FTSE Global Markets by FTSE Global Markets

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SECURITIES LENDING: THE CUSTODIANS FIGHT BACK I S S U E S E V E N • M AY / J U N E 2 0 0 5

Euroclear leads on strategy Pharmaceuticals at the crossroads The glory–glory days of portfolio trading

DOES TRANSITION MANAGEMENT NEED A CODE OF PRACTICE?

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Outlook EDITORIAL DIRECTOR:

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s part of our growing focus on the provision of investment services, we take an in-depth look at a number of key product areas in this issue – namely securities lending, sub-custody services and portfolio trading. The market in many areas of investment services is becoming increasingly crowded, diverse and complex. That complexity is also beginning to have consequences. The implementation of Basel II, for example, will have a long term impact on the provision of securities lending services and may encourage custodian lenders to fight back for market share lost to the successful and growing army of third party agency lenders and specialist auction services, such as ESecLending. In similar vein, our opening market leader feature focuses on a new initiative, promoted by Credit Suisse First Boston, that transition management providers adopt a code of practice, or T-Charter, as it is becoming increasingly known. As the transition management market becomes more competitive and diversified, clients reportedly find it difficult to make proper assessments of the services on offer. Some providers would have it that the time is ripe for clarity as to the proper definition of modern day transition management services and a requirement that transition managers provide basic performance guarantees. Others think a charter unworkable. We canvass the rising debate as to its value. There are myriad reasons why portfolio trading is gaining in prominence. Not least is a trend towards quantitative ‘top down’portfolio management and a growing requirement for asset managers to respond quickly to market movements. But even while portfolio trading grows apace, the sector is itself in flux. We take a long and detailed look at the opportunities and challenges facing this increasingly arcane business. Andrew Cavenagh meanwhile reviews the vicarious fortunes of the pharmaceuticals industry. The sector is undergoing a critically testing period. The share prices of leading US and European companies are in the doldrums, even while profits remain robust. Can they cope with the pressures of radical change demanded by today’s healthcare industry? Our cover story however belongs to Chris Gorog, chairman and chief executive officer of digital-music service Napster. Gorog says the company’s newly launched Napster To Go portable subscription service will revolutionise the way we all listen to music and that he is willing and able to take on the mighty Apple Computer and its galactically popular iPod digital-music player. Dave Simons explains why Gorog thinks he has more than a fighting chance of success.

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F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 5

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Contents COVER STORY NAPSTER ..................................................................................................................Page 36 Flush with $100m in available cash, in February of this year Napster chairman and CEO Christopher Gorog finally unveiled Napster To Go, a portable subscription music service that very well may revolutionise the way we listen to music. Dave Simons finds out about the man and the company that made one of the music industry’s most dramatic comebacks.

REGULARS MARKET LEADER

TEETH AND THE T-CHARTER ..............................................................Page 6 Does the transition management market really need a code of practice? We tell you why it does and why it doesn’t.

SYNDICATED LENDING AT THE MARGINS ........................Page 14 Pricing, structure, documentation and covenant packages are all under pressure.

IN THE MARKETS

LIFETIME SUPPORT ......................................................................................Page 17 Neil O’Hara reports on the mounting demand for annuities.

THE IMPORTANCE OF BEING ICB ................................................Page 18 The battle to provide a seminal industry classification benchmark

TIMED IN, TIMED OUT ............................................................................Page 20 Neil O’Hara explains why investors should consider their voting rights.

IS MEXICO LOSING IT’S APPEAL? ................................................Page 22 Benedict Mander explains why investors are chary of Mexico.

TAIWAN’S GLOBAL ROADSHOW ................................................Page 25 REGIONAL REVIEW

Ian Williams outlines the island’s key selling points.

INVESTING IN SOUTH AFRICA ........................................................Page 28 Ian Williams assesses the market’s appeal.

AXA’S BENDAHAN TOPS FUNDS IN EUROPE ..................Page 32 New fund manager performance league table is launched.

CUKUROVA SETS THE PACE ..............................................................Page 34 How four big sell-offs will affect investor appetite for Turkish risk.

EQUITY REPORT

SUB-CUSTODY: A RACE TO THE FINISH ................................Page 46 Tim Steele reports on the outlook for sub-custodian services in Europe.

REITS FIND A HOME IN EUROPE ..................................................Page 80 The growing appeal of REITs as an investment vehicle.

INDEX REVIEW

Market Reports by FTSE Research ................................................................................Page 86 Companies in this issue ..................................................................................................Page 85 Calendar ............................................................................................................................Page 96

M AY / J U N E 2 0 0 5 • F T S E G L O B A L M A R K E T S

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Contents FEATURES EUROCLEAR ON THE FAST TRACK ............................................Page 41 Armed with a new corporate structure Euroclear is quietly confident of the applicability and efficacy of its two-pronged forward business strategy. At its heart, the plan calls for a single platform for all five markets in Euroclear, plus Euroclear Bank. Francesca Carnevale talks to Pierre Francotte, CEO of Euroclear.

STP’s NEW FOCUS ........................................................................................Page 50 These days firms now focus on the business objectives underlying STP, such as increasing efficiency between trade counterparties, improving margins, reducing transaction costs and minimising failed trades. By Rekha Menon

PORTFOLIO TRADING: UPSIDE ALL THE WAY ..............Page 54 These are golden days for portfolio traders, backed by better technology, a solid business pipeline supplied by transition managers and the growing popularity of ‘top down’ portfolio management. Trading strategies, benchmarks and the market structure are all set to become even more sophisticated and competitive.

SECURITIES LENDING ..................................................................................Page 60 The big changes in the securities lending market have already happened. Competition from new lenders cut the ties that bound securities lending to custodians and now the market is living with the consequences. But custodians are fighting back. Francesca Carnevale explains how and why.

PHARMACEUTICALS ....................................................................................Page 67 The pharmaceutical industry is facing a crisis of confidence. Following a spectacular bull run between 1994 and 2001, US and European pharmaceutical company share prices have stagnated as investor confidence has fallen away. Even so, profits remain high. What’s the answer? Andrew Cavenagh reports.

LIFESTYLE FUNDS ............................................................................................Page 71 Only a few years ago, 401(k) plan participants were clamouring for more investment choice. Plan sponsors then added more products, but too quickly everyone complained they had so many choices they could not decide what to do. Enter the life cycle fund, a product that is taking the 401(k) world by storm. Neil A. O'Hara reports.

HEDGE FUNDS REPORT ............................................................................Page 74 So far small but constantly growing institutional investor allocations, proposed Securities and Exchange Commission regulations and new management strategies are subtlety changing the $480bn US hedge fund industry. By Karen Jones

M AY / J U N E 2 0 0 5 • F T S E G L O B A L M A R K E T S

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Market Leader TRANSITION MANAGEMENT

TEETH & THE T-CHARTER Enjoying boom times, the transition management (TM) market is increasingly crowded and complex. While competition has increased service levels and choice (and helped push down fees), the selection process for transition management has become more difficult. In the search for consistency, the elimination of conflicts of interest and even double charging, leading providers have come up with the idea of launching a code of practice, or ‘T-Charter’ as it is becoming known. Is it a force for good? Francesca Carnevale tries to find some answers. N DECEMBER 2004, at a Euromoney conference on The Future of Transition Management an end-of-session discussion panel delivered rather more than the conference delegates had bargained for. The panel – chaired by Tim Wilkinson, managing director, transition management at Citigroup – included TM doyen Graham Dixon, managing director, transition services at Credit Suisse First Boston (CSFB) and Andrew Williams, investment consultant at Mercer Investment Consulting. Dixon boldly threw aside the anodyne discussion topic and invited everyone to get down to a more meaningful discussion. There was an important question facing TM, he said. “Is it time for the market to finally agree standards of practice?”he asked. From that spur of the moment talkshop, a comprehensive market consultation exercise on the need for a code of practice [the so-called T-Charter] was kick-started that could have significant repercussions for the transition management sector. Dixon, like many other transition managers,

Graham Dixon, managing director, transition services at Credit Suisse First Boston

believes the time is ripe for the charter. And, he thinks, it is imperative for market practitioners themselves to lead the effort towards self-regulation. “Many users of TM services do not have the weapon of withholding repeat business,” explains Dixon, “we would like a charter to protect the non-expert user, for example, a corporate pension fund which does not have the technology and means to monitor and measure portfolio transactions. Professional users, for example a fund management dealing desk, do not need this protection. They already have a level battleground for business and weapons of mass destruction if required.” The debate over the usefulness of a T-Charter hangs on the mounting complexity of the TM offering. A big change has occurred as investment banks, such as Lehman Brothers and specialist brokers, such as Instinet and ITG, as well as integrated offerings from JP Morgan and Citigroup have taken on the big custodian houses, such as Bank of New York, State Street, Mellon and Northern Trust. The

result is a patchwork of service providers, often with differing definitions of TM itself. In the context of the United Kingdom market, says Mercer’s Williams, “five years ago when we started researching transition managers we were looking at six or seven firms, now it involves at least 16 major players and the different approaches to the business mean different business models on offer. It is harder for clients and consultants to choose the right transition manager.” It is not an issue of competition, expands Citigroup’s Wilkinson,“it is a question of competence and delivering an efficient solution to the client. Even looking at the most simplistic scenario of moving $100m from one manager to another, the Fund could lose between 100 and 150 basis points of performance if the portfolio transition is not managed properly; versus typically 25 to 30 basis points if it is.” Jody Windmiller, director of transition management at UBS stresses: “If it is implemented, the T-Charter will go a

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Market Leader TRANSITION MANAGEMENT Tim Wilkinson, managing director, transition management at Citigroup

long way to raising awareness of the services and processes involved in transitions. That includes knowing the right questions to ask of your transition service provider. It is an assurance of a baseline level of integrity.” Since the publication of seminal research, undertaken by Bob Werner, at Frank Russell Securities, Inc. back in 1999 revealed a surprisingly wide gap between promised cost estimates and delivered performance in the portfolio transition management business, there has been a simmering and unresolved tension in the market. Werner conducted a study of more than 100 pension funds in the United States, Canada, Australia and Europe between 1999 and the first quarter of 2001 to see if low-cost estimates resulted in low cost transitions for clients. Werner found that “they do not, and clients generally were unaware that such a substantial gap exists.” The research also raised other issues, such as the supply of unreasonable estimates by providers simply to win business. It also highlighted the mis-selling of

services where so-called TM specialists, or what Dixon refers to dismissively as “part-time transition managers,” who in practice provide portfolio trading services instead of the distinctive and specialist portfolio TM offering. Werner claimed he also found conflicts of interest rife in the business, with some large investment banks bidding low on TM project fees, only to make up the revenue shortfall through trading activity via their proprietary accounts. As Citibank’s Wilkinson posits: “it is the ultimate conflict. Can you act for the client and the bank at the same time?” Index funds, Werner continued, also have a strong incentive to maximise crosses with their internal funds, regardless of the impact on the transition client’s destination portfolio. That would imply therefore that while many transition managers play fair – some do not and it is harming business. “The very fact that one of the stated objectives of the T-Charter is to ‘protect clients from poor or questionable practices’ indicates that implication to be correct,”says Windmiller. In January this year, Dixon invited 10 or so major providers in the market to a meeting where he set out his ideas and where he asked them to help him thrash out a draft code of practice, or T-Charter which could, in the words of State Street’s European TM team “have teeth,” be widely adopted by the market and at the same time give a large degree of comfort to clients. Perhaps it was the time of the month with little business to transit, or perhaps it was the fact that frustration with certain market practices had built up to boiling point. Whatever the reason, the kickoff meeting was packed, according to attendees. It included Dixon, Wilkinson, Williams and Windmiller, Paul Samuel of Barclays Global Investors, Julie Dickson from Mellon,

Josephine Defty of Russell Investment Group, Rakesh Manani from Goldman Sachs, Peter Walker from Merrill Lynch Investment Managers (MLIM), Rick Di Mascio from Inalytics, John Minderides from JP Morgan, Lachlan French from State Street, Alex Johnstone from Bank of New York and Tony Nash from Deutsche Bank. The meeting was chaired by another doyen of the TM market Nigel Foster, who built up his market reputation at ECrossnet and MLIM. Foster was brought on board as a sort of “respected elder statesman” says Dixon, “who is ensuring the market is properly lobbied and canvassed for input and opinions.” A number of people and institutions came under fire at the meeting. With the first flush of frustration articulated, people at the meeting soon found a more proper direction and some 12 marketcritical issues were hammered out into a draft charter that would be the basis of extensive market consultation. Comprehensive meeting notes were sent out to participant and non-participating firms, asking for comment and suggestions. A second meeting was arranged for February, and while fewer institutions turned up to that follow-up meeting, a more substantive form to the elements of a possible charter began to emerge and the “twelve points were reduced to a more manageable eight,” says Dixon (please refer to Box 1: What the T-Charter might contain). The market reaction to the proposed charter is mixed. As Wilkinson says, “all non-investment banks are likely to be very supportive of this charter.” Meanwhile Simon Hutchinson, head of European transition management at Northern Trust says “Realistically,

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it is not too controversial and we are not massively surprised about what is in there.” Questions about the efficacy of the charter rest on various points. First that it might be too prescriptive and “create a rod for our own backs,” according to one leading transition manager. Dixon counters with “if the charter is causing you to do something not in the interests of the client, then we will change it. We are deliberately trying not to be too prescriptive. It is the spirit of what we are trying to do that is important.” UBS’s Windmiller concurs.“It is a fine balance though,” she warns. “The

initial draft was certainly too prescriptive. There are so many different types of transition managers and it was important that the charter be seen not to favour one business model over another. A key consideration behind the initiative was that clients had more choice, rather than less.” John Minderides, managing director, transition management at JP Morgan acknowledges that the draft charter is, “more constructive than I thought it might be.” He explains that TM specialists already work in a highly regulated environment. “Pre-hedging, for instance, is already covered by the

Financial Services Authority (FSA) rules anyway. It not an issue unique to transitions in a primary way.” A third element is that it is too UK centric. Again, Dixon counters with the fact that the principles of the charter have a global application.“We weren’t thinking of anything other than immediate market concerns when this came up. However we are seeing interest from the US about its applicability.” UBS’s Windmiller acknowledges that the charter is “probably UK-centric at the moment.” However, she points out that there are more transitions undertaken in the UK than elsewhere

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Market Leader TRANSITION MANAGEMENT

in Europe, although, “we are seeing more interest from European clients and eventually the charter will become a global phenomenon.” “Off the record” transition managers mention other concerns such as one broker TM specialist who says “I doubt many transition managers will be able to get their signature on the charter without some substantial input from their firm’s compliance people, and that may ultimately take the teeth out of the initiative.” “I worry about that,” says Dixon, who explains that that particular requirement flows from the consensus view that the T- Charter “has teeth.” He also points out that the FSA, which may be supportive of the self-regulatory element in the draft charter, is the natural institution with which compliance officers can have a productive dialogue. Others point out that while there is a strong belief that some houses are winning business falsely “there is no

connection between that and post event performance,” although the same transition manager concurs that “people should be more honest about measuring post trade. Guarantees about crossing, for instance, are nonsense [sic].” Others question the need for a separate team saying, “How can you possibly leverage the broader expertise of your bank by ring-fencing transition management?” Then again says another provider,“given that a lot of the issues are aimed at pension fund trustees, it may be that the National Association of Pension Funds (NAPF) should also be involved, rather than the FSA, which covers even market professionals who do not actually need this charter.” Some critics see the charter as an indirect marketing exercise by the people who raised the issue “giving added credibility to the people who are associated with it”; others say it that in important essentials, it still

WHAT THE T-CHARTER MIGHT CONTAIN

T THIS STAGE of the market consultation process eight guiding principles have been suggested as the basis for a workable T-charter. Transition managers: • Must disclose any potential conflicts of interest when they submit bids to clients and explain how those conflicts will be managed. • Should guarantee confidentiality to the client and show or prove how they will keep confidentiality. • Should confirm that the required experience, resources and processes are in place for each transition assignment. • Should specify the performance benchmark that reflects the objectives of the transition and track records carefully. • Should confirm that systems are accurate and timely. • Should present cost estimates in the same way. The layout of specific costings should be common to all TM bids, so that clients can compare bids side by side. • Must disclose all fees ahead of the transition and provide detailed calculations of fees after the transition has taken place. • Should follow appropriate dealing practices on pre-hedging, crossing and foreign exchange.

Simon Hutchinson, head of European transition management at Northern Trust

remains light.“In some ways it brings the lowest common denominator of capability to the fore,” says another transition manager. TM providers should be accountable not only for their performance in safeguarding portfolio profitability but also, where relevant, the activities of third party agents, that are trading out the portfolio.” Windmiller jumps to the defence. “I understand the concern about the charter achieving the lowest common denominator, but that can still be a very high standard indeed. In addition clients will be assured of this baseline level of integrity. That’s a really good thing. It has to be said that if a TM manager does not sign up, there should be a compelling reason why.” According to Mercer’s Williams, where the T-Charter really breaks new ground is in the area of cost estimation. There is a real drive to formulate a standard template, where every assumption made in a bid is stated “so that when you receive bids from a request for proposal they can be compared on a like basis or, at least you should know where all the assumptions have originated,”he says. Northern Trust’s Hutchinson thinks that as the nature of the business changes, and client’s grow in sophistication and they themselves set the level of demand for more

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Market Leader TRANSITION MANAGEMENT

transparency and better practice. “Increasingly clients are looking for deeper service relationships with transition managers. The fact that the business is much more complex than simply trading out of one portfolio structure into another, means that clients are looking for a much deeper understanding of their strategies and preference and are looking for a relationship which covers regular assignments.” The latest draft charter is currently with the FSA for guidance and feedback. So far, reports Dixon, the feedback is extremely positive. “The FSA is interested and supportive and have asked to be kept informed of progress. The syndication to the investment consultants has uncovered 100% support, and three firms have agreed to collaborate on the T-Charter

cost estimation template,” he states. The next round of talks with transition management providers is scheduled for May. Dixon is also waiting on further input from clients, investment consultants and transition managers on the latest draft. The most valuable element of the consultation so far adds Mercer’s Williams is “having the majority of transition managers in a single room, discussing important market issues. It’s been pretty powerful.” It is still too early to say whether the charter will undergo further modification and streamlining and whether it will come into formal existence some time soon. “Something that makes the industry more transparent for everyone can only be a good thing,” says JP

Morgan’s Minderides. Windmiller at UBS is sure that “bidding for business will become more standardised,” if the T-charter is adopted. She cautions, however, against the charter putting too much emphasis on costs.“Teamwork, clarity of process, reporting capability and depth of resources across asset classes are equally important considerations. There are several different business models, evincing the different strengths and expertise,”she explains. “Having that choice available is good for the client.” The last word should, perhaps, go to Dixon who says,“As an absolute minimum, the duty of any transition manager is to act in the client’s interests, in good faith, with due skill and care, and in accordance with best execution rules. Is it too much to ask?”

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In the Markets SYNDICATED LOANS

Bumper syndicated lending extracts its price Investor appetite is allowing borrowers to procure competitive terms across the debt markets, with public and private bond spreads also narrowing during 2004 and the beginning of this year. For syndicated loans, however, it is not only pricing that is under pressure but also structure, documentation and covenant packages. Ian Fitzgerald, director and head of loan syndication at Lloyds TSB Capital Markets, looks at the market’s prospects for the rest of this year.

Figure 1: Transaction volumes in European syndicated lending 1999-2004 600

800

600 400

500

300

400 300

200

200 100

Source: Dealogic

Volume $bn

2004 2nd half

2004 1st half

2003 2nd half

2003 1st half

2002 2nd half

2002 1st half

2001 2nd half

2001 1st half

2000 2nd half

2000 1st half

100

1999 2nd half

Number of transactions

700

500

1999 1st half

financial covenants. Although some bankers argue that such lending is evidence instead of unusually strong banking relationships. There is also a wider trend in the European market to leverage deal structure against credit quality. In the more conservative United Kingdom market this has manifested itself in efforts to fix financial covenants against a single criterion – rather than the traditional two or three – for some investment-grade borrowers. But pricing, covenants and structure are all ultimately factors within the relationship between the borrowing company and the lending banks. As such, lending decisions will remain a response to the credit strength of the

Volume ($bn)

UMPER LENDING VOLUME in 2004, including substantial increases in leveraged loans, has left the syndicated loan market finely balanced. But it has failed to stem growing competition between banks and that continues to drive down pricing. Given that balance-sheet lending decisions – both for investment-grade and loans further down the credit curve – are now supported by sophisticated riskengagement mechanisms, (including a new generation of credit risk instruments) it is not clear how this pricing cycle will compare with previous cycles. Neither is it clear which banks will manage to stay in the market when pricing finally bottoms out. Investor appetite is allowing borrowers to procure competitive terms across the debt markets, with public and private bond spreads narrowing – a trend begun last year. It is not only pricing that is under pressure but also the structure, documentation and covenant packages attached to transactions. This is especially true for more creditworthy borrowers in the market and particularly the continental markets. Veolia and RWE, for example, tapped the French and German markets respectively with few or weakened

company and its need for wider banking support. The combined effect of both this structural compression and the pressure on margins is a narrowing in pricing differentiation between stronger and weaker credits. This is partly why banks are putting resources into widening their marketing franchises to focus more closely on mid-cap and regionallybased companies. Another area that is benefiting substantially from the depressed major M&A market is, of course, the private equity-led acquisition finance business. The level of LBO/MBO loan transactions was up by 78% across Europe last year – again, encouraged by fierce competition between banks taking place against a relatively stable economic background. In the longer run, this combination may mean the market will contract to the extent that only the strongest international banks can compete in the investment-grade lending market. By

No. of transactions

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the same token, smaller regional banks are being forced to refocus on their home or preferred markets. It is clear that banks without a certain critical mass in their balance sheet are finding it harder to compete with those that have built a strong franchise, underpinned by the support structures and products to sustain volumes. Indeed, a consolidation is now underway that has resulted in most UK investment-grade market liquidity being provided by the top 12 banks. And in the western European market as a whole, a similar proportion is provided by a mere 20 top tier banks. But even as this polarisation takes

Figure 2: Refinancings dominate European syndicated lending

France

Germany

Refinancing

Source: Dealogic

M&A

place, a question mark still hovers above pricing. How long will lenders continue to fund at what are increasingly tight rates? With pricing approaching its cyclical low point – and given that such a high percentage

. ard

w No

LBO/MBO

Other

of borrowers have completed or are completing recent refinancings – one has to wonder where the market is headed. While uncertainty lingers over a possible resurgence in big ticket M&A, the market could remain

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In the Markets global economy. This is augmented by the steady release of strong corporate sector results, continued bank liquidity and a stable geopolitical outlook. For this situation to change dramatically will, I believe, require a major shift in at least one or more of these factors. And in the absence of these shifts, current market dynamics make this an excellent time for borrowers to raise debt finance.

throughout the years of 1987 and 1988. And while banks continue to voice their concerns over returns and relationship profitability, there is substantial liquidity embedded within the system and no real signs of a change in current market trends. History tells us that these trends do at some point reverse, but what will be the trigger? Ultimately the market is being driven by a seemingly robust

European syndicated loan volume by country 1999 to 2004 600

500

Volume ($bn)

400

300

200

United Kingdom

France

Germany

Italy

Netherlands

Spain

2004 2nd half

2004 1st half

2003 2nd half

2003 1st half

2002 2nd half

2002 1st half

2001 2nd half

2001 1st half

2000 2nd half

2000 1st half

1999 2nd half

100

1999 1st half

SYNDICATED LOANS

vulnerable to pricing shocks. And, as pricing begins to bottom out, relationship histories are becoming an increasingly vital consideration for banks. They are also becoming more important for companies as they consider where they might raise funds to participate in a potential M&A surge. As such, companies are likely to benefit by selecting their core liquidity providers with care. Exactly what will happen for the rest of 2005 is difficult to predict. Generally speaking, UK corporate balance-sheets are in good shape – so the big questions remain whether cash rich large-cap companies will indeed approach an amenable loan market for more aggressive M&Arelated purposes and where the bulk of that demand will rest – in continental Europe or, as in the past, firmly in the UK. It is also clear, however, that loan market pricing has not yet reached the low levels that the market suffered during 1995 and 1996 – or even

Others

Source: Dealogic

RECORD LENDING IN 2004

ad anyone said in January last year that a new record in syndicated lending would be set by the end of 2004 they would have received short shrift. Back then bank liquidity far exceeded demand and margins continued to narrow even as deal volume and numbers remained largely flat. By mid summer however, that changed. The French and German markets led the pack, with demand driven by industrial and utility refinancing and they even seemed ready challenge the UK’s historical dominance. In France, for example, 39 of the CAC 40 companies refinanced, while in the UK only 38 of the FTSE 100 refinanced or restructured. The £2bn Land Securities transaction – itself for a restructuring and notable for its innovative securitisation structure – was a high-profile exception to this. In a late rally however, a substantial number of UK borrowers finally began to come to market, taking advantage of competitive conditions. Another area that provided a rich appetite for new loans – both in the UK and on the continent – was sponsor-driven leveraged buyouts. The largest of the leveraged transactions in the market was to support the acquisition of the AA by CVC Capital Partners and Permira Europe. These trends also exposed a greater degree of investor appetite than many previously assumed. Equally, it highlighted the fact that market conditions had expanded further than expected to accommodate the demand. In the UK for instance, expansion came via a substantial increase in mid-market, rather than big-ticket corporate borrowing. The average transaction size in the UK was $550m, compared to the average combined deal size in France and Germany of $950m. Larger transaction sizes on the continent reflected deeper demand for new money and ultimately pushed up overall volumes. European lending volumes rose to $887.7bn–up 44% on 2003, while volume was up in France by a whopping 139%, in Germany by 39%, and in the UK by 42%.

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Lifetime support Demand is expected to rise for immediate annuities, which convert lump sums into income streams guaranteed for life – though sales to date remain meagre. Neil A. O'Hara investigates a product that may finally be about to realise its potential in the US market. RADITIONAL PENSION INCOME annuities may soon be an endangered species. Recent US Department of Labor figures, show the number of private sector employees covered by defined benefit plans dropped from 30.1m in 1980 to 22.6m in 1999, while defined contribution plan coverage rose from 14.4m to 46.9m over the same period. In addition, many defined benefit plan participants now can and do, choose a lump sum distribution at retirement. “There is an increasing need for guaranteed lifetime income because of fewer defined benefit pension plans, the uncertainty of social security, earlier retirements and longer life spans,” says Jac Herschler, vice president of Prudential Annuities, a unit of Prudential Financial, Inc., “To date, the solutions have not been the annuitisation of those assets.” Shared risk lies at the heart of any annuity pool. An insurance company will make higher payments to survivors because life expectancy for the group is more predictable than for individual participants. Yet research conducted by Prudential shows that Americans prefer to retain control over their retirement savings.“It’s a visceral negative reaction to sharing risk when it comes to payout,” says Herschler, “People have an aversion to the idea that those who die early make lifetime payments to the ones who live longer.”In contrast, consumers readily accept shared risk when they buy life insurance, which has opposite cash flows: the long-lived fund lump sum

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 5

payments to those who die young. Unlike immediate annuities, deferred annuities, which are primarily used for tax-sheltered accumulation, do not participate in a risk pool unless the holders elect to do so when withdrawals start. Until then, the assets remain under the holders' control. Some insurers now permit deferred variable annuity holders to make regular withdrawals without joining a pool. Those contracts retain the liquidity of a deferred annuity while generating income similar to an immediate annuity – but there is a catch. “It falls short of the immediate annuity because once you are out of money, you are out of money,” says John Meyer, a senior vice president in charge of the individual annuity department at New York Life Insurance Company, “That is the beauty of immediate annuities. Once you make the bet, you are guaranteed to get that payment for the rest of your life.” Herschler does not believe consumers are ready to embrace annuitisation yet. “The breakthrough for the industry in addressing longevity risk is going to come from an accumulation vehicle from which you can take withdrawals,” he says. Prudential now offers an optional guarantee on its deferred variable annuities that will continue minimum payments for life even if poor investment performance and withdrawals deplete the account and the holder never chose to annuitise. The company charges a fee for the

insurance, but upon death the account balance – if any – passes to a designated beneficiary or the holder's estate. If Prudential’s guarantee catches on, it will attract more money to deferred variable annuities. These flexible vehicles allow investors to select among asset classes in subaccounts that operate like mutual funds. Without a guarantee, payouts under a variable annuity reflect the investment performance of the chosen sub-accounts, which are typically managed by mutual fund advisers. Immediate annuities with terms similar to Prudential's guaranteed contract offer higher income in exchange for ceding control of the assets. That should be a powerful selling point, but annuity providers have failed to get the message across to consumers. Financial advisers, through whom annuities are sold, resist the idea. Advisers who charge a percentage of assets face a drop in revenue if clients buy immediate annuities; some refer to it as “annuicide”, according to Michael Henkel, president of Ibbotson Associates, a research and consulting firm that focuses on asset management. Annuity providers who spy an opportunity in the guaranteed income market are trying to storm the barricades. In August 2003, New York Life introduced its latest immediate annuity, which gives consumers more flexibility and allows advisers to choose a lower commission rate that lasts 10 years instead of a one-time payment. The product attracted $292m in 2004, about 5% of New York Life’s total annuity sales compared with 2% to 3% for most providers.“We see that growing pretty rapidly over the next 5 to10 years,”says Meyer. A recent NASD rule change could jump start immediate annuity sales: for the first time, broker-dealers may use statistical simulations as well as straight line projections in sales materials.

