broker/dealer operation. The reason is straightforward. “We wanted to have more control and prevent information

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leakage. The investment firm has built a global trading desk that boasts over 40 traders in nine locations with an average of 12 years experience,” he says. “We believe that our value add is in our people, process and technology,” explains Cronin. “Our traders have the latitude and the access to trade on virtually every exchange, ATS, dark pool and algorithm. They also have very strong relationships with our broker dealer counterparts. We are not trying to manage our business to any artificially high percentage being done electronically. We have an incredibly diverse spectrum of order flow with some having high immediate alpha expectations and others with low or negative alpha expectation.” According to Cronin: “The objective is to effectively align our trading strategies and tactics with these alpha expectations. Our fund managers may spend months uncovering ideas for their portfolios, but trading these ideas in micro seconds is generally not their primary objective. Trading their stocks in the most efficient and effective way and most importantly at the right price is. To achieve this we want to have as much control of our orders as possible and to understand well how our orders are being handled once they enter the marketplace.” Cronin adds: “This is no easy task given the fragmented nature of the

markets and the conflicted economics of brokers and exchanges. For example, what happens if we send an order to one place which subsequently sends it to another and another? Ensuring there is no information leakage or gaming as the order goes through this crucible can be quite complicated. We have been working with our broker dealer counterparts to customise existing algos to ensure our orders are being routed appropriately and we continue to develop our own transaction cost analysis model with inputs from thirdparty data. This proprietary model takes a number of factors into consideration including the context of the trade and the alpha expectations.” As for the future, along with many in the industry, Cronin believes that one of the main challenges will be the regulatory environment. “There are not that many barriers to entry to become an exchange. It took NASDAQ six years to become a stock exchange while today, it would take six weeks. Competition among exchanges has generally been advantageous, however. Competition has an ugly stepsister and that is that there is not a great deal of coordination of rules between the exchanges. This was clearly on display on May 6th.” The flash crash highlighted the need to have much more synchronisation between exchanges regarding policies and procedures, he posits. “The events of May 6th also showed us that there is a greater interdependency of the equity, options and future markets, particularly the connection between price discovery and the broader stock market. Going forward we need a much more consistent approach to be applied across all types of market,” says Cronin, pointing to the SEC/CFTC proposals on circuit breakers as an example. “We think they are a good idea but we would opt for a limit up/limit down system—which would allow stocks experiencing rapid declines to continue trading within a narrow range of prices. We would then make sure that all exchanges honour this rule set.” I

FACE TO FACE

INVESTABLE INDICES: MARK MAKEPEACE, FTSE GROUP, CHIEF EXECUTIVE OFFICER

The index universe has made a number of innovative leaps over the past decade: developments such as fundamental indices, indices which incorporate environmental, social and governance criteria, indices as the basis for new investable products, such as exchange-traded funds (ETFs) and indices that stabilise risk over the markets’ natural cycles. Leading and supporting these developments, FTSE Group has diversified and elevated a number of investable themes that can be utilised by investors in building portfolio strategies. Francesca Carnevale spoke to FTSE Group chief executive officer Mark Makepeace about market risk, salient trends and the outlook for future development of new index families.

Leveraging new market dynamics NDEX INVESTMENT CONTINUES to go from strength to strength: the sheer depth and extent of index families has ballooned over the last five years, providing ever more specialised benchmarks and investment tools, as investor approaches and asset allocation strategies have themselves multiplied and evolved. Moreover, as asset managers now tailor their investment strategies to tightly defined objectives, the opportunities for customisation of indices have also increased. A further fillip has been provided by the explosion of index-based investable products: such as options, futures and exchange traded funds; opening up the potential for an entirely new spectrum of index-linked investment strategies. Surveying the growth, Mark Makepeace, chief executive of FTSE Group, acknowledges the multiplicity of opportunities available: “We often talk about the number of indices we offer quoting that FTSE Group now offers well in excess of 120,000 indices. The actual figure itself doesn’t matter. It is the trends that they speak to that count: namely that the quality and range of indices has increased dramatically over time as well as the degree to which firms such as ourselves have changed the way we do business.” Makepeace acknowledges that as the capital markets now appear to have reached important turning points, so too has the role of the index provider.“It is not a structural change perhaps,” he notes.“After all, the main players, and I include FTSE, MSCI and S&P in that

mix, have remained essentially the same players over time. Rather that we are opportunities-rich which has meant that our product set has expanded enormously.” Moreover, Makepeace believes in the competitive dynamic between the leading index providers as a vital bellwether of change in the investment universe. “We are one of three truly global providers, with the rest trying to compete with the global product range we offer. The challenge for each of us is to continue to add value and remain competitive. I believe in competition as an engine of business growth and development. The new niche players have their role in specific areas of the market. They keep us all on our toes as you cannot afford to ignore new trends,” he says.

Risk perception has changed Nonetheless, he acknowledges the systemic changes that are bringing that turning about: “Macro-factors are causing investors to acknowledge that they face serious examination of the ways in which they have invested in the past. The perception of risk has changed; investors are shifting away from equities and towards multi-asset investments. At the same time there is a shift of wealth from west to east which is moving at an accelerating pace. This trend has huge significance. Up to now, China has remained a semi-closed market but once it fully opens, it will fundamentally overturn traditional investment allocations,” he notes.

The name of the game in the modern investment world is diversification, holds Makepeace. It is taking many forms, he explains, including investors moving from a domestic focus to a global view. “They are diversifying through the adoption of strategic indices alongside market capitalisation applications in the market. That may involve a small cap or value bias, but they are diversified nonetheless. The big asset owners are asking for more customisation of indices and the creation of a wider set of index families that allow them to achieve this diversification.” This movement is understandable; particularly as underlying markets are themselves in flux and multi-asset investment strategies have superseded traditional 60/40 mix of equity and fixed the income asset allocations. “Market capitalisation weighted indices, for all their advantages, do create concentration in large-cap stocks, which might not always fit with a diversified investment strategy mix. We continue to respond to these changes through innovative index structures such as fundamentallyweighted, efficient-weighted and diversified indices. We have also launched recently the FTSE StableRisk Index Series , enabling investors to access multiple asset classes,”says Makepeace. The first game-changer in this regard was the creation of the FTSE All-World Index Series, holds Makepeace, which he says was quickly followed by the Group moving its index building beyond market capitalisation based indices. Not all products have gained

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equal traction however. He concedes that developments, such as socially responsible investment indices, have been slower to take off when compared with the traditional index set and have now been overtaken by environment, social and governance (ESG) indices, which is “aiding investors thinking about sustainable investment issues, including initiatives such as the UNPRI and the UK’s Stewardship Code,” he explains. The Stewardship Code, established by the UK’s Financial Reporting Council (FRC), aims to enhance the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibilities. The FRC sees it as complementary to the UK Corporate Governance Code for listed companies, which was revised in June last year. Institutional shareholders are free to choose whether or not to engage in the Code, but their choice will be a considered one, based on their investment approach. Their managers or agents are then responsible for ensuring that they comply with the terms of the mandate as agreed.“We support these initiatives. FTSE Group has always maintained transparency in its index solutions from public methodologies to open communication on corporate actions and index reviews. All of these developments ensure investors’ interests are kept at the heart of our services so that they can make informed decisions,” he adds.

Leveraging global trends In the near future, the most successful index providers will be those providing a full service operation on a global scale, moving from index creation to services offering analytical support. This has a range of applications, notes Makepeace. It has particular resonance these days in the growth of indices in investment areas that are perhaps illiquid and difficult to measure, such as property or stocks in frontier markets. Even in advanced markets, notes

FTSE GLOBAL MARKETS • APRIL 2011

Mark Makepeace, FTSE Group, chief executive officer. Photograph kindly supplied by FTSE Group, March 2011.

Makepeace: “There is a search for liquidity among certain types of funds. As an index provider we start with a total view of the world and strive for a balance between representation and reducing the cost of getting in and out of illiquid investments.” It is not an easy task, he concedes, given that liquidity means something different for each client. “For many clients, liquidity will be increasingly customised; do not forget however that investors will invariably pay a premium for liquidity, so some investors prefer illiquid stocks which they can hold over the long term,”he says. Elsewhere, FTSE Group sees continued opportunity in tying up with a host of exchanges in key markets. Among the latest developments in this regard is the link up with the Casablanca Stock Exchange. “Partnering with exchanges is a part of our business strategy. In Africa and Asia for example, we continue to develop partnerships with

exchanges. Our thrust will be on bringing products to suit retail investors. So, we hope to license mutual funds, exchange-traded funds or index fund managers for using FTSE indices. There is already a demand from emerging markets fund managers for customised indices which suit their asset allocation and investment strategies,” he notes. “We will continue to expand in Asia, the Middle East and Africa.” Actually, he adds: “We probably partner more than anyone else: either with market specialists, such as Research Affiliates and EDHEC, or particular institutions. The top management of the group have to spend a lot of time with clients; it forces and encourages us to spot the next big development and make the step change that allows us to leverage that opportunity.” Surprisingly perhaps for such a mature market, the fastest growing business region for FTSE Group is the United States. “We have benefited from increasing awareness of our brand and from US asset managers using new strategy-indices.” Looking ahead, Makepeace remains excited about the opportunities that the market can provide despite volatile times. He believes that the dominance of traditional derivatives exchanges will be challenged by the new trading platforms such as Turquoise.“As a firm believer in competition, we will be working with both existing exchanges and new entrants armed with relevant platforms to offer investors the best possible range of investible products: either on a customised basis or in the creation of benchmarks with broad market application. With so much opportunity, the challenge for FTSE Group is having fleetness of foot to both adapt to and leverage change. “Where we can improve, we will and where we can enhance our service provision to clients it is imperative we remain at the forefront of innovative product development. Every three years we have doubled in size; we intend to maintain that drive,” he says. I

FX VIEWPOINT

FX CHALLENGES: LIQUIDITY, NEW PORTALS & JAPAN

Foreign exchange liquidity has been and will be a recurring theme. In mid-February the putative bank-only liquidity pool commonly referred to as Pure FX died on the drawing board. Shed no tears for this stillborn enterprise: it was, after all, nothing but a misbegotten notion destined to search endlessly and futilely for critical mass, a retrograde reaction at a time when new concepts are in high demand, given an environment of enhanced regulatory scrutiny. The idea of a banks-only liquidity pool was so inherently flawed, in particular given the circumstances, that one can only shake one’s head at the reasoning behind it. Banks aren’t making enough money off FX as it is? Erik Lehtis, president of Dynamic FX Consulting, highlights the month’s prime issues.

Who serves who in FX? E MUST NOT think that just because the Pure FX initiative has given up the ghost the motivations behind it have also faded into grey. The major banks in FX have a special antipathy for the high-frequency trading community, and will search for another way to bar it from the price discovery process. While success in that venture will benefit the banks’ bottom lines, it will harm their customers, who will have to accept (on faith) that their orders are being executed at best available prices, despite the fact they cannot see the order book. There is already some talk of another bank-only portal being launched by ICAP, which runs EBS, the largest liquidity pool in FX. The one-word question this pattern begs is: why? Less pithily: whose interest is served by creating a liquidity pool in which only banks can play? Are customers somehow better off? The fact that FX volumes have grown by leaps and bounds since non-bank participants gained API access in 2004 strongly suggests that FX has never been healthier. How are restriction of access, and the ensuing reduction in participation, in the best interests of natural consumers of FX liquidity? The fact of the matter is that just because banks have been the mainstay of the foreign exchange market for decades, and have

jealously guarded access to it, doesn’t mean that a bank-only model is in the best interests of the market at large. One thing banks tend to forget at times like this, and in fact most of the time, is that the market does not exist to serve banks; rather, banks exist to serve the market. We all know what happens when a monopoly exists. Think of the interbank market as an oligarchy. Bank profits from FX have never been greater, and yet, apparently, they still aren’t enough. Instead of trying to win the game by blocking competition, banks should be focusing on winning by out-innovating the competition and playing the game better than the non-bank proprietary traders. Highfrequency techniques are not the sole province of the prop space. If banks were to integrate these practices into their business models, they would discover that they have nothing to fear from HFT. The natural interest banks enjoy from customer flow bestows upon them an inherent advantage over the HFT crowd that should be insurmountable. HFT itself is not radioactive, but fallout from the debacle over Pure FX [not to be confused with the UK forex specialists of the same name] may drift over to a debate the market is sorely in need of. Elsewhere, there is no lack of drama in the market, with the JPY

Erik Lehtis, president of Dynamic FX Consulting. Photograph kindly supplied by Dynamic FX Consulting.

defying conventional expectations of weakening as Japanese insurance companies, banks, and government agencies all desperately repatriate assets back home where there is no end to the country’s needs both immediate and ranging out beyond one’s furthest gaze. We cannot comprehend (in its entirety) the devastation wreaked on northern Japan, or its long-term impact on the financial markets. In the short term, after ranging uncomfortably between 80.00 and 85.00 versus the USD since last September, and between 81.00 and 84.00 since the new year, JPY smashed through to the downside in mid-March, hitting a low then of 76.50, and is in all likelihood bound for greater levels of appreciation in the days ahead. The obvious fact, however, is that the yen’s future strength is deeply compromised by the damage done to Japan’s infrastructure, population, and national psyche. Continuing uncertainty over the long-term fallout on the country’s nuclear power industry, the virtual shutdown of the country’s automotive industry, the outflow of foreign and domestic professional staff from Tokyo (albeit temporarily), and the massive cost of rehabilitation of the northern region and its population, will haunt the country for a long time. It invariably places epic stresses on the currency over the near term. I

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COVER STORY Photograph © Petrafler / Dreamstime.com, March 2011.

WAITING FOR GLENCORE Swiss commodities company Glencore International AG is readying for a London initial public offering (IPO), which could be the largest in the City this year. The flotation looks likely to be delayed, however, with its scheduled late-April deadline possibly being pushed back by some weeks. Market volatility, due to events in Japan and North Africa, could stymie the firm’s plans in the short term. Vanya Dragomanovich reports.

NTIL THE QUAKE in Japan and unrest in the Middle East rattled equity markets, analysts expected that Glencore would have pricing ready for its initial public offering by the end of April, traditionally one of the best times in the year for metals markets. It was not to be. Deteriorating market conditions have already put the brakes on the listing plans of other European companies. These include French media group Lagardère, which has postponed the listing of its 20% stake in television channel Canal+, and Danish firm ISS, which has called a temporary halt to its planned $2.8bn Copenhagen debut. “Market conditions are a bit choppy and they will want to achieve the best pricing,”says Vincent Lepine, equity analyst at Exane BNP Paribas, by way of explanation, though perhaps stating the obvious. The FTSE 100 had something of an indifferent March: climbing back 3% in the week following losses sparked by the earthquake that devastated northern Japan. Nonetheless, trading volumes were only 77% of the index’s average 90-day volume by month end in the run up to US job figures which were (at the time this magazine went to press) expected to jolt the benchmark one way or another. For most of March the index remained in a range near to its 50-day moving average (around 5,933); unexciting to say the least, though given market conditions (the FTSE 100 had fallen to a three-month low on March 18th), shows some underlying strength. What this means for Glencore’s eventual IPO and aftermarket pricing is difficult to predict. Certainly the UK markets could do with a fillip, and essentially the firm has a strong business story to tell potential investors; not least that it owns 30% of FTSE 100 mining company Xstrata, which looks like being a valuable long-term asset. Around a third of Xstrata’s revenue is derived from coal, a fuel that is expected to boom over the near term: a natural consequence perhaps given increasing doubts over the near-term outlook for the nuclear industry in the wake of the Fukushima disaster. Analyst Shore Capital tipped Xstrata shares, which were approaching 1400p in late March, putting the value of the company at more than £40bn.

The question tickling analysts is how much Glencore is worth, and it has not always been an easy task for outsiders to discern. Historically, the company has been reticent over its affairs. Any official announcements tend to be pared down, and can be fairly described as low key. Its 2010 results, for instance, published in March this year on its website, are condensed onto two A4 sheets of paper. There are other signs of its caution: the company’s South African-born chief executive Ivan Glasenberg gave his last public interview in 2003. Even so, company spokesmen stress that in its corporate actions the firm has few such qualms and has provided full disclosure of its financials to bondholders and potential investors.

The Glencore mystique Glencore was set up in 1974 by financier Marc Rich, who sold out to the current owners in 1994. Some of Glencore’s mystique lingers from those Rich years—and the fact that in 1983 he was indicted in the US for tax evasion and buying oil from Iran during sanctions. By 2001, Rich (if not his reputation) was white washed when he was listed as one of 141 people granted a presidential pardon on Bill Clinton’s last day in office at the White House. Away from the limelight, Glencore in the meantime was steadily building its business reach. The company started to come to the market’s attention once more as it began to issue debt to secure sources of metal, coal and oil, and as it began a spending spree, encompassing miners, farmers and wells. To finance its expansion, Glencore has raised more than $8.7bn in the bond markets since 1996, presumably disclosing detailed financials to banks, investors and ratings companies along the way. While the firm has undoubtedly ratcheted up its asset tally, the liabilities side of the firm’s financials has not been laggard either. Last year was a particularly active year for the company in the debt capital markets. Glencore successfully completed the refinancing of its core committed revolving credit facilities worth $10.3bn last May. The same year, Glencore also

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issued close to $3bn of long-term bonds: including €1.250bn in Eurobonds, CHF600m in Swiss franc bonds, $350m in perpetual bonds and an additional $300m-worth of convertibles. At the time, Bloomberg reported that the firm’s six-year Swiss franc notes were priced at CHF100.552 to yield 3.607%, at a somewhat hefty 240 basis points more than the benchmark mid-swap price. In part that pricing was no doubt based on some mixed ratings by Moody’s Investors Services and Standard & Poor’s attributed to Glencore bonds and bank loans. In December 2008, for instance, Standard & Poor’s (S&P) cut Glencore’s credit rating to BBB-/Stable/A-3, its lowest investment grade; no surprise perhaps as conditions at the time were tough for one and all, not least miners as commodity prices softened during the financial crisis. It did not change its outlook for the firm in January 2009, following news of Glencore’s proposed sale of its Colombian coal operations to Xstrata, which at the time had a BBB/Negative/A-3) S&P credit rating. Neither did S&P change the rating in its latest release, dated September 14th 2010. The ratings specialist mentioned in the same report: “Constraining factors include the company’s significant adjusted debt, trading-related risks (including volatile working capital), the cyclical nature of mining activities and country risk.” Because of its rating and the implied risk, Glencore’s bonds have traditionally traded with a risk premium. Once the company carries out an IPO, spreads are likely to tighten, says Felix Freund, portfolio manager at Union Investment in Frankfurt, which manages €160bn of assets and is an investor in Glencore bonds. He also expects to see a convergence with Xstrata bonds, which have similar spreads to Glencore’s. Glencore’s two-year bond is trading 97 basis points (bps) over swaps and the four-year bond is trading at 170bps over swaps. S&P also points out that while Glencore’s access to the debt capital markets “has been good”, the agency has significant debt maturities in 2011, “which in our view will require ongoing refinancing. For example, $2.3bn of loans secured against Xstrata shares mature in September 2011”.

