Evolution in Equity Markets: Focus on Asia

Overview: Evolution in Equity Markets Kathryn Dixon Jost, CFA Vice President, Educational Products No market can escape the inevitable changes that arrive with each new development in technology. Around-the-clock and around-the-globe trading, electronic platforms, and unprecedented retail involvement are only a sample of the rapid changes occurring in global trading venues. Nowhere is this truer than in Asia. Asian trading venues have undergone multiple layers of transformation in the past decade and will continue to evolve as the world physically and temporally compresses through technological innovation. The merger of exchanges in Hong Kong and Singapore, general market liberalization, conflicting regulatory requirements, broker consortiums, and electronic communication networks have all played an integral part in Asia’s changing trading scene. The influence of the retail investor, by virtue of the ease and prevalence of Internet access, is altering the way institutional investors evaluate both investments and trading strategies, encouraging institutional investors to adopt such tools as intelligent trading order management systems and adaptive behavior techniques to improve performance. Market volatility remains high in Asia, but the opportunities for diversification are good. Strong fundamental valuation techniques that press beyond the basics of analysis and consider the ramifications of differing accounting standards and practices are needed by analysts to identify Asian companies that will produce alpha in a diversified portfolio. Regulatory disequilibrium has opened the doors for using derivative products in many Asian portfolios. Although the derivative markets in Asia are less developed than their European or U.S. counterparts, they are coming on strong. Other change is evident in the substantial challenges presented to the oldline, traditional brokerage firms in Japan and South Korea by the “New Economy” brokerage firms, both domestic and international, that are bringing innovative financial opportunities to the retail investor. It is thus time to use real options as a valuation technique in the private equity market. In general, the online, real-time trading environment that pervades the world, including Asia, is altering the structure of traditional modes of trading. All investors can benefit from this irreversible evolution in the markets, exchanges, and other trading venues that make up the global equity arena. The authors of this proceedings, Evolution in Equity Mar-

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kets: Focus on Asia, present their solutions to New Economy investing issues and their insights about successful investing for those operating in the markets today and in the future. Philip Gray—the moderator of the conference, “Equity Valuation and Portfolio Management in the Information Technology Era” held October 24–25, 2000, in Hong Kong, on which this proceedings is based—summed up the speakers’ comments by concluding that the basics of good fundamental analysis are still viable and desirable in the new-fangled equity markets, but a vigilant eye toward new developments is necessary. Most of all, common sense should prevail in an age of new valuation paradigms and new investment concepts. All financial companies will eventually be forced into online, Web-based structures to remain competitive. Profit margins for online trading have already narrowed markedly, and the impact of lower transaction costs is reverberating through the global markets on both the buy side and the sell side. The democratization of information is another online phenomenon that gives the retail investor unprecedented knowledge with which to make decisions. Global consolidation of trading networks and brokerage firms will gradually overcome the limitations found in the fragmentation of liquidity that currently prevails in the global markets.

E-Finance and the Shifting Financial Landscape Frederick Grede in “The New Financial Landscape in Asia” discusses the current state of financial affairs in Asia, particularly in Hong Kong. Grede notes that the Hong Kong exchanges were at the forefront of the wave of global exchange mergers. Today, distinct threats, such as broker consortiums and electronic communications networks, and substantial challenges, such as globalization and conflicting standards, are nipping at the heels of the HKEx (Hong Kong Exchanges and Clearing). On the other hand, these potential difficulties are balanced by the opportunities presented by mainland China— a major source of growth for the Hong Kong markets. Also, a positive influence on the exchange is the potential to expand the number of trading hours from the current four-hour trading day. Three trends are pervasive in Hong Kong and the other Asian equity markets: globalization, technology, and an

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Overview increasingly established market structure. Exchanges will continue to move across borders thanks to technology, which is now breaking down country barriers. At the same time, technology is making trading cheaper, more transparent, and much faster. The Singapore Exchange (SGX) is the result of the recent combination of the Stock Exchange of Singapore and the Singapore International Monetary Exchange. In “The Singapore Story,” Ho Yew Mun discusses the pressures buffeting the equity and derivative markets in Singapore, primarily driven by technology and regulatory reform. The SGX is seeking international exchange alliances and pursuing public ownership—demutualization—of the exchange. The memory of the Asian crisis in the late 1990s lingers in the minds of Singapore market makers, who are taking steps to ensure both their and the exchange’s survival. Thus, the SGX has instituted a wide-ranging program that has introduced new products, a new trading and access infrastructure, and market liberalization. Structural changes are mandated throughout the trading venues of Asia, and the rest of the world, so that they can adapt to new industry developments as they unfurl. The online brokering firms of Korea and Japan have created highly efficient and profitable operations by riding the crest of the Internet wave. Korea has the highest penetration rate for online equity brokerage in the world, and as of July 2000, 61 percent of total market turnover in Korea was generated by online brokering. Explosive growth in Japan’s online brokerage market is directly related to the deregulation in commission rates in October 1999. And second boards for trading specifically in the young, highgrowth initial public offerings (IPOs) of Internet companies have sprung up in many Asian countries. Robert Zielinski cautions, however, in “The Alchemy of E-Finance,” that the Internet may also be the precursor of the destruction of shareholder value. Zielinksi and his colleagues at ABN AMRO Securities are concerned that the Internet may actually trigger a financial crisis. The Internet bubble may ultimately mimic the Asia bubble that burst in 1997.

Equity Portfolio Construction The high degree of return volatility in the Asian equity markets highlights the need for appropriate asset allocation techniques to ensure that the diversification benefits of this sector do not dissipate. Hon Cheung states in “Portfolio Construction Techniques for Asia” that these concerns can be overcome through the use of mean–variance methodologies and risk–return distributions created through bootstrapping and Monte Carlo simulation. Even though Asian equities are only a small fraction of the global

equity markets, the diversification added by the sector is worthy of the effort undertaken by managers to identify and manage the downside event risk and unpredictable return behavior associated with the sector. Client expectations are another concern of managers investing in Asian equities. There is a general lack of familiarity in Asia with strategic asset allocation concepts, and the task of managing client expectations cannot be underestimated. Choosing the benchmark that most accurately reflects client objectives is one way to manage client expectations, particularly in a volatile market environment. Harold Kim also discusses the volatile climate surrounding the Asian equity markets in “Derivative Strategies for Asian Equity Portfolios,” focusing on the regulatory environment that encompasses the sector. Because of differing bureaucratic and regulatory restrictions among the Asian nations, some equity derivative products, or “cash-alternative” products, have sprung up to fill the void created by prohibited transactions, entry barriers to country markets, and underdeveloped derivative markets. Market-access-type products (“delta one” products, whose prices move on a one-to-one basis with the prices of the underlying securities) predominate. Kim reviews three arbitrage trades that surfaced in 2000, each with a derivative element, and also discusses how index swaps are used in Asia and the reason why option products do not play an important role at this time. The institutional and retail derivative markets differ in that the retail markets are dominated by structured products, such as capital guarantees, and the institutional markets have been driven by regulatory and foreign-ownership restrictions. Both are projected to change over time in their composition: The institutional markets will become more option oriented, and the retail markets will become more delta-product oriented.

Equity Valuation Technological evolution in the equity markets affects all facets of the investment process—from trading and best execution to investment policy and asset allocation to individual stock analysis and selection. Using the proper equity valuation technique is intrinsic to choosing the equity investment that will provide alpha for clients, and nowhere is this more important than in today’s Asian equity markets. Richard Lawrence in “Valuation Fundamentals in Asia” endorses a disciplined procedure to evaluate the financial health of Asian companies. He recalls the principles supported by Benjamin Graham, the founder of modern security analysis and the father of value investing, in the 1930s and 1940s and states that these principles are still valid today. A brief history

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Evolution in Equity Markets of the origins of traditional accounting measures is followed by a review of the financial evaluation tools, disciplines, and procedures that are used at Lawrence’s firm, Overlook Investments. Each of these analytical processes offers a breadth and depth that leaves no stone unturned in the search for pertinent information about a company. Lawrence continues with a discussion of the commonly observed characteristics of successful Asian companies. He then touches on the required assistance (primarily regulatory liberalization) that Asian markets need to make headway from this point forward. In “Valuing Technology Companies: Weaknesses of Traditional Accounting Methods and Strengths of Real Option Applications,” Robin Fox reviews why traditional accounting procedures, such as generally accepted accounting principles in the United States, are not adequate for capturing the valuation issues of New Economy companies, which are prevalent throughout Asia. Several suggestions ranging from real options to a knowledge-based accounting process to an economic asset-based accounting system have been proposed to address “outdated” accounting measurements and standards. Using real options is a solution that has worked for certain industries (specifically, the mineral exploration industry) to quantify investment opportunities. It is a model with great flexibility— one that has viable applications for quantifying investment issues of New Economy companies. Interestingly, the traditional business model of Chinese family businesses is similar to the New Economy management style; these parallels are drawn in detail by Fox.

Future of Global Trading The evolution in the equity markets, including the equity markets of Asia, has been driven by technology, and technology will continue to shape the future of markets and global trading. Institutional and retail investors alike have been profoundly affected by

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technological innovation, and in the future, technology will continue to serve as a catalyst for and transformer of markets, investment strategies, and brokerage services. In “The Future of Global Trading,” Greg Robinson predicts that dramatically reduced interaction costs for both transactions and information will spur the unbundling of exchange and brokerage services. Consolidation of trading venues is occurring through mergers and alliances hand in hand with the proliferation of new trading venues created through broker consortiums and electronic trading networks. Robinson observes that, ironically, although technology has generated much disequilibrium in the markets, technology holds the key to stabilization.

Conclusion Investors participate in securities markets because they expect change—the anticipated directional change in price that comes from luck and good analysis. It should come as no surprise then that the markets, which were created to accommodate securities whose values constantly change, change themselves. This evolution in equity markets has accelerated recently because of the influx of new technology, notably advances in the Internet. Investors (and the markets) have learned that this new technology can be a blessing as well as a curse. The Asian markets—which perhaps are not as firmly entrenched in the old, traditional ways as are the U.S. and European markets—are responding to these changes rapidly and creatively. Online trading, the merger of exchanges, and the demutualization of exchanges are increasing in Asia. No one can predict with 100 percent accuracy how securities prices will change; and no one can predict with 100 percent accuracy how the securities markets will change in Asia. But one thing is certain: Rather than fearing change, Asian markets embrace it. And if investors are going to operate successfully in these markets, they must embrace change as well.

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The New Financial Landscape in Asia Frederick J. Grede Chief Operating Officer Hong Kong Exchanges and Clearing Limited Hong Kong

All Asian exchanges will eventually succumb to the technological winds of change. The Hong Kong exchanges were some of the first to take action by merging in March 2000 to form the HKEx. Each Asian exchange faces distinct threats to its existence (broker consortiums and electronic communications networks), challenges it must meet head on (globalization and conflicting standards), and unparalleled opportunities for growth (increasing trading hours and new listing sources, particularly mainland China).

he financial landscape is changing all over the world but perhaps most dramatically in Asia. In this presentation, I will discuss what this new financial landscape looks like in Asia (in Hong Kong in particular) and cover Hong Kong’s solution for becoming part of (and not left out of) this new landscape. Then, I will discuss some of the threats that I see to the exchange community, the challenges that exchanges face, and the opportunities that the exchanges can take advantage of in Asia.

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New Financial Landscape The new financial landscape could be characterized as a buyer’s market where issuers’ preferences are honored and where alliances and mergers of exchanges are taking place. Buyer’s Market. The new financial landscape is a buyer’s market driven by investors’ needs. It consists of real-time, anytime, anywhere trading. I could trade the U.S. markets over the Internet using my laptop computer at home. I would not trade them well, but nonetheless, the possibility exists for anyone, anytime, anywhere in the world to trade. That is a major trend in the globalization of markets. Technology is the venue for the immediate access to investment information—much better information than what investors were previously able to get. Technology, also, is providing better securities pricing and Editor’s note: The joint Question and Answer session of Frederick J. Grede and Ho Yew Mun follows Mr. Ho’s presentation.

lower transaction costs because of investors’ enhanced ability to access the markets and to do so more quickly. Markets are becoming much more efficient because of the greater transparency created by the continous advent of new technology; all segments of the marketplace are benefiting from this change. Retail investors, more so than other market participants, are benefiting like never before from the trend in enhanced exchange and trading venue competition. Issuers’ Preferences. Access to international capital markets is becoming much easier for issuers. Issuers have more opportunities to access international capital markets, where they can find more liquidity—larger pools of investors who are willing to participate in these companies. In addition, they are increasingly looking for the most attractive regulatory environments in which to list—an additional reason to participate in the international capital markets. Alliances and Mergers. These changes in the financial landscape have led to a number of different competitive strategies. From the perspective of the exchanges, creating pools of liquidity worldwide can lead to better pricing facility, lower transaction costs, more sophisticated risk management techniques, more fluid transmission of risk management information, and regulatory harmonization throughout the world—all of which can be accomplished by alliances among exchanges. Consequently, alliances and mergers are at the top of most exchanges’ strategic business plans. Particularly in Europe, the merger of

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Evolution in Equity Markets exchanges continues to fuel additional efficiencies, increase access to the marketplace, and lead to economies of scale among the different exchanges.

The Hong Kong Solution Hong Kong has been addressing the trends of the new financial landscape. Until early 2000, the situation in Hong Kong was as follows. It had two exchanges: the Hong Kong Stock Exchange (HKSE) and the Hong Kong Futures Exchange. They operated essentially three separate markets–one for stocks, one for futures, and one for options—and each exchange had its own clearing organization. In September 1999, the members of both exchanges voted to merge and demutualize the organizations to form the new exchange, called the Hong Kong Exchanges and Clearing (HKEx). The merger was formally completed on March 6, 2000. On June 27, 2000, to broaden ownership, the exchange became publicly listed and traded on the HKEx. The brokerage community in Hong Kong has done fairly well with respect to the merger. Before the merger, a seat on the futures exchange was worth about HK$3 million; after the merger, each broker got about 1.3 million shares in the new company, which trades today for about HK$15 million. Many of those brokers, however, are leaving the business and selling their shares in the exchange, which is leading to a significant transformation in the exchange’s shareholder base from the traditional local brokerage community to a significant number of international investors. One of the reasons for the merger was product and systems integration. Now after the merger, the HKEx has the ability to offer an integrated array of products and services. It is integrated horizontally with a primary market for new listings, a secondary market for adding liquidity in securities, and a full range of derivative products. Warrants, futures, and options are actively traded. The HKEx is also integrated vertically from pretrade market information to order routing systems, trade execution systems, and a whole array of post-trade services—such as clearing, financial guarantee, delivery, payment, registration, and custodial functions. Recent events in Hong Kong will have a significant effect not only on the brokerage and the institutional investing communities but also on the retail investment business. In June 2000, the HKEx closed the futures exchange trading floor and put all of its products on an electronic trading system. The growth in the futures market has been positive since then, and a number of new products have been added, some of which are designed to appeal to the retail sector of the marketplace, in order to introduce retail investors to the use of futures and options.

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At the end of October 2000, the stock exchange released its new trading system called AMS-3. The stock exchange had been trading electronically for a number of years; now, it is also an open system. With an open front-end system, brokers can tie their order-routing systems or their customers’ Internetbased activity directly into the stock exchange for straight-through processing. That functionality will have a significant impact on the Hong Kong and Asian business community because online trading is virtually nonexistent in Hong Kong, although the major international online brokerage firms—such as E*trade, Charles Schwab & Company, and PricewaterhouseCoopers—are coming into Hong Kong in a big way. Significant growth in the market is likely to result from the advent of online trading in Hong Kong.

Threats Exchanges face four main threats to their livelihood: business-to-business (B2B) operations, electronic communications networks (ECNs), broker consortiums, and competing exchanges. B2B Operations. Thousands of B2B exchanges are being created worldwide, and the technology providers are making money in this sector. But I do not know of any pure exchanges that are making money in the B2B area, and I guarantee that 90 percent of B2B companies will not be successful. B2B operations, however, are the natural evolution of the marketplace, because they offer a wide variety of products, grades, quality, and buyers and sellers. These markets will eventually move to standardize certain kinds of products, such as benchmark pricing, and eventually will develop such products as forwards, futures, and options that will directly compete with the traditional exchange community. Many of the B2Bs are now exploring financial guarantees for transactions, which is essentially the core of the exchange business. As a result, many of the traditional exchanges are closely watching what happens in the B2B area, but few are serious about entering that marketplace. ECNs. The ECN business is not a threat to the exchanges in Asia, but it is a threat to the markets in Asia. The ECN business is dominant in the United States, particularly for the Nasdaq, but the Nasdaq uses a different business model from that of the HKEx. The Nasdaq uses a quote-driven system in which competing specialists post their bids and offers. The ECN business developed as a crossing business, in which ECNs could cross their customer orders and then send what they could not match themselves to the Nasdaq. In effect, the HKEx, which uses an order-

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The New Financial Landscape in Asia driven system that matches buyers and sellers when their bid and ask prices are equal, is already operating as an ECN. So, I do not see the ECN business as having much of an impact in Hong Kong. On the other hand, many of the major ECNs have made no secret of their plans to expand their business internationally. They are already moving into Europe, and the more mobile, more competitive ECNs will most likely penetrate the Asian markets soon.

ing floor, but trading floors cannot be put in different locations around the world. Thus, the solution is to close down trading floors and move toward screenbased trading, because screens are extremely mobile. In order for exchanges to extend their reach and take advantage of technology, cross-border trading and cross-border access have become a major part of the exchanges’ survival strategies.

Broker Consortiums. Brokers are beginning to move into the exchanges’ space. Morgan Stanley Dean Witter & Company has created a venture with the OM Group to form Jiway, a stock trading business in Europe. Merrill Lynch & Company recently announced that it will also get into the stock exchange business. And in the United States, a consortium of brokers formed a new business called Broker Tech to essentially serve as the consortium’s own exchange. These brokers have either been unhappy with the performance of the exchanges or wanted to compete with the exchanges. An interesting corollary is whether the exchanges will move into the brokers’ space now and begin to have direct contact with the customers.

Government Policies. Government policies pose another big challenge, particularly in Asia. These policies include significant currency restrictions, conflicting regulatory policies, and differing regulatory restrictions between countries. Many countries in Asia would like to open access to their markets, but the Asian financial crisis of 1997 and 1998 is still fresh in the minds of the regulatory community. Opening a market can create a conflict between attracting international business and protecting the local market. I have seen a number of different conflicts in those policies in Hong Kong alone. The problem goes back to the saying that business is global but politics is always local. The trend for government policies to protect the local markets will probably continue for some time.

C o m p e t i n g E x c h a n g e s . Exchanges have always competed with each other for orders, and given the advances in technology, exchanges have begun to expand their reach internationally. Hong Kong and Singapore should be able to add stocks, new products, futures, or derivative products from each other’s market. This trend toward increasing competition among the exchanges will most likely continue. Thus, the exchanges will be forced to decide whether they are comfortable with increased competition among themselves or whether they prefer to increase the level of cooperation with one another—a choice that would lead to more mergers and alliances. The problem that most of the exchanges face is that if they do not cooperate with other exchanges by forming alliances or by merging, then they may be left without any partners in the international marketplace.

Challenges The Asian exchanges are facing challenges from a number of corners, including globalization, government policies, standards, technology, readiness, and education. To compete, exchanges will have to implement effective strategies for meeting these challenges. Globalization. The biggest challenge for the exchanges is how to take advantage of the trend toward increased globalization of the investment industry. Historically, the exchanges have had a trad-

Standards. Standards present yet another big challenge for the Asian markets. Listing requirements are different in many countries, which creates problems for international investors and international brokerage firms attempting to do business in different markets. Different disclosure rules and different standards of supervision exist. Moreover, different technology standards are in place. Hong Kong has tried to take steps toward encouraging international standards in the area of accounting. At the end of October 2000, the HKEx announced that it would accept financial reports using U.S. GAAP (generally accepted accounting principles) and international accounting standards as well as Hong Kong GAAP. Again, I see a trend, at least among the exchange community, of continuing to move toward international standards. Unfortunately, U.S. standards may not always be appropriate in the local market. Technology. Technology creates lower barriers to entry, which will bring increasing competition to the exchange community. Exchanges are moving from floor-based to screen-based trading, but doing so is a major cultural, financial, and technological challenge for many of the exchanges. Moving to screen-based trading also requires a significant investment in new technology. Many of the exchanges have huge infrastructures and huge financial investments in old technology, and this old

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Evolution in Equity Markets technology makes it difficult for exchanges to adapt to the needs of the newer marketplaces. Readiness. Most of the brokerage community in Hong Kong is not ready for electronic trading, which is why the major international online brokering firms are coming into Asia. The brokerage community will face increasing competition, and some consolidation in the Hong Kong brokerage industry will likely occur. Education. Education is the last big challenge. Education is needed not only in the securities markets but also in the derivative markets. Investors, and even the brokerage community, are not familiar with the use of futures and option products. As a result, increased efforts to improve education among the retail community and the brokerage community are on the horizon.

The data in Table 1 also reflect the opportunities available for the Hong Kong markets. The market capitalization of all Hong Kong stocks listed on the HKSE in 1999 was almost four times the GDP of Hong Kong, which shows how thoroughly the market is saturated with Hong Kong companies. But looking at mainland China and Hong Kong combined shows that the market capitalization of securities listed on the Hong Kong, Shanghai, and Shenzhen stock exchanges was only about 82 percent of the combined GDP of both countries. Thus, significant growth prospects for new listings coming from mainland China are possible.