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In the Markets INDUSTRIAL CLASSIFICATION BENCHMARKS

ICB builds up market share It is often stated that the benchmark used to describe an asset class or investment opportunity is one of the most basic assumptions in the creation of an investment programme, from asset allocation decisions to performance evaluation. Inevitably then, competition to provide the investment market’s preferred industry classification system is heating up. N EARLY MARCH, Thomson Financial (TF), an operating unit of the Thomson Corporation announced it would adopt the recently launched Industry Classification Benchmark (ICB) as its standard classification tool across a range of its global data products and services. Thomson Financial is the first global data provider to adopt the new classification system from FTSE Group and Dow Jones Indexes. Launched jointly in January 2005 by Dow Jones Indexes and FTSE Group, ICB is beginning to establish itself as a seminal classification system, classifying some 40,000 companies and 45,000 securities around the world. “It represents a truly global solution to our clients’ classification needs,”said Sarah Dunn, chief content officer at Thomson Financial in March. The desire to provide a comprehensive industry classification system has been underway for decades, since the US government established industry classification systems to organise industries into more definable categories back in the 1930s. In the US the Census Bureau

traditionally used the Standard Industrial Classification (SIC) system. That changed when Congress passed the North American Free Trade Agreement (NAFTA), and the US, Canada and Mexico jointly developed a newer system called the North American Industry Classification System (NAICS). Regardless of the system type, industry classifications can be an effective method for extracting industry information and generating prospect lists. Today index providers have joined the search for optimal industry classification by providing accurate and transparent sector definitions. FTSE Group originally developed its Global Classification System in the spring of 1999 and was quickly taken up by stock exchanges in Athens, Cyprus, Egypt, Johannesburg, London and Madrid, as well as Goldman Sachs, Hang Seng, HSBC, ING Barings, Nicholas Applegate Capital Management, Reuters and US-based investment consultants Frank Russell. This original classification allocated companies to an industrial sub sector that most closely defines the nature of

its business. In its first iteration, this was determined by the proportion of overall profit arising from each business area within a company. The system comprised 10 economic groups, 39 industrial sectors and 102 industry sub-sectors. Over time the investment industry has witnessed a growing requirement for an internationally accepted industry classification system. One that allocates a clear economic activity description to one and only one class. It is necessary to achieve this, so that economic activity can be accurately measured, without fear of duplication. Without such a classification and a complementary integrated statistical infrastructure some economic activity could be double-counted or not counted at all. It is also useful for interindustry comparisons of key economic performance measures. More pertinently for the investment industry, classifications aim to enhance the investment research and asset management process for financial professionals worldwide. In response, leading index providers have worked hard to develop an optimal industrial classification system. In an effort to provide a superior classification system, FTSE Group and Dow Jones Indexes announced that they would merge their industry classification systems in February last year and created ICB. The system was fully operational by January 2005. Major index providers including the Hang Seng (HSI) in Hong Kong, the Russell 3000 Index family in the US and the FTSE Xinhua (FXI) in China, have already adopted the industry classification system, and STOXX Ltd uses ICB for its indices across Europe. The Financial Times, The Wall Street Journal, CNBC, SmartMoney Magazine and Dow Jones Newswires also use the classification system, while exchanges such as NASDAQ, the

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James Cemprola, managing director, ICB

New York Stock Exchange (NYSE), Euronext, the Swiss Exchange and the Johannesburg Stock Exchange are expected to take up the classification imminently. Not everyone uses the same system and competition is rising between ICB and the Global Industry Classification System (GICS). GICS was developed by Morgan Stanley Capital International (MSCI) and Standard & Poor’s (S&P). The GICS structure consists of 10 sectors, 24 industry groups, 64 industries and 139 subindustries and which are reviewed annually. Most notably perhaps, NOREX, the strategic alliance of eight Northern European securities exchanges, implemented GICS as the official standard for the classification of listed securities a couple of years ago.

Transparent and Rules-Driven ICB represents a Global Industry Classification solution for the investment community, says James Cemprola, Managing Director, ICB, “our role is to bring a market leading product to bear, that accurately and comprehensively classifies companies and securities.”The main benefit is the sheer reach of the system, which

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 5

incorporates 40,000 companies and 45,000 securities (equity based), explains Cemprola. It allows speed in delivery. He adds,“if you are planning an IPO for example, we can deliver the appropriate classification within 48 hours.” The applicability is also appreciated by the custodians, “who require a strong standardised product, and which allows consistent reporting within industrial sectors.” The merger of FTSE Group’s and Dow Jones’s systems resulted in a “dramatic increase in coverage,” continues Cemprola. It is a development firmly in line with market requirements, he says as “for global investment services providers, such as Goldman Sachs, State Street and Northern Trust, for example, you need to provide an extensive and global system that more than matches their operational scale, while for exchanges such as the London Stock Exchange, or the Athens Stock Exchange, there is the benefit that everyone is utilising the same system.” Thomson Financial deciding to use ICB was an important strategic step for the classification system, explains Cemprola. “ICB will be utilised across a broad range of TF products including

Thomson One, Datastream, Worldscope and First Call, and TF clients also have the opportunity to sign up for the full ICB universe product on a pass through basis.” What makes ICB interesting, says Cemprola is that it contains four classification levels, which includes 10 separate industries to help investors monitor broad industry trends, 18 special Supersectors that can be used for trading, 39 sectors and 104 sub sectors which “if you utilise a bottom up investment strategy, you can screen using the granular sub sector classification,” he adds. Companies within sectors are assigned on a primary revenue basis, rather than the old methodology which determined a company’s classification by the proportion of overall profit arising from each business area within a company. “ICB is an important development for both Dow Jones Indexes and FTSE Group and the marketplace. Many of our clients are adopting and organising around the new system, and ICB represents a comprehensive and global industry classification solution for use throughout the investment community,” adds Cemprola.

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That cuts no ice with N SEC PROPOSAL to Brandon Becker, a partner at enforce a 16.00 hour Wilmer Cutler Pickering Hale deadline for mutual & Dorr, who argues that SEC fund orders has drawn flak enforcement actions affect the from the industry because, in outcome. “If you do your practice, it would impose a rulemaking after you have much earlier deadline for already sewn up the leading investors in 401(k) plans. firms with settlement orders “Many investors use you have chilled that intermediaries to receive the conversation going forward,” orders,” says SEC he said. Firms that have Commissioner Roel C. already committed to new Campos, “I think it is safe to procedures in settlements say we will have a hard close have no reason to oppose a 4pm rule. It is a matter of to rule extending those whom does the order run?”He procedures to other players appears to favour a clearing who might otherwise gain a house that collects all orders competitive edge. over an audit trail to verify that Market timing arbitrage investors entered orders before opportunities would vanish if the market close. mutual fund prices reflected Next day pricing of mutual fair value, the “ultimate funds would be a cheaper and solution” according to more effective alternative, Commissioner Campos, according to Richard Herring, although he acknowledges it Jacob Safra Professor of has practical limitations. International Banking at “That is an art,” he says, “We Wharton Business School. “It have asked the industry to makes market timing harder, price at fair value where day trading becomes hopeless, appropriate.” Portfolios with and it is easier to avoid late large positions in Asian and trading as well,”he said. Funds Eighteen months after the market timing European securities are that welcome market timers, scandal broke, the Securities and Exchange particularly vulnerable to such as some Rydex funds Commission (SEC) is still debating how best stale prices from different (which are index and sector to curb the practice. Neil A. O'Hara reports. time zones, Griffin notes. funds that are designed to match a specific benchmark with no expressed strong support for a hard “Those funds should look at trading costs) could opt out as long as 4pm close. The SEC softened another appropriate countermeasures for they disclosed their policies and deterrent to market timing when it short term traders,” he adds, “US backed away from mandatory 2% equity portfolios are not an efficient applied them to all investors alike. Ken Griffin, founder and CEO of redemption fees on short-term mutual vehicle for market timing.” “Fair value pricing is a scary place Citadel Investment Group, believes fund trades; the final rule leaves state-of-the-art technology can redemption fees to the fund board's to go,” says Herring, “It is very eliminate market timing. “The ability discretion. “We were concerned subjective.” Only half in jest, he to create same day straight through mandatory redemption fees might suggests the SEC should have processing of mutual fund trades is a make retail investors feel this was required hedge funds caught in the matter of will,” he says, “It is a much somehow a more costly way to invest,” market timing scandal to disclose simpler solution, which does not said Commissioner Campos at a recent their models.“Funds could then turn require people to understand that they Harvard Business School seminar, who market timers’ weapons against bought at tomorrow's price. That is felt the change reflected the agency’s them to protect long term investors,” he concludes. very confusing to retail investors.” He rulemaking flexibility.

JUSTICE

DELAYED

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Regional Review NORTH AMERICA

WILL THE SALSA SOUR IN MEXICO? Investors in Mexico have been dancing salsa all the way to the bank. For the last two years Mexico’s stock market has been sizzling hot. In March it reached its highest level for 10 years and came close to regaining ground lost in the devastating Tequila crisis of 1994-95, reaching a value of $183.4bn compared to $195.8bn before the devaluation. Mexico’s Indice de Precios y Cotizaciones (IPC), the general equities index has soared more than 40% in each of the past two years, but following United States Federal Reserve chairman Alan Greenspan’s comments in mid-March, is market sentiment turning? Benedict Mander reports from Mexico City. “

F IT ISN’T already, the party will very soon be over for Mexican equities, as the US Federal Reserve has taken the path of raising interest rates at a faster pace than it has probably wanted to do. The latest inflation data suggest that it would be somewhat heroic to keep its promise of ‘measured’ increases. Therefore the market in Mexico remains very exposed to any change of speed by the Fed,” says Dr Rogelio Ramirez de La O, an economist with Mexico Citybased research firm Ecanal. Bond Snodgrass, an analyst at Mexico City-based boutique Vera

Research agrees,“We are moving into a phase of less enthusiasm in Mexican markets than we have seen over last few years,” he explains. “People are concerned about what is going on with the US budget deficit, as the only way for it to be funded is for interest rates to go up.” This is hurting stock markets, “although Mexico is in a good shape to weather this: domestic interest rates are way too high, so high that this will act as a shock absorber,”he adds. Ricardo Amorim, head of Latin America research for WestLB, thinks that the strength of the Mexican peso is an issue, saying it is “one of the only

currencies in Latin America that is overvalued as compared to historical standards – in 2004 the Mexican economy was the second slowest growing among the nine largest Latin American economies and it may be the slowest growing one in 2005.” Competition with China is costing Mexico part of its US market share and political uncertainty may cause capital outflows, he adds, “in short, I believe that the peso will depreciate and that the Mexican stock market is unattractive for foreign investors”. Tim Heyman, president of Heyman and Associates, explains that most Mexican assets “in terms of price to book valuation are the third highest after the US and India. The Mexican market doesn’t look cheap,” he says. However, he also has an issue with the definition of the Mexican stock market, observing that it needs to be viewed in a wider context.“People are beginning to ask what we really mean when we talk about the ‘Mexican’stock market,” says Heyman.“With so many de-listings and acquisitions by foreign

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companies recently, there are many by 75%, while Telmex is raising its fewer stocks now – in fact there are dividend by 12% from last year. Both only really ten major stocks, and they companies are also increasing the are not necessarily very Mexican any amount of money set aside to buy back more.”He pointed out that companies their shares, with America Movil such as America Movil, Telmex, increasing its buyback fund by Cemex, Bimbo and Grupo Mexico all US$455m and Telmex by US$546m. Carlos Hermosillo, an equities Ricardo Amorim, head of Latin America have major operations outside Mexico – in the case of Cemex some 55% of its analyst for Vector Casa de Bolsa, research for WestLB pointed out that the rise of the stock operations are abroad. Even though many may believe market has meant that while last similar-sized economy. According to that, overall, Mexican stock markets year dividends were at around 3%, the finance minister Francisco Gil are fully valued, global investors have they have now fallen to 1-2% this Diaz, the new law should contribute not lost interest in individual Mexican year. But he remains more optimistic “to better capitalising Mexican stocks. As Heyman points out, “The than others: “Although asset prices in companies, to their growth, to less leading companies here are good Mexico have reached historic highs it economic volatility, to the access of dividend payers and a lot of analysts is not the case for PE ratios which are medium-sized companies to the are recommending them this year below their historic average. I do not exchange, to job creation and to a given an environment of rising see Mexican stocks as expensive democratisation of capital.” But one negative factor that has right now, especially with a decline interest rates.” Three of Mexico’s four largest of some 10% during March. And if historically harmed the Mexican stock companies, which together dominate you compare them to US stocks, markets – political risk – has hitherto almost half of the stock market, Mexican PE ratios are about 20% remained in the wings. “With such performed so well last year that they lower. The average on the IPC is good and stable macro variables in Mexico, until recently the markets carried out stock splits in March to currently 16.5 times.” Also, a new law governing the stock seemed impervious to political risk. allow greater liquidity for investors. Telmex's shares gained about 16% in markets, which is currently awaiting But it is plausible to claim that some of 2004, while Cemex shares climbed approval from the Senate, is intended the recent correction – although it was 33%; and investors in America Movil to increase investment, improve rights mostly matched by other emerging reaped a return of nearly 100%. Latin for minority shareholders and boost markets so it is difficult to say with any America's biggest mobile phone the number of companies quoted on certainty – is explained by the fact that company America Movil split each the exchange. Mexico only has 150 this Lopez Obrador business is share into three, while fixed-line listed companies, while there are beginning to creep in,”says Heyman. market leader Telmex swapped two some 1,500 in South Korea, which is a Mexico has recently been in political new shares for every current turmoil owing to moves to one. The two companies, impeach Mexico City’s mayor controlled by the fourth Andres Manuel Lopez Also, a new law governing the stock richest man in the world Obrador – who is also leading markets, which is currently awaiting Carlos Slim, account for the polls to win the approval from the Senate, is intended about a quarter of Mexico's forthcoming elections in 2006. to increase investment, improve rights stock market and are Many interpret the among the businesses best impeachment process as an for minority shareholders and boost the known to Latin American attempt by his political number of companies quoted on the investors. They were soon adversaries to knock out their exchange. Mexico only has 150 listed joined by Cemex, the third most dangerous competitor companies, while there are some largest cement company in from the presidential race. 1,500 in South Korea, which is a the world, which split its One thing is for sure: the shares in two. troubles the elections may similar-sized economy. America Movil also cause can only increase as they boosted its annual dividend draw closer, say local analysts.

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ASIA

TAIWAN’S ROADSHOW BANGS THE DRUM FOR NEW INVESTMENT DOLLARS is a very reasonable T IS “PROBABLY better At the beginning of May the Taiwan Stock regime both in terms of to be the leader in the Exchange mounts its global road show to attract money exchange, money emerging market world more investors to the island, beginning in the flows in and out of the than to be just one of the neighbourhood with Hong Kong and Singapore. country from institutional crowd in developed When they see how that works, says Leon Ku, investors – it’s a complete markets!” wryly exclaims senior executive vice president of the Taiwan Stock 180 degree change.” Leon Ku. While Taiwan’s Exchange, the show will move within weeks to However, not everyone expansion of economic London, Edinburgh, New York and Boston. is so impressed, and the growth to 4.6% this year Doubtless investors will be impressed with the consensus has it that the may look almost sluggish progress the island’s markets have made – but they Taiwan market still has by standards set by China will need convincing that the progress will some distance to travel. In (currently 9.5%) or continue. Ian Williams reports. the 2004 IMD World Malaysia, it is more than Competitiveness Report, the enough to go round by The Battle for Investment – FTSE Taiwan vs. a Selection reliability of Taiwan's stock anyone else’s reckoning. of Asian Markets market information The currency, backed by 200 180 ranked only 34th, massive reserves, is not tied 160 compared with Singapore to the US dollar, so while it 140 (ranked 3rd) and Hong has appreciated relatively, 120 100 Kong’s 22nd position. it has not done so to the 80 Problems with English extent of pricing the island 60 language skills, and out of the global markets. 40 20 bureaucratic attitudes in It is government policy 0 both private and public to develop the island as a life still dog business. much more important Most investors would financial centre than it is FTSE China FTSE South Korea FTSE Hong Kong FTSE Singapore FTSE Taiwan also be happier with a less now, and it has been Data as at 31 March 2005. Source: FTSE Group confrontational attitude to passing legislation and Steve Champion is head of the New mainland China, not just because of encouraging reforms to that end. Ku suggests, dispassionately, that York listed Taiwan Greater China Fund the volatility it puts in the market but “the securities industry is now in the and author of “The Taiwanese Bubble” because restrictions on direct travel hands of a government that has no about more volatile days of the market and trade inhibit Taiwan from being historical connections or burden, so in the 1980’s. He says that “In the part of the regional market, which is they are able to carry out reforms that to early days it was illegal for non- where it would have a real their mind are in the best interests of the Taiwan residents without ID cards to comparative advantage. For example economy and industry.” He is referring open an account in a brokerage house, Europeans are concerned that several to the victory of the Democratic and even if you managed to open an thousand “European” company Progressive Party that ended the fifty account and made money in the stock products made in the mainland are year old domination of the Nationalist market there were foreign exchange banned from entry to the island. In fact, in addition to the Party with its bureaucratic, intricate and controls so you could not take the intimate linkages with the business money legally out of the country. And government’s own moves to reform, all of that has disappeared. Now there Ku has presided over a series of establishment.

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changes to the regulations of the Taiwan Stock Exchange, many of which are targeted at foreign investors, one of the more visible being an extension to three days for them to settle on deals, allowing them to bring in funds from abroad with fewer chances of hiccups. While he admits there is more to come, he does credit outside pressure from investors for many of the reforms that have opened up the markets, and helped position the island so that it can seriously consider the transition to being a regional centre. Assisted by the opening, currently foreign participation in the Taiwan Stock Exchange is now about 25%, up from single digits a decade ago. “We know that there is European and US money, and our list shows who. There is also money from Hong Kong and Singapore, but some of them represent US/European interests,” comments Ku. “The local institutions have about 10 to 15% market capitalisation but they have a buy and hold strategy, so from a turnover point of view they are a small proportion.” Indeed, many pension and investment funds are held in low interest bank accounts, and some international investment banks are looking hungrily at the opportunity to use the funds more profitably. The list of industries in which foreign ownership is restricted has been progressively shrinking. Kong Jawsheng, the Taiwan Finance Minister, led a road show earlier this year to persuade foreign investors to buy stakes in the state-owned industries. With a loud-talking Beijing, some Taiwanese are worried at People’s Republic of China money infiltrating the island, but as Ku points out,“From the regulatory side, it is not that easy to monitor the ultimate source of capital, whether it has PRC roots or not.” Indeed at a recent investment forum,

an advisor to Taiwan’s President, urbanely pointed out “If Chinese missiles pose no threat to the Taiwan markets, why should Chinese money?” Several money managers agree with Ku that the political risk has already been factored into prices so “the value and the market dynamics offers very little downside risk while the market reforms make an attractive opportunity from a market viewpoint.” In contrast, the PRC has been very eager to allow Taiwanese capital and companies to set up on the mainland. It is a key reason why, despite the occasional hair raising missile rattling standoffs across the Taiwan Straits with the mainland, Western investors have seen potential not only in Taiwan’s own resilient and maturing economy, but also from Taiwan businesses’ deep involvement in the mainland. Western investors in Taiwanese companies can get a stake in the Chinese boom, but with the benefits of the island’s legal and regulatory system protecting them from capricious mainland officials. This is the explicit strategy of Steve Champion’s Taiwan Greater China Fund, which had been investing for a long time in Taiwanese domestic but switched strategy at the beginning of last year. The idea was to have a play in China through Taiwan since “in Taiwan, the corporate governance, market regulations, transparency, accounting standards, legal systems all those good things are better and well developed.” An additional advantage is the freedom of information based on very lively local press. While playing the China card, Champion comments, that Taiwan is now “a value market: it has relatively high dividend yields, relatively low price book ratio, its volatility is way

Taiwanese Bronze Dragon Sculpture. Photo courtesy of istockphoto.com

down – it’s a market where a reasonable person sitting in whatever country could allocate a portion of their capital, because what you have there are very high quality companies, currently selling at low prices.” Driehaus Emerging Markets fund portfolio manager Emery Brewer affirms, “In the first quarter of 2004 the Taiwan market did extremely well and it was really tech sector, but primarily local plays. And the real estate sector, which went up there. We saw interest rates come down. We saw people buying up real estate, the banking sector did really well, particularly we saw big boom in consumer landing and credit card growth, mortgage growth.” He also confirms the degree of market maturity and finds the companies he deals with “very open, very transparent. Most of the stocks we cover we can get research reports. They are very open to people coming talk to them. In fact, on the tech side, they report monthly, so you get monthly sales data, you see the pricing data. It’s very transparent. The management is very keen in supplying as much information and data so that people can make judgments if the cycle is going to turn and the company is well positioned to take advantage of the cycle.” He is also impressed with the reporting standards of the local banks, which are also now branching out onto the mainland.

M AY / J U N E 2 0 0 5 • F T S E G L O B A L M A R K E T S

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Regional Review AFRICA & THE MIDDLE EAST

Rand impacts investment inflows

ar -0

N MARCH AN an International Monetary Fund report on the composition of capital flows into South Africa found an interesting anomaly; a pattern of capital inflows that are the inverse of typical inflows into emerging markets. While comparable countries, such as Poland, Malaysia and Mexico, generally Currency volatility accounts for relatively low levels of FDI, but not for experience direct foreign investment the country’s high levels of portfolio investments, according to a recent (FDI) inflows of around 2.5% to 2.6% of IMF report on South Africa’s capital flows. Ian Williams reports. GDP and portfolio inflows around 1.5% London had always been more of GDP, in South Africa, it is the other at R6.38, the rand has depreciated by way around. FDI accounts for only 1.5% about 14% from the high of involved in South Africa than New York, so Old Mutual, the insurance of GDP, while less stable portfolio R5.6175/$1.00 at the end of last year. But there are other anomalies company, Anglo-American and South inflows now account for 3.5% of GDP. The openness of the South African impacting on investment inflows. African Breweries all listed in London, economy, the degree of exchange rate South Africa’s isolation in the 1970s although they maintained their listing volatility, exchange controls and resulted in a highly developed financial on the Johannesburg Stock Exchange inflation are key ingredients of the infrastructure and industry, which in as well. Since then, gold, platinum, local investment environment. some ways was shielded from coal, diamonds and other commodity Although currency volatility ups the competition by international sanctions. prices have risen in the face of global and South African uncertainty of demand for exporting The result is a strong infrastructure on demand companies and may reduce the the one hand but a third world gross manufacturing has proven very profitability of FDI, its impact on national income level for the majority competitive on the world stage, portfolio inflows into the country is of the population, which has a chronic making up over a third of exports, Julie Pfeffer, emerging markets less clear. After all, portfolio investors 28% unemployment. The new majority elected equity analyst with DuPont Capital can always hedge currency risk and continued volatility invariably attracts government has tried to harmonise the says “For better or worse the Rand is portfolio investors with a higher risk two by building on the economic base, still to a great extent influenced by tolerance. What is emerging however and South African companies, once the commodity prices. And if you look at the prices of big is that the Rand/dollar commodity exports, for exchange rate is proving South African Rand vs. US Dollar – March 2000 to 2005 15 example, gold, platinum central to the debate over 14 and coal, they have all currency stability, with an 13 gone up so much in dollar attendant knock on effect 12 terms [and even in Euro on US investor appetite for 11 10 terms] that the Rand has South African risk. 9 been buoyed up by that.” After the US Federal 8 Additionally, “we still Reserve took interest rates 7 have quite high interest up to 2.75% in March there 6 5 rates in South Africa was a rise in expectation relative to the rest of the that US interest rates will Data as at 31 March 2005. Source: FTSE Group world,” says Pfeffer, “so move up to 3.75% by year there is still a pretty end. The obvious result was that investors are switching heavily into world was opened up to them, took to substantial fair trade in the interest rate dollar assets, at the expense of global the global economy with alacrity. differential between its rates and emerging market equities and bonds. South African Breweries’ acquisition of everywhere else.” She also points to Commodities and metals have also Millers in the US and other assets in continuing and favourable macroeconomic trends in the country. been sold sharply down. With the dollar Europe turned the traditional tables.

MAY/JUNE 2005 • FTSE GLOBAL MARKETS

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Regional Review AFRICA & THE MIDDLE EAST 30

ar -0

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Inflation is low, “and the government Africa.“As income levels have gone up maintain that growth will entail there are a lot more people that are coping with two distinctively South budget is quite strong,”she says Taking all this together with a well brought into the formal economy in African challenges: one is the developed and active local market South Africa and that helps. If you appalling casualty rate of HIV/AIDS, (with a lot of liquidity), it is not look at the regional retailers, for which takes its toll on both the formal surprising that South Africa looks instance, they have had a massive run and informal sectors. There, the increasingly attractive to American in retail revenues and profits have government is better equipped than most in the continent to investors. Indeed, in a rise to the challenge. perverse way, the legacy of FTSE/JSE All-Share General Retailers Index vs. FTSE/JSE The other challenge is Apartheid has enhanced All-Share Index 350 how to bring together the its attractiveness, since it is parallel universes of the now the only politically 300 developed economy in correct and financially 250 South Africa with the sound African play. For 200 underdevelopment, poverty example the New York and unemployment of State employee’s pension 150 much of the population. It is fund announced that it 100 here that the government’s was putting $300m into 50 project of Black Economic the country last year for Empowerment, although just those reasons. provoking one or two While American funds FTSE/JSE All-Share General Retailers Index FTSE/JSE All-Share Index grumbles, seems to be often invest in South Data as at 31 March 2005. Source: FTSE Group accepted by the business Africa through London, there are increasing opportunities skyrocketed.” She stresses the establishment as a reasonable through New York where half a dozen potential for the banking sector exchange for government cooperation companies have American Depository “orderly and growing,” and sees the on broader economic issues. To help maintain all foreign interest, Receipts (ADRs) on the New York banks as “criminally cheap”. Driehaus’s emerging markets fund and to keep the economy growing, the Stock Exchange (NYSE). Three gold miners, SAPPI, Telkom, and SASOL manager Emery Brewer hit upon a government, the JSE and the long had a NASDAQ listing. They tangential but successful way to tap corporate sector have been engaged in witnessed a large burst of turnover in the profits from the booming real a revamping of their listing rules, their investor interest when they shifted to estate markets “For the last couple of governance guidelines and issues the NYSE, although the reasons for years, we have been buying some of such as exchange controls, which that squarely rest with soaring oil the local retailers that sell furniture. despite a government pledge to prices. Buying SASOL, however, also So, we have seen extremely strong abolish them eventually, still linger. The effect of the regulation and the gets you a global energy stock, having sales growth, double digit 20+% recently opened a new gas to liquid coming out of retail sector and a lot of overseas listings has been to untangle plant in Qatar. SASOL also enjoys the these stocks in the last two years had the cross shareholdings and some of added benefit of technology it a tremendous run.”And, of course, as the clubby atmosphere that the developed(under the old and now the dollar falls, for US investors it has financial sector had, and to enhance long defunct sanctions regime) to been double your money even before the concept of accountability to shareholders. Julie Pfeffer concludes the local growth. make synthetic oil products. Although the rising Rand may hurt “It is quite easy to invest in the Although SASOL still makes up a significant part of the value of the competitiveness eventually, the market. There are no restrictions on Johannesburg Securities Exchange economic upswing is based both on a foreign investors that you see in many (JSE), Pfeffer notes that, in the last rising domestic economy and the other emerging market countries. This year or so, her fund has shifted its commodity surge fuelled by East market has a long history and is very centre of gravity from resources Asia’s insatiable appetites. As a well developed and through the time I towards more domestically oriented, consequence South Africa is on a have been there I have never had a consumer oriented stocks in South firmer footing than it has been. To problem of trading there.”

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Regional Review EUROPE

AXA’s Bendahan tops funds in Europe RIC BENDAHAN, PARIS-based manager of the Europe du Sud fund, and who works for AXA Investment Managers, has emerged as Europe’s best performing retail fund manager in a new survey by Citywire, the financial information group. Bendahan tops a list of Europe’s top 100 fund managers which have been drawn by Citywire from the performance records of more than 2,500 fund managers over a three year period ending in December 2004. Altogether the managers run some 3,700 funds that are available for sale to retail investors in one or more European markets. The funds included in the survey invest in 12 principal sectors, ranging from global and European equities to global and emerging markets bonds. Some 54 of the funds were in global equities, 17 in European equities, 16 in global bonds and a further 16 were in global mixed assets. North American equities accounted for 15 of the funds in the list, while Emerging Markets equities only managed three listings and only one European small-cap equity fund made it into the Top 100.