Estimates of company worth The last official valuation of the company was in 2009 when Glencore issued $2.2bn of convertible bonds, which pegged its value, at the time, at around $35bn. Since then, the value of commodities has risen sharply and the company is now estimated to be worth closer to $60bn. “This doesn’t seem unreasonable,” says Freund. Even so, it is generally regarded as difficult to put an exact value on the firm. Robin Bhar, senior metals analyst at Credit Agricole, says: “It would take an equity analyst a week, and that is if he doesn’t eat or sleep, to pore over the Glencore numbers, and to come up with an ironclad valuation.” What makes the valuation so difficult, he explains, is the fact that Glencore’s business consists of two distinctly different segments: production, and trade and marketing. Glencore holds 34.5% in Xstrata, the world’s fifth-largest miner, 8.8% in Russia’s Rusal, which is also the world’s largest

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aluminium miner, a 44% stake in Century Aluminum, 70.5% in Minara Resources, 74.4% in Katanga Mining, and that is just the listed companies. It also holds stakes in a number of unlisted companies dotted across the Americas, Asia, the Middle East and Africa. On top of that, Glencore markets metal, oil, coal and agricultural commodities not only from its own production facilities but also from a whole host of third parties, and provides financing, logistics, and supply chain services. According to Bhar: “It is relatively straight-forward to value the company’s mining operations, but how do you value its trading and marketing operations?” What makes it difficult is that it is not clear how long any of the marketing contracts are for, whether it is a matter of months or years. It is a point picked up and expanded upon by S&P in its September 2010 ratings update, where it states: “The company is exposed to potentially significant cash margin and working capital swings.” Even so, it counterbalances the comment with an acknowledgement that Glencore has “good bank relationships and could also provide more security to raise additional finance if need be. Glencore seeks to maintain a significant liquidity buffer (that is cash and undrawn committed lines) of at least $3bn at all times.”Additionally, company spokesmen point to the fact that Glencore has relationships with several thousand suppliers and numerous marketing agreements, which can compensate for any fluctuations in supply (and by extension revenue) across the globe. For instance, Glencore has a marketing deal with the world’s biggest nickel miner, Russia’s Norilsk Nickel “but the company indicated that they are keen to do more of its marketing themselves and to sell directly rather than through a middleman”, notes Bhar. On top of that are the complexities of making long-range forecasts for the value of commodities such as copper that have fluctuated wildly in price in recent years, and assessing the political risk inherent in operating in countries such as the Democratic Republic of Congo, Colombia and Kazakhstan. “A large portion of [its] business is marketing and trade. It is shipping out commodities; you have to hedge out to do this, and you have to cover your mark-to-market risk. The company has grown into such a big market player. Its counterparties are major banks and those banks are willing to lend to it. The majority of Glencore’s funding comes from banks,”outlines Union Investment’s Freund. In 2010, around 98% of the commodities bought by Glencore were either forward sold or hedged. In March, the company said its net income for 2010 rose to $3.8bn from $2.72bn a year earlier. Revenues were up 36% on the year to $144.98bn from $106.36bn. The rise in profits was a direct reflection of a fierce recovery in commodity prices in 2010, particularly metals and grains. Earnings before interest and taxation (EBIT) increased 60% to $5.29bn, compared to $3.3bn in 2009. The contribution from industrial assets was up 72% to $2.95bn and rose by 47% from marketing to $2.33bn. “This performance is in line with the average quarterly result we achieved in the record year of 2007, prior to the onset of the global slowdown. The largest

COVER STORY

Archive photo of SUAL Chairman Viktor Vekselberg, RUSAL Chairman Oleg Deripaska and Glencore CEO Ivan Glasenberg, L-R, seen during the signing of a merger deal on October 9, 2006 to create the world’s biggest aluminium producer. Photograph by Alexander Bundin/Photas/Tass/Press Association Images, supplied by Press Association Images, March 2011.

increase in 2010 EBIT contribution was in the metals and minerals segment, which benefited from stronger metals prices and improving market sentiment in important enduser industries such as automotive and construction,” noted an official company release. Glencore also said its cash and undrawn bank facilities were about $4.22bn at year-end, above its internal minimum target of $3bn. Had it not been for the credit crunch and the slump in commodity prices in late 2008, Glencore would probably have listed three or four years ago. Sources close to the company say that one of the reasons for listing this year is that Glencore is looking to disentangle itself from an internal arrangement with staff, leaving the firm vulnerable to exits by any of its leading employees with a rather large stake in the company. In extreme circumstances, it could lead to situations in which the company’s hand might be forced to divest some assets in order to pay off its dues. However, there are other reasons for the flotation: to strengthen the firm’s balance sheet, to allow it to better compete in the global markets, and to help finance acquisitions in the near future. The board of Glencore consists of five industry insiders, including Willy Strothotte, who was chief executive of Glencore until a decade ago and is chairman of Xstrata. Strothotte is due to stand down from his role at Xstrata at the next annual general meeting and will be replaced by Sir John Bond. However, Strothotte is expected to continue as chairman of the board of Glencore. Other members are: chief executive Ivan Glasenberg; Zbynek Zak, Glencore’s former chief financial officer; Craig Davies, the former chairman of US-based Century Aluminum, and Peter Pestalozzi, the Zurich-based lawyer who has been the trading house’s external counsel since 1993. In 2009, the value of what top executives could walk away with if the company listed was estimated at around $240m each. This figure could now potentially be almost twice as much. Glencore’s complex financial arrangements were also illus-

trated two years ago when the firm issued convertible bonds. Media reports at the time claimed that in exchange for the cash injection, the company indicated it intended to work towards an IPO or merger within three years and that if market conditions were suitable for a transaction and it failed or decided not to do so, it would have to pay a series of fees to bondholders equivalent to about 20% of their investment. The top four investors were private equity fund First Reserve, asset management firm BlackRock, the Government of Singapore Investment Corporation, and China’s Zijin Mining Group; though the company did not confirm this point. Notwithstanding the swirl of claim and counterclaim; the simple fact is Glencore is likely to use funds raised through an IPO to help it initiate a takeover of Swiss-based miner Xstrata, which is itself a major producer and exporter of coal, nickel, gold, vanadium and ferro-chrome. Any merger proposal by Glencore will have to go through an approval process from Xstrata’s board. The company has form in this regard. The last time Glencore came to the market to raise capital was its 2009 $2.2bn convertible bond issue, which the company spent shortly afterwards buying back Colombian coal mine Prodeco. Glencore had transferred ownership of Prodeco to Xstrata in 2009 in lieu of taking part in Xstrata’s $6bn rights issue. The Prodeco mine was valued at $2bn and Glencore bought it back for around $2.5bn. For potential future shareholders the listing could be even more interesting. “If the IPO goes ahead it could propel Glencore into the big league. If you take the top five mining companies in the world—BHP Billiton, Rio Tinto, AngloAmerican, Norilsk and Xstrata—Glencore could end up perhaps number two,” says Credit Agricole’s Bhar. Glencore is certainly not a company to sit still but nor is the market it operates in. How well it does going forward will depend to a large extent on commodity prices and, barring earthquakes, tsunamis and wars, they are likely to continue to rise for a little while longer. I

APRIL 2011 • FTSE GLOBAL MARKETS

EQUITY OPTIONS

Photograph © Rochak Shukla / Dreamstime.com, supplied March 2011.

MAINSTREAM EXCHANGES LOOK TO COMPETE IN EQUITY OPTIONS Intense competition from alternative trading venues using advanced electronic mechanisms has severely eroded the profitability of the major exchanges over the years. Consolidation is viewed as the most logical means of stemming the tide. Additionally, unlike the comparatively lowmargin, cash-equities business, increased exposure to equity options has the potential to pack the most wallop, dollar for dollar. David Simons reports from Boston. N THE WAKE of the NYSE and NASDAQ super-mergers several years ago, regulators sought to encourage competition by sanctioning faster order routing, low-latency connectivity networks and various other trade-cycle enhancements. This set the stage for the mass influx of alternative trading venues—many of which would ultimately siphon market share from the incumbent exchanges. With equity trading volumes stagnating and margins increasingly compressed due to extensive competition, today the derivatives market remains one of the last bastions of profitable exchange activity. “In contrast to the eroding margins associated with other asset classes, the options trade really does represent a very attractive opportunity for the investment world, one that continues to grow annually as well,” affirms Andy Nybo, principal and head of derivatives research for TABB Group. Global regulatory pressure to bring much of the standardised over-the-counter (OTC) product set into the world of centralised clearing, as well as potentially more transparent platforms for trading, bodes well for properly-positioned exchanges. Indeed, franchises

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with a strong presence in derivatives have seen their valuations rise substantially over the past several years. In an effort to improve ailing margins, major exchanges are setting their sights on this vibrant market as never before, in the process quickening the already heady pace of industry consolidation. As these dominant players get set to join forces, experts believe that a new battle—this time for control of the powerful equity options space—may be in order.

Weighing their options In February, Deutsche Börse, Germany’s largest stock exchange, agreed to merge with the New York Stock Exchange. The mammoth deal was the largest in a massive round of consolidation announcements to hit the industry since the start of the year. Estimates suggest that total annual trading volume from a combined Deutsche Börse-NYSE Euronext could top $20trn. Earlier, Europe’s pre-eminent trading venue, the London Stock Exchange, revealed plans to acquire Canada’s TSX Group, which, if approved, would make the joint venture the fourth-largest exchange worldwide.

EQUITY OPTIONS

The impetus behind the mega-mergers: greater access to the lucrative world of options trading. A merged Deutsche Börse/NYSE would constitute no less than five different options and/or futures exchanges—Deutsche Börse’s (DB’s) International Securities Exchange (ISE) and Eurex, along with NYSE’s Amex, Arca and Liffe—resulting in a possible 40% stake in single-stock options volume, according to some estimates. The deal faces tough scrutiny, however, particularly among European regulators who worry about the impact of a possible options monopoly. Efforts to force DB/NYSE to jettison portions of its derivatives holdings would likely be a deal-breaker, say some analysts. Craig Pirrong, professor of finance at the University of Houston’s Bauer College of Business, remarks: “The main attraction is the potential to exploit clearing efficiencies and profits and DB considers integrated clearing an essential part of its business model. I would think that DB would rather stand pat with its current business than merge and amputate its clearing operations.” The merging party didn’t end there. In March, global exchange operator IntercontinentalExchange (ICE) acquired broker-dealer Ballista Securities, which specialises in executing complex multi-leg options transactions through an electronic platform. Through its integration with existing options-negotiation platform YellowJacket, Ballista will allow ICE to enhance its presence in the options-trading arena. Meanwhile, BATS Global Markets upped the ante by announcing it would purchase Chi-X Europe, the European Union’s (EU’s) leading ATS. If approved, the combined company could secure over 33% of UK blue-chip stock trade, which, according to Joe Ratterman, president and chief executive officer of the Kansas City-based BATS, would be “a tremendous boost for competition in pan-European trading in the face of increasing consolidation among incumbent exchanges”.

Cross talk As if merger-mania wasn’t enough, in February came news that the International Securities Exchange (ISE), the world’s top ranking equity options trading venue, would finally bring to market its Qualified Contingent Cross (QCC), which will allow member firms to cross contracts without having to expose order data to outside participants, assuming certain standards have first been met. QCC is seen as a way for ISE to offer large, trading floor-type crossing capability within an efficient, electronic environment. QCC did not come easy. Initially approved by the SEC in the summer of 2009, opposition from chief competitor the Chicago Board Options Exchange (CBOE) in the form of a procedural appeal from parent company CBOE Holdings last year led to a retooling of ISE’s original model. Gary Katz, president and chief executive officer of ISE, said that the long-awaited QCC will “allow for fair competition between floor-based and electronic options exchanges for these large-size contingency trades”. According to Katz, the QCC order type isn’t really a new phenomenon. Large, complex options orders are already being crossed—transacted without exposure to the market

Regulators must avoid the notion that “if it works for equities, it will work for options as well,” says Anthony Saliba, chief executive officer, LiquidPoint. Unlike equities, which represent an ownership stake in any given company, options-contract transactions are capable of transferring various types of risks, he adds. with guaranteed execution—on the exchange floors. What makes QCC different, says Katz, is the ability to execute certain qualified orders electronically, thereby providing participants with the kind of speed, efficiency and immediate transparency normally found within an electronic environment. “For the first time since September 2009, we can compete for these institutional tied-to-stock options orders on a level playing field with floor-based exchanges,” notes Katz. Not everyone shares Katz’s enthusiasm. Anthony Saliba, chief executive officer, ConvergEx Group’s LiquidPoint, calls QCC “a potentially dangerous precedent for the listedoption market structure”. Unlike equities, the available liquidity of the “term insurance policies” represented in the individual option contracts is not constrained by shares outstanding, says Saliba. “Liquidity is created through a diverse network of market makers spreading risks across all related series,” he says. By limiting price-discovery and marketmaker participation, QCC hampers the ability to provide liquidity, says Saliba. “Ironically, this function allows price to be determined by broker-dealers away from the exchange network of market makers, thereby reducing the relevance of listed-option exchanges and potentially damaging the risk-mitigation product.” By allowing ISE to compete more effectively for those order types, QCC could have a dramatic impact on exchanges that have essentially been able to keep these types of orders “on the floor,” says Nybo of TABB Group. Market makers, whose livelihood is directly linked to having access to order flow, could be substantially affected by this turn of events. “It is a real game-changer in the options market, no doubt, and it raises the question as to whether there will be further attempts at taking this kind of internalisation methodology one step further.” This in turn has led to calls for a more thorough examination of current regulatory standards. “An in-depth review of options-market structuring may be in order, so that participants will be able to clearly see how things might evolve once the market is fully developed,” says Nybo. Through its sanctioning of the qualified contingent cross, the SEC has, in effect, set a precedent in that it marks the first time that options orders are not completely exposed to the market-making community or the public at large. “It is a departure from other types of trading protocol that have existed on the options market in that a trade is locked in before it is even brought to the exchange,” says Nybo. “As

APRIL 2011 • FTSE GLOBAL MARKETS

such, it’s easy to see how this could potentially open up a can of worms, going forward.” Because it is reserved for tied-to-stock options orders where the options component is a minimum of 1,000 contracts, in reality the QCC order type benefits any sophisticated institutional investor, broker dealer or inter-dealer broker using complex trades to execute their trading strategies, maintains Katz. Why, then, all the fuss over QCC? “It has always been a competitive issue,” explains Katz. “These orders have always taken place on exchange floors. Exchanges with trading floors were very vocal in their opposition to QCC because until now, they had that exclusive volume. We are now allowed to compete for this business on a level playing field.” Katz refutes the argument that order types such as QCC will lead to an irreversible trend of unlit options activity. He says: “Critics have used phrases including ‘dark pools’ and ‘slippery slope’ to scare people, but QCC is really none of these things. As an exchange, competition for order flow is a fundamental tenet of our market and we would not do anything to damage that principle. Participants in the US options market benefit from tight and competitive quotes in a transparent, liquid environment where order flow interacts and participants can get the best price. Unlike the equities market, retail order flow is never internalised. QCC—which is only for certain large, complex, institutional order flow— does not threaten this market structure at all.” With QCC up and running, some of ISE’s main competitors are themselves investigating similar order-processing initiatives. Speaking shortly after the QCC launch was unannounced, CBOE executive vice-chairman Ed Tilly said his company would assess the impact on order routing stemming from QCC’s approval in an effort to determine “if we should pursue similar functionality”.

Different type of market In light of ongoing developments, it is imperative that regulators have a keen understanding of the nuances that exist within the options arena. For starters, regulators must avoid the notion that “if it works for equities, it will work for options as well,” offers LiquidPoint’s Saliba. Unlike equities, which represent an ownership stake in any given company, options-contract transactions are capable of transferring various types of risks. It is because of these differences that the market needs to be viewed and understood independently, particularly with regard to issues affecting transparency, says Saliba. The same holds true when weighing the impact of flashorder activity on listed options. “The flash auction serves as a simple and fair method of providing liquidity at the moment as a quote refresh,” says Saliba. “Since market makers are at risk of having their quotes hit on multiple, or even all series of options simultaneously, prudent risk management requires that options market makers refrain from posting their best quotes for each series they are quoting. Listed-option market makers adapted to the always-fluctuating liquidity needs of their market’s participants by using

FTSE GLOBAL MARKETS • APRIL 2011

Gary Katz, president and chief executive officer ISE. “For the first time since September 2009, we can compete for these institutional tied-tostock options orders on a level playing field with floor-based exchanges,” notes Katz. Photograph kindly supplied by ISE, March 2011.

this quote refresh functionality to ‘awaken’ potential or additional liquidity.” The debate over flash orders within the options industry has been largely fought along competitive lines, says Katz, adding that if flash were to be banned in the electronic markets, “the SEC would need to find a way to translate that into the floor environment where orders traded in open outcry are only exposed to a subset of the entire marketplace”. In their request for comments on flash orders, the SEC asked for input on whether the use of flash orders in the options markets should be evaluated differently than their use in the equity markets, leaving open a window to preserve flash treatment for options. A decision from the SEC is still pending. “With widely differing fee structures in the options industry, there is an economic rationale for why a customer who sends an order to an exchange with one particular fee model would want their order to be executed on that exchange rather than routed out,” says Katz. “With flash in the options market, customers are not only guaranteed to receive the best execution, but they have the opportunity for price improvement. Importantly, their right to make a decision about where to execute their orders—whether that is based on transaction fees, customer service or other factors—is preserved.”I

SECTOR REPORT: MUSIC

From left to right: US rappers YG, 50 Cent, Snoop Dogg, Ty Dolla Sign, German Till Lindemann of Rammstein and UK R&B artist, Jessie J. Original photographs supplied by Press Association Images, March 2011.

THAT’S WHY THEY CALL IT THE BLUES The music industry remains at a crossroads, facing myriad new opportunities (and, of course, threats) created by the digital age. Consumers are downloading more music than ever before while enjoying a rich variety of choice in terms of the type of music they listen to and the avenues from which they receive it. However, this revolution in music consumption has not translated into bigger revenues for the music industry. While live music continues to be a reliable income stream, consumers’ appetite for attending live events appears to have reached a plateau in the wake of the global financial crisis and recession. The music industry is certain to look radically different in a decade’s time but nobody—least of all it seems the major labels—knows exactly which way the wind is blowing. Joe Morgan reports from Berlin, the new lodestone for popular music. INCE THE ADVENT of the internet and the digital revolution in music, which has enabled millions of consumers across the world to obtain artists’ music for free, the traditional business model of major music labels has been forced to adapt to harsh realities of the digital age. When the revolution in the migration towards digital music first started, music labels at times appeared seemingly clueless as to how to act as compact disc (CD) sales plummeted. Meanwhile the industry has lined the pockets of corporate lawyers, commanded to launch multiple lawsuits against websites and individuals publishing the music of artists for free. “Revenues [at major music labels] grew until the late Nineties and then collapsed and are now in a constant state of decline, year-on-year,” explains Howard Davies, a partner specialising in broadcast media at Deloitte. “This is nearly all due to the shift away from

physical products to digital products. Consumers have gone from purchasing an album for $15 to cherry-picking a handful of songs they like from [an] album and buying them on a download-to-own basis for $3.” The plight of the major record labels tells its own story. Warner Music Group in the last quarter of 2010 reported widening quarterly revenue losses, as potential bidders circled the troubled major record label. EMI has been put up for sale by Citi, the US investment bank, which wrested control of the label from Terra Firma, the private equity firm owned by financial speculator Guy Hands, after it faced collapse under a £3.4bn debt pile. Meanwhile, Vivendi’s music business, Universal, has suffered from falling compact disc sales, and is expected to have cut some €100m in costs this year. While record labels in the 1990s benefited from consumers replacing their album and cassette collections with CDs,

APRIL 2011 • FTSE GLOBAL MARKETS

this habit has not been replicated in the digital age we now live in. Falling CD sales have been largely responsible for a 25% drop in total revenues in CDs, vinyl, cassettes and digital downloads from $38.6bn in 1999 to $27.5bn in 2008, according to statistics published by the International Federation of the Phonographic Industry (IFPI), a trade body representing the global recording music industry. For example, CD sales in the UK fell by 6.1% in 2009, according to IFPI research. “With streaming services such as Spotify [a cloudbased online music service] there are new ways to access music. For sure, mid-to-long-term there will be no more CDs. That is a given,” says Daniel Haver, chief executive officer of Native Instruments, a music technology company based in Berlin. Even so, the CD market is not yet in terminal decline. In pockets, in Europe, for example, sales are still strong. “Physical sales” still account for 85% of music revenue in Germany, according to IFPI research. Major music labels also continue to enjoy lucrative revenue streams through the ownership of back catalogues, which read like a who’s who of the major best-selling artists of the past 60 years.

