GM Cover Issue 18.qxd - FTSE

ASIAN SECURITIES LENDING ENTERS A NEW GROWTH PHASE 

ISSUE EIGHTEEN • MARCH/APRIL 2007 

OUTSOURCING 

PRIVATE EQUITY 

BNY/MELLON 

SETS THE 

BENCHMARK 

CPDOs SQUEEZE 

CREDIT SPREADS 

BGI’s KRANEFUSS: 

ETFS & THE NEXT 

GENERATION 

US CUSTODY: HOW MUCH CONSOLIDATION CAN ONE MARKET TAKE?

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Bill Stoneman, Lynn Strongin Dodds, Ian Williams, 

Mark Faithfull. 

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FTSE GLOBAL MARKETS • MARCH/APRIL 2007 

Outlook 

THREE WORDS SAY it all for this edition and those words are: 

consolidation, consolidation, consolidation. Wherever you look in 

this dynamic opening quarter of 2007, the compelling storyline is 

the dramatic pick up in merger activity across both the exchange world 

and the custody market; with equally dramatic and far reaching 

consequences for the global investment market. 

Bank of New York shook custodians at year end 2006 by agreeing to 

purchase Mellon Financial Corporation for roughly $16.5bn, giving the 

combined company—to be called Bank of New York Mellon 

Corporation—some $17.5trn in assets under custody. “The deal is so 

compelling that it is likely to pressure some of the company’s competitors 

to think about acquisitions,” wrote analyst Richard Bove of Punk Ziegel 

shortly after the deal was announced. Sure enough, in early February 

State Street Corporation countered Bank of New York’s gambit with its 

own agreement to purchase Boston-based Investors Financial Services 

Corporation, the holding company for Investors Bank & Trust, for $4.5bn. 

What now for JPMorgan? The bank had spent most of 2006 trumpeting 

itself as the world’s leading custodian with $13.9trn in custodial assets. 

While it was revelling in its victory parade, Bank of New York and State 

Street were all the while planning to regain their one-two positions 

through accretion. As a consequence, the bank is now once again deposed 

to third place, behind State Street’s $14.1trn and BONY-Mellon’s megatrillion 

market share. If JPMorgan’s route to dominance is yet dependent 

on organic growth, it will be some while before it regains the top slot once 

more. Not only that, with the quest for scale continuing to drive the 

industry, analysts say that more mega deals are on the way, which may yet 

again change the geography of the global custody league tables. Dave 

Simons talks to the main players in the increasingly complex game-plan 

that is now the custody market. For more, please turn to page 48. 

Equally, in the exchange market seismic shifts are underway as 

traditional exchanges seek to protect their own turf against both hostile 

and friendly acquisition moves by market hungry competitors. At the 

same time those very same exchanges are beginning to cast envious 

glances at the exponential success of established derivatives exchanges, 

which appear to be enjoying runaway growth in a market that even in 

today’s heady trading atmosphere is only a fraction of what it will be over 

the coming decade. A new geography of alliances, services and product 

innovation is underway, which promises to re-write the book of securities 

trading in the second decade of the 21st century.To find out what it might 

look like, turn to page 81. 

In all cases the inevitable questions are: is big really better? If so, better 

for whom? The shareholders? The institutions involved? Or, more 

pertinently, the clients? Is consolidation the only response to an 

increasingly globalised market in which 24/7 access is a bare-minimum 

service level? An expert, any expert, is yet to write the empirical research 

report which categorically states that investment services and trading 

services provision will best benefit users if only a few providers remain on 

one or more continents. In diversity, there is choice. In choice can be found 

real competition and then, in turn, a propensity by service providers to 

provide quality and not just quantity in service provision. Is that not worth 

a basis point of two of cost to an end user? The debate begins here … 

Francesca Carnevale, 

Editorial Director 

February 2007 

1

2 

Contents 

COVER STORY 

REGULARS 

MARKET LEADER 

INDEX REVIEW 

IN THE MARKETS 

FACE TO FACE 

REGIONAL REVIEW 

INVESTMENT 

SERVICES 

DEBT REPORT 

CAPITAL MARKETS 

INDEX REVIEW 

BGI AND THE NEXT GENERATION OF EXCHANGE 

TRADED PRODUCTS ..................................................................................Page 44 

Lee T Kranefuss, the architect of BGI’s ETF strategy and chief executive officer of the 

company’s Intermediary Products and Index & Markets Group, thinks that ETFs 

continue to be a growth market “and we expect to continue to be the leader in it.” 

BGI is now marketing the next generation of exchange traded products and is showing 

how effective collaboration across the wider Barclays Group benefits both the asset 

management firm and its clients. Art Detman reports from San Francisco. 

PUTTIN’ ON THE CREDIT SQUEEZE ........................................................................Page 6 

Few innovations in the financial markets have created as big a stir as constant 

proportion debt obligations (CPDOs). Neil O’Hara explains why 

TESTING THE LIMITS OF THE FTSE’S BULL RUN............................Page 12 

Capital Spread’s Simon Denham asks how long can the good times last? 

INVESTMENT APPROACHES THAT MIMIC HEDGE FUNDS..............Page 14 

Neil O’Hara looks at how mainstream investing is encroaching on hedge fund strategies 

CREATING A NEW SPIN IN SECURITIES LENDING........................Page 23 

JPMorgan’s Sandie O’Connor explains the bank’s new securities lending solutions 

SAUDI ARABIA BEATS THE ODDS ....................................................Page 26 

Irrespective of its stock market performance the Saudi economic boom continues 

MIDDLE EAST REITS COME OF AGE ................................................Page 34 

Mark Faithfull reports on the impact of the region’s expanding real estate sector 

TURKEY’S ELECTIONS CREATE A STIR ....................................................Page 39 

Lynn Strongin Dodds on the economic impact of this year’s presidential elections 

MICEX MAKES A PUSH FOR MARKET SHARE ................................Page 41 

The Moscow exchange makes a push for growth in a banner year 

US CUSTODY: THE IMPACT OF MARKET CONSOLIDATION Page 48 

Is bigger really better? Dave Simons reports on the market impact of the current 

round of mergers and acquisitions that is redrawing the custody league tables 

ASIAN SECURITIES LENDING COMES OF AGE..............................Page 60 

Growing in confidence, a string of Asian countries are introducing or re-introducing 

securities lending. Rekha Menon reports on a market that is fighting fit 

EXPORTING SPANISH COVERED BONDS ....................................Page 66 

Runaway growth enjoyed by Spain’s covered-bond market must take a different turn in 

2007. Andrew Cavenagh reports on moves to export Cedulas Hypothecarias to the US 

PFANDBRIEF: THE CALM BEFORE THE STORM ......................Page 70 

Pfandbrief issuance volumes have remained level this year. 2005’s regulatory changes 

should begin to impact positively on new issues in 2007 

DEPOSITARY RECEIPTS IN THE SPOTLIGHT ................................Page 85 

After a moribund period, issuers are returning to the American Depositary Receipt 

market. Is it a short term trend, or does it point to a wider use of the DR market? 

Market Reports by FTSE Research ................................................................................Page 92 

Index Calendar................................................................................................................Page 104 

MARCH/APRIL 2007 • FTSE GLOBAL MARKETS

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4 

Contents 

FEATURES 

BANK OF NEW YORK/MELLON MERGER ....................................Page 55 

On December 4th, 2006 Bank of New York Corp. (BNY) and Mellon Financial Corp. said they 

will merge, creating the world's largest securities servicing and asset management firm. The deal 

is expected to be complete in the third quarter of 2007. The new company will be called Bank of 

New York Mellon Corp., and be the world’s leading asset service provider, with $16.6trn in 

assets under custody and $8 trn in assets under trusteeship. It will also rank among the top 10 

global asset managers with more than $1.1trn in assets under management. So, what can we 

expect now from this powerhouse? Bill Stoneman reports. 

THE PEETZ EFFECT ..............................................................................................................Page 58 

In the spring of 2006, Bank of New York [BNY] agreed to sell its middle market and retail 

business to JPMorgan Chase in return for JPMorgan’s corporate trust business. The 

transaction has resulted in the bank leading the corporate trust services market by well 

more than a country mile. BNY now boasts a trust business serving 90,000 clients, covering 

$8 trn in total debt, which involves some 3,700 employees in 54 offices in 18 countries. 

Francesca Carnevale talks to Karen Peetz, BNY’s senior executive vice president, in charge 

of the bank’s global trust business, on the operation’s forward strategy. 

PRIVATE EQUITY FUND ADMINISTRATION ....................................Page 74 

Mainstream investors will recognise the drivers behind the rise of fund administration 

services to private equity firms: improved efficiency, a requirement to gain access to 

better technology without attendant investment costs, a heightened focus on corporate 

governance and reporting transparency. To this mix must be added breakneck growth 

and increased complexity in the private equity industry. In a dynamic and more complex 

world, it makes sense for private equity firm to outsource in-house administration 

services to skilled practitioners. Enter global custodians with multi-jurisdictional clout. 

Can the traditional providers to the private equity community continue to compete? 

Francesca Carnevale reports. 

OUTSOURCING: THE RISE OF ALTERNATIVES ..........................Page 78 

Outsourcing has benefited from a climate marked by intense regulatory pressure, rising 

operational costs and an increasingly complex menu of alternative investments. No 

surprise then that an efficient outsourcing platform has become a highly valued commodity 

for asset managers requiring a solid base of support that will allow them to focus on their 

core competencies.on transition managers, who are required to not only transit portfolios 

efficiently, but also to add value throughout all stages of the process. By Dave Simons. 

THE EXPANDING WORLD OF DERIVATIVES EXCHANGES..Page 81 

In the arcane world of derivatives exchanges, the only problem (well, almost) is how to 

spend the rising tide of revenue flooding into the coffers of the major houses. Barely having 

scratched the surface of the potential for global growth, no one could fault the exchanges for 

resting on their laurels. But eager eyes in mainstream exchanges now look upon this Eden 

with undisguised envy and are slowly formulating their plans to grab at least some of the 

hallowed turf. Will they succeed? 

TOBACCO: ASIA LIGHTS UP ....................................................................Page 88 

Japan Tobacco’s impending $14.7bn takeover bid for the British giant Gallaher gives some 

insight into what is at stake in a market that is paradoxically contriving to become more 

regulated and more globalised at the same time. Up for grabs are the still growing markets 

of Asia, which are increasingly important to tobacco firms now that smoker numbers are 

shrinking in western markets. Who will win out in this new battle for market share? 

Ian Williams reports 


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CPDOS SQUEEZE CREDIT SPREADS 

6 

Market Leader 

CPDOs Squeeze 

Credit Spreads 

Few innovations in the financial markets have cause as big a stir 

as constant proportion debt obligations (CPDOs), the latest twist 

in structured products ABN Amro introduced last August. 

Although the new instrument offers leveraged exposure to 

investment grade credits comparable to the constant proportion 

portfolio insurance notes (CPPIs) ABN Amro developed in 2003, 

the similarity ends there. CPPIs have variable coupons and a 

guarantee of principal at maturity, whereas CPDOs look like 

conventional floating rate notes: they deliver interest payments 

at a fixed margin over LIBOR and a bullet payment of principal at 

maturity that is not guaranteed. Neil O’Hara reports on the rise 

of the leveraged asset class. 

CPDOs BECAME THE talk of the 

market overnight. Investors 

pining for yield could suddenly 

get 200 basis points (bps) over LIBOR 

on a 10-year note in a leveraged 

structure robust enough to earn a AAA 

rating on both interest and principal 

payments—an improvement over 

CPPIs, for which only principal is 

rated. While other players immediately 

copied the structure, ABN Amro still 

sponsored about half the $2bn of 

CPDOs issued during 2006. 

Within weeks of the first issue, 

market participants blamed CPDOs 

for a sharp fall in investment grade 

credit default swaps index spreads; the 

Dow Jones iTraxx fell from 35bps in 

July 2006 to 26bps in late September. 

The high initial leverage (typically 

15:1) does give CPDOs a 

disproportionate influence on the 

market. Every $100m issued generates 

$1.5bn selling pressure on spreads. 

Nevertheless, the $30bn initial 

leveraged principal of all the CPDOs 

issued in 2006 cannot account for such 

a dramatic tightening. 

A heavy issue calendar in all 

leveraged credit products, including 

collateralised debt obligations 

(CDOs), CDO squared and leveraged 

super senior notes contributed to 

spread compression, too. Participants 

say the market over-reacted in 

anticipation of future issuance of 

CPDOs and other leveraged credit 

instruments.“The coupon you can get 

is very dependent on the starting 

spread on the credit default swaps 

index that you are referencing,” says 

Alexandre Linden, a senior director at 

Derivative Fitch, Fitch’s rating agency 

dedicated to derivatives. 

Linden points out that if the index 

spread drops from 40bps to 30bps, the 

gross spread on a structure levered 

15:1 shrinks 150bps, enough to push 

the coupon down from 200bps to 

around 125bps. CPDOs attract AAA 

ratings from the agencies despite the 

high initial leverage because the 

Within weeks of the first issue, market 

participants blamed CPDOs for a sharp fall in 

investment grade credit default swaps index 

spreads; the Dow Jones iTraxx fell from 35bps 

in July 2006 to 26bps in late September. The 

high initial leverage (typically 15:1) does give 

CPDOs a disproportionate influence on the 

market. Every $100m issued generates $1.5bn 

selling pressure on spreads. Nevertheless, the 

$30bn initial leveraged principal of all the 

CPDOs issued in 2006 cannot account for 

such a dramatic tightening. Photograph by 

Alan Heartfield, supplied by Dreamstime.com, 

February 2007. 

structure incorporates self-correcting 

mechanisms that reduce the 

probability of default, according to 

Linden. The cash-in protects a 

successful structure against any 

subsequent widening in spreads, the 

excess margin over LIBOR provides a 

buffer against credit losses and when 

the index components roll over to a 

longer maturity every six months the 

new portfolio delivers incremental 

income [Please refer to box on page 10: 

How a CPDO works]. 

Both CDX and iTraxx are based on 

the most liquid investment grade 

credits with an average maturity of 

five years. Every six months, the 

indices are reconstituted to eliminate 

any names that have dropped below 

investment grade rating and extend 

the maturity from 4.75 to 5.25 years. 

“You expect to receive some spread 

pickup because you take a longer 


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IDEAS THAT 

CHANGE 

THE WORLD


8 

Market Leader 

maturity exposure,” Linden says. The 

rollover also limits the credit risk in 

CPDOs to a migration from 

investment grade to default in a sixmonth 

period that matches the index 

re-composition dates. It can happen— 

witness Enron and WorldCom, 

however it is rare. 