Table 1. Market Capitalization/GDP for Various Exchanges, 1999 Exchange

Opportunities

Hong Kong

The Asian exchanges may be facing challenges, but they are also looking at opportunities. The biggest opportunities (for the HKEx in particular) come from China, the second board markets, and a variety of other sources (such as alliances and product offerings). China. China presents the biggest opportunity for the Asian financial markets. Significant listings on the Hong Kong exchange have come out of mainland China, about 48 companies so far. In fact, the vast majority of Chinese enterprises’ access to the international capital markets comes through the HKEx. From 1993 to 1999, Chinese enterprises raised US$35 billion in Hong Kong, compared with US$7 billion in the United States and US$192 million in Singapore. The Shanghai exchange is designed to attract capital from within China itself, but it could begin to encourage foreign financial investors to increase their participation. The Shenzhen exchange increasingly looks as if it will be the market for the second board—for smallcap securities and new listings. Although many capital and currency controls and restrictions on foreign trading activity still exist in China, Internet trading provides an example of the potential growth of Chinese markets. Internet trading in China has grown from mid-1999 to late 2000 by 500–600 percent (based on the number of participants). But as of the end of 2000, those trading on the Internet represent less than 1 percent of the population of China. By comparison, the numbers for Internet trading and penetration in other countries in the region—Taiwan, Singapore, and South Korea in particular—approach 30–40 percent. The growth opportunities coming out of China, simply given the population, will be significant in the years to come.

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Market Capa/GDP 386%

Switzerland

258

London

201

Amsterdam

176

Toronto

125

New York

124

Paris

105

Tokyo

102

Germany

68

Italy

62

Mainland Chinab and Hong Kong

82

Note: The exchanges presented here are the top stock exchanges based on the market cap in that month. The exchange selected for each country is the most representative one. a Market capitalization is valid as of December 1999 and excludes investment funds. b Mainland China includes Shanghai and Shenzhen stock exchanges.

Sources: International Federation of Stock Exchanges’Monthly Statistics, Economist Intelligence Unit Country Data, Census and Statistics Department Web site, and Hong Kong Special Administrative Region Government.

GEM. In November 1999, the Hong Kong Stock Exchange started the Growth Enterprise Market (GEM), which is a second board market. The purpose of these second boards is to encourage smaller companies to list, usually by creating different standards from the ones required of companies listing on the main board. Second boards exist throughout Asia— in Malaysia, Taiwan, Singapore, Korea, and Japan. In Hong Kong, the amount of capital raised is an important measure of the success of these particular ventures. Table 2 shows the funds raised on the second boards from inception through June 30, 2000.

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The New Financial Landscape in Asia Table 2. Funds Raised from Inception of Second Board through June 30, 2000 Inception Date

Funds Raised (U.S. millions)

GEM

11/99

$1,340

KLSE 2nd Board

1988

47

ROSE

1989

365

Country

Second Board

Hong Kong Malaysia Taiwan Singapore

Sesdaq

1987

70

South Korea

Kosdaq

1996

1,084

Japan

Mothers

12/99

642

Note: KLSE = Kuala Lumpur Stock Exchange; Sesdaq = Singapore Securities Dealers Automated Quotation; Kosdaq = Korean Securities Dealers Automated Quotation; Mothers = market of the high-growth and emerging stocks.

Other. Exchanges will be able to take advantage of other opportunities, such as alliances, trading hours, capacity, and new product offerings. In terms of alliances, the Nasdaq and the NYSE have been active in trying to form worldwide alliances. Some alliances have also formed in the derivative markets. The HKEx is actively involved in those kinds of discussions. The difficulty, however, is that different exchanges use different business models. Although the HKEx is driven by revenue and shareholder value, other exchanges are driven by the desire to create trading opportunities for their members. These types of exchanges have operating models that are different from those of the HKEx. The HKEx is fully electronic; the NYSE, for example, is floor based. The Nasdaq uses a quote-driven system, but the HKEx uses an order-driven system. The business strategies of the various exchanges worldwide are not yet harmonized to the point at which alliances will be easy to implement. The ability to increase the trading hours of the Hong Kong market is an important opportunity for the exchange. Technology allows the markets to be open 24 hours a day, but the HKEx is open for only four hours a day: It is open from 10:00 a.m. to 12:30 p.m., shuts down for two hours for a nice leisurely lunch, and then reopens from 2:30 p.m. to 4:00 p.m. Although I do not think that the HKEx will operate on a 24-hour basis, I would definitely expect all the

Asian markets to expand the access to their markets and their hours of trading. Capacity expansion in the systems used by the exchanges is another opportunity for exchange growth. As a result, the HKEx, along with the other Asian exchanges, will most likely invest additional capital in its existing systems to prepare for expected future market growth. New product offerings are another big area of opportunity for the exchange community. Asia’s exchange community is primarily equity based, so I would look for the exchanges to diversify beyond the equity markets into various types of debt instruments (to the extent that is possible). Short-term money markets are a fairly successful product in Hong Kong, but the exchanges may move back to their traditional roots in basic commodity trading. I would also look for popular products on other exchanges, such as exchange-traded funds, to surface as new products on the Asian exchanges.

Conclusion I came to Hong Kong primarily because the growth opportunities in this part of the world are better for the financial markets than they are anywhere else. The markets in Hong Kong are merged, demutualized, publicly traded, and completely electronic. I have found three general trends in Hong Kong. The first trend is the globalization of the market. Exchanges will continue to expand their reach across borders, particularly using technology to increase and improve access to their markets. The second trend is improving technology, because it offers exchanges the ability to expand. Technology has made trading cheaper, better, more transparent, and much quicker for international investors worldwide. Finally, the market structure generally will benefit significantly from these new developments. The number of market makers in Hong Kong has increased, particularly with electronic trading. The future of the retail business is optimistic, and the markets in Hong Kong offer institutional investors the most attractive product opportunity.

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Evolution in Equity Markets

Question and Answer Session Frederick J. Grede Ho Yew Mun Question: How do you deal with the conflict between the need to have a transparent market and the need to preserve market confidentiality? Grede: The stock exchange discloses broker names, but the futures exchange is completely anonymous. This practice may be partly attributable to historical reasons, but markets, particularly electronic markets, have to be anonymous. The real issue is which type of investor you are trying to attract. Retail investors like to know what the institutional investors are doing so that they can follow in their footsteps. But the only way to attract activity from institutional investors is to provide anonymity. Ho: The trading in the market— offers and orders—has to be anonymous to engender confidence. Hence, the dealers know the counterparty only after the trade is done. We are beginning, however, to make available to market participants (other than brokers/dealers) and the end clients information on the extent of the depth in the market. Doing so will provide substantial information about market liquidity. Question: What steps have been taken to alleviate the perceived credit problems of broker/dealers? Grede: Different steps have been taken to address some of the credit issues—including direct investor participation, where investors can deposit their funds directly with the exchange and bypass the broker. We probably have 5,000 or

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6,000 direct investor participation relationships. Question: How does the cost of the regulatory burden on market participants in Asia compare with other areas of the world? Ho: We have reviewed and revised our trading and listing rules—in response to and in consultation with the market. I don’t think our rules are out of sync with international practice, and I am sure that our regulation costs are lower than in the United States. Grede: My basis for comparison is the United States. I can list a myriad of issues involving U.S. regulations with which I have some difficulty. Hong Kong, like most of the other Asian markets, is still locally focused; it is not focused on attracting business from outside its borders. For example, for a broker to open up an account with a retail customer, the broker has to have a face-to-face interview with that customer. That requirement makes no sense to me, because how are local brokers in particular going to be able to attract international business? The derivative business has many disclosure rules—such as having to disclose the beneficial ownership of any position of more than 200 contracts. The hedge fund proprietary traders, institutional investors, and business in Hong Kong are discouraged because of some of these requirements. Question: Do you believe that your government fully understands the economic benefits of a highly sophisticated and transparent international exchange?

Ho: Yes, because the changes that the Singapore market has experienced over the past two years have been initiated by our government. Grede: Yes, the government in Hong Kong has been particularly supportive of these major restructuring initiatives. Question: Which products were the most successful and which were the most disappointing relative to your original expectations? Ho: We expected the recent launch of the STI futures to do better than it did, but it has not sparked the interest of the retail sector of the market. A factor in its lack of acceptance may be poor understanding of the futures market. On the other hand, a recent success was the Taiwan equity index futures contract. Grede: Electronic trading has probably been the biggest accomplishment in Hong Kong over the past year. The Hong Kong Futures Exchange actually closed the trading floor and put everything on an electronic system. Worldwide floor-based trading system growth is flat to negative; electronic trading system growth is positive. Electronic trading also allows us to do a number of different things. We’ve seen significant growth in our main product, the Hang Seng Index (HSI), as well as option trading on the HSI contract. Our HIBOR (Hong Kong Interbank Offered Rate) contract, which is a short-term money market instrument to which we added some strip functionality, allows you to extend the yield curve and has had some considerable success.

©2001, Association for Investment Management and Research

Valuation Fundamentals in Asia In October 2000, we launched a minicontract on the HSI contract (on the size of the Hang Seng Index), and it has been doing about 10 percent of the total volume— about 2,000 contracts a day. For a new contract, this is very encouraging. It is designed to attract the retail segment of the marketplace, and that’s a trend that is occurring worldwide. It took us awhile to get the minicontract approved, but we persisted. I think that retail investors should have every possible tool available so that they can participate in the marketplace to the extent that the large institutions do. The launch of that contract was done in conjunction with a significant educational campaign on the use of futures and options. I think we’re very clear: We don’t want retail business unless participants understand the mechanics of trading futures and options. Question: To what extent is Shanghai a threat down the road? Grede: I don’t think that Hong Kong and Shanghai are in competition. The Shanghai market will grow; the Chinese markets will grow. Shanghai’s percentage of business coming out of China will continue to increase. But there is still a considerable way to go with the Chinese stock markets before they meet international standards. Many brokerage firms and investors will participate in and invest in those markets, but before they put significant amounts of capital at risk in them, they’re going to have to be comfortable with the ways of doing business—international standards of accounting, disclosure, regulation, and so on. The

Chinese markets have a way to go before they will have the confidence of the international investing community. Question: Over the past 20–30 years, numerous attempts at crossborder listings have been made in Europe and the United States. Recently, similar attempts have been made in Hong Kong and Singapore. (I call them unnatural listings whereby U.S. companies are brought to Hong Kong or Singapore with a huge furor and large press attention, and then no trades take place.) Is this one aspect of the cross-border business that is doomed to failure? Ho: For a successful cross-border listing in Singapore, the company has to do an IPO at the early stage. A secondary listing or a subsequent listing without an offer would not work to create interest and liquidity. Companies from China or Taiwan that have come to Singapore do enjoy sustained interest and liquidity because they were issued as IPOs with a concurrent listing/offering in Singapore. Grede: I think you will see crossborder listings migrate to most liquid markets, and they will increase. We trade seven Nasdaq stocks in Hong Kong, but they don’t trade that actively. And we’ve had a number of difficulties with the trades in Hong Kong dollars: They’ve been very expensive for retail investors and have had different board lot sizes. I can’t quickly say what the price of Intel is that trades on the Hong Kong Exchange, because it takes me half an hour to do the conversions to

©2001, Association for Investment Management and Research®

figure out what the relevant price is. On the other hand, the United States has a pretty active and growing after-hours market. Nasdaq is looking for international outlets in the exchange community for its stocks as competition to the afterhours ECN markets. So, I would continue to look for various types of worldwide cooperative arrangements throughout the U.S., European, and Asian time zones and then within the same region. There is an ADR (American Depositary Receipts) market that is pretty strong in the United States and a GDR (Global Depositary Receipts) market in Europe, so why isn’t there something similar in Asia? Question: How would one value the HKEx’s stock? Grede: It is hard to determine the value of the stock. Only three exchanges worldwide are publicly listed: the OM Stockholm Exchange, which is the Swedish exchange, HKEx, and ASX, which is the Australian Stock Exchange. The London Stock Exchange (LSE) is not really publicly traded. OM is not a comparable situation to the HKEx because it has a large technology business that provides trading systems not only to the brokerage community but also to the exchange community. ASX is not comparable because it has a 90 percent dividend payout policy. Thus, the HKEx is in new territory. That said, on a P/E basis, the HKEx trades at 20 times earnings compared with 56 for the OM, 26 for the LSE, and 23 for the ASX (data are as of October 2000).

11

The Singapore Story Ho Yew Mun Senior Vice President and Division Head, Securities Trading Singapore Exchange Limited 1 Singapore

The Singapore Exchange—crossroad of the Eastern and Western investment communities—is progressively adapting to the demands of a technologically driven world. Recently formed from the combination of the Stock Exchange of Singapore and the Singapore International Monetary Exchange, the Singapore Exchange is pursuing public ownership of the exchange, regulatory reform, and alliances with other exchanges around the globe. The Singapore Exchange has also launched a second board, Sesdaq, to foster development of newly formed small companies.

he Asian financial crisis of the late 1990s and the technological revolution have changed the trading environment in Asia, and the Singapore market is adapting to the new environment to ensure its survival. The new paradigm for the Singapore Exchange involves deregulation, integration, and technology and is leading to new global distribution strategies, new trading and access infrastructure, market liberalization, and new products. In this presentation, I will discuss the changing environment in Singapore and the opportunities that this changing environment provide for the Singapore Exchange.

T

Financial Market Liberalization Singapore market liberalization includes demutualization, open access for dual membership, a regulatory framework similar to that of the U.S. SEC and U.K. Securities and Futures Authority (SFA), the use of Singapore dollars for fundraising, and the initial public offering (IPO) of the Singapore Exchange. In December 1999, the Stock Exchange of Singapore (SES) and the Singapore International Monetary Exchange (SIMEX) were merged into a new corporate entity—the Singapore Exchange (SGX). 1 Mr. Ho is now managing director of equity capital markets in the Investment Banking Group of the Development Bank of Singapore.

Editor’s note: The joint Question and Answer session of Frederick J. Grede and Ho Yew Mun follows Mr. Ho’s presentation.

6

Consequently, a member can now be a futures member and a securities member with a single membership. The SGX believes that the benefits of convergence include savings through capital efficiency and allowing members to provide a complete, one-stop service to their clients in securities and derivative trades. At the time of the merger, restrictions on the number of securities trading memberships were lifted, and membership was opened to all market participants that met the membership requirements. This new structure offers an improved use of capital requirements and savings in terms of operational costs for entities that combine futures trading and securities trading operations. The capital requirements are now risk based, which allows brokerage firms to make a more efficient use of capital. Regulation of listed companies is also changing. Singapore is moving to what many call “disclosurebased regulation” for listed companies and toward creating an SEC/SFA-style regulator. Singapore is also writing new laws and regulations that will span the entire spectrum of securities traded in the market. Singapore recently liberalized securities commissions; now, the brokerage firms set the commission rates for their customers. The hope is that this liberalization of commissions will cause the use of online trading to expand. The government also decided to allow the use of Singapore dollars to fund local and overseas companies, which had been restricted in the past.

©2001, Association for Investment Management and Research®

The Singapore Story Finally, in September 2000, the SGX announced its plans to go public before the end of the year.2

•

Changing Environment

•

Those who have been following the Singapore market have seen many significant changes over the past several years. The government has had several study groups and committees reviewing financial market operations. Most of their recommendations have been accepted or are being considered for implementation. The SGX itself is responding to the changing environment by putting more emphasis on crossborder listings, alliances, and new product development and by improving its mutual offset system and cross-border trading linkages. Increased Cross-Border Listings. The SGX is trying to increase the number of listings by foreign companies. As Table 1 shows, currently about 80 entirely foreign-owned, foreign-operated, and foreign-located companies are listed on the SGX.

Table 1. Foreign Enterprises Listed on the SGX, July 2000 Domicile of Enterprise

Number

Hong Kong

37

China

12

Southeast Asia

11

Japan

7

Taiwan

3

Australia

2

Europe

3

Alliances. The SGX has undertaken a number of global alliances and cooperative agreements to expand cross-border listing of companies and other products. In the fall of 2000, the SGX had established or was in the process of pursuing relationships with the following exchanges. • CME (Chicago Mercantile Exchange)/GLOBEX: The SGX has an established and successful relationship with the CME/GLOBEX alliance. This alliance was the world’s first arrangement to facilitate trading of the same product in different time zones. • ASX (Australian Stock Exchange): The SGX is working on an alliance with the ASX to crosstrade securities on both markets. The venture is scheduled to launch sometime in June 2001.

2 On November 23, 2000, after this presentation was given, the SGX became a publicly listed company.

•

•

Amex: The SGX entered into a joint venture with Amex to trade Amex exchange-traded funds (ETFs) in the Singapore market. KSE (Korean Stock Exchange): The SGX is in discussions with the KSE to develop opportunities together. TSE (Taiwan Stock Exchange): The SGX and TSE are continuing to discuss regulatory issues and the cross-trading of securities. Some of these bilateral regulatory issues have a long timeline for completion and many aspects to be addressed. NSE (National Stock Exchange of India): The SGX has launched the S&P Nifty Index futures contract with the NSE. It is another partnership that the SGX is building on. The developments are expected to cover trading in futures contracts as well as trading in securities.

New Products. The SGX is working on launching (or has launched in some cases) a number of new products: the ST Index (Straits Times Index) futures contract, the S&P Nifty Index futures contract, Amexlisted ETFs, and ASX-listed stocks.

Technology The primary force that the SGX and other exchanges and markets in Asia are responding to is the unrelenting advancement in global technology. The advent of wireless technology, the popularity of online trading, and the proliferation of electronic communications networks are the imperatives forcing change. The SES, and now the SGX, had always been in the forefront of trying to adopt new technology. The SES had electronic or computer trading since 1989, and by about 1990, there was no longer a physical trading floor at the SES. In 1993, the Singapore Telecom IPO was the first to use the SES’s electronic share application system. The electronic share application system is a convenient way to buy shares. A person can use an automatic teller machine card at the local ATM to apply for shares and confirm the number of shares bought and subsequently allocated. There is, therefore, no physical handling of applications nor scrips. The system has a fast turnaround and does not affect the overnight cash market. Another example of the SES’s use of technology is the electronic payment of dividends in Singapore since 1995. The SGX is committed to being at the forefront of technology. In October 2000, the SGX published a white paper on the outlook for the exchange. The paper includes an outline of what the SGX is doing and what it expects to be doing one or two years down the road. The basic message is that the SGX will adopt the FIX 4.2 protocol, the documentation and testing of which will be available to the public by March 2001.

©2001, Association for Investment Management and Research®

7

Evolution in Equity Markets This protocol allows the participant brokers to enter the SGX computer directly without using the SGX’s current proprietary trading system.

Development of New Markets The SGX continues to look for opportunities in new markets. As do other exchanges in the region, the SGX has a second board—the Sesdaq (Singapore Securities Dealers Automated Quotation). A common misconception is that the second boards will be inferior to the main boards. The SGX, however, is committed to maintaining a high degree of regulatory integrity for the Sesdaq. The introduction of this new exchange was intended to complement and foster growth in the Singapore economy by promoting the listing of start-ups and by helping smaller companies that are unable or have difficulty finding and getting bank financing. The Sesdaq was established to engender the confidence of market participants, and this sense of confidence is paramount to the corporate governance of the exchange and the transparency of its reporting. The Sesdaq includes companies of all industries, ranging from manufacturing to hotel/restaurant services. Some of these companies have grown to be main-board companies, and some were mentioned in Forbes Global’s list of the 300 best small companies in the world.3 The SGX also revised its requirements to help high-quality emerging companies list on the main board. Most exchanges use a track record requirement for listing, but in 1999, the SGX adopted a market capitalization requirement of at least S$80 million based on the IPO’s issue price.

Metamorphosis of the Regulatory Regime The SGX has undergone a metamorphosis in its regulatory regime and has emerged with a disclosurebased regime. In 1999, the SGX proposed the adoption of the International Organization of Securities Commissions’ standards of prospectus disclosure and documentation. In doing so, the SGX recognized all internationally accepted accounting standards— U.S. generally accepted accounting principles, U.K. GAAP, and International Accounting Standards GAAP. Many professionals trading in the Singapore markets are familiar with U.S., U.K., or European companies and are generally aware of the accounting standards that apply to them. Moreover, public information is now readily available and accessible. The SGX was one of the 3

Forbes Global, “The 300 Best Small Companies” (October 30, 2000).

8

early users of the Internet to make information available to investors. In the early days, the SGX also adopted what the SEC now calls “fair disclosure.” All listed companies are required to e-mail their corporate news to the SGX on a secure network. This news is then posted on the SGX Web site. Thus, the financial community and the public have concurrent access to every announcement, every prospectus, and any other important financial news involving a Singapore-listed company. Consequently, no one dealing in the Singapore investment community should operate at a disadvantage. As a guiding principle, the SGX seeks growth in the marketplace without any compromise in quality. The goal is quality, integrity, and transparency.

Challenges in the New Environment The SGX will face many challenges as a result of the new market environment. These challenges include retaining liquidity, educating investors and analysts, and continuing to get listed companies to make greater disclosure and be more transparent in what they are doing. As the market experiences greater intraday volatility, our market surveillance will likewise increase. Market participants in general, and retail investors in particular, need to understand risk and that they have to take responsibility for their investment decisions. The public still complains loudly about losing money in the stock market. The SGX is focusing on three main areas to meet these challenges: deregulation, competition, and education. To address deregulation, the SGX is adopting international standards of corporate governance and disclosure. To address competition, the SGX is encouraging “contests” that rate the best companies according to their standards of disclosure. To address investor education, the SGX is sponsoring seminars to create awareness about a wide range of issues, from how the market operates to new products on the exchange. For example, the SGX recently held successful seminars to educate market professionals about the life sciences and technology businesses. The SGX arranged for a series of wellinformed scientists and entrepreneurs, including one of the top life science analysts from the United Kingdom, to talk about investing in life science companies and the dangers in the valuation models being used for these companies. The SGX will continue in its efforts to help the Singapore market grow by helping the investment community to become better informed.

©2001, Association for Investment Management and Research®

The Singapore Story

Conclusion The Asian financial crisis and the technological revolution have changed the trading environment in Asia, creating the need for structural change. The Singapore market needs to make this structural change to ensure survival; thus, the SGX is being reengineered in a number of ways (e.g., improving its

trading engines, front end, clearing system, and so on) and has plans to introduce international standards. More challenges are sure to come as additional developments unfold, which is very exciting. The SGX intends to ride these waves of change and come out on top.