A change in business model The reality is that major record labels are continuing to increase revenues from digital music, a channel which generated $4.3bn in 2009, according to IFPI statistics. In 2009, single tracks crossed the 1.5bn mark for the first time, up an estimated 10% on 2008. Digital albums grew by about 20%, double the rate of single tracks. Nowadays about 20% of albums sold in the US and about 15% of those sold in the UK are digital, according to the IFPI Digital Music Report 2010. This revolution in digital music has forced major record labels to make dramatic changes to their business models. “The industry is in flux. It is quite difficult for the major record labels to work out how they re-orientate their business model fast enough in order to remain a successful growing business in what is undoubtedly a different mode of consumption now,” says Davies of Deloitte. Keith Jopling, a music industry analyst based in London, says that while music labels and publishers have previously been “lean back” licensors—developing a consumer proposition and being careful to manage channel conflict and cannibalisation—they are now having to treat every artist as a small business, offering a range of products and experiences while widely licensing the core music tracks. “Models like Topspin Media [which provides digital tools for artists to promote their work] do this for a range of artists already and these services look increasingly attractive. Labels need to act more like Topspin but also somehow use their scale and catalogue to keep the bigger deals coming in,” says Jopling. “They will need to work with services as long-term partners not just licensors, offering more innovation support including exclusives, joint-marketing and product development,” he adds. Jopling says that “superstar acts” are becoming more important to major record labels. In the US in 2009, four acts sold more than 10m tracks online, including Lady Gaga,

FTSE GLOBAL MARKETS • APRIL 2011

Daniel Haver, chief executive officer of Native Instruments, a music technology company based in Berlin. Photograph kindly supplied by Native Instruments, March 2011.

Black Eyed Peas, Michael Jackson and Taylor Swift, according to IFPI statistics. In addition to high music sales, superstar artists also provide music labels with more revenue streams which can be developed, including brand sponsorship and adjacent product sales such as Dr Dre headphones. “The profit and loss for these artists looks very different from the album and singles sales which dominated accounts just a few years back,” says Jopling.

High costs of marketing Nevertheless, the music industry continues to spend about $5bn worldwide per year on developing and marketing artists, according to the IFPI Recording Industry in Numbers 2010. The report estimated that global music companies invest about 16% of their total revenues in artists and repertoire (A&R) discovery, with much of this money comprising advances to artists. On top of that, an estimated further 13% of revenue is spent on marketing artists. Another consequence of the new internet age that major record labels have had to contend with is that new online communication portals provide artists with more autonomy, enabling them to promote themselves independently of a music label. Notably the Arctic Monkeys, an English indie rock band, built up their fan base on Myspace, the online social network. “There are quite a few artists now who are not signing up directly with a music label. The internet has given them a marketing channel without having to rely upon a big publisher,” says Davies of Deloitte. Haver of Native Instruments says that while the brand of an artist was previously created by a record company—traditionally by making music videos for music networks such as MTV and ensuring CDs made it on to the shelves of record stores—the musicians now have far more opportunities to market and develop an image themselves.“Selling a song will not make an average artist’s living any more.

SECTOR REPORT: MUSIC

Instead it has become just a base revenue stream, as well as a crucial promotional tool. Now it is about building upon this, creating more revenue streams and building a brand through concerts and merchandise, looking for licensing opportunities and raising the artist’s profile through social media and blogs,” says Haver. Meanwhile, the music industry continues to be blighted by the burgeoning activities of those involved in music piracy. “To continue investing in new artists, we have to tackle mass piracy,” says John Kennedy, chairman and chief executive of the IFPI. The recording industry trade body estimates that, overall, music sales fell by about 30% between 2004 and 2009, as a result of illegal file sharing. “At the moment, about 90% of music downloads are unlicensed and illegal,” says Davies of Deloitte. “If this figure could be changed to about 50% there would be great potential for growth in digital music.”

Crackdown on illegal downloads Nonetheless, the music industry can take comfort from an increase in countries cracking down on illegal downloading. For example, in 2009, legislation requiring internet service providers (ISPs) to tackle peer-to-peer piracy was adopted in France, South Korea and Taiwan. New technology is also creating new opportunities for the music industry to grow. SoundCloud, a file-sharing social network based in Berlin, is helping to spearhead a new trend in the future growth of the music industry where online social networks become the new frontline in consumers’ consumption of music. SoundCloud—which is funded by Doughty Hanson Technology Ventures, a private equity firm based in London—now has 3m users since it launched its service in 2008. Artists and record labels using the platform include Kylie Minogue, Domino Records, Zero 7 and Snoop Dogg. Mark Mulligan, vice president and research director, consumer product strategy at Forrester Research in London, describes SoundCloud’s business model as “very robust”, pointing to its capacity to build applications that provide Global music industry turnover (1973-2009) In billions. $15 8-track LP/EP Tape

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artists with a private music utility, which he says is absolutely fundamental to the future of the music industry. Mulligan envisions SoundCloud playing an important part in a new age where music is seamlessly distributed via electronic applications such as the iPhone and social networking websites including Facebook, enabling listeners to create their own “music mash-ups”, which can be shared with their friends. “In Berlin you have a new generation of technology-enabled content providers, an area where a lot of the future growth in the music sector will be,” says Mulligan. Another Berlin-based music technology company Mulligan claims as being “at the vanguard of the music production industry”—which has been dominated for years by Apple’s Logic and Avid Technology’s Pro Tools—is Ableton. Mulligan thinks SoundCloud and Ableton are pioneers in shaping what the music industry will look like in five or ten year’s time, playing a key part in the “resurgence in the relevance of electronic music”. “These companies are creating a new paradigm, a new construct in the way people use music that is enabled by the internet and digital technology,” he says. Ableton already generates modest annual revenues of between €10m and €15m, with 120,000 paying subscribers of its flagship Live product. “Ableton has changed the way electronic music is created with its Live software, which enables a DJ, or any live musical artist, to interact with an audience during a performance,” says Mulligan.

Blurring the lines “Modern music production and DJ technology have re-opened a new creative approach to music, blurring the lines between music producers and music consumers,” says Haver of Native Instruments, which declines to reveal how much money it is making. Native Instruments states that annual revenue is in “eight figures”, having enjoyed a 60% growth in revenue in 2009. Until, such nascent technologies become part of the mainstream of music consumption among consumers, the traditional avenue of live music continues to be a lucrative revenue stream for the industry. “There is much more of a focus on live music now. A lot more time and effort is devoted to live events and live performances,” says a senior music industry source. However, he says that revenues reached a plateau in 2007 and 2008 and have since declined in the wake of the global financial crisis and recession. “It is true to say that in North America at least, there has been a downturn in the amount of concerts that music fans are going to and Americans seem to be spending a little less on entertainment,” says Charlie Presburg, managing director of London-based Pollstar, a trade publication covering the worldwide concert industry. Pollstar estimates that total ticket revenues for major concerts in North America fell from $4.6bn in 2010 to $4.25bn in 2009, the first time since 1995 that it has recorded a decline in concert industry ticket sales. Furthermore, the top 50 worldwide concert tours grossed a combined $2.96bn in 2010, which was about an 11% decrease from $3.34bn in 2009. I

Source: RIAA year-end shipment statistics, Bain analysis. Supplied March 2011.

APRIL 2011 • FTSE GLOBAL MARKETS

PENSION FUNDS

GERMAN FUNDS MIND THE PENSIONS’ GAP Photograph © Martin Konz / Dreamstime.com, supplied March 2011.

The pension fund industry in Germany mirrors the resurgence of the country itself. After a decade of reform it finds itself in robust health while its peers in other European countries continue to struggle in the aftermath of the global financial crisis. By Joe Morgan. ERMAN COMPANY PENSION schemes emerged from the crisis of 2008 comparatively well. There was a dip in the values of funds but this was below 10%—nothing like the situation in the UK where the value of pension funds fell by about 20% on average, says Nikolaus Schmidt-Narischkin, managing director, head of fiduciary distribution pension solutions at DB Advisors, the institutional asset management arm of Deutsche Bank in Frankfurt. “Now we are back to where we were [pre-2008]. That is, with a lot of large-cap German companies back to being able to fund their liabilities.” The risk-averse nature of German pension funds, which has resulted in funds shying away from equities and holding about 75% of their assets in fixed-income products, meant that pension funds did not take a sizeable hit when global stock markets plummeted in the aftermath of the collapse of Lehman Brothers in September 2008. German pension funds have historically always been risk-averse, only holding about a quarter of their investment portfolio in cash equities. Even so, Germany has continuously received bad ratings from consultants such as Mercer on the sustainability of its old age provisioning in comparison to other countries in Europe, such as Denmark, France, the Netherlands, Norway, Switzerland, Sweden and the UK. Research carried out last year by Aviva, the London-based global insurance company, in conjunction with Deloitte, the London-based accountancy firm, found that Germany had the second biggest pensions

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gap—the difference between the income people need to live comfortably in retirement, and the actual income people can expect—in Europe. Germany had an annual pensions gap of €468.8bn, according to the Aviva research. Europe’s biggest economy has one of the lowest birth rates in the region with the proportion of its population aged over 65 set to almost double to 30% by 2035. Furthermore, according to statistics from the German Federation of Health Insurance Companies (BKK), the number of employees aged 55 and older in Germany increased by 49% from 2000 to 2010. However, Schmidt-Narischkin of DB Advisors says the country’s pensions industry has made significant progress in improving levels of sustainability in its pension provisioning over the past decade. “The government has made huge inroads into making the whole thing sustainable. On the corporate pension side, since 2000 there has been a massive trend of funding existing corporate schemes. A lot has been happening there so that by now, we see a funding ratio of corporate pension schemes of about 65% to 70%,” says Schmidt-Narischkin. He points to a major shift in the approach used by German companies in the management of their pension scheme liabilities and attributes this in part to German companies’desire to comply with International Financial Reporting Standards (IFRS), principles-based international accounting standards, which enables them to be compared with their peers in the US and Europe. “Compliance with IFRS meant funding pensions

PENSION FUNDS

schemes was not seen any more as basically unfunded debt on the balance sheet. So beginning in 2000 we had a rally towards funding,” says Schmidt-Narischkin. “What we basically saw in Germany over the past ten years was a rise in sequential funding to about 85% or 95% of pension fund liabilities. We saw a long rally towards funding.” Major German companies such as Deutsche Telecom, the telecommunications giant, and Adidas, the sportswear manufacturer, have switched from holding pension schemes on their balance sheet to moving towards fully-funded schemes. The health of the German pension fund industry is borne out by research from Towers Watson, the global professional services company, which this year published a report on the global pensions industry which found that pension assets in Germany had the highest growth rates among nations surveyed over the past five years. The research found that pension assets in Germany, relative to gross domestic product (GDP), had increased from 10% to 14% over the past ten years. The asset management pension fund industry in Germany is dominated by Allianz Global Investors, the asset management arm of Allianz, the global insurance company, BlackRock, the global asset management firm, DB Advisors, Goldman Sachs and JP Morgan. Martin Katheder, director, head of pensions markets at Allianz Global Investors in Munich, which is Germany’s largest asset manager, says he is discussing ways to make pension fund governance more transparent with pension fund and institutional clients. “This is similar to trends we are seeing in the UK or the Netherlands where plan sponsors are trying to streamline their governance and reassess governance, risk management procedures and strategic asset allocations with regards to losses suffered due to the financial crisis and recovery plans set in place,” says Katheder. He says the biggest challenge German pension funds face has been a low interest rate environment—given the highlevel of fixed-income investments held by funds in the country—which threatens to change amid possible upward pressure on interest rates in the near term, coupled with rising levels of inflation. “This is haunting our clients right now and this is where sophisticated asset management solutions and risk management solutions come in, just to prepare for a potential rise in interest rates,” says Katheder. “Pension funds need to consider a range of measures to protect against a loss in the asset value such as inflation hedging and investing in commodities and renewables. Emerging markets will also become more important in the future.” The benign low interest rate environment resulted in February 2001 in the finance ministry in Germany decreasing the life insurance guaranteed interest rate (GIR)— the maximum interest rate insurers are allowed to promise as legally binding while selling their policies—from 2.25% to 1.75%. Dr Sabine Horstmann, a project manager at Gesellschaft für Versicherungswissenschaft und -gestaltung (GVG) in Cologne, which represents stakeholders including bodies from the insurance sector and health service on social policy

Nikolaus Schmidt-Narischkin of DB Advisors. “Compliance with IFRS meant funding pensions schemes was not seen any more as basically unfunded debt on the balance sheet. So beginning in 2000 we had a rally towards funding,” says Schmidt-Narischkin. Photograph kindly supplied by DB Advisors, March 2011.

issues, says this reduction in the interest rate has become a contentious issue in Germany. “A lower GIR makes life insurance policies less attractive for consumers. The new GIR will be effective from January 2012 onwards. The insurance industry itself has argued that a reduction by 0.25 percentage points would be sufficient. Consumer protection bodies have argued that 0.5 percentage points would be appropriate,” explains Horstmann. Meanwhile, fiduciary management, which involves the outsourcing of the day-to-day management of a pension scheme to a lead manager, has also emerged as a recent growing trend in Germany. Schmidt-Narischkin of DB Advisors points to growing demand for these services, whereby consultants or asset managers go into a strategic partnership with corporations, helping to oversee increasingly complex aspects of asset and liability management of pension fund schemes. Schmidt-Narischkin says corporate pension schemes in Germany are relatively small, when compared to those of other western nations such as the UK or the Netherlands, with the assets of most schemes valued at below €1bn. He says the smaller size of the schemes makes outsourcing to fiduciary managers more attractive, given the complex issues of asset management and liability management which they face. Fiduciary managers are outsourced to perform complex tasks such as setting a strategic allocation, tactical allocation, monitoring, crisis intervention, reporting and potentially

APRIL 2011 • FTSE GLOBAL MARKETS

Martin Katheder, director, head of pensions markets at Allianz Global Investors in Munich. “Pension funds need to consider a range of measures to protect against a loss in the asset value such as inflation hedging and investing in commodities and renewables,” he says. Photograph kindly supplied by Allianz Global Investors, March 2011.

addressing issues of sustainable investment. He adds: “In Germany, the value chain is split up into different service providers. But you have one provider basically setting everything up taking up responsibility in the face of the plan sponsor and basically guaranteeing results.” A recent trend in Germany is a migration from defined benefits schemes, where a pension is determined by a set formula rather than investment returns, to defined contribution schemes, where responsibility for ensuring an adequate retirement shifts to a scheme’s members, who will have their income directly linked to investment returns. Most new pension schemes set up in Germany are now defined contribution schemes. “The trend towards defined contributions is very strong. The government is providing incentives to these schemes in the form of early retirement options and socalled ‘flex-time’ models offering the employee the option to save parts of his or her bonus or part of his or her base salary, left over vacation days, stuff like that. Invest that and use it for early retirement,” explains Schmidt-Narischkin. New legislation, named the Familienpflegezeitgesetz, which is expected to come into force either later this year or early in 2012, will enshrine in law steps taken by the government in Germany to promote long-term care insurance. The German pension industry is in the process of adapting itself to provide solutions which meet the requirements of the Familienpflegezeitgesetz rules, combined with the growth of defined contribution schemes which have com-

FTSE GLOBAL MARKETS • APRIL 2011

pulsory long-term care insurance components. Meanwhile, Solvency II, a pan-European Union (EU) review of the capital adequacy regime for the insurance industry in the region, is expected to have a major impact on German corporate pension fund schemes. Trade bodies representing the industry in Germany have given warning that the directive— which aims to establish a revised set of EU-wide capital requirements and risk management standards that will replace the current solvency requirements—could lead to tighter regulations that would make pensions more unaffordable. Senior representatives of Germany’s pensions and insurance industry are lobbying officials in Brussels for a differentiation in the rules of the directive applying to institutional pension funds and corporate pension schemes. Katheder views the raising of the retirement age in Germany from 63 to 67—which is to be phased in gradually from 2012 to 2029—as a “huge opportunity” for the private pension fund industry in Germany. “The weight of the state pension will shrink and steadily decrease and that is the big opportunity we have here,” he says. “More and more corporate sponsors are becoming conscious of the risks of the future obligations they have to meet with regard to their pension system and are now scrutinising methods and thinking about how best to organise their pension schemes,” he says. Katheder says a reassessment of how to fund pension liabilities is not just restricted to major companies listed on the Xetra DAX 30 Index, which by the end of 2009 had liabilities of about €220bn, covered by about €145bn of assets. He adds that the country’s Mittelstand sector of small and mediumsized businesses has become more conscious of the future obligations that will have to meet to serve their pension schemes. Katheder says that in order to manage the balance sheet of their future pensions liabilities, Germany’s Mittelstand companies are exploring more sophisticated ways of managing pension schemes. “They are pooling assets from different vehicles and have a kind of a comprehensive riskmonitoring and risk-reporting approach, which not only takes into account the asset management side but also the liabilities side,” he says. “So they are not managing the risk any more solely confined to the asset side but they are also taking into account the liability side and they are managing, for example, criteria like funding levels equity index.” Katheder says this more sophisticated approach to managing pensions liabilities among Mittelstand businesses has improved levels of transparency in pension schemes and enhanced levels of corporate governance, providing firms with a more holistic view of their pension liabilities. The German pension fund industry appears well equipped for the future despite having to meet the challenge of the requirements of an increasingly ageing population. A shrinking of state-funded schemes is creating new opportunities for the industry to exploit. Meanwhile, improving levels of risk management in the corporate sector, coupled with advances in levels of transparency and corporate governance, will only enhance the standing of German pension schemes, when compared with other schemes in Europe and North America. I

ASSET MANAGEMENT

Photograph © Elena Ray / Dreamstime.com, supplied March 2011.

The Institute of International Finance (IIF) forecasts that GCC countries are returning to solid growth, underpinned by higher oil prices that are supporting production and exports, robust government spending, and some normalisation of global trade and capital flows. Overall, real GDP is projected to expand by 4.4% in 2010 and 4.7% in 2011. The GCC countries are estimated to have a savings rate of 39% in 2009, significantly higher than the international average of 21%. Qatar alone continues to have one of the highest savings rates among GCC countries, 37%, and the lowest private spending rate as a percentage of GDP at 25%. The trends signify sustained potential for the deepening of the asset management industry in the region.