If credit spreads widen between 

index rollover dates, CPDOs will 

suffer a mark to market loss but 

higher income from the reconstituted 

credit default swaps index portfolio 

rebuilds the NAV over time. In back 

tests run at potential investors’ 

request, ABN Amro found that in one 

scenario spreads would have to tick 

up 700bps over a three-year period 

from first issuance and then stay at 

that level through maturity to 

jeopardise full repayment of CPDO 

principal. “It would have paid all the 

coupons but would not quite have 

enough cash to pay the entire 

principal at maturity,” says Andrew 

Feachem, a structured credit marketer 

in ABN Amro’s London office, “You 

really have to throw some pretty 

extreme situations at the transaction 

for it to fail.” 

Feachem sees a bigger threat to the 

CPDO structure if defaults tick up but 

spreads do not, an unlikely outcome 

given the strong positive correlation 

between credit spreads and default 

rates in past credit cycles. In practice, 

credit spreads tend to revert to the 

mean; if spreads do blow out, history 

suggests they will not stay at that level 

and any shift back from wide spreads 

toward the mean will allow CPDOs to 

recoup earlier losses. The rating 

agencies will grant a AAA rating only 

if thousands of simulations based on 

different assumptions about credit 

spreads, mean reversion, liquidity and 

volatility allow the CPDO to make 

timely payments of interest and 

principal in almost every case. 

Feachem says CPDOs placed so far 

Andrew Feachem, structured credit marketer in ABN Amro’s London office. ABN Amro found that 

in one scenario spreads would have to tick up 700bps over a three-year period from first issuance 

and then stay at that level through maturity to jeopardise full repayment of CPDO principal.“It 

would have paid all the coupons but would not quite have enough cash to pay the entire principal 

at maturity,”says Feachem,“You really have to throw some pretty extreme situations at the 

transaction for it to fail.”Photograph kindly supplied by ABN Amro, February 2007. 

have tended to exceed that hurdle— 

99.3% in the case of Standard & 

Poor’s—by a comfortable margin, 

which reduces rating and price 

volatility.The potential rating volatility 

of CPDOs (much higher than for 

conventional bonds) has sparked a 

discussion at Moody’s over whether 

the agency should develop a 

quantitative measure for rating risk to 

help clients distinguish among 

equally-rated securities, according to 

Olivier Toutain, vice president and 

senior credit officer at Moody’s. 

Toutain believes CPDOs and other 

leveraged credit vehicles are putting 

intense downward pressure on credit 

spreads that will not let up until credit 

fundamentals deteriorate. To Dan 

Ivascyn, an executive vice president 

and portfolio manager at PIMCO in 

Newport Beach, California, CPDOs 

combine the excess spread 

accumulation developed to build 

credit support in rated CDO equity 

tranches with the high leverage 

embedded in super senior CDO 

tranches. He notes that although the 

six-monthly index rollover purges 

weak credits, the portfolio may still 

suffer realised losses. 

Credit default swaps prices of 

downgraded names usually drop 

because existing contracts do not 

reflect the higher spread implied by a 

lower rating. At the rollover date, the 

CPDO has to pay the difference to the 

swap counterparty when it replaces 



10 

Market Leader 

the positions with new investment 

grade credit default swaps trading at 

current market spreads. For example, 

the first index roll after the rating 

agencies downgraded auto-related 

credits in 2005 would have imposed a 

significant cost on a CPDO. “You do 

not actually need defaults,” Ivascyn 

says,“You just need negative migration 

where the cost to roll into the new 

index is high enough for long enough 

that you whittle away your capital.” 

PIMCO is working to model how 

CPDOs would have performed in 

crisis periods before the credit default 

swaps indices were developed about 

four years ago. Ivascyn suspects 

index-related CPDOs would have 

suffered rating downgrades during the 

technology bust in 2001/2002; mark to 

market losses might even have 

approached the cash-out threshold 

for the most leveraged transactions. 

CPDOs would have fared better 

through the Russian debt default in 

1998 when spreads blew out only 

briefly. “If the structure does not get 

stopped out, it can withstand 

temporarily wider spreads as long as 

they snap back,” he says,“It will look 

ugly on a mark to market basis for a 

while before it recovers.” 

Although increasing leverage to 

recoup from losses looks like 

throwing good money after bad, the 

mechanism does tend to reduce 

volatility. Losses occur when spreads 

widen or defaults tick up, so CPDOs 

increase leverage when spreads are 

high and cut it when spreads are low. 

That is the exact opposite of CPPIs, in 

which leverage increases as spreads 

tighten and falls when they widen — 

a counterintuitive buy-high sell-low 

approach that encourages trendfollowing 

momentum trading. 

The CPDO advantage disappears if 

it triggers a cash-out, however. 

“Whether it’s a CPDO or CPPI, you 

have a tremendous amount of credit 

leverage that can get unwound very 

quickly in widening spread 

environments or panic scenarios,” 

Ivascyn says. 

The CPDO structure may soon be 

applied to other credit classes, 

including high-yield, emerging 

markets and asset-backed securities, 

ABN Amro’s Feachem says. Bankers 

are already working on managed 

transactions, in which a bespoke 

collateral pool replaces the credit 

default swaps in the indices. 

Managed collateral helps investors 

diversify their portfolios because it 

distinguishes one transaction from the 

next, whereas all index-related 

CPDOs have the same underlying 

credit exposure. Managed deals get 

away from slavish adherence to the 

index rollover date, too, which should 

reduce transaction costs. The 

enthusiastic investor reception of 

CPDOs and frenetic pace of 

innovation are sure to spur additional 

developments during 2007. 

HOW A CPDO WORKS 

Dan Ivascyn, an executive vice president and 

portfolio manager at PIMCO in Newport 

Beach, California, says CPDOs combine the 

excess spread accumulation developed to build 

credit support in rated CDO equity tranches 

with the high leverage embedded in super 

senior CDO tranches. He notes that although 

the six-monthly index rollover purges weak 

credits, the portfolio may still suffer realised 

losses. Photograph kindly supplied by 

PIMCO, February 2007. 

The financial alchemy behind a CPDO relies on a dynamic leverage 

mechanism. At the outset, the present value of future payments, 

including coupons at LIBOR plus a margin of up to 200 bps and a 

bullet payment at maturity, exceeds the proceeds of the CPDO note issue, 

or net asset value (NAV). To fund the shortfall, the sponsor uses the 

proceeds of the note issue as collateral to support short sales of the onthe-run 

5-year CDX and iTraxx investment grade credit default swaps 

index components at an initial leverage ratio of 15:1. The collateral pays 

LIBOR, and if, for example, the initial index spread is 40 bps, the credit 

default swaps generate a 600bps spread over LIBOR, of which 200 bps are 

paid to note holders. The excess spread builds up the NAV over time to 

cover the shortfall and acts as a buffer against potential defaults. The 

leverage cap, which is a function of NAV and credit spreads, is designed 

to protect the sponsor against the possibility that the NAV could fall 

below zero if credit spreads blow out and/or the default rate ticks up 

dramatically, the so-called gap risk. If the NAV drops to 10% of par — the 

cash-out point — the structure is unwound and note holders receive 

whatever is left after the sponsor has bought back the credit default swaps 

that are still on the books. 


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SHORT TERM BENCHMARK INDEX PERFORMANCE 

12 

Index Review 

Can the FTSE 100’s 

bull run continue? 

Many analysts are calling for a renewed surge in commodity 

prices after ‘me too’ investors have been finally pushed out of 

the sector. News of two major hedge fund disasters in the copper 

market is, in all probability, just the tip of the iceberg, hiding a 

good deal of other poor performances elsewhere. Even the 

renowned Goldman Sachs took a heavy hit on its commodity 

funds. With support holding in gold and silver and traders 

hoping for a floor in copper at around 23,000, there is 

confidence returning to the mining sector which may well give 

the FTSE 100 a sunnier outlook than in 2006. Simon Denham, 

managing director of spread betting firm Capital Spreads, looks 

at the short term outlook for benchmark indices. 

WITH INTEREST RATES now 

at 5.25%, some 

commentators have begun 

to worry that the Monetary Policy 

Committee (MPC) is fighting the 

wrong battle. Most inflation in the 

pipeline has been caused by factors 

beyond the control of interest rates— 

things such as energy, food and 

taxation. The likelihood is that these 

will fall out of the consumer price 

index (CPI) as time decay works its 

magic. Unfortunately, in raising rates, 

the MPC has re-awakened underlying 

wage demand as workers with 

mortgages and loans to pay look at 

their increased outgoings and want 

more money. 

If the rate increases actually ignite 

secondary inflationary pressures, then 

the Bank of England could be in for a 

longer, harder battle than if they had 

left rates quietly unchanged at 4.5%. 

Add to this mix a government not 

famed for its strength in reining in 

public sector spending. Consequently, 

the central bank will unlikely get help 

from this quarter. Money supply 

remains at historically high levels. 

Furthermore, Chancellor and premierin-waiting 

Gordon Brown will not 

want his first act in office to be the 

unpopular one of tightening the 

public purse. The budget deficit is 

forecast at something in the region of 

£20bn this year. Something tells me 

that this may get much bigger before 

the brakes are applied. 

Like other benchmark indices, the 

FTSE 100 has had an almost unbroken 

bull run since early 2003—even the 

market correction back in May of last 

year failed to break the major weekly 

upward trend line. We are now 

pushing the Bollinger band envelope 

at 6375. In the past, unless the bands 

have been on a steep upward trend, 

this has been something of a sell 

indication. However, over the last six 

weeks or so we have noted a lack of 

enthusiasm in taking the market 

higher. At the start of 2006, the DAX 

was 200 points or so below the FTSE 

100. It now stands over 500 points 

higher and, since the peaks of May last 

year, for all of the merger mania, the 

FTSE has rallied just 3.4% against 

7.7% for the Dow and 8.3% for the 

Simon Denham, managing director, Capital 

Spreads. Photograph kindly provided by 

Capital Spreads, December 2006. 

S&P.The question is: will the UK index 

start to recoup some of this deficit or 

are there other factors at work? 

One pointer to note is the base rate, 

which has gone up by 0.75% since the 

last US squeeze and the 

corresponding rise in Sterling. The fact 

is that to a US or Far Eastern investor, 

buying in dollars or Yen, Britain looks 

decidedly pricey. Another major 

influence has been the commodities 

markets. For all of the headline 

grabbing comment, gold, oil, copper, 

and heating oil for example, are 

actually substantially below levels 

seen mid-way through 2006. In turn, 

this has seriously impacted on some 

of the real heavyweights in the FTSE 

100—including Billiton, Rio Tinto and 

Shell. But the big sheet anchor has 

been BP which has, all on its own, 

kept the FTSE 100 lower by some 190 

points since April 2006. 

In all of this there is also the 

anomaly that is the US Volatility Index 

(VIX). Overall volatility has been 

drifting downhill for the last few years 

and VIX is flirting with the 10% level. 

This is a historically low level just as 

the markets are all rallying to, if not all 

time highs (certainly 5 or 6 year 

highs). In times past a low VIX has 

preceded a period of extreme price 

action (generally to the down side) as 

option strategies have tightened to 

strike prices that are increasingly close 

to the current levels in an attempt to 

maintain sale revenues. It is this 

potential for a rolling attack on 

cheaply sold PUTs that has some 

commentators worried. 


NEW INVESTMENT APPROACHES THAT MIMIC HEDGE FUNDS 

14 

In the Markets 

A MOVEABLE FEAST 

All three products use factor models that solve for the closest correlation between the 

performance of the average hedge fund and a basket of investable market benchmarks. The 

developers built on academic studies that analysed hedge fund returns from a performance 

attribution perspective.“We turned that on its head,” says Michael Dellapa, director of 

investment research at Rydex,“If it’s useful for explaining performance, then it’s useful for 

building products as well.” Photograph supplied by Dreamstime.com, February 2007. 

AS MAINSTREAM PRODUCT 

developers deconstruct hedge 

fund returns into idiosyncratic 

(alpha) and market-related (beta) 

components, they are finding cheaper 

ways to capture hedge funds’ 

performance attributes. At the same 

time, traditional managers are offering 

modestly leveraged long-short 

portfolios that encroach directly on 

turf that was once the exclusive 

preserve of hedge funds. 

New investment approaches 

typically take root among institutions 

before they reach retail investors, but 

synthetic hedge funds are an 

exception. The first products offered in 

the US came from Rydex Investments, 

a Rockville, Maryland-based 

quantitative money manager that 

distributes mutual funds to retail 

investors primarily through 

independent financial advisors. 

Rydex launched its Absolute Return 

Strategies Fund and Hedged Equity 

Fund in September 2005, almost a 

year before the Merrill Lynch Factor 

Index (MLFI) came to market aimed 

at institutional investors. A similar 

product, the Goldman Sachs Absolute 

Return Tracker (ART) fund, debuted in 

Europe last autumn and will be 

offered it to institutions in Asia and 

North America as soon as it complies 

with local regulatory requirements. 

All three products use factor models 

that solve for the closest correlation 

between the performance of the 

average hedge fund and a basket of 

investable market benchmarks. The 

developers built on academic studies 

that analysed hedge fund returns from 

In the classic science fiction 

movie Invasion of the Body 

Snatchers pod people replicate 

the human hosts they destroy 

in every respect but one: the 

substitutes are devoid of 

emotion. Today, the hedge 

fund industry faces a similar 

invasion of synthetic products 

that purport to mimic the 

performance of hedge funds 

by investing in liquid indexrelated 

derivatives that owe 

nothing to human judgement. 

It is a sign that the line 

between traditional investment 

managers and hedge funds is 

beginning to blur. Neil 

O’Hara reports. 

a performance attribution perspective. 

“We turned that on its head,” says 

Michael Dellapa, director of 

investment research at Rydex,“If it is 

useful for explaining performance, 

then it is useful for building products 

as well.” 

In addition to equity, fixed income 

and commodity indices, Rydex 

incorporates skill-based factors 

including market neutral; value, 

growth and size exposure; stock- and 

industry-level momentum; merger 

arbitrage; and credit default swaps. 

Even though Rydex limited its 

universe to investable vehicles, it was 

able to generate return streams that 

closely match those derived from the 

increasingly utilised Fama-French 

performance attribution model, which 

contains non-investable elements. For 


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16 


example, to generate an investable 

value factor, Rydex ranks the 

components of the Standard & Poor’s 

900 Index by conventional value 

measures including price to book, 

price to earnings and price to cash 

flow. It buys the top ranked names 

and sells short lower ranked names in 

the same industries to create a valuebiased 

basket. Rydex uses OTC 

derivatives to capture other skillbased 

factors not susceptible to the 

basket approach. 