“I think the biggest surprise was the spread of fund groups”, says Richard Lander, director, Citywire Holding Ltd.“Despite the talk of consolidation, there were 80 groups represented here. No one really dominated and you have a big spread from the biggest pan-European groups, such as DWS Investments and Crédit Agricole, to really small outfits such as Riverfield or Salzburger Sparkasse.” Bendahan’s fund focuses on the stock markets of Portugal, Spain, Italy and Greece, “where companies have been growing rapidly over the last decade to catch up with the more developed economies of northern Europe,”says Lander. In second place behind Bendahan is Markus Kaiser, who runs several funds for Frankfurtbased investment house Veritas SG Investment Trust. Meanwhile, German firm, DWS Investments, has the most fund managers in the Top 100. It has five managers in the list, while Crédit Agricole has four and HSBC and Jupiter each have three. However, more of the top managers are based in the United Kingdom than in any other country. Some 25 are based in the UK,

with 20 in Germany, 14 in France and 8 in Switzerland. Lander explains that the Europe Top 100 Fund Managers’ list contains the managers who have produced the best performance “taking account of the risks they have taken against their funds’ benchmarks.” Citywire distinguishes its tracking by following the performance records of fund managers, rather than tracking the funds themselves, “in the belief that the talent of the individual manager is a crucial factor in delivering extra performance for investors.” The company’s performance records “also take into account managers who run multiple funds or change jobs.” The research also found that German investors have the best access to the Top 100 fund managers. Of the 157 funds they run, 74 are registered for sale in Germany, while another 50 are available in Austria. They are followed by Luxembourg, which although it is primarily a fund administration centre, rather than a retail fund market, has 54 of the funds available for sale, the United Kingdom (with 46), France (43), Spain (36) and the Netherlands (23).

The Citywire Top 10 European Fund Managers Pos Name

Group

Fund(s) Currently Managed

Licensed for sale in:

1 2 3 4 5 6 7

Eric Bendahan Markus Kaiser Daniel Varela Christophe Gay David Pastel Laurent Bouin1 Stephan Albrech

AXA Investment Managers Veritas SG Investment Trust Banque Piguet & Cie RSI Asset Management Pastel & Associés CPR Asset Management Albrech & Cie

France Germany Luxembourg and Switzerland Germany, Luxembourg and Switzerland France France Austria, Germany and Luxembourg

8 9 10

Karl Surma Tobias Klein Luigi Ripamonti

“schilling” Asset Management First Private Investment Management Anima

AXA Europe Du Sud Cap A2A Basis, A2A CHANCE Piguet Global Fund International Bond EUR C Sirius Fund Japan Opportunities Valeur Intrinseque CPR Obli-Reactif, CPR Croissance Reactive DAB Adv I Fds - Albrech & Cie. Optiselect Fd A Ord SAM Vermoegensverwaltung Global EUROPA Aktienfonds ULM FP Anima America

Source: www.citywire.co.uk

Austria Germany Italy

1. Laurent Bouin left CPR Asset Management in February 2005

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Regional Review EUROPE

CUKUROVA SELL-OFFS GENERATE INVESTOR HEAT Once again, the US Federal Reserve’s stress on mounting inflationary pressure sent jitters throughout the emerging markets in March. Led by the private sector, Turkey was one of the fastest growing emerging markets in 2004, with GDP and GNP growth figures of 6.3% and 6.6% respectively and is sufficiently armoured to weather the shock of the capital outflows that resulted. Growth this year will fall to around 4.5%, still healthy by any standards – but the real temperature of investor interest in the country this year will likely be affected by private sector developments, such as continued divestments by the Cukurova Group. OUR SWING TRANSACTIONS, together worth approximately $10bn in new foreign investment money will put their mark on capital inflows into the Turkish economy this year. The announcement in late March that Finland’s Telia Sonera intends to buy a 27% stake in Turkcell for $3.1bn, not only means a much needed capital injection into the Cukurova group, but signals a growing willingness for nonTurkish companies to commit to long term direct investment in the country once more. The fate of Cukurova Holding appears to be centre stage in the selloff of Turkish assets, particularly in the buoyant telecommunications sector. In late February, Cukurova sold around 24bn shares, worth around $174m, in Turkcell to JP Morgan (equal to just under 2% of Turkcell shares) to sell on to nonTurkish investors, which left the Cukurova group holding a minority 40% stake. Funds from the sale of the shares were used to amortise

debts owed to Yapi Kredi Bank, including $100m in annual interest payments and monthly payments of $15m to SDIF. Yapi Kredi Bank, another Cukurova company, itself is under the hammer and it now looks as if the bank will be successfully sold off to a joint venture between Koç Bank and Italy’s Unicredito. In a separate move, Garanti Bank, majority owned by the Sahenc family, is also looking for a foreign buyer. A mandate was awarded to Morgan Stanley in mid-March to find a buyer for one of Turkey’s leading export financing houses and commercial bank. Garanti has been looking, so far unsuccessfully, for a buyer since a projected deal with Italy’s Bank Intesa fell through in early 2004. Turkey’s banking sector is ripe for increased foreign investment with a slew of middle ranking banks up for sale, with additional consolidation possibilities in the market. Vakifbank, Sekerbank are among the key names on the

block, with the government reporting “significant” interest building up on the back of consistent economic growth. A block sale or public offering in Vakifbank, Turkey's seventh largest bank by assets, is still likely although there are still issues outstanding regarding the nature of its ownership. Currently foundations and charities hold 75% of Vakifbank, with 25% owned by the employee pension fund. Until the bank’s ultimate shareholding is restructured to facilitate its privatisation however, it is unlikely that a sale will be able to take place any time soon. On the public sector side, the government has announced its intention to re-inject some life into the country’s mordant privatisation programme with the sell-off of iron and steel major Erdermir and oil and refining company Tupras. The combined value of these public and private sector sales is well over $10bn. The moves have resonance as the outlook for indirect investment capital inflows appears to be more volatile over the short term. In spite of a flow of generally market friendly news, as hedge funds and global banks “used to capitalising on a popular carry-trade in emerging markets, started to unwind their ˙¸ leveraged positions,” according to Is Bank researchers. The reasons for the outflows were varied. Investors took Federal Reserve chairman Greenspan’s reported comments that current low long term bond

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The degree of foreign investor a joint-stock Company under the yields represented a “conundrum” to heart by selling holdings in low yield interest in Turkcell is no surprise. With ownership of the Undersecretariat of long-term government bonds. In a total market capitalisation of Treasury of Republic of Turkey. Turkey’s specific case, additional $10.5bn and a good operating year Through its mobile subsidiary AVEA concerns rested on the delay in the behind it, the company is enjoying (the recently established company as a ˙¸ – country’s IMF standby agreement. It solid growth in subscriptions. Telia result of the merger of Aycell and Is ˙ Türk Telekom provides is a telling point. Until this year Sonera’s interest in Turkcell is also T IM), telecommunications Prime Minister Erdogan continued significant in a wider regional play. In integrated the process of economic reform, early March Turkcell had announced services from PSTN to various other working closely with the IMF and that it had submitted a pre- value added services. An extensive investment program World Bank. The upshot was that any qualification application for a 26% negative impact of the Iraq war was stake in the privatisation of Pakistan undertaken during the late 1980s has well contained, and reforms Telecommunication Company Ltd led to a broad network, which is ranked today as the world’s introduced during the 13th largest network by last three years, together FTSE All World Emerging Banks 300 capacity. As a result of the with the implementation 250 growth in mobile services, of a floating exchange and the continued rate produced a more 200 dynamics of the Turkish robust economy. “All the 150 economy, revenue from key economic signals for 100 telecom services is set for the economy are continued strong growth. extremely positive,” says 50 Continuing strong cash Meltem Agçi, general 0 flow, improving margins manager of Oyak through operational Securities in Istanbul. All World Emerging Banks Turkey Banks effectiveness, strong “However we obviously Data as at 31 March 2005. Source: FTSE Group dividend yields, and rapid cannot easily decouple expansion of mobile ourselves from that emerging markets tag, which (PTCL); though the deal is not a slam business especially after the recently invariably affects capital inflows from dunk, as at least 26 other companies, completed mobile consolidation and time to time. But the underlying including the United Arab Emirates’ margin improvement for value added Telecommunications and Singapore services should, in theory, make the fundamentals remain positive.” process relatively easy. The Turkish economy performed Telecommunications Ltd (Sing-Tel). A firm decision is expected some However, the telecommunications credibly in 2003 and 2004. Interest rates came down significantly, the Turkish time in the autumn. Through its provider has been up for grabs for lira regained stability, the new Turkish Fintur subsidiary, Turkcell has also some time. The government passed lira was introduced, and economic enjoyed strong market growth in the legislation enabling the sale of growth and inflation targets were southern Europe, having achieved more than 49% of Turk Telecom to achieved. The economy is driven 3.5m subscribers in the region by the foreign investors around three years primarily by private consumer end of last year. Fintur has also ago and a final decision on the sell off demand, which accounts for around begun offering telecoms services in is expected this year. Financial 70% of nominal GDP, compared with the Ukraine. Meanwhile Turkcell advisors on the sell off include BNP about 15% of GDP for public Holding has also applied for the Paribas, PDF Corporate Finance and consumption. Fixed capital investment right to buy a significant stake in the Denizbank, while legal advisers demand accounted for about 25% of privatisation of local telecoms include Turkish legal firm Cerrahoglu GDP in the mid-1990s but has steadily provider Türk Telekomünikasyon & Baker Mackenzie. The formal tender announcement for the fallen since to around 17% of GDP, A.S¸ . (Türk Telekom). with over 30% of this carried out by the In 1995, as part of the division of the minimum 51% of Türk Telekom public sector. As the Turkcell Holding postal and telecommunications shares is expected to be launched deal shows, however, this may change. services, Türk Telekom was created as before the end of 2005.

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As the century turned Napster rapidly became the world’s first so-called peer-topeer (P2P) file sharing service. This made it possible for users to exchange music as MP3 files. Napster’s popularity was instantaneous and enormous and by mid-2000 some 20m users were visiting Napster’s website, making it the fastest growing home-software application in history. Only a year later however, cashstrapped and dogged by dozens of lawsuits, Napster stared bankruptcy in the face. These days, the company is riding high again and Napster finds itself nipping at almighty Apple’s heel once more. Dave Simons reports on how it was done.

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ICTURE THIS. YOU are scanning the radio on the drive home from work when, by chance, you catch the last few seconds of a favorite old hit from way back when. “Haven’t heard that one in years,” you think as the song fades. And what with the monotony of modern radio, chances are several more years will pass before you’ll hear it again. Let us say, however, that there was an online music library that allowed you to download in seconds any number of memorable melodies – including obscurities such as the one you stumbled upon this evening – any time, day or night. You could even transfer your songs to a portable digital-music player and bring them with you on the road, if you wanted. Sounds intriguing, doesn’t it? Meet Chris Gorog, chairman and chief executive officer of digital-music service Napster, who presides over such an Internet-based music bank, containing well over one million songs. Gorog believes that there are lots of folks just like you out there, who would gladly pony up $10 each month for the privilege of having unlimited access to their favorite music, or, for an additional $5, have the ability to drag-and-drop the tunes into a portable MP3 player. In fact, Gorog is so sure that his company’s newly launched Napster To Go ‘all-you-can-eat’ portable subscription service will revolutionise the musiclistening experience, that he is willing to take on the mighty Apple Computer and its insanely popular iPod digital-music player – quite possibly the most soughtafter listening device since the advent of the transistor radio. Why would Gorog think he even has a fighting chance against such a behemoth? Let us go back to that long-lost song on the radio. As a Napster subscriber, you could conceivably locate and download the song onto your personal computer (PC) or add it to your digital player’s song bank. Chances are, after a week or so you would have your fill of the forgotten classic and delete it from the track lineup, knowing full well that you could simply download it again in case you ever got the urge to hear it once more. In short, owning the song isn’t nearly as important as having access to it. Therein lays the fundamental difference between Apple and Napster. Those who use Apple’s own online music library, the iTunes Music Store, are charged a fee for each track they download and then get to keep the tracks for good whether they need to or not. And if you want to pack your iTunes for your next business trip, Apple insists that you use their proprietary iPod player. By contrast, Napster believes that you would rather pay a set fee each month and in return have access to as much music as your player can store. More important, Napster makes it possible for you to listen to the music on any one

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of a number of compatible players. It is called variety – and Chris Gorog thinks it is the key to Apple’s seemingly impenetrable lock on the digital-music business.

The download motherlode The company that today finds itself nipping at Apple’s heel is an incarnation of the start-up enterprise that literally put downloadable music on the map. Founded in 1999 by Shawn Fanning, a freshman at Northeastern University in Boston, Napster became the world’s first so-called P2P file sharing service, which made it possible for users to exchange music as MP3 files (a process that reduces the size of larger audio files while still maintaining goodquality sound). Napster’s popularity was instantaneous and enormous. By mid-2000, 20m users were visiting Napster’s website, making it the fastest growing homesoftware application in history. Naturally, Napster’s free distribution system posed a potentially serious threat to the record industry. Before long, lawyers representing labels and artists sought to shut down the company on the grounds that it violated copyrights. Assuming a defensive posture, in 2001 Napster made plans to launch a fee-based service, but by the end of that year a Federal judge ordered the company offline until further notice. Cash-strapped and dogged by dozens of lawsuits, in 2002 the once-mighty Napster filed for Chapter 11 bankruptcy protection. While Napster was quickly disintegrating, Apple was preparing to make media history. In 2001 came the iPod, a revolutionary audio device that utilised a sizeable hard-disc (initially 5GB, ultimately as high as 60GB) to store audio files. Then in the spring of 2003, Apple came up with a novel concept, one that owed in part to the success of Napster: to give the minions their music downloads, but

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make them part of a legal,‘pay-for-play’service, dubbed the could access virtually anything you could think of, iTunes Music Store. Users could purchase songs at 99 cents download it to your PC, move it to your portable player, apiece or $9.99 for an entire album. Business was brisk completely unfettered,” says Gorog. “People who right off the bat. Within a week, Apple had moved over one experienced that just lit up with the glee of discovery. So million songs. It would reach the 300m mark by early 2005, right away, we made it our goal to replicate the original helped along by succeeding generations of iPod, which Napster model in a safe, legal environment.” In the autumn of 2003, a new, fee-based Napster 2.0 was would ultimately account for an incredible 82% of all digital player sales. So astounding was the iPod/iTunes offered to the public as a viable alternative to iPod/iTunes. phenomenon that when Apple unveiled its iMac G5 Users could pay $10 per month for unlimited downloads, computer in the fall of 2004, the accompanying marketing or, like Apple’s iTunes, could opt for the Napster Lite slogan read, “From the creators of iPod.” Not surprisingly, version at 99 cents per song. In late 2004, Roxio sold off its investors have piled in, driving Apple’s stock price from a consumer-software division and began operating under pre-iPod low of $7 to a recent high of $45, with most of the the name of Napster. Its stock began trading on the NASDAQ a short time later. gains coming within the last 12 months. Flush with $100m in available cash, in February of this year Key to Apple’s tremendous success has been – big surprise – a highly strategic and incredibly effective Gorog finally unveiled the real deal: Napster To Go, a marketing campaign, which right from the start portable subscription music service that allowed customers to emphasised the simplicity of the iTunes system, in the download an infinite number of tracks from Napster's online process allaying the fears of the world’s considerable song library to a compatible digital-audio player. Under the technophobe population. Apple’s approach has been so new plan, Napster To Go subscribers pay a flat rate of $14.95 each month for unlimited spot-on – and its product so usage. If the subscription lags, good, by and large – that further access is denied and millions of Internet-music Flush with $100m in available cash, in all previously downloaded neophytes have cheerfully material removed.The process plunked down $300 for the February of this year Gorog finally is made possible through the standard 20GB iPod, unveiled the real deal: Napster To Go, a use of Janus, an extension to seemingly oblivious to the portable subscription music service that the digital rights management fact that their player was allowed customers to download an system (DRM) of Microsoft’s incompatible with any other infinite number of tracks from Napster's Windows Media, which online music source. Despite online song library to a compatible allows users to transfer this apparent flaw, subscribed-to tracks from a competitors have so far been digital-audio player. Under the new plan, desktop computer to a unable to put so much as a Napster To Go subscribers pay a flat compatible portable player. dent in the Apple armor. rate of $14.95 each month for Janus allows rights-protected But Gorog thinks all that is unlimited usage. songs to be distributed to about to change. “With customers through a Apple, you are talking about subscription model such as expert marketing,” he says, “and you have to take your hat off to them. But it cannot Napster's, and subsequently copied to portable devices, continue that way for very long. You can control the whereupon they will expire at a specified date. Gorog points to the “fluidity”of the system, which makes software, hardware, the marketing message, all the while ensuring that consumers have a successful experience, and it possible to easily move back and forth large portions of it all works very well in early adoption. But in mass anyone’s personal music library. “If you had a 20GB adoption, consumers demand choice, price flexibility, and portable device, you could easily have a replica of the music cross-platform inter-operability. I am very content with you have downloaded to your hard drive with you at all times,”says Gorog.“Want to take the top 20 jazz albums of where we stand strategically on that point.” all time along on your next business trip? Boom – drag and drop. And there it is. It really is a powerful tool.” New Napster How does Gorog react to his detractors who complain, The seeds of Napster’s revival were sown back in late 2002, when Gorog, then CEO of digital media manufacturer ‘Great – as soon as I stop paying that $14.95, they take Roxio, purchased the trademark and assets of the original away all my songs”? “I think what it comes down to is that Napster for $5m in cash. Despite the company’s people will change their view about what is important, and spectacular fall from grace, Gorog believed that Napster’s we are already seeing that happening,” says Gorog. “For brand name and proprietary technologies still had those who want to collect and own the music, we still have significant long-term value. But Gorog saw something our à la carte service. But another tremendous aspect of this more.“I’d always held that it really wasn’t about being free system is that you have the potential for a much more – that it was about this extraordinary experience where you informed and enlightened listening audience, just by virtue

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of the fact that you have ready access to such a tremendous volume of music.”

Napster’s Numbers Napster’s optimism over its subscription-service launch is borne out in the recent numbers. In the final quarter of the 2004 fiscal year, Napster took on 90,000 new subscribers, a 50% increase from the previous quarter, while the company’s revenues jumped 30% to $12.1m from $9.3m just three months earlier. Though still running in the red (with an expected Q4 loss of $0.63 a share), in March Napster boosted its revenue guidance for the current quarter by $1m to $15m. Piper Jaffray has raised Napster’s

in ways that have never really been done before.” If Napster’s current subscriber base seems miniscule compared to iTunes’ 300,000,000 downloads, observers say that it’s the trend that counts. By the end of the decade, analysts believe that the higher profit margins of Napsterstyled subscription plans will eventually meet and then exceed iTunes-based pay-per-play plans to the tune of $890m vs. $800m in revenues. “We are looking at a market that is expected to move from around 15-20m portable players today, to upwards of 80m in just a few short years,”says Gorog.“That is a major portion of the market still ahead of us. So that is something that we are obviously really focused on.”

By the end of the decade, analysts believe that the higher profit margins of Napster-styled subscription plans will eventually meet and then exceed iTunes-based pay-per-play plans to the tune of $890m vs. $800m in revenues.

fiscal 2006 revenue estimate to $86.5m and its subscriber base to 655,000 (from a current 270,000), with an “outperform” price target of $14. The analyst expects that the success of Napster To Go will be closely tied to the movement of Janus-enabled portable audio devices, which at present includes manufacturers such as Samsung, iRiver, Dell and Creative. MSRP for Napster-compatible players currently ranges from around $225 to $450, though IDC analyst Susan Kevorkian sees prices eventually dropping to under $100 in some instances. While this may create some badly needed competition for the iPod, Kervorkian believes that subscription services such as Napster’s will first have to allow customers to become acclimated to the idea of “renting” music on their portable players. Additionally, says Kevorkian, some people may find the Napster system a bit more challenging than Apple’s, but she also added that the Napster To Go model is “novel, it is leveraging technology for music consumption

FTSE GLOBAL MARKETS • MAY/JUNE 2005

Though Napster’s list of compatible players currently includes only a handful of models, by the fall, Gorog expects there to be upwards of 50 to 60 different varieties to choose from. “I think it will be difficult to find a WMAbased player that isn’t compatible with Napster To Go before very long,”says Gorog. Analyst Mark Mulligan of Jupiter Research in London admits that subscription plans such as those espoused by Napster may indeed have a bright future.“Napster To Go will significantly enhance value for existing customers and will be the tipping point for many ‘wavering voters,’” remarks Mulligan. Although the plan may not make Apple “twitch nervously” over the near-term, Mulligan called Napster To Go a “milestone,” one that significantly strengthens the subscription service proposition. “Sure it will take time for consumers to become familiar with the rental model, let alone the portable rental model,” says Mulligan,“but when music fans get their heads around the concept, subscription

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services offer the ability to consume much more music for Hear today, gone tomorrow much less money then with à la carte.” If over the next several years Napster’s business plan turns Gorog expects steady state margins on the subscription out to be a successful one, observers may point to the fact side to range anywhere from 30% to 40% going forward, or that Napster was in some respects the first company to roughly four times the profit margin on the download truly acknowledge that music is no longer the tactile business.“Which is pretty healthy for us,”he says. commodity it once was. Of course, this is nothing new. The How does Apple feel about the upstart Napster fragile plastic and puny cover space of the compact disc encroaching on its digital domain? Hard to say. Though long ago de-emphasised the visual aspect of the Apple officials declined an traditional album, while interview request, in a the ability to copy music Can Napster find the key to break Apple’s hold on the recent e-mail to musicin digital form has digital-music business? industry executives, Apple allowed listeners to 450 CEO Steve Jobs noted bypass song sequencing 400 how Napster’s Janusaltogether and simply 350 based security system compile and shuffle tracks 300 could be breached simply by any number of artists at 250 by manually recording the will. And then there is the 200 downloaded music stream issue of portability. With 150 – which, as Mulligan laptops now 100 points out, can just as outnumbering desktops 50 easily be accomplished on and cell phones fast iTunes. “The difference of replacing land lines, Apple Computer FTSE US Media & Entertainment Index course is that you have to having the ability to cart FTSE US Info Tech Hardware Index FTSE US Software & Computer Services Index pay for each track rather around your entire record Data as at 31 March 2005. Source: FTSE Group than a flat fee for an collection in a device the unlimited amount,”adds Mulligan. size of your shirt pocket is enormously enticing, Gorog considers the Jobs’ jab an indication that Apple particularly where the all-important youth demographic is does indeed take Napster quite seriously.“When I think of concerned. “Downloads to the PC only has not really our competition going forward, in the short term, obviously resonated among 18-24 year olds,”notes Gorog.“But with I’m thinking of Apple,” says Gorog.“But in the long term, portability, they go crazy. And that demographic is the one I’m really not, mainly because I think they are going to that has had the most passionate interest in this product. marginalise themselves as they traditionally have by That’s very exciting for us.” working with a closed proprietary system – a walled As audio gradually transforms completely from a garden, if you will – for their consumers. And what ends up physical medium to a bunch of bits and bytes on the happening is that their customers can’t really relate with computer, Napster appears to be unusually well positioned the rest of the technological world.” to serve the new disposable music marketplace. In iPod’s proprietary design, Gorog sees a vulnerability he “I’ve watched my kids buy a CD, and once they’d rip it, is more than willing to exploit. For instance, because Apple they could roller-skate over the original if they wanted hasn’t licensed its software to to,” says Gorog. “It didn’t third parties, the iPod isn’t matter – because at that Napster makes it possible for you to available to use with Napster point they didn’t value it. listen to the music on any one of a To Go. “While I think that is What I believe is happening number of compatible players. It is called unfortunate for Apple, in is an absolute paradigm variety – and Chris Gorog thinks it is the reality it becomes a great shift in all media but in competitive advantage for music in particular where key to Apple’s seemingly impenetrable us,” says Gorog, “because we people will clamor for lock on the digital-music business. have built all of our instantaneous access to technologies on the Microsoft everything, anytime, platform, which is very important in the MP3 player market, anywhere. That is what they will pay for and that is what especially since Microsoft has market-share leadership in they will really value. Let us face it – if you were a record the hard-drive and flash-memory categories.” collector, you spent years dragging around all those Of equal significance, says Gorog, is the number of albums and CDs from place to place, listening to only a leading digital-entertainment manufacturers who are small percentage of them while all the rest gathered dust. going into the average living room with equipment built on But in this new environment, the idea of owning a CD, or the Microsoft platform. And the same holds true for car a set of music files, or whatever, will become less audio says Gorog, “under this scenario, compatibility is essential. And, in time, the whole concept of how we obviously not an issue going forward.” value our music will change for good.” Fe b

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Pierre Francotte, chief executive officer (CEO) of Euroclear SA/NV

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IN PURSUIT OF THE STRATEGIC DOUBLE

CORPORATE PROFILE: EUROCLEAR

Armed with a new corporate structure and a perspicuous business plan, Euroclear has it all to play for. Formally announced at the end of last year, the two strands of Euroclear’s forward plan combine the harmonisation of market practices across the Euroclear group’s five domestic European markets and in the international securities markets, with the creation of a single transactionprocessing platform. Francesca Carnevale went to Brussels to discuss the substance behind the strategy and found Euroclear’s chief executives evoking a powerful polemic on the business drivers for change.

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UROCLEAR’S NEW MEDIUM and long-term directional strategy hinges on two elemental tasks. The first is a project to migrate the processing of securities transactions to a single settlement engine (or technology platform) serving three of the central securities depositories (CSDs) that form part of the Euroclear group – namely Euroclear Bank, Euroclear France and CRESTCo – by the end of 2006. The second element builds on the single settlement engine project and involves the harmonisation of market practices within the Euronext-zone markets of Belgium, France and the Netherlands and the launch of a single processing platform to service this market. This second strand is described in a recent Euroclear market update paper as “an integrated settlement solution for stock exchange and over-the-counter (OTC) activities,” and it is expected to be underway by 2007. In four-to-five years then, the world’s largest provider of domestic and crossborder settlement services will operate a single transactionprocessing platform for all the markets in Euroclear, encompassing settlement, custody and collateral management, and using one common interface to send and receive instructions and reports. The articulation of the new strategy is significant, by any standards, and that for a number of reasons. First, it reflects the growing confidence of Euroclear to act decisively in a marketplace that is still seeking answers to questions regarding the long-term structure of panEuropean cross-border settlement (and clearing) services. It clearly lays out Euroclear’s particular road map. Second, it cuts one of the Gordian knots in the European settlement weave, namely that the creation of a unified market is not possible in the near term partly because of a complex structure of legacy settlement systems already in place. Third, it makes sense from a purely business perspective. With today’s focus on servicing every phase of the investment lifecycle as a means of customer retention and client acquisition, the back-office transaction management aspects need to be as efficient as possible. Finally, the strategy is an inevitable response to an increasingly demanding client base that is simultaneously becoming more global in its outlook and now requires an appropriate infrastructure able to cope efficiently and cost effectively with cross-border settlement— particularly when this involves instruments denominated in multiple currencies and/or a diversified securities portfolio. That infrastructure perforce requires an up to date, robust and high-capacity settlement platform. Acknowledging the convergence of these factors in the drive towards a pan-European settlement solution, Pierre Francotte, chief executive officer (CEO) of Euroclear SA/NA, explains the “business sense” behind the strategy. His is a particularly Continental polemic, with inevitable geopolitical undertones.“It is the drive for Europe itself to become more competitive,” he states. “Euroclear, in this regard, is a catalyst for change, spearheading consolidation among CSDs and market practice harmonisation.” In kick-starting its new business model, a restructuring

of the Euroclear business was itself a priority. At the beginning of this year, a new structure was announced. Euroclear SA/NV was established as the new holding company of the group's national and international central securities depositories (CSDs). The new company, incorporated in Belgium and with branch offices in Amsterdam, London and Paris, owns the group's shared securities-processing platforms and delivers a range of services to the group's depositories, including development of its technology platform. As part of the restructuring of the group, Euroclear Bank has relinquished its ownership of the group's three CSDs and instead becomes a sister company to them, under the ownership of Euroclear SA/NV. CIK, the Belgian CSD will likely also become a sister company of the other Euroclear depositories later this year, subject to final completion of the purchase agreement with Euronext. In part, the restructuring was a natural precursor to the implementation of the single platform initiative. It provides the institutions, which have a stake in the Euroclear business, with greater comfort. According to Francotte, "The new structure minimises systemic risk by segregating the group's CSDs and their clients in the highly unlikely event of Euroclear Bank's insolvency." At the time of the restructuring, Francotte moved from being CEO of Euroclear Bank to becoming the first CEO of the new Euroclear SA/NV. Ignace Combes, deputy CEO and vice chairman of the management committee of Euroclear SA/NV meanwhile explains that: "The impact of this restructuring on Euroclear's clients is minimal. As Euroclear SA/NV only provides services to the other Euroclear group entities, clients will continue to access Euroclear services through Euroclear Bank, CRESTCo, Euroclear France or Euroclear Nederland, as they have always done." Operationally, as an additional safeguard, in the light of events such as 9/11, Euroclear is in the process of establishing a state-of-the-art business-continuity programme, focusing on two live synchronous data centres. “The business will continually rebalance between them,” explains Combes. “If one falls out, the other takes over. Obviously, there needs to be a certain distance between the two centres. Today’s sophisticated technology is able to ensure that the two are perfectly synchronised, if located within a reasonable distance.” The plan is to establish the two live data centres and a third asynchronous data centre in another country some time in 2006. The advantage of having a third data centre, explains Combes, is that if a force majeur event occurs, “Euroclear will be able to restart, in a different country, within a maximum period of three hours.” Internally then Euroclear’s strategy has cohesion and depth. Externally, Euroclear is hearing the beat of a different drum. In the broader business context, it quickly becomes apparent that for Francotte at least, a committed European, the heart of the matter of Euroclear’s broadbrush strategy rests with the Lisbon Agenda of March 2000

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Euroclear’s New Corporate Structure (As of January 1 2005)

EUROCLEAR PLC EUROCLEAR SA/NV London

EUROCLEAR SA/NV Brussels

EUROCLEAR SA/NV London

EUROCLEAR BANK Brussels

EUROCLEAR FRANCE Paris

Euroclear’s Former Structure

CRESTCo London

EUROCLEAR NEDERLAND Amsterdam

CIK Brussels [2005*]

EUROCLEAR PLC

EUROCLEAR SA/NV Brussels

EUROCLEAR FRANCE Paris

CRESTCo London

when the EU heads of states and governments agreed to make the European Community (EC) “the most competitive and dynamic knowledge-driven economy by 2010”. “We are all in this for the long term,” he stresses, “and we are now focused on the remaining obstacles to developing a truly European capital marketplace.”Europe's barriers in becoming a single market have come down to a significant degree, he maintains. In specific areas, such as clearing and settlement, initiatives such as SWIFT’s ISO 15022 messaging, which allows CSDs and their clients to communicate in a standardised manner, has invariably helped the overall trend. There is also regulatory and industry support, with bodies such as IOSCO, ECSDA and ISSA keen to see greater co-operation between Europe’s CSDs and ICSDs. Francotte also cites other significant initiatives that have emerged alongside the Lisbon Accord, such as the MiFD’s European Passport, allowing banks already regulated in one EU country to provide services on a remote basis within the EU without additional regulation.