GCC ASSET MANAGEMENT GROWS IN CONFIDENCE C OMMENT ABOUT THE asset management industry in the Middle East is often rife with preconceptions. At one time, there might have been some truth in statements such as: private equity is more suited to the Middle East than equity; or, there is no secondary market in local bonds so fixed income funds are not possible; or even, Islamic funds offer lower returns and higher costs than the conventional alternatives. These days, however, they are no longer necessarily true. Even so, the asset management industry in the Middle East continues to be idiosyncratic. It does not work in precisely the same way that asset management operates in advanced markets, for instance. Neither does it work in quite the same way that the asset management industry works in Asia either. For instance: large agglomerations of assets in the region tend to be swept into sovereign wealth

funds. According to Mark Watts, head of fixed income, asset management group, at the National Bank of Abu Dhabi (NBAD): “The institutional market in the GCC is less developed than in the G7 and assets are often mismatched versus liabilities. Insurers in the Middle East for instance are heavily biased towards equities—some as much as 70%— which leads to a massive mismatch between their exposure and their likely liabilities.”Watts believes that it may require a change in their regulatory structure to alter their behaviour. Watts has something of an evangelical outlook. He is, for example, a super-keen proponent of the opportunities offered by fixed income asset management in the region.“I want to open the eyes of investors in the region to the joys of fixed income investing in the Middle East,” he says, without a hint of irony. He believes that the fixed income market has evolved significantly over the past few years in

APRIL 2011 • FTSE GLOBAL MARKETS

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ASSET MANAGEMENT

a way that provides local managers real opportunity to generate significant returns for their investors, and he is equally keen to dispel some of the myths which still surround the business. He explains that five years ago local bond issuance volumes tended towards small-scale issues (usually sub$500m) and which were distributed locally to banks which in turn tended to hold on to the securities until maturity. Larger deal sizes (worth up to $1bn) with international distribution now tend to be much more common. Nonetheless, low secondary market trading volumes continue to provide a challenge, continues Watts, who compares the characteristics of the secondary market for Middle East corporate debt with that of investment grade corporations in the United States, where spreads can be wide. Nonetheless, he holds that an experienced team should always be able to source liquidity near the mid-price. “As bonds sourced in the region are now distributed globally, we have invested heavily in our relationships with groups, such as the family offices in Switzerland, which allows us to tap into pools of liquidity in the secondary market that are not necessarily available to everyone.” Equally, NBAD has had to invest is in its own research capability.“Traditional credit ratings are of limited use to us and there is limited research on most of the companies in the GCC. This means we have to do a lot of primary research to undertake in areas such as corporate balance sheets and on sovereign support.”Although Watt concedes that this lack of third-party research increases costs, he thinks that NBAD’s bottom-up valuations (based on local market expertise) allow the asset gatherer to uncover alpha that is sometimes missed by emerging market debt funds managed out of Europe and the US. US funds, he believes, tend to have a bias towards issuance out of Latin America, while European funds tend towards Eastern Europe. Either way, he holds: “They rarely convince me they make any meaningful distinction between debt issuance out of Dubai and that of Abu Dhabi, for instance”.

The opportunities that abound in the asset management segment have already attracted firms including JP Morgan and State Street to set up operations in countries such as Qatar. There they have launched asset management operations in addition to supporting the nascent asset management segment with securities services Invest AD is another Abu Dhabi-based player that puts great store by its own research capabilities. David Sanders, chief investment officer of Invest AD’s asset management division, says there is a clear distinction between their approach and that of other local managers. “A typical equity house in the region will be largely benchmark driven. This

Shashank Srivistava, QFC Authority acting chief executive officer. “We are looking to encourage the asset management industry. This means not just front office operations, but specifically the middle office and also back office services as well. There are also other associated opportunities in services such as product distribution channels and transfer agency,” he says. Photograph kindly supplied by QFC Authority, March 2011.

means that it will have a high concentration in telecoms, banking and real estate sectors as these tend to dominate GCC indices.” He compares this with the Invest AD GCC focus fund, which typically holds 20-30 stocks from across the GCC.“In each case we will meet with the management and get to know the business before we commit. In some situations we may decide not to hold stocks in a particular sector if we believe there is no medium-term upside as was the case with real-estate at times through 2010.” Actually, a good number of Invest AD’s funds, particularly those focusing on Africa, have a hybrid structure that overcomes the relative shallowness of equity markets in some countries in which it invests. This, says Sanders, allows Invest AD to look at the “pre-IPO market and large private companies which dominate some economies in the region”. He says: “National telecom companies can only be IPO’d [sic] once,”adding wryly: “Once you have missed an opportunity like that you have missed it for good.” Even so, higher risk can sometimes mean higher rewards. “These frontier market funds, even those that are predominantly equity based, should typically not be taken from an institutional investor’s equity asset allocation but is more comparable to an alternative investment in terms of its higher-risk, higher-return profile,” says Sanders. Invest AD used to be known as the Abu Dhabi Investment Company (ADIC) and was founded in 1977 to invest on behalf of the Abu Dhabi government. In 2007 the company was given a new mandate, to attract and manage thirdparty funds as well as continuing to manage state-owned

APRIL 2011 • FTSE GLOBAL MARKETS

assets. Since 2009 the company has attracted around $500m in third-party assets across its broad spectrum of funds and, adds Sanders, includes a number of innovative third-party agreements. These include a sub-advisory business where the company manages a Mena UCITS fund on behalf of BHF Bank and a similar arrangement in Hong Kong with Quam Ltd. More recently, the asset manager has also entered into a joint venture with Japanese financial services company SBI Holdings to create an Africa fund in which each party has committed an equal sum of $50m.

International players

David Sanders, chief investment officer of Invest AD’s asset management division. “A typical equity house in the region will be largely benchmark driven. This means that it will have a high concentration in telecoms, banking and real estate sectors as these tend to dominate GCC indices,” he says. Photograph kindly supplied by Invest AD, March 2011.

Mark Watts, head of fixed income, asset management group, at the National Bank of Abu Dhabi (NBAD): “The institutional market in the GCC is less developed than in the G7 and assets are often mismatched versus liabilities. Insurers in the Middle East are heavily biased towards equities, which leads to a massive mismatch between their exposure and their likely liabilities,” he says. Photograph kindly supplied by the National Bank of Abu Dhabi, March 2011.

FTSE GLOBAL MARKETS • APRIL 2011

The growth of investible wealth, and the emergence of a nascent local fund management industry, is providing fertile ground for foreign asset gatherers, some of which are now expanding operations in the region. Invariably this has encouraged their sales teams to sell branded products through local private banks or they enter into a white labelling type arrangement as witnessed with Riyad Bank and Fidelity. Increasingly however, asset management firms are redefining their operational remit in the wider region, providing in-house research to clients and some plan to launch and distribute locally-managed funds. The opportunities that abound in the asset management segment have already attracted firms including JP Morgan and State Street to set up operations in countries such as Qatar. There they have launched asset management operations in addition to supporting the nascent asset management segment with securities services, a sub-trend that a local institution, such as the Qatar Financial Centre (QFC), is keen to tap into. “We are looking to encourage the asset management industry,”explains QFC Authority acting chief executive officer Shashank Srivistava. “This means not just front office operations, but specifically the middle office and also back office services as well. There are also other associated opportunities in services such as product distribution channels and transfer agency.” QFC has walked the talk for some years, having undergone a strategic restructuring at the start of 2010, which has focused the development agency to concentrate on attracting incoming asset management, insurance and reinsurance providers. Srivistava thinks there are obvious synergies between these sectors with the insurance sectors generating premiums which must be reinvested. He believes this in turn provides stable investment capital for the asset management sector, which in turn creates an institutional demand for the region’s equity and debt. He firmly believes that locally incorporated managers will benefit from being closer to the GCC markets and invariably pushes the advantages of Qatar’s situation: its relative closeness to India and to frontier markets in Africa gives it a significant geographic advantage. “As an economy which is a net generator of capital, Qatar and the supportive regulatory regime of the QFC mean we are well placed to create an asset management hub that will provide a welcome boost to asset management and the capital markets, not just in Qatar but across the GCC.” I

SECURITIES SERVICES

The provision of Islamic securities services has seen a step change with the announcement in early March by HSBC Securities Services that it had launched HSBC Amanah Securities Services, which provides Shari’a compliant services globally to both Islamic investment managers and traditional investment managers managing Islamic funds.

A STEP CHANGE IN ASSET SERVICES FOR ISLAMIC FUNDS HE ISLAMIC ASSET management industry and the services that support it have been evolving at a steady pace over the last decade. Now comes a gear change in the provision of securities services for investors and asset managers specialising in Islamic funds. HSBC Securities Services (HSS), in conjunction with HSBC Amanah, the HSBC Group’s global Islamic financial services division, launched HSBC Amanah Securities Services in early March. The new securities services vehicle, provides Shari’a compliant securities services globally and claims a superior footprint in that it offers a consistent, Shari’a compliant asset servicing range backed by a service set approved by the bank’s independent Shari’a board. The service range encompasses accounting and administration, global custody, transfer agency, banking and treasury services and is provided in 17 markets across the Middle East, Asia-Pacific, Europe and the Americas. The move is timely: appetite for Islamic funds is rising steadily among both Islamic institutions and conventional investment firms. Ructions in the Middle East may have tempered some investment flows into the region of late; but overall the potential for the growth of Islamic investment vehicles and opportunities for asset service providers is growing. The launch of the HSBC Amanah Securities Services offering is predicted on two elements. One, the globalisation of Islamic investment flows. Islamic investment vehicles are domiciled in jurisdictions as diverse as Malta, Jersey, Luxembourg and the Cayman Islands. Two, there is a growing trend towards refining the definitions what constitutes compliance with Islamic law; witness the efforts by countries such as Qatar to reinforce segregation of Islamic and conventional accounts. Operating on the principles of Islamic law the Islamic value proposition, among others, prohibits interest (riba) and hold that business conduct should be on the basis of sharing profit and risk. Various estimates put the value of Shari’a compliant assets under management at somewhere around $150bn and rising, albeit slowly, providing a still well of business for custodians. At the end of 2010, Consultants Ernst & Young warned that the Islamic fund industry was showing signs of waning, with 27 Islamic fund liquidations reported in 2010, with only 29 new funds launched. The consultancy also points to the fact that many Islamic funds are relative minnows in a global context with many funds worth less than $100m. It is perhaps not surprising that Islamic funds do not always find it easy. Shari’a compliant fund managers have a

limited pool of assets to invest in, a shortage of religious scholars who can advise on the shari’a compliance of funds and a multiplicity of tax and regulatory environments that sometimes make it hard for demand for Islamic assets to thrive. Shari’a boards sometimes provide conflicting advice and some boards have charged exorbitant fees. Real estate, which has been a mainstay of the segment, has also had indifferent performance in many countries since the financial crisis, which has not helped to raise the value of many existing funds. All told it has been a harsh few years for the segment. With the Islamic investment services industry in flux; it appears timely for HSBC to launch a product offering predicated on rigour in both its internal processes and its service set that is fully compliant with Shari’a strictures. This involves even the terminology utilised with the fund administration service set. The bank’s services have been overseen by its independent Shari’a board which has confirmed the bank has under-taken the correct procedures to ensure it is fully Shari’a compliant, rather than being Shari’a friendly. In support of the bank’s measures it has issued a fatwa. HSBC Amanah Securities Services’ launch came only a few weeks after the central bank in Qatar issued a directive which requires commercial banks operating in the jurisdiction to either alter the status of their Islamic finance windows by the end of this year or close them. The move was billed as a serious effort to more clearly describe the distinction between Islamic finance from conventional commercial banking practices, where the central bank says risk is passed on to the customer. Other market watchers think that the central bank’s move has deeper concerns. Qatar’s conventional commercial banking operations handle and manage over 80% of banking assets in the country. The move is seen by some commentators as a reaction to complaints by the country’s Islamic banks that their business growth is hampered by conventional banks offering Islamic services through their Islamic windows. Many banks were taken aback by the ruling, including the country’s other leading banks, such Qatar National Bank, Commercial Bank of Qatar and Doha Bank, which will now have to now find ways to meet the central bank’s directive. Perhaps however HSBC Amanah Securities Services has two advantages in meeting these regulations: the strict adherence of its offering to Shari’a principles, dictating the clear segregation of Islamic accounts from conventional asset management funds. Second, that it has experience in the Malaysian market of operating a separate Islamic compliant legal entity. I

APRIL 2011 • FTSE GLOBAL MARKETS

ISLAMIC FUNDS

USING COMMODITIES MURABAHA TO MANAGE CASH Aligning a money management fund and Shari’a compliance doesn’t immediately spring to mind as a workable notion. Not so, says Chris Oulton, chief executive officer and founder of Prime Rate Capital Management, a provider of liquidity and fixed income products. Prime Rate has launched an Islamic liquidity fund, the first Shari’a compliant liquidity instrument of its kind. RIME RATE CAPITAL Management, which has £2.5bn in assets under management, has launched an open ended liquidity fund that invests in short term instruments that is compliant with Shari’a principles. Domiciled in Ireland, the fund is designated as a Qualifying Investor Fund (QIF), which will be listed on the Irish Stock Exchange. According to the fund management firm’s chief executive, Chris Oulton, the fund offers investors“a highly rated security that provides same day access to their funds and a competitive return within a Shari’a compliant structure.” Although the fund was initially launched in November, it is now readied for subscriptions. Oulton expects the fund to reach a minimum $250m in assets, “though it is difficult to see a top limit to a fund of this kind,” he adds. Oulton says the fund is designed to appeal to Islamic international investors who can utilise their investment in the fund to help manage their own liquidity; to banks and other institutions to distribute onwards to their clients and for use as the cash element in a Shari’a –compliant product structure. “We think it has appeal to a wide range of investors with different profiles,” he says. The fund is something of a departure for the money manager. “We are cash management specialists,” says Oulton. “We were approached with the idea of structuring an Islamic compliant investment vehicle that would leverage our strengths in the short term investment segment. In consequence and mindful of the ethical and principles based requirements of Islamic investors, we have structured a fund which we believe has appeal and application to both Islamic and conventional investors.” Oulton provides the example of a private equity fund with un-utilised cash, which could benefit from investing in the fund as part of a cash management strategy. The structure is backed by a fatwa issued by the Shari’a board of Yasaar Limited, an independent Shari’a consultancy, and is signed by four Islamic scholars, including Sheikh Essam Ishaq, Dr Mohammad Akram Laldin, Dr Aznan Hasan and Dr Mohammed Burhan Arbouna. BNY Mellon Fund Services is the custodian and fund administrator. The fund invests exclusively in commodity murabaha transactions, sourcing commodities from traditional market sources and utilises a multiple counterparty transaction structure, says Oulton. Because there is a physical commodity, such as metals, underlying the trade, the transactions can be structured to be Shari’a compliant. He cautions that there is a

Photograph © Eti Swinford / Dreamstime.com, supplied March 2011.

limit on the range of commodities that the fund is suited to investing in: “It can be a high value metal, such as platinum or a base metal; however it does not work with precious metals, which are viewed as cash equivalents or commodities which are hard to distinguish. It must be identifiable as a physical asset and warrantable,” he adds. Transactions involve the purchase and then later sale of commodities at a profit. The buyer purchases at a higher price through a daily deferred payment structure.“In other words, the buyer is paying a premium because he has had access to or use of the goods before he’s had to pay for it,”says Oulton. The fund invests 100% of its net asset value each night in a murabaha commodity transaction which is due for payment the next day: once payment has been made,“I am now back in 100% cash,” says Oulton, “allowing then the investor to draw down invested funds, should he require. You can see a deal every day, accessing the inventory of the London Metals Exchange (LME). We have created a unitised version of what investors do in the over the counter (OTC) market; in fact, we have greatly simplified what is a complicated OTC structure. Commodity murabaha structures or contracts based on LME commodities have been used by many GCC banks to manage liquidity positions and its appeal is spreading elsewhere. Malaysia, for one, is pushing ahead with efforts to encourage the establishment of interbank money market instruments based on palm oil. It has some form in this regard having established its own commodity murabaha structure back in 2007, with the central bank issuing notes backed by palm oil supplies, the country’s benchmark commodity. The central bank has now teamed up with the Securities Commission and Bursa Malaysia, to establish a market infrastructure based on the operational model of LME which, it hopes will encourage growth in commodity murabaha transactions locally.I

APRIL 2011 • FTSE GLOBAL MARKETS

ETFs

The ETF industry is definitely growing faster than the US mutual fund industry, which took more than 60 years to break through the $1trn mark. ETFs and ETPs achieved the same value in less than 20 years, but there are complications. The original concept of ETFs was that they were a low-cost, transparent, simple product. There is now much confusion because there are so many different innovations and variations. The feeling in the industry is that there needs to be more information about the different products available on the marketplace and what they are for. Some funds that call themselves ETFs are not even funds. Some products are not funds and there is a lack of transparency and clarity regarding the product structures and index replication methodology. Lynn Strongin Dodds reports.

KEEPING ETFS ON THE STRAIGHT AND NARROW product structures in the marketplace.”At XCHANGE-TRADED FUNDS the moment, there are various terminolo(ETFs) bucked the financial crisis and gies being bandied about with some enjoyed impressive double-digit providers using exchange-traded products growth this past year with providers (ETPs) as an umbrella for ETFs, exchangeboasting a flowing stream of assets under traded commodities or currencies (ETCs) management (AUM) as well as new and exchange-traded notes (ETNs) Others products. They have not only plunged make the distinction between the classic deeper into existing offerings but also into ETFs and bundle the other products under different asset classes and regions. The the ETP banner. Typically though, the defdanger though is that the industry will inition for ETCs are products that allow become too complicated and stray from investors to gain exposure to commodities its roots of being an easy to use, relatively and currencies without trading futures or inexpensive product. taking physical delivery. ETNs, on the other As Tom Rampulla, managing director of hand, are unsecured debt securities that Vanguard UK, notes: “The original concept pay a return linked to the performance of a of ETFs is that they were a low-cost, transsingle security or index. They are subject to parent, simple product. Now there are many counterparty risk in that the creditworthidifferent innovations and variations and ness of the issuer can have an impact on the that has caused a lot of confusion. There Photograph © Robnroll / note’s final return and value. needs to be more education about what the Dreamstime.com, supplied Although the definitions may vary, all different products are on the marketplace March 2011. agree that 2010 was a banner year and the and what they can be used for. There also pace is set to continue for the next few needs to be more due diligence conducted around the fund. Just because it has a low total expense ratio, years. Fuhr says: “We expect global asset under management it does not mean that the fund is of high quality. Investors in ETFs and ETPs to continue to grow at a rate of 20%–30% need to look at other factors such as how well the ETF is annually over the next few years. This will take it to approximately $2trn in asset AUM by early 2012. We estimate the tracking its index as well as the bid-ask spread.” Deborah Fuhr, global head of ETF Research and Implemen- US AUM will reach $2trn in 2013, with European AUM at tation Strategy at BlackRock, agrees, adding: “We are seeing $500bn in 2012. Overall, the industry is definitely growing funds calling themselves ETFs which are not even funds. faster than the US mutual fund industry which took 66 Some products are not funds, some do not provide trans- years to break through the $1trn mark—while ETFs/ETPs did parency on their underlying portfolios nor offer in-kind the same in 18 years.” The latest research from Fuhr shows that at the end of creation/redemption. I think there needs to be more clarity and transparency around the product structures and index January 2011, the global ETF industry boasted 2,501 products replication methodology. The performance, as well as the tax with 5,701 listings and assets of about $1.3trn from 138 and regulatory implications of using these products can be providers on 47 exchanges around the world. This compares very different. I believe that one of the challenges for the to 2,055 ETFs with 3,941 listings and assets of $984.0bn from industry this year is to agree on the definitions for the various 114 providers on 40 exchanges at the end of January 2010.

FTSE GLOBAL MARKETS • APRIL 2011

ETFs

David Gardner, head of sales for iShares EMEA, which is part of BlackRock. Photograph kindly supplied by BlackRock, March 2011.

Deborah Fuhr, global head of ETF Research and Implementation Strategy at BlackRock. Photograph kindly supplied by BlackRock, March 2011.