At 1.4%, the Rydex funds charge 

fees comparable to long-only mutual 

funds but far lower than funds of 

hedge funds, which typically levy a 

1% management fee and 10% 

performance fee on top of the 1% to 

2% management fees and 20% 

performance fees for the underlying 

Michael Dellapa, director of investment 

research at Rydex says that developers built on 

academic studies that analysed hedge fund 

returns from a performance attribution 

perspective.“We turned that on its head [at 

Rydex],”he says “If it is useful for explaining 

performance, then it’s useful for building 

products as well.” Photograph kindly provided 

by Rydex, February 2007. 

hedge funds. It even undercuts 

investable hedge fund indices, the 

cheapest funds of hedge funds, which 

still have to pass through fees on the 

constituent hedge funds. 

The low fees will help offset any 

tracking error between returns on the 

funds and the Dow Jones Hedge Fund 

indices against which they are 

benchmarked. Rydex does not 

pretend to match the performance 

exactly, but since inception it has 

achieved a better than expected 85% 

correlation.“We are trying to deliver at 

the retail level the essential franchise 

of hedge funds: that is, over time, 

some level of absolute return using 

strategies that don’t have high degrees 

of correlation with equity strategies,” 

says David Reilly, Rydex’s director of 

portfolio strategy. The firm is just 

beginning to attack the institutional 

market and sees its first mover 

advantage in synthetic hedge funds as 

an important part of that push. 

The Merrill Lynch and Goldman 

Sachs products use different factors 

but are otherwise similar in concept. 

As befits products aimed at 

institutional investors, fees are lower: 

total expenses for the MLFI come in a 

little less than 1%, while the Goldman 

Sachs ART charges a 1% management 

fee plus administrative expenses. 

Merrill Lynch’s model tracks its 

benchmarks better than Rydex does, 

too; in back tests, the MLFI achieved 

90%+ correlation to a composite of 

hedge fund indices over 10 years and 

95%+ in the most recent periods. 

According to Jeffrey Gabrione, head 

of Americas manager research at 

Mercer Investment Consulting in 

Chicago, synthetic hedge funds 

compete most directly with investable 

hedge fund indices, which parcel 

investors’ money out to the 

constituent hedge funds in proportion 

to their weighting in the index. Both 

products aim to deliver hedge fund 

William Crerend, chief executive officer of 

EACM Advisors, a fund of hedge funds 

manager based in Norwalk, Connecticut. He 

believes synthetics and 130/30 portfolios 

compete mainly against long-only or long 

biased hedge fund strategies. In effect, 

traditional products that most closely resemble 

hedge funds are nipping at the heels of hedge 

funds that are the least different from 

traditional investments.“The more truly hedged 

and skill-based a product is the more difficult it 

is to track reliably through some basket,” 

Crerend says. Photograph kindly supplied by 

EACM Advisors, February 2007. 

beta, the performance of the average 

hedge fund; neither can substitute for 

the excess return, or alpha, generated 

by top hedge fund managers. With 

lower fees, the synthetics need only 

come close to matching the 

performance of investable indices to 

gain market share based on price. 

“Clients are willing to pay for alpha, 

but they are less and less willing to 

pay for beta,”Gabrione says. 

Although Gabrione foresees 

increasing acceptance of synthetics, 

he expects traditional money 

managers will make greater inroads 

on hedge fund turf with another 

product, the leveraged long-short 

portfolio. In most cases, these 

portfolios—typically 130% long and 

30% short—generate additional alpha 

from the underlying long-only 

strategy for the same level of risk. 

Although 130/30 managers do sell 

short individual stocks, Gabrione 

believes they are more interested in 

leveraging returns on the long side, 

rather than looking for alpha on both 

sides the way a long-short equity 

hedge fund manager does. 

The 130/30 portfolios don’t have the 

same flexibility as hedge funds, either. 


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18 


Institutions expect them to deliver a 

leveraged return relative to a 

benchmark, not an absolute return. 

It’s a strategy for which the leverage 

can be tailored to meet specific 

objectives, too. Fees are higher than 

for long only portfolios but lower than 

true hedge funds, Gabrione says; 

around 0.75% management fee plus a 

10% performance fee, for example, 

although some managers forgo the 

performance fee in exchange for a 

higher management fee. 

Todd Trubey, a mutual fund analyst 

at Morningstar in Chicago, believes 

the 130/30 strategy appeals primarily 

to institutions, which often favour 

diversified portfolios with a precise 

risk reward profile. Although it has 

proved popular among retail investors 

in Europe, he knows of only one retail 

mutual fund in the United States, the 

ING 130/30 Fundamental Research 

Fund, which has attracted just $10m 

Jeffrey Gabrione, head of Americas manager 

research at Mercer Investment Consulting in 

Chicago, thinks that synthetic hedge funds 

compete most directly with investable hedge 

fund indices, which parcel investors’ money out 

to the constituent hedge funds in proportion to 

their weighting in the index. Both products aim 

to deliver hedge fund beta, the performance of 

the average hedge fund; neither can substitute 

for the excess return, or alpha, generated by top 

hedge fund managers. Photograph kindly 

supplied by Mercer Investment Consulting, 


since its launch in April 2006. 

The 130/30 concept is a natural 

evolution for traditional asset 

managers and their easiest entry into 

alternative assets classes, according to 

William Crerend, chief executive 

officer of EACM Advisors, a fund of 

hedge funds manager based in 

Norwalk, Connecticut. He believes 

synthetics and 130/30 portfolios 

compete mainly against long-only or 

long biased hedge fund strategies. In 

effect, traditional products that most 

closely resemble hedge funds are 

nipping at the heels of hedge funds 

that are the least different from 

traditional investments. “The more 

truly hedged and skill-based a 

product is the more difficult it is to 

track reliably through some basket,” 

Crerend says. 

Factor models like synthetic hedge 

funds rely on historical data to 

determine the weighting for each 

factor. It is like driving by the rearview 

mirror. It works well enough on a 

straight road but it is hard to navigate 

around corners, let alone a hairpin 

bend. EACM finds that algorithmic 

investment strategies—used for years 

by commodity trading advisors and 

others—do not readily adapt to 

change, whether it is a new 

environment not reflected in past data 

or a market inflection. “It is the 

Achilles heel of these strategies,” 

Crerend says, “The ability of skilled 

active managers to run dynamic 

portfolios has proven very challenging 

to replicate.” Algorithm-based 

managers must clear a higher hurdle 

than others to win a place in EACM’s 

portfolios as a result. 

To Charles Gradante, managing 

principal at Hennessee Group, a 

hedge fund consultant based in New 

York, synthetic hedge funds have as 

much — and as little — to offer as 

other algorithms he has watched 

come and go on Wall Street over the 

David Reilly, Rydex’s director of portfolio 

strategy says,“We are trying to deliver at the 

retail level the essential franchise of hedge 

funds: that is, over time, some level of absolute 

return using strategies that don’t have high 

degrees of correlation with equity strategies.” 

The firm is just beginning to attack the 

institutional market and sees its first mover 

advantage in synthetic hedge funds as an 

important part of that push. Photograph kindly 

provided by Rydex, February 2007. 

past 20 years. The successful ones 

make a splash for a year or two until 

market conditions change and the 

models no longer deliver consistent 

performance. Even if synthetic hedge 

funds prove an exception, which 

Gradante doubts, they will only 

deliver returns comparable to hedge 

fund indices.“I do not see where the 

alpha is coming from in using 

algorithms, especially because they 

are based on historical data,”he says. 

Gradante bristles at the idea that 

hedge funds—real or synthetic— 

deliver absolute returns, too. “I am 

very surprised that Goldman is using 

that term.There is no such thing as an 

absolute return strategy, one that 

always delivers positive returns,” 

Gradante says. He believes absolute 

return is a misnomer for the low 

correlation between the performance 

of hedge funds and traditional asset 

classes. Still, he recognises that for 

investors seeking hedge fund beta 

synthetics will be a winner based on 

price — provided their performance 

does match investable hedge fund 

indices. The acid test for the body 

snatchers will come when the 

markets encounter a systemic 

problem—the financial equivalent of 

a hairpin bend. 



ERISA exemption creates new SecLending 

opportunities for pension plans 

2007 ushered in a new era for US pension plans and custodians, thanks to regulatory changes that are 

opening the door to lending portfolio securities in select foreign jurisdictions. By Michael P McAuley, 

senior managing director and chief product officer for State Street’s Securities Finance business. 


Global custodians have significant experience 

in processing securities lending transactions 

with foreign borrowers and holding foreign 

collateral on behalf of other US and non-US 

clients. With the DOL exemption, they can 

now leverage this infrastructure and 

experience to assist US pension plans in 

conducting securities lending transactions in 

foreign markets and accepting foreign 

collateral. Photograph supplied by 

Dreamstime.com, February 2007. 

IN LATE 2006, the United States’ 

Department of Labor (DOL) issued 

prohibited transaction exemption 

(PTE) 2006-16 under the Employee 

Retirement Income Security Act of 

1974 (ERISA). The new PTE, which 

allows pension plans to both lend 

securities outside the US as well as 

accept certain foreign collateral, took 

effect on January 2nd 2007. 

Plan sponsors and fiduciaries are 

already exploring ways to take 

advantage of potential opportunities 

created by the new class exemption. 

By enabling pension plans to better 

utilise their securities inventory, the 

foreign lending exemption should 

increase lending activity. 

For custodians, the new exemption 

should result in an increase in 

securities lending activity in pension 

plan portfolios. US pension plans can 

take comfort in the fact that global 

custodians have been supporting this 

type of non-US securities lending 

activity for many years. Global 

19 

SECURITIES LENDING

SECURITIES LENDING 

20 


Michael P McAuley, senior managing director 

and chief product officer for State Street’s 

Securities Finance business. McAuley writes: 

“For market participants, the DOL class 

exemption represents the culmination of years of 

effort to bring US securities lending rules in line 

with the reality of today’s global financial 

markets.” Photograph kindly supplied by State 

Street, February 2007. 

custodians have significant experience 

in processing securities lending 

transactions with foreign borrowers 

and holding foreign collateral on 

behalf of other US and non-US 

clients. With the DOL exemption, they 

can now leverage this infrastructure 

and experience to assist US pension 

plans in conducting securities lending 

transactions in foreign markets and 

accepting foreign collateral. 

Prior to the new PTE, pension plans 

that had portfolios of foreign fixed- 

income securities—such as sovereign 

bonds—had little or no opportunity to 

lend those securities, due to a lack of 

demand from US borrowers. This 

asset class should now generate 

additional lending opportunities due 

to increased demand as pension plans 

add foreign borrowers to their list of 

approved borrowers. Moreover, plans 

will in many cases now be permitted 

to accept collateral denominated in 

the same currency as the foreign 

securities they are lending. This will 

eliminate the foreign exchange 

component of the collateral process. 

It may also provide new cash collateral 

investment opportunities. 

New PTE levels the playing field 

For market participants, the DOL 

class exemption represents the 

culmination of years of effort to bring 

US securities lending rules in line 

with the reality of today’s global 

financial markets. Following the 

initial 1981 ERISA class exemption 

(PTE 81-6) that set out the 

requirements for securities lending by 

US pension plans, lending activity has 

steadily grown along with the 

evolution of financial markets. With 

this growth, custodians built 

securities lending programmes and 

infrastructure for their clients that 

were not regulated by ERISA. 

Since the initial exemption in 1981, 

the US gradually fell behind other 

countries in the regulation of 

securities lending by pension plans. 

Plan sponsors in the US have long 

faced more restrictive securities 

lending requirements than foreign 

plans, which in many cases are limited 

only by potential cross-border tax 

concerns. Therefore, along with new 

opportunities for greater utilisation, 

the new exemption also affords 

another welcome benefit for US plan 

sponsors—a more level playing field 

versus foreign plans. 

In addition, global custodians can 

now lend securities for US pension 

plans utilising the experience and 

infrastructure developed over the 

intervening years. 

An additional safety net 

Interestingly, the DOL’s new PTE 2006- 

16 is not the only recent change that 

provides new opportunities for pension 

plans to expand securities lending. In 

2006, Congress re-wrote parts of ERISA 

itself, adding a new service provider 

exemption. Practitioners are still 

debating the scope of this new 

provision. However, once some of the 

issues surrounding its requirements are 

clarified, many believe that it will 

provide plans with a statutory 

exemption that will be easier to comply 

with and allow all types of securities 

lending transactions, including 

transactions not currently permitted 

under the new class exemption. 

In the interim (because the DOL’s 

class exemption is more detailed in its 

language and requirements) pension 

plans are more likely to use it as their 

regulatory map—even with its 

narrower provisions, until the 

requirements of the service provider 

exemption are clarified. 

That is not to say that pension plans 

will not immediately benefit from the 

ERISA revisions. Even with the DOL 

exemption as their regulatory map, 

pension plans will still have the new 

statutory exemption as a reassuring 

“safety net” of authority for their 

broader lending practices. Provisions 

offer plans direct access to 

international lending. 

The DOL’s new class exemption 

includes two key provisions. US 

pension plans can now lend directly 

to certain broker-dealers and banks 

outside the United States, specifically 

in the United Kingdom, Canada, 

Japan, Germany, the Netherlands, 

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22 


Australia. Qualifying foreign banks 

must have equity capital of at least 

$200m and be subject to regulation by 

the relevant banking agencies in their 

home country. Similar qualifications 

are required of foreign broker-dealers, 

including equity capital of at least 

$200m. Plans can now accept certain 

foreign collateral, as well as an 

expanded list of US collateral linked 

to SEC Rule 15c3-3. 

Prior to the DOL exemption, 

pension plans could only lend to US 

borrowers, except in a few instances 

where the DOL granted individual 

exemptions. In selecting countries 

eligible for direct foreign lending, the 

DOL looked at countries for which it 

had previously granted individual 

securities lending exemptions. 

For pension plans to lend to 

borrowers in permissible jurisdictions 

other than the United Kingdom and 

Canada, the exemption requires plans 

to have a borrower default 

indemnification (indemnity) from a 

US bank or broker-dealer lending 

fiduciary. For the United Kingdom and 

Canada, borrowers must agree to 

submit to US jurisdiction, appoint an 

agent for service of process in the US 

and agree to settle disputes 

exclusively in US courts. Otherwise, 

an indemnity from a US bank or 

broker-dealer fiduciary is also 

required. The new exemption also 

applies to security loans that are 

structured as repurchase agreements, 

provided all conditions and 

requirements are met. 