©2001, Association for Investment Management and Research®

9

Evolution in Equity Markets

Question and Answer Session Frederick J. Grede Ho Yew Mun Question: How do you deal with the conflict between the need to have a transparent market and the need to preserve market confidentiality? Grede: The stock exchange discloses broker names, but the futures exchange is completely anonymous. This practice may be partly attributable to historical reasons, but markets, particularly electronic markets, have to be anonymous. The real issue is which type of investor you are trying to attract. Retail investors like to know what the institutional investors are doing so that they can follow in their footsteps. But the only way to attract activity from institutional investors is to provide anonymity. Ho: The trading in the market— offers and orders—has to be anonymous to engender confidence. Hence, the dealers know the counterparty only after the trade is done. We are beginning, however, to make available to market participants (other than brokers/dealers) and the end clients information on the extent of the depth in the market. Doing so will provide substantial information about market liquidity. Question: What steps have been taken to alleviate the perceived credit problems of broker/dealers? Grede: Different steps have been taken to address some of the credit issues—including direct investor participation, where investors can deposit their funds directly with the exchange and bypass the broker. We probably have 5,000 or

10

6,000 direct investor participation relationships. Question: How does the cost of the regulatory burden on market participants in Asia compare with other areas of the world? Ho: We have reviewed and revised our trading and listing rules—in response to and in consultation with the market. I don’t think our rules are out of sync with international practice, and I am sure that our regulation costs are lower than in the United States. Grede: My basis for comparison is the United States. I can list a myriad of issues involving U.S. regulations with which I have some difficulty. Hong Kong, like most of the other Asian markets, is still locally focused; it is not focused on attracting business from outside its borders. For example, for a broker to open up an account with a retail customer, the broker has to have a face-to-face interview with that customer. That requirement makes no sense to me, because how are local brokers in particular going to be able to attract international business? The derivative business has many disclosure rules—such as having to disclose the beneficial ownership of any position of more than 200 contracts. The hedge fund proprietary traders, institutional investors, and business in Hong Kong are discouraged because of some of these requirements. Question: Do you believe that your government fully understands the economic benefits of a highly sophisticated and transparent international exchange?

Ho: Yes, because the changes that the Singapore market has experienced over the past two years have been initiated by our government. Grede: Yes, the government in Hong Kong has been particularly supportive of these major restructuring initiatives. Question: Which products were the most successful and which were the most disappointing relative to your original expectations? Ho: We expected the recent launch of the STI futures to do better than it did, but it has not sparked the interest of the retail sector of the market. A factor in its lack of acceptance may be poor understanding of the futures market. On the other hand, a recent success was the Taiwan equity index futures contract. Grede: Electronic trading has probably been the biggest accomplishment in Hong Kong over the past year. The Hong Kong Futures Exchange actually closed the trading floor and put everything on an electronic system. Worldwide floor-based trading system growth is flat to negative; electronic trading system growth is positive. Electronic trading also allows us to do a number of different things. We’ve seen significant growth in our main product, the Hang Seng Index (HSI), as well as option trading on the HSI contract. Our HIBOR (Hong Kong Interbank Offered Rate) contract, which is a short-term money market instrument to which we added some strip functionality, allows you to extend the yield curve and has had some considerable success.

©2001, Association for Investment Management and Research

Valuation Fundamentals in Asia In October 2000, we launched a minicontract on the HSI contract (on the size of the Hang Seng Index), and it has been doing about 10 percent of the total volume— about 2,000 contracts a day. For a new contract, this is very encouraging. It is designed to attract the retail segment of the marketplace, and that’s a trend that is occurring worldwide. It took us awhile to get the minicontract approved, but we persisted. I think that retail investors should have every possible tool available so that they can participate in the marketplace to the extent that the large institutions do. The launch of that contract was done in conjunction with a significant educational campaign on the use of futures and options. I think we’re very clear: We don’t want retail business unless participants understand the mechanics of trading futures and options. Question: To what extent is Shanghai a threat down the road? Grede: I don’t think that Hong Kong and Shanghai are in competition. The Shanghai market will grow; the Chinese markets will grow. Shanghai’s percentage of business coming out of China will continue to increase. But there is still a considerable way to go with the Chinese stock markets before they meet international standards. Many brokerage firms and investors will participate in and invest in those markets, but before they put significant amounts of capital at risk in them, they’re going to have to be comfortable with the ways of doing business—international standards of accounting, disclosure, regulation, and so on. The

Chinese markets have a way to go before they will have the confidence of the international investing community. Question: Over the past 20–30 years, numerous attempts at crossborder listings have been made in Europe and the United States. Recently, similar attempts have been made in Hong Kong and Singapore. (I call them unnatural listings whereby U.S. companies are brought to Hong Kong or Singapore with a huge furor and large press attention, and then no trades take place.) Is this one aspect of the cross-border business that is doomed to failure? Ho: For a successful cross-border listing in Singapore, the company has to do an IPO at the early stage. A secondary listing or a subsequent listing without an offer would not work to create interest and liquidity. Companies from China or Taiwan that have come to Singapore do enjoy sustained interest and liquidity because they were issued as IPOs with a concurrent listing/offering in Singapore. Grede: I think you will see crossborder listings migrate to most liquid markets, and they will increase. We trade seven Nasdaq stocks in Hong Kong, but they don’t trade that actively. And we’ve had a number of difficulties with the trades in Hong Kong dollars: They’ve been very expensive for retail investors and have had different board lot sizes. I can’t quickly say what the price of Intel is that trades on the Hong Kong Exchange, because it takes me half an hour to do the conversions to

©2001, Association for Investment Management and Research®

figure out what the relevant price is. On the other hand, the United States has a pretty active and growing after-hours market. Nasdaq is looking for international outlets in the exchange community for its stocks as competition to the afterhours ECN markets. So, I would continue to look for various types of worldwide cooperative arrangements throughout the U.S., European, and Asian time zones and then within the same region. There is an ADR (American Depositary Receipts) market that is pretty strong in the United States and a GDR (Global Depositary Receipts) market in Europe, so why isn’t there something similar in Asia? Question: How would one value the HKEx’s stock? Grede: It is hard to determine the value of the stock. Only three exchanges worldwide are publicly listed: the OM Stockholm Exchange, which is the Swedish exchange, HKEx, and ASX, which is the Australian Stock Exchange. The London Stock Exchange (LSE) is not really publicly traded. OM is not a comparable situation to the HKEx because it has a large technology business that provides trading systems not only to the brokerage community but also to the exchange community. ASX is not comparable because it has a 90 percent dividend payout policy. Thus, the HKEx is in new territory. That said, on a P/E basis, the HKEx trades at 20 times earnings compared with 56 for the OM, 26 for the LSE, and 23 for the ASX (data are as of October 2000).

11

The Alchemy of E-Finance Robert G. Zielinski, CFA Director of Financial Research ABN AMRO Securities Tokyo

Asian financial institutions have been rushing madly to offer their services over the Internet and thereby build highly efficient and profitable operations. The experiences to date, however, in the online brokering markets of South Korea and Japan show that the Internet may actually be a destroyer of shareholder value. Moreover, a number of companies have exploited the boom to relieve investors of their money. Our hunch at ABN AMRO Securities is that the Internet represents fool’s gold to financial institutions and may actually contribute to a financial crisis.

inancial institutions have caught the Internet wave, as have most companies in this day and age. Asian financial institutions are certainly no exception. Practically every financial institution in Asia is hoping to build a competitive advantage through the Internet and thereby create massive amounts of shareholder wealth. In practical terms, however, most of the activity has focused on online brokering, primarily in the more developed countries of South Korea and Japan. Korea has the highest penetration rate for online equity brokerage in the world. In 1998, online trading was just 4 percent of total market turnover in Korea, but as of July 2000, it had risen to 61 percent. Korea also has seen explosive growth in the number of online accounts, reaching 3.4 million as of July 2000. Unlike in the United States, the online brokering market is not dominated by Internet start-ups but by the major traditional brokers. The top five Korean firms by turnover control 65 percent of the market, leaving no room for start-up companies to establish themselves. Japan’s online brokerage market has also seen explosive growth. Japan finally deregulated commission rates for individuals in October 1999, and everyone rushed into the online brokering market. The stampede included all the major traditional Japanese brokers, new purely online brokers, and the foreign online brokers that made their fortunes in the United States, such as E*Trade Group and DLJdirect. People got so excited that they even set up new stock exchanges for the young, high-growth Internet companies.

F

12

In this presentation, I will give my initial conclusions about e-finance based primarily on the online brokering experiences of South Korea and Japan and also explore the potential of the Internet for turning dross into gold. (Note that these conclusions are indicated in the presentation by quotation marks.) “All Financial Companies Must Go Online.” Whether they like it or not, all financial companies must go online because using the Internet offers definite cost advantages, primarily from economies of scale. Also, the marginal transaction costs are generally zero, and no branch offices or human resources are involved. Online brokering is selfservice. Before e-finance, companies themselves had to do the paperwork for trades, such as filling in the forms and placing the trade. With online transacting, the customer does all the work. A comparison of the costs of running a typical financial company and the costs of running an e-finance company is compelling. The traditional insurance company, for example, takes in US$100 of premium, sees US$60 go out as claims, pays the insurance agent about US$18 in commissions, and has the rest eaten up by selling, general, and administrative (SG&A) expenses. So, the insurer’s underwriting income is zero, and the only income the company has is the interest income earned on premium payments received from the insured. The traditional brokerage firm pays employee compensation equal to about 50 percent of revenues, has some overhead expense, and is left with pretax profits of about 30 percent of

©2001, Association for Investment Management and Research®

The Alchemy of E-Finance revenues. The traditional bank—say, a Hong Kong bank—lends out money at 9 percent, pays 5 percent on its deposits, pays 2 percent to run the branch offices and cover overhead expenses, and is left with a pretax return on assets of 2 percent. With the e-finance companies, the cost savings are tremendous. The e-insurer, which sells insurance over the Internet, does not have to pay an agent, and its customers fill in the applications themselves, so the e-insurer saves on SG&A. It still makes nothing on underwriting, but it can lower premiums by 33 percent. For the e-broker, the savings passed on to clients are much greater, about 80 percent of traditional brokerage commissions. The e-bank saves the customer about 25 percent over the traditional bank, either in terms of lower lending rates or higher deposit rates. The conclusion from these data is that all financial companies will go online because doing so provides compelling cost savings. Going online is a pure information technology (IT) investment. Thanks to the Internet, the e-finance business now requires only a few nerds and a computer. “Structural Factors Determine Growth.” How quickly these three types of e-finance companies (e-insurer, e-broker, and e-bank) grow is largely determined by structural factors. So far, only online brokering has emerged in Asia, because the cost savings in this industry are most obvious. Online brokers can offer much lower commission rates because they have no branches, no sales force, and a small staff. Online brokers also offer convenience. An investor can place orders at home 24 hours a day. In addition,

the execution is transparent: The order goes directly to the market, where it is executed automatically. Also, trading securities is a transaction that occurs frequently. In contrast, depositing money in a bank or buying insurance occurs far less frequently and is typically associated with a long-term relationship that requires trust. In addition, especially in Asia, obtaining a bank or insurance license is difficult. In Japan, for example, only one bank license has been awarded in the past 60 years, and that just happened recently. Structural factors that have played a secondary role in the growth of online brokerage are Internet penetration and commission deregulation. Access to the Internet on the part of customers is the key criterion for growth of any Internet business. As shown in Figure 1, Singapore, Hong Kong, Taiwan, Japan, and Korea have a much higher Internet penetration rate than do China, India, Thailand, and Indonesia. In these latter countries, the majority of the population is not yet online, so e-business cannot grow there. Another secondary structural factor influencing online brokering growth is deregulation of brokerage commission rates. Where commission rates are regulated, online brokers cannot offer the cost savings that attract people to online brokering. Commission rates for brokerage are deregulated in Korea, Japan, and Taiwan; therefore, in those markets, the online brokers can offer cost savings to their customers. Hong Kong, Singapore, Malaysia, Indonesia, and Thailand still have fixed commission rates, although Thailand recently deregulated its brokerage commissions.

Figure 1. Percentage of Population with Internet Access, 1999 Percent 35 30 25 20 15 10 5 0 Singapore

United States

Hong Kong

Taiwan

Japan

Korea

China

India

Note: Internet populations for Thailand and Indonesia are negligible.

©2001, Association for Investment Management and Research®

13

Evolution in Equity Markets “Response of Traditional Firms Influences Growth.” The response of the traditional finance firms is important to the growth of the online market. How brokerage firms responded to the rise of the Internet is revealing. In the United States, the major brokers generally ignored the market, so all of the growth came from new online brokers, such as DLJdirect. As a result, the online brokering market took years to develop. In contrast, in Korea, every major broker offered online brokering as soon as feasible, and the Korean online brokerage market skyrocketed. Japan’s online brokering experience has been between those extremes. All the brokers, including the “Big Three”—Nomura Securities, Daiwa Securities, and Nikko Securities—offer online brokerage services, but they all market it as simply an alternative sales channel. In fact, four online strategies are being pursued in Japan. The purely online brokers, such as Monex and E*Trade Japan, are the only listed online financial institutions in Asia. Some brokers, however, are combining traditional brokerage with purely online subsidiaries; an example is Nikko Beans. Traditional brokers that are also offering online services include Nomura and Daiwa, the leaders in Japan in

terms of number of customers. The purely offline brokers are the 80 small retail brokers operating in Japan. The online Japanese brokerage firms are trying various pricing strategies. The most successful online broker in Japan, Matsui Securities, allows an investor to trade all day for ¥3,000. Monex, the low-cost provider of financial services, offers one trade for ¥1,000. Nikko Beans’ charges are not stated per transaction or per transaction size but are based on the amount of client assets it maintains in a custody account. Nomura offers a 15 percent discount off its full-rate price for online trading, and Daiwa Securities offers a 50 percent discount. E*Trade, which has been suffering from a slow start, cut its commission rates to ¥100 a trade for the month of October 2000 in order to bring in customers. “Online Businesses Have the Potential for Rapid Growth.” Korea provides a good example of how rapidly online brokerage can grow. Figure 2 shows the growth in the number of online brokerage accounts from almost nothing in the beginning of 1998 to about 3.4 million in July 2000. The number of online accounts now represents close to 40 percent of total brokerage accounts. Almost everyone in Korea

Figure 2. Growth in Korean Online Brokerage Accounts, January 1998–July 2000 Thousands of Accounts

Percent of Total

4,000

40

3,000

30

2,000

20

1,000

10

0

0 1/98

4/98

7/98

10/98

1/99

Number of Online Accounts (left axis)

14

4/99

7/99

10/99

1/00

4/00

7/00

Percent of Total Accounts (right axis)

©2001, Association for Investment Management and Research®

The Alchemy of E-Finance appears to have gone online, and one of the keys to getting people to switch from offline to online has been commission cuts. Figure 3 shows the relationship between the commission cuts and the volume of online equity trading. The Korean brokers first made a 50 percent commission cut in online rates compared with the offline rates in May 1999, and two months later, they cut the existing online rate by 70 percent. So, the rate is down about 85 percent from what it was for offline rates in a little over a year’s time. The same phenomenon occurred in Japan. The Japanese online brokering market took off in October 1999 when the industry deregulated commission rates for individual investors. As shown in Figure 4, the number of accounts has now reached 1.3 million and the number of online brokers is about 55. “The Internet Is Just Another Distribution Channel.” I have visited a number of traditional Japanese brokers that offer online brokerage services, and I always ask how well their Internet business is doing. They usually avoid giving a straight answer by claiming that they look at the Internet as just another distribution channel rather than a whole new way of doing business.

Such attitudes used to demonstrate ignorance on the part of management about the long-term potential of the Internet. They did not “get it.” But on reflection, I too have come to view the Internet as just another distribution channel (although a new one). The Internet has been rapidly accepted by the public but not as fast as personal computers or cellular phones. Moreover, from a historical perspective, the Internet appears to be just the next stage of development in communication. Initially, all communication was by voice. It was slow, virtual, and interactive. Then, communication moved to the mail services, which was slow and physical. The telegraph followed and was faster than mail and still physical. Then, the telephone appeared and was fast, virtual, and interactive. The fax soon followed and was fast and physical but not interactive. Now we communicate via the Internet, which is fast, physical, and interactive. Yet in the “big scheme of things,” the Internet is not particularly special. The Internet companies have just substituted “E” for “T” (as in telephone) in the sense that Yahoo! is the Yellow Pages, Amazon.com is the Sears, Roebuck & Company catalog, and so on.

Figure 3. Volume Growth in Korean Equity Trading, January 1999–July 2000 Won (trillions)

Percent of Total

200

80

150

60 70% Commission Cut 40

100 50% Commission Cut

50

20

0

0 1/99

3/99

5/99

7/99

9/99

11/99

Online Equity Trading Volume (left axis)

©2001, Association for Investment Management and Research®

1/00

3/00

5/00

7/00

Online Percent of Total Trading (right axis)

15

Evolution in Equity Markets Figure 4. Growth in Japanese Online Brokerage Accounts, May 1999–August 2000 Number of Accounts (thousands)

Number of Brokers 60

1,400

1,200

50

1,000 40 800 30 600 20 400 10

200

0

0 5/99

7/99

9/99

11/99

1/00

5/00

8/00

Number of Online Brokers (right axis)

Number of Online Accounts (left axis)

The Japanese brokers certainly treat the Internet as simply another distribution channel. They all offer online trading; in fact, they force their small customers to go online so that these customers will not bother their salespeople. The small customer who comes into the branch office looking for one-on-one service is immediately signed up to an Internet account and then pushed out the back door. This strategy accounts for a lot of the online growth in Japan. The commission structure of most Japanese firms depends on the level of service. The farther the customer gets from the company or from individuals in the company, the less costly providing service becomes—from face-to-face interaction, to the call center, and ultimately to the Internet or ATM (automated teller machine) network. Daiwa’s strategy, for example, is that a client who uses the call center gets 25 percent off the full face-to-face execution charge; a client who trades over the Internet receives 50 percent off the regular trading charge. As a result, three types of online brokers coexist in Japan. The Big Three traditional brokers, with their high commission rates, offer research and service. If someone is dealing with Nomura online and has a problem, he or she can simply call and talk to a

16

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salesperson. The purely online brokers are at the other extreme; they offer the lowest rates and deal with young, relatively active investors. The third group, the foreign online brokers, made a big splash coming to Japan but then mistakenly hooked up with the old, traditional Japanese companies. Their strategy has been to dominate the middle ground, but to date, these companies have not been successful. “The Internet Fosters Entrepreneurship.” A case that illustrates this point is Monex, which was founded by a partner of Goldman, Sachs & Company, Oki Matsumoto. He convinced Sony Corporation to be the major shareholder in his company, Monex. Monex is a high-quality online broker. It offers a plain vanilla product—online brokering. It offers no margin trading or research, and its call center, which is outsourced, operates only between 9 a.m. and 5 p.m. Monex spends virtually nothing on advertising, because through its Sony ties, it benefited from the approximately US$287 billion Sony has spent on advertising over the past 40 years. Monex charges the lowest brokerage fees in the industry—¥1,000 a trade. Monex was listed at the beginning of August 2000, and Figure 5 shows Monex’s share price since then. The initial public offering (IPO) price was ¥45,000,

©2001, Association for Investment Management and Research®

The Alchemy of E-Finance Figure 5. Monex’s Share Price Chart: Closing Prices, August 2000– October 6, 2000 Yen 130,000

115,000

100,000

85,000

70,000

55,000 40,000 IPO

8/10

8/17

8/24

and the price peaked at ¥144,000 a week later in intraday trading, although it closed off its high at roughly ¥125,000 on that day. The shares have held up relatively well and are still above their IPO price, a rarity for Internet stocks. Now, Monex is hiring investment bankers. “Biggest by Accounts Is Not Necessarily Biggest by Volume.” In the United States, Internet companies are traditionally valued in terms of market capitalization per account. If such a basis were applied to Japan, then Panel A of Figure 6 would imply that Nomura and Daiwa have the most valuable online brokering franchises. But trading volume for each online broker provides a different ranking, as seen in Panel B. By this criterion, the real winner turns out to be Matsui Securities. Matsui is the market leader despite the fact that it has only about 35,000 accounts. And, by my estimate, it controls about 25 percent of the online brokering market in Japan. With one-tenth the customers of Nomura, it does twice the number of daily transactions as Nomura. Founded in 1914, Matsui Securities is an old Japanese broker. It went into call-center brokering around 1991 and added Internet brokerage in about 1997. Its strategy has been to target small business owners and wealthy individuals. Matsui also offers margin trading, which turns out to be a key to building volume by bringing in the big hitters. At present, only Matsui and ORIX Corporation offer margin trading. When Matsui originally offered the singlerate (¥3,000) to trade all day, it quickly built the highest brokerage volume in the Japanese market. Matsui is expected to be listed sometime in 2001.