One of the main drivers behind the momentum is the collective push into passive products in the wake of the financial crisis. Disappointing performance from active managers focused the investment community’s mind on simple, more transparent and liquid vehicles such as ETFs. A recent report by US-based consultancy Cogent Research reflects these trends by revealing that, as of October of last year, 75% of retail investors owned mutual funds, a three percentagepoint drop from a year earlier, and 19 percentage points below October 2006. By contrast, over the same four-year period, the proportion of investors reporting that they owned ETFs rose to 11% from 7%. Other contributing factors are that the ETF industry has become more innovative. Products no longer just track the major indices but have expanded into fixed income, commodities, currencies and listed real estate. In addition, in the US, online brokers such as Charles Schwab as well as fee-based advisers have stepped up their marketing campaign. Moreover, there are a growing number of exchanges planning to launch new ETF trading segments, while regulatory changes in the US, Europe as well as several emerging markets have allowed funds to make larger allocations to ETFs. This does not mean though that investors have abandoned active strategies. Instead they are using both in a complementary fashion. As Manooj Mistry, the head of Deutsche Bank’s db x-trackers UK division, says: “There is a greater understanding of how the product works and the best ways to use them. For example, asset managers are using ETFs as tools to gain exposure to different markets and asset classes as well as combining them with active management. These styles are no longer seen as mutually exclusive and providers such as db x-trackers now market their ETFs as building blocks for a diversified portfolio.” Mistry notes ETFs are also adroit tools for taking advantage of market movements.“We are seeing many asset managers use ETFs as part of a core-satellite investment approach alongside active products, either for cheap beta or more short-term tactical moves. For example, if the markets fall, they can use them to quickly switch to bonds from equities or gain exposure to a particular sector or region.”

Manooj Mistry, head of Deutsche Bank’s db x-trackers UK division. Photograph kindly supplied by Deutsche Bank, March 2011.

David Gardner, head of sales for iShares EMEA, which is part of BlackRock, says: “The industry is definitely maturing and investors are much more at ease with the products. In Europe specifically we are seeing two major themes. Fund managers are applying much more rigour to selecting active managers and post-2008 have turned to ETFs for their beta exposure. They are also using ETFs to quickly trade in and out of markets without impact.“ As for the development of the European market, Gardner notes: “Although Europe is behind the US in terms of assets under management, the trajectory of growth is similar when looking at the double-digit growth rate. One of the main differences between the two is the constituents of the ETF market. The US has a larger retail base and hedge funds play a more dominant role while it is mainly an institutional market in Europe. This could change with the introduction of regulation such as the Retail Distribution Review in the UK.” The general consensus is that the European ETF industry should get a boost from RDR, which is to ban commission payments on advised sales from 2013. ETFs typically do not pay commission and this is why they have not to date been attractive to UK independent financial advisers. Another impetus is expected to come from UCITS IV whereby providers will have to offer a standardised “key investor information” document rather than a current simplified prospectus. This should make it easier for investors to compare and contrast products. However, despite the regulatory changes, few believe the European retail/institutional divide will reach the 50/50 split seen in the US. Recent industry studies show that retail investors are barely visible in Europe, accounting for only about a tenth of the market. Nizam Hamid, head of ETF strategy at Lyxor Asset Management, says: “Although I think the RDR will increase retail take-up, I do not see the same split between institutions and retail investors in the US. I think it will be 75/25 in Europe. The reason is that the savings market is different and does not have the same degree of retail participation as the US which is tax oriented self directed. There is also not the same degree of pension savings held in different vehicles.” I

APRIL 2011 • FTSE GLOBAL MARKETS

SECURITIES LENDING ROUNDTABLE

NEW PARAMETERS IN SECURITIES LENDING

Photograph by Herzog Images Photography (www.herzogimages.com), supplied March 2011.

Attendees

Supported by:

(From left to right) CHARLES RIZZO, chief financial officer, John Hancock Mutual Funds MARK PAYSON, managing director and global head of trading and asset liability management for securities lending, Brown Brothers Harriman JIM McDONALD, global head of trading for the securities finance business, State Street Corporation JEFF PETRO, head of money market trading, Federated Investors JOSH GALPER, managing principal, Finadium CHRIS POIKONEN, executive vice-president, eSecLending

FTSE GLOBAL MARKETS â&#x20AC;˘ APRIL 2011

ROUNDTABLE

INTRODUCTION & THE CHANGING RELATIONSHIPS BETWEEN BENEFICIAL OWNERS & THIRD PARTY LENDERS JEFF PETRO, HEAD OF MONEY MARKET TRADING, FEDERATED INVESTORS: Federated Investors manages approximately $350bn in assets, of which $275bn is in money markets assets, which fall under my trading responsibility. My team also has the securities lending responsibilities for the firm. We approach portfolio managers as customers in the program, evaluate lenders, drive the RFP process and monitor the program with our custodian. Managing the securities lending program for Federated also involves reporting to the chief investment officers on a quarterly basis, participating in the credit process, and then ultimately cash reinvestment. I’m learning that we may be a bit different than other mutual fund companies, which have a dedicated business area for securities lending. There’s a different feel from the beneficial owners these days and clearly a turn from the standpoint of responsibility. These days there is a definite need to understand and report how your program is performing, but more importantly, where the true risks are. CHARLES RIZZO, CHIEF FINANCIAL OFFICER, JOHN HANCOCK MUTUAL FUNDS: Our security lending program is a multi-billion dollar program and we exercise a lot of operational and compliance oversight within the fund administration team. The collateral vehicle is managed in-house by our affiliate investment manager, John Hancock Asset Management. Over the past few years I have sensed more openness with regard to lending agent’s operational platforms. Clearly, there’s a lot more transparency provided to beneficial owners on operational controls.You see a lot more SAS 70 reports being done and a greater willingness of allowing onsite visits to observe operational practices and controls and to talk to the personnel involved in your lending program. Moreover, understanding the risk practices, compliance controls, policies and procedures is extremely important, particularly with programs like ours with welldefined risk parameters the lending agent needs to comply with.You have to make sure that the security lending agent is able to take those risk parameters and guidelines, embed them into their platform, and monitor compliance daily, with exception-based reporting a best practice. MARK PAYSON, MANAGING DIRECTOR AND GLOBAL HEAD OF TRADING AND ASSET LIABILITY MANAGEMENT FOR SECURITIES LENDING, BROWN BROTHERS HARRIMAN: I am responsible for overseeing three regional trading desks in Boston, London, and Hong Kong, and for management of our asset liability process. Beneficial owners are starting to realise that there were two radically different experiences over the last few years and that certain groups performed better from a securities lending perspective than others. These differences were largely based on differences in the lending philosophy employed by the beneficial owner, and those that participated in value lending programs performed better. Employing

a value lending philosophy wouldn’t require radical changes or be too much of an effort for the plan or client, yet can yield very different results. Second, people now realise that it’s important to understand how each dollar of revenue from securities lending activity is generated—is it from collateral reinvestment, a risk trade or a collateral downgrade trade, or an intrinsic value trade? Then for every dollar of revenue generated, beneficial owners now better understand how much risk they are incurring. These changes have been a huge benefit to all industry participants. JIM McDONALD, GLOBAL HEAD OF TRADING FOR THE SECURITIES FINANCE BUSINESS, STATE STREET CORPORATION: We manage a comprehensive agency lending business for a diverse global client base. In my role I am responsible for the distribution of assets, which is done across six global sites including Boston, London, Toronto, Hong Kong, Tokyo and Sydney. This global scope brings significant value in evaluating the assets we are managing. Essential to the role is having a broad understanding of the supply and demand dynamic in the market and then developing strategies that yield optimal returns for each customer. Part of this process is offering the appropriate collateral options for the lender. Our program manages multiple currencies in cash and a varied selection of noncash collateral in order to best fit with client interests. Beneficial owners do generally have a higher level of engagement with the lending process now and have become more active participants in how the product is managed. In addition to offering a high level of transparency and communication, our role as agent is working with clients to define their specific parameters and interests and then to best develop a strategy that aligns with particular expectations. JOSH GALPER, MANAGING PRINCIPAL, FINADIUM: Finadium is a consulting firm with a specialty in the asset servicing markets, including custody, securities lending, collateral management, and prime brokerage. We also publish a research subscription ten times a year. Parts of these are surveys of market participants, including beneficial owners. Other reports focus on more topical or regulatory issues. In our experience from our surveys, the main change that has occurred in the last two years is a very strong focus on communication in risk management. In our latest survey of US plan sponsors we found that communication in relationship management was a more important driver of quality service from an agent lender than even revenue generation. We think this trend is going to continue and speaks to the increased oversight that plan sponsors and other beneficial owners are putting towards their securities lending programs. CHRIS POIKONEN, EXECUTIVE VICE PRESIDENT, ESECLENDING: eSecLending is an independent third-party securities lending agent. We have a global footprint with offices in Boston, London, and Sydney. I’m responsible for global business development and strategy focusing on all valueadded growth opportunities across our business lines. With respect to trends, we are seeing beneficial owners not only request, but expect highly customised solutions from their securities lending providers. They are no longer satisfied with an

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off-the-shelf product and favour a tailored service offering that addresses their unique needs. Beneficial owners realise that they can have their program managed their way, as opposed to being subject to a greater pooled approach where they are merely a participant. There is also a clear focus from the beneficial owner community on risk management and overall best practices as it relates to securities lending.

MARKET COMPLEXITY & NEW ROUTES TO MARKET: HOW BEST TO MANEOUVRE IN THIS ENVIRONMENT? JIM McDONALD: It is incumbent upon the agent lender to understand all the different routes to market and the different products that exist to generate securities lending returns. Our primary objective as the agent should be in understanding and then properly explaining all the options in order to optimise returns for the beneficial owner. There are numerous ways in which a lender can access the lending market. Even within a traditional discretionary lending model there are varied methods for tailoring participation in the market. Each of the routes may have their pros and cons and the results may be completely different for any one specific beneficial owner. It should be the responsibility of the provider to introduce their client to the options that exist and work with the client to implement something where it makes sense. If the client is looking at generating securities lending-type returns through synthetics such as single stock futures or swaps, the key is in understanding the goals of that client and that the risks are clearly defined as part of the process. CHARLES RIZZO: Whether you’re talking about an agent lending program, an auction market, or an exclusive based model, with possible performance upside on stated guarantees, there are a lot of different ways in which beneficial owners/mutual funds can generate lending fee revenue through the lending of securities. One area that maybe a service provider could do better on from my perspective is to consider all the various lending options and consult with the beneficial owner on opportunities to increase lending revenues given any stated risk parameters of a particular program as the market is continually changing. Instead of waiting for the client to come and ask whether an auction program for example might provide more intrinsic value versus an agency program, or asking whether is now the best time to get into an exclusive arrangement for certain fund portfolios, a security lending provider should be proactive. It is incumbent on the service provider to approach the client with revenue generation ideas and explain the risks and the benefits so that beneficial owners are better informed as to what opportunities exist and to facilitate good decisionmaking. There is perhaps a misunderstanding that the beneficial client understands everything about the various lending alternatives and how they function and which lending options may be better in certain market environments. I’m not sure that that’s the case with all beneficial

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Jeff Petro, head of money market trading, Federated Investors. Photograph by Herzog Images Photography, supplied March 2011.

owners. So the service providers need to look out after the beneficial owner’s best interests at all times which makes for a good relationship. JOSH GALPER: Our experience is that beneficial owners generally are not aware of the underlying options of routes to market, particularly when you get into topics such as central credit counterparties. This is somewhat surprising because, again, at conferences and various roundtables the idea of a central credit counterparty is brought up repeatedly. However, when you go and you speak with many beneficial owners and you ask them: are you aware of this, have you looked into this? Mostly the response is: well, we heard about it at the conference but we didn’t do anything about it. The result is that beneficial owners are relying on their agent lender providers in order to steer them in the right directions. JEFF PETRO: I represent a segment of beneficial owners that are very risk-averse. In my case, securities lending is an alpha generation activity and it remains the decision of the portfolio manager to take additional risk should he view it as alpha-worthy. I realise there are other mutual fund groups with a different lending profile, that weigh risk differently; but I know in my own firm that if it is perceived to be an undeserving risk then we’re out. So the barriers to entry on new routes may be a bit higher for a portfolio manager and/or a board as we deviate from our current risk profile. CHRIS POIKONEN: I believe the service side is able to provide high-touch services to their clients in this space. Most agent lenders have the ability to offer their clients multiple routes to market, whether that be an auction platform for price discovery, agent managed exclusives, discretionary lending on a best efforts basis, or the ability to embrace central counterparties. The key is for those providers to be able to offer full service agency based on each of their lenders’ unique requirements and their individual risk/return profile at a very high level. This is where you tend see the most differentiation from provider to provider in the marketplace. MARK PAYSON: The education level of beneficial owners varies widely; our clients are well aware of the options available, and pros and cons of each. What we try to do is educate them and ask key questions to understand their goals from securities lending and then to identify the route

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to market that will best achieve returns within the risk profile they are comfortable with. One of the challenges faced by our industry, particularly with the disruption we’ve seen, is the tendency to run away from what is still a very good product. At its core, securities lending had no issues through this credit crisis. The returns are strong and its risk background is tested. However, as we bring new products to market, such as central counterparties, the industry should be mindful of the speed at which this is done – doing this too quickly, for example to capitalise on a fear or short-lived inefficiency in the market, could work against the industry. We must first be able to articulate which beneficial owners will benefit from the new products and how. It’s important to have the tools available in our arsenal, but I would caution against change for the sake of change. JEFF PETRO: The ICI, which represents the mutual fund industry, has arranged for us to meet with the Federal Reserve on a semi-annual basis. Participants are sharing what they think are the current and future stresses in the market. These are very healthy conversations that cover everything from the very granular to the potential lightning bolt. CHARLES RIZZO: I have a couple of thoughts. It is really important for a securities lending provider to understand our risk philosophy, but we don’t want to have a service provider not ignore opportunities in the marketplace irrespective of the risk parameters we have set. Currently we have, for example, an asset cap on our lending program. So our risk committee has established a certain dollar threshold by which we don’t want to go over without the committee reviewing and approving any increase. Say our service provider came to us with a dividend arbitrage opportunity and proposes to us if we put on an additional X amount of dollars out on loan we could gain an additional amount of basis points. This example may require us to approve some guideline amendments to our program if we decide to move ahead. The service provider could have just said:“We can’t do this so we’re not going to communicate it to the client because they have certain rules and we have to follow them.” Even so, they’re guidelines and what we want is to make sure that our provider understands the guidelines and is following them, but where there are market opportunities, to present them and let our security lending working committee mull over the opportunity. The other example is that risk can come in different forms. I’ve gotten a lot of education recently on the novation process. It is a mechanism to keep loans outstanding for a longer period of time which I should state is not necessarily bad and in some cases very helpful and necessary. An example: Borrower A is returning the stock; the security lending provider could keep that stock outstanding by novating it to Borrower B. The issue with that (from a risk standpoint) is that it could be that the rebate rate being paid to the borrower is less favourable to the funds and more favourable to the borrower; because if that loan were to come back into inventory and get reissued it might pay less of a rebate to the new borrower due to a change in interest rates. Thus through novation a borrower can get a loan that pays a higher return on their cash collateral, hence

Chris Poikonen, executive vice-president, eSecLending. Photograph by Herzog Images Photography, supplied March 2011.

loan stays out longer, but fund does not maximize the intrinsic value on the loan. Therefore, just understanding the mechanics of the program and making sure that the lending agent understands how you want your program to be run is really important so that you are not taking risks or causing potential shareholder dilution because you’re not maximizing the spread. JOSH GALPER: In terms of associations with beneficial owners, the Mutual Fund Directors’ Forum has taken steps to educate mutual fund boards about securities lending and best practices. I don’t see anything similar on the plan sponsor side. In terms of the beneficial owner’s responsibility to communicate with their agent lender, I agree that in a best-case scenario there should be very active communication and the plan sponsor should be able to say: “These are my parameters,” and have the agent respond. In reality that works for the top 5% to 10% of the largest funds. There are hundreds of participants in the securities lending market who don’t have the staff or the know-how to have that conversation with their agent lender. Although securities lending is now perceived as an investment product by pretty much everyone, as opposed to a back office product, I still think that there is a gap in that final step of communication so that both parties have a good understanding of why the plan sponsor or mutual fund or insurance company is engaged in lending, and for the agent to be able to be proactive for that client. MARK PAYSON: I agree that there is still an education and communication gap across some sections of the market, particularly US plan sponsors. As an industry, we need to continue to re-build trust with beneficial owners. We do not see this among our clients, but there are beneficial owners who still mistrust the marketplace. There is also concern over the alignment of interests between beneficial owners and securities services providers. To continually build trust among beneficial owners, I think the industry needs to spend a lot of time with beneficial owners when introducing new routes to market, new markets for lending, new collateral types, etc. As a firm, BBH spends a lot of time doing this, and as a result we know our clients feel comfortable with the parameters and risk profiles of their programs.

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When the industry experienced issues during the financial crisis, there were no surprises for our clients. They fully understood the risks involved, accepted and managed them, and came out of the crisis in a good position because of it. CHRIS POIKONEN: From our perspective every one of our clients is a separate and unique book of business. We do not commingle assets or utilise a queue or an algorithm to distribute individual client assets to the market. We create customised securities lending solutions based on the specific requirements of each of our clients. No two accounts are entirely alike, so we do not look to offer a one-size-fits-all approach to lending. We spend a significant amount of time understanding our clients risk return profile and their expectations at the outset. Clients tend to be very clear with us on how they want their program managed so there is no misunderstanding when we begin lending on their behalf. The risk and performance management process is continually reviewed with clients to ensure that we’re delivering what they expect of us. FRANCESCA CARNEVALE: It seems beneficial owners are asking the service side to step up to the plate. Irrespective of whether you are a custodian lender or not, how do you differentiate the sort of quality of care that the beneficial owners seem to be asking you to provide? JIM McDONALD: I think it has always been that way. It’s about understanding your customers and their expectations, and then designing a product or a program that meets those requirements. We run a very large and diversified program, and it’s not a one-size-fits-all offering. For example, some fund complexes are looking only to lend specials in the equity market, but there are many lenders interested in lending their more liquid assets as well and that product may include a cash investment product. It is a very wide and varied market and it is imperative that the lending agent be skilled at achieving the appropriate value for all the assets they manage.