Expanded collateral requirements 

Beyond opening the doors to securities 

lending in these foreign jurisdictions, 

the DOL also broadened collateral 

rules to allow pensions plans to 

participate in more loans. First, the 

DOL linked the new collateral 

requirements to SEC Rule 15c3-3, 

expanding ERISA’s original collateral 

limits — US Treasury securities, US 

dollar cash or letters of credit—to 

include, in part, certain debt securities 

issued by US governmental agencies 

(e.g. Fannie Mae), CMOs, assetbacked 

securities and corporate debt. 

Moreover, plans will in 

many cases now be 

permitted to accept 

collateral denominated in 

the same currency as the 

foreign securities they are 

lending. This will eliminate 

the foreign exchange 

component of the collateral 

process. It may also provide 

new cash collateral 

investment opportunities. 

Second, four types of foreign 

collateral are permitted under the new 

class exemption: 

• Debt securities backed by a multilateral 

development bank (e.g. the 

European Bank for Reconstruction 

and Development, the Asian 

Development Bank) 

• Highly rated foreign sovereign debt 

securities 

• Cash in Euros, Sterling, Canadian 

Dollars, Swiss Francs, or Japanese 

Yen 

• Letters of credit issued by a foreign 

bank meeting specified criteria. 

These broadened collateral rules not 

only allow pension plans to 

participate in more loans, but, in 

many cases, plans can also realise 

marginally more lending income. 

This income will be a result of 

borrowers no longer needing to go 

beyond their inventory as frequently 

when obtaining and financing the 

necessary collateral for a securities 

loan as well as reducing the cost of 

any such financing. 

Under the DOL exemption, the 

following minimum collateral levels 

are now required. US collateral must 

be 100% of the market value of the 

loaned securities. Foreign collateral, if 

denominated in the same currency as 

the loaned securities, must equal at 

least 102% of the market value of the 

loaned securities — unless the 

lending fiduciary is a US bank or US 

broker-dealer providing the plan with 

an indemnity. With an indemnity 

from a US bank or broker-dealer, the 

minimum foreign collateral is reduced 

to 100%. 

Foreign collateral denominated in a 

currency different than the loaned 

securities must equal at least 105% of 

the market value of the loaned 

securities. However, with an 

indemnity from a US bank or brokerdealer, 

the minimum foreign collateral 

is reduced to 101%, provided that the 

collateral is in Euros, Sterling, 

Japanese Yen, Swiss Francs or 

Canadian Dollars. 

For collateral in all other currencies, 

the minimum remains 105%, even 

with indemnification. Experienced 

agents can best support lending 

growth The new opportunities 

presented by the DOL class 

exemption have spurred plan 

sponsors and fiduciaries into action. 

Plans are reviewing their portfolios for 

foreign lending opportunities, and, to 

smoothly effect the expanded lending, 

will be seeking out global service 

providers with the most extensive 

experience working with foreign 

broker-dealers and dealing with 

cross-border legal and tax concerns. 

Sorting through their options may 

add a layer of complexity for pension 

plans. However, one thing is certain. 

The new opportunities for greater 

securities utilisation and provides 

worthwhile motivation. 


Face to Face 

JPMORGAN TAKES 

A NEW TURN IN 


The convergence of mainstream investment strategies with 

hedge fund strategies is a pivotal element in the growth outlook 

for securities lending and all growth projections for the industry 

are upward. However, regulatory and competitive challenges in 

the industry at large, now call for new approaches to the service 

mix. Sandie O’Connor, JPMorgan’s global head of securities 

lending, for one, wants the bank to focus on client delivery and 

break out of its traditional custodian mould and offer securities 

lending services to those clients who do not have a custodial 

relationship with the firm. The focus is on elevated levels of 

client service to a broader customer base, giving its non-custody 

securities lending clients access to its distributional strength and 

risk management expertise. 

IN EARLY FEBRUARY, the New York 

State Teachers’ Retirement System 

(NYSTRS), the second largest public 

retirement system in New York State 

and one of the top ten by size in the US, 

selected JPMorgan Worldwide 

Securities Services as its first noncustody 

lending agent for fixed income 

securities totalling $12bn. While 

something to celebrate in itself, the 

agreement signals a sea-change in 

JPMorgan’s approach to the provision 

of securities lending services. 

Until a few years ago the securities 

lending market was straightforward. 

Asset managers and beneficial owners 

bundled their custody and securities 

lending mandates. Custodian 

providers, such as JPMorgan, State 

Street, Citigroup and Northern Trust, 


competed with each other on price, 

knowing they could pick up additional 

fee revenue for lending securities in 

their portfolio on a ‘best efforts’ basis. 

Even today, custodian lenders benefit 

from the tendency of asset managers to 

outsource all or part of their back office 

operations, with securities lending 

mandates often attached to the overall 

package. It was and remains a degree of 

‘stickiness’ in the business that allows 

custodian lenders to retain a 

substantial, even dominant, role in the 

overall securities lending marketplace. 

Like State Street, JPMorgan now 

wants to play in an increasingly diverse 

and complex marketplace as an agent 

lender to both custody and noncustody 

clients. In part, the move 

recognises that third party lending 

operations, such as Dresdner Kleinwort 

Wasserstein (DKW), that do not 

provide custody services, have been 

steadily picking up market share over 

the last few years. Some of that 

business has come from new clients 

bringing in new liquidity. Some has 

come at the expense of custodian 

lenders. The market is further 

complicated by the rise of specialist 

securities lending auction houses, such 

as eSecLending and direct market 

access (DMA) by pension giants, such 

as Holland’s Robeco, which have both 

in-house expertise and regulatory 

approval to participate in the market. 

Distribution capability, operational 

strength and innovative technology are 

key buzz words in the vocabulary of 

Sandie O’Connor, managing director 

and global head of the securities 

lending and execution products 

business of JPMorgan Worldwide 

Securities Services. O’Connor is 

responsible for domestic and 

international securities lending, foreign 

exchange, futures and options clearing 

and transition management and is 

focused on positioning the Securities 

Lending and Execution Products 

business for growth. 

O’Connor’s latest initiative in 

delivering market facing product is to 

break JPMorgan to out of its traditional 

23 

JPMORGAN’S NEW TAKE ON SEC LENDING

JPMORGAN’S NEW TAKE ON SEC LENDING 

24 

Face to Face 

custodian lender mould — a move 

driven largely by market forces. “We 

think that securities lending clearly 

provides value independent of custody. 

Securities lending is not processing, it is 

about risk management and 

distribution capability,” maintains 

O’Connor. It is that thinking that 

delivers JPMorgan a ‘win-win’equation, 

adding, “We continue to value our 

custody clients who are part of our 

securities lending programme, and 

these relationships enable us to be key 

suppliers in the marketplace. But why 

not offer services in securities lending 

to those institutions that have their 

assets under custody elsewhere?” 

Increasing levels of demand for 

securities from prime brokers and 

hedge funds crystallises the need for 

beneficial owners and asset managers 

to better leverage their investments by 

providing access to their assets and 

generating incremental returns. Today’s 

increased transparency demands high 

levels of performance from agent 

lenders and more balanced splits 

between lenders and beneficial owners. 

The advantages of working with the 

bank, says O’Connor, include, “A 

customised lending programme 

tailoring risks and returns for each 

beneficial owner, access to an efficient 

operating infrastructure (even if they do 

not have assets under 

custody with us) and the 

benefit of scale, including 

our global distribution and 

depth of firmwide 

resources. However, that 

expertise and product 

offering is not enough. We 

need to make it easy for 

broker dealer and 

beneficial owner clients to 

deal with us. We are 

raising the bar with all the 

clients that we serve.” 

This 360 degree or 

around the clock/around 

the globe client service dedication is 

increasingly important, she thinks, 

particularly as the main area of focus 

around the global securities lending 

business during the last year and a half 

are regulatory and tax issues. MiFid 

and Basel II have focused everyone on 

transparency and infrastructure 

capacity. Additionally the debate on 

corporate governance is continuing to 

impact the industry. The biggest issue 

arguably is the Agent Lender 

Disclosure Initiative (ADLI), an SEC 

ruling that came into effect last 

October, which ensures that the 

identity of beneficial owners is known 

to the securities borrowers. ADLI has 

placed more complex (and costly) 

requirements on agent lenders – with 

an attendant requirement on 

infrastructure and IT development; 

which some market watchers think will 

play into the strengths of the global 

players. O’Connor agrees and views 

JPMorgan’s move as the latest 

evolution in the business.“Everything is 

about creating the biggest pools of 

liquidity — something that is also being 

demanded by our client community.” 

That community says O’Connor is 

increasingly sophisticated and as a 

consequence is now focusing less on 

“how they get to market and more on 

what they get from the market.” 

Securities lending shifts up a gear 

3-Year Price Performance (USD Terms) 

160 

140 

120 

100 

80 

60 

Source: FTSE Group and Datastream, data as at 31 January 2007. 

Sandie O’Connor, JPMorgan’s global head of 

securities lending. Photograph kindly supplied 

by JPMorgan February 2007 

The issue for lenders then is flexibility 

and an-all encompassing service 

offering.“We leverage auctions, such as 

Equilend, and we do auctions from our 

own desks.” She believes that the most 

important developments lie around the 

significant increase in competition 

around derivatives, and she 

acknowledges that the bank’s eye, “is 

keenly focused on that competition, 

particularly in the area of credit default 

swaps which have replaced demand for 

corporate bonds and there’s more to 

come.” Equally, she says, “foreign 

exchange is becoming an increasingly 

important consideration for clients who 

are hedging future flows. We regularly 

ask ourselves, are we cutting edge in 

derivatives and can we help beneficial 

owners do more and achieve alpha? We 

forcefully answer in the affirmative.” 

Additionally, the emerging markets 

are an area of greater interest, most 

notably in Taiwan, though markets such 

as India, China, Russia and Brazil have 

all shown signs of developing an 

offshore securities lending 

framework. As securities 

lending grows at a dramatic 

pace, our clients can enjoy 

increased yield from their 

investments. According to 

O’Connor, today’s securities 

lending trends point to an 

eventual flight to quality and 

global strength. Yet, says 

O’Connor, even with scale 

and global reach on offer, the 

overarching requirement is 

quality of service. “We don’t 

take clients for granted,” 

notes O’Connor. 


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MIDDLE EAST: NEW ISSUES ADD TO SAUDI GROWTH STORY 

26 

Regional Review 

The Saudi Stock Exchange (Tadawul) all-share index (TASI) has tumbled from a high of 20,634 on 

the 25th February 2006 to a low of 6,916 by the end of January this year, a fall of 66%. For most 

economies a stock market fall of this magnitude would precipitate an equally severe downturn in 

retail and industrial activity, with a recession the most likely outcome. In Saudi Arabia the very 

reverse has occurred. Even the naturally cautious International Monetary Fund (IMF) predicts an 

increase in real GDP growth in Saudi Arabia to reach 6.5% this year, up from 5.8% last year. 

NEW ISSUES CALENDAR 

BUOYS SAUDI GROWTH 

Real estate is Saudi Arabia’s boom industry. An artist rendering released by Emaar Development in Riyadh, Saudi Arabian shows the Financial 

Island perspective of the planned King Abdullah Economic City in Jiddah. A consortium of three Saudi and Emirates companies plans to build a 

$26.7bn ($22.4bn) city on the Saudi Arabian seaside that is being called the largest-ever private development in the kingdom's history. Since the 

photograph was released, the project has been increased in size and the first foundations are now being laid. Photograph provided by Emaar, via 

Associated Press/EMPICs, February 2007. 

Y 

“ 

OU NEED TO distinguish 

between the real economy 

and the stock market,” 

explains Talal Al-Qudaibi, chief 

executive officer (CEO) of Riyad Bank. 

“While the stock market may have 

suffered significant falls to date we 

have witnessed very little spill-over 

effect on the wider Saudi economy. 

Retail spending appears to have held 

up well, the bank’s commercial lending 

to domestic firms has actually 

increased over this period and direct 

foreign investment by overseas firms 

into the Kingdom is at record highs.” 

Even so, the TASI remains 

stubbornly in the doldrums despite 

the efforts of the Capital Markets 

Authority (CMA), the local market 

regulator, to boost investor 

confidence. In January, Abdulrahman 

Al-Tuwaijri, chairman of the CMA 

announced the suspension of trading 

in two firms listed on the Tadawul as a 

result of financial losses, and stated 

that the CMA would apply similar 

actions against all listed firms with 

losses that exceed 75% of their capital. 

The CMA hopes this measure 

combined with others such as 

improved transparency of the market, 

and the re-introduction of IPO activity 

will have the desired effect. 



28 


The repercussions of these reforms 

have yet not been felt. All three firms 

that joined the Tadawul in January, 

Advanced Polypropylene Company 

(APPC), Al-Babtain Power and 

Telecommunication Co., and Fawaz 

Abdulaziz Alhokair Company suffered 

sharp falls from their offer prices, albeit 

in a market continuing to suffer falls 

across the board. Market watchers are 

nonetheless alive to the debut, and 

subsequent performance, of Malath 

Insurance, one of the 13 newly licensed 

insurance companies scheduled to list 

in February. Will Malath follow suit? Or 

will it buck the trend and show an 

uptick in the aftermarket? 

One issue under consideration to 

help stimulate the market is for the 

CMA to open the market to 

international investors. While GCC 

nationals and foreigners resident in the 

John Coverdale, CEO of Saudi British Bank 

(SABB) which directly (and now indirectly 

through its HSBC investment banking joint 

venture) has been responsible for seven of the 17 

initial public offerings (IPOs) on the Tadawul 

since the beginning of 2005 believes that 

allowing direct access by international 

institutional investors would have a number of 

benefits .Photograph kindly supplied by SABB, 


Kingdom are able to invest directly in 

the Tadawul, international investors 

from outside the region are restricted 

to investing indirectly through Saudi 

country funds. 

John Coverdale, CEO of Saudi 

British Bank (SABB) which directly 

(and now indirectly through its HSBC 

investment banking joint venture) has 

been responsible for seven of the 17 

initial public offerings (IPOs) on the 

Tadawul since the beginning of 2005 

believes that allowing direct access by 

international institutional investors 

would have a number of benefits .“As 

the largest stock market in the region 

institutional investors would most 

likely to always require at least some 

exposure to the market. As long-term 

value investors rather than short term 

speculators this should mean that 

some of the volatility we see today 

would be greatly reduced,”he says. 