8/31

9/07

9/14

9/21

10/6

“The Online Firm Is Less Profitable than the Traditional Firm.” Because online brokerage is less profitable than traditional brokerage, analysts should value online brokers at a discount to traditional firms, not at a premium. No profits may actually be made over the Internet in the long run, because online brokering simply gives too much power to the customer. For example, in Korea, online brokering gave investors a choice for the first time: They could trade offline and pay 50 basis points per trade or go online and pay 10 bps. Once an investor is online, he or she can easily switch from one broker to another. In fact, most customers of online brokering tend to maintain three or four accounts spread among different firms. Best of all, the online investor does not have to deal with traditional brokerage salespeople. As a result, almost all the investors in Korea have gone from trading offline to trading online. Figure 7 shows the average value of shares traded per account online versus offline at various points from the beginning of 1998 to mid-2000. Since the middle of 1999, online traders have been doing about twice the amount of business as offline traders, which has destroyed the profitability of Korean brokers. Korean brokerage firms used to think they were smart for being early to offer Internet financial services and for thus stopping any young start-up companies from developing. In fact, this strategy has ruined the Korean firms. For one thing, the margins are much lower for an online trade than an offline trade. I estimate that the brokers earn a net profit of roughly 40 bps per offline trade versus about 5 bps for an online trade. Online brokerage has also led to

©2001, Association for Investment Management and Research®

17

Evolution in Equity Markets Figure 6. Size and Trading Volume of Online Brokers in Japan Daiwa

A. Accounts per Broker

E*Trade Japan Nomura Daiwa

Monex

DLJ direct Japan SFG Securitiesa E*Trade Monex

Nikko

DLJdirect SFG Securitiesa

Matsui

Nikko

ORIX

Matsui

0

50,000

100,000

150,000

200,000

250,000

300,000

Number of Accounts

ORIX 0

50,000

100,000

150,000 200,000 250,000 300,000 B. Trading Volume per Broker Number of Accounts

350,000

Matsui B. Trading Volume per Broker Daiwa Matsui DLJ direct SFG Securitiesa Daiwa Monex DLJdirect SFG Securities

a

Nomura Monex E*Trade Japan Nomura 0

4,000

2,000

6,000

8,000

10,000

12,000

Number of Trades per Day

E*Trade Japan

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

Number of Trades per Day Note: Data are as of the end of September 2000. a

DLJdirect SFG Securities (DLJdirect Japan) is a joint venture between DLJdirect and Sumitomo Bank.

price wars. To get and keep customers, the brokers cut their commission rates more and more—down to 5 bps in some cases. It is also putting pressure on offline brokerage commission rates: If a trade is only 10 bps online, people want a discount for offline trading. In short, their online brokerage is destroying their revenues. Figure 8 is my estimate of the effective average commission rate of the Korean brokerage

18

industry. It has been steadily falling since the beginning of 1999 when online brokering began to take off in a big way. The industry’s average revenue per transaction has fallen from 45 bps to about 23 bps. Figure 9 shows that the Korean brokers’ share prices have also collapsed. The same pattern is apparent in Japan. Table 1 shows commission rates, based on the size of the

©2001, Association for Investment Management and Research®

The Alchemy of E-Finance Figure 7. Online versus Offline Trading in Korea, January 1998–July 2000 Won (millions) 70 Average Online Volume 60 50 40 30 20 Average Offline Volume

10 0 1/98

4/98

7/98

10/98

1/99

transaction, before deregulation and the lowest rates after deregulation. An investor trading ¥10 million of shares paid ¥82,000 in commissions in September 1999. A month later in October, the price was ¥1,900— down about 98 percent. I predict that the traditional

4/99

7/99

10/99

1/00

4/00

7/00

Japanese brokerage industry will be destroyed by the Internet just as the Korean industry has been. The destruction will take longer in Japan, however, because the Big Three traditional brokers in Japan are still holding their commission rates for online

Figure 8. Korean Brokerage Industry Revenues and Commission Rates, January 1998–July 2000 Won (billions)

Basis Points

1,000

50

45

800

40 600 35 400 30 200 25

0

20 1/98

4/98

7/98

10/98

1/99

4/99

Estimated Commission Revenues (left axis)

©2001, Association for Investment Management and Research®

7/99

10/99

1/00

4/00

7/00

Average Commission Rate (right axis)

19

Evolution in Equity Markets Figure 9. Korean Brokerage Industry Share Prices, January 1998– September 2000 January 1998 = 100 800

600

400

200

0 1/98

5/98

9/98

1/99

5/99

Table 1. Online Commission Rates in Japan Size of Transaction (¥millions) 0–0.21

Regulated Rate (¥)

a

2,500

New Lowest Rate (¥)

b

1,000

0.21–1.0

2,500–11,500

1,000

1.0–1.8

11,500–18,700

1,000–1,800

1.8–5.0

18,700–47,500

1,800–1,900

5.0–10

47,500–82,500

1,900

10–50

82,500–272,500

1,900–3,900

aAs

of September 1999. As of October 1999.

b

brokering relatively high. They have not offered steep discounts to compete with the online firms. Roughly 30 percent of all retail brokerage transactions are now done online in Japan, which has had a negative impact on many small Japanese brokers. E*Trade Japan just began offering a special promotion rate of only ¥100 a trade. I estimate that a trade costs at least ¥500 a transaction to the online broker. So, E*Trade Japan is giving away its services to build up its business. Some of the lessons the online brokers in Japan and Korea can teach analysts are that profits depend on the number of transactions, not accounts, and that traditional brokers with a back office infrastructure in place have a cost advantage over online start-ups in Internet brokering. Another lesson is that the early mover gains the most market share. It is difficult for latecomers to break into the market. In addition, offering margin trading to clients is critical to stimulating customer trading. Finally, one of the killers in this business is inactive accounts; therefore, online

20

9/99

1/00

5/00

9/00

brokerage firms might begin to charge people who keep accounts but do not trade. “The Internet Cannot Replace Bricks and Mortar.” Not only is the Internet just another distribution channel, I believe the Internet cannot replace bricks and mortar. Many of the Internet firms have also started to reach this conclusion, which is why they are merging with real-world firms. Table 2 shows that, despite the rise of traditional online brokering and e-finance firms, a lot of brokerage merger and acquisition activity has been occurring around the world and sale prices are continuing to rise for traditional brokers. On average, companies are paying about 3 times book value and 17 times earnings to acquire brokerage firms. These high valuations imply that the game is not over for traditional firms. In fact, the hottest e-finance company in Japan could be Ito-Yokado Bank. Ito-Yokado owns 7-Eleven Japan and 7-Eleven in the United States. With 8,000 franchise stores throughout Japan, the 7-Eleven Japan operation has been very successful. Anybody who lives in Japan knows that 7-Eleven is the place where you can pay all your bills: the telephone bill, electricity bill, gas bill, and so on. In fact, these shops handle 800 million bill payments a year. So, Ito-Yokado was already involved in handling financial transactions when it decided to set up an Internet bank with ATMs located in each 7-Eleven store. The strategy was that Ito-Yokado would rent floor space from the franchisee for the ATM and would increase traffic flow to stores. The announcement of this plan made 7-Eleven Japan’s share price skyrocket. For a brief period, it was the most valuable retailer in the world after Wal-Mart.

©2001, Association for Investment Management and Research®

The Alchemy of E-Finance Table 2. Worldwide Brokerage Mergers and Acquisitions, 2000 Month Announced

Acquirer Name

Target Name

September

Dresdner Bank AG

Wasserstein, Perella & Company

September

Chase H&Q

J.P. Morgan & Company

September

Goldman Sachs

Spear, Leeds & Kellogg

August

Credit Suisse First Boston

Donaldson, Lufkin & Jenrette

August

MONY Group

Advest Group

July

UBS AG

PaineWebber Group

June

Merrill Lynch & Company

Herzog Heine Geduld

April

Chase Manhattan Corporation

Robert Fleming

February

Charles Schwab & Company

CyBerCorp

January

Citigroup

Schroders PLC (Investment Banking)

January

Charles Schwab & Company

U.S. Trust

Transaction Value (million)

Price/Book Value

US$1,369

NA

NA

34,423

3.4

16.3

6,500

NA

NA

13,558

3.0

18.2

Mean

Price/Forward Income

293

1.9

14.4

12,243

3.5

18.5

914

NA

NA

6,920

3.8

NA

488

NA

NA

2,202

1.7

NA

2,619

8.6

30.8

5,230

3.3

17.2

NA = not available.

The Ito-Yokado banking concept is based on the fact that two employees are always in each 7-Eleven store, the stores have security systems with cameras, and the stores operate 24 hours a day. The major problem was getting a bank license from the Ministry of Finance, which is terribly worried that this company could destroy the Japanese banking industry. Most customers in Japan hate Japanese banks; they would more than welcome the alternative of using Ito-Yokado and its bank. A typical Japanese bank has 300–400 branches, whereas Ito-Yokado’s 7-Eleven outlets number 8,000—and the service is better at Ito-Yokado. Ito-Yokado is also trying to get into e-commerce. All of its 7-Eleven stores are linked through a satellite information system, and all transactions are recorded in a central computer. The idea is to turn each of its small franchise stores into a huge Wal-Mart by allowing people to pay for their Internet products at 7-Elevens. A customer could order something over the Internet and then go to the local 7-Eleven to pay for it. This approach would allow those without credit cards to participate in e-commerce transactions. Also, having customers take delivery at local 7-Eleven stores as well as paying for merchandise there would lower delivery charges and eliminate a major problem with Internet buying—the physical distribution to customers’ houses. The delivery companies dislike home delivery because often no one is home, they cannot deliver the product, and they have to return another time. 7-Eleven has 250 distribution centers, makes 10 deliveries per store a day, and can easily deliver books, televisions, and computers along with soft drinks and magazines.

“The Internet Encourages New Financial Markets.” The development of the Internet and the rise of online brokering led to the creation of such new stock markets in Asia as Mothers (market of the high-growth and emerging stocks), Nasdaq Japan, and GEM (Growth Enterprise Market) for small start-up companies. Unfortunately, the performance of IPOs (primarily Internet companies) in these markets has been appalling. Table 3 shows the performance of IPOs on Nasdaq Japan from the listing date through October 2000. A few winners’ share prices went up momentarily before they went down, but the field is

Table 3. Performance of IPOs on Nasdaq Japan since Listing through October 2000 Company Digit

Industry Group

First Closing Price

Price Change 132.7%

Media

¥623,000

cyber communications

Internet

540,000

96.3

Gala

Internet

930,000

54.8

ImageONE Company

Computers

1,300,000

30.0

Eneserver

Electronics

4,230

10.6

Noda Screen

Electronics

5,001,325

Systems Engineer Kintetsu World NextCom Sotec Company

Internet Transportation

1,031

5.0 (18.4)

1,370

(19.7)

Telecom

6,650,000

(21.1) (27.8)

Computers

2,120,000

Dream Train

Internet

2,700,000

(42.2)

Magclick

Internet

4,100,000

(46.3)

E*Trade Japan

Internet

1,400,000

(63.0)

Vector Company

Internet

2,920,000

(91.8)

Note: Nasdaq Japan was established in June 2000.

©2001, Association for Investment Management and Research®

21

Evolution in Equity Markets paddy. The NAV remained unchanged because the assets were in land rather than cash. The developer then presold 100 homes for the rice paddy at US$500,000 each, earning a 50 percent profit. The analysts ran back and did the discounted cash flow, and suddenly, the NAV of the company was US$25 million. The Thai real estate developer then announced another future project. Again, the analysts did all the calculations, and the NAV of the company doubled to US$50 million. The Thai real estate developer then issued its IPO, in which a million shares were sold at US$50 each, and suddenly the Thai real estate developer’s company was worth US$100 million. Now, the main shareholders sell some more land to the company to extract the cash the company raised from the IPO. The company never completes its original project, and its value falls to zero. Figure 10 shows the share price performance of Bangkok Land during a period similar to what I have just described. The question I would like to ask is whether any real difference exists between the scam pulled by Thai real estate developers and what is happening today with e-commerce start-up companies? Both the real estate developer and the Internet start-up sell a dream. The real estate developer shows the prospective buyer pictures of a nice house, maybe with dogs out front, in a nice community. The Internet start-up shows the prospective investor the number of site visitors, viewers, eyeballs, and so on. But each type of company has a problem. The real estate developer usually has no idea about how to actually build a house. The Internet start-up usually has no idea about how to actually monetize the eyeballs. They

crowded with many more losers than winners. Part of the problem is that many start-up Internet companies have no revenues, profits, or established business. The alchemy of e-finance has been the ability of e-commerce entrepreneurs to take a mere business concept and turn it into wealth. “The Internet Bubble.” The “bubble” aspect of the Internet is the belief that anyone with a homepage can be a financial institution. Other recent bubbles have caused similar price run-ups, ending with a crashing thud. Exhibit 1 is an example from the real estate bubble in Thailand in 1992.

Exhibit 1. Hypothetical Thai Real Estate Developer Net Asset Value or Discounted Cash Flow

Action 1. Set up company with 1,000,000 shares

US$1,000,000

2. Buy rice paddy for US$1,000,000

1,000,000

3. Presell 100 homes at US$500,000 (50% profit)

25,000,000

4. Announce another similar project

50,000,000

5. IPO: Sell 1,000,000 new shares at US$50 each

100,000,000

6. Main shareholders sell land for cash

49,000,000

7. Never complete original project

0

In early 1992, the hypothetical Thai real estate developer set up a company with a million shares with a par value of US$1 each. The company then had a net asset value (NAV) of US$1 million, and the developer took the US$1 million and bought a rice

Figure 10. Bangkok Land’s Share Price Performance, 1990–2001 Baht 300

250

200

150

100

50

0 90

22

91

92

93

94

95

96

97

98

99

00

01

©2001, Association for Investment Management and Research®

The Alchemy of E-Finance both, therefore, turn their attention to more practical matters, such as how to cash out of their business to become rich, either through a bank loan or an IPO; at that point, the assorted victims enter the picture. Examples abound of e-finance start-ups that victimized innocent investors. Figure 11 shows that the share prices of online brokers in the United States peaked in the middle of 1999 and have been coming down ever since. In Asia, a good example of an e-finance bubble bursting is one of 1999’s big winners

in Japan—Softbank, whose share price is down about 90 percent from its peak, as shown in Figure 12. Softbank is a company in Japan that publishes PC magazines and began investing in Internet start-ups at an early stage. It became an industry giant. One of its companies, Softbank Finance or, more specifically, the listed company E*Trade Japan, epitomizes the alchemy of e-finance. E*Trade Japan was set up by Softbank and the E*Trade Group of the United States. It purchased a

Figure 11. Share Prices of U.S. Online Brokers, October 1998–October 2000 U.S. Dollars 60

50

40

30 E*Trade 20 AmeriTrade

10

DLJdirect 0 10/98

2/99

6/99

10/99

2/00

6/00

10/00

Figure 12. Softbank Share Price, January 1998–September 2000 Yen 60,000

50,000

40,000

30,000

20,000

10,000

0 1/98

7/98

1/99

©2001, Association for Investment Management and Research®

7/99

1/00

7/00

9/00

23

Evolution in Equity Markets failing retail broker called Osawa Securities, which had a small network of six branches. E*Trade Japan closed all of these branches and moved the Osawa sales force to a call center from where they could phone their customers. Then, the company had E*Trade Group in the United States give the new company a Web page and Internet trading capability. Osawa Securities subcontracted all activities out to E*Trade Group. Softbank, in turn, artificially boosted the revenue of the company before its IPO in 2000 by allocating it underwriting business, while keeping the new company’s operating costs low by paying its advertising expenses. It then listed E*Trade Japan on the Nasdaq Japan exchange at a price of 10 times book value. How misleading this IPO was to investors can be seen from the information disclosed at the time of the IPO, shown in Panel A of Table 4. In fiscal year 1999, E*Trade Japan supposedly had total revenues of ¥4.5 billion, or roughly US$45 million—but much of this revenue was fake. E*Trade Japan reported ¥2 billion

in equity brokerage commissions, but at best, about ¥650 million came from Internet business. The rest of the money came from the call center, which was simply orders placed over the phone. E*Trade Japan says the distinction does not matter. The important point is that the business is “online”—whether it is over the Internet, over the telephone, or over a string connecting two cans, online is online. E*Trade Japan also did some underwriting, which is good, but everything it underwrote was Softbank-related IPOs. E*Trade Japan made a lot of money through investment trusts—but with only one investment trust, a Softbank-related private equity fund. So, the numbers are dicey. In fact, one-third of E*Trade Japan’s revenues came from Softbank. The picture is even worse when E*Trade Japan’s expenses, in Panel B of Table 4, are examined. In the 2000 fiscal year, the company had no advertising expense; Softbank Finance paid for all advertising. Because E*Trade Japan bought Osawa Securities so cheaply, E*Trade Japan even wrote its investment

Table 4. E*Trade Japan Financial Data, Fiscal Year Ended March 2000 Business

Amount Reported (millions)

Comment

A. Revenues Equities Brokerage commission Onlinea Call centera Underwriting

¥2,595 2,020 652 1,368 575

Investment trusts

1,285

Total commissions

3,881

Internet business Orders placed by phone Softbank-related IPOs Softbank private equity fund

Other service income

201

Paid by Softbank Finance

Trading profit

339

Uncertain source

Financial income

101

Total revenues

¥4,521

1/3 from Softbank

B. Expenses/extraordinary gains and profits Financial expenses Operating expenses Fees paid Advertising Personnel

872 0 1,657

Business fees

526

Operating profit

¥910

Nonoperating income

496

Nonoperating expense

39

Recurring profit Pretax profit Taxes Net profit a

24

¥45 3,566 Softbank Finance paid ¥995 million Labor-intensive call center Paid to E*Trade U.S. ¥447million gain on Osawa Securities

¥1,368 1,202 –171

Osawa’s accumulated losses

¥1,372

Estimate.

©2001, Association for Investment Management and Research®

The Alchemy of E-Finance back up to book value and realized a gain, and of course, did not pay any taxes. In fact, the company got a tax refund. E*Trade Japan proudly pointed to the fact that it was an Internet company that could report a net profit. But if advertising expenses had been added in and the extraordinary gain stripped away, E*Trade Japan would have had a large operating loss. The company got away with it, however— at least long enough to issue the IPO of ¥1.5 million (which put the value of the company at about US$1.5 billion). But since then, the company’s value has only fallen; as of October 2000, E*Trade Japan’s market price was one-third of its IPO price. The parent company of E*Trade Japan is Softbank Finance, which has created numerous companies that together appear to create a typical e-finance group of the future. The structure and relationships resemble a holding-company web in the same way Mitsubishi or any other keiretsu or chaebol does. All companies included in the Softbank finance web are finance-related: E*Advisor, Cognotec, CyberCash, E*Trade, E*Real Estate, E*Netcard, Morningstar, E-Loan, Web Lease, and InsWeb Corporation. The various companies in Softbank’s web do not actually perform a service beyond offering comparison shopping or acting as a middleman. For example, InsWeb allows a shopper to compare insurance premium rates; Morningstar allows an investor to compare fund performance. With E*Loan, loan rates can be compared from various financial institutions, and E*Advisor teaches e-finance. In my opinion, Softbank is counting on investors’ gullibility in listing these companies as if they added value. Softbank did indeed make money through the IPO, but eventually, it is all going to go terribly wrong. “The Internet May Lead to a Financial Crisis.” Before the Asian financial crisis, everyone talked about Asia’s tremendous potential—1.2 billion consumers in China, and so on, which would lead to a tremendous demand for all types of products and services. As a result, numerous companies borrowed and invested to meet that potential demand, and the process of this investment supported GDP growth. Everything was going well until the banks ran out of money. Then, the investment stopped, and of course, everyone who was working for these companies was suddenly unemployed. The demand disappeared, and GDP collapsed. As a result, some 70 percent of the loans in Indonesia, 60 percent in Thailand, and 35 percent in Korea became nonperforming; most Asian

banks failed during the collapse of the Asian equity bubble in the mid-1990s. The Internet bubble could repeat that history. The pending Internet financial crisis could take one of two forms. One version is as follows: Everyone has by now recognized the tremendous potential of the Internet. They have all been madly investing in Internet technology to meet demand, which has supported the sales of Intel, Microsoft Corporation, Dell Computer Corporation, Cisco Systems, and so on, which are helping people get online by offering the solutions customers demand. If no one uses the Internet, however, all that IT investment will be only a huge waste of money. Could Internet use decline? I find that I have become tired of using the Internet. Am I a harbinger of pending financial crisis? The second version of financial crisis is as follows: All financial services go online, which produces mass unemployment and empty office space. Financial analysts and investment managers will no longer be employed because their work will all be done by computers. GDP will plummet because GDP by and large equals gross national income, which equals wages, rents, profits, and taxes. But there will be few wages in the financial sector because everyone will be unemployed. Rents will almost disappear because close to half of all office space is rented by financial institutions. Profits in the financial sector will be nonexistent because the marginal transaction cost will be zero. And with no profits to tax, taxes will also be nonexistent. “In Conclusion, All That Glitters Is Not Gold.” The throng of Internet companies and Internet IPOs has created an iron triangle of entrepreneurs, investment bankers, and online investors—all conspiring to rob widows and orphans of their pension money and their trust funds. Thus, e-finance is increasing the need for scrupulous individuals, such as CFA charterholders, who will make sure investors are not hoodwinked by the dross. I have scanned numerous Internet reports, and I can assure you that they were not written by CFA charterholders. They are 200 pages long and filled with incomprehensible buzzwords. They all focus on the tremendous potential of Internet companies, but without fail, they omit the connection between market and profit and always recommend that investors buy the stock. Thank goodness that as of March 31, 2000, there were more than 16,000 CFA candidates in Asia who will hopefully rectify the situation.

©2001, Association for Investment Management and Research®

25

Evolution in Equity Markets

Question and Answer Session Robert G. Zielinski, CFA Question: What happens to investment analysts and investment research as your e-finance crisis model develops? Are analysts out of a job? Zielinski: No. In fact, the value of analysts is enhanced because they can recognize fog when they see it. The only problem is that analysts cannot monetize their reports. Right now, because brokerage commissions have come down so much, firms simply have no money to pay analysts. Question: What are your views on the fund management industry in light of e-finance? Zielinski: The interesting thing about fund managers has been

26

their ability to maintain their prices. They don’t offer any discounting, and they are still holding their fees at 1 percent. They are putting pressure on stock brokers to cut their commission rates, but they’ve kept their rates relatively high. I think fund managers will be fine. In fact, although fund product distribution over the Internet has not taken off in Japan or in Korea, e-commerce will help distribute fund management products because customers can buy them over the Internet. Question: In Europe, the United States, and Asia, volume has been inversely proportional to commission rates, so as margins and high transaction rates come down, will

there be a compensating increase in the volume? Zielinski: Clearly, growth in trading did pick up because of the Internet in Korea and, for a while, in Japan. But the basic problem is that the price cutting on the Internet is tremendous. When commission rates come down 80–90 percent, a 10-fold increase in volume is needed to compensate for the rate cut. For e-finance companies to make money, they must have a bull market plus volume. Once we enter a bear market, which is inevitable, we’ll see that just because Internet trading is cheap doesn’t mean that investors will trade.