VALUE GENERATION, RISK & BENCHMARKING JOSH GALPER: Our view is that there’s a quantitative component and a qualitative component to benchmarking. The quantitative component is very useful to help you know where you stand vis-à-vis your peers. The qualitative component is a lot trickier. It involves understanding what your risk parameters are, what the market’s risk parameters are, how you view your program, how you interact with your agent lender, what you get from your agent lender, what you pay for those services, and what you pay for those services in relation to the other relationships that you have with your agent lender, whether in custody or cash management or some other services. We’ve actually worked quite hard on benchmarking. Our solution is a combination of helping beneficial owners get the quantitative data that they need but also providing a level of education that lets a beneficial owner make their own decision about benchmarking themselves. With appropriate information, including understanding market trends, understanding peer behaviour,

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and the surveys that we do, a beneficial owner can then sit back and say:“Okay, if I want to benchmark our firm against our peers we have these quantitative data, we have some quantitative data points, and we have this education—this market intelligence piece, if you will—that informs us about market risk.”We feel that that’s the best way to go. JEFF PETRO: It has been a very difficult process to try to understand benchmarking appropriateness and accuracy. It seems to me like it’s a bit like a 529-Plan. It’s hard to match apples to apples, and although providers may disagree, I believe it is still a work in progress. I’ve never seen myself compared to the market and losing. I don’t know how everybody wins. I question that. Realistically, I don’t know how you compare it unless you take the same portfolio, pick two different lenders and utilise a best execution service. It really is that specific. It’s pitting two things that are inherently imperfect against each other. So from that standpoint I haven’t found it to be satisfying. The other thing is that there’s not a lot of money to go out and pay for this service in this low income environment. CHRIS POIKONEN: Before value generation strategies are discussed with a lender, you must first understand their appetite for risk. The risk management discussion helps us build their program around their requirements and helps us manage their desired lending strategies with clarity. Once the risk management framework is firmly in place, we can then look to maximize returns based on the agreed parameters. With respect to benchmarking, we believe that securities lending is still an inefficient marketplace. The various data aggregators have done a great job establishing tools to help participants understand market level activity. That said, benchmarking is still not an exact science in this business. We consider these the best available tools to help monitor performance generally, but they are not the only way to quantify performance or provide attribution analysis for a given lender. The lending agent should be in the best position to offer additional value added information and reporting to help explain client specific performance or peer group analysis. MARK PAYSON: Benchmarking data is available but the problem is that it is an imperfect tool. As such it should be used an indication of performance rather than an absolute fact. There are so many variables in each trade and across each client that perfect benchmarking is impossible to achieve in our industry. It is important to acknowledge that while you want to add value to all beneficial owners, the level of customisation that an agent can provide is dependent on the beneficial owner’s portfolio structure. If I break it up generally into two worlds—intrinsic value and general collateral—we need to acknowledge that one agent cannot trade general collateral any better than the next. GC lending is screenbased, non-OTC and as such there isn’t much room for added value. The value-add is in having an agent that can efficiently manage the asset and liability sides of the equation. This is an entirely different skill set than in the equity lending market. We do provide benchmarking, and we’re very comfortable showing exact and detailed results. We don’t win on every individual name, but our job is to ensure that on a like

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Josh Galper, managing principal, Finadium. Photograph by Herzog Images Photography, supplied March 2011.

portfolio we’re beating the market benchmark by what we think is a pretty substantial margin across all asset classes. Benchmarking can get a little expensive for the agent lender, but it’s required in order to give clients additional comfort that they’ve selected the right partner to execute their trades. It is vital for beneficial owners to ask themselves if their business fits within an agent’s sweet spot: can this agent generate value in a particular space? If the answer is“no”, it is probably best to go somewhere else. JIM McDONALD: Mark’s right, it’s more than just a benchmark. Moreover, single-stock benchmarking can be very misleading and there are so many variables that are moving positions around on a daily basis. What you want is for your provider to show you that it is worth taking a look at some of those different products and then use industry data, if you can, to understand what is your return, how did the agent lender get you to that return, and how much is involved in collateral versus the value of your positions. Then consider whether or not it is aligned with your expectations and what you believe to be acceptable against the somewhat opaque system of benchmarking as it exists today. CHARLES RIZZO: Managing risk versus being reactive to risk is interesting to me. We’re in a stable environment right now and it seems to me now is the time to really take a holistic looks at your program and understand where your risks are. I know there are a lot of tools out there that beneficial owners could utilise to help them better understand how their programs are going to react to certain market events, such as risk-adjusted performance, valueat-risk, spread variability and NAV variability risk analytics. A lot of providers on their websites have these tools; but it is not clear to me that all clients understand how to use them. That provides a real opportunity for lending providers to go to those clients that really don’t have their focus on risk planning and maybe help them understand what the risks are and how these risk tools may help them. How you use those tools in a way in which you can understand clearly what risks could occur if certain events

transpire and have appropriate policies and practices in place to be able to manage potential risks is important. From an intrinsic value standpoint there are potential conflicts when you have assets that are general collateral in nature and also specials or higher value loans. Trying to determine if you’re getting the best price on a special when you have a lot of GC balance is difficult without appropriate benchmarking. At some point there is an opportunity to maybe have a second or even a third provider where, if you’re smart about how you allocate those portfolios, you could construct it so that similar portfolios are at each provider; and so the types of names that are in those portfolios, that are being lent out, provide sort of an internal benchmark so you can compare your values putting one provider revenue numbers versus the other. It might even drive that provider to be more motivated to push harder for more value for you. Industry benchmarking tools also can be useful in comparative lending analysis.

ALTERNATIVE STOCKS, ETFS & JUDGING RETURNS JOSH GALPER: The introduction of other kinds of products, such as ETFs, into a lending program isn’t an earth-shaking event. It looks and feels like an equity product. I don’t personally think that that’s been a driver or a major factor in creating change in the securities lending industry. JIM McDONALD: I don’t think it’s necessarily the lender participating in those products that’s having an impact on the move away from specials in the equity space. It’s more the dynamics on the demand side. What you see from the demand side is a lot more trading around ETFs and indexbased products in order to get short exposure, whether it is for hedging purposes or exposure without going big into specific names. We’ve seen a certain reduction in the overall specials to a general collateral type of relationship over the last couple of years. Currently it’s relatively low on a historic basis. I do think that’s just the changing dynamic around the level of leverage in the market, how people are trading positions, and how they’re getting exposures in their portfolios to the short side of the market. The result is that you will see more demand for ETFs and other products of that nature. Even so, even with ETFs, there’s a lot of growth potential. You’re starting to see those products show up more in portfolios, but it is not ubiquitous. MARK PAYSON: I agree with Jim—the introduction of ETFs and indexing products is more of a demand side issue. Their value will be, like many products, cyclical in nature. Currently there’s a lot of regulatory ambiguity, there’s a lack of conviction; along with all of the factors we’ve been discussing that provide challenges to the demand side. These products offer an easy way to hedge, a safer way to make some bets without having strong conviction on individual names. That will change as we move into the latter half of 2011 and into 2012. ETFs will still be in demand from a lending perspective; but I would expect the number of stockspecials to rebound closer to 2006/2007 levels.

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CHARLES RIZZO: The ETF market clearly has had explosive growth, and with basket creation and hedging against the ETFs, that clearly is creating loan demand and should continue. Offsetting that has probably been the deleveraging going on within hedge funds so, from a beneficial owner perspective, those two forces are sort of going against each other. Long term, to the extent that we are now starting to see the hedge funds getting back to normal and you have ETF growth happening, it should create a good dynamic for a lending environment where you have a lot more borrowers competing for the names in your portfolios. In turn, this will hopefully generate better value creation for beneficial owners.

WHERE IS OPPORTUNITY KNOCKING? CHARLES RIZZO: I have an interesting opportunity, actually, and there are a lot of investment vehicles that use leverage as part of their investment strategy. Closed-end funds are a good example. The way lending comes into play is that there are a lot of banks that will offer credit facilities for leverage. One way to lock in very favourable financing is to engage in what’s called rehypothecation. Rehypothecation is just a fancy word for security lending because typically in a financing arrangement you have to pledge securities through the custodian bank in the name of the credit provider to secure that financing. The financier will take those pledged securities in a rehypothecation program and then use those securities for their own internal purposes as a means to get cash as part of financing their own operation. So you could take a name in a portfolio that’s pledged to XYZ Bank. XYZ Bank could then take that and put it into its own lending program and lend it out to a borrower to generate cash. This is a way for leveraged closed-end funds to secure a very competitive market rate on its financing and generate some additional performance by sharing in the revenue generation through the use of rehypothecation, which a lot of people may not know about. It could clearly advantage commingled investment vehicles that utilise leverage. That’s definitely one opportunity I see out there. MARK PAYSON: When the demand side turns around, it will create increased returns in securities lending. There are still new markets opening in South East Asia, Latin America and other areas; and alternative ways to generate returns via different forms of collateral, whether it be non-cash or equities. These are all areas that clients, working with their lending agents and consultants, can explore. However, I would encourage clients to make sure they’re getting many different views and many different opinions and that they truly understand the opportunities available, but importantly some of the changes that would need to be made to their programs. Different routes to market, whether exclusive or agency, single-stock futures, or a central counterparty via an exchange, are tools at everybody’s disposal. As beneficial owners re-engage and become more comfortable with securities lending, agents can use these routes to market, if appropriate, as a tool to help enhance returns.

FTSE GLOBAL MARKETS • APRIL 2011

JEFF PETRO: I continue to do analysis on lending our short assets. There’s a growing need to borrow Treasury bills, so I must determine if the benefit to the shareholder outweighs the perceived liquidity and credit risk. Also, lendable assets in our UCITS funds are growing and we want to continue to explore these opportunities. We are in Europe right now, but we’re trying to look a little bit more across the globe. So, from our standpoint, we’re hoping that’s where the growth is. JOSH GALPER: I see one clear-cut opportunity and one ambiguous, difficult situation that create both opportunities and challenges. The opportunity is in self-lending. A beneficial owner that has a long-only account and then a separately-managed long/short account can arrange for the long account to lend to the long/short account. That can happen all in one custodial house or in an arrangement between a custodian and a prime broker to lend to a particular hedge fund: there are a lot of different ways that that can go. It’s a real opportunity for plan sponsors and mutual funds and insurance companies to maximize their revenues. The challenge that I see is Basel III, which has phenomenal and tremendous impacts on the securities lending and collateral management markets. On the one hand, it could create a dramatic new set of winners and losers; by securities lending agent and also by product. On the other hand, there are some real constraints to how banks currently do business right now. In fact, I’d bring up rehypothecation as something that will be under some tremendous strain once Basel III becomes fully implemented. I’d also say that different agent lenders have groupings of clients that are more used to doing business in a certain way that will be more conducive to Basel III. Other agent lenders have clients that will look at the requirements of Basel III and might be a little more reticent or might need education in order to change some practices. JIM McDONALD: Some of the opportunities are dependent upon the demand side of the market. We do expect that there will be an increase in opportunities as the year progresses and trading patterns return to more normal conditions. The demand side of the market has been heavily

Charles Rizzo, chief financial officer, John Hancock Mutual Funds. Photograph by Herzog Images Photography, supplied March 2011.

ROUNDTABLE

weighted to the long side of the equity markets which has constrained borrowing needs, but we do expect that will begin to reverse at some point and in doing so means some leverage starts to be deployed to the short side of the market again. Some of the markets that we’re looking at in the emerging side are starting to open up further such as Taiwan and Brazil. There is also opportunity if you have lenders that are interested in a flexible collateral profile. If you have flexibility in collateral and have an agent with the expertise in managing the collateral you will match more directly with the interests from the borrower base and can earn material spread. Due to regulatory direction or just balance sheet management, the traditional borrower base is incentivised to utilise their assets more efficiently than they have been in the past. A secured lending transaction that is collateralised through a direct pledge of assets or through a repurchase agreement with those same assets can be a good risk return trade. An example might be an equity lender that lends secured against liquid equities as collateral resulting in a highly correlated transaction that can produce additional yield. There is definitely opportunity in this trend for lenders around the globe. CHARLES RIZZO: I’ve noted that not all agent providers have the capability to do the bonds borrow model in the US. The US is primarily a cash collateral market. If we see continued low interest rates for the foreseeable future and unemployment is sort of staying where it’s at and inflation isn’t picking up, there’s no real need for the Federal Reserve to hike rates, certainly in the short term. What does that mean in terms of investment risk or the ability of the manager to create alpha in the portfolio by generating a yield above the Federal Fund’s rate? So you may find that the bonds borrow model (to the extent that the supply side has come up with an operational model to share with their clients) could be an alternative lending model for certain programs. It takes away the investment risk in the current cash reinvest model where certain managers could be reaching for a higher yield and getting into asset classes that aren’t really matching up with the short-term liability nature of the lending program like we saw during the credit crisis. Maybe it is an alternative that people should look at. I just don’t think that right now a lot of the providers have that capability. Some do, some don’t. CHRIS POIKONEN: If I can speak from the demand side perspective for a moment: they will tell you that if you could appeal to their term funding needs (i.e. locking up assets for 90 days or greater) you will realise significantly greater returns than when compared to shorter duration activity. These lenders would also appeal to a much wider audience of counterparts who have specific requirements imposed upon them by new or perceived regulatory changes. This is a huge opportunity for select beneficial owners that might have liabilitydriven investments held to maturity or who are long cash for an extended period of time. That said, a good majority of beneficial owners cannot or will not look to engage in these term transactions regardless of spread due to the perceived or real risks associated with a transaction. From a lender’s per-

spective I still think the greatest opportunity from a risk/return perspective remains yield enhancement for tax disadvantaged assets. It is a short duration trade that generates a relatively large return when all things are considered. In this environment, lenders do not have as many opportunities that offer them as much spread in as short a period of time. CHARLES RIZZO: Clearly, that is one way to enhance the yield in a cash collateral vehicle if you can match up a security loan term with an offsetting investment in the collateral investment vehicle of say similar duration. That is, it has a longer-term maturity to it and possibly could pick up additional basis points. The problem that you could have is if you’re in a 40 Act Mutual Fund that’s registered as a money market fund; those types of securities in a portfolio could be deemed to be illiquid. Moreover, you have a 5% illiquid bucket right now under the money market reform rules. So it really limits the opportunity you have to go to your agent lender to do term borrows because you don’t want to be long on the liability side, and not be able to match that up on the portfolio side. Term borrows may be a better fit in a registered money market vehicle managed under the old money market roles which allowed for a 10% liquidity bucket, and a 90-day weighted average maturity instead of 60 days. Alternatively you could go into a partnership structure which may provide you a little more investment management flexibility. So depending on the structure you’re in you could use term loans to your advantage to pick up additional yield on the investment side because the manager could then go longer out and pick up additional basis points. However, be aware of the risks associated with investments that are not liquid as meeting cash margin calls during periods of market volatility can be challenging.

THAT OLD CHESTNUT REGULATION: WILL VOLUMES RETURN? WILL INNOVATION BE STYMIED? CHRIS POIKONEN: When new regulation discussions began in the marketplace, many demand side participants slowed or halted their activities altogether as they attempted to understand how these newly-proposed rules might impact them. This pause had a natural knock on effect to the lenders, as there was less lending volume, less spread opportunities and subsequently less revenue to go around. Now, once you have clarity on these regulations, one should expect participants to quickly adapt to the new norms. The end result will likely be increased volumes, increased spread opportunities and increased returns for those participants who remain active in the lending markets. JEFF PETRO: Because of so much regulatory reform, we clearly saw a pause with respect to borrower uncertainty. For my part, I sense the return of growth in the hedge fund industry beginning to make a difference in utilisation. Whether that’s because regulation is clearly behind them or they are growing organically, I can’t be sure.. JOSH GALPER: Regulation is going to create a necessity, and that necessity is the mother of innovation in this case.

APRIL 2011 • FTSE GLOBAL MARKETS

Mark Payson, managing director and global head of trading and asset liability management for securities lending, Brown Brothers Harriman. Photograph by Herzog Images Photography, supplied March 2011.

There are substantial conflicting regulations both at the global level and also at national levels that are going to play out in securities lending and collateral management over the next couple of years. That will require pretty much everyone in financial markets who deal in these areas to react very quickly and really think through their current product offerings and where they go. MARK PAYSON: The speed with which we will get some clarity is the most important thing. Nobody’s going to play with their money when they don’t know the rules in which they’re operating. I have no doubt that innovation will prove out. While I don’t know definitively what the final form will be, there will be a somewhat dramatic shift in the services provided by the various market participants. Longer term, I think we’ll be better off than we’ve been in the last couple of years in terms of both profitability and opportunity. JIM McDONALD: It’s important that everyone stays involved in the process as rule-making goes forward. Changes in regulation often present challenges and opportunities and it’s important to stay involved with the process to help avoid any unintended consequences that could be detrimental to the market.

THE DEBATE OVER THE ROLE OF CENTRAL COUNTERPARTIES: GOOD OR BAD FOR THE INDUSTRY? CHRIS POIKONEN: The debate about the use of a CCP model for securities lending is healthy for the industry. If we just focus from a US perspective, there are clear benefits to the interdealer marketplace and the beneficial owners. These benefits include price discovery and greater distribution to a wider universe of counterparts. There is also the opportunity for this model to evolve over time and possibly offer benefits to the short term cash markets. It is important to understand the pros and cons of any distribution channel, but there does not appear to be any downside to having more options. I believe that this debate will certainly continue, particularly if regulatory changes force the industry in this direction.

FTSE GLOBAL MARKETS • APRIL 2011

JIM McDONALD: The way this conversation has evolved of late is interesting in that it derives more from products being introduced to the marketplace rather than at the request of the consumer. I don’t believe that most lenders came out of the crisis identifying counterparty risk as their greatest issue so I don’t know that the concept is answering what would be considered to be a real need. Certainly, it’s important for lenders to look at what products are available, to understand what the benefits may be, and also what may be the limitations. Obviously regulatory consideration for the use of a CCP for securities lending requires watching but currently, I don’t think it is answering a compelling question for the beneficial owner. JOSH GALPER: As Mark noted earlier in this conversation, securities lending didn’t have a problem of any great stance. Even the failure of Lehman Brothers did not create any major problem. In fact, I know very few firms that had to use their indemnification at all. Most, if not every single one, were able to buy in securities using collateral on hand. As the conversation about CCPs goes forward it’s important to understand what problems they do solve in the market and how they can be used to the greatest benefit for the widest variety of market participants. My biggest concern is that regulators look at over-the-counter derivatives and CCP markets and then look at securities lending and align the two in one way or another, and slap the CCP model onto securities lending without thinking through what are the implications. So that is an ongoing concern for me. JEFF PETRO: It’s interesting because in September of 2009 during an SEC roundtable, regarding central clearing counterparties, the lenders on the panel were rightfully fighting for their right to determine price discovery. Once the realisation came that the SEC was not backing down, everybody began to embrace this new player. I believe that there has been a level of co-operation and acceptance among market participants. From the standpoint of the beneficial owner, we can’t tell if our utilisation or price discovery is enhanced because of this acceptance. Nobody really knows what it means to them at this point. But, again, it’s going to be a rush to knowledge at some point. CHARLES RIZZO: It is not clear to me yet on how an exchange or clearing house-type model is going to benefit beneficial owners. There are some aspects to it maybe that are appealing, I guess price transparency being one and possibly increased demand as borrowers get supply from one facility. We don’t really have problems with counterparty risk issues. Many of us have agent lenders that use multiple borrowers diversifying borrower risk and offer indemnification on loan issues. The risks that happened were more on the investment management side than on the lending side. We’ll have to wait and see. It is an interesting question: if these clearing house models have been out there for a few years, why haven’t the custodian banks and agent lenders used them to any great extent, to lend through those networks? In periods of market stress, it would also be more difficult to manage margin calls as the relationship aspect of the loan borrower is lost in a clearing house model.

ROUNDTABLE

MARK PAYSON: It’s the interdealer market that’s really using this right now. However, there has been some confusion in the market and many people aren’t sure if we are talking about a central counterparty, an exchange, or both combined. With any exchange, even if it is combined with a central counterparty, you need liquidity to give it validity. BBH will continue to support conversations around the product and then enter at a point in time when we think it is beneficial to our clients and the strategy they’re trying to employ. Charlie is right though, the discouraging part is that no matter how many prospective clients and beneficial owners I talk to, I find that they still don’t understand how a CCP works for the securities lending business, and specifically they are concerned that a CCP model gives them less control over the counterparties they are trading with, and the collateral that they are taking, than their current agency lending program. Add that to the potential for having to put up margin, which they don’t need to do today, and this translates into a lack of interest in the concept right now. Again, there may well be a place for a CCP, and that could be in the interdealer market, but right now we don’t see many beneficial owners looking to participate. JEFF PETRO: I met someone yesterday who had an interesting take on this. He said:“We don’t want you to embrace a product because we’re telling you to or the SEC is telling you to. We want you to embrace it because we think it’s the right product for the market. Until that happens nobody should embrace it”.