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EUROCLEAR NEDERLAND Amsterdam

Deregulation of large swathes of the financial services industry and the implementation of the single currency, were key reasons for shifting patterns of investment in the European theatre. “The first effect was that any investor, from anywhere in Europe, could more readily take a position in, say, French equities, for example. Second, it has allowed a discernable shift towards sectoral investment as foreign exchange risk has been largely eliminated,” he explains. Combine this change with the ability to do crossborder business at a lower cost, “and you see a mounting propensity or greater appetite for investment beyond national borders,”he adds. At the same time, expands Francotte, cross-border trading in European equities is expected to continue growing, spurred by individualisation of pension plans, improved trading technology and expertise, and the rise of a multiplicity of investment styles. “Short-term trends aside, this increase in trading volumes is a long-term trend, and is here to stay. It is all the more important then that a

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cheap, efficient post-trade environment is created for this growing pool of cross-border investors,”says Francotte. Painfully aware of the constrictions still extant in the fragmented clearing and settlement landscape in Europe, he dramatically explains the scarifying magnitude of the costs of fragmentation borne by the market, “which are estimated to be in the order of €4bn to €5bn a year.” He further cites the supporting example of Merrill Lynch,“who kindly said we could quote their numbers, though the figures are a few years old,” he qualifies. “Its total trading, clearing and settlement costs were more or less the same in both the US and Europe, but it is the volume that these costs apply to that is astounding. Merrill Lynch was spending exactly the same amount of money to trade 2m shares on the NYSE each day as it did for 70,000 shares across Europe.” Clearly, he says, expanding on his theme: “Thinking as an investment banker, I have to ask,‘If I am to grow business, where can I do it?’” Francotte positions broader geopolitical considerations as a further shift in gear. Competition is intensifying between the financial markets of North America, the Far East and Europe. Inevitably then, he posits, “Investment bankers will tell you that the currently fragmented posttrade infrastructure in Europe is such that it is having an impact on their future business decisions.” Francotte’s views are particularly trenchant given that Euroclear has emerged from this patchwork to date as the world’s largest provider of domestic and cross-border settlement and related services for bond, equity and fund transactions. Governed by 24 market institutions and two independent directors, and owned entirely by its customers, the Euroclear group comprises Euroclear Bank, based in Brussels, as well as Euroclear France, Euroclear Nederland and CRESTCo, the central securities depositories of France, the Netherlands, and the UK and Ireland, respectively. How Euroclear got there is almost the stuff of airport thrillers. Driving competition, consolidation and acquisition have been the watchwords of the European settlement (and clearing) markets during the last decade, with relationships, alliances, mergers and intense acquisition activity acting as moving pieces on the European checker board. The hand controlling the moves was obvious. Historically, all markets had their own CSDs to handle the settlement of domestic and transactions. Each of these platforms had evolved according to the particularities of their own marketplace and local regulatory regimes. In consequence, the market is now rife with a lack of standardisation, which didn’t really matter that much when the majority of settlement activity stemmed from domestic trades. But with the rise of crossborder trading and a growing demand for cost efficient cross-border settlement services, a network of standalone CSDs was increasingly untenable. Two institutions emerged as drivers of change: Clearstream, an alliance of Cedel and Deutsche Börse Clearing (now owned entirely by Deutsche Börse), and the

Brussels-based Euroclear. While both have tried and are still trying to unify cross-border clearing and settlement in their own image—in trying to achieve their goal, they chose entirely different approaches. Clearstream favours a ‘vertical silo’ model, where the exchange only allows clearing and settlement to occur in the post-trade businesses that it owns. Euroclear however, prefers a more open, horizontal approach, a perspective also championed by the European Securities Forum (ESF). The horizontal approach means that the provision of settlement services is exchange neutral, meaning that exchange members are free to choose the settlement location that best meets their needs. Clearstream was acquired by Deutsche Börse back in February 2002. Euroclear then remained free to pursue its open-ended approach of gradually acquiring several of Europe's CSDs, with each acquisition providing a boost to Euroclear’s growth strategy. And soon, under Euroclear’s new business model, the CSDs in the Euroclear group will become a single settlement infrastructure provider, “offering significant cost savings and reducing operational risk,”says Francotte. Euroclear and Clearstream have long lived alongside each other in an atmosphere of uneasy truce. In November last year, Clearstream and Euroclear announced they had successfully implemented the second phase of a new Automated Daytime Bridge between both CSDs. The 'Bridge' is an electronic communications link that facilitates the efficient settlement of securities transactions between counterparties in Clearstream Banking Luxembourg and Euroclear Bank. This second phase provides improvements, such as the extension of instruction deadlines and same-day Bridge transactions between the CSDs and builds on an initial phase, which was completed five months earlier. The first phase, completed in June 2004, delivered improved settlement efficiency and enabled customers to reduce their costs by having more opportunities to settle Bridge transactions that failed during the overnight process. While on the surface, it appears a common-sense move, it was a long time in coming and neither party arrived there too gracefully. Clearstream Banking Frankfurt had for some time previously fallen foul of the European Commission, which had found it in breach of competition rules in refusing to supply Euroclear Bank with certain clearing and settlement services. Everyone appears to have made up and Euroclear plays down any residual hard feelings. Explains Combes, “We sit together on important industry institutions, such as ECSDA. We also have common interests, like the Bridge, on which we will both build.” Tellingly perhaps, although Euroclear’s annual results announcement mentioned the Bridge initiative, it pointedly mentioned“larger numbers of new and existing clients have elected to settle their securities transactions on a book-entry basis in Euroclear Bank, with Bridge transactions accounting for a dwindling proportion of overall business.”

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Francotte does not duck the issue of competition and the essential dynamic of the battle between the two entities to determine the future structure of clearing and settlement in Europe. “In the end, it will be the market to decide which model best suits their needs by placing their business with the best provider. If there is to be a monopoly, it should be decided by the market and not our regulators,” he maintains. But Francotte insists he would prefer an open and competitive marketplace which gives users choice. “There is no need to create a monopoly. It won’t necessarily help the situation,”he adds. Combes concedes that there is still much to be resolved in the market place before either Euroclear’s or Clearstream’s approach will win the day. For the time being, Euroclear appears to have the upper hand. But there is still much to play for, with the Italian and Spanish clearing and settlement systems, among others, remaining firmly independent of either Euroclear or Clearstream. Irrespective, it does not appear to worry Francotte overly much. His sanguine view stems from a firm belief that Euroclear is planted firmly in a business area in which there is need for competition, not less of it. Nor does Euroclear have pretensions beyond what it regards as its natural hinterland. “We have no overseas acquisitions in mind,” explains Combes. “Our main focus is on Europe. If a customer wants us to add a link to a market we do not already serve, we will add that link to the 32 local-market CSD relationships already in place. We take the view that there are many ways to work with CSDs. We do not need to buy them outright.” Combes is also keen to stress that part and parcel of Euroclear’s strategy is to work closely with the appropriate regulatory authorities. Understandably then, in Francotte’s road map, the agreement between Euroclear and Euronext on the acquisition of CIK, the central securities depository of Belgium, a wholly owned subsidiary of Euronext, is a natural outer marker. The acquisition process began in November 2004 and the deal is expected to be finalised by the summer, subject to appropriate legal and regulatory process. The deal with Euronext builds on a July 2001 deal between the parties that transferred CIK’s book-entry settlement and custody business to Euroclear. Under the terms of the new arrangement, both the book-entry business and the physical securities activity of CIK – including the newly launched ‘Printing on Demand’service, SICAV settlement and nominative register management, among others – will be consolidated in Euroclear.“Belgian clients will be able to benefit from a single entry-point for all of their settlement activity, physical as well as immobilised,” explains Combes. “The acquisition by Euroclear of CIK will help to facilitate the completion of Euronext’s business model,” he expands. “Eventually, this will lead to a unified settlement platform to complement Euronext’s single order book. It will also further ease crossborder trading and provide a natural environment for CIK and the other Euronext-market CSDs to continue developing other services for their clients.”

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Ignace Combes, deputy CEO and vice chairman of the management committee of Euroclear SA/NV.

Combes is keen to stress that through acquisition, Euroclear has “grown in understanding.” There are a “lot of things we discovered,”he explains. “Local CSDs were very effective, for example, in the way in which they consulted with their market. Consequently, as a group, we have learned how to get input and consult more effectively. We have also learned to be more sensitive to local aspects.” Aside from the obvious market drivers that are propelling Euroclear on its current route, there are also more piquant reasons still for Euroclear’s growth plan. According to its annual report, Euroclear group recorded across the board gains in operating performance through 2004, including a 20% increase in settlement turnover and a 10% rise in the value of client assets held in custody. The total value of securities transactions settled last year was ?307.1trn and securities held for Euroclear clients reached ?13.1trn. Growth, says Combes, “can be attributed to a combination of satisfying our clients’ day-to-day needs everyday and making progress on delivering a post-trade infrastructure that will meet their needs in the future.” It is apparent that Euroclear nowadays “enjoys a much greater sense of the role it needs to play in the markets,” says Combes.“Teamwork is a strong internal motor. We are a much more integrated organisation these days, with a real sense of shared objectives.” Francotte adds that, “Euroclear has taken on a big challenge, not always pleasing everybody. It is important to stress that we are striving to improve the local and international appeal of the capital markets in Europe.” It is an imperative, thinks Francotte. “If we don’t take this role, if we don’t succeed, we believe Europe’s capital markets will move somewhere else. So where we need to take the initiative, let’s take the initiative.”

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SUB-CUSTODY

In a hard hitting article, Tim Steel posits the view that the outlook for sub-custodian services in Europe will be much tougher than before. In an increasingly sophisticated and complex market, the resolve of many sub-custody providers will be tested as their infrastructure, reach and product set are stretched and tested again and again.

SUBCUSTODY RACING TO THE FINISH HERE IS PLENTY of anecdotal evidence to suggest that a significant number of sub-custodians in Continental Europe have yet to wake up to certain unpalatable realities. Market consensus has it that the majority of the region’s agent banks face a challenging future. Unable to offer the breadth of product set and geographic reach now demanded by an increasingly sophisticated and diversified client base – or indeed to fund the sort of infrastructure investment necessary to rectify those shortcomings – it is argued that the genus of monomarket sub-custodian that have traditionally serviced the local custody, clearing and settlement needs of institutional investors and intermediaries face imminent extinction. The past few years have seen the inexorable rise of panEuropean providers, notably Citigroup and BNP Paribas, offering multiple product lines across multiple markets. While Europe remains a deeply fragmented proposition as far as post-trade processing is concerned – a tangle of diverse and at times flat out contradictory regulatory, legislative and tax environments give the lie to any notions of a single common market – it is still possible for these pan-regional players to build and leverage economies of scale. As Brian Todd, head of network management, EMEA for JPMorgan Investor Services – which is principally a buyer

of sub-custody services in Continental Europe – notes: “Sub-custody is bought on the basis of service, but that service is pretty well defined in terms of what it takes to be a sub-custodian: custody, settlement, corporate actions, income collection, securities lending and borrowing. So ultimately it comes down to being a commercial conversation around price, settlement cut-offs, systems, the number of markets a provider can service – and if you buy in bulk, you can get a better price.” Consolidation in the sub-custody sphere in recent years has been driven by two engines: strategic reviews within individual banks – pace the merger of BNP and Paribas in France – and by banks deciding that they only to want to compete in those lines of business where they can build significant scale and/or market leadership. For many, this product set no longer includes sub-custody. “As a result we are now down to two or three quality providers in each market and at the same time we are seeing emergence of the pan-regional sub-custodians,” says Todd.“This trend is not one that is going to go away, and over time we will see the consolidation of individual subcustodians into those groups.” Stephen Brown, regional head of network management, Europe, Middle East, Africa and Americas at Northern Trust – another buyer of sub-custody services in Europe – stresses

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that the shift towards pan-regional providers does not mean there are no longer any good indigenous mono-market providers to be found. Brown concedes that Northern’s network today largely comprises regional providers. “Over the last few years we have changed our custodians in a number of markets and on all but one occasion we have consolidated with a regional provider,”he says. Lack of scale and geographic reach is a problem for monomarket providers, he adds, while strong pan-regional players can boast credit and service quality across more than one location. “The fact that they are regional providers demonstrates clear commitment to the business,” Brown says. “They also tend to evidence greater investment in technology based upon capability and contingency planning, and typically also have broader experience and client base. For us as a global custodian we can certainly derive relationship, servicing and pricing advantages from using a single provider across multiple markets.” While sub-custody clients might give the impression that service is less important than cost, in reality they want the best of both worlds: top quality service allied to a keen price. “That is not an easy balance to strike,”says Jon Lloyd, head of clearing, settlement and custody at BNP Paribas Securities Services. “European integration and harmonisation is taking longer to achieve than predicted and it is also proving very expensive – 25-30% of my IT budget for the coming year is being spent on implementing mandatory market changes. Now, I have a broad franchise across Europe to amortise that against, but for a monomarket provider that is a huge amount of cost to take onboard. Factor in Basel II and TARGET 2, and the monomarket provider is extremely exposed.” Factor in the commercial aspirations of the region’s depositories (of which more later), and it is easy to understand why many of those sub-custodians that have not quit the business – casualties include Dresdner in Germany, Bank Leu in Switzerland, CSFB in Russia and most recently ABN AMRO, which sold out to Citigroup – are looking to alliances and white labelling in order to survive. Both ING Bank and Allied Irish Bank, for example, have tied the knot with The Bank of New York. The global custodian has also just signed a custody deal with Natexis Banques Populaires which is expected to evolve into a fully fledged alliance in due course. Giulio di Cerbo, managing director, Citigroup Global Transaction Services, sees white labelling as an important growth area going forward. “Sub-custodians are asking themselves whether they have the necessary scale and how core the business is to them,” he says. “They could obviously choose to sell or to enter a joint venture but a number of banks, while recognising there is a need for a pan-European solution, are looking to retain their clients and their business. In that situation we can white label the offering on their behalf. “They continue to service their client base and distribution channels, but rather than investing in other European linkages, they can leverage our scale and single common

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Stephen Brown, regional head of network management, Europe, Middle East, Africa and Americas at Northern Trust

technology across multiple jurisdictions. It makes little difference to Citigroup whether the volumes coming in originate from Germany, France or Italy, so we can provide one price across multiple jurisdictions, one set of standards, one set of reporting, one communication methodology – and those save costs both for the client and us,”says di Cerbo. New European directives mean major clients no longer buy or sell through a local country broker but rather are members of exchanges, he continues. “However, for many broker-dealers and banks that is an unwelcome cost burden. So we now provide on-exchange clearing and, in addition, peripheral services such as cross-border margining and access to multiple CCPs and depositories. Should securities not come in as expected, we will deliver them from our lendable portfolio to the exchange on behalf of our client, and we also provide inter-day liquidity and inventory financing where banks and brokers have residuals in their account at the end of the day.”

Asian sub-custody In Asia, however, there are no such concerns. As Paul Hedges, global head of securities services at Standard Chartered Bank, notes a key difference between the post-trade environments in Asia and Europe is the harmony at the depository level.“I sit on the Asia Pacific Central Securities Depository Group (ACG) and while the depositories do communicate with each other, the level of harmonisation and linkages you see in Europe simply does not exist here,”says Hedges.“The ACG is talking about hammering out various Memorandums of Understanding between CSDs, but we are a long way away from that becoming a reality – and for the right reasons, as every market in Asia is clearly very different, with no common currency or regulatory framework.” For his part, Colin Brooks, deputy head of custody and

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SUB-CUSTODY Giulio di Cerbo, managing director, Citigroup Global Transaction Services

clearing at HSBC in Hong Kong, feels that Asia has come a long way in the last five or six years in terms of uniformity – “settlement cycles have come into line and all the markets are dematerialised, there is an overall view that markets need to be more transparent and there must be a level playing field between market participants” – but he agrees that the region remains some way away from seeing the sort of linkages between exchanges and depositories now so common in Europe. As for the sub-custody product in Asia, Brooks says it too has matured considerably in recent years. “In the past you were judged on your ability to settle a trade efficiently and process a corporate action,” he says. “These days, however, our clients want much more of us – they expect us to truly act as their eyes and ears on the ground, to act as their business partner and to really understand what their business entails and provide them with a customised suite of products.” Paul Hedges says that, whereas the region’s subcustodians have traditionally serviced ‘Western’ clients, there is now a fast growing Asian client base as a result of demographic changes, the rise of provident funds and personal retirement plans as well as new investment by Asian non-government and government institutions both within and without the region. He believes this shift will directly benefit pan-regional players like Standard Chartered and

HSBC. “In Europe we have seen a move towards pan-regional sub-custody provision for a number of reasons: commonality of currency; harmonisation on the regulatory front but primarily due to acquisitions,” says Hedges. In Asia, however, the growth of the pan-regional providers has primarily been driven by consumer banking presence and latterly wholesale banking activities, he adds. “Certain markets – Malaysia, Korea, Indonesia, Japan – have traditionally been dominated by mono-market banks with immense local influence stemming from huge, predominantly corporate businesses,” says Hedges.“In addition, in some markets – Singapore for instance – the mono-market players have been protected by the regulatory environment and ownership rules, as we were restricted from offering certain services. “What has changed over the last couple of years, and indeed has gained significant momentum in the past 6-8 months, is that due to demographic and other changes the buyers of sub-custody services are starting to look at Asia as an investment destination in itself – but they only want to access the region through a single window. So the region will follow the same path as Europe – but for different reasons, and at a different level of intensity.” Colin Brooks believes that the traditional strengths of pan-regional providers – scale economies, deeper pockets, streamlined access to multiple markets – will prove compelling going forward.“The truth is that these days there are really only a few markets – such as Japan, Australia and Singapore – where you still have serious mono-market providers,” he says. “There was a huge shakeout during the Asian crisis at the end of the Nineties, at which time a lot of local banks saw their credit ratings lowered and they consequently lost a lot of business. As a result, many no longer offer sub-custody as a product, and we have since seen an approximate halving in the number of active sub-custody providers in the region.” As a pan-regional provider will often already be servicing a particular client in multiple markets, when that client comes to review their arrangements in another market, it is simpler to go with the provider they already know, adds Brooks.“We already know their priorities, and so are able to tailor our services to those requirements in a new market,”he says.“We are also very much aware of not just regional but also global best practice, which again puts us at an advantage.” Nonetheless, Brooks acknowledges that competition in the sub-custody arena remains fierce, with continued downward pressure on margins.“That said, I have been in this business 15 years and that has always been the case,” he adds. “One way to manage that is to bring on more clients and expand the breadth of product we offer to

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include higher margin offerings. If you are just offering vanilla custody, the attraction of investing in that product in isolation is far more limited than it was a few years ago, but if you view it as an essential foundation supporting other products it makes a lot more sense.”

Flexible services and solutions Jon Lloyd believes there is now a greater appreciation of the role of the sub-custodian as a risk manager, a source of lobbying expertise and connectivity and a source of cost avoidance.“Clients also see us as a very important cushion against the volatility in the marketplace,” he adds. “As we push for consolidation and harmonisation in Europe, the sheer volume of change is so much greater than before and that leads to higher levels of risk. The fact that the client can avoid getting involved in that day-to-day, with us taking away that pain, is becoming an important part of the relationship.”Lloyd cites recent examples of market changes in two key markets: “In Italy there have been a number of issues with the Express II platform which we have sought to minimise; similarly there are currently changes going on in Spain which are causing major market disruption.” However, Lloyd feels it is important to strike a balance between consolidation and the competition issues it raises – not least on the depository front. As JPMorgan’s Brian Todd notes, the ability to access markets directly, in the process lowering costs and streamlining operations by eliminating multiple clearing and settlement interfaces, is a perennial threat to sub-custodians.“There are two types of clients,”he says.“Global custodians like ourselves who are buying subcustody for our traditional ‘buy and hold’ markets, and then there are the broker-dealers who are buying it in order to pass trades through the market in real time and support a trading operation – and they are opening up to the idea of becoming direct remote member participants.” This impingement by depositories into the sphere of commercial banking is seen as fundamentally uncompetitive by Lloyd. “There are ways and means of competing: either directly by attracting your competitors’ clients through the quality of your product offering; or you can compete via pricing,”he says.“While there has been a lot of fanfare in the UK market with CREST bringing down the cost of settlement, we are seeing the Dutch, French and Belgium central securities depositories (CSDs) all increasing prices. That is a great way to make the sub-custodian suffer, because they are being squeezed on one side by clients wanting lower prices and then on the other by rising prices at CSD level. That is not a healthy dynamic – depository consolidation was supposed to be about economies of scale, harmonisation and driving down costs for the market.” Over at Citigroup – which, like BNP Paribas, is a leading light within the Fair & Clear pressure group opposed to what its members see as the CSD’s unchecked expansionist tendencies – Giulio di Cerbo is equally blunt. “There are commercial entities like banks and then there are utilities, such as depositories, which should be user owned,”he says.“We want a strongly regulated post-trade

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environment just as there is the pre-trade world, and we do not want to see utilities running commercial or liquidity risks.” (The depositories, on the other hand, reject any suggestion that their move up the value chain is in any way uncompetitive or inappropriate). Stephen Brown says that Northern Trust already self-clears and self-custodies in the United States, United Kingdom and Canada. The bank will also have to consider this option in Europe “if the market can create a single quality asset servicing European CSD”.“Certainly Euroclear’s plans for its integrated custody and settlement engine for its markets – is on paper an attractive proposition, although it will no doubt also bring some new operational challenges,” he says. However, Brown concedes that, for now, sub-custodians still have an edge to servicing the more sophisticated and demanding global custodians. “Sub-custodians offer the experience, understanding, and broad local knowledge and expertise that depositories do not generally have,” he says. “However, some depositories, including Euroclear, are already in the sub-custody space, and they are working hard to offer the premier sub-custody service that global custodians demand.” “Providing core services is fundamental. But just as important is the ability to be flexible and create flexible solutions. That is not something depositories are not known for – they tend to provide a ‘one size fits all’ service, whereas as global custodians our clients are constantly challenging us to do different things, and so we need our sub-custodians to be flexible and innovative.That is not something depositories can yet offer,”Brown adds.

Colin Brooks, deputy head of custody and clearing at HSBC in Hong Kong

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STRAIGHT THROUGH PROCESSING

STP puts on a mature mantle Tony Freeman, head of European industry relations at Omgeo

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Once considered the holy grail of securities trading, Straight Through processing (STP), the automated passage of a securities trade from execution to settlement, is no longer in the limelight these days. These days, say market watchers, there is a much more mature appreciation of what straight through processing is about. Firms are now focusing more at the business objectives underlying STP such as increasing efficiency between trade counterparties, improving margins, reducing transaction costs and minimising failed trades. Rekha Menon reports.

“Harmonisation of market practice is essential to eliminate unnecessary differences between markets and thus enable single developments to accommodate the needs of different markets. Message standardisation too is extremely important for STP. The ISO 15022 standard for instance, is a very powerful tool that has enabled automation in areas such as corporate actions where it was not possible earlier," he says. The securities industry is currently involved in a variety of STP-related projects, right from implementing messaging protocols like FIX to automating the trade allocation, confirmation and matching process. While the sell-side is broadly acknowledged as having invested heavily in STP, the buy-side has often been the target of criticism for its reliance on fax machines to interact with ITH THE DEMISE of the Global Straight counterparties.“The buy-side’s primary goal is to pick the Through Processing Association (GSTPA), right investment, manage investment performance and coupled with the indefinite postponement of the manage client relationships. Improving back end drive to reduce trade settlement cycles to T+1, it would operational efficiency is, more often than not, considered appear that the industry’s romance with straight through secondary,” explains Guy Eden, solutions director at processing has gone sour. However, this interpretation Sungard Business Integration. However, it would be unfair to tar the entire buy-side could not be further from the truth. While the term STP may have lost some of its shine, the proposition it offers – with the same brush. UBS Global Asset Management, for to reduce costs and operational risk through increased instance, is currently in the process of implementing a global STP hub for the firm’s global trade confirmation automation – is still as applicable today as it was earlier. system based on STP “The reason why people vendor Checkfree’s trade aren’t actively talking about confirmation and settlement STP is because there are no “Improving back end operational solution. Another large asset grandiose initiatives in the management firm T. Rowe pipeline such as GSTPA. efficiency is, more often than not, Price is working on a large Straight through processing considered secondary,” explains Guy internal in-house STP is actually a stream of Eden, solutions director at Sungard project and is in the process developments. Some events Business Integration.” of implementing STP might grab the headlines, vendor Smartstream’s but the process continues solution for reconciliation, unabated,” explains John Gubert, global head of HSBC Securities Services. “The confirmation and settlement. In fact, a buy-side survey securities industry is inherently inefficient and with conducted last year by Investit, a UK-based investment continuously increasing volumes, the imperative is to management consultancy, revealed that in equities and increase the level of automation to reduce the cost and fixed income, most large investment managers are achieving acceptable levels of STP in the post-trade risks involved,”he says. STP might no longer be the buzzword in the securities processing environment. “The UK is one of the most industry, but the earlier intensity has given way to a more advanced countries in terms of buy-side automation for mature appreciation of what straight through processing is equities trading, with a large majority of the trade all about. Firms are now focusing more at the business allocation-confirmation process in London being objectives underlying STP such as increasing efficiency automated. In contrast, the US has a much lower level of between trade counterparties, improving margins, reducing automation with continental Europe falling somewhere in transaction costs and minimising failed trades. Despite between. In the US, even some of the large investment there no longer being a pressing requirement to shorten managers use paper to manage the allocationsettlement cycle times to trade plus one day (T+1), last year confirmation process,”says Eden of Sungard. In the current economic environment, cost is the biggest the Securities Industry Association (SIA) in the US reiterated its commitment to efforts to move the industry to deterrent for investment managers looking to automate their manual processes. The effort and expense involved in an STP environment. According to Gubert there are three key imperatives for automating the trade process is just too high. Operating the industry to achieve an STP environment – under tight budget constraints, many investment managers harmonisation of market practices, message are now choosing to focus on their core competencies standardisation and reference data management. while outsourcing their back office operations. The last few

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years has seen a rapid rise in the number of such important by-product for the asset management firms,” outsourcing deals among the buy-side, with the main says Pamela Brewster, senior analyst at research firm, beneficiaries of this trend being the large custodian banks Celent Communications. The number of investment management transactions such as State Street, Bank of New York, BNP Paribas, JP Morgan and Mellon. For instance, JP Morgan Investor that can be concentrated within an outsourcing Services (JPMIS), the custody arm of JP Morgan, provides organisation is ultimately the key to achieving high STP levels, says Tony Freeman, middle and back office head of European industry outsourcing to leading buyrelations at Omgeo, the joint side firms such as Schroders “While cost reduction and risk venture company of and Morley Fund mitigation are the main triggers for Thomson and the US Management, while State such outsourcing deals, STP is an Depository Trust & Clearing Street provides outsourcing important by-product for the asset Corporation (DTCC) which services to firms including provides technology for the ABN Amro Asset management firms” post-trade pre-settlement Management, Investec and arena. Freeman believes that AXA Investment Managers. Recently ING Investment Management in Europe although currently outsourcing is still an immature announced that it would be outsourcing its investment business idea, it does have the potential to significantly operations from post-trade to settlement to Bank of New improve STP levels in the future. Omgeo itself has recently come out with a new product York (BNY). By providing access to better technology than they could that is directly targeted at low-to-medium volume otherwise afford, outsourcing provides investment investment managers that are still using manual processes. managers with the opportunity to achieve high levels of This light web based interface to Omgeo’s central trade automation. ”While cost reduction and risk mitigation are matching solution, CTM (Central Trade Manager) will the main triggers for such outsourcing deals, STP is an allow small buy-side firms to process their domestic and cross-border trade allocations electronically.“Omgeo CTM allocation interface will provide an easier and cheaper route for lower volume fund managers to realise the significant cost savings and risk reductions that come with automated trade processing,”explains Freeman. The launch of this new service is the result of extensive collaboration between Omgeo and six leading broker/dealers, ABN AMRO, Citigroup, Credit Suisse First Boston (CSFB), JPMorgan, SG Corporate & Investment Banking and UBS. Recent analysis conducted between Omgeo and a number of clients indicates that by capturing details earlier in the life-cycle of a trade and through the electronic automation of the trade allocation process, operating costs and trade failures can be reduced by up to 70%, with sameday affirmation rates rising by as much as 80% or higher. Roddy Scotland, investment admin manager at Edinburgh Partners, an investment management firm piloting Omgeo CTM allocation interface, voices the firm’s expectations from the service,“Using Omgeo’s new solution will enable us to achieve same or next day settlement for cross-border, domestic equity and fixed income trades. This means that we can focus on maximising returns and delivering superior customer service to our clients.” With a similar aim of helping investment managers achieve higher levels of automation, JP Morgan Investor Services (JPMIS), the custody arm of JP Morgan, has launched a thin, web-enabled solution for the entry and transmission of global custody instructions by fund managers called ‘Browser Trade Input’ (BTI). “Straight through processing has already been achieved by major financial institutions, largely through SWIFT ISO15022 progress. Now smaller players who are not on the SWIFT John Gubert, global head of HSBC Securities Services

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network can be brought into an electronic age using tools such as BTI,” says David Kane, securities processing executive at JPMIS. The industry is finally waking up to the potential of improving the STP environment by involving smaller players. Keeping the classic 80/20 rule in view - small nonautomated firms contribute only 20% of the volume, but account for nearly 80% of the total population of firms active in the investment management space – the potential efficiency gains achieved by automating small buy-side firms are bound to be enormous. James Daniels, head of European client service team at CSFB sums it up,“One of the reasons why I think this solution (Omgeo Allocation Interface) is important is that it offers another choice for the smaller investment managers who until now have had very few choices. If they were unable to invest in heavyweight technology like the full Omgeo product or to build a FIX link with their brokers, their only option was to continue ‘as is’ or to outsource. Now they have another option. The investment manager community is diverse and has different needs and we need to provide as many options as we can for those investment managers to improve their processes.”