Another knock-on effect of allowing 

international investors’ access to the 

Tadawul, thinks Coverdale, will be an 

improvement in the quality of research 

available to investors. “Currently the 

market is underserved in terms of the 

availability of company specific rather 

than broader macro and sector 

research.” Eisa Al-Eisa, managing 

director (MD) and CEO at Samba 

Financial Group agrees there is not 

enough public research available on 

the Tadawul—particularly on 

individual companies. However, he 

thinks, “there will be a natural 

evolution of the market, and I expect to 

see more quality research emerge with 

the growing competition among asset 

managers and investment companies. 

We fully plan to maintain our market 

leading position in research.” 

International investors would be 

keen for exposure to planned IPOs 

such as the Saudi Arabian Mining 

Company (Maaden) which is looking 

to raise between $1.9bn and $2.5bn in 

the third quarter to fund corporate 

Eisa Al-Eisa, managing director (MD) and 

CEO at Samba Financial Group agrees there 

is not enough public research available on the 

Tadawul— particularly on individual 

companies. However, he thinks,“there will be 

a natural evolution of the market, and I 

expect to see more quality research emerge 

with the growing competition among asset 

managers and investment companies. We 

fully plan to maintain our market leading 

position in research.” 

expansion. According to Maaden’s 

CEO, Abdallah E. Dabbagh, the money 

will be used to help to finance a 

phosphate production plant for 

fertiliser, and an aluminium project 

which have a predicted combined cost 

of $10bn. However the IPO in which 

Maaden will sell at least 40% of its 

stock to the public and possibly 10% to 

two government institutions will only 

be open to Saudi investors. 

As a result of the delay in the 

number of IPOs, there has been a 

significant increase in the number of 

private transactions. “Over the last 12 

months we have managed several 

private transactions of varying sizes 

with strategic investors. Of these, three 

would have been likely IPO candidates 

on the Tadawul”, explains Salman Al- 

Deghaither, head of investment 

banking, Gulf International Bank 

(GIB). He believes that there are a 

number of benefits to a private 

placement with a select number of 

high-net worth individuals prior to a 

future listing.“Just as with an IPO the 

company must have a strong future 

strategy but with a private placement 

the costs are much lower and it 

provides capital for the company to 

invest whilst allowing it time to bring 

its corporate governance and reporting 



30 


up to the exacting standards now 

required by the CMA. The result is a 

more profitable company with a more 

compelling ‘investment story’ for 

investors when the company does 

eventually come to market.” 

Saudi Arabia’s growing debt market 

also promises to be a draw for 

investors. A rush of corporate debt was 

expected in the second half of 2006, 

following Saudi Basic Industries Corp’s 

(SABIC’s) SR3bn issue in July last year. 

The introduction of the Sukuk law in 

the Kingdom has not led to a massive 

upsurge in new issues. However, both 

SABIC, the world’s largest chemical 

company by market value, and Saudi 

Aramco have publicly announced their 

commitment to issue more domestic 

debt in the future. Mutlaq al-Morished, 

SABIC’s chief financial officer, 

announced in early February that 

affiliates of SABIC could borrow as 

much as $9bn this year. SABIC 

meantime estimates it will invest as 

much as $30bn to boost output by 60% 

to 80m tonnes per year by 2012—up 

from 50m in 2006. SABIC has already 

appointed BNP Paribas, Arab Banking 

Corporation and Samba as financial 

advisers and lead arrangers for a 

$4.8bn loan for the Saudi Kayan 

project. It may be that, like the SABIC 

financing, it too is converted to a 

Sukuk. Aramco meanwhile has 

earmarked an even greater investment 

expenditure of $137bn for the period 

2006-2010. 

Project finance will again dominate 

the market in 2007. HSBC is heavily 

involved in project finance for the 

Saudi power and water sectors, 

advising on the Shuaiba 3, Shuqaiq 2 

and Ras Azzour. The SR9bn Shuaiba 3 

water and electricity production 

project, 110 km south of Jeddah and 

due to be operational in 2008, was 

awarded to a Saudi-Malaysian 

consortium, the Saudi-Malaysian 

Water and Electricity Company, on a 

build-operate-transfer (BOT) basis. 

The plant however will be owned and 

run by the recently established 

Shuaiba Water and Electricity 

Company (SWEC), the first private 

Saudi company for the production of 

water and electricity. It is 60% owned 

by the consortium, 32% by the Public 

Investment Fund and 8% by SEC. 

Initially, credit support is being 

provided by the Ministry of Finance 

but an IPO is planned to help finance 

the project. 

Although investor interest in 

issuances from quasi-utilities such as 

Aramco, SABIC and the Saudi Electric 

Company (SEC)—which is rumoured 

to be arranging an issuance for later in 

the year—remains buoyant, more 

keenly they expect the Kingdom's first 

sovereign issue to establish the 

ultimate benchmark for the Saudi 

market. The Saudi Arabian Monetary 

Agency (SAMA) is coy about its 

intentions, but local bankers believe it 

is preparing to launch its first sovereign 

issue sometime in 2007. 

The opportunity to arrange 

international financing for the 

Kingdom is one that is attracting 

attention from both within and outside 

the region. Estimates for the value of 

announced projects vary between 

$400bn and $1trn over the next 15 

years, figures well in excess of what can 

be funded by government and private 

sector resources alone. More 

pertinently for the banks, it adds up to 

a whole lot of fee income. The 

wholesale entry of bulge bracket banks 

into Saudi Arabia on the back of that 

potential business is well documented. 

Now, regional banks are also seeking a 

piece of that pie.“We have applied for 

an investment banking license to the 

CMA and are expecting to hear back 

shortly,” relates Douglas Dowie, CEO 

at National Bank of Dubai (NBD) 

which has recently invested heavily in 

its investment banking capabilities. 

Robert Eid, CEO, at Arab National Bank 

(ANB).The residential real-estate sector is 

expected to experience significant growth in the 

Kingdom over the next decade, providing “a 

significant new income stream for Saudi banks,” 

thinks Eid.“We believe that the next significant 

boost to banking growth in the Kingdom will be 

the financing of the residential real-estate 

market on which ANB is well placed to 

capitalise,”he adds. Photograph kindly supplied 

by ANB, February 2007. 

“With our presence in the Dubai 

International Financial Centre (DIFC) 

NBD is well placed to assist Saudi 

institutions seeking external financing 

through some form of listing on the 

Dubai International Financial 

Exchange (DIFX). 

In February one of Saudi Arabia’s 

leading residential real estate 

developers, the Riyadh-based Dar Al- 

Arkan Real Estate Company (DAAR) 

issued the first international Sukuk by 

a Saudi corporate. The three year 

$425m Sukuk Al-Ijara was listed on the 

DIFX and was lead-arranged by ABC 

Islamic Bank, Saudi-based Arab 

National Bank (ANB), Standard Bank, 

Unicorn Investment Bank and 

Germany’s WestLB all of whom also 

acted as book-runners and underwriters 

of the deal. DAAR is not new to 

accessing Islamic financing. In May 

2006, Samba arranged an SR810m 

Murabaha facility for the company to 

finance its Al-Qasser residential project 

in Riyadh. The company is currently 

involved in or planning over 20 

residential developments throughout 

Saudi Arabia and targets 

approximately 65,000 residential units 

by 2009. Overall DAAR estimates that 

the housing market in the Kingdom is 

expected to increase by 25% in 5 years, 

from 4.34m units in 2004 to 5.4m units 

in 2010. 



32 


Additionally, the residential realestate 

sector is expected to experience 

significant growth in the Kingdom over 

the next decade, providing “a 

significant new income stream for 

Saudi banks,” thinks ANB’s CEO, 

Robert Eid.“In recent years the banks’ 

have benefited from the development 

of the consumer credit market and 

following that the development of the 

capital markets. We believe that the 

next significant boost to banking 

growth in the Kingdom will be the 

financing of the residential real-estate 

market for which ANB is well placed to 

capitalise,” he adds. Recent data backs 

up Eid’s thinking. Borrowing levels in 

Saudi are relatively low with mortgage 

housing finance representing only 2% 

of GPD—opposed to 17% in Malaysia, 

50% in the USA, and 72% in UK. 

SABB’s Coverdale however 

maintains that the size of the existing 

loan market has been underestimated. 

“People did borrow money from the 

banks to finance land purchases and 

building costs but these were 

categorised as personal loans rather 

than as mortgage finance,” he says. 

Since SAMA issued new guidelines 

about the size and multiples allowed 

on personal loans this is no longer an 

option for potential home buyers. 

What is not in doubt, however, is the 

size of the potential market. “166,000 

new homes will have to be added to 

the housing stock every year just to 

keep pace with the growing Saudi 

population and this is before you take 

into the account any replacement of 

existing homes,” explains John 

Sfakianakis, chief economist, SABB. 

A further boost to the housing 

finance market should come from the 

new mortgage law which is expected 

before the end of year. While complete 

details are not yet known it is hoped 

the law will clarify some grey areas of 

property ownership and provide a legal 

framework which allow for the 

development of new mortgage 

products. However it is not for the lack 

of mortgage products which has held 

back the domestic housing market. 

Many banks already offer some form of 

mortgage products with both 

conventional and Islamic options 

available.“Riyad Bank already offer a 20 

year Murahaba Home Finance product 

which will is totally Shariah compliant 

and requires only a 5% deposit,” says 

Al-Qudaibi. “The problem is not the 

lack of finance available but a lack of 

housing stock.” 

Currently there is virtually no 

secondary housing market in Saudi 

Arabia. Traditionally houses are passed 

down from generation to generation 

without ever being placed on the open 

market. As there have been few large 

scale residential developments or 

secondary market, in order to buy a 

property a family has to purchase a plot 

of land, organise a contractor to 

construct the home and then attempt 

to arrange the provision of utilities.The 

fact that extended families have tended 

to live together in the property is 

reflected in an average property size of 

400 square metres. Add to this the fact 

that until recently, apartment buildings 

were managed and individual 

apartments were not for sale has 

meant that there have been significant 

barriers to young Saudi families 

wishing to purchase homes. 

To overcome the shortfall ANB is 

establishing a housing finance 

company in association with DAAR 

subsidiary Kingdom Installment 

Company (KIC), the International 

Finance Corporation (IFC) and the 

Housing Development Finance 

Corporation of India. ANB’s Eid 

believes that this “best of breed” 

approach has a number of benefits. 

“Firstly by teaming up with the most 

accomplished developer in the 

Kingdom we can ensure a steady 

supply of high quality homes. Secondly 

Talal Al-Qudaibi, chief executive officer (CEO) 

of Riyad Bank explains that,“While the stock 

market may have suffered significant falls to 

date we have witnessed very little spill-over 

effect on the wider Saudi economy.”Photograph 

kindly supplied by Riyad Bank, February 2007. 

the long-tenure involved in mortgages 

is not naturally suited to the traditional 

commercial banking model. HDFC has 

significant experience of the housing 

market and by separating this business 

out from the bank it allows the 

company to apply more suitable risk 

modelling and financing techniques 

whilst still leveraging our customer 

base. The result is that for the first time 

Saudi consumers will be able to look to 

the collective skills and expertise of a 

leading retail bank and a specialist real 

estate finance company to structure 

and make affordable Shariah compliant 

funding solutions for residential 

properties constructed by DAAR or any 

other reputable developer.” 

For investors seeking exposure to the 

Saudi real-estate market without 

actually buying bricks-and-mortar, 

Samba has launched a new Shariah 

Compliant Real Estate Fund, the first of 

its kind in the Kingdom under the 

umbrella of the Real Estate Investment 

funds bylaws and regulations issued 

recently by the CMA. “The fund’s 

activities cover several investment 

areas, such as acquiring and 

developing residential, commercial and 

investment lands for sale or lease; 

financing residential, commercial and 

industrial real estate projects and 

selling them in instalments, as well as 

other real estate financing need. The 

Fund will be eligible also to invest in 

equities of real estate companies” says 

Samba’s Al- Eisa. 


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MIDDLE EAST: REITS BEGIN TO ENTER THE MARKET 

34 


REITs on the STARTING BLOCK 

With no taxation in many Middle Eastern markets and restricted investment rules for foreign 

ownership of property in a number of nations, the incentives to develop regional real estate 

investment trusts (REITs) have remained limited. However, as analysts call for international 

investment standards in the Gulf to widen its global appeal and with Far Eastern exchanges 

trying to cash in on Shariah-compliant institutional products, REITs may yet have their place. 

Mark Faithfull reports. 

Khalifa Stadium in Qatar has put infrastructure to the fore in the development of its own property strategy and many of the projects were 

assigned to coincide with the Asian Games, which took place late last year. Photograph independently sourced by Mark Faithfull, February 2007. 

THERE HAS BEEN an awful lot of 

talk about real estate investment 

trusts (REITs) in the Middle East. 

However, despite a huge property 

boom in the region, there has been 

very little action.The Middle East is rife 

with enormous building projects, from 

the Las Vegas-style sprint to create a 

major leisure and shopping destination 

in Dubai, to the infrastructure and 

Asian Games led development of 

Qatar and the property-focused catchup 

being played in Abu Dhabi. Add to 

this a slew of schemes in Bahrain, the 

emergence of Egypt and particularly 

Turkey as investment attractive nations 

and the pending housing shortage in 

the Kingdom of Saudi Arabia (KSA) 

and any investment vehicle with a 

property bent would seem an 

enticing proposition. 

Even so, the fundamental appeal of 

REITs in the Western and Far Eastern 

markets in which they currently 

prosper is their charitable, tax free 

status. In a region where many energyrich 

nations charge no business or 

personal tax, and where foreign 

property ownership and investment 

opportunities are at best restricted and 

often not permitted at all, the wait for a 

suitable trust-based investment vehicle 

is still on. However, tentative first steps 

have been made into the MENA 

property market, where Gulf investors 

are the most active players. 

Financial liquidity is estimated at 

$2.3trn, of which $1.5trn is 

concentrated in the Gulf Co-operation 

Countries (GCC) alone. But tapping 

into this market without taking the 

risky step of direct property investment 


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has been difficult and so, in a 

bid to help create more 

internationally acceptable 

investment opportunities, the 

Dubai Financial Services 

Authority (DFSA) introduced 

rules permitting the operation 

of REITs within the Dubai 

International Finance Centre 

(DIFC) last August. 