PREPPING FOR THE FUTURE CHARLES RIZZO: I want to learn more about expanding use of risk metrics and analytics and how can they be used as predictive tools so that we can do additional predictive modeling scenarios. From that standpoint, education is good and it allows me to think about things that maybe others are doing so I can adopt some better practices in terms of how lists can be better managed. So that’s really exciting. CHRIS POIKONEN: The take-away for me is to continue to listen closely to our clients. What solutions are they looking for from their service providers? What additional help and guidance do they need to achieve their goals in this space? How do they feel about the changing landscape and are they properly informed? We have to keep in mind that clients have many choices, and one of the choices is not to participate or to make changes. Providers have to innovate and plan for the future or risk being ill prepared for what the market brings next. MARK PAYSON: I’ll continue to listen to dialogue, to take a critical view of the business that BBH is offering to the market and to proactively educate both prospects and current clients objectively on what we’re seeing in the market, where the changes are going. While it is too early to define the final outcome, regulation will play an enormous part in the future of our industry. The industry has come out of a very difficult few years and we’re all in this business to make money for our clients; but we need to make sure this is being done in a

Jim McDonald, global head of trading for the securities finance business, State Street Corporation. Photograph by Herzog Images Photography, supplied March 2011.

smart, intelligent way. While we know securities lending is an investment management product, nearly all beneficial owners will acknowledge that their intention is not to use securities lending as a true alpha-generating product. Instead, most mutual funds will say it’s about shareholder value. So they are definitely focused on generating revenue, but within an intelligent framework. JEFF PETRO: I believe that the real challenge is going to be another 12 months of zero to 25 basis points Fed Funds. My firm is an active participant in Tri-Party Repo reform effort within the Federal Reserve-sponsored Payments Risk Committee. I realise that this effort and other positive market technicals are going to weigh heavily on short rates for the rest of this year. I also realise that when beneficial owners say they are going into 2A-7-like products, or 2A-7 funds, they have to realise that that’s going to push down their utilisation and income to an even lower level. Will they tolerate 15 basis points return or ten basis points return or five basis points return? Do we go back to more risk for increased utilisation? I’m saying the landscape, to use Chris’s word, is going to be different when we come here in 2012. I believe that there will be fewer beneficial owners that will participate in the market that I just described. I also do not know what will happen to the lender community. I need to make sure that my lender is focused on my products and my best interest, even in this environment. Can the lender community sustain another year of zero interest rates? I really believe it’s a challenge, and, in the here and now, it’s a bigger challenge than rising interest rates. JIM McDONALD: It is an evolving marketplace and it can be a very complex product. Right now, it’s clear that it’s about having a dialogue with beneficial owners to help them to understand what the opportunities and challenges are going forward. The key is listening and understanding what their expectations are, and then working to align those with reality in order to deliver opportunities for customers going forward. JOSH GALPER: Our challenge over the next year is figuring out how to best communicate with beneficial owners in a way that is straightforward, encapsulates some of the major issues that they’re facing, and helps them look to a forward-looking stance about their participation in various activities in asset servicing.I

APRIL 2011 • FTSE GLOBAL MARKETS

(Week ending 18 March 2011) Reference Entity

Sector

Federative Republic of Brazil Government United Mexican States Government Republic of Italy Government Bank of America Corporation Financials Republic of Turkey Government JPMorgan Chase & Co. Financials Kingdom of Spain Government MBIA Insurance Corporation Financials General Electric Capital Corporation Financials Telecom Italia Spa Telecommunications

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Sov Sov Sov Corp Sov Corp Sov Corp Corp Corp

15,393,819,871 8,529,697,367 27,437,432,479 5,835,200,778 6,724,269,165 5,096,394,509 18,838,384,310 4,717,100,340 11,837,927,199 2,736,533,562

171,579,851,591 122,735,964,456 304,860,412,048 79,909,624,608 142,334,065,678 81,379,726,561 165,801,243,100 82,066,821,982 100,936,499,025 72,647,479,985

11,991 9,715 9,224 8,646 8,519 8,440 7,949 7,897 7,867 7,528

Americas Americas Europe Americas Europe Americas Europe Americas Americas Europe

Gross Notional (USD EQ)

Contracts

DC Region

304,860,412,048 87,027,736,433 165,801,243,100 85,201,260,449 171,579,851,591 59,111,939,517 100,936,499,025 122,735,964,456 80,481,592,985 49,788,989,230

9,224 4,514 7,949 2,650 11,991 4,396 7,867 9,715 4,241 5,457

Europe Europe Europe Europe Americas Europe Americas Americas Europe Japan

Top 10 net notional amounts (Week ending 18 March 2011) Reference Entity

Republic of Italy French Republic Kingdom of Spain Federal Republic of Germany Federative Republic of Brazil UK and Northern Ireland General Electric Capital Corporation United Mexican States Portuguese Republic Japan

Sector

Market Type

Government Government Government Government Government Government Financials Government Government Government

Sov Sov Sov Sov Sov Sov Corp Sov Sov Sov

Net Notional (USD EQ)

27,437,432,479 18,887,470,679 18,838,384,310 16,606,647,084 15,393,819,871 11,912,482,959 11,837,927,199 8,529,697,367 7,550,128,939 7,428,209,586

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 18 March 2011)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

Corporate: Financials 3,291,969,429,569 Sovereign / State Bodies 2,612,969,118,395 Corporate: Consumer Services 2,200,112,782,986 Corporate: Consumer Goods 1,632,021,656,432 Corporate: Technology / Telecom 1,354,095,021,215 Corporate: Industrials 1,288,691,929,408 Corporate: Basic Materials 1,010,774,124,338 Corporate: Utilities 793,487,582,240 Corporate: Oil & Gas 466,571,383,121 Corporate: Health Care 344,409,876,741 Corporate: Other 146,060,829,118 CDS on Loans 71,046,466,707 Residential Mortgage Backed Securities 70,440,282,424 Commercial Mortgage Backed Securities 20,387,994,580 CDS on Loans European 5,289,498,226 Other 1,765,274,515 Muni:Government 1,395,400,000 Residential Mortgage Backed Securities* 85,099,800 Muni:Other 65,000,000 Muni:Utilities 33,150,000 CDS Swaptions 15,000,000

425,805 194,579 358,215 254,316 205,086 217,605 160,680 122,171 84,971 59,969 14,859 18,637 14,103 1,870 748 137 145 5 3 13 1

*European

FTSE GLOBAL MARKETS â&#x20AC;˘ APRIL 2011

References Entity

Gross Notional (USD EQ)

Contracts

Kingdom of Spain

7,495,698,722

421

Republic of Italy

6,619,181,334

300

Japan

5,052,078,000

760

Portuguese Republic

4,102,602,345

166

Federative Republic of Brazil

2,985,470,000

186

UK and Northern Ireland

2,917,400,000

376

French Republic

2,698,560,983

122

General Electric Capital Corporation 2,365,490,552

144

Hellenic Republic

2,064,448,380

160

Republic of Korea

2,060,840,000

287

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

All data ÂŠ 2011 The Depository Trust & Clearing Corporation This data is being provided as is and can only be used by you pursuant to the terms posted on the DTCC website at dtcc.com/products/derivserv/data_table_i.php

The Fidessa Fragmentation Index (FFI) was launched to provide a simple, unbiased measure of how different stocks are fragmenting across primary markets and alternative lit trading venues. In short, it shows the average number of lit venues you should visit in order to achieve best execution when completing an order. So an index of 1 means that the stock is still traded at one venue. Increases in the FFI indicate a fragmentation of trading across multiple venues and as such any firm wishing to effectively trade that security must be able to execute across more venues. Once a stock’s FFI exceeds 2, liquidity in that stock has fragmented to the extent that it no longer “belongs” to its originating venue. The Fidessa Fragulator® allows you to query several billion trade records to get a complete picture of how trading in a given stock is broken down across lit venues, dark pools, systematic internalisers and bilateral OTC trades.

FFI and venue market share by index Week ending 11th of March 2011 VENUES

INDICES

FTSE 100

CAC 40

DAX

OMX S30

SMI

FFI

2.47

1.97

1.92

1.98

9.70%

2.01 3.58% 5.72%

7.16% 0.02%

4.77%

8.40%

27.26%

22.23%

5.72% 16.67%

19.75%

0.25%

1.19%

Europe

Amsterdam BATS Europe Berlin Burgundy Chi-X Europe Deutsche Börse Dusseldorf Equiduct Frankfurt Hamburg Hanover London Munich NYSE Arca Europe Paris SIX Swiss Stockholm TOM MTF Turquoise Xetra

20.22% 67.86% 0.03% 0.07% 0.65% 0.07% 0.01%

56.33% 0.07% 0.13%

0.23%

0.08%

62.90% 67.75% 69.86% 0.03% 4.34% 0.01%

6.24%

VENUES

3.72%

2.88%

4.11%

VENUES

INDICES

S&P 500

INDICES

S&P TSX Composite

FFI

4.90 13.43% 3.84% 0.06% 0.36% 5.99% 7.34% 23.96% 3.99% 2.06% 0.64% 23.27% 0.11% 14.95%

4.50 12.14% 3.54% 0.15% 0.37% 6.68% 7.22% 23.73% 4.14% 1.75% 0.58% 24.38% 0.27% 15.07%

FFI

2.12

2.11

Alpha ATS Chi-X Canada

20.75% 8.98%

21.03% 9.76%

Liquidnet Canada

0.35%

0.17%

Omega ATS

2.04%

2.77%

Pure Trading

4.72%

3.67%

Toronto

61.15%

60.35%

TriAct MATCH Now

2.01%

2.25%

BATS BYXX CBOE CHXE EDGA EDGX NSDQ NQBX NQPX CINN NYSE AMEX ARCX VENUES

INDICES S&P ASX 200

HANG SENG

FFI

1.00

Asia

INDICES

Australia Hong Kong

Canada*

DOW JONES

INDICES

VENUES

FFI

99.76% 100.00%

S&P TSX 60

INDEX NIKKEI 225

INDICES

Japan

GLOBAL TRADING STATISTICS

Fidessa Fragmentation Index (FFI) and Fragulator®

Chi-X Japan JASDAQ Kabu.com Nagoya Osaka SBI Japannext Tokyo ToSTNet-1 ToSTNet-2

1.24 1.28% † 0.04% † † 1.08% 89.36% 8.24% †

Figures are compiled from lit order book trades only. Totals only include stocks contained within the major indices. *This index is also traded on US venues. For more detailed information, visit http://fragmentation.fidessa.com/fragulator/. † Market share <0.00%

APRIL 2011 • FTSE GLOBAL MARKETS

COMMENTARY By Steve Grob, Director of Group Strategy, Fidessa

N RECENT WEEKS there have been a number of announcements about potential exchange mergers. The proposed tie-ups between the LSE and Canada's TMX group and between NYSE Euronext and Deutsche Börse in particular have captured the industry's imagination. The direct impact (or the threat) of fragmentation has driven these exchanges to put aside their nationalistic tendencies and seek international co-operation. The impact of fragmentation on the respective domestic indices of the LSE and TMX, for example, is illustrated in charts 1 and 2.

may not actually be good for their long-term financial health simply because they are available. It is ironic that in their bid to break up the national monopolies of exchanges the regulators seem to have encouraged the creation of global ones in their place. The global trading landscape will look somewhat different if the mergers currently proposed do go ahead, as illustrated in chart 3. Chart 3: Lit value (EUR) February 2011 post-consolidation wave scenario (All stocks traded on the following venues are included)

Chart 1: Lit turnover breakdown, FTSE 100

Venue

(February 2011)

NYSE Group* + Deutsche Börse Group* NASDAQ Group* BATS LSE Group* + TSX Tokyo + Osaka Shanghai Chi-X + Bats Europe EDGX Shenzen EDGA Hong Kong Korea Australia + Singapore Madrid BYXX SIX Swiss Taiwan NSE ToSTNet-1 Alpha ATS Bangkok Kosdaq others ( ‹ 0.5%)

0.24% 0.2 Equiduct Equi

5.81% 5.8 Turquoise T urqu

LSE 56.93%

Other 43.07%

26.84% % Chi-X

9.96% 9.9 Bats Europe Eu

0.22% 0.2 Nyse Arca

Chart 2: Lit turnover breakdown, S&P/TSX 60 (February 2011) 10.46% 10.4 Chi-X Can Canada

TSX 68.02%

Other 31.98%

16.65% %

1.18% 1.1

Alpha ATS TS

Om Omega ATS

Value (EUR)

Market %

1,205,150,731,830 775,708,348,597 328,255,021,357 314,373,807,376 289,686,448,745 242,748,448,208 181,671,573,890 178,873,078,204 175,428,507,643 118,467,426,786 86,602,500,293 70,824,540,273 57,120,255,384 53,311,052,025 49,657,088,753 49,488,563,472 48,952,810,675 42,930,075,228 28,465,021,846 28,401,785,355 23,660,713,951 22,770,988,075 117,048,477,462

26.84% 17.28% 7.31% 7.00% 6.45% 5.41% 4.05% 3.98% 3.91% 2.64% 1.93% 1.58% 1.27% 1.19% 1.11% 1.10% 1.09% 0.96% 0.63% 0.63% 0.53% 0.51% 2.61%

3.06% 3.0 Pure Tra Trading

*NYSE Group: Nyse Arca, NYSE, Paris, Amsterdam, NYSE Amex, Brussels, Lisbon. NASDAQ Group: NASDAQ, NASDAQ BX, Stockholm, NQPX, Oslo, Helsinki, Copenhagen. Deutsche Börse Group: Deutsche Börse, Frankfurt, Xetra International. LSE Group: LSE, Milan, Turquoise

Faced with increased domestic competition they are looking to increase their scale, creating the global equivalent of a financial multi-asset supermarket that allows them to offer economies of scale and, more importantly, deeper and more diverse liquidity to their customers. These super exchanges should be able to provide greater efficiency of capital through margin offsets and offer new products and services. Where they own their own IPR - in derivatives, for example - they can potentially generate higher fees on these types of products. If the exchanges can indeed deliver these economies of scale investment managers should be able to enjoy much lower trading fees. But of course there is also the issue of transparency and that is something the regulators are going to be looking at particularly because so many of them will be involved in each of these sprawling new super exchanges. It is important that investors are not being discounted products that

But maybe big isn't always beautiful and it's rather too soon to write off the alternative community. After all, these new alternative venues have provided much of the innovation in markets, particularly in terms of products and of course pricing. They certainly have the support of the HFT community who want to see as many different venues as possible so they can arbitrage between them. The banks and brokers want to make sure that they have options available in case these new super exchanges get a little bit too big for their own good. The simple fact is that the concept of a national stock exchange died when the regulators first started introducing competition and breaking up their historical monopolies. One thing is for sure, we are going to see more mergers and acquisitions in this space and the venues that ultimately succeed will be either very niche and focused or have the capacity to operate on a huge scale. I

All data © Fidessa group plc. All opinions and data here are entirely the responsibility of Fidessa group plc. If you require more information on the data provided here or about Fidessa’s fragmentation tools, please contact: fragmentation@fidessa.com.

FTSE GLOBAL MARKETS • APRIL 2011

GLOBAL ETF SUMMARY

Global ETF assets by index provider ranked by AUM As at end February 2011 Index Provider MSCI S&P Barclays Capital Russell FTSE STOXX Dow Jones Markit NASDAQ OMX Deutsche Boerse Topix NYSE Euronext Nikkei Hang Seng EuroMTS SIX Swiss Exchange WisdomTree PC-Bond Grupo Bolsa SSE Indxis Structured Solutions CSI Intellidex BNY Mellon Morningstar S-Network ISE Zacks Other Total

No. of ETFs 400 330 86 72 168 225 143 115 62 51 54 43 9 13 29 17 35 18 13 17 6 26 32 36 16 10 15 10 11 495 2,557

February 2011 Total Listings AUM (US$ Bn) 1,408 $339.5 591 $322.0 213 $114.8 105 $83.9 398 $56.6 787 $53.1 265 $52.2 336 $45.8 110 $35.8 181 $35.5 65 $16.6 86 $15.9 17 $15.1 34 $15.1 111 $9.3 30 $8.8 42 $8.6 22 $7.8 14 $7.8 18 $7.1 7 $6.7 34 $6.0 38 $3.4 39 $3.2 17 $2.2 10 $2.1 33 $2.0 10 $1.2 12 $0.9 769 $88.3 5,802 $1,367.4

% Total 24.8% 23.5% 8.4% 6.1% 4.1% 3.9% 3.8% 3.4% 2.6% 2.6% 1.2% 1.2% 1.1% 1.1% 0.7% 0.6% 0.6% 0.6% 0.6% 0.5% 0.5% 0.4% 0.3% 0.2% 0.2% 0.2% 0.1% 0.1% 0.1% 6.5% 100.0%

No. of ETFs 10 15 2 2 7 4 5 3 1 6 1 2 0 0 0 0 0 0 0 3 0 1 1 0 0 0 0 0 0 34 97

Total Listings 78 25 2 4 13 7 7 24 9 10 1 2 1 0 0 0 0 1 0 3 0 3 5 0 0 0 0 0 0 52 247

YTD Change AUM (US$ Bn) $1.7 $20.9 $3.6 $3.4 $1.7 $4.4 $4.7 $0.7 $4.1 $3.5 $0.0 -$0.7 $0.5 -$0.2 -$0.2 -$0.1 $0.1 $0.2 $0.1 $0.6 $0.9 $0.2 -$0.1 $0.3 -$0.4 $0.2 $0.3 $0.1 $0.1 $5.6 $56.1

% AUM 0.5% 6.9% 3.2% 4.3% 3.0% 9.0% 9.8% 1.5% 12.9% 10.9% 0.2% -4.1% 3.3% -1.5% -1.6% -1.6% 1.4% 2.3% 1.9% 9.1% 16.1% 4.1% -3.8% 10.8% -15.6% 8.9% 15.9% 10.4% 13.1% 6.7% 4.3%

% TOTAL -0.9% 0.6% -0.1% 0.0% -0.1% 0.2% 0.2% -0.1% 0.2% 0.2% 0.0% -0.1% 0.0% -0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.1%

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

Top 5 global ETF providers by average daily turnover As at end February 2011 Average Daily Turnover (US$ Mil) Feb-2011 % Mkt Share Change (US$ Mil)

Provider

Dec-2010

% Mkt Share

SSgA

$18,667.3

40.3%

$24,254.1

41.1%

$5,586.8

3.9% Change (%)

Direxion Shares

14.2% Others

29.9%

iShares

$14,028.5

30.3%

$17,631.5

29.9%

$3,602.9

25.7%

5.5%

ProShares

$2,660.7

5.7%

$3,270.4

5.5%

$609.7

22.9%

ProShares

PowerShares

$2,413.3

5.2%

$3,242.4

5.5%

$829.1

34.4%

Direxion Shares

$1,860.7

4.0%

$2,285.1

3.9%

$424.3

22.8%

Others

$6,710.2

14.5%

$8,380.8

14.2%

$1,670.5

24.9%

Total

$46,340.7

100.0%

$59,064.2

100.0%

$12,723.5

27.5%

41.1% SSgA

5.5% PowerShares

29.9% iShares

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

Top 20 ETFs worldwide with the largest change in AUM As at end February 2011 ETF iShares MSCI Emerging Markets Index Fund SPDR S&P 500 PowerShares QQQ Trust Energy Select Sector SPDR Fund iShares S&P 500 Index Fund iShares MSCI EAFE Index Fund Vanguard MSCI Emerging Markets ETF iShares S&P 500 iShares S&P MidCap 400 Index Fund iShares FTSE China 25 Index Fund iShares MSCI Japan Index Fund iShares Russell 2000 Index Fund db x-trackers MSCI Emerging Market TRN Index ETF Market Vectors Agribusiness ETF Technology Select Sector SPDR Fund SPDR Dow Jones Industrial Average ETF iShares MSCI Canada Index Fund iShares Russell 1000 Growth Index Fund iShares Russell 1000 Value Index Fund Vanguard REIT ETF