David Kane, securities processing executive at JPMIS

GETTING THERE IS EASY FTSE Global Markets is your passport to 20,000 issuers, fund managers, pension plan sponsors, investment bankers, brokers, consultants, stock exchanges, and specialist data providers. If you would like to order reprints of any of the articles in this issue or discuss advertising insertions, tip-ons, supplements, sponsored sections, bookmarks or your own special requirements Contact: Paul Spendiff Tel: 44 [0] 20 7074 0021 Fax: 44 [0] 20 7074 0022 Email: paul.spendiff@berlinguer.com

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PORTFOLIO TRADING

It is a truth universally acknowledged that a basket of shares in need of rebalancing is in want of a good portfolio trader. These are lambent days, as demand for their specialist (and sometimes arcane expertise) is on the rise. But even while portfolio trading grows apace, the sector is itself in transition – facing a new set of opportunities and challenges. Trading strategies, benchmarks and the market structure are set to become even more sophisticated and competitive.

THE UPSIDE OF

PORTFOLIO

TRADING Zachary Tuckwell, global head of portfolio trading at Dresdner Kleinwort Wasserstein (DrKW)

FTER A PERIOD of lacklustre growth throughout the 1990s a noticeable uptick in volumes has occurred during the last four years. Market talk has it that in 2005 portfolio (or program) trading is finally walking tall. Back in 1995 portfolio trading accounted for barely 12% of all trades on the New York Stock Exchange (NYSE). By 2000 this ratio had crept up to just under 20%. According to specialist research house Greenwich Associates, the proportion of portfolio trades in relation to total trades now executed on the exchange rose from 44% in 2003 to 50% last year. That percentage appears to be on the rise again, as in early March the NYSE reported that portfolio trading accounted for 52.8% of its average daily trading volume. Money managers routinely use portfolio trading to invest cash inflows, implement tactical asset allocations, manager or portfolio transitions and rebalance portfolios. There are myriad reasons why portfolio trading is gaining. Not least is the increased availability of technology, a

trend towards quantitative ‘top down’ portfolio management, a greater focus on transactions costs, and a growing requirement for asset managers to respond quickly to market movements explains Emad Morrar, managing director, Lehman Brothers International (Europe). In that context he says, “portfolio trading is a critical execution method.” Portfolio trading also allows asset managers to help control commission payments, the market impact and the opportunity costs associated with their trades. And “put simply, the price of program trading is lower than that of single stock trading,” says Stavros Siokos, head of alternative execution sales at Citigroup. The ability to deliver high quality executions for a large list of stocks is one of the main reasons for its increasing acceptance. Efficiency is a cornerstone of the business and automation of portfolio traders is of particular benefit to asset managers and bankers both. The ability to break down a sizeable (and otherwise market-seismic) block of shares into different combinations (say into specific

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countries or sectors) which can be traded more easily, is a plus for asset owners and the market, explains Garth Ritchie, head of European equities trading at Deutsche Bank in London. The algorithms used in automated trading facilitate easier and more liquid orders and also give traders the time needed to structure and effect the trading of more complex baskets, he adds. Automation also helps keep the business efficient – a point noted by the rather tight numbers of traders in portfolio trading operations. However, as important is the fact that customers are sensitive to execution quality and prefer a greater degree of discretion when entering the market, something which automation confers effectively. One of the benefits of a good portfolio trading desk is to be able to understand and accommodate diverse investment styles and approaches. In some instances, for example, orders from clients have special limitations, such as cash neutrality, sector neutrality, derivative overlays, or volume-controlled execution. “The flexibility provided by computer-based portfolio trading systems means we can meet our customer’s Stavros Siokos, requirements precisely,” explains Ritchie. Lehman’s head of alternative execution Morrar agrees. A key element of using portfolio trading is sales at Citigroup its ability to handle the complexity that results from intra-day market volatility. “Managing a quantity of Like a number of houses, Deutsche Bank and DrKW futures to trade throughout the day while staying market neutral is a complexity easily handled,” he notes. The have aligned the portfolio trading business with cash speed with which a trader can prepare a list and get it to equities. Ritchie, prior to being promoted to head of the exchange is considerably faster than if done via block European equities trading was in fact head of portfolio trading.“Our focus is for our FPT client base to mirror our trades, he adds. Two approaches to execution dominate the business. cash client base,” expands DrKW’s Tuckwell, though he The first is risk execution, which incorporates a variety of points out that this is a relatively recent phenomenon as trading strategies specific to benchmarks or specific prices previously the bank’s global portfolio trading operations set by the client. It is also quite common for trades to be had been aligned to the bank’s derivatives business. “DrKW offers clients an accompanied by a ‘best integrated and bespoke efforts’ mandate. Generally approach where our GPT these are referred to as cash equity teams will visit agency trades, where the Leading index providers have steadily clients together and prices the asset manager moved to free float adjusted indices – strategise together, whether gets are the prices the broker a move designed to avoid supply and it is a transition or agency achieves on his behalf. “In deal. We listen to a client’s this case, no particular demand distortion of share prices. objectives and then provide benchmark is given and a best fit trading strategy to execution decisions will be accommodate their needs.” made directly by the This linkage with cash equities has invariably created portfolio trader on a multitude of factors, including liquidity and expected market direction,”explains Andrew opportunities for small, niche players to leverage business, Freyre-Sanders, vice president, portfolio trading at particularly among the rising independent brokerages. JP Morgan Securities Ltd. At DrKW, explains says Zachary Competition is invariably growing and the established Tuckwell, global head of portfolio trading at Dresdner historical dominance of houses such as Citigroup, Lehman Kleinwort Wasserstein (DrKW), the business is split three Brothers, Deutsche Bank, JPMorgan and others in the ways: “with the bulk being a combination of pure agency, portfolio trading segment is beginning to come under fire where the client takes the risk, and pure risk, where the from quarters such as ITG and Instinet. These are not your bank takes the risk. The remainder is a mix that includes typical custody firms with natural access to portfolios from guaranteed close and guaranteed volume weighted either custody or transition management flow. ITG does average price [VWAP], where the risk is generally split claim transition management expertise, but Instinet for one sells its portfolio trading services instead” on being a equally between either the bank or the client.”

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PORTFOLIO TRADING Emad Morrar, managing director, Lehman Brothers International (Europe)

pure agency broker, with the same sophisticated tools and expertise, but without the conflicts of interest,” explains Natan Tiefenbrun, president of Instinet Europe, “we earn our money entirely through commissions and never by competing with clients”. It is a pivotal selling point for the specialist broker. Tiefenbrun would have it that some of the investment banks do not, in fact, act in the best interests of clients. He cites the potential for front-running or pre-hedging which, which he says, could compromise the relationship between the client and broker. He explains: “If a portfolio trade is undertaken on a risk basis (where the broker guarantees the price) then how the broker subsequently unwinds the portfolio is his own business. However, in seeking risk bids for a portfolio, the client has already given them the information on the characteristics and constituents of the portfolio, and that can allow them to trade against the client, if they wanted to do so, even before the risk-price has been set. For agency trading, the question is whether you can get a true agency execution from a firm that conducts agency and principal trading side by side – data mining of customers’

algorithmic trading to fee a bank’s own proprietary trading decisions is commonplace.” Instinet’s business model is different, says Tiefenbrun. “The way we pay our staff ensures it is aligned with our customer’s best interest. We do not undertake principal trading, we preserve anonymity and confidentiality and an assured code of conduct ensures fair treatment, whether you are a large or small customer,” he explains. The response of most of the houses to the gauntlet of Instinet is phlegmatic. “DrKW offers a comprehensive and high quality GPT service and our risk offering is, as with other houses, very competitive and therefore our client business has been increasing steadily – we do not preposition trades,” says plain speaking Tuckwell, at DrKW, agency, guaranteed VWAP, and exchange for principal, or EFP.“Our risk offering, as with other houses, is very competitive and our business has been increasing steadily. We have no need and are not going to pre-position.” For some, the competitive argument is on a different plane. To compete at a high level in this business investment banks now provide a comprehensive range of execution services including “global agency and risk portfolio trading, hybrids, derivative portfolio strategies with futures and exchange-traded funds (ETFs) quantitative portfolio trades,”says Ritchie. Within that the portfolio trader also has to provide liquidity, comprehensive risk management services, cash collateral financing and various analytic tools which can be applied before and after trading. Though Tiefenbrun concedes that there are significant differentials in structure and form and even breadth of total product offering between firms such as Instinet and the global investment banks, he believes that trade for trade Instinet provides the same if not more degree of care and support. Tiefenbrun insists “on an unprecedented level of transparency and we also have the advantage of not undertaking principal trading, which gives our customers comfort.” But there are other competitive considerations. Instinet, just like the investment banks, has a high level proprietary

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On the surface that kind of development appears to be portfolio trading system, “built up over many years,” says Tiefenbrun. He concedes however that new entrants in every traditional portfolio trader’s nightmare. today’s market would require a significant investment in Nevertheless increasing customer sophistication is seen as a benefit rather than a technology, “which would challenge. For one, “at put the business out of the Citigroup portfolio trading hands of the smaller allows institutional investment banks wanting to Mounting complexity means few banks investors to implement enter the business, for sure.” can compete at these service levels, simultaneous investment Perhaps the highest decisions across a large degree of competitive suggests Freyre-Sanders, who explains number of securities pressure has been felt most that “the launch of structured portfolio throughout the world,” in the area of analytics. “A trading involves producing an allmaintains Stavros Siokos at few years ago, for example, encompassing service, which invariably Citigroup.“That by itself can very few offered pre-post means high barriers for entry. not be achieved by direct trade tools. Now, it is a sine market access. Asset qua non,” interjects JP managers will invariably Morgan’s Freyre-Sanders. have to access that global Pre trade analysis gives investors “the necessary data to make informed trading capability through us and houses like us.” Like Deutsche decisions at both a macro and micro level and provides Bank, Lehman Brothers, and JP Morgan, Citigroup’s the necessary inputs for trading algorithms,” explains portfolio trading group encompasses around key teams Adam Toms executive director, global portfolio trading situated around the world. “The bank’s global market and advisory at Lehman Brothers. “Post trade analysis share provides a distinct advantage in our ability to meanwhile concentrates on cost measurement and the service our clients,” says Siokos. Although Siokos notes “significant direct market access performance of the trading algorithms.” Mounting complexity means few banks can compete at these service levels, suggests Freyre-Sanders, who explains that “the launch of structured portfolio trading involves producing an all-encompassing service, which invariably means high barriers for entry.”Technology is a particular consideration, he suggests “because our clients have differing technology preferences and security concerns we can deliver our analytics either as a desktop application or through a web-based browser. It helps make us single stop guys. The underlying premise is the search for execution to live on its own.” Given the breadth of service it makes sense that more often than not portfolio trading services are provided in conjunction with global custody business and transition management services and because of that, most investment banks provide a multi-asset execution capability, although portfolio trading is, specifically, an “equities-only business,”explains Lehman’s Toms.“From that point of view, we note a dealing desk progression,” adds Seema Arora, vice president, portfolio trading, JP Morgan Securities in London.“These days most buy side firms will use a centralised dealing desk to manage the execution of trades. However, we are now seeing a different breed of buy side dealer, especially on larger dealing desks, who require a variety of trading tools including: direct access to the market and the use of sell side algorithms for greater control and anonymity.” As early as the spring of 2003 Fidelity Capital Markets, the Adam Toms, executive institutional trading arm of Fidelity Investments largely director, global portfolio began the direct access trend, utilising the enhanced the trading and advisory at quantitative modelling capabilities of its portfolio trading Lehman Brothers. operation as a key selling point of its service.

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that investors are subject to flow” it is “not as popular as in rebalancing portfolios. you might expect.” To be Combine that with effective, he points out, you There are myriad reasons why portfolio regulatory pressures to need a big sized trading desk trading is gaining. Not least is the understand the costs and and not every buy side increased availability of technology, a fees that are being charged institution can afford ten to trend towards quantitative ‘top down’ in the industry and the fifteen traders to hand, backed portfolio management, a greater focus strain builds and builds. by a small quant team. Consequently, “there is Equally, if something does go on transactions costs, and a growing incessant pressure on wrong you have no broker to requirement for asset managers to margins and margins are help cover your position – so respond quickly to market movements. being pressed to there is the added comfort of sub-economic levels,” transferring those operational acknowledges Deutsche risks to the specialist.” Bank’s Ritchie. “There is While portfolio trading remains a high volume, low margin business, it will always a new entrant to break ranks and come in at a continue to suffer particular stresses. The downside to the favourable price, to win business,” – a point not lost changes in portfolio construction is the transactions costs in the market. “It is question of positioning, expands Lehman Brothers’ Morrar. We compete on product quality, not price – that is a losing game.” DrKW’s Tuckwell agrees. “Relationships are an incredibly important consideration, Natan Tiefenbrun, president putting a human face on the trade and then of Instinet Europe trying to add value at every level. Everyone has their particular strength. You can win business just on price, but you can not keep it, if you are not adding value throughout the execution chain.” It is a complex balance, suggest Lehman Brothers’ Toms between “people, systems such as algorithms and the value-added analytics and advisory on a pre and post trade basis and getting the balance right all the time.” Morrar expands, saying that portfolio trading cannot be commoditised.“If you do that, there is no need for the quant teams or the analytics. Once you have made the decision to commoditise the business you have lost the game.” Utilisation of algorithmic trading strategies alone does not, in fact, guarantee better results. Investors need to specify appropriate macro level strategies and select brokers who can align micro level pricing algorithms with their overall objectives. Ritchie meanwhile takes the pragmatic stance that “at some level market forces will prevail and the buyside will comprehend the level of service they get for the price they pay.” For the time being however portfolio trading volumes are pushing through at a heady rate and volumes are still compensating for the lack of really healthy margins. “We have seen geometric growth,” admits Ritchie, acknowledging “portfolio transitions a key customer of the portfolio trading desk.” For Deutsche Bank this note has particular resonance as the bank remains one of the top two transition management houses in the world

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by volume of portfolio assets transited.“It certainly gives us an edge,”he concedes. The importance of an inhouse transition management business however is neither ubiquitous, nor always fundamental to portfolio trading volumes. Siokos, for example, anticipates that only around 20% of portfolio trading undertaken by Citigroup this year will be a direct result of portfolio transitions. “In our firm,” he says, “‘Chinese walls’ exist between the transition management team and portfolio tracing.”However, he concedes that “transition management is a particularly strong element this year as a number of major indices have undergone a restructuring. Imagine how many index funds have had to readjust because of this.” Since 2000, leading index providers have steadily moved to free float adjusted indices – a move designed to avoid supply and demand distortion of share prices. In turn, capitalisation weight has shifted from low free-float companies to high free-float companies, requiring significant change or rebalancing of passive investment portfolios benchmarked against specific indices. Index providers FTSE and MSCI were early movers, moving to free float adjusted indices in stages between 2001 and 2002. Now a broad range of free float calculated indices are available in the market, ranging from the Dow Wilshire Indices to the SENSEX (Malaysia) and TSE (Japan) indices in Asia. Last year Standard & Poor’s (S&P) announced it was moving to free float index calculations in two stages: half the float adjustments for each constituent were made in March, with the remainder scheduled for September. As portfolios are continually rebalanced to compensate for changes, there is no doubt that portfolio traders have benefited and continue to benefit from portfolio transitions. At the top end explains Lehman Brothers’ Morrar “with more complex multi-asset business, we would work directly with our transition team, which has separate reporting lines from our portfolio trading

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Garth Ritchie, head of European equities trading at Deutsche Bank in London

business. If it is equity only then it is in practice just a big portfolio trade, unless the client specifically wants a transition management project team around it.” It is not an uncommon request, adds Adam Toms, “some clients want the trades undertaken behind Chinese walls. And with the equity markets on something of a rebound we are seeing more equity-only transitions.” The relationship between portfolio trades and portfolio transitions would suggest seasonal peaks and troughs though DrKW’s Tuckwell notes that traditional trading patterns are in flux as “many passive managers are working smarter. There are a lot of people, both active and passive, who are looking at index make-up and starting to anticipate which way things will move. Some managers are not waiting for specific announcements and are moving slightly before or after an expected rebalancing of an index. It is changing the pace and tempo of the business.”

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CUSTODIAN

LENDERS

SECURITIES LENDING

Andy Clayton, head of securities lending at Northern Trust

FIGHT BACK The big changes in the $2trn securities lending market have perhaps already happened as increased competition from new lenders and the umbilical cord which largely kept securities lending and custody tied together was finally cut. Todayâ&#x20AC;&#x2122;s market is living with the consequence of those changes. Diverse lending routes and new providers of liquidity are changing the structure of the market. But now the custodians are fighting back, arguing that they alone are the true providers of transparency and proper risk management and, they say, regulatory requirements are playing onside. Francesca Carnevale reports.

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Better process, better price. Looking to maximize securities lending returns for your portfolio? There is a better way. eSecLending takes an active approach to securities lending by managing customized programs for institutional investors. Unlike the traditional agency approach, where many lenders’ portfolios are grouped together and their securities wait in a queue to be borrowed, eSecLending markets each client’s portfolio individually and awards lending rights to the optimal bidders.

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SECURITIES LENDING

ORTH OF THE River Thames, Wayne Burlingham, head of securities lending, institutional fund services, EMEA, at custodian lender HSBC’s Mariner House offices in London, ruminates as he ponders the evolving structure of today’s market. “I think we all agree the big concern these days is the effect of competition. Margins have been drifting down for years and it is a challenge to construct operations to handle higher volume and lower margins.” Meanwhile, almost in frustration, Tim Smollen, managing director and global co-head, agency securities lending at Dresdner Kleinwort Wasserstein (DrKW) in London, says “tell me something different about securities lending. It has been about the same issues for too long.” Both cut to the heart of the matter. That is that the growing segment of third party agent lenders is successfully challenging the traditional foundations of the business, but at a price. How that challenge will pan out over the next few years is still to be decided. According to Andy Clayton, head of securities lending at Northern Trust, “competition isn’t necessarily a bad thing. Custodian lenders are doing a good job for clients but need to spend more time telling them about it. Securities lending being item 7 on a custody service review agenda is not the way to respond to the threat of third party agent lender sales professionals.” Securities lending involves the temporary exchange of securities, generally for cash or other securities of equal or greater value. Borrowers of the securities are also obliged to redeliver the same quantity of the same securities at a determined future date. Equities, government bonds and other fixed income instruments are all included in the asset mix. Bonds are among the largest area of securities lent, though equities “are more lucrative,” says Burlingham. “Portfolio return is affected by the utilisation rate (the proportion of securities out on loan),” explains Smollen, and that depends on the demand for particular stocks. Securities ‘borrowers’ borrow on an ‘open’competing basis with other counterparties or sometimes on an exclusive basis. The assets they borrow are generally used to supply two areas of demand. First is the demand from banks and brokers (including the securities borrower’s proprietary

Fredrik Carstens, DrKW’s managing director of agency lending and head of EMEA marketing

trading desk) who will need the securities to support market positions. A second and fast growing area of demand is from prime brokers which provide support for the wide varieties of trading strategies employed by hedge funds. Until a few years ago the securities lending market was pretty linear and straightforward. Securities lending was a key component of the custody offering. Asset (or beneficial) owners bundled their custody and securities lending mandates and custodians, such as State Street, Citigroup, HSBC, Northern Trust and JP Morgan, competed on price knowing they could pick up additional fee revenue for lending securities in their client’s portfolio on a ‘best efforts’ basis. It created relative cosy relationships as each side benefited from the structure. It was a classic ‘win-win’ relationship as the lender paid the client revenue resulting from securities on loan and the client paid fees to the lender for the privilege of lending out the assets. Even in recent days, custodian lenders have benefited from the tendency for asset managers to outsource back office operations, with securities lending mandates often part of the package. There are various examples that can be quoted. Mellon was selected by F&C to provide investment administration services, the functions outsourced included securities lending, among others. AXA Investment Management, meanwhile, agreed an outsourcing arrangement with State Street in March, with a securities lending arrangement attached. Equally, HSBC recently scored ‘the double’ with UK fund management company Gartmore. With that kind of stickiness inherent in the business, it is no wonder that custodian lenders are peddling hard to retain their dominance. Ed O’Brien, executive vice president and head of State Street’s securities finance/lending business thinks the issue is clear cut. “In today’s market an established player with expertise and inventory becomes a valuable player. We work as a custodian lender, but also as a third party lender. People choose us not only because of the synergy we have with our custody operation, but also because of our robust reporting capabilities, cash investment processes and our large client base.” Even so, both O’Brien and Burlingham acknowledge growing competition for securities mandates from other sources. Pure third party lending agents such as DrKW (that act as a specialist lending agent and do not provide custody securities) for instance, are picking up substantial business volumes. Some of that business is resulting from new clients bringing in new liquidity. Equally some of the business is coming at the expense of the custodian lenders. There is much to play for – particularly outside the United States. “There’s a big push with pension plans and insurance companies in Europe,”agrees State Street’s O’Brien. Asia is also opening up, he adds. Today approximately 20% of Japanese funds lend. There are growing opportunities out there.”

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But the custodian lenders are not just discomfited by the loss of fee revenue. Burlingham explains, â&#x20AC;&#x153;The rise of the third party agents invariably adds to operational risk. If a third party lender is included in a chain handling corporate actions, dividend payments and recalls, it all adds up to the potential for mistakes being made.â&#x20AC;? Certainly, â&#x20AC;&#x153;the avoidance of the additional challenges of supporting a third party agent provides extra incentive to win the business,â&#x20AC;? adds Clayton. DrKWâ&#x20AC;&#x2122;s Smollen is quick to disagree.â&#x20AC;&#x153;With advances in technology, particularly on the SWIFT front, there is a minimal amount of operational risk in what, in many instances, is a straight-through process.â&#x20AC;? Nonetheless, business for the third party agents is brisk and building apace. For example, from a standing start in August of 2002, DrKWâ&#x20AC;&#x2122;s third party agent lending business is now approaching $100bn out on loan, says Smollen. Third party agents vary widely in service offering and in market expertise. DrKWâ&#x20AC;&#x2122;s market position, for instance, is built upon the securities lending teamâ&#x20AC;&#x2122;s extensive capital markets expertise.â&#x20AC;&#x153;We started this business at JP Morgan,â&#x20AC;? explains Fredrik Carstens, DrKWâ&#x20AC;&#x2122;s managing director of agency lending and head of EMEA marketing, â&#x20AC;&#x153;then at Deutsche Bank and then here.â&#x20AC;?One of DrKWâ&#x20AC;&#x2122;s competitive advantages is the positioning of the agency business in capital markets alongside the bankâ&#x20AC;&#x2122;s trading desks which

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Wayne Burlingham, head of securities lending, institutional fund services, EMEA

provide invaluable access to services such as research as well as trading and risk management tools. Carstens states that DrKW is now the worldâ&#x20AC;&#x2122;s second biggest repo house. â&#x20AC;&#x153;We compete on performance,â&#x20AC;? says Smollen and â&#x20AC;&#x153;we simply have more assets on loan at better spreads, benefiting from the fact that we are smaller and are able to maximise revenues on every portfolio,â&#x20AC;? adds Carstens. DrKWâ&#x20AC;&#x2122;s specialist niche however is difficult to replicate and

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SECURITIES LENDING

Tim Smollen, managing director and global co-head, agency securities lending at Dresdner Kleinwort Wasserstein

the contenders in the securities lending market often hover in both the custody and third party agent camps. RBC’s third party agent business has a totally different approach and model. RBC’s approach is based around the concept of broker-dealer as principal.“Clients authorise us to on-lend on a discretionary basis within our programme,” explains Fred Francis, vice president, RBC Global Services. RBC acts as a principal and “borrowers only see RBC as the counterparty,” he explains. “Record keeping and documentation is simpler in that legally we areliable. This programme model is a big seller to both borrowers and lenders. Clients clearly understand where the risk lies,” he adds. What this means however is that RBC is particularly careful with whom it deals and secondly that cash as collateral is limited to small portion of the total collateral it accepts. “While some borrowers will want to

Ed O’Brien, executive vice president and head of State Street’s securities finance/lending business

provide cash as collateral, cash is the most expensive commodity there is,” explains Francis. However, he continues, for this approach to work effectively the technology infrastructure supporting the business must be extensive. On a proprietary basis,“RBC has created a loan and collateral inventory that provides it with the asset management capability required to handle large volume business. We’ve made sizeable investments to ensure a seamless process with our third party clients,”he says. The bank is also making strides in conduit lending – another variation on the overall theme. Francis explains: “a client can hire us to direct the securities lending programmes of other custodians,”which, he says, is gaining in popularity. A different handle again is provided by Swiss American Securities Inc., in New York (SASI), whose special niche is introducing US securities from non US institutions –“supply that is not typically available,”says Ed Anselmin, senior vicepresident of operations. Anselmin explains that the key opportunity for his operation is the institution’s ability to bring in substantial new liquidity. However, while acting as an “intermediary”in the securities lending market, Anselmin acknowledges that supply often originates from its custodial operations, particularly in Europe. Anselmin says that SASI adopts a highly aggressive market approach. “It hangs on level of service, and the ability to pay the best rate. We will trade at spreads that maybe other people don’t want to do.” Enter then eSecLending, majority-owned by financial services firm Old Mutual plc, with its specialist auction process. Known as eSecAuction, it provides principal borrowing arrangements with multiple users through a proprietary web application. “We are providing borrowers with access to reliable supply – under circumstances where borrowers bid competitively for access in a blind auction,” explains Susan C. Peters, eSecLending’s chief executive officer. To date, the firm has auctioned just over $500bn of securities since its inception back in 2000 and in January this year was utilised by the Ohio Public Employees Retirement System, in a mega-auction which allowed a group of major financial institutions to access $31bn in US equities, for a period up to one year – after which time the rights to the securities will be auctioned again. Direct lending or direct market access (DMA) is also a feature of the market, though few fund managers undertake the activity themselves, given the investment in technology and business volumes required to justify a goit-alone strategy. Dutch mutual fund giant Robeco has gone down this route, having obtained the necessary regulatory clearance. According to RBC’s Francis,“DMA is growing in the North American market, but in Europe it is diminishing as few houses could really extract value. The prospect of single digit returns, the focus on outsourcing and the increasing demands on performance and innovation will drive outsourcing of securities lending. I think the trend to outsource by European beneficial owners will gather pace for some time to come.”As a consequence of this diversity clients too, view the business differently.“In these revenue and cost conscious days, a few extra basis points

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here and there really mean something and this is feeding the competitive cycle,”explains Burlingham. Change has come about for a confluence of reasons. In some cases, fund management firms have themselves become more sophisticated and complex structures; more insistent on separating different churches and states within their organisation. Consequently, securities lending mandates are not necessary awarded by the same managers that award custody mandates. Smollen backs this approach: “our view is that custody is a back office function and securities lending is increasingly a front office activity.” Burlingham thinks the issue is less clear cut.“Much depends on the approach of the asset owners,” he maintains. “Significant UK funds such as Morley and M&G see securities lending as core fund management business – that is, front office. AXA on the back of their reported discussions with State Street, seem to be viewing it as more of a back office business that is suitable for potentially outsourcing to a custodian lender,” Burlingham says. According to Northern Trust’s Clayton,“for a large client, the selection of a securities lending agent should be considered in the same manner as an investment manager appointment, particularly given the value a good lending agent can add.”Jamie M. Ball, managing director and head of capital markets of ABN AMRO Mellon Global Securities Services, agrees.“Different fund managers

view securities lending in different ways. And that fact that proxy voting is very important to fund managers does define how they are willing to have their portfolios lent. Third party lending structures do not generally work when managers actively seek to vote their holdings.“ eSEcLending’s Peters thinks that it is less of an issue in the United States, where more beneficial owners are prepared to lend out their portfolios.“We are seeing both a greater number of clients as well as the continued expansion of existing client mandates,” she says. “It’s an exciting time as we work with managers directly to optimise their overall investment returns.” Burlingham also points to the structural differences between the United States (US) and European markets.“It would be more unusual for US asset owners to handle securities lending operations internally. In the United Kingdom, it is the exact opposite,” and that he thinks is a key driver of the rise of third party lenders in the US. Equally, in the US, large pension funds such as the CalPERS at one time would have often outsourced all their securities lending requirement to one custodian lender. “Now that’s changed and CalPERS uses a multitude of securities lenders,”he adds. DrKW’s Smollen is adamant about the advantages inherent in the third party agent offering. “The business

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Jamie M. Ball, managing director and head of capital markets of ABN AMRO Mellon Global Securities Services

becomes more transparent,” he maintains – a key consideration these days. “We also compete on performance, as there is generally better revenue generated and the interests of the parties are more effectively aligned as a high degree of customisation is possible.” Stephane Haot, global head of securities lending at Dexia Fund Services, thinks that while in the short term there is room for everyone, over the medium to long term important market developments will once again push the business back into the hands of the custodians.“Our belief is that not everyone will be able to cope with new regulations, new trading strategies, IT investments and risk concerns, particularly in the light of Basel II implementation,”he says. “The market is becoming more challenging, will lead to concentrations, and custodians will eventually win the battle for business.”Jamie Ball adds that custodian lenders are also increasing the flexibility of their offerings to clients. “As an example, we have I-Bid, our own internet auction product. With 297 clients, we find they range across the spectrum of client types. We need to be as flexible as possible in order to meet their needs, particularly those of the largest, who often want to have different approaches to the market.“ Haot believes the battleground in the marketplace rests in the large beneficial ownership sector. “At the moment, everyone is tempted to try the various methods of lending available to them, internal methods, third parties, auctions and via custodians,”he adds.“For the time being the market is assisted by generally bearish conditions and the acknowledgement by asset managers that these days securities lending is part of the strategic investment equation.” HSBC’s Burlingham concurs. “The obvious connotation of that is an increased awareness of risk,” he says, explaining that these days the bank provides indemnification, if required. For banks with such a large balance sheet, indemnification is an easy sell, but says Burlingham “if someone does not have that level of balance sheet backing, what is their indemnity worth?” Ed O’Brien acknowledges the advantages that custodian lenders have in this regard.“We are Basel II compliant already, having introduced an advanced risk management system. We have also received exemption from the US Federal Reserve Bank to net certain activities because we have already met the Basel II criteria. But we know there are institutions out there working under a Basel II lite [sic] scenario because full compliance is proving a challenge to some.”Northern Trust’s

Clayton, meanwhile, says“custodian lenders should always be strong on risk management – it is a key attraction to many clients of Northern Trust that we have not experienced a loss in our lending business. Staying in step with regulatory changes is key to business retention, but custodians need to evolve from this base and be more innovative in order to grow the business.” Minimising risk is a key component of Dexia’s approach and compartmentalising its onshore and offshore businesses per similar client types. “Our strategic view is that considering lending advances, tax harmonisation trends, cost contingents coupled with risk regulation, we believe you need a large supplier for all these developments,”says Haot. He cites as an example of the attention to detail the way the bank operates its offshore securities lending operations.“We treat it separately, and build up specific baskets which we trade, on an internal auction basis, with prime brokers to maximise utilisations and related revenues. Of course the follow up work is more complex and detailed.”The bank has also built up an extensive internal grading system for all counterparties to extract the best value for its clients. He acknowledges Dexia has a highly risk averse approach,“but it gives clients an exceptional degree of comfort in all the lending stages,”he states. An added consideration says SASI’s Anselmin is that in the US market regulation has resulted “in some tightening away from anticipated settlement failures. There used to be a market,” he explains, “in securities which were difficult to settle.” The passage of the Securities and Exchange Commission’s SHO regulation last August, which defines ownership of securities and specifies aggregation of long and short positions and which also requires broker-dealers to market sales in all equity securities as long, or short, or short exempt, has changed the willingness of clients to “short those transactions,”he says. As well, he points out the same regulation has insisted on real transparency in the market.“I am in full support of the SEC’s efforts in increasing transparency,” says Anselmin, “especially regarding the technical reporting of beneficial ownership – an initiative backed by the SIA Securities Lending Division.”