©2001, Association for Investment Management and Research®

Portfolio Construction Techniques for Asia Hon W. Cheung Managing Director State Street Global Advisors Singapore

Asian equities are a small fraction of the global equity markets but are a good source of diversification and worthy of consideration in an asset allocation context. Asset allocation within the Asian markets has its own unique issues, such as high levels of market volatility, appropriate allocation techniques, and a lack of client familiarity with strategic asset allocation concepts. These peculiarities can be overcome by common approaches to asset allocation, including mean–variance methodologies and risk–return distributions created through bootstrapping and Monte Carlo simulation.

ortfolio construction involves deciding how much to invest in an “asset”—be it an asset class, a country, or a security. It is one of the fundamental questions that financial advisors must address. A key to making this decision is to take a step back and review the investment objectives of the client. Some examples of investment objectives are to minimize shortfall risk for a stream of fixed future cash flows (for which the portfolio construction technique of bond immunization may be appropriate), to maximize returns subject to a certain level of risk (mean– variance optimization), or simply to comply with a request by the client to “do your best.” The typical investment cycle begins with a client, say, a plan sponsor, and continues through a process of strategic asset allocation in which the plan sponsor creates policy decisions appropriate for its particular investment needs. These policy decisions are then translated into a benchmark from which the investment manager will implement—actually buy and sell based on the benchmark—the plan sponsor’s directive and create the portfolio. This presentation focuses on the portfolio construction techniques that are associated with the strategic asset allocation process as well as the benchmarking process and is less concerned with the techniques used in active country and security selection. In my examination of portfolio construction techniques in Asia, I will first put Asia within a global context. Next, I will discuss allocating assets within Asia and the cash/equity allocation decision within one market (Singapore). Finally, I will address how

P

investment professionals can better manage client expectations, particularly in the Asian markets.

Asian Allocations in a Global Context Within the MSCI World Index, Asia excluding Japan and Australia has a weight of 1.60 percent, an extremely small percentage of the total index. Therefore, for an investment manager who is benchmarked against the MSCI World Index, Asia is not a particularly important asset class. Asia does, however, represent an important source of potential excess returns as well as a good source of diversification in global portfolios. Figure 1 shows in Panel A the five-year relative returns of Asia (a composite of the MSCI Pacific ex Japan and All Country Asia ex Japan indexes) versus the rest of the world (MSCI World Index) from 1976 to 2000. In Panel B, it shows the five-year rolling correlations of Asian markets versus the markets in the rest of the world for the same time period. Relative returns have been mixed over the past 25 years; however, the Asia/world correlations indicate a fairly consistent and beneficial level of diversification from Asian investments. Figure 2 shows risk versus return for different portfolio mixes from 1975 to 1999 in five-year increments. Using the aforementioned indexes to proxy the world and Asian markets, the risk–return frontiers depict the various portfolios invested 100 percent in

©2001, Association for Investment Management and Research®

27

Evolution in Equity Markets Figure 1. Returns and Correlations for Asia versus World, 1976–2000 A. Five-Year Relative Returns Return (%) 20

10

0

–10

–20

–30 76

79

82

85

88

91

94

97

00

94

97

00

B. Five-Year Rolling Correlations Correlation 1.0

0.8

0.6

0.4

0.2

0 76

79

82

85

88

91

Note: Asia is represented by a composite of MSCI Pacific ex Japan and MSCI All Country Asia ex Japan indexes and the world by the MSCI World Index.

world markets (indicated by the solid square in the figure) at one extreme and 100 percent in Asian equities (indicated by the solid circle) at the other extreme. The portfolio mix shifts between the two investments (90 percent/10 percent world/Asia, 80/20 world/ Asia, etc.) along the line. Panel E of Figure 2 suggests

28

that in the most recent past five years, which fell during the Asian crisis, Asian investments did not provide the returns or diversification benefits in keeping with historical precedent. It would be wrong, however, to expect a similar outcome in future periods based on this particular episode. Panels A

©2001, Association for Investment Management and Research®

Portfolio Construction Techniques for Asia Figure 2. Risk and Return of Portfolios Invested in Varying Amounts of World and Asian Markets, 1975–99 D. 1990–1994

A. 1975–1979 Return (%)

Return (%) 10

30 25

100% Asia

100% Asia

8

20 6 15

100% World

4

10

100% World

2

5

0

0 0

10

20

0

30

20

10

30

Risk (%)

Risk (%) B. 1980–1984

E. 1995–1999

Return (%)

Return (%) 25

15 100% World

100% World

20 10

15 10

5

5

100% Asia 0

100% Asia

0 0

20

10

30

0

20

10

30

Risk (%)

Risk (%) C. 1985–1989 Return (%) 34

32

30 100% Asia 28 100% World 26 0

20

10

30

Risk (%)

Note: Asia is represented by a composite of MSCI Pacific ex Japan and MSCI All Country Asia ex Japan indexes and the world by the MSCI World Index.

©2001, Association for Investment Management and Research®

29

Evolution in Equity Markets through D indicate that, although the case for enhanced diversification with Asian equities has been mixed, generally, the result has yielded a reasonable trade-off of risk and return in each of the five-year increments examined, with the exception of 1980– 1984 and 1995–1999. Thus, the impact of a modest exposure to Asia has been either enhanced returns or reduced risk—even if only slight. So, from the point of view of a non-Asia-based investment manager, returns in Asia seem to be a little unstable, but a case for at least some degree of risk diversification can be made.

Asian Country Selection: Mean–Variance Approach Once the decision has been made to invest in Asian markets, investment managers need to be aware of some unique challenges. Volatilities are significantly higher in Asia than in developed markets, and standard techniques are not sufficiently robust to cope with this high level of volatility. In addition, Asia is faced with investors who have dual objectives: They want to beat their benchmarks but do not want to lose money. (This topic is discussed in the last section of this presentation.) One of the first steps that needs to be taken in any portfolio construction process is to set the benchmark that most appropriately addresses the client’s risk and return objectives. One standard technique for setting this benchmark is the mean–variance approach. I will examine this approach in detail in this section. For the analysis in the rest of this presentation, I define Asia to include Hong Kong, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan, and Thailand. I exclude Australia, China, Japan, and New Zealand. The omissions, however, do not invalidate the results. Mean–Variance Approach. The framework for mean–variance analysis is as follows. First, a portfolio weight, w, encompassing n assets is set. By using this portfolio weight, one can then characterize the statistical properties of the portfolio return, R(w), given the expected return, µi, the variance, σi2, and the correlation, ρij , among the assets, i and j (with returns ri and rj), held in the portfolio: Portfolio weight: (w1,w2,…,wn) = w n

Portfolio return:

∑ wi r i

The mean–variance approach is a two-step process. The first step is the focus of this presentation— the benchmarking/policy setting stage. It is an optimization over absolute risk–return space: min var [ R ( w ) ] subject to target E [ R ( w ) ] = Rtarget . w

In other words, as an investor, I want to minimize my absolute risk, or my total portfolio volatility, and maximize my total portfolio return. The second step is active management. Given a benchmark, which comes from this absolute risk– return optimization, the objective is to choose an optimal portfolio given a defined risk budget. Active management is about managing this risk budget. That is, given benchmark b, min var [ R ( w ) – R ( b ) ] w

subject to E [ R ( w ) – R ( b ) ] = ∆R target .

Managers are trying to maximize the amount of excess returns they can generate. Three inputs are crucial in the first stage of the mean–variance approach, or the optimization process: the risk, the correlation, and the expected returns of the assets under consideration. The manager must determine these parameters, the appropriate strategic goals, and the benchmarks for each client. The result is the typical efficient frontier of portfolios (i.e., the assets and combination of assets that create the highest return portfolio subject to a given level of risk). The efficient frontier shown in Figure 3 covers the 1985–99 period and is based on the historical returns, risks, and correlations for that period. The primary benefit of using mean–variance optimization is that it creates a sense of security, because it provides the investment manager with a

Figure 3. Efficient Frontier, 1985–99 Return (%) 30

25

20

= R( w)

i =1

Expected returns: E(ri ) = µi Variance: var(ri ) = σi2

Correlation: corr(ri,rj) = ρij

30

15 10

20

30

40

Risk (%)

©2001, Association for Investment Management and Research®

Portfolio Construction Techniques for Asia precise solution to the portfolio construction question. But some dangers do exist in blindly accepting such a mathematical solution. In particular, the stability of the three key inputs (risk, correlations, and returns) can affect the conclusions drawn at the end of the optimization process. ■ Risk. The first input is risk, as measured by volatility of returns. Table 1 shows three five-year subperiods from 1985 to 1999 for the nine markets I defined as Asian. Volatility appears relatively stable. There have been a few blips, but generally, the countries can be categorized into a low volatility group, such as Hong Kong and Singapore, and a high volatility group, such as Taiwan and Korea. Thus, the risk input tends to be stable over time. The average volatility for the 15-year period is 38.2 percent, with a range of 32.4 percent in the 1990–94 period to 43.6 percent in the most recent five-year period. ■ Correlations. Table 2 shows the correlation input for the same three five-year increments ranging from 1985 to 1999. It shows the correlation between each of the nine markets and the overall Asian average. The correlation input is also reasonably stable over time. Table 2 gives some idea about the average correlation properties for each of the nine markets and how they behave with respect to each other. The average correlation for the region for the past 15 years is 0.63. ■ Returns. Looking at returns in Asia over the same 15-year period from 1985 to 1999 shows that returns were very unstable. Table 3 lists the returns for each of the Asian countries for each of the fiveyear increments within the 15-year period. The average return for the region ranged from 39.9 percent in the 1985–89 period to –5.1 percent in the most recent five-year period. ■ Optimization. Certain inputs, in particular returns, can severely affect the optimization process. To determine the comparative impact of each of the three main inputs—risk, correlations, and returns— on the optimization process, I looked at two subperiods: the five-year period from 1985 to 1989 and the following five-year period from 1990 to 1994. I examined the characteristics of the mean–variance paradigm by changing each of the inputs in the optimization process from one subperiod to the next. In constructing the optimization, I used the risk, correlation, and return data in Tables 1, 2, and 3. I should point out that, in practice, few people simply use the raw historical return numbers without amendment in the optimization process. As I changed each, or a combination, of the three inputs of risk, correlations, and returns, I substituted that input for the respective risk, correlation, or return data for the 1990–94 subperiod. For example,

Table 1. Market Volatility for Asian Countries Country

1985–89

1990–94

1995–99

1985–99

Hong Kong

31.0%

26.7%

34.1%

30.6%

Singapore

30.1

21.0

32.2

28.1

Malaysia

28.3

26.2

50.2

36.5

Thailand

27.9

33.9

55.3

41.1

Philippines

38.3

35.1

40.2

38.9

Taiwan

52.2

50.2

32.2

46.2

South Korea

27.8

29.9

58.8

41.4

Indonesia

51.1

29.9

59.7

48.5

India

30.2

38.5

29.9

33.0

Average

35.2%

32.4%

43.6%

38.2%

United States

17.7%

12.5%

14.0%

15.0%

Table 2. Correlations for Individual Asian Countries versus the Asian Average Country

1985–89

1990–94

1995–99

1985–99

Hong Kong

0.67

0.79

0.78

0.73

Singapore

0.80

0.82

0.88

0.81

Malaysia

0.72

0.79

0.83

0.79

Thailand

0.62

0.79

0.89

0.83

Philippines

0.33

0.80

0.84

0.70

Taiwan

0.41

0.65

0.68

0.53

South Korea

0.20

0.37

0.59

0.49

Indonesia

0.22

0.60

0.81

0.61

India

0.10

0.19

0.32

0.22

0.45

0.65

0.73

0.63

Average

Table 3. Returns for Asian Countries Country

1985–89

1990–94

1995–99

1985–99

Hong Kong

25.8%

27.2%

14.1%

22.2%

Singapore

17.0

16.0

3.8

12.1

Malaysia

12.2

15.2

–11.6

4.6

Thailand

46.7

19.0

–24.0

9.9

Philippines

88.4

15.2

–13.7

23.2

Taiwan

69.7

–3.7

1.6

18.4

South Korea

51.5

–1.3

–3.1

13.1

Indonesia

28.7

–0.8

–14.8

2.8

India

19.2

17.1

1.9

12.5

Average

39.9%

11.5%

–5.1%

13.2%

United States

20.4%

8.7%

28.6%

18.9%

beginning with the 1985–89 efficient frontier, I used the 1990–94 risk data and kept all else equal. I then substituted the risk and correlation data for the 1985– 89 subperiod for that of the 1990–94 subperiod, and finally, I changed all three inputs. My findings suggest that risk is a stable input to the optimization process, even if the notion of volatility implies quite a bit of fluctuation. And the efficient solution, or optimization, shifts only slightly when the correlation input is changed. This finding is consistent with the idea that risk is a stable input and correlations

©2001, Association for Investment Management and Research®

31

Evolution in Equity Markets only a little less so. When the return input was altered, however, the efficient—or optimized—solution dramatically shifted. This drastic alteration indicates that, as previously found, returns are unstable and as such are the most important input in the optimization process. Ex Ante and Ex Post Efficient Frontiers. When an optimization is done, investors often get the impression that the investment manager’s ex ante expectations are a fait accompli. Although the optimization process in theory allows managers to produce an optimal portfolio for the client, often the investor overrates the performance of optimization as a strategic asset allocation tool ex post, which is illustrated in Figure 4 using the analysis above. The ex ante optimization run at the end of 1989 using 1985–89 data generates an efficient frontier that investors may find compelling. But if this efficient frontier solution is implemented for 1990–1994, the ex post realized characteristics of the 1985–89 “efficient” frontier are far from the new efficient frontier. With hindsight, investors would find the results disappointing.

Figure 4. Ex Post Realization (1990–94) of Ex Ante “Efficient” Frontier (1985–89) Return (%) 30 Ex Ante Efficient Frontier

25 20 15 10

Ex Post Realization of Ex Ante "Efficient" Frontier

5 0 0

10

20

30

40

Risk (%)

The manager must be cognizant of the impact of the three major inputs and apprise the client of the fallibilities of the portfolio asset allocation that was determined using an optimization tool. One of the key issues investment managers must manage is client expectations, because actual returns can be vastly different from the returns expected from, at least in the minds of clients, mean–variance optimization. Mean–variance optimization is definitely a useful tool, but the investment manager should take care not to create expectations that are unrealistic.

32

Asian Country Selection: Alternatives to Mean–Variance Alternatives to the mean–variance approach are available. In my experience, the typical investor’s definition of risk is not volatility of returns, as addressed in the mean–variance approach, but, rather, exposure to downside risk. Most of the investors in Asia do not care about standard deviation of excess returns or standard deviation of portfolio returns. All they want to know is how much money they can potentially lose if they invest in a particular product. The good news is that downside risk and volatilities have a strongly correlated relationship. In the previous section, I argued that the main problem with the mean–variance approach is that it creates unrealistic expectations given the unstable nature of the expected return inputs. Alternatives to the mean–variance approach should, therefore, focus on those inputs that are most stable (i.e., risk). Furthermore, investor communication can be enhanced by discussing risk not in terms of volatilities but rather in terms of downside loss and by examining the impact of investment horizon on risk. Downside Risk. From what I have observed, investors in Asia are much more familiar with the concept of downside risk than they are with the rather theoretical concept of volatility of returns. Thus, talking about risk in the context of downside risk could be an important mechanism with which to communicate and manage investor expectations in Asia. As a general principle, investment managers, regardless of their location, should describe concepts in a way that investors can understand. Furthermore, when looking at portfolios that contain optionality, keep in mind that there is asymmetry in the payoff. The potential for gaining money is different from the potential for losing money. In this situation, volatility is not the appropriate concept to use for risk evaluation, but downside risk might be. First, I will demonstrate that volatility of returns and downside loss are equivalent concepts. By looking at a graph of the volatility of a market in relation to the maximum historical downside risk of that market (this relationship is shown for the Hong Kong equity market in Figure 5 by the open square), one can see that the two measures of risk are intimately related. This finding is true for the U.S. markets and the other eight Asian markets and holds if returns are reasonably symmetrical and follow a normal distribution. So, volatility is equivalent to the concept of downside risk. Because downside-risk measures are comparable to volatility measures, downside risk might be a better tool with which to communicate asset

©2001, Association for Investment Management and Research®

Portfolio Construction Techniques for Asia allocation ideas within an internal management team or to a client.

Figure 5. Volatility and Maximum 12-Month Rolling Downside Risk for Asian and U.S. Markets, 1985–99

Long-Term Investment Horizon. Asian markets are more volatile than developed markets. Thus, long-term investing, particularly in an Asian context, can reduce annualized return surprises. Encouraging long-term investing as the key risk reduction tool in a portfolio is also a viable objective in benchmark setting. Therefore, another approach to mean–variance analysis when structuring benchmarks is to focus on downside risk and long-term investment horizons. Figure 6 shows the behavior of returns in relation to the investment horizon for Hong Kong equities based on the MSCI Hong Kong Index in U.S. dollars calculated using a rolling one-year return and a rolling two-year return for the period from 1985 to 2000. In each month, I looked at the return for the previous 12 and 24 months, moved forward one month, recalculated the number, and so on. Based on the one-year rolling annualized return, if an investment manager had invested at the beginning of 1993, she would have doubled her money after one year— 116.7 percent a year. But if the manager had invested on July 31, 1997, she would have experienced a 55 percent decline from that date to July 31, 1998. The

Maximum Downside (%) 0 United States

–20

–40

–60 Hong Kong –80

–100 0

20

40

60

Volatility (%) Note: The U.S. market is represented by the circle; the Asian markets by the squares.

Figure 6. Rolling One-Year and Two-Year Annualized Returns: Hong Kong Equities, 1985–2000 Rolling Return (%) 150

100

50

0

–50

–100 85

86

87

88

89

90

91

92

Rolling One-Year Return

93

94

95

96

97

98

99

00

Rolling Two-Year Return

Note: Hong Kong equities are represented by the MSCI Hong Kong Index in U.S. dollars.

©2001, Association for Investment Management and Research®

33

Evolution in Equity Markets dispersion of returns during this 15-year period is much lower for the rolling two-year annualized returns. The greatest downside risk during the period is 23.4 percent, as opposed to the 55 percent calculated using the one-year rolling return. This exercise can be repeated for three-year, four-year, and five-year rolling returns. The pattern that emerges is that a long-term holding period can reduce annualized risk. Thus, investment managers should encourage their clients to take a long view of equities.

odology can be applied to test the robustness of my judgment calls—whether a 70/20/10 allocation to risk/capitalization/GDP, for example, or a 65/25/10 allocation works better. This approach is similar to the concept of stress testing ideas—not just accepting an idea but applying different regimes and scenarios to gain some insight into the robustness of the idea. From the weighting schemes assigned to each input, an investment manager could then create a composite score from which she could think about potential benchmark weights.

Market Characteristic Risk Weighting. Risk is robust and is a useful quantitative tool in structuring portfolios, but other inputs can also be influential in the benchmark-setting exercise. These other inputs include the size of the market, the size of the economy, liquidity, and transparency. Table 4 offers an example of how these, as well as other, subjective inputs can be incorporated into the benchmark-setting process for Asia. I included downside risk in the analysis based on the premise of this section: It is a robust measure because it is likely that the portfolio manager’s assessment of downside risk will be realized in the next five years. I have also included the capitalization of the markets and the GDP of the respective countries. The spurious nature of the data can be reduced by assigning a score to each of the data sets. Hong Kong, for example, scores very high (positively) from a risk perspective because the downside risk historically has been very low. Thus, the Hong Kong and Singapore markets probably will have less downside risk than the other seven Asian markets if history is an adequate guide for the future. My weightings for risk, market capitalization, and GDP are not based on any scientific methodology; they are purely subjective. But scientific meth-

Tiered Structure Risk Weighting. I believe that the pure market capitalization approach to benchmark setting is fine within the 1.6 percent context that Asia represents in the MSCI World Index, but an investment manager who is given US$100 million and asked to put all of it into an Asian equity mandate might want to examine different benchmark methodologies more closely—for example, a tiered structure for allocating between different markets. In this approach, markets with similar composite scores are placed in one tier and an equal-weighting scheme is used for each tier so that the benchmark reflects a balanced country representation. Thus, three different risk tiers can be created: one for highscore markets, one for medium-score markets, and one for low-score markets. This approach is one way to apply a judgment call on risk and the other subjective factors. Table 4 illustrates potential benchmarkweighting schemes based on this tiered approach. For investment managers working in Asia, trying to set objectives and benchmarks with which they are comfortable is extremely challenging. Risk is one of the key inputs to the asset allocation process because it is a reasonably stable variable. But no right answer exists. Using judgment is an equally important input

Table 4. Setting Benchmark Weights: Example Using Various Inputs Market Characteristic Country Hong Kong

Downside Risk

Market Cap

GDP Weight

Risk

Market Valuation

GDP

Score Composite

Benchmark Weight

40.7%

8.7%

9

9

6

8.7

18.3%

Singapore

–3.2

10.0

4.7

8

6

3

7.1

18.3

Malaysia

–13.1

6.3

4.3

4

4

2

3.8

10.0

Thailand

–19.3

1.7

6.7

3

2

4

2.9

5.0

–4.9

1.5

4.2

7

1

1

5.2

10.0

Philippines Taiwan

8.2%

Ranking Score (weighting)

–6.3

17.8

15.8

6

8

7

6.5

18.3

South Korea

–19.4

12.2

22.3

2

7

8

3.6

5.0

Indonesia

–22.4

1.9

7.9

1

3

5

1.8

5.0

–7.8

7.8

25.4

5

5

9

5.4

10.0

India

Note: To get the number in the Score Composite column, risk is weighted 70 percent, market valuation 20 percent, and GDP 10 percent.

34

©2001, Association for Investment Management and Research®

Portfolio Construction Techniques for Asia in this process, because the theoretical framework of the process is not sufficiently robust for managers to use blindly without any additional qualitative inputs.