Country listed US US US US US US US United Kingdom US US US US Germany US US US US US US US

Bloomberg Ticker EEM US SPY US QQQQ US XLE US IVV US EFA US VWO US IUSA LN IJH US FXI US EWJ US IWM US XMEM GY MOO US XLK US DIA US EWC US IWF US IWD US VNQ US

AUM (US$ Mil) February 2011 $36,420.6 $94,779.0 $25,435.2 $10,866.7 $28,142.7 $39,125.4 $42,825.5 $9,388.3 $10,673.0 $6,809.5 $6,157.3 $16,300.4 $5,072.0 $3,777.3 $6,992.2 $9,841.8 $5,723.6 $13,677.6 $11,675.9 $8,479.4

AUM (US$ Mil) December 2010 $47,551.5 $89,915.3 $22,069.9 $8,396.4 $25,799.2 $36,923.1 $44,569.8 $7,905.8 $9,332.0 $8,131.1 $4,883.3 $17,498.4 $6,263.3 $2,631.5 $5,849.3 $8,729.2 $4,622.1 $12,580.0 $10,697.1 $7,503.7

Change (US$ Mil) -$11,130.9 $4,863.7 $3,365.3 $2,470.3 $2,343.5 $2,202.3 -$1,744.3 $1,482.5 $1,341.0 -$1,321.6 $1,273.9 -$1,198.0 -$1,191.2 $1,145.8 $1,142.9 $1,112.5 $1,101.5 $1,097.6 $978.8 $975.7

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

APRIL 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

Global ETF listings As at end February 2011 ASSETS UNDER MANAGEMENT (US$ Bn)

CHANGE IN ASSETS

No. of No. of Exchanges Providers (Official)

No. Primary Listings

New in 2010

New in 2011

Total Listings

2010

Feb-2011

US$ Bn

US Europe Austria Belgium Finland France Germany Greece Hungary Ireland Italy Netherlands Norway Poland Portugal Russia Slovenia Spain Sweden Switzerland Turkey United Kingdom Canada Japan Hong Kong China Mexico South Korea Australia Singapore Taiwan South Africa Brazil India Malaysia New Zealand Thailand Saudi Arabia UAE Indonesia Chile Botswana Egypt Israel Philippines Sri Lanka

919 1,116 1 1 1 261 409 3 1 14 23 12 6 1 3 1 1 12 25 114 12 215 169 81 43 20 19 67 20 21 14 26 7 17 4 6 4 2 1 1 -

173 268 55 59 1 12 2 1 3 1 13 58 3 60 51 12 18 8 6 15 15 12 3 3 4 1 1 2 1 -

23 44 4 22 2 6 10 12 1 3 5 5 1 2 1 -

919 3,884 21 23 1 484 1,221 3 1 14 509 108 6 1 3 1 1 68 80 615 12 712 197 84 72 20 308 67 41 74 17 26 7 17 5 6 4 2 1 1 50 -

$891.0 $284.0 $0.1 $0.1 $0.3 $59.9 $110.7 $0.1 $0.0 $0.4 $2.5 $0.3 $0.7 $0.1 $0.0 $0.0 $0.0 $1.2 $2.8 $38.0 $0.2 $66.7 $38.4 $32.2 $26.3 $10.1 $8.2 $5.3 $3.9 $3.6 $2.8 $2.3 $1.9 $0.4 $0.4 $0.4 $0.1 $0.0 $0.0 $0.0 -

$929.1 $299.1 $0.1 $0.1 $0.3 $62.6 $116.2 $0.1 $0.0 $0.5 $2.7 $0.3 $0.7 $0.1 $0.0 $0.0 $0.0 $1.3 $2.9 $40.1 $0.2 $71.0 $40.3 $32.4 $26.6 $11.3 $8.4 $5.4 $3.7 $3.0 $2.8 $2.2 $1.8 $0.4 $0.4 $0.4 $0.1 $0.0 $0.0 $0.0 -

$38.1 $15.1 $0.0 $0.0 $0.0 $2.8 $5.5 $0.0 $0.0 $0.1 $0.2 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.1 $0.1 $2.1 $0.0 $4.3 $1.9 $0.2 $0.3 $1.2 $0.2 $0.0 -$0.2 -$0.6 $0.0 -$0.1 -$0.1 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 -

4.3% 5.3% -7.3% 6.7% 0.8% 4.6% 4.9% 13.2% 7.3% 17.3% 8.0% 2.5% 3.4% -0.5% 8.6% 12.5% -6.5% 8.4% 1.9% 5.4% 15.7% 6.5% 5.1% 0.7% 1.3% 11.9% 2.0% 0.7% -5.2% -17.3% 0.3% -2.5% -4.9% 2.0% -1.3% -5.2% -6.5% 15.2% -9.1% -6.9% -

28 40 1 1 1 9 11 2 1 2 4 4 2 1 2 1 1 2 2 7 5 10 4 7 10 14 3 13 6 8 2 8 2 7 3 2 3 1 1 1 -

2 23 1 1 1 1 2 1 1 1 1 1 1 1 1 1 1 2 2 1 1 1 1 3 1 2 1 1 1 1 1 1 1 2 1 1 1 1 1 1 1 -

875 55*

ETF total

2,557

593

5,802

$1,311.3

$1,367.4

$56.1

4.3%

140

1,019

Location

*Includes two undisclosed HSBC/Hang Seng ETFs and five undisclosed ETFlab Investment ETFs. To avoid double counting, assets shown above refer only to primary listings.

Planned New

9 3 1 17 1 6 4 1 3 12 1 17 3 0 0 1 4 0 0 1 1 2 1 1

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

Regulatory Information BlackRock Advisors (UK) Limited (‘BlackRock’), which is authorised and regulated by the Financial Services Authority in the United Kingdom, has issued this document for access by professional clients and for information purposes only. This document or any portion hereof may not be reprinted, sold or redistributed without authorisation from BlackRock. This communication is being made available to persons who are investment professionals as that term is defined in Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion Order) 2005 or its equivalent under any other applicable law or regulation in the relevant jurisdiction. It is directed at persons who have professional experience in matters relating to investments. This document is an independent market commentary document based on publicly available information and is produced by the Global ETF Research and Implementation Strategy team. Specifically, this is not marketing nor is it an offer to buy or sell any security or to participate in any trading strategy. Affiliated companies of BlackRock may make markets in the securities of ETFs and provide ETFs in the form of iShares. Further, BlackRock and/or its affiliated companies and/or their employees may from time to time hold shares or holdings in the underlying shares of, or options on, any security of ETFs and may as principal or agent buy securities in ETFs. The opinions expressed are those of BlackRock as of January 2011, and are subject to change at any time due to changes in market or economic conditions. They should not be construed as a recommendation, investment advice, offer or solicitation to buy or sell any securities or to adopt any investment strategy. In particular, BlackRock has not performed any due diligence on products which are not managed by BlackRock and accordingly does not make any remark on their suitability. Prospective investors should take their own independent advice prior to making an investment decision. This document does not provide investment advice and the information contained within should not be relied upon in assessing whether or not to invest in the products mentioned. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this commentary may not be suitable for all investors. BlackRock recommends that investors independently evaluate each issuer, security or instrument discussed in this publication and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. The value of and income from any investment may go up or down and an investor may not get back the amount invested. The value of the investment involving exposure to foreign currencies can be affected by exchange rate movements. We also remind you that the levels and bases of, and reliefs from, taxation can change and is dependent upon individual circumstances. Although BlackRock endeavours to update and ensure the accuracy of the content of this document BlackRock does not warrant or guarantee its accuracy or correctness. Despite the exercise of all due care, some information in this document may have changed since publication. Investors should obtain and read the ETF prospectuses from the ETF Providers and confirm any relevant information with ETF Providers before investing. Neither BlackRock, nor any affiliate, nor any of their respective, officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. The trademarks and service marks contained herein are the property of their respective owners. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. © 2011 BlackRock Advisors (UK) Limited. Registered Company No 00796793. All rights reserved. Calls may be monitored or recorded.

FTSE GLOBAL MARKETS • APRIL 2011

Global Equity View 5-year Performance Graph (USD Total Return) Index level rebased (28 February 2006 = 100) FTSE All-World Index

FTSE Developed Index

FTSE Emerging Index

FTSE Frontier 50 Index

180 160 140 120 100 80 60

-1 1

Fe b

N ov -

Au g-

M ay -

Fe b-

ov -0 9

-0 9

Au g

M ay -

Fe b-

08 N ov -

Au g-

M ay -

Fe b08

N ov -

-0 7 Au g

M ay -0 7

Fe b07

N ov -

Au g-

M ay -0

-0 6

40 Fe b

MARKET DATA BY FTSE RESEARCH

GLOBAL MARKET INDICES

Global Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (28 February 2006 = 100) FTSE RAFI Developed 1000 Index

160

FTSE Developed ActiveBeta MVI Index

FTSE EDHEC-Risk Efficient Developed Index

FTSE DBI Developed Index

FTSE All-World Index

140 120 100 80 60

-1 1 Fe b

N ov -

Au g-

10 M ay -

10 Fe b-

ov -0 9 N

-0 9 Au g

M ay -

09 Fe b-

08 N ov -

Au g-

08 M ay -

Fe b08

07 N ov -

-0 7 Au g

M ay -0 7

Fe b07

N ov -

Au g-

6 M ay -0

Fe b

-0 6

Global - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (28 February 2006 = 100) FTSE EPRA/NAREIT Global Index

220

FTSE Global Government Bond Index

FTSE StableRisk Composite Index

FTSE FRB10 USD Index

200 180 160 140 120 100 80 60

-1 1 Fe b

N ov -

10 Au g-

M ay -

10 Fe b-

-0 9

ov -0 9 N

Au g

M ay -

09 Fe b-

08 N ov -

Au g-

08 M ay -

Fe b08

07 N ov -

-0 7 Au g

-0 7

ay -0 7 M

Fe b

N ov -

Au g-

ay -0 6 M

Fe b06

Source: FTSE Group, data as at 28 February 2011.

APRIL 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

USA MARKET INDICES USA Regional Equities View (USD Total Return) Index level rebased (28 February 2006 = 100) FTSE USA Index

FTSE All-World ex USA Index

160 140 120 100 80 60

-1 1 Fe b

N ov -

Au g-

M ay -

Fe b-

-0 9

ov -0 9 N

Au g

M ay -

Fe b-

N ov -

Au g-

M ay -

Fe b08

N ov -

-0 7 Au g

M ay -0 7

Fe b07

N ov -

Au g-

M ay -0

Fe b

-0 6

USA Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (28 February 2006 = 100) FTSE RAFI US 1000 Index

160

FTSE DBI Developed Index

FTSE EDHEC-Risk Efficient USA Index

FTSE US ActiveBeta MVI Index

FTSE All-World Index

140 120 100 80 60

-1 1 Fe b

10 N ov -

10 Au g-

M ay -

10 Fe b-

-0 9

ov -0 9 N

Au g

M ay -

Fe b-

08 N ov -

Au g-

08 M ay -

Fe b08

07 N ov -

-0 7 Au g

M ay -0 7

Fe b07

N ov -

06 Au g-

6 M ay -0

Fe b

-0 6

USA - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (28 February 2006 = 100) FTSE Americas Government Bond Index

160

FTSE FRB10 USD Index

FTSE EPRA/NAREIT North America Index

FTSE Renaissance IPO Composite Index

140 120 100 80 60

-1 1 Fe b

10 N ov -

10 Au g-

M ay -

10 Fe b-

-0 9

ov -0 9 N

Au g

M ay -

09 Fe b-

N ov -

Au g-

-0 8

M ay -

Fe b

07 N ov -

-0 7 Au g

-0 7

ay -0 7 M

Fe b

06 N ov -

Au g-

ay -0 6 M

Fe b06

Source: FTSE Group, data as at 28 February 2011.

FTSE GLOBAL MARKETS â&#x20AC;˘ APRIL 2011

Europe Regional Equities View 5-year Performance Graph (EUR Total Return) Index level rebased (28 February 2006 = 100) FTSE 100 Index

FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

160 140 120 100 80 60

-1 1 Fe b

N ov -

Au g-

M ay -

Fe b-

ov -0 9 N

-0 9

Au g

M ay -

Fe b-

N ov -

Au g-

M ay -

Fe b08

-0 7

N ov -

Au g

M ay -0 7

06 N ov -

Fe b07

Au g-

M ay -0

-0 6

40 Fe b

MARKET DATA BY FTSE RESEARCH

EUROPE, MIDDLE EAST, AFRICA (EMEA) MARKET INDICES

Europe Alternative/Strategy View 5-year Performance Graph (EUR Total Return) Index level rebased (28 February 2006 = 100)

140

FTSE RAFI Europe Index

FTSE4Good Europe Index

FTSE EDHEC-Risk Efficient Developed Europe Index

FTSE EPRA/NAREIT Developed Europe Index

FTSE All-World Index

120 100 80 60 40

-1 1 Fe b

N ov -

Au g-

M ay -

10 Fe b-

ov -0 9 N

-0 9

Au g

M ay -

Fe b-

N ov -

08 Au g-

08 M ay -

Fe b08

07 N ov -

-0 7 Au g

M ay -0 7

Fe b07

N ov -

Au g-

M ay -0

Fe b

-0 6

Middle East and Africa View 3-year Performance Graph (Total Return) Index level rebased (28 February 2008 = 100)

140

FTSE JSE Top 40 Index (ZAR)

FTSE CSE Moricco All-Liquid Index (MAD)

FTSE Middle East & Africa Index (USD)

FTSE NASDAQ Dubai UAE 20 Index (USD)

120 100 80 60 40

-1 1 Fe b

10 N ov -

10 Au g-

10 M ay -

10 Fe b-

ov -0 9 N

-0 9 Au g

09 M ay -

Fe b09

N ov -0 8

Au g08

-0 8 ay M

Fe b

-0 8

Source: FTSE Group, data as at 28 February 2011.

APRIL 2011 • FTSE GLOBAL MARKETS

ASIA-PACIFIC MARKET INDICES Asia Pacific Regional Equities View (Market-Cap, Alternatively-weighted and Strategy) 5-year Performance Graph (USD Total Return) Index level rebased (28 February 2006 = 100)

220

FTSE Asia Pacific Index

FTSE RAFI Developed Asia Pacific ex Japan Index

FTSE EDHEC-Risk Efficient All-World Asia Pacific Index

200 180 160 140 120 100 80

-1 1 Fe b

10 Au g-

N ov -

M ay -

Fe b-

ov -0 9

-0 9

Au g

M ay -

Fe b-

08 N ov -

Au g-

M ay -

Fe b08

N ov -

-0 7 Au g

M ay -0 7

Fe b07

N ov -

Au g-

M ay -0

Fe b

-0 6

Greater China Equities View 5-year Performance Graph (USD Total Return) Index level rebased (28 February 2006 = 100)

600

FTSE China A50 Index

FTSE Greater China Index

FTSE China 25 Index

FTSE Renaissance Hong Kong/China Top IPO Index

500 400 300 200 100

-1 1 Fe b

10 Au g-

N ov -

10 M ay -

10 Fe b-

ov -0 9

-0 9

Au g

M ay -

09 Fe b-

08 N ov -

Au g-

08 M ay -

Fe b08

07 N ov -

Au g

-0 7

M ay -0 7

Fe b07

N ov -

Au g-

6 M ay -0

Fe b

-0 6

ASEAN Equities View 18-month Performance Graph (USD Total Return) Index level rebased (31 August 2009 = 100) FTSE ASEAN 40 Index

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

200 180 160 140 120 100

-1 1 Fe b

11 Ja n-

-1 0 De c

ov -

0 N

Oc t1

p10 Se

-1 0 Au g

0 Ju l1

0 Ju n1

10 M ay -

Ap r10

ar -1 0 M

Fe b10

-1 0 Ja n

De c09

ov -0 9 N

Oc t09

Se p09

Au g

-0 9

Source: FTSE Group, data as at 28 February 2011.

FTSE GLOBAL MARKETS â&#x20AC;˘ APRIL 2011

INDEX CALENDAR

Index Reviews April - June 2011 Date

Index Series

Review Frequency/Type

07-Apr 07-Apr

FTSE TWSE Taiwan Index Series TOPIX

08-Apr 27-Apr 06-May

FTSE Value-Stocks Korea Index Russell US & Global Indices TOPIX

09-May 11-May 11-May 17-May 17-May 24-May 26-May Early Jun Early Jun Early Jun Early Jun 03-Jun 03-Jun 03-Jun 03-Jun 03-Jun 03-Jun 07-Jun 07-Jun

FTSE Value-Stocks China Index FTSE Value-Stocks Taiwan Index Hang Seng Russell/Nomura Indices MSCI Standard Index Series DJ STOXX Russell US & Global Indices ATX KOSPI 200 IBEX 35 OBX CAC 40 DAX AEX PSI 20 BEL 20 S&P / ASX Indices FTSE Vietnam Index Series TOPIX

07-Jun n/a

FTSE China Index Series FTSE Renaissance Asia Pacific IPO Index Series FTSE MIB FTSE UK Index Series FTSE Global Equity Index Series (incl. FTSE All-World) FTSE Italia Index Series FTSE techMARK 100 FTSEurofirst 300 FTSE/JSE Africa Index Series FTSE EPRA/NAREIT Global Real Estate Index Series FTSE Bursa Malaysia Index Series FTSE TWSE Taiwan Index Series OMX I15 DJ Global Titans 50 Dow Jones Global Indexes FTSE SET Index Series S&P US Indices S&P Europe 350 / S&P Euro S&P Topix 150 S&P Asia 50 S&P Global 1200 S&P Global 100 S&P / TSX S&P Latin 40 NZX 50

Quarterly review Monthly review additions & free float adjustment Semi-annual Monthly review - shares in issue change Monthly review additions & free float adjustment Semi-annual Semi-annual Quarterly review Quarterly IPO addtions Annual review Quarterly review Monthly review - shares in issue change Quarterly review Annual review Semi-annual review Semi-annual review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly Review Quarterly review Monthly review additions & free float adjustment Quarterly review

07-Jun 08-Jun 09-Jun 08-Jun 08-Jun 08-Jun 08-Jun 09-Jun 09-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun

Effective (Close of business)

Data Cut-off

15-Apr 29-Apr

31-Mar 31-Mar

15-Apr 29-Apr 27-May

31-Mar 26-Apr 29-Apr

13-May 20-May 03-Jun 31-May 31-May 17-Jun 31-May 30-Jun 08-Jun 13-Jan 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 30-Jun

30-Apr 30-Apr 31-Mar 31-Mar 30-Apr 29-Apr 25-May 31-May 30-Apr 31-May 31-May 31-May 31-May 30-Apr 30-Apr 30-Apr 27-May 31-May 31-May

17-Jun

23-May

Quarterly review Quarterly Review Quarterly review Annual review - Emgng Eur, ME, Africa, Latin America Quarterly Review Quarterly review Quarterly review Quarterly review

17-Jun 17-Jun 17-Jun

31-May 31-May 07-Jun

17-Jun 17-Jun 17-Jun 17-Jun 17-Jun

07-Jun 31-May 07-Jun 07-Jun 07-Jun

Quarterly review Semi-annual review Quarterly review Semi-annual review Annual review of index composition Quarterly review Semi-annual review Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review Quarterly review - shares Quarterly review

17-Jun 17-Jun 17-Jun 30-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun

31-May 31-May 31-May 31-May 31-May 31-May 31-May 09-Jun 03-Jun 03-Jun 03-Jun 03-Jun 03-Jun 31-May 03-Jun 31-May

Sources: Berlinguer, FTSE, JP Morgan, Standard & Poor’s, STOXX

APRIL 2011 • FTSE GLOBAL MARKETS

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