Stephane Haot, global head of securities lending at Dexia Fund Services

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change The pharmaceutical industry faces a critical five years ahead. After its spectacular bull run which lasted from 1994 to 2001 and which saw the market valuations of big US and European companies in the sector soar by more than 400% – share prices have stagnated or fallen over the past four years as investor confidence has ebbed away. While profits remain high, there is little incentive to change. Is there a new approach in the offing? Andrew Cavenagh reports. NVESTORS FEAR ESTABLISHED drug manufacturers are poorly positioned to cope with the pressures of a changing world, in which the demand for wider access to an acceptable level of healthcare is growing year on year. A continuing supply of innovative, life-enhancing – and affordable – prescription drugs is clearly vital to realising this goal. If the industry fails to deliver them, more government intervention is inevitable. Last year a group of 15 private-sector industry ‘stakeholders’ undertook a detailed investigation into the challenges that confront the sector and its likely future direction. The Pharma Futures group was set up and sponsored by three of the world's largest pension funds – Algemeen Burgerlijk Pensioenfonds (ABP) of the

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Netherlands, the Ohio Public Employees Retirement System, and the UK's Universities Superannuation Scheme, which – as long-term owners of pharmaceutical stocks – have a substantial interest in the sector's continuing profitability. The findings of the Pharma Futures report, published in December last year, made uncomfortable reading for everyone involved in the business. The report finds that fundamental change for the industry is inevitable since “muddling through” on the basis of the current business model will mean increasingly unsuccessful fire-fighting on a growing number of fronts. The report also highlights ways that the sector can manage this change and emerge profitable and successful. Critically, the report shows that these challenges will only be met if both the sector and its institutional investors change their thinking and adapt to the new circumstances. It concluded that unless the companies manage to bring innovative treatments to the market more quickly, the decline in the sector’s value will continue – as will the growing pressure from a broader society to see it overhauled. As well, the report said investor confidence in the sector’s ability to deliver sustainable shareholder value had eroded. Perhaps most worryingly – the report added that “trust is a key issue for this highly regulated sector and is under serious threat”. “People really are going through a crisis of confidence

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huge legacy cash flows from the with this sector,”says Stewart Adkins, glory years,”he explains. senior pharmaceuticals analyst at Looking forward, by contrast, Lehman Brothers and one of the 15 investors see mounting pressures members of the Pharma Futures on drug company revenues and panel.“In a global context, I think it is profits from a number of sources – going down.” He suggests that the fast-approaching expiry of annual growth rates in the sector will patents of a number of ‘blockbuster’ drop from 10% to 6-7%, unless the drugs, increasing pressure to big companies make drastic changes regulate prices in the US and a to their business models. proliferation of expensive lawsuits – The companies are all too aware arising from both civil litigation and that a watershed looms. As Hank regulatory investigations. “Longer McKinnell, chairman and chief term, I do not have a positive view executive officer (CEO) of the US in pharmaceuticals,” says Martin world-leader Pfizer, told his Eijgenhuijsen, the senior portfolio shareholders in February at the manager at ABP Investments who is presentation of the company's 2004 responsible for the fund’s equity results, “there can be no doubt that investments in healthcare (about Pfizer, along with other research4% of €156bn) and was another based pharmaceutical companies, is member of the Pharma Futures facing the headwinds of an panel. “I think it is a lot more operating environment quite unlike Stewart Adkins, senior pharmaceuticals analyst attractive than a couple of years ago, any we have ever seen.” McKinnell at Lehman Brothers but I don’t see real signs that the explained that “We face severe industry is recovering.” pricing pressures, a contentious The big concern on the near political atmosphere, and a maze of “People really are going horizon is the expiry of patents, new regulatory demands. We are in which undoubtedly represent a clear a period of ‘discontinuous change’ through a crisis of and present danger to companies’ – where many of the assumptions confidence with this earnings. The loss of revenue on an of the last half century no longer sector,” says Stewart ‘expired’drug is now estimated to be hold true”. Adkins, senior between 70% and 80% within a Bizarrely, the sector’s current pharmaceuticals analyst at matter of months, as opposed to the financial performance gives no figure of around 50% that was inclination of such impending crisis. Lehman Brothers. generally assumed a few years ago. Pfizer and the other three US and “Investors and analysts consistently European giants – GlaxoSmithKline, AstraZeneca, and Merck – collectively underestimate the impact this can have on earnings,” made profits of over US$30bn in 2004 on a combined maintains Adkins at Lehman Brothers. He adds that there turnover of more than US$130bn [see table]. Furthermore, has been no “meaningful pick-up”in new patent approvals Pfizer’s net income of US$11.36bn came from sales of to replace the revenue streams that are about to be lost. Zbinovec at Fitch, on the other hand, says expirations US$52.5bn – double the level of just five years ago – and the sector continues to command high credit ratings.“The will not be too much of an industry-wide issue this year. highly rated US pharmaceutical industry reflects strong The loss of patent protection for Abbott Laboratories’ credit profiles due to healthy balance sheets, superior immediate-release form of Biaxin and Johnson & Johnson’s margins, excellent liquidity and solid cash-flow Duragesic are likely to be the two largest instances. generation,”Fitch concluded in a report on the sector at the However, he acknowledges, there will be a large number of significant expiries in 2006.“That concerns me quite a bit,” end of last year. “Even the more troubled credits are still in the single-A comments Eijgenhuijsen at ABP. Affected companies will category,” adds Michael Zbinovec, the Fitch analyst in include Merck, Bristol-Myers Squibb and Pfizer. McKinnell warned his shareholders in February that the company Chicago who wrote the report. So why does this performance fail so utterly to impress would “lose patent protection on several of its best-selling the investment community? Despite its figures for 2004, medicines between this year and the end of 2007”. The impact of expirations will not be uniform across the Pfizer’s share price dropped 24% over the year. According to Adkins at Lehman Brothers, the disparity between the sector, however, and Zbinovec at Fitch says: “You almost sector’s financial performance and investor sentiment have to look at it on a company-by-company basis.” At the same time, the companies will have to face up to reflects the difference between its last 10 years and future prospects. “They’ve got huge legacy balance sheets and a big change in the drug-purchasing arrangements in the

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US. This is significant. The US alone accounts for 48% of by the FDA’s deputy director, Dr Sandra Kweder, to a US the industry’s global sales and probably nearer two thirds Senate panel on March 2 seems unlikely to help the company’s cause. Kweder reportedly indicated that it had of its profits. Further, it is the only significant market that is not taken over a year for warnings about the increased risk to appear on Vioxx labels because of protracted negotiations subject to price controls The Medicare Drug Improvement and Modernisation with the company over the wording. Zbinovec at Fitch observes that product liability Act (MMA) will offer senior citizens – who are incurring increasing out-of-pocket expense for their medications – awareness in the industry had already been heightened in a comprehensive drug benefits package for a premium 2004 – by Wyeth’s ongoing litigation of its diet drug, Bayer’s from the beginning of 2006 and is expected to lead continuing liability for Baycol, and Pfizer’s agreement in millions of retired people to abandon the private pension July to pay US$60m to settle a class action for the diabetes plans that presently meet part of their requirements. drug Rezulin (which it inherited when it acquired WarnerThis will, in effect, turn the Federal government into the Lambert in 2000). Further says Zbinovec, the overall level drug companies’ biggest customer in the US. "The of litigation is now at record levels. “I would say it far Government will become the largest funder [sic] of drugs exceeds the norm for the industry.” In terms of its financial impact on the sector, however, from 2006," says Adkins. “That changes the outlook for Zbinovec says one encouraging sign is that the drug the market quite considerably.” Although the Bush Administration is not in favour of the companies are adopting a tougher stance to such claims. government setting drug prices and believes the task is “Now the industry is fighting these cases tooth and nail.” Official investigations into better left to the private sector – and the MMA The Pharmaceuticals Sector – Surviving the Crisis of Confidence industry practices are also rising sharply. Through restricts government 900 2003 and 2004 the US interference in pricing 800 700 government secured decisions – it does seem 600 penalties and fines inconceivable that the 500 totalling US$2.5bn from government will hand over 400 the sector. Elsewhere, it is tens of billions of dollars to 300 a similar story. In the last the industry without some 200 week of March, for scrutiny of costs. 100 example, police in London Adkins says the federal 0 arrested Ajit and Kirti authorities are unlikely, for Patel, respectively chief example, to pay the prices Johnson & Johnson Pfitzer GlaxoSmithKline executive and chief needed to support the Novartis (REGD) Sanofi-Aventis FTSE Pharmaceuticals Index executive officer of the massive sales operations Data as at 31 March 2005. Source: FTSE Group Goldshields Group. Their that the drug companies arrest and release on currently maintain – the sector spends twice as much on marketing as it does on police bail was the latest development in an investigation research and development.“It will define corporate strategy the Serious Fraud Office began in 2002 into suspected price [going forwards],”he says.“I think the industry has backed fixing of generic medicines by companies supplying the National Health Service. itself into a corner." Zbinovec says the increasing number of investigations While the pricing model for the MMA has yet to be determined, Fitch suggests that the pressure for price cuts (the US Attorney’s office is currently looking into claims should be offset in part by the greater volumes of drugs against Pfizer, Schering-Plough, Bristol-Myers Squibb, Eli that will be distributed through the programme. However, Lilly, Johnson & Johnson and Wyeth) will inevitably raise it concedes that the overall effect on earnings remains the industry’s exposure to fines. But he adds that the impact of an adverse ruling on the companies’ credit rating “uncertain”. Meanwhile, product liability claims against drug would be minimal in most cases. The only way the industry can sustain its long-term manufacturers continue to rise and the trend shows no sign of abating. The litigation industry received a big boost profitability in the face of these internal and external from Merck’s decision to withdraw its Vioxx COX-2 pressures is to develop – and secure approval for – new selective inhibitor for arthritis and pain in September 2004, patented drugs. However, there has been a marked decline after studies showed that the remedy increased risk of in applications and approvals over recent years. The heart attacks and strokes. The company is now facing more number of new molecular entities (NMEs) approved by the than 800 individual law suits over Vioxx, and the number of FDA fell from 35 in 1999 to 21 in 2003, while the total of claims could expand exponentially. Allegedly officials at the new active substances (NAS) sanctioned by the European US Food and Drug Administration (FDA) estimate that up Agency for the Evaluation of Medicinal Products dropped to 55,000 deaths may be attributable to the drug. Testimony from 27 to 17 over the same period.

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The trend led the European Commission last year to investigate whether there was a “worldwide crisis” in innovation in the pharmaceutical sector. It commissioned a study from Charles River Associates, which concluded that the downturn was cyclical rather than permanent and that the level of authorisations was likely to pick up in 2005. However, investors still have reservations about the market value of the drugs that companies are currently developing. Eijgenhuijsen at ABP Investments worries that most are “product-line extensions” that will not provide the sort of returns that companies look for. “If I look at the potential profitability of the pipeline, that may be an issue going forward,” he says. “The industry really has to be innovative.” Adkins at Lehman Brothers says another problem is that the research is now going into new areas, where the failure or “redundancy”rate is much higher. He points to genomics as an example where it is taking much longer than first thought to develop treatments because there are so many “blind alleys” for researchers to follow. “Has the lowhanging fruit been plucked?”he asks.“Getting a biologically valid target for a drug is getting very difficult these days.” In the shorter to medium term, the drug companies also need to reduce their costs. Part of this will involve reducing overheads, and several companies – including Merck, Eli Lilly, Bristol-Myers Squibb and ScheringPlough – have embarked on restructuring exercises that include scaling back the large sales forces in primary care. Pfizer announced a big restructuring plan at the beginning of April, and Fitch’s Zbinovec says he expects more to follow throughout this year. “It’s moving in the right direction,” agrees Eijgenhuijsen at ABP. “All the others are following as well.” The other way for the industry to make meaningful savings will be to outsource more of its operations to lowcost, but fast-developing pharmaceutical jurisdictions such as China, India and Eastern Europe. The huge cost differentials have led most of the big companies to set up manufacturing operations in these countries – Adkins points to the example of a Czech generic drug producer that can manufacture products for 20% of the price of a German counterpart yet still make a 60% gross margin – but there is scope to farm out a lot more. Adkins says, for example it would be quite feasible for US companies to conduct the Phase I and II clinical trials in Asia – and achieve an overall saving of around 3% of ultimate sales. “You could still probably do 25% of your research and development in India at 20% of the cost.” If the short-term horizon looks bleak for the sector, however, long-term demographics are certainly in its favour as a continually ageing global population should ensure a growing demand for a vast range of existing and new treatments. As Pfizer’s chief McKinnell observes: “Widespread chronic conditions such as hypertension, depression, and lipid imbalances remain largely undiagnosed and untreated. People are beginning to realise that it makes far

David Schwartz, stock market historian

more sense to invest in disease prevention and early treatment rather than to accept the human misery and high cost of events such as heart attacks and strokes.” This has led some analysts to take a bullish view of the sector in the longer-term.“I think the demographics really look good for the pharma companies,” says David Schwartz, the independent stock market historian who wrote a strong recommendation for the sector on the London Stock Exchange’s web site in February. “I think these things go in cycles,” Schwartz says. “Pharmaceuticals were riding high for a long time and then they hit a bad patch, but all the reasons for these companies to fly as they did in the 1990s are still with us. I think for a long-term player this is a great place to be.” For an experienced investor like Eijgenhuijsen, however, the key to success in the sector will depend on the development on innovative – and more sophisticated – treatments that will be able to maintain attractive profit margins for a considerable length of time. “If you look at specific cancer drugs, if the industry develops a diagnostic tool with the drug then I think there will not be price pressure on the product.”

Table 1: Financial Performance of Leading US and European Drug Companies in 2004 Company

Turnover (US$bn)

Pfizer GlaxoSmithKline Merck AstraZeneca

52.5 37.2 22.9 21.4

Profit (US$bn) 11.4* 11.1** 5.8* 5.1** * Net income

Source: Various News Clips

** Profit before taxation

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FUNDS PROFILE

A SIMPLE QUESTION OF

LIFESTYLE FUNDS Times change. Only a few years ago, 401(k) plan participants were clamouring for more investment choices. As a result, plan sponsors added more mutual funds, more asset classes (even windows) into self-directed brokerage accounts. Soon participants were complaining they had so many choices they could not decide what to do. Enter the life cycle fund, a product designed for those who want to keep it simple. Neil A. O’Hara reports from New York on a product that is taking the 401(k) world by storm. EFINED CONTRIBUTION PENSIONS and 401(k) plans offer one distinct advantage over defined benefit plans: participants control the investment policy for their own retirement nest egg. Unfortunately, most people do a lousy job. “Participants in these plans rarely change their asset allocations once initially set,”says Michael Porter, senior research analyst at Reuters’ subsidiary, Lipper Inc., a provider of fund research and

fund intelligence which in March this year acquired two specialist hedge fund research houses: Hedgeworld and (in a separate deal) TASS Research, the institutional quality research house previously owned by Tremont Capital Management. “Yet if they don't reallocate their assets the system is going to fail. Most participants are not on course to achieving the 75% of pre-retirement income said to be needed to maintain their lifestyle in retirement,” explains Porter. Faced with an array of equity mutual funds offering growth, value or income in large, medium or small capitalisations, bond funds offering short, intermediate or long maturities, not to mention high yield bonds, real estate or alternative asset choices, many investors choose unwisely or throw up their hands. In the mid-1990s, fund advisers tried to simplify asset allocation decisions by offering lifestyle funds based on static risk profiles, typically aggressive, moderate or conservative. Each fund contains a different mix of equities, bonds and cash tailored to a particular risk tolerance that does not change over time and is automatically rebalanced.

Table 1: Asset Allocation for 2030 Funds Fund

Domestic Stock Funds

International Stock Funds

Fixed Income Funds

Money Market Funds

Fidelity Freedom 2030 Putnam Retirement Ready 2030 Wells Fargo Outlook 2030

69% 59% 60%

13% 25% 5%

19% 12% 20%

0% 4% 16% Source: Lipper Inc., March 2005

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FUNDS PROFILE

Michael Porter, senior research analyst at Reuters’ subsidiary, Lipper Inc.

A small but growing number of plan sponsors are using them as the default option for participants who do not make investment choices when they enrol. “It’s happening very gradually,” says Lucas, “Most fiduciaries are not as comfortable as they need to be to make that move.” If automatic enrolment takes hold, life cycle funds will grab an even larger share of the 401(k) market.

Lori Lucas, director of participant research at Hewitt

“They allow someone to say, ‘How much risk do I need to be taking?’” says Gina Sanchez, a portfolio manager at American Century,“It assumes they understand that when they are younger they can take more risk and when they are older they should take less risk.” In practice, many investors ducked the question. Almost half the assets in American Century’s three Strategic Asset Allocation funds are in the moderate portfolio. Plan sponsors discovered participants did not understand how to use lifestyle funds; some people bought all three risk profiles.“We had to do some education,”says Sanchez, “These days the majority of people pick one fund.” That helps, but investors still have to switch funds on their own as their risk tolerance changes. The variety of available life cycle funds is growing, with attendant diversity in the asset allocation mix, giving investors increasing choice. A recent Wall Street Journal report analysed lifecycle funds available from fund companies such as the Vanguard Group and T. Rowe Price as a sample of what is on offer. According to the report, the Vanguard fund blends 80% stock funds and 20% bond funds for investors who set a retirement target date of 2030. Not everyone uses the same strategies. For an investor who chooses the same 2030 retirement date, for example, T. Rowe Price invests 90% of an investor’s money in stocks. There are also lifecycle funds for people who are already retired. In these instances Vanguard puts 20% of the investor’s money into stocks, 75% in bonds and 5% into money-market funds. But, for the same retiree group, T. Rowe Price will put 40% in stocks, 30% in bonds and 30% in short-term bonds and money-market funds. Retirees can also stay with the lifecycle concept for up to 30 years after retirement so that they eventually have 20% of their money in short-term bond and money-market funds; 60% in other bond funds and 20% in stock funds. Sponsors have meanwhile started asking for a complete turnkey solution that would build a portfolio, automatically rebalance it and lower the risk profile over time. Fund advisers responded with target maturity date funds, such as American Century’s My Retirement series.“If you’re going to retire right around, say, 2045, you don’t even have to think about it,”says Sanchez,“We’re going to start you in an aggressive portfolio and we're going to end you up in a conservative portfolio. We’ll do all the work for you.” In effect, these funds provide basic financial planning as well as professional investment management. Life cycle funds of both kinds have attracted increasing interest among plan sponsors and participants. A March 2005 report by Lipper shows assets under management and inflows to these funds have jumped in the past two years (please refer to Figure 1: Total Life Cycle Fund Assets 1999-2004 and Figure 2: Estimated Net Inflows: 1998-2004) as more sponsors offer them. Back in October 2003 a study by Hewitt Associates, LLC found that 55% of 401(k) plans offered static risk lifestyle funds and 33% offered target maturity portfolios. On

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average, 37% of participants held life cycle funds in plans where they were available, skewed toward younger, shorter tenure employees likely to have the least investment experience (Please refer to the graph: Percent of Participants Holding a Lifestyle Funds – by Age). The Hewitt study also revealed that most investors do not use life cycle funds as a turnkey solution. “They've heard so often that you shouldn’t put all your eggs in one basket,” says Lori Lucas, director of participant research at Hewitt,“They have a hard time grasping that it’s okay in lifestyle funds because they are designed to be a complete portfolio.” She believes sponsors are trying to get the point across. Some advisors direct participants to either life cycle funds or to a menu of traditional funds during the sign-up process. “It makes it very clear that you take one path or the other but it is really not appropriate to combine them,”she says. Despite sponsors’ efforts, many participants still mix life cycle funds with other funds. “It defeats their intended purpose,” says Porter, “They over diversify and screw up what their asset allocation should be.” Life cycle funds do have some flaws. Most portfolios are funds of funds that give shareholders exposure to several other funds in the same family. “They’re only as good as that family’s lineup,” Porter says. Fund advisers use different asset allocation models for the same risk profile or target maturity date too (please refer to the table: Asset Allocation for 2030 Funds). The fees for these funds can be deceptive.“Some of the reported expense ratios include the weighted impact of the underlying expense ratios and some don’t,”Porter explains. The cheapest providers, including American Century, T. Rowe Price and Vanguard, simply pass through fees associated with the underlying funds, while others add a wrap fee at the fund of funds level that ranges from 0.05% at Principal to 0.20% at Frank Russell. “A small fee can make a significant difference in an investor’s balance by retirement age,”says Porter. Managers of the underlying funds do not necessarily coordinate their investments, which can distort the fund of funds' asset allocation.“We do check the overall positions to make sure we don’t have a whopper exposure in Microsoft, for example, because growth thinks it is growth, value thinks it is value and everybody owns it,” says Sanchez. For its static risk funds, American Century holds quarterly meetings among the managers for each asset class. “We make sure that we don’t have conflicting strategies within the same fund,”she says. Life cycle funds offer a cheap and effective way for investors with modest means to diversify their portfolios. A small but growing number of plan sponsors are using them as the default option for participants who do not make investment choices when they enrol. “It’s happening very gradually,” says Lucas, “Most fiduciaries are not as comfortable as they need to be to make that move.” If automatic enrolment takes hold, life cycle funds will grab an even larger share of the 401(k) market.

Total Life Cycle Fund Assets 1999-2004 ($bn) $160 $139.7

$140 $120 $101.4

$100 $80 $63.3

$57.9

$60

$69.2

$68.2

2001

2002 2003 2004 Source: Lipper Inc., March 2005

$40 $20 $0 1999

2000

Estimated Net Inflows: 1998-2004 ($bn) $30 $24.2

$25 $21.4 $20

$15

$10 $6.3

$4.7

$5.5

$6.8

$6.7

$0 1998

1999

2000

2001

2002

2003

2004

Source: Lipper Inc., March 2005

Percent of Participants Holding a Lifestyle Funds – by Age 50% 40%

40.7%

38.8%

36.6%

35.0%

33.0%

50-59

60+

30% 20% 10% 0% 20-29

30-39

40-49 Age

Lifestyle Fund Utilisation – by Age 20% 18%

17.4%

16%

5.6 5.4

14%

12.6%

12%

17.3% 5.5 11.6%

5.5

5.2 12.8%

5 4.6

10% 8%

4.5 4

6% 4%

3.5

Average Number of Funds

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0% 20-29

30-39

40-49

50-59

60+

Age Percentage of Participants with All Balances in a Lifestyle Fund

Average Number of Funds Held

Source: Hewitt Associates, LLC

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ALTERNATIVES

Alternating

current

There are more than 8,700 hedge funds today, representing nearly $1trn in global assets, with over 5,000 domiciled in the United States (US) alone according to Van Hedge Fund Advisors International LLC, an advisory firm that consults with institutional investors and high net worth individuals for hedge fund portfolio construction and manager selection. That said, small but growing institutional investor allocations, proposed Securities and Exchange Commission (SEC) regulations and new management strategies are subtly changing the $480bn US hedge fund industry. By Karen Jones AVID FRIEDLAND, PRESIDENT of Magnum US Investments Inc., and a director of the Hedge Fund Association, says that when Magnum entered the hedge fund business in 1994,“it was largely dominated by high net worth individuals and private Swiss banks. If you spoke to an institutional investor about hedge funds their eyes would glaze over, and they would say ‘no, no, we’re conservative and don’t like hedge funds’”. Magnum manages $250m in assets with both offshore and domestic fund of funds, including private label fund of funds and

sponsors several single manager hedge funds managed by third party managers. Lacklustre returns in the traditional equity markets have pushed some institutional investors into allocating a small portion of their portfolios to hedge funds, particularly fund of funds. Friedland says it has been a “painstaking process” over many years to get the institutional investor comfortable with the idea that hedge funds are, in many instances, “more conservative than mutual funds from an investment performance/risk analysis view-meaning the performance of the actual investment, taking aside factors such as manager risk, fraud, blowups, etc”. He also credits the spectacular “blow up” of Long Term Capital Management (LTCM) in 1998 with helping turn the tide of perception. “For years the media dismissed hedge funds as the exclusive club of the super rich and when LTCM blew up they learned that it was not a typical hedge fund but a highly speculative overleveraged vehicle that really got greedy,”he explains. Although the SEC stepped in afterwards, creating a major effect on financial markets, Friedland calls the LTCM debacle “a positive event for the growth of the hedge fund industry because it forced the media, uninformed investors and institutional investors to really look at what hedge funds are”. With a broad spectrum of investment strategies, both aggressive and conservative, he says, “any investor

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Meanwhile, industry attitudes could find a piece of their portfolio to regarding proposed SEC regulations allocate to a hedge fund”. depend on the current size of the Founded by D. Dixon Boardman in hedge fund organisation, the 1988 as a response to the US stock strategies they utilise and whether or market crash of 1987, Optima Fund not they are currently registered (as Management (Optima) is a SECapproximately 50% are). Since GAM registered $3.8bn investment advisor. is SEC registered, Anderson calls the The firm has a strong institutional proposed regulation that hedge fund focus with an experienced team of advisors managing over $25m in approximately 50 employees. Robert assets will be required to register by Picard, managing director, chief February 2006, a“non-issue”for GAM. investment officer and director of David Friedland, president of Magnum US He adds however, that certain US research says that most US corporate Investments Inc. hedge funds might “go with the twoand public pension funds “have to year lockup route or not except any seek out the best active management US investors to avoid registration.” in the world. And it is our view that Friedland says that though the the best active managers, by proposed regulation is forcing the definition, are those with the most manager to be a registered tools available to make money and investment advisor, “there is still no generate alpha.” regulation of the industry. No one is He adds that since hedge fund telling the manager how often he managers have the ability to enter needs to report his numbers to any number of strategies precluded investors, what portfolio information by the traditional long only equity he needs to disclose and how much and fixed income investing, they are a leverage he should use.” He does not “natural fit” for institutional think the SEC will ever “go down this investors. The incentive fee offered Robert Picard, managing director, path” and if they did, it would be many hedge fund managers on top of Optima Fund Management “dangerous”for the industry. their management fee also tends to What is clear about SEC help attract “the best and the regulations and chasing institutional brightest in this space.” investor allocations is that the ability Picard predicts that increased to run a business will be as essential allocation to alternatives will as performance. This is not continue for the next four to five necessarily the case with high net years regardless of what the market worth individuals who know they does.“I think the pain endured from may invest in an occasional “blow 2000-2002 was so severe that many up” over time and do not have a state and or corporate pension funds board of directors to answer to or are realising it would be very shortmedia headlines to contend with. sighted to disqualify investment.” That said, consolidation of smaller David Anderson, managing hedge funds into fund of funds or director of GAM, one of the world's multi-manager firms that offer an largest managers of fund of funds, operational business umbrella of says that historically GAM has been legal, marketing, accounting, more focused on the private side and David Anderson, managing director of GAM compliance and other services for a not active in the institutional space. However, they see it as a growth trend which they will now stake in each individual fund may become more prevalent. “In 2002 it became more difficult for new startups to be a part of. "The US institutional market is the world's largest. Clearly there is an appetite for alternatives and we manage overhead and generate the types of returns hope to be able to capitalise on it." GAM has $37.2bn needed to survive from a business perspective,”says Picard. under management and of that $19.3bn is in fund of funds. “Many of these groups have naturally polarised and He also notes a distinct shift over the last few years in the formed loose associations so they can rationalise their consultant community.“Three or four years ago many did accounting, legal and marketing and receptionist fees.” James Bianco, president of Bianco Research LLC, an not know hedge funds and were not equipped to recommend them to clients. That has all changed. Now all independent research organisation, feels that regulation the major firms have either a dedicated resource or are will “do what all government agencies do, hurt entrepreneurship”. He adds that it will be “harder for three much better at analysing and recommending.”