Techniques for the Single-Country Cash/Equity Decision To recap, I have examined how Asian equities fit into the global context and how, within Asian equities, techniques such as mean–variance optimization and various alternatives can be used to address the portfolio construction question. Another major issue concerning portfolio construction is the cash/equity allocation decision and related benchmarking issues. Many mandates in Asia are balanced; they are not just specialized equity mandates but use a benchmark that includes cash, bonds, and equities. I will discuss some ideas about how to approach that issue, especially about which asset allocation methods are the most robust and under which circumstances the various methods are appropriate. Historical Risk and Return. A manager begins the decision-making process by looking at the historical risk and return of, for example, the Singapore equity and cash markets. Figure 7 shows the five-year rolling returns and volatility for Singapore equities using the Straits Times Index for the 1990–2000 period. The return on equities in the Singapore market was approximately 11.1 percent over that period;

the return on cash was about 3.8 percent. The objective of this analysis is to determine for a Singaporebased investor the appropriate mix between cash and equities as a long-term policy decision. The risk and return of different portfolio mixes can be charted, as shown in Figure 8. As the line moves from left to right across the graph, the portfolio mix moves from 100 percent in cash to 100 percent in Singapore equities. The decision of where to be on that line is a question of risk preferences (i.e., looking at the historical risk– return relationship and deciding whether it is acceptable or not). What objectives, both risk and return, does the client have? If a manager has a pension fund in which the age of the average member is 31, being 100 percent in cash is probably not a good idea. On the other hand, if all the members of that pension fund are close to retirement, then probably 100 percent in equities is not appropriate. Again, a certain amount of judgment goes into the decision. Assume that the manager has gone through this evaluation process and has chosen a 30/70 mix in equities and cash, respectively. This mix results in a historical return of 6.9 percent and a historical risk of 8.7 percent over the period 1986 to 2000. Bootstrapping. So, how does the investment manager manage client expectations regarding the recommended asset mix? Professional asset management is about imbuing the right level of expectation— not too much, not too little. If the manager does not

Figure 7. Five-Year Rolling Returns and Volatility: Singapore Equities, 1990–2000 Percent 40 30 20 10 0 –10 –20 90

91

92

93

Annualized Risk

94

95

96

Annualized Return

97

98

99

00

Average Return

Note: Singapore equities are represented by the Straits Times Index.

©2001, Association for Investment Management and Research®

35

Evolution in Equity Markets Figure 8. Risk and Return of Portfolios Composed of Varying Amounts of Singapore Cash and Singapore Equities, 1986–2000 Return (%) 12 10 100% Equities 8 6.9% 6

30% Equities/70% Cash

4 2

100% Cash 8.7%

0 0

5

10

15

20

25

30

Risk (%)

exude sufficient confidence in his recommendation, he will not get the mandate. On the other hand, if the manager exudes too much confidence in his recommendation, he will likely be sued. To rectify this quandary of whether the presented expectations can be met, I use bootstrapping, which is a useful nonparametric technique for characterizing the behavior of financial assets (“nonparametric” means that the technique does not rely on assumptions about the underlying distribution to calculate a return series). The technique draws monthly returns at random from a full time series of returns (in the Singapore example, from May 1986 to June 2000). The technique then uses these random draws to create a time series of five-year returns (a 60-month data set) from which the risk and return of the 30/70 equity/cash portfolio mix can be computed. By repeating this process 1,000 times, the distributional features of the risk and return of the 30/70 (equities/cash) portfolio mix can be determined. This nonparametric technique is better than alternative parametric methods. For example, a parametric approach that assumes a normal distribution is not representative of market behavior; fat-tailed distributions do occur in real financial prices and are not reflected in the normally distributed world. In the bootstrap of the returns of the 30/70 Singapore mix, over a five-year period, using 1,000 sample runs, only in 50 cases did the returns fall below 1.4 percent. In some samples, returns were significantly negative; in other samples, the mix earned exceptionally high returns. The assertion that

36

I am able to make about Singapore based on the bootstrap analysis using data from 1986 to 2000 is that 95 percent of returns for the 30/70 mix were higher than 1.4 percent. I can take the same 1,000 observations and calculate the risk of these observations. I am most interested in the worst-case risk, the highest level of risk that the portfolio is likely to sustain with a 30/70 mix. In the Singapore example, I can say with a 95 percent confidence level that the volatility of the 30/70 portfolio asset mix is approximately 10.5 percent or less. The bootstrap analysis allows managers to make, with relative confidence, assertions about the future behavior of the asset classes under consideration. The idea is to make statistical inferences that are free of the normal distribution assumptions and that include the fat tails. The main focus is on identifying the lowest return—the historical maximum that the asset mix has lost during the observation period. A weakness of the bootstrapping technique, however, is that it relies on historical data, and history cannot prevent an anomaly from occurring in the future. So, variance-at-risk techniques and other quantitative measures of risk that rely on historical data will either work or not work depending on whether the future mimics the past. If the future outcome follows what was observed over the past 15 years, then bootstrapping can provide useful insight into the expectations that are communicated to clients. Thus, by using the bootstrapping technique, managers can find and adopt a relatively safe benchmark based on historical results. Although the use of such techniques allows

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Portfolio Construction Techniques for Asia managers to be more certain of what they can achieve, there is still a chance that what appears to be a safe 30/70 benchmark could earn a low or negative return even over a five-year horizon. Benchmark Rebalancing. Another portfolio construction issue related to benchmarking is how often and under what circumstances the adopted benchmark should be rebalanced. Is there a policy that the manager can use to trigger a benchmark rebalancing? This question arises because relative movements between asset classes will result in benchmark drift. For example, if the Singapore equity market appreciates, then the asset mix will no longer be 30 percent equities; it may be 31–32 percent, and the manager needs to reduce equities in order to rebalance the benchmark to 30/70. Does the manager rebalance every day? Every week? Every month? Rebalancing turns out to be an interesting source of portfolio efficiency and creates a much more effective benchmarking program. I simulated different rebalancing programs for this 30/70 equity/cash portfolio for the past 15 years. I assumed zero transaction costs so that there is a zero cost to move from cash to equities or from equities into cash. The optimal (highest returns, lowest risk) period for rebalancing the portfolio to the benchmark asset mix is approximately 10–15 weeks. This result is independent of the assumptions about transaction costs and is quite stable. If the transaction costs are changed to 0.5 percent or 1 percent, the same optimal time period for rebalancing occurs. A positive feature of the rebalancing is that it seems to cause a small peak in the returns and a small trough in the volatility of the portfolio. So, the rebalancing strategy itself is a good source of portfolio efficiency. The Holy Grail of investing, to reduce risk and to actually increase returns, is reasonably achievable by choosing an appropriate portfolio rebalancing strategy.

Managing Client Expectations Managers need to do more than simply construct portfolios; they need to manage their clients’ expectations about portfolio performance. To do so, managers must first look at the dual objectives that clients often implicitly adopt. Two tools that managers can use to frame clients’ expectations are capital guarantee strategies and Monte Carlo simulations. Dual Objectives. Clients can sometimes be schizophrenic, which often is expressed to the manager as an objective to “do your best.” If markets decline by 10 percent and the manager outperforms by 5 percent, clients are unhappy. If markets are going up by 30 percent but the manager has only

made 25 percent returns, clients are still unhappy. How do investment managers cope with this type of situation? In Asia, many investors feel uncomfortable with the idea of strategic asset allocation, benchmark setting, and getting the investment manager to manage portfolios conforming to that benchmark goal. This uneasiness can be explained. First, investors have little desire to set benchmark policy. It is a chore for all investors and a heavy burden for investors who perhaps are not familiar with key investment/allocation issues and in all likelihood harbor an implicit desire for the dual objectives of a high absolute return and never underperforming the benchmark. Passing the burden of achieving outperformance to the investment manager is more comfortable than having to assume that responsibility by making the benchmarking decision. A few techniques are available for creating a portfolio that can meet the typical client’s dual objectives. An allocation to absolute return strategies is one example. The trouble, of course, is that “absolute return strategy” is the polite term for “hedge fund,” and many investors in Asia do not like to invest in hedge funds (although hedge funds may be the ideal vehicle for this dual objective situation). A dynamic hedge program could also be created—a program to dynamically change the allocation between cash, bonds, and equities in response to market moves. C a p i t al G uar a nt e e S t r at e g i es . Often, a compromise solution is to make use of capital guarantee strategies as a means of providing protection against downside loss and participation in upside gains. I have seen a lot of interest in Asia in capital guarantee strategies, and for some reason, capital guarantee strategies appear to be popular among plan sponsors. The analysis of the success of a capital guarantee strategy can be instructive for the investment manager, and the risk and the return trade-offs inherent in capital guarantee strategies can be evaluated using an analytical technique called Monte Carlo simulation. A capital guarantee strategy normally unfolds as follows: Someone takes US$100 of the plan sponsor’s assets and invests 95 percent of the total in U.S. T-bills, which generate a yield of 5.26 percent. The remaining US$5 is then invested in a call-option program or a similar program that limits downside risk. On maturity, the capital guarantee is achieved because the T-bills generate US$5 worth of interest, which added to the US$95 of principal creates the capital guarantee. The call option either lapses worthless or can generate a significant positive return. Capital guarantee strategies are useful when there are regulatory or commercial reasons to need a guarantee. They are of particular interest for a short,

©2001, Association for Investment Management and Research®

37

Evolution in Equity Markets fixed time horizon for a specific tactical purpose. For example, if an investor thinks that over the next six months the equity markets may either collapse or perform very well, this view can be expressed through a call option purchase program, or a capital guarantee strategy. But as a strategic asset allocation strategy over the medium to long term, capital guarantee strategies are expensive. The cost of the option program used to generate the capital guarantee must be paid for either implicitly or explicitly. Better risk–return trade-offs exist—such as simply using a balanced framework rather than the capital guarantee framework. Monte Carlo Simulation. Monte Carlo simulation can be used to evaluate the risk and return tradeoffs that a capital guarantee strategy creates. The inputs to the simulation are the investment horizon (the number of years in the capital guarantee program), the risk-free rate, the expected equity market trend (the mean and volatility of returns assuming a lognormal random walk), and the cost of the call option—the key component of the analysis. A random number generator is used to create equity price movements over the investment horizon from which the terminal value of the capital guarantee strategy can be determined. By repeating this process 500 times, the distributional features of the terminal value can be examined. For one simulation, I used an investment horizon of five years, a risk-free rate of 5 percent, and stock prices that followed a lognormal random walk with annualized returns of 11 percent and volatility of 15 percent. I excluded fat-tail events and used only the normal distribution assumptions about the behavior of markets. I assumed that the call-option cost (as measured by the implied volatility of the purchased call option) equals the actual volatility level experienced in the marketplace. In other words, if the historical volatility is 15 percent, the call option will have an implied volatility of 15 percent. This assumption understates the cost of the call option and, therefore, overstates the benefit of a capital guarantee strategy because call options tend to trade at implied volatilities that are higher than historical volatilities. But in terms of examining the best case for a capital guarantee, it is obviously a reasonable assumption to make. Based on those assumptions, I found that the downside features of the capital guarantee strategy

38

performed much better than a 100 percent equity portfolio; the chance of capital loss for the 100 percent equity portfolio was more than 1 in 20. But by simply shifting from 100 percent equities to a 50/50 cash equity mix, this balanced allocation resulted in much smaller odds of capital loss while the expected returns were higher than the capital guarantee strategy. This conclusion was reinforced by increasing the investment horizon from 5 to 10 years; over 10 years, the chance of capital loss became insignificant, but the expected returns were better than the capital guarantee strategy. In summary, capital guarantee strategies can add value when used over a short time horizon for a specific tactical purpose, but as part of a medium to long-term strategic asset allocation, a better risk– return trade-off is available through alternatives, such as a balanced cash/equity approach.

Conclusion Although the returns of the Asian equity markets are highly unpredictable, the risk and correlations of the markets are relatively stable. Thus, by including Asian equities in their portfolios, investors can take advantage of diversification opportunities. But once an investor decides to include Asian equities in his or her portfolio, the investment manager is faced with the difficult tasks of establishing the asset allocation strategy and managing investor expectations. To set the asset allocation strategy, the manager can use mean–variance optimization, but it has certain limitations. In particular, it creates an environment that makes investors’ expectations of the end results unrealistic. Many tools are available to the investment manager that complement or are an alternative to mean– variance optimization. But as with any tool, they too have limitations. It is the responsibility of the investment manager to select the best tool for the situation at hand and to continually focus on the main goal throughout the process of setting the asset allocation and choosing the portfolio benchmark. The goal is to focus on the needs of the investor by ensuring that ideas are communicated clearly and effectively and that expectations regarding risk and return are realistic. Managing client expectations is one of the greatest challenges that the investment manager faces.

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Portfolio Construction Techniques for Asia

Question and Answer Session Hon W. Cheung Question: Table 2 shows a clear increase in correlation over the years. Does this suggest that country allocation is diminishing in importance? Cheung: Yes. This observation exists not only in Asia but also in other markets. We operate in global capital markets, and these markets are getting more integrated all the time. In Europe, for example, with the euro being introduced and European markets beginning to converge, the correlation patterns will, I think, increase significantly. Trying to project into the future in Asia, say the next 5–10 years, is still difficult because Asia is a region of as much dissimilarity as similarity: Hong Kong is very different from Indonesia, Thailand, and so on. So, although correlations have been increasing, I do not see a situation in which the correlations stop being useful in terms of spreading investment risk within a region through the welltried concept of diversification. Question: Have you ever looked at serial correlation in Asian markets? Is there a trending phenomenon, and can you capitalize on it? Cheung: We have looked at serial correlation for multiple asset classes in the developed markets but not yet in the Asian markets. One problem in trying to exploit serial correlation is that it is a very high turnover strategy. The fundamental law of active management says that to increase the information ratio, a portfolio needs either a skillful manager (and obviously it is difficult to increase skill level on demand) or a manager who takes many independent bets within the portfolio. So, managers in the

United States can spread their bets across a few thousand investment opportunities, but if a manager is trying to take advantage of serial correlation in a single market, the trick is to increase the breadth of the investments, the degrees of freedom, by taking more bets in that market within a given period. The implication is that if managers are trying to exploit serial correlation, they need cost-effective investment vehicles—such as derivatives, futures, or underlying cash vehicles. At the moment, the cost of trading in Asia is high compared with other markets, but cost structures are coming down throughout Asia. New instruments that can be used to exploit serial correlation are also being introduced frequently. Question: What types of investment vehicles are available in Asia that could exploit the concept of serial correlation? Cheung: At State Street Global Advisors, for example, we are creating a lot of exchange-traded funds throughout Asia. The most recent one we announced is in Singapore. These funds are designed to be extremely cost-effective to trade. Cheap-to-trade investment vehicles could make serial correlation much more exploitable in Asia. Assuming zero transaction costs, statistical tests can detect serial correlation in Asia just as they can for most other equity, currency, and fixed-income markets. Although people certainly want to follow trends, at the moment, serial correlation is probably borderline in terms of whether it is exploitable because of the high transaction costs involved in implementing these high turnover trades. But

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with changes in the types of instruments available, serial correlation will become a lot more exploitable within Asia. Question: What is the brand mark of your Singapore exchangetraded funds? Cheung: We don’t have a single brand mark. You’re probably familiar with the Hong Kong Tracker Fund. We are creating similar exchange-traded funds throughout Asia. Question: Given the increase in correlations, is the value added from active management declining in importance? Cheung: I don’t think there is a real cause and effect here. Increasing correlations do not necessarily mean that active management doesn’t work. All it means is that the diversification that international investors rely on through the correlation structure will become perhaps less important than in the past. International diversification is still an important investment theme. It is here to stay, despite the evidence of slightly increasing correlations. Most institutions have lived with international diversification for the past 15–20 years, and it would be difficult for them to suddenly say it is no longer relevant. What effect does correlation structure have on active management? I don’t think it really has any effect because active management is about the ability to forecast returns, and if that ability is still there, then I see no reason why the increased correlation structures should matter.

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Derivative Strategies for Asian Equity Portfolios Harold Y. Kim Director and Co-Head, Asia-Pacific Equity Derivatives Salomon Smith Barney Inc. Hong Kong

Since mid-1997, market volatility and a changing regulatory climate in Asia have presented a challenge to traditional fund managers. Equity derivative instruments geared to both institutional and retail markets have been developed to respond to these challenges. Selected trades in the region demonstrate the potential value that can be added by using derivative strategies.

n Asia, derivatives present an unusual opportunity for institutional investors to enhance the performance of their portfolios. Probably the biggest opportunities for adding value through derivatives stem from the many regulatory restrictions in Asia, because these restrictions often create market inefficiencies that can be taken advantage of with derivatives. To begin, let me note that when my colleagues in Asia and I talk about derivatives, we are talking about derivatives in a broad sense. In particular, we are referring to market-access types of products, which are “delta one” products, rather than the more traditional option product that one usually thinks of when referring to derivatives. With some exceptions, option-product markets are not well developed in Asia. As a result, and because the term is somewhat intimidating for our cash colleagues, we do not use the word “derivative.” Rather, we call derivatives “cash-alternative products.” This presentation will focus on these cash-alternative products and the strategies in which they can be used to enhance portfolio returns. The tremendous volatility of the markets has made the past few years very challenging for the typical fund manager in Asia. As Figure 1 shows, the Asian equity markets (as measured by the MSCI Asia Free ex Japan Index) had a huge run-up in 1993 and then bounced around in a relatively narrow trading range from late 1993 to mid-1997. The Asian crisis of 1997, which followed the Thai baht devaluation, is reflected in the sharp drop in the index that began in

I

40

mid-1997 and continued until mid-1998, when the index made an immediate and steep recovery. Not surprisingly, volatility also jumped, as Figure 2 shows. Such an environment is difficult for the typical cash fund manager, who can choose only between equities and cash. Managers who can use derivatives, however, have the flexibility to consider a broader range of strategies than is available to traditional managers. In addition, derivatives often represent the most efficient and cost-effective way of implementing a market view. In this presentation, I will discuss some of the derivative products available in Asia, some selected derivative strategies, several examples of derivative trades, and a general overview of market trends.

Equity Derivative Products Derivative products can be classified into two categories: (1) linear products that provide efficient exposure to indexes and stocks in the region, either leveraged or unleveraged, and (2) option and warrant products, including basket and single-index options in selected markets and single-stock structures, primarily in Hong Kong, Taiwan, and Singapore. The derivative products that trade in Asia range from simple to structured. Futures, which are listed, are a simple product. Equity index swaps and what I call “local share exposure products” or “access products” (products that allow investors to bypass regulatory restrictions or foreign ownership limits in different countries) are structured products. Futures,

©2001, Association for Investment Management and Research®

Derivative Strategies for Asian Equity Portfolios Figure 1. MSCI Asia Free Ex Japan Index, January 1992–September 2000 Index Level 500 450 400 350 300 250 200 150 1/92

1/93

1/94

1/95

1/96

1/97

2/98

2/99

2/00

Figure 2. MSCI Asia Free Ex Japan Index: Six-Month Rolling Standard Deviations, Weekly Observations, January 1992–September 2000 Standard Deviation (%) 35 30 25 20 15

10 5 1/92

1/93

1/94

1/95

1/96

swaps, and local access products fall into the first category of derivative products, linear products. The final type of product category that I will discuss is option and warrant products, which fall into the second category of derivative products and are not linear in nature. The bulk of Asian derivative instruments are delta one products, also referred to as “cash-alternative,” “local share,” or “market access” products. Delta one products are products that behave like stocks. If you buy a stock and it goes up USD1, you make USD1. If it goes down USD1, you lose USD1. Delta one products behave similarly.

1/97

2/98

2/99

2/00

The lack of option products in Asia stems from the illiquidity of the option markets themselves. Hong Kong’s Hang Seng Index (HSI) has some listed option activity but without great depth. The only active listed option activity is in South Korea, which has an extremely liquid market, but the activity is concentrated in the front month. So, unless the investor happens to want to trade the most recent month’s option contract in Korea, the investor is out of luck. Similarly, the OTC market is illiquid. The situation in Asia is very different from that in the United States, which has deep listed option markets and options are the first instrument that comes to mind when derivatives are mentioned.

©2001, Association for Investment Management and Research®

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Evolution in Equity Markets Futures. Futures are the bread-and-butter product of derivative traders. They were the first derivative product widely traded in Asia. Those who are not familiar with Asia are often surprised to find that Asian index futures markets exist not only in Hong Kong, whose futures market has been around for 14 years, but also in Korea, Malaysia, Taiwan, and Singapore, as Table 1 indicates. More recently, index futures on Indian indexes started trading both locally and on the Singapore Exchange (SGX). The liquidity of these Indian futures leaves something to be desired, but the situation should improve. Note that Table 1 shows Korean futures to be much more liquid than Hong Kong futures, trading anywhere from two to three times the notional in the Hong Kong market. The Korean futures market is the most liquid futures market in Asia—a fact that usually surprises people because one rarely hears about the market. It is an interesting market for professional traders because the market is 90 percent retail driven. A related product has been developed for U.S. onshore funds called “put/call combinations,” which allow U.S. funds to trade index contracts that are not approved by the U.S. Commodity Futures Trading Commission, such as the Korea Composite Stock Price Index (KOSPI) 200 and the Malaysian Kuala Lumpur Composite Index (KLCI) contracts. These products are put and call structures with execution and unwind levels determined as a function of actual execution levels for the underlying futures

hedge. The contracts are generally structured as local currency options, settled in either local currency or U.S. dollars. Equity Index Swaps. The index swaps market is closely related to the futures market. A swap represents an easy and efficient way of buying either index or equity exposure through a derivative contract—a legal contract. For example, rather than buying futures or stock, investors who want to buy exposure in the Taiwan index can do so through a swap. Swaps are very active in certain markets, and they are used globally by many institutional investors. I will consider a swap example in detail later in the presentation. Figure 3 shows where the swap spreads have traded from January 1997 to September 2000. A swap spread is a measure of how cheap or rich a swap is trading relative to fair value. If a price return swap (the index price return only swapped against a money market index less a spread on the notional amount of equities involved) is trading at, say, LIBOR minus 100 and the dividend component of the index’s return is 100 basis points (bps) a year, that swap is trading at fair value. As Figure 3 illustrates, most Asian swaps trade cheap. For example, as shown in Panel A, the Korean KOSPI 200 swap traded as low as –2,500 bps at the end of 1997. In real terms, that means that if I bought the KOSPI 200 in a price return swap and paid LIBOR minus 2,500 bps (ignoring the

Table 1. Regional Index Futures Markets in Asia Item

Hong Kong

Korea

Malaysia

Korea Composite Kuala Lumpur Stock Price Index Composite (KOSPI) 200 Index (KLCI)

Taiwan

Singapore

Index

Hang Seng Index (HSI)

Exchange

Hong Kong Futures Korea Stock Exchange Exchange (KSE) (HKFE)

Kuala Lumpur Options and Financial Futures Exchange (KLOFFE)

Singapore Exchange Singapore Exchange (SGX) (SGX)

Contract listing year

1986

1996

1995

1997

Contracts

13,000

70,000

1,500

12,000

1,500

Contract notional

USD100,000

USD34,000

USD20,000

USD30,000

USD30,000

USD notional

USD1.3 billion

USD2.4 billion

USD30 million

USD360 million

USD45 million

MSCI Taiwan

MSCI Singapore

1998

Approximate daily volume

Selected specifications Multiplier

HKD50

KRW500,000

MYR100

USD100

SGD200

Contract months

Spot, far, quarter

Quarter

Spot, far, quarter

Spot, far, quarter

Spot, far, quarter

Note: Other index futures contracts exist in Asia, although they trade with limited liquidity.