The new rules enable the 

flotation of REITs in the 

region for the first time, using 

the Dubai International 

Financial Exchange (DIFX) in 

a bid to attract international 

banks, asset managers and 

insurers to a 110-acre cluster 

of buildings in central Dubai, 

operating under a Westernstyle 

regulator. Since opening 

in 2004, it has given licences 

to firms including Citigroup, 

Morgan Stanley and Credit 

Suisse Group. However, there 

has hardly been a rush of new 

REITs to pick from. Arabian 

Real Estate Investment Trust 

(AREIT)—a joint venture 

company majority-owned by 

HSBC Bank Middle East and 

Daman—has confirmed but 

not fulfilled plans to list on a regional 

stock exchange such as Dubai Financial 

Market (DFM) and DIFX, some time in 

the “near future”. The $200m fund is 

currently registered in the Cayman 

Islands. “The GCC market is evolving 

fast and as laws regarding ownership 

become clearer we hope to launch 

funds which will be open to wider 

investor base that will be listed on 

regional stock exchanges,” says AREIT 

managing director Stephen Atkinson. 

AREIT plans to invest primarily in 

developed commercial and specialised 

properties in the GCC region in order 

to maximise stable cash flow.“The fund 

will focus on acquiring developed 

properties in the GCC region that 

Central Market is an upcoming scheme by Aldar Properties, 

which combines A-office space with traditional retail and a hotel 

as Abu Dhabi invests heavily in real estate projects, fuelled by 

energy riches and a desire to offer an alternative work, leisure and 

holiday destination to Dubai. Photograph independently sourced 

by Mark Faithfull, February 2007. 

combine cash flows with potentially 

strong capital gains over a five to seven 

year time horizon. The fund will target 

returns in the region of 15% IRR to 

investors,”declared Atkinson. 

Another potential fund emerged in 

December when Macquarie Bank, 

Australia’s largest securities firm, 

confirmed plans to start a $2bn UAE 

REIT with local partners. Macquarie’s 

real estate unit is in talks with Abu 

Dhabi Commercial Bank and the DIFC 

to form a trust which will acquire 

assets now owned by state-run DIFC 

as well as other UAE properties. Earlier 

last year Abu Dhabi Commercial Bank, 

the UAE’s fourth-biggest lender, 

entered in to a venture with Macquarie 

to allow customers to invest in 

property assets globally. The 

two banks also formed a 

venture to manage a $272m 

infrastructure fund for Abu 

Dhabi’s government. “REITs 

have been successful in other 

markets and we feel the 

timing is right for the rollout 

of such vehicles in the region,” 

Barry Barakat, a director of 

Macquarie, explains. 

Nevertheless, to attract 

investors REITs need a selling 

point and if it is not tax 

efficiency inducements then 

what is it? Transparency, the 

introduction of international 

standards for investment, a 

way of spreading risk across a 

property market that has 

suffered some setbacks— 

despite its full-speed-ahead 

strategy—and an opportunity 

to create funds suitable for 

Islamic investors seem to be 

the most obvious drivers. 

Indeed, the relatively small 

number of Shariah-compliant 

(adhering to religious 

strictures including prohibited 

business activities such as 

alcohol, pork, casinos or ammunition) 

investment opportunities in the Gulf 

region is a concern says Sameer Abdi, 

head of Islamic financial services, real 

estate with Ernst & Young. The Middle 

East could see Islamic capital shift to 

exchanges such as Malaysia and 

Singapore, which are busy pitching 

themselves as hubs, evidenced by 

FTSE and Bursa Malaysia establishing 

the FTSE Bursa Malaysia EMAS 

Shariah Index in January this year. 

“Converting some of the Shariahcompliant 

funds into REITs could be 

problematic,”reflects Abdi,“as there are 

issues based around transparency and 

procedures. The market is also quite 

young and has been fairly volatile but 


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38 


there would be some merit in these 

schemes converting to at least a more 

REIT-like, equity based investment. 

“We need to encourage the capital 

markets and in some ways this would 

be a natural progression to more 

transparency and better risk 

diversification. But that also requires 

more choice – one or two REITs is not 

enough, investors need a good 

selection of vehicles,”he adds. 

A year ago the Jeddah, KSA based 

Siraj Capital and Johor Corp of 

Malaysia agreed to develop and 

launch $500m of Shariah-compliant 

investment funds. Two open ended 

investment funds are planned; a REIT 

and a regional private equity 

investment fund (RUIF), each with an 

investment size of $250m. The REIT 

fund will focus on real estate 

investments related to tourism, 

education, property, industrial and 

technology parks, and will seek a 

listing on the Bursa (Malaysian) stock 

exchange. The RUIF will be focused 

on investments in strategic private 

equity sectors like palm oil, biodiesel, 

oil and gas industry and other 

related sectors that have technologybased 

components. 

Ultimately the real drivers for REITs 

if they are to thrive in the Middle East 

are that they can act as a mechanism 

for investors to get the advantages of 

professional management, a higher 

level of liquidity and a diversified 

portfolio, which reduces risk. 

Individuals therefore can then make 

small investments with some stability 

in income stream.“We would certainly 

welcome anything that brings in 

international money, which we feel is 

lacking for the market to really 

mature,” says Nicholas Maclean, 

managing director of CBRE Richard 

Ellis, Middle East.“But at the moment 

this is a tricky market for REITs. There 

is a culture of owner occupiers rather 

than companies selling 10 or 20 year 

leases to foreign companies, which is 

what is really being cried out for. But it 

will come.” 

In spite of a generally good news 

property story across the Middle East, 

the regional real estate sector has not 

been without its blips. The 

reawakening Lebanese economy was 

devastated by Israel’s attacks on 

Beirut, while in Dubai residential 

yields fell on buy-to-let residential 

properties last year, precipitating small 

capital falls in some areas. 

Bank, Australia’s largest 

securities firm, confirmed 

plans to start a $2bn UAE 

REIT with local partners. 

Macquarie’s real estate unit 

is in talks with Abu Dhabi 

Commercial Bank and the 

DIFC to form a trust which 

will acquire assets now 

owned by state-run DIFC as 

well as other UAE properties. 

Investment in a REIT could iron out 

some of those fluctuations. Stuart 

Gissing, regional director for Dubaibased 

Colliers International, cites 

Emirate Abu Dhabi as an example. 

“Abu Dhabi is at the onset of a real 

estate boom, with demand currently 

outstripping supply. As such, we feel 

that in the short to medium-term, 

healthy competition will exist 

between it and Dubai,”he reflects.“In 

the long-run, where we expect supply 

extensions to outstrip demand, the 

scenario may change with both 

Emirates targeting similar segments.” 

The office sector in Abu Dhabi is 

currently characterised by 

undersupply, adds fellow regional 

director Ian Albert. “Landlords are 

negotiating out of market norms and 

in the short-term, in consideration of 

anticipated increasing rentals in light 

of undersupply until 2009 at least, we 

expect capital appreciation in the 

office sector. In the medium-term 

with initial delivery of quality office 

space in the market, rental levels 

could stabilise, with stable capital 

values. In the long-term, however, 

with supply extensions of an 

unprecedented scale, we would expect 

rentals to soften and this could 

subsequently have a negative impact 

on capital values.” 

With such unpredictability Simon 

Thomson, managing director of UKbased 

Middle East retail specialist 

Retail International adds that with no 

taxation advantages REITs might 

prove more attractive for small and 

medium-sized investors. “At the 

moment there’s not much discussion 

about REITs in the Middle East but 

what they might provide is, for 

example, a way of creating a 

diversified structure for investing in a 

number of properties owned by a 

really go-ahead developer like 

Emaar,”he reflects. 

However, for local investors, more 

attuned to short-term speculative 

capital gain, it may be a bit of a 

challenge to present something which 

is by its nature a very stable, long-term 

bond-like structure and some of the 

region’s more risk-friendly investors 

may not find it particularly appealing. 

“The returns on property investments 

are going down and consequently 

REITs may become sexier,” reflects 

Maclean. ”New instruments are 

always welcome in the market and if 

they could, for example, be used to 

invest in companies which have 

acquired land for residential 

development in Saudi then that would 

be a very useful tool. If you are talking 

about REITs in the Gulf right now then 

there is not much to say. Come back in 

a couple of years’ time and that might 

be a completely different matter.” 



TURKEY’S ELECTION FEVER 

Wide-ranging structural reforms have meant cuts in state spending, a gradual move to liberalise the labour force and a revival of the privatisation 

programme. The government has generated over $10bn by selling off stakes in Tupras Refinery, an oil refinery, Telsim Mobile and Turk Telecom as 

well as Erdemir Steel. Moreover, the Central Bank became independent and succeeded in reducing inflation and stabilising the exchange rate. As a 

result, nominal and real interest rates declined significantly. Photograph by Tamer Yazici, supplied by Dreamstime.com, January 2007. 

Last May when emerging markets unexpectedly tumbled and the Turkish lira slid, the currency crisis 

of 2001 flashed before the investment community’s collective eyes. Much to the country’s relief, its 

economy and all important banking sector weathered the mini-storm thanks mainly to strong 

structural reforms and central bank support. This year investors know they are in for a bumpy ride 

as the country faces two potentially contentious elections. Lynn Strongin Dodds reports. 

TURKEY’S PRESIDENTIAL 

ELECTION — set for May — 

followed by general elections in 

November have eclipsed, albeit 

temporarily, the European Union (EU) 

accession talks which ran into trouble 

in late 2006. The EU suspended 

membership talks in eight policy areas 

because of Turkey’s refusal to open its 

ports to the Greek controlled half of 

the island of Cyprus — an EU member 

since 2004. Turkey said it would not do 

this until the EU took steps to end the 

Turkish Cypriot community’s isolation. 

For now, market participants are not 

unduly worried about Turkey gaining 

entry into the EU. The general 

consensus is that the country will 

eventually become part of the fold 

although it could be a long and 

tortuous affair, taking at least another 


ten years of negotiations. As Magar 

Kouyoumdjian, a credit analyst with 

Standard & Poor’s puts it, “The 

prospects for full EU membership is 

not the key issue. The more important 

question is whether the government 

will continue to implement the 

reforms to gain entry into the EU, 

continue to cooperate with the 

International Monetary Fund (IMF) 

and remain secular. The focus this year 

is on the elections.” 

Election jitters have already 

prompted the government to 

temporarily pull the plug on the 

privatisation programme of parts of 

the electricity distribution network. 

There are concerns that the potentially 

higher prices that might result from a 

state sell-off could hurt its chances in 

an election year.The Turkish public are 

already weighed down by some of the 

highest energy prices in the world. 

In the meantime, the country is 

holding its breath to see whether prime 

minister Tayyip Erdogan, head of the 

pro Islamic Justice and Development 

Party (AKP), will throw his hat in the 

presidential ring. Alternately, whether a 

compromise candidate will be found 

that will be more acceptable to the 

secular establishment, which includes 

the all-powerful Turkish military and 

the judiciary. 

Erdogan is keeping the pundits 

guessing, although an announcement 

is expected in mid-April. Industry 

observers are split as to which path 

Erdogan will follow. 

At first glance, there seems little to 

be worried about. The prime minister 

wields more power and the 

39 

EUROPE: THE IMPACT OF TURKEY’S ELECTIONS

EUROPE: THE IMPACT OF TURKEY’S ELECTIONS 

40 


presidency in Turkey is considered an 

important symbolic position as the 

seat of Mustafa Kemal Ataturk, the 

founder of modern Turkey. 

However, a closer look reveals that 

the position also carries great 

influence. For example, the president, 

who is elected by Parliament for a 

seven year term, is the head of the 

National Security Council (MGK) 

which consists of generals and 

government officials. Moreover, he is 

able to veto bills passed in Parliament 

or send them to the Constitutional 

Court for review. For example, 

outgoing President Ahmet Necdet 

Sezer, a staunch secularist, used the 

veto to block many AKP laws. 

Responsibilities also include making 

influential appointments and 

confirmations of high-ranking 

officials and university rectors. 

Scenarios are being played out at 

every level. For example, if Erdogan is 

elected as president and AKP retains its 

majority in the general election, then 

there are fears that too much power will 

be concentrated in the hands of the 

pro-Islamist party, blurring the lines of 

the separation of religion and state. 

Despite Erdogan’s economic reforms 

and pro-business stance, rumours are 

once again rife in some quarters that he 

has a hidden agenda to turn Turkey into 

a religious state.This is partly due to the 

fact that AKP, founded in 2001, grew 

out of the Islamist Welfare Party, which 

had been banned in 2000 by the 

military for allegedly threatening the 

country’s secular nature. 

Eli Koen, senior portfolio manager 

European Small Caps Equities — 

Emerging Europe for Fortis 

Investments, observes,“The Presidency 

is seen as the last stronghold of 

secularism and if Erdogan runs then 

this will give power to that political 

spectrum. The people who are most 

concerned are the secularists such as 

the army, parts of the media, judiciary 

and business. However, more people 

will care if there is a strong reaction 

from the international markets. If that 

happens, it could trigger economic 

volatility. At the moment, the markets 

have factored in the uncertainty and 

multiples in the stock markets are 

trading at a reasonable 10 to 11 times 

2007 earnings.” 

The other picture being painted, 

which perhaps would tarnish Turkey’s 

image even more is if Erdogan wins 

the presidency, but the AKP fail to 

secure a majority in the general 

elections. This could result in the clock 

being turned back to the turbulent 

years of coalition governments which 

hampered the growth and 

development of the economy. During 

the 1980s and 1990s, inflation and 

interest rates never climbed down 

from their lofty double digit heights 

while fiscal deficits only grew wider. 

Moreover, these alliances never 

lasted long enough to make a 

difference. According to Tevfik Aksoy, 

chief economist,Turkey with Deutsche 

Bank in Istanbul, between 1990-2000, 

Turkey witnessed over 12 

governments whereas the AKP will go 

down in history as one of the few 

parties that stayed the distance of the 

five year term. 

As Koen puts it, “In the 1980s and 

1990s, Turkey’s government was 

characterised by boom and bust. Debt 

to GDP was more than 100% while 

inflation was between 70% to 100%. In 

the past four years, there has been a 

significant change accompanied by the 

government following EU reforms. 

The country is growing consistently by 

5% over the last four to five years, 

inflation is below 10% and debt is 

under 60% of GDP which is in line 

with other European countries.” 

Elif Tokman, Istanbul-based head of 

financial institutions and public 

sector, Turkey at ABN AMRO, also 

believes that “businesses have factored 

in a certain amount of volatility due to 

the elections. I think we might see 

some slowdown in corporate and 

consumer spending but we do not 

believe there will be a major event that 

will block the progress of the 

economy. The regulatory bodies and 

Central Bank have expressed their 

intension to continue to focus on 

maintaining strong fiscal and 

monetary policies and no election 

scenario will change that.” 

Although there are mixed views 

about what the election outcomes will 

be, all agree, including critics, that the 

AKP has done an impressive job of 

navigating the country onto a path of 

strong, solid economic growth. When 

Erdogan came to power in 2002,Turkey 

could not have been in much worse 

shape.The country was in the throes of 

one of its worst recessions, triggered by 

a political crisis which caused the 

devaluation of the lira and a wave of 

banking and corporate bankruptcies. 