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ALTERNATIVES

funds “to capture that.” guys to raise $50m and set The FTSE Hedge Index Series However, he cautions that up shop. It protects the 160 they are “extremely interests of the $5bn, 300140 conscious of the liquidity or person shop because it is 120 illiquidity of the underlying easy for those guys to hire 100 countries,” and that if an an attorney and spread investor is looking for an their costs over 300 people 80 allocation to emerging to register.” 60 markets, “rather than He says the way the 40 investing in long only, they hedge fund industry is should be doing emerging structured innovation has markets in a hedged traditionally grown out of FTSE Hedge Index FTSE Hedge Directional Index fashion with a very limited small shops. “A lot of the FTSE Hedge Non-Directional Index FTSE All-World Index FTSE Hedge Event Driven Index amount of their portfolio.” hottest funds are the guys Bianco cautions that to that just opened their Data as at 31 March 2005. Source: FTSE Group avoid capacity in “certain doors because they are strategies devised over the going to have hands on last years”, hedge fund experience with the fund Alpha managers are “not supposed to managers should not get and the ability to convince chase the latest hot market trends like caught in a “group think”. investors they know what the public did in the 1990s”. He states that according they are doing and give to a recent Greenwich them the ability to get in Associates’ study, 82% of on the ground floor.” Regulation will “stifle creativity”for the startups and Bianco all distressed securities and about 33% of futures are now thinks that bigger firms will profit from that.“A lot of hedge traded by hedge funds.“If you have too many guys in credit fund managers come from bigger firms so they have a more default, convertible arbitrage, distressed securities, the over difficult time holding onto their best talent who leave and concentration of ideas can become horribly mispriced. start their own funds. Now with regulations putting up Whole sectors of strategies could wind up killing everybody when they stop working because we don’t have the proper hurdles, it is easier to stay where you are.” Bianco’s definition of the quintessential ‘alpha’ hedge mix of retail investors, beta-only institutional investors and fund manager is one whose returns “have nothing to do hedge funds playing off each other.”He adds that he does with whether the market is having a good year. A lot of not think this is a concern for long/short equity because ‘alphas’will try to return 7-8% in every environment so that “the universe you are dealing with is so much larger.” As far as the outlook for 2005, Friedman feels volatility of is why they go off into exotic land with bonds, commodities, emerging markets, credit defaults, the markets will dictate much of what happens. If they go convertible arbitrage and more.” Though alpha managers up and down for the right reasons, as opposed to a are “not supposed to chase the latest hot market trends like cataclysmic event such as a terrorist attack, hedge fund the public did in the 1990s,” he sees a small migration in managers can profit. “Last year was a pretty difficult year the hedge fund industry towards what he defines as a for hedge funds in general, part of that is too much money traditional “beta” type of manager, typical of the mutual in the industry today and some of the strategies are almost maxed out. If we have increased volatility, it will have a fund manager, which is tied to the equity markets. Picard also notes a subtle shift in hedge fund strategies, positive impact on many different strategies. If we continue which he believes will continue in 2005. “We will see the to have low volatility, many of the relative value, arbitrage distinctions between private equity, hedge funds and and spread strategies will find it quite difficult.” Meanwhile Anderson says GAM’s viewpoint is that mutual funds slowly changing. Hedge funds are starting to drift into mutual fund land with long-only management. It hedge funds are “the ballast in a portfolio, not the high is a very interesting trend.” He adds that as some private octane,” and that is particularly true of fund of funds. “Its equity firms have started hedge fund like products and idea is to diversify and lower risk by not trying to provide some hedge funds have introduced private equity-like 80% returns and then crash and burn next year. I think that with a single manager hedge fund, you take a lot of risk. In features such as three to 5 year lockups. As large amounts of capital flow into hedge funds in general, I think fund of funds are a lower risk option if done general, says Picard, traditional hedge fund strategies such as right and managed professionally.” He adds that the world is changing in recognising “you fixed income arbitrage, convertible arbitrage or merger arbitrage are “becoming more difficult areas to generate simply can’t be in long in stocks or bonds through all returns.” He feels the best active managers are seeking out economic cycles. Hedge funds provide the opportunity to new areas and opportunities to make money. One of these is not only provide absolute returns, which most say they are in the emerging markets and Optima has a dedicated fund of trying to do, but also lower the correlation in portfolios.” ar -0 0

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GLOBAL PENSIONS:

RISKY BUSINESS OR RISKING BUSINESS? EGULATORS AND GOVERNANCE advocates argue that the stock price collapse of such former corporate stalwarts as Adelphia, Enron, Parmalat, Tyco, and WorldCom was due in part to poor governance. These corporate scandals, along with other factors such as directors’remuneration, have combined to turn the spotlight on the way publicly-listed companies are run, and their impact on pension funds. While the public’s interest is driven by concerns about the final levels of their pensions, there is broader concern surrounding the important role pension funds’ play in the stability of the economy. According to figures published by UBS Global Management, around 25% of UK pension funds’ assets were invested in overseas equities in 2001, compared with just 10% in 1981. The global nature of the pensions industry means poor corporate governance in the US, and other countries, matters to the UK pensions market because, at some point it will affect that market and indeed affect the individual pensions of many UK citizens. Furthermore investors are increasingly recognising the fact that ownership responsibilities do not end at national borders, especially in light of Parmalat, Ahold and others. Poor corporate governance, through a lack of checks and balances on the board, or inadequate reporting by auditors, can ultimately wipe out the assets within a given pension fund. The anxiety surrounding UK’s so called ‘pensions crisis’ has led pension holders to demand assurances that their assets are invested in a low risk manner. The recommendation is to avoid investing in companies that have poor governance standards, structures and practices. Fund managers need to have complete confidence that the companies they invest in are run in accordance with good corporate governance standards. By adopting practices such as having at least two-thirds of independent directors on the board, establishing an independent nominating committee, making the compensation

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committee fully independent, companies can take significant steps towards giving confidence to wary institutional investors who manage their portfolios in the interests of pension holders. So, the implications for the UK economy, as a whole, are clear. Good corporate governance will lead to more sustainable economic growth, because the economy is less

CORPORATE GOVERNANCE

The regulatory landscape is now beginning to have an impact on global business and capital markets – including the Operating and Financial Review (OFR) in the UK; the Tabaksblat Code in The Netherlands and the Sarbanes-Oxley Act (SOX) in the United States, which relates to all SEC registered companies. Companies are now asking a vital question: what is the return on investment of corporate governance? In simple terms, the answer for fund managers buying stock in listed companies is increased confidence. Research shows there is a correlation between poor corporate governance practices and higher investment risk. Stanley Dubiel, director of international research, Institutional Shareholder Services explains.

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- Two Months

- One Month

WorldCom

86%

Enron Corp

99%

Tyco

65%

Parmalat

96%

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vulnerable to a systemic risk. However, ultimately, it is the found that the presence of state takeover laws decreases question “does poor governance put investments at higher plant-level efficiency in terms of total factor productivity or risk?” that will make pension fund managers sit up, take return on capital. They showed that this result is, at least notice, and invest in companies that do not carry the partly, due to increased agency costs evidenced by increased compensation for CEOs and employees. baggage of a bad governance structure. Further research also demonstrates that board size does In the first academic study of its kind, research undertaken by Lawrence Brown, Ph.D. and Marcus Caylor matter. A fairly clear negative relationship appears to exist of Georgia State University clearly demonstrated the between board size and firm value by market capitalisation impact that board composition and practices can have on (Eisenberg, Sundgren, and Wells 1998; Yermack 1996). Too company performance. The study revealed that big a board is likely to be less effective in substantive companies with weaker corporate governance perform discussion of major issues (Jensen 1993; Lipton and Lorsch more poorly, are less profitable and have higher volatility 1992) and to suffer from free-rider problems among than firms with stronger corporate governance structures. directors in their supervision of management (Hermalin The study showed a correlation between corporate and Weisbach 2001). When examining the composition of boards, a lack of governance and stock price volatility; with issuers in the bottom decile of industry-adjusted Corporate Governance independence, with boards dominated by insiders, suggests Quotient (CGQ), a database and ratings service used by that they are not expected to play their role as effective institutional investors as a governance-based risk tool, monitors and supervisors of management. This is having share price volatility that is 6.20% above their particularly the case when the board chairperson is also the industry-adjusted average. The research found that those in firm’s chief executive officer (CEO). Put simply, two jobs into the top decile of industry-adjusted CGQ have share price one ‘does not go’. In addition, outside directors provide firms volatility that is 5.63% below their industry-adjusted with windows or links to the outside world, thereby helping to secure critical resources and expand networking. That average – a risk difference of 11.83%. The examination of profitability, risk and dividend outside viewpoint or perspective is fundamental in ensuring payouts showed that return on investment (ROI) and a better approach to adopting good corporate governance return on equity (ROE) in the top decile of CGQ rated practices because those individuals are bringing more varied companies outperformed the bottom decile companies by experience and insights to the corporate table. Also research 18.7 % and 23.8%, while dividends payouts of companies by Core, Holthausen and Larcker (1999) suggests that CEO in the top decile outperformed bottom decile companies by compensation is lower when the CEO and board chair positions are separate. more than 10.4%. This At the end of the day, research clearly FTSE ISS Corporate Governance Index Series 130 how can you guarantee demonstrated the financial 125 that corporate governance impact bad boards can 120 is providing a system or have on shareholder value. 115 structure which ensures When we examine the 110 the creation of a safe pair issue of shareholder 105 of hands or the creation of rights, companies that 100 a safety net for a given diminish shareholder 95 company? Currently, the rights by, for example, 90 level of corporate protecting directors from governance expertise the need to seek reFTSE ISS Developed CGI (USD) FTSE ISS Europe CGI (USD) FTSE ISS Euro CGI (USD) required of fund managers election or the issuing of FTSE ISS US CGI (USD) FTSE ISS UK CGI (USD) FTSE ISS Japan CGI (USD) is simply to carry out their shares with restricted Data as at 31 March 2005. Source: FTSE Group duties as if they owned voting rights, are generally the assets themselves. worse investments than 120 They must set out their those with stronger investment policy in a shareholder rights. 100 Statement of Investment Gompers, Ishii, and Principles (SIP), which Metrick (2001) found that 80 includes a section on firms with strong 60 corporate governance. shareholders' rights in However, a typical UK relation to provisions for 40 equity portfolio contains defending against shares in 100 different takeovers perform better 20 companies and it can be and have a higher market difficult therefore for a valuation. Bertrand and 0 fund manager to make Mullainathan (2003) -40 -30 -20 -10 10 20 30 40 50 60 70 80 0 De c-0 3

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Four Months

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informed decisions about a single company’s corporate governance practices. This problem is starting to be resolved however as governments begin to set standards for corporate governance. It cannot just be the markets that impose a solution, lawmakers and regulators also have their part to play in this debate. Currently best practice principles for UK corporations are set out in the Financial Services Authority’s (FSA’s) Combined Code on Corporate Governance. The Code provides a framework that is intended to minimise risks to shareholders created by poor company organisation and management. This is considered prudent for the achievement of long-term growth in shareholder value sought by pension funds and indeed all investors. The code deals with the management’s role in structuring and remunerating the board, and also institutional investors’ role with regard to the company. The ‘comply or explain’approach of the Code recognises that circumstances will vary from company-to-company and situations may make it difficult or inappropriate to implement all of the Code’s recommendations. While a minority of companies appear to consider the Combined Code to be of little importance and do not give the Code’s corporate governance recommendations priority, it has certainly gone some way in ensuring long term shareholder value. Additionally this year the largest 1,000 UK companies will be required to publish an operating and financial review as part of their annual report that will include a section on corporate governance. These regulations allow fund managers to factor in information about a company’s corporate governance in their investment choices. Again, this particular requirement demonstrates the growing demand for companies to paint a fuller picture of what they do, how they operate within a given environment and how their business impacts on other stakeholders. Nowadays companies are not solely being judged by their balance sheet. However, outside the UK, the situation for pension fund managers has been complicated by standards of corporate governance that vary according to a country’s legal, regulatory and tax regime. For instance, while most of the boards and board committees in the US and UK are composed of a majority of independent directors, the boards of utilities in continental Europe and Japan most often are not. Corporate governance in the US came in for sharp criticism following a series of high profile corporate failures. The response came in the form of the SarbanesOxley Act. The act tightened public companies’ reporting obligations and accountability standards for their directors, executives and auditors considerably. In Europe, the EU has indicated that it is keen for Europe’s big investors to be more active in defending shareholder rights, and has embarked on a strategy of harmonising standards among member states. The European Commission’s plan has three main cornerstones: strengthening the role of nonexecutive directors, increasing the transparency of directors’ remuneration, and ensuring the collective responsibility of board members for financial statements

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 5

BOX 1: WHAT CORPORATE GOVERNANCE ISSUES SHOULD BE MONITORED?

ere are some areas that trustees and fund managers should be aware of regarding the management of companies in their portfolios: • Independent nominating committees and boards of directors • Distinction and separation between chief executive officers and board chairmen • Accountability of executive managers to boards of directors • The appropriateness of executive remuneration and dividend policy • The extent to which auditors are truly independent • Openness to take-overs and buyouts (against poison pill defences)

and key non-financial information. Either way, you can see that there is a growing trend for the convergence of many of these new requirement or disciplines. Gradually, opinion on good corporate governance is beginning to converge as well. Beyond localised standards, the interests of pension fund managers, and the wider institutional investment community, in transparent, comparable and consistent international standards may well force large firms to converge upon a common framework. The Anglo-American model of corporate governance depending, as it does, on global financial markets may well become the reference standard for all firms whatever their national origins. As corporate governance issues continue to rise in prominence, pension fund managers will increasingly have to adopt a new low risk approach to investment management. By taking corporate governance into account when making investment choices, fund managers can protect pension holders from the unnecessary risks associated with poor executive structures.

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REITS

The

Christopher Laxton, chairman of APUT and specialist real estate investment fund manager at Morley Fund Management.

Growing REITs World of

In mid-March the United Kingdom government published a second discussion paper for the introduction of REITs, in the lead up to the 2006 Finance Bill. The paper has been very warmly received, with many of the property industry’s wish list seemingly taken on board by the Treasury and it is a timely move as other European countries are also preparing to introduce REITs enabling legislation. In parallel, however, the rise of offshore pooled property vehicles is offering investors a broader range of tax efficient investment vehicles. Is the European real estate party about to heat up? Francesca Carnevale reports.

EAL ESTATE INVESTMENT trusts (REITs) legislation will likely be a recurring theme in the European real-estate landscape for the rest of this year. After three years of steadily declining office rental

R 80

values, European office markets are beginning to stabilise. Improved economic growth figures and corporate profits through 2004 have once more encouraged increased investment in the sector. At the top end of the market rental decline has been countered by an up-tick in demand in the UK, France and Central Europe says a recent CB Richard Ellis data release. However, in some cities, such as Brussels, Lisbon and (even) the City of London, investors continue to be dogged by oversupply as growth in city-related employment and new construction starts remain low. Even so, European real estate has seen more than €50bn of new investment dollars over the last five years, according to recent DTZ Research. In particular, investors are targeting new locations – particularly in the higher yielding EU accession states, such as the Baltic countries, Hungary and the Czech Republic – evidenced by a 23% increase in cross-border activity, mostly acquisitions by US and Middle Eastern investors. Around 70% of the European real estate

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c-9

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 5

REITS

market in listed REITs was market is owned by The FTSE EPRA/NAREIT Global Real Estate Index Series estimated by Morgan governments and 3000 Stanley to be worth corporations. Privatisation around $70bn last year, of land assets will be a 2500 although they are notable feature of the 2000 increasingly popular as an European market over the investment asset. The coming decade, says 1500 Asian REITs market, Fraser Hughes, research 1000 centred in Singapore, director at the European South Korea, Japan, Hong Public Real Estate 500 Kong, New Zealand and Association (EPRA), the Australia is similarly not for profit trade FTSE EPRA/NAREIT North America Index FTSE EPRA/NAREIT Europe Index valued. Compare that with association, established in FTSE EPRA/NAREIT Asia Index FTSE EPRA/NAREIT Global Index Australia, which on a 1999 and based in standalone basis accounts Amsterdam. EPRA’s Data as at 31 March 2005. Source: FTSE Group for 10% of the global members include the majority of the leading real estate companies and market and which,“proportionally has the largest and most investment institutions in Europe. The French government, sophisticated market,”according to Hughes. A REIT is a company that buys, develops, manages and for example, intends to dispose of €1.5bn of its real estate sells real estate assets. REITs – unlike traditional real estate assets over the next three to four years. Investments by Europeans are also on the rise, propelled companies – do not pay tax as long as they pass their by the growing diversity of available property investment profits on to investors in the form of dividends. In general, vehicles. Capital-raising is also likely to increase in 2005 as they are restricted to generating property rental income. the rise in real estate equity prices through 2004 means the REITs enjoy some important benefits however. They are sector is trading on a much narrower discount to net asset more liquid than traditional private real estate ownership value (NAV). For some years, most companies have relied as their shares are usually traded on stock exchanges. heavily on debt as a source of new capital and a number of Other advantages, such as high dividends and those companies currently trading at premiums close to transparency, have only added to their appeal. For the time being interest is squarely focused on the NAV may now want to rebalance their capital structure. However, “direct investment still dominates the European UK, where, in his March budget, chancellor Gordon Brown landscape,”explains Judy Hill, chief executive officer (CEO) took a positive step towards the introduction of REITs. To at the European Association for Investors in Non-listed be precise, Mr Brown has not given an unqualified Real Estate Vehicles (INREV). Launched only in May 2003, assurance that a UK REIT will be introduced. Instead the INREV now has over 150 members, principally major Exchequer indicated that if a workable solution to institutional investors, fund managers and advisers across "challenging issues" referred to in the March 2005 discussion paper on UK Real Estate Investment Trusts, a Europe and concentrates on the unlisted market. Investors have lobbied consistently for REITs-enabling discussion paper, issued jointly by the Treasury and the legislation in Europe, as they are considered an optimal Inland Revenue can be resolved without additional loss of vehicle to introduce more liquidity and tax efficiency into tax revenue, it aims to legislate for REITs in the upcoming the marketplace. Publicly traded REITs also open up the Finance Bill 2006. The discussion paper is the result of over nine months of commercial real estate sector to smaller, retail investors. However, INREV’s Hill points out that, “REITs do not consultation with the market, which ended in July last year. necessarily have the best correlations with the property A leading role was played by the Association of Property market, but are better correlated with the equity market.” Unit Trusts (APUT), giving valuable input on the Hill maintains that “if REITs are genuinely tax efficient establishment of tax efficient listed vehicles. Market makers structures, they will sit alongside other non-listed vehicles had expected the government to have accepted REITs by very well.” She sees opportunities for the REITs market to now, but the paper was warmly received. “What it boils become an important exit route for “limited partnerships, down to now is a further period of consultation,” says say with a finite life, seven years for example. It may make Christopher Laxton, chairman of APUT and specialist real sense for them to convert to a REIT rather than liquidate.” estate investment fund manager at Morley Fund For the time being the European REITs market remains Management. Originally, the Exchequer was known to small compared with that of the United States where, in favour calling the vehicles Property Investment Funds 2004, they carried a total market value of approximately (PIFs) but now appears to have swung around popular $290bn (although in the context of the total US $4.5trn thinking that the UK should adopt the internationally property investment market, it too remains a relative recognised REITs moniker. As well, says Laxton, the minnow, accounting for around 3% of total real estate government is also reviewing the rules governing collective market capitalisation). In contrast the entire European property investment schemes as part of a broader market

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review exercise.“Two kinds of scheme are under review,”he explains, “retail and qualified investment schemes. The revision of both these vehicles could be very successful, as at the moment neither is very tax efficient.” The issue is pressing. While much of the UK real estate market is publicly listed, the rise of offshore real-estate holdings, particularly in the Channel Islands, continues Laxton has “affected the Inland Revenue’s intake.”Property unit trusts (PUTs) and in particular, the UK offshore realestate market, have become popular, having grown in value from £1bn back in 1998 to around £20bn today. In part this is a result of changes to stamp duty tax. Tax received in 1998 from the UK listed property sector was about £350m, which fell to about £200m in 2003, largely the result of property investment firms moving assets offshore. Interest in offshore vehicles was prompted by an increase in government stamp duty payable by UK property funds “from 0% to 4%” says Laxton, particularly as transfers of UK-situated land to and from partnerships offshore were expressly excluded from this tax. The result “was a stampede to set up pooled vehicles offshore,”he says. Any delay by the government will further spur the growth of pooled vehicles and also raises the probability that the market will develop other products that offer investors a proxy for UK REITs.“The Channel Island regimes are very tax efficient,” says INREV’s Hill, “If eventual legislation is positive for REITs and there are no penalties on conversion, there may be an incentive to change. If not, then things will remain as they are.” Hill notes that a tremendous momentum has built up, “We noted rapid market growth in 2004 with a record number of vehicles.” Already, the launch of UK-listed, Channel Island-registered structures that are typically

Judy Hill, chief executive officer (CEO) at the European Association for Investors in Non-listed Real Estate Vehicles (INREV).

closed-end, modestly geared, accessible to retail investors and have tax characteristics similar to those envisaged under the proposed REIT structure are already opening up new investment avenues. More pertinently perhaps for the Exchequer, it may have inadvertently prompted the development of an unregulated offshore real estate investment market and the introduction of REITs could slow the trend. A PUT is a collective investment scheme where the underlying properties (mainly direct property investments, though indirect investments can also be undertaken) are held on trust for participants. There are two types of PUTs,

FTSE EPRA/NAREIT: A WORKING RELATIONSHIP

arly in the year, FTSE Group assumed responsibility for the calculation of the EPRA/NAREIT Global Real Estate Index Series. New index rules and data enhancements presaged the launch of a new FTSE EPRA/NAREIT Global Real Estate Index Series, which is structured in so that it can be considered to represent general trends in all eligible real estate stocks worldwide. A key feature of the index series is that it is calculated on a real time basis. The index series is broken down into three index families and 37 separate indices is designed to reflect the stock performance of companies engaged in specific aspects of the North American, European and Asian real estate markets. Some 274 property companies, REITs and property development companies form the basis of the index series. The companies spread across three regions (Asia, Europe and North America) and some 28 countries. Prior to FTSE taking over the calculation of the index series, it had been undertaken by Euronext. According to EPRA’s research director Fraser Hughes, the move to FTSE provisions of global real time calculations for the indices was “a natural evolution of the success of the series.” In May 2000, the EPRA-Europe index was launched, in conjunction with the Amsterdam Stock Exchange. The original EPRA/NAREIT Global Real Estate Index was then launched in 2001 and very quickly became the recognised benchmark for dedicated global real estate investors. The move comes at a significant time in the market, as transparency in the European real estate market is increasing. This has been driven, in part, by the widespread introduction of performance benchmarks, which provide investors with a long-term analytical framework for portfolio appraisal. It has also has increased the credibility of real estate as an institutional asset class and reduced the risk premium it commands. Over the medium term, the opportunities opened up by the new indices are immense, says Hughes. “Last year we began work on the development of a derivatives market and more latterly at the end of 2004, we launched the AXA Eurozone ETF, which is listed on Euronext in Paris. This vehicle ensured that investors with real estate capability could buy exposure to the whole of the European market through the ETF.” The next stage, continues Hughes, is the development of a suite of ETFs as a step towards the development of a fully-fledged derivatives market in European real estate.

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authorised and unauthorised. Authorised PUTs are regulated by the Financial Services Authority (FSA) and are primarily designed for private investors, who pay corporation tax on income, but not capital gains tax. Unauthorised PUTs are available to both exempt and nonexempt investors and income and capital gains are subject to tax at the basic rate of income tax. Exempt investors are able to reclaim the tax suffered by the trust. Non-exempt investors are subject to tax on the gross amount of the distributions they receive. Unauthorised PUTs can be sited onshore or offshore. Offshore PUTs are resident outside the UK, commonly Jersey, Guernsey and Ireland, are managed locally and not liable for UK tax and are normally structured to be tax transparent. It is difficult to make a direct comparison between PUTs and listed property stocks.“The valuation of PUTs is based on net asset value,” says the APUT website, whereas property stocks are affected by a number of other factors, such as gearing and stock market fluctuations. APUT is the collective voice of the UK property unit trust sector. It currently has 31 member funds, with current combined total assets of around £10bn. Pooled property trusts are high on its agenda, rather than REITs at present, though Laxton, wearing his Morley hat, “welcomes the development of other property investment vehicles as they are likely to encourage wider investment in property as a whole”. APUT and INREV last year announced their intention to collaborate closely to drive forward best practice and transparency amongst pooled property vehicles across Europe. INREV’s Hill explains “APUT and INREV share many common objectives, such as encouraging transparency among pooled property funds. Together we form a much stronger voice.” Among the initiatives pursued by the associations is the linking of the APUT/HSBC/IPD Pooled Property Index with the soon to be launched INREV Index for European non-listed vehicles and to develop the APUT Code of Practice to encompass a far broader range of funds, such as UK Limited Partnerships. For the time being the continental European REITs market has coalesced around supporting legislation in the Netherlands, Belgium and France. And irrespective of what is happening in the UK, other European countries, namely Italy, Finland, Sweden and Spain, are expected to adopt REITs enabling legislation some time this year or next. REITs have been particularly strong performers over the past few years – although with higher volatility than privately held real estate. In the United States, for example, REITs as a whole traded consistently at a significant premium to the underlying net asset values of their holdings between 2000 and 2003, with the NAREIT Equity Index earning an annualised total return of 19.7% during this period. Last year was not as good however and in general, US REITs suffered some volatility beginning in April 2004. As a whole though the sector managed to stay within a more equitable price range; trading on or near net asset value.

WHAT’S LIKELY IN THE ANTICIPATED UK REITS STRUCTURE? What’s likely? •

•

Most likely investments will not be confined to UK property; all property types (commercial or industrial for example) and property located anywhere in the world will be eligible. The REIT may be externally or internally managed—the government thinks this is something that should be decided by the market. The new vehicle will be named UK-REIT and will be structured as a corporation, business trust, or similar association, managed by a board of directors or trustees. There had been talk that it would be referred to as a private investment fund (with the unfortunate acronym PIF), but that was abandoned so as not to isolate investor choice in an increasingly global market place by differentiating the UK REIT vehicle in this way. It is unlikely however that a single property vehicle will qualify for REIT status. The activities of the UK REIT will either be classified as non-taxable ("ring-fenced property letting business") or taxable ("non-ring-fenced business"). At least 75% of the total gross income (and at least 75% of the gross value of the assets) must relate to the ring-fenced property letting business. The precise demarcation of activities into ring-fenced and non ring-fenced business is still open to discussion however. Limited development activity within the 75% tests will be allowed, but will attract corporation tax. Have no more than 20% of its assets consist of stocks in taxable REIT subsidiaries. At least 95% of the REITs net ring-fenced income after appropriate deductions and capital allowances will have to be distributed. There will not be a minimum holding period set for assets held in a REITs structure. No more than 50 percent of the shares can be held by five or fewer individuals during the last half of each taxable year and shares need to be fully transferable.