42

©2001, Association for Investment Management and Research®

Derivative Strategies for Asian Equity Portfolios Figure 3. Index Swap Spreads, January 1997–September 2000 A. Korea's KOSPI 200 Spread (bps) 1,000 500 0 –500 –1,000 –1,500 –2,000 –2,500 –3,000 1/97

7/97

1/98

7/98

KOSPI 200 Offer

1/99

7/99

1/00

9/00

1/00

9/00

KOSPI 200 Bid

B. Taiwan's MSCI Taiwan Index (MSTW) Spread (bps) 200 0 –200 –400 –600 –800 –1,000 –1,200 –1,400 1/97

7/97

1/98

7/98

MSTW Offer

1/99

7/99

MSTW Bid

C. Thailand's SET (Stock Exchange of Thailand) Index Spread (bps) 400 200 0 –200 –400 –600 –800 –1,000 –1,200 1/97

7/97

1/98

7/98

SET Index Offer

©2001, Association for Investment Management and Research®

1/99

7/99

1/00

9/00

SET Index Bid

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Evolution in Equity Markets dividend component, which is small for Korea), I effectively received 25 percent outperformance to own the Korean index. In other words, somebody was implicitly saying to me: “If you buy the Korean index, I will not only pay you all the price return in the index, but I will also give you an additional 25 percent, regardless of what the index does. If the index is down 30 percent, you will only lose 5 percent. If the index is up 10 percent, you will make 35 percent.” Similarly, consider the Taiwan index in Panel B. For the middle part of 1997, the Taiwan equity index traded around the LIBOR minus 1,000 bps level. If I was willing to buy the Taiwan index, my counterparty was going to pay me the Taiwan index return and an additional 10 percent. When I first started talking to fund managers about Asia a few years ago, they could not believe that such a trade existed. The idea of somebody saying he or she would pay the Taiwan index return and an additional 10 percent sounded crazy. Why should these swaps trade this cheap? Why should somebody pay this much for someone else to buy the Korean or Taiwan index? The answer is that investors cannot short easily in either Taiwan or Korea. In Taiwan, for about six or seven months in late 1997 and early 1998, investors could buy the Taiwan index and get paid 10 percent because a lot of assets, such as convertible bonds and closed-end funds, were trading very cheap, as much as 20 percent below intrinsic value. Traders, including hedge funds and proprietary trading desks, wanted to buy the underlying cheap asset at a 20 percent discount, pay the counterparty 10 percent, and take out the other 10 percent. Of course, a convergence event would have to occur to cause the cheap asset to return to fair value. Why does the fund manager not simply buy the basket of cheap assets himself to realize the 20 percent? First, no guarantee exists that a convergence event will occur; the assets might even get cheaper. Second, the manager would have to run tracking error relative to the index, which can be difficult to manage at times. So, instead, the manager should just buy the swap and make the extra 10 percent. Many of these trades exist because of market inefficiencies and frictions—in this particular case, the lack of shorting capability. Because the markets are inefficient, a shadow price exists for restricted or regulated activities, such as the ability to short or the ability to buy local shares that have hit their foreign limit. Derivative products often allow a fund manager to unlock the value created by these inefficiencies.

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OTC Local Share Exposure. Local access products in both OTC and listed form provide exposure to the underlying local shares in selected markets, allowing investors to gain long (or in selected cases short) exposure efficiently by bypassing issues related to foreign investor approvals and local currency and custody issues. The products enable investors to purchase exposure without paying foreign share or ADR (American Depositary Receipt) premiums. The OTC products are generally structured as zero-strike call options or swaps. Listed instruments generally take the form of zero-strike call warrants or equity-linked notes. The notes often carry physical redemption features that allow them to be purchased by a wider range of institutions than the plain vanilla warrant product alone allows. The local access exposure product is most popular in Korea, Taiwan, and India—markets that require foreign investors to undergo approval procedures before being allowed to invest in the country. In Taiwan, for example, investors need to be a qualified foreign institutional investor (QFII) to invest there. As part of the process, investors are approved for a certain amount of capital to which they are limited. Suppose a fund manager wants to trade in TSMC (Taiwan Semiconductor Manufacturing Company) and does not have the time to go through the paperwork and approval process to get QFII status. The manager wants to move quickly and buy exposure in TSMC and does not want to pay the ADR premium. In this case, her only option is to turn to a local access product. In India, the foreign investor approval process is quite onerous. Capital gains taxes are also imposed on all investments, but India has capital gains tax relief with only a select group of countries, one of which is Mauritius. Thus, local access products using a Mauritius vehicle can offer investors an efficient way to buy stock exposure that minimizes the impact of both the regulatory process and tax issues. Options and Warrants. As I mentioned earlier, the listed and OTC option markets are not well developed in Asia. The exceptions to this are the local warrant markets, which are developing at a fast pace throughout the region. In conjunction with the warrant markets, the equity-linked note (ELN, or reverse convertible) market is also growing because warrant issuers use ELNs to hedge their volatility exposure. More recently, long-dated structured products have also been gaining in popularity. In particular, the Hong Kong covered warrant market is well established, although activity levels are sensitive to market sentiment. Recently, warrant issuance and trading in Singapore have picked up on

©2001, Association for Investment Management and Research®

Derivative Strategies for Asian Equity Portfolios the back of market deregulation. The Taiwan OTC market was active in 1997, but turnover levels have declined recently; however, the onshore warrant market has been growing steadily over the past year.

Selected Strategies Derivatives allow implementation of a broader range of strategies than is possible using straight equity. In addition, derivatives often represent the most efficient and cost-effective way of implementing a market view. In this section, I will review three specific strategies: cheap index or single-stock exposure, local share versus ADR trades, and basis trades (futures versus cash). In all cases, the trades generally stem from some inefficiency in the markets. Cheap Index or Single-Stock Exposure. From time to time in Asian markets, index and singlestock swaps trade cheap to fair value. Investors can purchase these cheap swaps and simply sell out the corresponding equity positions. If investors manage the transition slippage correctly, they are guaranteed outperformance relative to the baseline performance of the underlying equity. This cheapness arises from the lack of stock borrow in many of the Asian markets. In Taiwan, borrow is limited to local brokers and local investors, so most foreign institutional investors do not have that ability to borrow. In Korea, a borrow system exists, but it is highly systematized and skewed against foreigners. So many restrictions about borrowing govern foreigners that, practically speaking, it is nearly impossible for foreign investors to do, and even if an investor can borrow, it is very expensive. The many restrictions surrounding the ability to borrow give rise to equity index swaps trading cheap when certain conditions exist. Index swaps might trade cheap when market sentiment is negative and short-side instruments (such as futures) are either nonexistent or illiquid or when certain instruments within the country are trading cheap as an asset class. Single stocks trade cheap when stock borrow is limited or restricted, either because of regulatory constraints or lack of supply. For investors in these markets who hold these long positions, a smart and simple trade is to sell these equities or index positions and buy these cheap swaps or other structures. I am using a swap as an example trading instrument, but these instruments do not have to be swaps. They can also be zero-strike call options, in which case, for example, an investor pays USD98 for USD100 worth of exposure and the investor’s contract value is essentially the value of the stock. Any delta one instrument (such as a zero-strike warrant,

zero-strike call option, or swap) can be used to capture this value. ■ Components of index swaps. Equity indexes and single-stock swaps are legal contracts that replicate buying or selling of the underlying equity index or stock over a particular time period. Swaps usually have two components: an interest rate component, equivalent to the funding charge or credit on a given equity position, and the equity component, equivalent to the gain or loss on any movement in the underlying equity. These swaps allow investors to implement asset allocation views as overlays on stock portfolios, to lock in outperformance when cheap swaps become available, and to purchase local share exposure rather than expensive foreign shares. A long equity swap position is equivalent to borrowing money at a specific rate and buying the underlying share or shares that make up the equity index. A short equity swap position is equivalent to borrowing and selling the underlying share(s) and receiving a credit on the proceeds raised. A counterparty who is long a particular equity swap would pay an interest rate (funding rate) charge that is usually quoted as LIBOR plus or minus a defined spread and would receive the appreciation or pay the depreciation in the equity position. If I execute a swap versus a counterparty (suppose you are the counterparty), other than for collateral or credit reasons, no cash changes hands at the time the swap is initiated. We fix the terms, the strike price, the exchange rate, and the interest rate and spread, but we do not exchange cash. We agree that at expiration (or at resets), if you are long and I am short and if the market goes up, I pay you; and if the market goes down, you pay me. If it is a total return swap, I pay you dividends, and because you are long, you pay me some sort of an interest rate. We quote the interest rate as LIBOR plus or minus a spread. Conversely, a counterparty who is short an equity swap would receive a funding credit and pay any appreciation/receive any depreciation in the underlying equity. ■ Index swap structures. Swaps are flexible instruments; Exhibit 1 displays the various types of swaps that can be structured. For example, the currency element of the swap is flexible. The swap can be a U.S. dollar composite swap, in which investors buy the KOSPI 200, for example, but have the full exchange rate effect flow through so that the index is actually denominated in U.S. dollars. Or investors can buy a local swap, which means they are buying the index performance in South Korean won. Alternatively, investors can buy “quanto” swaps, those in which the currency exchange rate is fixed; when the local index goes up a certain percentage, the payout

©2001, Association for Investment Management and Research®

45

Evolution in Equity Markets Exhibit 1. Swap Variants

Table 2. Example Terms for MSTW Swap

Variable Item/ Swap Type

Item

Comments

Currency ADR or composite

Quanto

Local

Index converted at prevailing FX (foreign exchange) rate into ADR currency; base interest rate in ADR currency. USD ADR style is default for Asian equity index swaps.

284.28

350.88

TWD/USD FX

33.135

31.753

USD8.57945

USD11.05029

Index swap units

Index converted using fixed FX rate into quanto currency; base interest rate in quanto currency (e.g., USD). Index in local (equity) currency; interest rate in local currency.

Price return only

Excludes dividends; default for Asia equity index swaps.

Total return

Return calculation includes dividends; index swap buyer receives net dividends paid during life of swap.

Termination Nonbreakable

Swap has no option to terminate prior to maturity (or termination subject to market conditions, if possible).

Breakable

Swap can be terminated with advance notice, generally one or two days notice. Usually includes break fee paid by terminating party—fee ranges from 1–2 percent of current notional.

in U.S. dollars for a U.S. dollar investor also changes by that percentage. Dividends can be included or excluded, and termination clauses are negotiable, which is an important point for many institutional fund managers. ■ Index swap example. Suppose that an investor is buying an equity swap on the MSCI Taiwan Index (MSTW). The swap is a U.S. dollar composite style price return only swap. The notional amount is USD5 million, the maturity is six months, and the pricing is six-month USD LIBOR minus 300 bps. For this example, assume that dividends in Taiwan are about 100 bps a year. So, the swap represents a discount of 200 bps to fair value. (Because the investor is receiving only the price return and not the dividend payment, LIBOR minus 100 is the fair value for the swap.) In this example, the investor is buying at LIBOR minus 300 bps, so the investor should outperform any movement in the index by 200 bps annualized, or by 100 bps over the six-month period. Assume the investor initiated a trade on March 15, 1999, with expiration on September 15, 1999. Table 2 shows the associated market statistics. The MSCI Taiwan Index went from 284.28 to 350.88, and the Taiwan dollar strengthened slightly from 33.135 to 31.753. The notional amount is USD5 million, and the

Expiration Date September 15, 1999

MSTW close USD price

Dividends

46

Trade Date March 15, 1999

582,788.10

Initial notional

USD5 million

Six-month USD LIBOR

5.06%

Assumed spread (bps)

–300

six-month U.S. dollar LIBOR rate is 5.06 percent. The long side of the swap is paying LIBOR minus 300 bps. Given those statistics, the following cash flows result at the expiration of the swap. All the strike and the settlement prices are in U.S. dollars. Because the index increased, the investor receives the index appreciation: 582,788.10 units × (USD11.05029 – USD8.57945) = USD1,439,980.07.

And because the investor is long, the investor pays the funding charge, which is LIBOR minus 300 bps: USD5 million × (5.06% – 300 bps) × (184 days/360) = USD52,644.44.

So, the investor receives a total payment of USD1,387,335.63 million—a good trade. How does this swap compare with investing in the stocks directly? I mentioned that the swap is 200 bps cheap. Where does the outperformance of the swap come from? Someone who had invested the same amount (USD5 million) in the index by buying stocks would have received a gain of USD1.465 million (which includes a dividend return of 100 bps annualized). On the swap, the investor received USD1.387 million. Note, however, that with the swap, the investor also had USD5 million of cash to play with. Assume that the investor took the USD5 million, put it in the bank, received LIBOR (which is why LIBOR is the base case for fair value), and earned another USD129,000. Adding that amount to the swap payment calculated above, one can see that the investor made USD1.517 million in total. Comparing the two scenarios, one can see that the outperformance on the swap is USD51,000, which is USD100,000 annualized or 200 bps on the USD5 million. Is this a realistic example? The answer is yes. As seen in Figure 3, Taiwan traded at minus 1,000 bps for six or seven months in late 1997 and early 1998. At that time, about 25 closed-end funds traded in Taiwan, and they all traded about 20 percent cheap to net asset value. In addition, a lot of convertible

©2001, Association for Investment Management and Research®

Derivative Strategies for Asian Equity Portfolios bonds traded 15–20 percent cheap because convertible bonds are not immediately convertible in Taiwan and some complications are related to converting. So, hedge funds and proprietary trading desks assembled a portfolio of these cheap assets, tried to track the index with minimal tracking error, and then, not being able to short the index because of market restrictions, sold the index in the form of a swap. The rational reason why index swaps were trading so cheaply was that the assets (closed-end funds and convertible bonds) underlying the index were even cheaper. If a fund manager’s mandate is to manage equities, not to capture relative value differences, why not lock in a sure 10 percent outperformance rather than run the risk of not achieving the 20 percent and maybe even suffering from underperformance? Locking in 10 percent in a market rife with uncertainty makes the investment manager look like a hero. ■ Index swap opportunities in 2000. The Asian markets are not as cheap as they were back in late 1997, but some cheap assets can be found; however, it is unlikely that investors will see the minus 1,000 bps (or minus 10 percent) pricing levels in index swaps that occurred in Taiwan anytime in the near future. The underlying asset classes (the convertible bonds and closed-end funds) are just no longer as cheap as they once were. As of September 25, 2000, the MSCI Taiwan Index swap spread was trading at around minus 250 bps and the KOSPI 200 at around minus 300 bps.

Local versus ADR Trades. Local versus ADR trades are popular in Asia. Foreign ownership limits and restrictions on conversions of ADRs in various Asian equity markets—primarily Korea, Taiwan, and India—are responsible for selected ADRs trading out of line with regard to the underlying local shares. ADRs generally trade at premiums to the local shares; hence, products that provide local share access allow investors to minimize losses arising from ADR premium compression. A common strategy is to sell the ADR and buy the local share when the premium trades at excessive levels and to buy the ADR and sell the local share when the premium goes to zero or a discount. Korea has some of the bigger ADR names— Pohang Iron & Steel Company, Korea Electric Power Company (KEPCO), SK Telecom, and Korea Telecom. In Korea, foreign ownership limits have generally been repealed or liberalized as a result of International Monetary Fund mandated deregulation, so the ADR premiums on most Korean stocks have all but disappeared. But selected stocks in strategic industries (such as the four stocks just mentioned) still have foreign ownership limits; the ADR premiums on these stocks increase and compress as a consequence of market pressures. Figure 4 shows the premium for Korea Telecom (i.e., the ADR versus the local) as it dropped from 30 percent in early May 1999 to below zero in late 1999

Figure 4. Korea Telecom ADR Premium to Local Share, May 26, 1999, to September 25, 2000 ADR Premium/Local (%) 35 30 25 20 15 10 5 0 –5 –10 –15 5/26/99

8/4/99

10/13/99

12/22/99

©2001, Association for Investment Management and Research®

3/1/00

5/10/00

7/19/00

9/25/00

47

Evolution in Equity Markets and early 2000. The Korea Telecom ADR premium deteriorated when the Korean government announced plans to increase the foreign ownership limit to 49 percent, although a timetable for the increase has yet to be announced. As of October 2000, the premium had increased to 22 percent versus the local. A sensible trade for an ADR investor would have been to sell the ADR at a high (30 percent) premium and switch to a local access structure; the investor would then have been insulated from the compression in the premium to zero percent. If an investor had bought the ADR during the period when the premium was negligible or nonexistent, the investor basically would have received a free option on any possible premium expansion. Recently, the potential for another such trade occurred in KEPCO when the company issued USD1 billion in exchangeable bonds. After the bonds were issued, the ADR premium fell to zero and then sprang back to 10 percent versus the local. Investors could have either traded the premium movement directly or taken advantage of the fact that another investor wanted a short position in KEPCO local shares and bought an outperformance structure on the shares. Basis (Futures versus Cash Index) Trades. Another example of a cheap asset trade is trading the

futures versus the cash index, known as the basis trade, shown in Figure 5. The lack of borrow in selected markets results in futures often trading cheap relative to the index spot level; theoretical relationships often do not hold. When market sentiment is poor and futures are going south, lack of borrow prevents arbitrageurs from making sure that futures and cash trade in line. In Taiwan and Korea in particular, futures often trade cheap, which is why the index swap trades cheap. One way to take advantage of the situation is to do the swap and lock in 200–300 bps. The other way is to trade the futures directly. Many customers do both types of trades. Again, these are smart, simple trades that take advantage of the fact that the long position in Asia is a scarce commodity. People want to short, and people will pay to short, so if you are a natural long holder of stock, as most fund managers are, it makes sense to take advantage of the long.

Focus on Trades I have not mentioned option products, gamma, or exotic risk—only cash trades and market-access products. The market-access products are derivatives in the sense that their prices depend on the price of another underlying asset, but these derivatives are different from other derivatives in that they are driven by legal or regulatory issues or restrictions,

Figure 5. KOSPI 200 Index and Futures Basis, January 4, 2000, to September 25, 2000 130 Index Level

Basis

120 140

35

110 130

24

100 120

13

90 110

02

80 100

–11

70 90

–20

60 80

–3 –1

1/4/00 70

2/4/00

1/4/00

3/4/00

4/4/00

5/4/00

6/4/00

7/4/00

8/4/00

9/4/00 –2

60 2/4/00

Index Level (left axis) 3/4/00 4/4/00 Index Level (left axis)

48

4

5/4/00

6/4/00

Basis (right axis) 7/4/00 8/4/00

–3 9/4/00

Basis (right axis)

©2001, Association for Investment Management and Research®

Derivative Strategies for Asian Equity Portfolios not optionality-related issues. About 80 percent of what we trade at Salomon Smith Barney is this cashalternative type of derivative. In this section, I will cover three specific trades that occurred during 2000, each of which had a derivative angle. Those investors who understood the derivative angle and were willing to trade derivatives were able to take advantage of the situation and generate outperformance. PCCW/HKT. One such trade was the Pacific Century CyberWorks (PCCW)/Cable & Wireless HKT (HKT) trade. HKT was bought by PCCW, which gave shareholders of HKT an option: For one share of HKT, they could either take 1.1 shares of PCCW or 0.7116 shares of PCCW and HKD7.23 in cash. The two offers had equal value with PCCW at approximately HKD18.61. The standard risk arbitrage trade was to short PCCW and buy HKT any time the value of the two stocks traded out of line with each other, but because PCCW was tightly held, the stock did not have much of a borrow, and the borrow that did exist was snapped up quickly. So, the risk arbitrageurs, who would normally make sure that HKT and the two PCCW offers traded relatively in line based on the probability of the merger going through, were not able to do their job because they could not get the short side of PCCW. Investors could buy HKT with-

out any problem, but they could not short PCCW. As a result of the difficulty in shorting shares of PCCW, HKT traded at a discount to one of the exchange offers: 0.7116 shares PCCW plus the cash in exchange for Hong Kong Telecom. In most efficient markets, as time progresses and it looks more certain that the deal is going to go through, the risk arbitrage discount or premium narrows. In this case, the discount did not narrow because PCCW had no borrow. The board of Cable & Wireless HKT approved the deal, but the discount did not narrow. PCCW approved the deal, but the discount still did not narrow. Finally, the last regulatory and legal approvals were received, and the offer still traded at a discount because no borrow existed for PCCW. There was a one-week period at the end when all the approvals had gone through and there was no reason the acquisition was not going to happen (the transaction had gone unconditional), but the discount still persisted, again, because of the lack of borrow in PCCW. The most straightforward way to take advantage of the situation was to sell PCCW and buy HKT. Those who did so picked up 3–5 percent in total return immediately. And those who were lucky enough to wait until the last day picked up around 11 percent, as Figure 6 illustrates, because the spread

Figure 6. Premium/Discount of PCCW Offers Relative to HKT, May 1, 2000, to August 7, 2000 Percent 25 20 15 10 5 0 –5 –10 –15 5/1/00

5/15/00

5/29/00

6/12/00

6/26/00

HKT/1.1 PCCW

©2001, Association for Investment Management and Research®

7/10/00

7/24/00

8/7/00

HKT/0. 7116 PCCW+HKD7.23

49

Evolution in Equity Markets widened as a result of the trading activities of a large index tracking fund. Those investors who were risk averse and who did not want to take the chance that the merger might not go through could have sold their PCCW shares and bought PCCW synthetically from traders who were willing to pay 3 percent to get the short position. These investors would not have made the whole 5 percent spread but only 3 percent because they gave away some of the spread to get the trade done, but they would have escaped the event risk of the acquisition not occurring. This simple trade made a lot of sense for a fund manager with a PCCW position, who

could switch to a synthetic PCCW position for two to three weeks, thereby picking up 200–300 bps of outperformance (absolute, not annualized). HSBC Holdings/CCF. Figure 7 shows another derivative trade example. HSBC offered to buy Crédit Commercial de France (CCF), and its offer encompassed an implicit option. The offer was that for each share of CCF, shareholders could receive either 13 shares of HSBC or 150 euros. HSBC was giving to each shareholder of CCF a long position in 13 shares of HSBC as well as a put on HSBC struck at 150 euros for 13 shares.