Despite scepticism about his 

alliances and credentials, Erdogan has 

not only doggedly stuck to the 

conditions embedded in the $10bn loan 

agreement with the IMF but also 

assiduously followed the EU blueprint 

for accession. He continues to remain 

on track despite the stalled EU talks. 

The government is currently drafting 

detailed legislative plans to continue 

aligning the country’s laws with EU 

standards. Edward Parker, a senior 

director of Fitch Ratings says,“Although 

there were concerns about the Islamic 

roots of the ATP, the government has 

implemented sound economic reforms. 

The country has been enjoying its best 

and most sustained growth since the 

1960s. Foreign direct investment is 

expected to rise to $18bn, which equals 

the FDI amount for the past ten years 

put together.” 



MICEX COMES OF AGE 

LAST YEAR MARKED watershed 

for MICEX. By total turnover of 

trading, the MICEX is the largest 

exchange in Russia, the CIS, Central 

and Eastern Europe, though the 

growth of the volume of exchangebased 

transactions, primarily in 

corporate securities, now means that 

MICEX ranks among the world’s top 20 

exchanges by volume. According to the 

MICEX’s president Alexander 

Potemkin, record-high levels of 

exchange-based turnover are a direct 

result of new exchange products and 

services and the growing attractiveness 

of the stock market as a means for 

investors to leverage the Russian 

growth story. “Our main achievement 

over the last 15 years,” says Potemkin, 

“is building an efficient infrastructure 

supporting the national capital 

market, based on advanced exchange 

and information technologies.” 

That infrastructure is now extensive. 

The MICEX Group comprises the 

MICEX stock exchange, the National 

Mercantile Exchange, MICEX 

Settlement House, the National 

Depositary Center, the National 

Clearing Center, and a host of regional 

exchanges. The Group has several key 

markets: foreign exchange, equities, 

corporate and regional bonds, 

government securities, the money 

market and derivatives. In 2006, the 


Diagram demonstrating the growth of Gazprom shares during trading at Russia’s Stock 

Exchange in Moscow, Friday, Jan. 13, 2006. Russia's main stock exchange reported heavy 

trading volumes in shares of OAO Gazprom, the largest gas producer in the world, on the 

first day that the state company was directly listed on its main, dollar-denominated index.. 

Photograph by Sergey Ponomarev, supplied by Associated Press/EMPICs, February 2007. 

It has been a banner twelvemonth for the Moscow Interbank 

Currency Exchange (MICEX) and 2007 promises more of the same. 

According to Alexei Rybnikov, the MICEX Stock Exchange’s chief 

executive officer (CEO), “last year was marked by an explosive growth 

of liquidity of the exchange-based market for corporate securities.” 

total volume of trading in all markets 

of the MICEX Group amounted to 

R52.04trn (just over $1.9trn), doubling 

volume year on year and equal in value 

to about twice Russia’s annual GDP. 

The Group has ridden an upward 

market, and the MICEX Index has 

grown by 68% over the year. Potemkin 

explains that MICEX has spent time 

improving the exchange’s system of 

index management and increased the 

number of securities in the index by 

adding common shares in Gazprom, 

Mobile Telesystems, Uralsvyazinform, 

RBK Information System, Rosneft, 

Polus Gold and preference shares in 

Transneft, thereby increasing its appeal. 

Since the beginning of 2006, the 

number of securities traded on MICEX 

has increased 44%, while the number 

of issuers admitted to the main board 

has grown by 40%. 

The MICEX Index, which is the 

price-weighted index of Russia’s most 

liquid stocks, has been calculated 

since 22 September 1997. Right now 

the index comprises 21 securities and 

is calculate in real time 

A number of significant 

developments underpinned MICEX’s 

explosive growth over the last few 

years. Among these are the tripling of 

the exchange’s corporate securities 

market, in large part supported by a 

raft of new market issuers. Corporate 

bonds now account for 8% of the 

Group’s revenue. Last year 225 

companies offered their securities on 

MICEX, with a combined issuance 

value of just over $17bn, almost the 

volume of the previous year, and the 

exchange also reports a significant 

uptick in secondary market trading of 

corporate bonds (a market now worth 

just under $68bn). Interest in shares of 

mutual funds is also growing. The 

volume of exchange-based trading of 

the funds tripled last year and 

amounted to around $186m. Growth 

in the trading of mutual funds was 

provided an important fillip with the 

launch of specialists on the exchange, 

with three trading institutions granted 

specialist status. Additionally the first 

mortgage securities were launched on 

the exchange last year. 

But perhaps the most important 

event that took place on the stock 

41 

EUROPE: MICEX RIDES A RISING TIDE OF BUSINESS

EUROPE: MICEX RIDES A RISING TIDE OF BUSINESS 

42 


market in 2006 was the liberalisation 

of the market for Gazprom shares.“We 

managed to partially reverse the 

outflow of liquidity generated by 

trading in Russian assets” says 

Potemkin. The share of trading in 

shares on the MICEX in the total 

(global) volume of trading in Russian 

shares, including GDRs and ADRs, 

grew from 59% to 71% between 

January and November 2006, he adds. 

The top five most actively traded 

stocks on the exchange include 

Gazprom (accounting for 32%), RAO 

UES (25%), LUKoil (14.6%), Norilsk 

Nickel (6.3%) and Sberbank (6.1%). 

The MICEX Stock Exchange has 

played an important role in domestic 

initial public offerings (IPOs). In the 

corporate bonds market, the exchange 

has long been a democratic leader by 

the number and the total volume of 

placed securities. In 2006, the 

exchange has also tried to attract more 

IPOs in the share market. Last year, 

seven companies used MICEX to 

launch their IPOs, including Rosneft, 

Severstal, OGK-5 and others, which 

raised about R350bn (around $13bn). 

“In the early days, we regarded 

exchanges such as the London Stock 

Exchange as competition. Then we 

understood that global depositary 

receipts gave us more advantages than 

losses,”says Potemkin. 

The exchange’s foreign 

exchange related business 

also grew, with trading 

volumes almost reaching 

$1bn in value. The 

exchange has also 

encouraged liquidity in 

the exchange based 

currency market. To cut 

participants’ costs, while 

maintaining the reliability 

of exchange-based 

trading in foreign 

currency, MICEX lowered 

its commission in the 

dollar/rouble segment for all 

instruments and in the Euro/Rouble 

segment for swaps. The effectiveness 

of the move is apparent: the volume of 

Euro-Rouble swaps business grew by 

a factor of 20. At the same time, the 

exchange also launched interest 

bearing futures on the exchange’s 

derivatives market. MICEX also takes 

credit for the development of collective 

investments and the doubling of 

individual investors on the exchange 

as the exchange introduced online 

trading. Individual investors now 

account for around 30% of trading on 

the exchange. Additionally, it launched 

government savings bonds, while 

organising Bank of Russia’s lending 

operations (through collateral 

crediting). Russian banks can now use 

the MICEX System of Electronic 

Trading to effect deposit transactions 

with the Bank of Russia to place funds 

on the Bank of Russia’s deposit on 

“demand” terms as well as credit 

transactions (collateral crediting). 

Besides, the MICEX has introduced 

the second (evening) trading session, 

in the course of which participants can 

effect deposit and credit transactions 

with the Bank of Russia on fixed terms. 

The Group has also done extensive 

work in upgrading the capital markets 

servicing infrastructure, which has 

MICEX leverages Russia’s Economic Boom 

3-Year Price-Performance (USD) 

400 

350 

300 

250 

200 

150 

100 

50 

*based on backcast data. 


resulted in increased business volumes 

across the range of Group services.The 

value of securities in depositors’ depot 

accounts with the National Depository 

Centre, Group’s clearing and 

settlement arm, grew 86% to around 

R3.3trn, with shares accounting for 

around one third of that amount. In 

August last year, the National Clearing 

Center was founded by the MICEX 

and the NDC and received a central 

bank licence to perform banking 

operations. The move was significant 

for the further development and 

diversification of the MICEX Group, 

maintains Potemkin. The National 

Clearing Center now provides clearing 

in exchange-based and OTC markets. 

“An important area of our work was 

the promotion of cooperation with 

foreign exchanges and financial 

institutions,”confirms Potemkin, who 

stresses that the exchange “takes an 

active part in the work of the 

International Association of 

Exchanges of the CIS countries, 

which coordinates the development 

of orderly capital markets in the 

Commonwealth countries”. 

Cooperation memoranda were signed 

with both the London Stock 

Exchange (LSE) and Deutsche Börse, 

which “confirms MICEX’s status as 

Russia’s leading exchange,” notes 

Potemkin, who is keen to 

note also that the exchange 

has moved far to 

international standards of 

listing and disclosure of 

information on securities 

and issuers. “The 

implementation of these 

agreements will help to 

improve the reliability of 

the exchange system of risk 

management and the 

transparency of the Russian 

stock market for 

international investors,” 

he says. 


COVER STORY: BGI 

44 

MORE THAN 130 exchange-traded funds were 

launched in 2006, to push the year-end total over 

335, comprising $418bn in assets, up 39% from 

2005. Some 225 more ETFs are expected this year, making 

them the fastest-growing asset class in the American 

financial market. The rush to market these days is so fast 

that during a single week in January some 22 funds were 

filed with the US Securities and Exchange Commission 

(SEC) by one investment advisor alone. 

Lee T Kranefuss, the architect of BGI’s 

ETF strategy and chief executive 

officer of the company’s Intermediary 

Products and Index & Markets Group, 

ETFs continue to be a growth market 

“and we expect to continue to be the 

leader in it,” he says. Photograph 

kindly supplied by Barclays Global 

Investors, February 2007. 

BGI: 

THE DOMINATOR FACTOR 

Exchange-traded funds (ETFs) are hot. In the US alone, ETFs top $450bn in assets, a figure that could 

reach $2trn in 2010. San Francisco-based Barclays Global Investors (BGI), a majority-owned 

subsidiary of Barclays Bank PLC, holds a 60%-plus market share in America and aims to dominate 

the world market for ETFs for time to come. Its first-place rank appears secure for the time being. 

However, the profusion and complexity of ETF offerings is multiplying almost exponentially and 

competition for market share is increasing. Keeping up with BGI though might be hard. Working 

in concert with other elements of the Barclays Group, BGI is now marketing exchange-traded notes 

(ETNs), which BGI says is the next evolution of exchange-traded products. Art Detman reports from 

San Francisco on how and why BGI’s dominance will be hard to break. 

ETFs are open-ended mutual funds or unit trusts that 

trade like individual stocks, and are multiplying like 

rabbits. While early ETFs tracked traditional stock market 

indices, the sector has now broadened to include fixed 

income, commodities and narrowly focused sector stock 

portfolios. ETFs can be sold short making them a valuable 

tool for hedge funds and investors using active managers 

can use ETFs with core-satellite investment strategies. 

Investors can purchase ETFs to generate a market return 


elatively cheaply in US large caps for example, and look to 

active managers who they believe will outperform their 

benchmark in other markets. 

ETFs are also the fastest growing segment of BGI, the 

largest money manager in the US, with $1.7trn total assets 

under management. Of this, $300bn is in some 190 ETFs, 

called iShares, a net cash increase of $60bn from a year 

earlier. Out of the US mutual fund families, only Capital 

Group’s American Funds pulled in more net new money 

than BGI’s US iShares. “It’s a growth market,” 

acknowledges Lee T Kranefuss, architect of BGI’s ETF 

strategy and chief executive officer (CEO) of its 

Intermediary Products and Index & Markets Group, “and 

we expect to continue to be the leader in it.” 

Although markets in Europe, Latin America and Asia are 

far less developed in terms of ETFs, Kranefuss is optimistic 

about their potential.“The US had its first ETF in 1993,”he 

says. “If you plotted growth of the US ETF market from 

1993 to today, and then started at zero in Europe in 2000, 

you would find that Europe’s Year One and Year Two were 

faster growing than Year One and Year Two in the US. That 

is because there is a much higher level of comfort and 

knowledge about ETFs today than back in 1993.” 

At the end of 2006 BGI took a big step in Europe with the 

acquisition of Munich-based INDEXCHANGE Investment 

AG, the ETF advisor/provider owned by Bayerische Hypound 

Vereinsbank AG (HVB), Germany’s second-largest 

bank for €240m. [HVB was taken over by Italian banking 

giant UniCredit in 2005.] “The combined business will 

create a powerful force to accelerate the development of 

ETFs in Europe,”said Barclay’s president Bob Diamond in a 

statement at the time of the transaction. BGI’s purchase 

was a strong statement of intent, widely interpreted as the 

first in a series of possible acquisitions across Europe and 

Asia to drive innovation and accelerate the uptake of ETFs. 

INDEXCHANGE’s €15.2bn of assets under management 

was rolled into iShares. With the stroke of a pen, BGI 

doubled its European market share to nearly 47%, well 

ahead of the 24% of Société Générale’s Lyxor, BGI’s closest 

European competitor. 

iShares already had a presence in the UK, France, Italy, 

Switzerland, the Netherlands and Germany and BGI sees 

expansion opportunities in France and Italy in particular. 

In Asia, where ETFs are still relatively new, iShares has an 

operation in Hong Kong. Even so, the actual numbers were 

small—about $44bn (about €30bn) for the newly enlarged 

BGI iShares Europe versus $22.4bn for Lyxor—but inflows 

have since risen rapidly. “The ETF market is the fastest 

growing market within all asset management classes in 

Europe,” says Chris Sutton, CEO of iShares Europe. “We 

think there is more growth in the future than in the past – 

and in the last years, iShares Europe has had growth of 

80% yearly,” adding,“The acquisition of INDEXCHANGE 

supports a key element of our strategy which is to be in 

each local market and serve their specific needs.”“The story 

is pretty much the same around the globe,”Kranefuss says. 

“Asia and Latin America are just a little behind Europe but 


are growing quickly. Two years ago we listed iShares on the 

Mexican exchange. Since then we’ve had very good success 

in Mexico. Same thing in Asia. They [see] ETFs as a core 

investment.” 

The story of BGI’s dominance of the ETFs market is a 

classic. It is the one where the prime mover did not 

leverage its innovation, and much later a rival firm came 

along that understood its potential and capitalised on it in 

a wider marketplace. The first ETF, the Standard & Poor’s 

Depositary Receipt, known as SPDR, was in fact created in 

1993 by State Street Global Advisors (SSgA) together with 

the American Stock Exchange (Amex). At the time, Amex 

was seeking a new security to boost volume and even today 

lists more ETFs than any other exchange. The SPDR was 

followed by an S&P mid-cap index and a fund indexed to 

the Dow Jones 30 Industrials. However, it wasn’t until the 

NASDAQ 100 tracking stock—the famous QQQQ—was 

introduced that ETFs became a big hit. “It was the right 

product for the moment,” says J Parsons, head of BGI’s 

intermediary sales. “It was a highly volatile, tech-heavy 

basket of stocks, exactly what was in favour.” 