“There is a growing perception that the European market with REIT developments still in their infancy is becoming even more attractive than the American one,”says EPRA’s Hughes. In 2004, says Hughes, European REITs outperformed their US counterparts. The European benchmark, the EPRA index, generated a total return of 41.73% in 2004, measured in euros, while the US benchmark, the EPRA/National Association of Real Estate Investment Trusts (NAREIT) index, returned 24.19%, also in euro terms. On average, the gross dividend yield for European REITs is expected to rise to 4.7% in 2006 from 4.5% this year, according to a UBS research report. The average gross dividend yield for US REITs, in contrast, is expected to fall to 4.0% in 2006 from 4.7% this year. So far, interest in European REITs has come mostly from banks and institutional investors, but says Hughes, a notable trend is increasing interest from overseas investors. The explanation is clear; European REITs are still cheaper than those in the US and Asia.

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Company Name

Page

Company Name

Page

Company Name

Page

Company Name

Page

Abbott Laboratories

DPM Mellon

Investec

Pharma Futures

ABN AMRO

Dresdner Kleinwort Wasserstein

IOSCO

Piper Jaffray

ABN Amro Asset Management

Driehaus Emerging Markets

iRiver

Principal

Adelphia

DuPont Capital

Ishii

Prudential Annuities

Ahold

DWS Investments

ISSA

Prudential Financial, Inc.

Ecanal

ITG

Reuters

16 32

Algemeen Burgerlijk Pensioenfonds

Ecrossnet

Johannesburg Stock Exchange

Riverfield

Allied Irish Bank

ECSDA

Johnson & Johnson’s Duragesic

Roxio

America Movil

Eli Lilly

JP Morgan

RWE

American Century

EM Applications

JPMorgan Investor Services

Salzburger Sparkasse

Apple

Enron

Jupiter Research

Samsung

Apple Computer

eSecAuction

Land Securities

SAPPI

eSecLending

Lehman Brothers

SASOL

Schroders

52 18

Asia Pacific Central Securities Depository Group

AstraZeneca

Athens Stock Exchange

AXA Investment Management

AXA Investment Managers

Bank Leu

Euroclear

Lipper Inc.

Euroclear Bank

Lloyds TSB Capital Markets

Euroclear France

London Stock Exchange

Securities and Exchange Commission

Securities Industry Association

Serious Fraud Office

SG Corporate & Investment Banking

Euroclear Nederland Euromoney Euronext

42 6 17

Long Term Capital Management Magnum US Investments Inc. Mellon

Mercer Investment Consulting

Bank of Ireland

Bank of New York

European Agency for the Evaluation of Medicinal Products 69

Barclays Global Investors

European Commission

Metrick

Bertrand and Mullainathan

European Community

Microsoft

Biaxin

Fair & Clear

MiFD

Bimbo

Federal Reserve

MLIM

BNP Paribas

Fidelity Investments

Bristol-Myers Squibb

Fitch

Morgan Stanley Capital International

Cedel

Frank Russell

Morley Fund Management

Celent Communications

Frank Russell Securities, Inc.

Cemex

FTSE Group

Charles River Associates

Citadel Investment Group Citigroup

Standard & Poor’s

State Street

STOXX Ltd

16 51

SWIFT

Swiss Exchange

T. Rowe Price

Napster

Taiwan Greater China Fund

NASD

Taiwan Stock Exchange

GAM

NASDAQ

TASS Research

GlaxoSmithKline

Goldman Sachs

National Association of Pension Funds

Telkom

Telmex

Goldshields Group

National Health Service

The Bank of New York

Gompers

New York Life

The Financial Times

Greenwich Associates

New York Stock Exchange

The Wall Street Journal

Grupo Mexico

Nicholas Applegate Capital Management

Thomson Corporation

Thomson Financial

NOREX

Tremont Capital Management

Tyco

UBS

UBS Global Management

Citywire

Clearstream

CNBC

Creative

Credit Agricole

32 6

CRESTCo

CVC Capital Partners

Dell

Depository Trust & Clearing Corporation

Sungard Business Integration

Citigroup Global Transaction Services

Credit Suisse First Boston

Merck

SmartMoney Magazine

Deutsche Bank

Deutsche Börse

Deutsche Börse Clearing

Dexia

Dow Jones Indexes

Hang Seng

Harvard Business School

Hedge Fund Association

Hewitt Associates, LLC

HSBC HSBC Securities Services Inalytics ING Bank ING Barings ING Investment Management Instinet

16 51 8 47 16 52 6

Institutional Shareholder Services 77 International Monetary Fund

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 5

North American Free Trade Agreement

Northeastern University

Northern Trust

Ohio Public Employees Retirement System 67 Old Mutual

Omgeo

Optima Fund Management

Parmalat

Permira Europe

Pfizer

COMPANIES IN THIS ISSUE

FTSE Global Markets Company Directory

US Food and Drug Administration 69 Vanguard Group

Veolia

Vera Research

Veritas SG Investment Trust

WestLB

Wharton Business School

Wilmer Cutler Pickering Hale & Dorr

Au st F FT TS rali SE E A a A C Be us lg tria iu FT m/ AC SE Lu x C FT A SE ana C De da A n FT C m SE ar k F A FT inla C n S FT E F d A SE ran C Ge ce FT SE FT rma AC ny Ho SE AC Gr ng Ko eec e ng FT Ch AC SE in Ir a A e C FT land SE AC I ta FT FT ly SE SE A FT Ne Jap C SE th an er Ne la AC nd w Ze s A a FT C l a SE nd A FT No SE rw C P ay FT SE ortu AC g Si ng al A a C FT por e S FT E S AC SE pa F i FT TSE Sw n A e SE Sw de C n Un i ite zerl AC a d Ki nd ng AC d F T om SE A US C A AC

86 FT SE ob

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MARKET REPORTS BY FTSE RESEARCH

FT SE

MARKET REPORTS

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FTSE Global Equity Index Series – Global Q1 2005

31st December 2004 - 31st March 2005

FTSE Regional Indices Performance (USD) 120

FTSE Global AC

115

FTSE Developed Europe AC

110

FTSE Japan AC

105

FTSE Asia Pacific AC ex Japan

100

FTSE Middle East & Africa AC

FTSE Emerging Europe AC

FTSE Latin America AC

-2 0

FTSE North America AC

FTSE Regional Indices Capital Returns (USD)

-2

-4

-6

FTSE Developed Country Indices Capital Returns

8 6

Dollar Value

-4

Local Currency Value

-6

-10

-8

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

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FTSE All-Emerging Country Indices Capital Returns 60 50 40 30

Dollar Value 20

Local Currency Value

10 0

FT SE

Ar ge FT ntin SE a B AC FT raz SE i l A F T Ch C ile S FT FTS E C A hi C SE E na Cz Col A u ec C h mbi Re a A p FT ub C li S FT E E c A SE gy C Hu pt A n F T ga C FT SE ry SE In AC In dia do A n FT e C SE sia AC I FT sr S a FT E K el A SE or C M ea FT alay AC SE si FT M a A C SE ex ico FT Mor A SE oc C Pa co AC ki s FT FT tan SE SE AC Ph Per u ili F T p p i n AC SE es AC Po F FT TS lan SE E R d A So us C sia ut AC FT h A SE fric FT Ta a A S E iw C Th an F T a i l AC SE an Tu d A rk C ey AC

-10

FTSE Global All Cap Sector Indices Capital Returns (USD) 15

Capital

Total Return -5

tru

M O inin il Bu & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap e c e & rsi e & Me r En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n Fo Go bile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca i s ev le ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al ho s H rs & ld ea Bi Pr lth ot od ec uc hn ts Ge o ne To log b y M r ed Lei al R acc ia su et o & re ai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s ica g R po tio et rt n aile Se rs r U t E l vice ilit ec s ie tric s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw Te & Re pan e ar ch Ot al ies n e h E & olo er sta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

-10

Stock Performance Best Performing FTSE All-World Index Stocks (USD) Hyundai Hysco 78.9% Orascom Construction 72.4% Orascom Telecom Holdings 71.7% NET Servicos de Comunicacao PN 65.5% Oriental Weavers 64.2%

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

Worst Performing FTSE All-World Index Stocks (USD) Elan Corporation -88.3% LG Card -66.2% Mosenergo -58.6% Doral Financial -55.6% Delphi Corporation -50.3% No. of Consts

Value

Actual Div Yld

7,843 1,103 1,877 4,863 2,980 1,877 174 84 1,525 173 2,680 1,330

301.87 295.80 395.19 356.98 180.61 346.66 473.91 442.94 326.19 401.04 280.76 311.68

0.8% 0.5% 2.2% 0.8% 0.8% 0.6% 2.7% 1.7% 1.9% -1.6% 0.4% 0.0%

-1.3% -1.9% 0.4% -0.8% -1.3% 0.8% 0.8% 3.7% 0.1% -5.2% -2.3% -1.5%

2.05% 2.20% 1.73% 1.65% 2.10% 2.95% 3.56% 1.73% 2.76% 2.72% 1.68% 0.98%

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

F T S E G L O B A L M A R K E T S â&#x20AC;˘ M AY / J U N E 2 0 0 5

tio

% ed

ve l

FT SE

Al l-E m er gi De ng ve lo p FT ed SE ex De US ve FT lo pe SE d FT De Eu SE ve ro De lo pe pe ve d lo As pe ia d As Pa ia ci fic Pa ci fic ex Ja pa n FT SE Eu ro zo ne FT SE FT SE De ve US lo pe FT d SE AC De ex ve US lo p e FT d SE LC De ex ve US lo pe FT d M SE C De ex ve US lo pe d SC ex US

FT SE

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

c-0 4

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7:55 pm

-0 5

8/4/05

28 -Fe b

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MARKET REPORTS BY FTSE RESEARCH

MARKET REPORTS

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FTSE Global Equity Index Series – Developed ex US Q1 2005

31st December 2004 - 31st March 2005

FTSE Developed Regional Indices Performance (USD) 115

FTSE Developed (LC/MC)

110

FTSE Developed Europe (LC/MC)

FTSE Developed Asia Pacific (LC/MC)

105

FTSE All-Emerging (LC/MC)

100

FTSE Developed ex US (LC/MC)

FTSE US (LC/MC)

-2 0

FTSE Developed Asia Pacific ex Japan (LC/MC)

FTSE Developed Regional Indices Capital Returns (USD) 14

-2

FTSE Developed ex US Indices Sector Capital Returns (USD)

Capital

-4

Total Return

-6

-8

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

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Stock Performance Best Performing FTSE Developed ex US Index Stocks (USD) ISS A/S 45.9% Chiyoda Corp 42.9% Kingboard Chemical Holdings 41.2% Caltex Australia 40.8% Sembcorp Marine 40.5%

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

Worst Performing FTSE Developed ex US Index Stocks (USD) Elan Corporation -88.3% Net One -38.3% Creative Technology -35.5% Abitibi-Consolidated -32.9% Fisher & Paykel Appliances Holdings -31.8%

No. of Consts

Value

Actual Div Yld

1,365 743 2,108 872 511 779 300 3,733 527 1,877 4,863

195.53 484.10 177.54 264.53 196.80 179.96 290.74 328.53 308.28 376.88 409.66

1.6% 0.1% 0.8% 1.0% 1.8% -0.3% 0.1% 1.6% 1.4% 2.4% 2.3%

-0.5% -2.3% -1.5% 0.5% -0.2% -1.9% -0.5% -0.1% -1.1% 2.0% 3.8%

2.45% 1.73% 2.07% 2.70% 2.82% 1.74% 3.45% 2.40% 2.55% 1.73% 1.65%

FTSE Global Equity Index Series – Asia Pacific Q1 2005 31st December 2004 - 31st March 2005

FTSE Asia Pacific Regional Indices Performance (USD) 110

FTSE Global AC FTSE Developed Asia Pacific (LC/MC) FTSE Developed Asia Pacific ex Japan (LC/MC)

105

FTSE Asia Pacific (LC/MC) FTSE All-Emerging Asia Pacific AC

100

FTSE Japan (LC/MC) ar -0

-Fe 28

-M

n-Ja 31

-D

-0

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

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% 0

-2

Gl ob al AC FT ia S Pa E D ci e fic ve De (L lop ve C/ e lo M d p ex ed C) Ja A pa sia n P (L ac FT C/ i f i M c SE C) A As llia Em Pa er ci gin fic g FT AC SE As D FT i a ev SE Pa elo Ja ci pe pa fic d n AC In de x FT ( LC SE /M As C) ia Pa ci fic (L C/ FT M SE C) As ia Pa ci fic FT M SE C As ia Pa ci fic FT SC SE As ia Pa ci fic LC As

FT SE

As ia

FT SE

Pa c

ifi c

-4

FTSE Asia Pacific All Cap Sector Indices Capital Returns (USD) 15

Capital

% 0

Total Return -5

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

-10

tru

MARKET REPORTS BY FTSE RESEARCH

FTSE Asia Pacific Regional Indices Capital Returns (USD)

Stock Performance Best Performing FTSE Asia Pacific Index Stocks (USD) Hyundai Hysco 78.9% China Intl Marine Containers (B) 62.7% Pakistan Telecom 59.0% Lotte Midopa 56.2% Dacom Corporation 55.7%

Worst Performing FTSE Asia Pacific Index Stocks (USD) LG Card -66.2% Macronix International -39.9% Net One -38.3% Polaris Software Lab -36.9% Creative Technology -35.5%

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

No. of Consts

Value

Actual Div Yld

7843 3207 1339 498 841 1868 300 779 560 479

301.87 326.08 184.34 311.14 362.01 383.51 290.74 179.96 203.63 115.46

0.8% 0.3% 0.0% -0.2% 0.8% 2.7% 0.1% -0.3% 1.0% -0.4%

-1.3% -0.5% -1.1% -1.7% 1.2% 5.4% -0.5% -1.9% 1.7% -2.5%

2.05% 1.89% 1.91% 1.97% 1.67% 1.71% 3.45% 1.74% 2.52% 0.98%

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

M AY / J U N E 2 0 0 5 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

tru

% Eu ro pe SC

M C

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 5

ar -0

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FT SE

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FT SE

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

MARKET REPORTS

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FTSE Global Equity Index Series – Europe Q1 2005

31st December 2004 - 31st March 2005

FTSE European Regional Indices Performance (EUR) 108

FTSE Global AC (EUR)

106

FTSE Developed Europe ex UK LC/MC (EUR)

104

FTSEurofirst 300 (EUR)

102

FTSE Developed Europe AC (EUR)

FTSEurofirst 100 (EUR)

100

FTSE Eurozone LC/MC (EUR)

FTSEurofirst 80 (EUR)

FTSE European Regional Indices Capital Return (EUR)

FTSE Developed Europe Sector Indices Capital Returns (EUR)

Capital

Total Return

-2

-4

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

MARKET REPORTS

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MARKET REPORTS BY FTSE RESEARCH

Stock Performance Best Performing FTSE Developed Europe Index Stocks (EUR) ISS A/S 52.6% Deutsche Boerse 31.0% Fresenius AG (PFD) 29.0% Banca Antonventa 28.9% Continental 28.0%

Overall Index Return (EUR)

Worst Performing FTSE Developed Europe Index Stocks (EUR) Elan Corporation -87.8% Benetton -23.5% MLP Ord -23.2% Unibail -21.0% T-Online Ag -18.3% No. of Consts

Value

Actual Div Yld

7843 1609 210 358 1041 1525 84 748 1035 300 80 100

267.45 290.18 323.89 351.43 365.35 289.00 392.43 301.25 301.27 1085.34 3843.14 3620.82

-0.4% 2.2% 2.0% 2.9% 2.2% 2.2% 2.0% 2.4% 2.7% 2.2% 2.6% 2.1%

3.2% 4.8% 3.8% 6.7% 8.4% 4.7% 8.5% 4.6% 4.7% 4.2% 3.8% 4.0%

2.05% 2.75% 2.89% 2.43% 2.27% 2.76% 1.73% 2.66% 2.57% 2.86% 2.90% 3.07%

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

FTSE UK Index Series – Q1 2005 31st December 2004 - 31st March 2005

FTSE UK Index Series Performance (GBP) 120

FTSE 100

115

FTSE 250

110

FTSE 350 FTSE SmallCap

105

FTSE All-Share 100

FTSE AIM 5 ar -0 -M

FTSE techMARK

-F eb -

-D

-Ja n-

ec -

FTSE All-Share Sector Indices Capital Returns (GBP) 15

% Capital

Total Return -5

tio

O inin & il Bu & g ild Ch Ga in em s F g or M ica El S ec te es a ls t e tr on Ae l & try eria ic ro O & ls & sp th Pa p En Ele ace er M er gi ctr & e ne ic D ta er al ef ls Ho in Eq en us Au g & ui ce pm eh to ol mo Ma en d c Fo Go bile hin t od s od & ery Pe Pr s rs & Par od on Te ts u a ce Ph l Ca rs Be xtile ar re & ve s m & r P ro age ac H ce s eu ou ss tic se o al ho H rs s & ld ea Bi Pro lth ot d ec uc hn ts Ge o ne To log M L ral ba y ed ei R cc ia su et o & re ail En & ers Su ter Ho pp tai tel or nm s Te F tS e l e oo co d er nt v m & m D Tra ice un ru ns s ic g R po at e rt io ta n ile Se rs r U t E l vice ili ec s tie tr s icit -O y th e B r In ve L In ank st ife sur s In m A a en ss nc fo Sp rm e t C ur e at cia om an So ion lity p ce ftw Te & Re an ar ch Ot al E ies e no he s & lo r ta Co gy Fin te m H an pu ar ce te dw rS a er re vi ce s

-10

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

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Best Performing FTSE All-Share Index Stocks (GBP) Elementis Game Group RAC Xaar Axon Group

73.9% 46.5% 46.1% 45.1% 41.6%

Worst Performing FTSE All-Share Index Stocks (GBP) Nord Anglia Education -57.6% Danka Business Systems -48.0% Phytopharm -46.9% Jessops -37.6% Plasmon -34.1%

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

No. of Consts

Value

Actual Div Yld

Net Cover

P/E Ratio

100 250 350 355 705 350 1057 100

4894.37 7130.51 2498.72 2907.27 2457.73 3381.41 1088.75 1134.26

0.9% -0.5% 0.7% 1.0% 0.7% 2.8% 1.2% -8.3%

1.7% 2.8% 1.8% 5.4% 1.9% 7.3% 8.3% -5.2%

3.22% 2.64% 3.13% 1.99% 3.09% 2.22% 0.41% 1.47%

2.15 1.96 2.12 0.28 2.08 -1.86 -0.17 -

14.48 19.36 15.02 176.89 15.54 0.00 0.00 -

FTSE Xinhua Index Series 31st December 2004 - 31st March 2005

FTSE Xinhua Index Series Performance (RMB/HKD) - Q1 2005 130

FTSE/Xinhua China 25 (HK$)

125

FTSE Xinhua All-Share (RMB)

120 115

FTSE Xinhua Small Cap (RMB)

110

FTSE/Xinhua China A50 (RMB)

105

MARKET REPORTS BY FTSE RESEARCH

Stock Performance

FTSE Xinhua 600 (RMB)

100

FTSE Xinhua China Government Bond Total Return Index (RMB)

ar -0

n05

31 -M

28 -Fe

-Ja 31

31 -D ec

-0 4

FTSE Xinhua Index Series Index Name

FTSE/Xinhua China 25 (HK$) FTSE/Xinhua China A50 (RMB) FTSE Xinhua All-Share (RMB) FTSE Xinhua 600 (RMB) FTSE Xinhua Small Cap (RMB) FTSE Xinhua China Government Bond Total Return Index (RMB)

Consts

Value

Actual Div Yld

25 50 997 600 397 27

8254.83 4088.34 2259.88 2435.58 1624.64 92.13

1.2% -0.2% -1.9% -1.3% -5.0% 2.8%

-0.5% -2.3% -7.6% -6.8% -12.4% 4.6%

3.03% 1.67% 1.45% 1.56% 0.80% 3.99%

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

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FTSE Hedge Management Styles (USD) - 5-Year Performance 160

FTSE Hedge

140

FTSE All-World

120

Directional

100

Event Driven Non-Directional

80 60

5 ar -0 M

04 Se

4 ar -0 M

03 Se

02 p-

ar -0 M

ar -0

01 Se

1 ar -0 M

00 Se

ar -0

MARKET REPORTS BY FTSE RESEARCH

FTSE Hedge Index Series

*March 05 figures are indicative.

FTSE Hedge – Management Styles & Strategies (NAV Terms) Index Level*

1 mth

3 mth

Ann Return (5-Year)

Volatility (3-Year)

Directional Equity Hedge Commodity Trading Association (CTA) / Managed Futures Global Macro

3021.75 2064.91 2038.71 1888.85

-0.6% -0.7% 0.1% -0.4%

-0.1% 1.4% -3.3% -1.1%

8.0% 7.1% 11.5% 7.3%

4.8% 4.3% 15.8% 6.1%

Event Driven Merger Arbitrage Distressed & Opportunities

3059.01 1992.08 2080.55

-1.3% -0.4% -2.1%

-0.6% -0.5% -0.6%

3.7% 2.1% 5.1%

4.6% 1.8% 7.6%

Non-directional Convertible Arbitrage Equity Arbitrage Fixed Income Relative Value

2969.57 1945.21 1979.41 1990.20

-0.1% -1.4% 0.5% 0.0%

0.3% -2.7% 1.7% 0.9%

4.7% 8.4% 5.8% 2.2%

1.7% 5.0% 2.9% 1.4%

FTSE EPRA/NAREIT Global Real Estate Index Series FTSE EPRA/NAREIT Global Real Estate Index Series Performance (Total Return) - Q1 2005 110

FTSE EPRA/NAREIT Global Total Return Index ($) FTSE EPRA/NAREIT North America Total Return Index ($)

105

FTSE EPRA/NAREIT Europe Total Return Index (€)

100

FTSE EPRA/NAREIT Euro Zone Total Return Index (€)

FTSE EPRA/NAREIT Asia Total Return Index ($) 5 ar -0 M

-0 5 Fe b

5 Ja n0

c-0

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

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FTSE EPRA/NAREIT Global Real Estate Indices (Total Return) Index Name

FTSE EPRA/NAREIT Global ($) FTSE EPRA/NAREIT North America ($) FTSE EPRA/NAREIT Europe (€) FTSE EPRA/NAREIT Euro Zone (€) FTSE EPRA/NAREIT Asia ($)

Consts

Value

Actual Div Yld

275 135 78 30 62

1618.83 1849.07 1704.31 1711.75 1256.01

-0.4% 1.4% -0.8% 0.8% -3.0%

-4.9% -6.5% 1.4% 4.9% -3.3%

4.12% 4.97% 3.34% 4.41% 3.12%

FTSE Bond Indices FTSE Bond Indices Performance (Total Return) - Q1 2005 FTSE Eurozone Government Bond Index (€) FTSE Euro Corporate Bond Index (€) FTSE US Goverment Bond Index ($) FTSE Pfandbrief Index (€)

103 102 101 100 99 98

-0

ar -0

5 -0

Fe b

Ja n

c-0

FTSE Gilts Index Linked All Stocks (£) FTSE Japan Government Bond Index (¥) FTSE Euro Emerging Markets Bond Index (€) FTSE Gilts Fixed All-Stocks (£)

FTSE Bond Indices (Total Return) Index Name

Consts

FTSE Eurozone Government Bond Index (€) FTSE Pfandbrief (€) FTSE Euro Emerging Markets Bond Index (€) FTSE Euro Corporate Bond Index (€) FTSE Gilts Index Linked All Stocks (£) FTSE Gilts Fixed All-Stocks (£) FTSE US Government Bond Index ($) FTSE Japan Government Bond Index (Y)

251 311 44 343 9 29 111 220

Value

149.12 172.26 194.88 139.57 1843.63 1791.85 142.34 110.44

0.0% 0.3% -0.8% -0.3% 0.1% 0.1% -1.1% 0.2%

1.2% 1.0% -0.1% 0.7% -0.1% -0.1% -0.4% 0.7%

Actual Div Yld

3.60% 3.33% 4.91% 3.91% 1.85%* 4.63% 4.56% 1.01%

* Based on 0% inflation

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

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

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

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

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

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

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

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CALENDAR

Index Reviews May-Sept 2005 Date

Index Series

Review Type

Effective Data Cut-off (Close of business)

13-May 17-May May/Jun Early Jun Early Jun Early Jun Early Jun 1-Jun 3-Jun 3-Jun 3-Jun 8-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 14-Jun 15-Jun 15-Jun 15-Jun 15-Jun 15-Jun 15-Jun 15-Jun 15-Jun 16-Jun 1-Jul 7-Jul 25-Jul 1-Aug 12-Aug 17-Aug 31-Aug Aug/Sep Early Sep Early Sep 1-Sep 2-5-Sep 5-Sep 7-Sep 7-Sep 8-Sep 9-Sep 9-Sep 9-Sep 9-Sep 9-Sep 13-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 15-Sep Sep/Oct

Hang Seng MSCI NZSX 10 Russell US Indices ATX KOSPI 200 IBEX 35 KFX OBX DAX OMX S30 FTSE UK FTSE All-World FTSE techMARK 100 FTSEurofirst 300 FTSE eTX NASDAQ 100 S&P MIB S&P/ ASX 200 S&P US Indices S&P Europe 350/ S&P Euro S&P 500 DJ Global Titans 50 S&P Midcap 400 PSI 20 STOXX S&P/ TSX TOPIX New Index Series TSEC Taiwan 50 OMX H25 CAC 40 Hang Seng MSCI FTSE All-World NZSX 10 ATX S&P US Indices SMI Index Family S&P MIB DAX FTSE/ Hang Seng Asiatop FTSE UK FTSE All-World FTSE techMARK 100 FTSEurofirst 300 FTSE eTX FTSE Multinational FTSE TMT S&P MIB STOXX STOXX Blue Chips DJ Global Titans 50 S&P US Indices S&P Europe 350/ S&P Euro S&P 500 S&P Midcap 400 S&P/ ASX 200 S&P TSX Russell US Indices CAC 40

Quarterly review 6-Jun Annual review 31-May Quarterly review June Annual review 24-Jun Quarterly review 30-Jun Annual review 9-Jun Semi-annual review 1-Jul Semi-annual review 17-Jun Semi-annual review 17-Jun Quarterly review Semi-annual review 1-Jul Quarterly review 17-Jun Annual review - Emgng Eur, ME, Africa, Latin America 17-Jun Quarterly review 17-Jun Quarterly review 17-Jun Quarterly review 17-Jun Quarterly review / Shares adjustment 17-Jun Quarterly review - shares only 20-Jun Quarterly review 17-Jun Quarterly review 17-Jun Quarterly review 17-Jun Quarterly review 17-Jun Annual review 17-Jun Quarterly review 17-Jun Semi-annual review 1-Jul Quarterly share adjustment 17-Jun Quarterly review 17-Jun Semi-annual review 28-Jul Quarterly & annual review 15-Jul Quarterly review 29-Jul Quarterly review 1-Sep Quarterly review 9-Sep Quarterly review 31-Aug Annual Review / Japan 16-Sep Quarterly review Sep Quarterly review 30-Sep Phase 2 float adjustment 16-Sep Semi-annual review 30-Sep Semi-annual constiuent review 19-Sep Quarterly review/ Ordinary adjustment 16-Sep Semi-annual review 16-Sep Quarterly review 16-Sep Annual review/ Developed Europe 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Annual review 16-Sep Annual review 16-Sep Quarterly review - shares & IWF 19-Sep Quarterly review 16-Sep Annual review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 30-Sep Quarterly review Oct/Nov

31-Mar

31-May End of May

31-May 30-May 7-Jun 31-Mar 31-May 3-Jun 3-Jun

15-Jun 31-May 1-Jun 31-May 17-Jun 30-Jun 30-Jun End of Jun 30-Jun 30-Jun 31-Aug 31-Jul 31-Aug 31-Aug 6-Sep 30-Jun 31-Aug 2-Sep 2-Sep 30-Jun 6-Sep 1-Sep 1-Sep 14-Sep

31-Aug 31-Aug

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

M AY / J U N E 2 0 0 5 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

UNICEF.QXD

9/4/05

7:27 am

Page 1

The children of Darfur in Sudan are caught up in a horrific conflict which is having a devastating effect on their lives.

UNICEF/ HQ04-0292/Christine Nesbitt

Over 1 million people have fled their homes and entire villages have been destroyed and hundreds of lives have been lost. Children’s lives are at great risk of disease and malnutrition. Water and shelter are in short supply. Right now, children are depending on UNICEF to stay alive. To find out more about how you and your company can help UNICEF when an emergency occurs, please contact victorial@unicef.org.uk or visit: www.unicef.org.uk/emergencyrelief if you are in the UK or www.supportunicef.org if you´re outside of the UK Thank you for your support

With a presence in over 190 countries, UNICEF (the United Nations Children’s Fund) is uniquely positioned to react quickly to emergency situations such as the one in Sudan. We have been working tirelessly since the emergency began, providing medical supplies and access to safe water and sanitation. To carry out our emergency work, we desperately need the help of individuals and companies. FTSE already support UNICEF (over £900,000 donated through FTSE4Good so far). In doing so, they help us to alleviate the distress and hardship caused to children who find themselves suffering because of emergency situations like the one in Darfur.

MARKET REPORTS

8/4/05

7:55 pm

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