In March 1996 BGI introduced a family of ETFs for 

institutional investors, though they remained obscure and 

grew slowly. In 1997 Kranefuss — an electrical engineer 

with an MBA in finance — joined BGI after six years with 

The Boston Consulting Group.“The first year and a half I 

spent doing a corporate strategy study across all the 

company’s lines of business, looking for opportunities and 

trying to figure out where we should focus our efforts. One 

of the holes we saw was in BGI’s offerings for non-pension 

institutions and individual investors.” 

The US ETF market was then worth around $20bn in 

total assets—most of which were in the SPDR and QQQQ. 

By then, BGI had 17 ETFs, all country funds and all 

complicated to manage. In 2000, Kranefuss simplified and 

re-branded these World Equity Benchmark Shares (WEBS) 

as iShares, expanded the concept across a much larger 

universe of indices and offered them not only to 

institutions but also, as exchanged listed securities, to 

individual investors. The rest, as they say, is history. The “i” 

Global ETF Market – Split by Geographical Region 

Over the last quarter, the global ETF market has increased by 12.9%. EMEA saw the 

largest regional increase of 14.3%, while North/South America increased by 13.1%. 

However, the Asia Pacific region has increased by 8.2%. 


45


46 

in iShares doesn’t stand for anything in particular. 

Kranefuss says it could represent any of several words: 

innovative, index, integrated, intelligent. Whatever, iShares 

is a better brand name than WEBS. “With iShares, 

institutional quality index funds were made available to the 

average retail investor,”says Amy Schioldager, head of US 

indexing at BGI.“That was the biggest change, the quality 

of product available to the retail investor.” 

In May 2000, Kranefuss rebranded 17 WEBS as iShares 

funds—they accounted for less than $2bn in assets and no 

more than 3% of the ETF market—and in the year’s second 

half introduced 37 more iShares ETFs. Meanwhile, Parsons 

had sales people visiting registered representatives at 

broker-dealers and financial advisors of all kinds. They 

worked on salary, not commission, and their role was 

largely educational. “By offering a broad set of products,” 

says Parsons,“we actually made this an acceptable universe 

of investments. People could say,‘I have an asset allocation 

style that I want to execute,’ and we could offer them a 

complete suite of funds to invest in that style. Never before 

was that true.You could not cover the universe.” 

The largest of the ETFs is the iShares MSCI EAFE Index 

Fund, with $39bn in assets and as 2006 ended, BGI’s 

smallest was the iShares Dow Jones US Insurance Index 

Fund with $19m in assets. Expense ratios range from 0.09% 

for the iShares S&P 500 Index Fund to 0.74% for its 

emerging market funds: including Taiwan, South Korea, 

South Africa, Brazil and China. Kranefuss and Parsons 

concede that in 2000 there were few believers in ETFs 

outside of BGI.“Industry analysts were saying that this is a 

niche market that will never grow,” says Parsons, “Today, 

most analysts say that ETFs will be the fastest growing 

financial services product for the next five to ten years. And 

that the total market will be $1trn to $2trn.Those are pretty 

nice numbers.” 

At day’s end, the credit must go to Kranefuss, the first to 

recognise that ETFs can replicate more than just a handful 

of broad market indices and therefore be used for more 

than just beta ballast in a portfolio. Granted, even today 

the SPDR remains the largest ETF, comprising $64bn of 

ETF assets under management and accounting for nearly 

15% of the entire ETF market. Additionally, most of the 

other top ten ETFs are broad-based funds widely used as 

the beta portion of accounts whose managers seek aboveaverage 

returns in the alpha portion by investing in other 

types of securities. The Tarbox Group, an investment 

advisor based in the monied environs of Newport Beach, 

California explains that, “ETFs are the core of our client 

portfolios,” says vice president Mark Wilson. “We use the 

standard indices to build about 40% or 50% of each client’s 

portfolio. Then we use other types of investment vehicles 

around that.”Tarbox favours Three iShares funds: the EAFE 

Index Fund, S&P Mid-Cap 400 Index Fund, and the Russell 

2000 Index Fund. However, Wilson uses other index funds 

as well, such as the Charles Schwab institutional S&P 500 

index.“It is actually a little cheaper,”he explains.“We do not 

have to pay a transaction fee to buy it. When we started 

Chris Sutton, CEO of iShares Europe, says,“We think there is more 

growth in the future than in the past – and in the last years, iShares 

Europe has had growth of 80% yearly.” He adds,“The acquisition of 

INDEXCHANGE supports a key element of our strategy which is to 

be in each local market and serve their specific needs.” Photograph 

kindly supplied by BGI, February 2007. 

At day’s end, the credit must go to 

Kranefuss, the first to recognise that 

ETFs can replicate more than just a 

handful of broad market indices and 

therefore be used for more than just beta 

ballast in a portfolio. 

using [ETFs], our clients did not know an ETF from a hole 

in the ground. But the ETF indices have been very difficult 

to beat during the past five years. … I am sure our clients 

are happy that they have them in their portfolios.” 

For all that, the fastest growth for ETFs is among more 

specialised funds, many of which are becoming 

increasingly used as substitutes for single stock positions. A 

partisan for this approach is Michael Jones, managing 

director and chief investment officer of Wachovia Securities 

of Richmond, Virginia, which extensively uses ETFs in 

managing $5bn of separate accounts.“A lot of people view 

ETFs as simply index management. That is not what we 


elieve at all. It is not about passive management. It is 

about active investment management with lower risk than 

traditional investment tools would make possible. With 

ETFs, you can implement an asset-allocation strategy and 

make continual adjustments in that strategy — increasing 

or decreasing small caps, shifting from value to growth or 

vice versa, whatever appears necessary to optimize return,” 

says Jones, “You can set up sector strategies, sub-sector 

strategies, even sub-sub-sector strategies.” 

It is a flexibility that XACT Fonder and Lyxor have 

leveraged, as have others through the launch of a raft of 

FTSE RAFI ETFs in February. Their move clearly shows that 

ETFs are indeed moving away from pure passive 

management to more active strategies. 

Then, too, there is the advantage of minimising wrong 

individual stock selection. “If 

you had wanted to be in 

integrated petroleum 

companies for the past 

couple years, you could have 

bought Exxon Mobil or 

British Petroleum,” Jones 

says. “But if you bought BP, 

you would have missed the 

boat. You would have had the 

right concept, but because of 

the specific security with 

which you implemented the 

strategy, you wouldn’t have 

performed. With an ETF, you 

do not have to make that 

one-stock decision. You can 

buy a fund that has 

everybody in integrated oil, 

and if that strategy is correct, your portfolio wins and your 

investor wins.” 

Wachovia also uses ETFs to reduce turnover in actively 

managed portfolios of individual stocks. If an asset 

allocation model calls for 20% of a portfolio to be in small 

caps, 15% will be in individual stocks and 5% in ETFs.“If 

we want to underweight small caps,” explains Jones, “we 

don’t tell the asset manager to sell three shares of each of 

his stocks. Instead, we liquidate the ETF and, boom; we are 

5% underweight in small caps.” Jones points to hedge 

funds to clinch his argument. “Hedge funds are the 

pioneers in the ETF market. We are right on their heels. 

The rest of the industry is going to follow along because 

ETFs create the ability to do things for a client that simply 

was not possible before this technology became available.” 

San Francisco based advisory firm Main Management, 

with $200m under management, has taken Jones’s views 

to their logical conclusion.“We use only ETFs here,” says 

president Kim Arthur. “We did not want to use mutual 

funds because of the higher imbedded fees, lack of 

transparency, and lack of tax efficiency, so our whole 

business model has been built on 100% ETFs.”Typically, 

its portfolios have anywhere from ten to fifteen ETFs in 


them, “the majority of ETFs that we use are iShares 

[though] we use a little bit of WisdomTree and 

PowerShares, too,”notes Arthur who explains that iShares 

funds are based on indices weighted by market 

capitalisation, while WisdomTree funds are based on cash 

dividends and PowerShares funds reflect fundamentals 

and technical analysis. 

It is here in fact that BGI really stakes its claim, providing 

products based on meaningful and established indices. 

Early in the year BGI introduced eight iShares fixedincome 

ETFs, all based on Lehman Brothers indices. Unlike 

some other advisors, it has resisted the temptation of 

creating trendy indices simply for the sake of additional 

revenue. Instead, it has focused on recognised indices 

created by third parties and the firm believes that its links 

with index providers, such 

as FTSE Group, will be an 

area of significant growth in 

Both Kranefuss and Parsons 

the future. The diversity of 

concede that back in 2000 there were ETFs in this space is 

few believers in ETFs outside of BGI exemplified by the iShares 

(and maybe not many even inside 

FTSE/Macquarie Global 

BGI). “Industry analysts were saying Infrastructure 100 ETF and 

the iShares FTSE 

that this is a niche market that will 

EPRA/NAREIT Asia 

never grow,” says Parsons. “Today, 

Property Yield Fund ETF 

most analysts say that ETFs will be the (FTSE Group now has a 

fastest growing asset class for the next diverse range of ETFs, 

five to ten years. And that the total including the Claymore 

FTSE RAFI Canadian Index 

market will be $1trn to $2trn. Those 

Fund and the Powershares 

are pretty nice numbers,” he adds. 

RAFI ETF Series).Then, too, 

competition is growing 

from other quality advisors, 

such as Vanguard. Money managers pay more attention to 

how well an ETF tracks its benchmark than to its brand 

name, so just by the draw of the straw BGI will eventually 

lose market share, even as BGI’s ETF’s asset increase. 

For both BGI and investors this is a good thing, not least 

because the firm will not rest on its laurels. The next 

generation of exchange-traded products has already come 

to market. In fact, there is a proliferation of “iProducts”.The 

latest being exchange-traded notes (ETNs), issued under 

the iPath brand. iPath ETNs are 30-year unsecured, 

subordinated senior debt securities listed on the New York 

Stock Exchange and issued by Barclays Bank PLC that 

essentially promise to pay investors the return of a 

commodity index, minus annual fees of 0.75%. However, 

no principal protection exists. ETNs are similar to ETFs, but 

they differ in structure.“iPath ETNs are complimentary to 

iShares,” explains Philippe El-Asmar, head of investor 

solutions, Americas, at Barclays Capital, which is the 

issuer’s agent. “iPath ETNs are innovative investment 

products that were introduced in June 2006 to provide 

access to difficult-to-reach markets with the trading 

flexibility of an equity.” BGI assists in the promotion of 

iPath ETNs to intermediaries. 

47


48 

Four ETNs are currently available: two representing 

commodities indices (Goldman Sachs Commodities Index 

(GSCI) and the Dow Jones-AIG Commodity Index), the 

third covering oil and the most recent represents the MSCI 

India Index. [Please refer to the Chart: Comparing ETFs with 

ETNs.] ETNs like ETFs are designed to provide low-cost 

exposure to commodities and other investments, usually by 

tracking an index, and since they both trade like stocks, 

provide a chance to hedge against a market downturn. 

However, there are several key differences and the biggest 

are the treatment of tax and credit risk. 

Observers say ETNs could end up being more tax 

efficient than commodity ETFs, which continually “roll” 

futures, meaning they move into longer-dated contracts to 

maintain exposure rather than taking physical possession 

of the commodities. Any capital gains are passed along to 

investors and are taxed as 60% long-term gains and 40% 

short-term gains. Conversely, Barclays says ETNs should be 

taxed as prepaid contracts tracking an index. Therefore, 

investors should only pay taxes if they recognise a gain 

when they sell the ETN or when the note comes due, if 

they chose to hold it that long. Even so, the tax advantage 

remains theoretical at this point. Barclays acknowledges 

the US Internal Revenue Service (IRS) has not made a 

definitive ruling on the tax treatment of ETNs, so there is 

some uncertainty, particularly for investors in markets 

outside the US, who are subject to domestic tax rulings. 

Although Barclays has only four ETNs right now, their 

structure means they can be applied to any tradable index, 

opening the door to many more in the future. Opportunity 

lies close to home as asset classes such as timber; foreign 

currency bonds, foreign commercial real estate and equity 

volatility in the US still lack an index security. BGI however, 

is looking to cast the net even farther afield, seeing 

opportunity wherever investors want particular market 

exposure. As El-Asmar says, “The ETF mutual fund 

structure can be difficult in some asset classes, so we have 

created [these alternative] structures to help our clients 

gain exposure to specific markets or securities. The China 

iShare, for instance, gives investors real exposure to the 

market. But what of places such as India, Russia and 

specific commodities? That is where the ETN concept offers 

Philippe El-Asmar, head of investor solutions, Americas, at Barclays 

Capital explains that: “iPath ETNs are complimentary to iShares. 

iPath ETNs were introduced in June 2006 to provide access to 

difficult-to-reach markets with the trading flexibility of an equity.” 

Photograph kindly supplied by Barclays Capital, February 2007. 

real value to clients looking for low cost, tax efficiency and 

trading flexibility.” 

The concept of increasing liquidity by accessing an entire 

class of assets as if it were an individual stock is in its 

infancy, but will continue to grow fast and while that trend 

continues, BGI will try to expand its product offerings and 

set a benchmark of a kind for rival firms to beat. What is 

significant is BGI’s willingness to leverage expertise 

elsewhere in the Barclays Group to develop and bring 

product to market. It is an ability that might continue to 

give it an edge, compared to other large asset management 

firms attached to wholesale and investment banks that 

perhaps have been unwilling to blur the edges of 

marketing and product innovation among different parts of 

the same institution. 

COMPARING ETNS AND ETFS 

Features ETN* ETF 

Issuer Barclay’s Bank Barclay’s Global Investor 

Liquidity Daily, On Exchange Daily, On Exchange 

Registration Securities Act of 1933 Investment Company Act of 1940 

Recourse Issuer Credit Portfolio of Securities 

Principal Risk Market and Issuer Risk Market Risk 

Institutional Size Redemption Weekly, To the Issuer Daily Via Custodian 

Short Sales Yes, On an Uptick or Downtick Yes, On an Uptick or Downtick 

Tracking Error No Yes 

Expense Ratio 75 bps 75 bps 

Source: BGI iShares, February 2007 

* Please note that this table compares the GSCI ETN & ETF.

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