Figure 7. HSBC/CCF Trade 45

A. HSBC Implied Volatility and Realized Volatility, January 3, 2000–June 14, 2000

40 50 35 45

Volatility (%)

30 40 25 35 20 30 1/3/00

1/21/00

2/10/00

3/1/00

3/21/00

4/10/00

4/28/00

5/18/00

6/7/00

25 At the Money Implied

Realized

20 1/3/00

1/21/00 2/10/00 3/1/00 4/10/00 4/28/00 5/18/00 B. HSBC Outperformance Relative3/21/00 to HSI, April 3, 2000–June 14, 2000

At the Money Implied HSBC Return/HSI Return .30

6/7/00

Realized

B. HSBC Outperformance Relative to HSI, April 3, 2000–June 14, 2000

.25

HSBC Return/HSI Return

1.30 .20 1.25 .15 1.20 .10 1.15 .05 1.10 .00 4/3/00 1.05

4/21/00

5/11/00

5/31/00

6/14/00

1.00 4/3/00

50

4/21/00

5/11/00

5/31/00

6/14/00

©2001, Association for Investment Management and Research®

Derivative Strategies for Asian Equity Portfolios The impact of this put option was felt in the market immediately. Panel A shows that the at-themoney implied volatility for HSBC, a measure of how volatile a stock is expected to be in the future, fell dramatically upon announcement of the offer. Implied volatility fell because HSBC gave this huge put option to CCF shareholders, and the professional community realized it. For those who were quick and who could trade volatility, selling HSBC volatility was a smart trade to do. The delta hedging activity surrounding this option led to the realized volatility, as well as implied volatility, of HSBC falling, and HSBC shares traded with a floor price of 150 euros (the put strike) for several weeks. At the time, people were nervous about the Hang Seng Index, interest rates, and so on. The HSI did fall quite a bit, and HSBC outperformed by 20 percent, as shown in Panel B, solely because of the existence of this offer. As soon as the offer ended, HSBC fell in line with the rest of the market. Two points are noteworthy: (1) For those who could do the derivative trade, were quick, understood the situation, and were sophisticated traders, selling HSBC volatility was a good way to make money directly; and (2) for those who could not do the derivative trade, understanding the implications of the trade to anticipate the behavior of the stock price was important, because the implied put affected both the volatility and the trading level of HSBC. TelecomAsia. TelecomAsia Corporation is the last example I will discuss of a trade with a derivative element to it. TelecomAsia is one of the largest stocks in Thailand. At the beginning of 2000, a major creditor of the company granted a nontradable purchase right—a long-dated option—to shareholders. This purchase right was part of a complex restructuring that TelecomAsia was undertaking. The option was long dated, complex, not tradable, and had a lot of intrinsic value. The problem was that people did not know how to look at this right to purchase TelecomAsia. The right was not tradable and was designed to sit on investors’ books for 2–8 years. Thus, institutional investors had a difficult time understanding what it was, how it should be valued, and how it would affect the stock price.

Market Trends The Asian markets have been evolving and changing over time, but the types of changes have differed between the institutional and retail markets. Changes

in the institutional market have centered primarily around regulatory issues, whereas changes in the retail market have focused on the development of new products. Institutional Market. On the institutional side, the market developments and deregulation that have occurred over the past 10 years will continue, but the evolution will not proceed smoothly. In time, the Asian derivative markets will more closely resemble the developed derivative markets: They will be more option oriented and less regulatory and foreignownership-restriction driven. But that eventuality is still a few years away. If someone had said two or three years ago that the Taiwan local access trade would still exist today, I would not have believed it. But even with the changes that have occurred in Taiwan, the local access trade is still an active trading area. India is a good example of how new markets can develop. India was not on anybody’s radar screen a few years ago, but it was an incredibly active and hot market in 1999. The Indian market is full of restrictions, and until it and other Asian markets deregulate rapidly, the potential exists for some type of access trade and the desire for an outperformance product. Retail Market. On the retail side, the structured product market appears to be developing strongly in Asia. Until recently, active warrant markets existed in Hong Kong and were being developed in Taiwan and Singapore, but that was the extent of that type of market in the region. Now, a lot of activity in longerdated capital guarantee products is taking place. That kind of product had been sold in Asia for several years but only on a sporadic basis. Now, this market is becoming more systematized, and many of the big European producers and distributors of this product are entering the Asian markets. The Asian retail markets are developing more in line with the European, rather than the U.S., retail markets. Similar to the European experience, the warrant markets and the capital guaranteed structured products are likely to develop most rapidly. Longer-dated volatility products will gradually emerge as a more important component of the markets. Two to four years from now, the Asian securities business might very well be 50 percent option, gamma, and vega products and 50 percent delta products rather than the 80/20 (option, gamma, vega/delta) split that exists now.

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51

Evolution in Equity Markets

Question and Answer Session Harold Y. Kim Question: From your perspective at Salomon Smith Barney, do swap contracts tend to run to maturity? Kim: Swaps are traded for two reasons by our customers. One reason is that they use swaps for access—a single-stock product that fund managers buy and sell in the same way they buy and sell stock. There is no particular reason a manager would hold the swap to maturity, unless it happened to coincide with his holding horizon for the stock. The other reason is to lock in outperformance over a period of time—for example, buying a Taiwan swap at LIBOR minus 10 percent. Such a trade tends to run to maturity because the manager is looking to capture all of that outperformance. Question: Regarding the access trade product, how active is the market? Kim: The market is very active for the access trade product. In fact, a good chunk of foreign investor activity in Taiwan, for example, is access related. In India, about 30– 40 percent of the activity from foreign investors is access related. Question: How wide are the spreads on an index swap? Kim: In general, the index swap market is meant more for investors to lock in a position for a certain period of time than for active trading; therefore, the bid–offer spreads are relatively wide and should be considered when you are buying and selling. The bid–offer spread may be 200–300 bps for the more liquid markets, such as Taiwan and Korea.

52

Question: How does Salomon or any such house make money in derivatives? Kim: A brokerage house can make money in derivatives in two ways. One is to broker the trade to make a commission: Find a counterparty and take a spread to cross the trade. The other way is through the proprietary trading book where the trading desk takes and manages the position. Question: If an investor wants to short the market, and theoretically this cannot be done in Asia, how is the brokering house hedging its risk? Kim: The lack of hedging instruments is the reason Asian index swaps do not trade often. Certain smaller markets, such as Indonesia and Thailand, trade by appointment only. For a trade to occur, we need to find a counterparty who naturally wants to take the other side. Say you want to sell a swap. It might take a week or more to execute the trade. These index swaps are not meant to be actively traded instruments but, rather, positions held for some amount of time. In more liquid markets, such as in Taiwan and Korea, where a futures contract can be used to hedge the swap, the futures market defines where the index spreads actually trade. Because the futures markets are quite liquid, the swaps in these markets can trade reasonably frequently and in reasonable size. Question: Say that I am a big customer of Salomon and I’ve signed all the various compliance forms. How do you know whether I am authorized to deal in the product that you are offering me?

Kim: As the securities business becomes more complex and more global, legal- and credit-related issues such as these are becoming increasingly more complicated. And as the business becomes more complex, it becomes even more important for these issues to be managed properly. For example, a large number of our clients are U.S. based. Suppose we get a call from a New York hedge fund in the middle of the night and the person says she deals with our New York desk. She wants to sell USD20 million of the Taiwan index. Can we execute the trade? Well, we have a lot of checks that we must go through to be able to execute the trade, and if we do not complete those checks, we cannot do the trade. We have to check with the appropriate credit and legal people to make sure that they have received the right documents and authorizations, which can mean a 3 a.m. call to the New York credit officer or deferring the trade until we can make sure that we have the right approvals. Question: A lot of mystery surrounds the guaranteed funds you mentioned. If someone wanted to set up a guaranteed fund, what strategies are available? Kim: We work with customers all the time to design products, such as guaranteed funds, to distribute within Asia. In the case of guaranteed funds, there are several ways to set up the structure. For example, we might sell a customer an option on the basket of stocks that he has chosen to market; the customer then wraps up the option with either a zero-coupon bond or a market-linked deposit to provide the fixed-income component. The package is then put into a trust and marketed as a separate, standalone fund.

©2001, Association for Investment Management and Research ®

Valuation Fundamentals in Asia Richard H. Lawrence, Jr., CFA Managing Director Overlook Investments Limited Hong Kong

Investing in Asian companies can reap rewards for investors only if investors use a disciplined procedure to evaluate the financial health of Asian companies. Investors must stretch beyond the boundaries of standard fundamental analysis and closely examine companies’ accounting policies, management attitudes, and pro forma financials. Investors also need the assistance of Asian market regulators and governments to encourage further development of the Asian markets.

he fundamental valuation principles endorsed by Benjamin Graham in the 1930s and 1940s are still valid in the investment community of today. In this presentation, I will begin by reviewing the origins of traditional valuation measures. I will then cover some of the tools, disciplines, and procedures that we use at Overlook Investments for financial analysis in Asia. Next, I will discuss some characteristics that we commonly see in successful Asian companies. And finally, I will speak briefly about some of the required assistance from regulatory and governing bodies that investors need in Asia as the markets (and investors) move forward.

T

Traditional Valuation Analysis: The Origins of Valuation Benjamin Graham is the founding father of financial analysis. Everything analysts study in terms of financial analysis has its roots in Graham’s work, particularly The Intelligent Investor and Security Analysis.1 Unfortunately, his insights are often forgotten in this world of high-tech valuations. In the late 1960s, investors used return on equity (ROE) and the DuPont model to assess value. At that time, the well-known DuPont model broke ROE into four simple components: profit margin, asset turnover, capital structure and financial leverage, and tax 1 Benjamin Graham, The Intelligent Investor: A Book of Practical Counsel (New York: Harper, 1949). Benjamin Graham, David L. Dodd, and Sidney Cottle, Security Analysis: Principles and Technique, 4th ed. (New York: McGraw-Hill, 1962).

burden. The DuPont model allows analysts to analyze the sources, both good and bad, of ROE. For example, two companies may have the exact same ROE, but one might have gotten there by having fast asset turnover, efficient use of equity, and high profit margins and the other through a lot of debt, as happened in the 1990s in Asia. The DuPont model provides a simple framework for analyzing both good sources and bad sources of ROE. One of the best books of this era is Cohen, Zinbarg, and Zeikel’s book Investment Analysis and Portfolio Management.2 One does not have to go far in the DuPont model, however, to see that it has critical limitations, particularly when it comes to international investing. ROE as a number is badly distorted by accounting weaknesses. Assets are acquired over time and thus are affected by inflation and possibly currency devaluations in certain countries. Furthermore, the DuPont model does not take risk into consideration, which more than anything is what investors in Asia need to consider, and it does not connect the financial analysis with market valuations. Investment Analysis and Portfolio Management was an important stepping stone in the development of financial analysis, but it has some flaws. David Swensen, chief investment officer at Yale University, represents the new breed of investor. He is regarded as one of the top institutional investors in the world today, and as such, his methodologies, 2

Jerome B. Cohen, Edward D. Zinbarg, and Arthur Zeikel, Investment Analysis and Portfolio Management (Homewood, IL: R.D. Irwin, 1973).

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Evolution in Equity Markets beliefs, and procedures are closely followed in the United States and overseas. Under his guidance, the Yale University Endowment has gained notoriety because it has generated industry-leading returns over the past 15 years without being a leveraged bull market operator in the U.S.-listed equity market. In fact, over the past 15 years, the Yale Endowment’s percentage of assets invested in listed equities has steadily declined. Swensen presents his philosophy in his book Pioneering Portfolio Management.3 Swensen sees the world as a spectrum going from very efficient markets to very inefficient markets. He believes inefficient markets are the best place to find equity fund managers who consistently have an opportunity to add value. The more inefficient the market, the more Swensen believes in active management. Swensen is also a strong believer in smaller companies and in holding a concentrated portfolio. He believes that a portfolio with only a few companies provides a greater opportunity to add value than a diversified portfolio with many companies. And in some of the most interesting parts of the book, Swensen has taken an aggressive approach to addressing conflicts of interest by demonstrating his preference for smaller, independently owned fund management companies over the large, supermarket style of financial firms in the world today. In addressing conflict of interest, he has looked closely at fees, incentives, related-party dealings, and misalignment of interests between fund managers and investors. During the past 15 years, the investment world has been greatly affected by the MSCI indexes, the existence of which has encouraged managers to index large portions of their portfolios. Many investment managers have given up on the process of trying to invest clients’ money actively through analysis of value and risk. Swensen gives hope to serious investors that active management can add value.

Tools, Disciplines, and Procedures To discuss the tools, disciplines, and procedures for financial analysis in Asia, I must begin with accounting policies in Asia. Accounting policies matter, and investment managers must know them by country, by industry, by sector, by individual company, and also by culture. From there, I will discuss cash flow, the evaluation of management, projections, Overlook’s “earnings digest,” enterprise value and operating free cash flow, and finally, valuation criteria. 3 David F. Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment (New York: Free Press, 2000).

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Accounting Policies in Asia. At Overlook, we keep coming back to two guiding principles. One is that we want to focus on cash. It may sound obvious, but the great companies create cash while marginal companies create reported earnings. By focusing our financial analysis on cash generation, a lot of suspect accounting policies become apparent. The second guiding principle is that we look at accountingadjusted numbers. We manually adjust income statements, balance sheets, and cash flows for distortion caused by inappropriate accounting policies. We have found that we have to make manual adjustments for about 70 percent of companies because of nonstandard or inappropriate accounting policies caused by people either trying to aggressively avoid taxation or more commonly to overstate earnings. One does not have to look far to find these accounting irregularities. Some of the leading companies are abusing accounting policies. My favorite examples of abuse are accounting policies surrounding unconsolidated subsidiaries, spin-offs, capitalization of costs, and mistiming of income and expenses. Thus, investment managers must investigate the accounting policies of each business they scrutinize. Cash Flow. “Cash flow” is an abused term. People constantly call things cash flow that we do not consider to be cash flow. Investment managers must be precise, because mistakes are costly in this business. At Overlook, we talk about five distinctly different cash flow measures: • Working capital cash flow, or inventory plus accounts receivable minus accounts payable, shows whether working capital is expanding over time in an efficient manner. When a company grows, will it require a lot more inventory and receivables, or will it be able to squeeze cash out of its suppliers or perhaps even have negative working capital? Many successful companies have negative working capital, which is valuable because as they grow, their businesses are actually producing cash. • Cash flow as profits refers to net income adjusted upward or downward because of inappropriate accounting of depreciation, goodwill, or other income statement items. • Free cash flow is defined as EBITDA (earnings before interest, taxes, depreciation, and amortization) minus maintenance capital expenditures. It is a useful ratio that shows how much cash the business can generate over a specific period of time. • Operating free cash flow is defined as EBITDA minus maintenance capital expenditures and minus maintenance working capital requirements and is the purest definition of cash flow.

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Valuation Fundamentals in Asia Unfortunately, we have found that operating free cash flow can be distorted and difficult to calculate on a consistent basis. • Cash flow of corporate structure relates to the flows between entities within a corporate structure. This type of cash flow occurs particularly in holding company structures or complicated business structures that consist of the listed entity and three or four business units. Often, the debt is in one business unit, the cash is in another, and the large capital spending requirement for future growth is in a third unit. Frequently, some of the units will have minority investors or industry partners. Inevitably, a misalignment results. This situation can be expensive for minority investors in Asia. Generally, we have learned to avoid holding companies because of such problems. But those managers who do include holding companies should map out the company’s corporate structure, isolate where the cash-generating assets are, isolate where the debt is, and see whether a mismatch exists. If a mismatch exists today, the company’s management probably has a track record of undertaking corporate finance actions that have not been in the minority investors’ interest. The 1997–98 bear market in Asia taught investment managers a lot about this type of cash flow. Finally, I would like to list a few items that do not represent cash flow: capital inflows, profits generated from the sale of assets, profits generated from the sale of nonrecurring items, and revaluation of assets. These are not sources of cash flow. Evaluation of Management. When looking at Asia, the issue of management is important. In so many cases our success or failure can be traced back to the managers and their attitudes. Unfortunately, evaluating management is, and always has been, an imperfect art, which is why so little has been written on the topic. We often find that the top managers can be much more misleading than the middle managers in an organization. Most likely they reached the top of their company because they are good salespeople. At Overlook, we follow certain guidelines to defend against deceptive management practices. First, we realize that no set formula exists for guaranteeing success. Typical investors in Asian companies, investing from South Korea to Indonesia, must deal with a myriad of cultural issues; however, we have found some common traits that lead to success. One is integrity. Does the person have the integrity to run a public company? Has he or she run a public company properly in the past? Another is transparency. Is management supportive of transparency? Managers shuffle the deck and create fog for a reason. Nev-

ertheless, many companies and many managers are dedicated to transparency—going beyond the listing requirements of the Hong Kong Stock Exchange (now a part of Hong Kong Exchanges and Clearing Limited), which is still struggling with the issue of getting companies to report balance sheets twice a year.4 Ironically, many managers are happy to have stricter transparency requirements, but they are struggling with the fact that the Hong Kong Stock Exchange does not require it. A final issue is how controlling shareholders (such as members of the family that owns the company) have aligned their financial interests with the interests of minority shareholders. We often see “family” managers who prefer that the share price stay low because they want opportunities to buy the stock. Such actions are not aligned with the interests of the majority of shareholders. Similarly, issues of executive compensation must be carefully watched. What is good for investors is having stock options that are dispersed widely throughout the company, as opposed to having all of the stock options go to one person. Investors need to find companies with managers who have truly aligned their interests with investors. If people invest in companies whose managers’ interests are not aligned with their own, they have no one to blame but themselves. Management should also be evaluated based on the corporate finance track record of individuals. Tigers do not change their stripes. I have been working in Asia for 16 years, and I am constantly amused at how true that statement is. If someone who was in trouble in 1981 escaped bankruptcy by undertaking a deep discount rights issue, then you can anticipate that person will repeat these actions if he or she falls into trouble again. If that person has relied in the past on buying assets from his or her own group or own family, that person will do it again. When evaluating the managers’ track record, look for deep discount rights issues, asset injections from family-owned assets, and pyramid corporate structures going back as far as possible. A 5-year track record is more valuable than a 2-year record, and a 15-year track record is more valuable still. That 15-year track record allows the investor to evaluate most accurately the corporate finance track record of managers. It also shows exactly how businesses are going to behave through cycles—including how volatile the earnings and the operations will be and if the business will be able to self-finance growth. An investment manager can gain confidence in a company by 4 As of March 6, 2000, the Hong Kong Stock Exchange, the Hong Kong Futures Exchange, and the Hong Kong Securities Clearing Company merged into one holding company, the Hong Kong Exchanges and Clearing Limited (HKEx).

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Evolution in Equity Markets evaluating how managers and businesses have behaved over long-term cycles, particularly with regard to how the owner financed his or her business. Never ignore the value gained from detailed projections and return visits. We spend a lot of time with CEOs working with projections and learning about the financial characteristics of the business. The key criterion is whether the business is self-financing, but we are also working with the CEO to identify what that person’s expectations are about the future. In addition, we forecast what we expect the business to achieve six months out, one year out, and one-anda-half years out based on the CEO’s expectations. Those projections can provide early warning signals of price deterioration if the business does not achieve those short-term goals. By getting closely involved with management, notably the CEO, the investment manager can gain valuable insight into the integrity of the CEO and see whether the business can finance its own growth. Projections. When looking at projections, keep in mind that every business is different. Retail businesses are distinctly different from manufacturing businesses and service businesses; each finances itself differently. Each company’s valuation spreadsheet should be custom designed for the individual business, because by custom designing the spreadsheet, the investment manager is forced to think deeply about the critical factors affecting the specific business. Having an integrated income statement, balance sheet, and cash flow statement are also important. When I started in this business, integrating those three components was a big hassle because it had to be done with a calculator, but it is obviously easier now. When doing the calculations, the investment manager should clearly identify any assumptions made, and the numbers should be calculated as far back as possible to see how the business has reacted in different macroeconomic conditions. The investment manager needs to have insights into the cash flow dynamics of the business. I always ask myself what the balance sheet will look like three years out. I also want to know if the business can self-finance or if it will have to raise capital externally. Inevitably, if the company needs to go to the capital markets to raise capital, it will need to do so in a market similar to today’s, and no one wants to have to raise equity or debt in a weak market. Through the detailed work of developing financial projections, the investment manager will get a good feel for the consistency of the business in different economic conditions. Look at what the markets have gone through in the past 15 years. If an investment manager does not gain a thorough understanding of how a business will perform in future business

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cycles, that manager is not analyzing the company closely enough. To determine if a business can selffinance, at Overlook we stress test our projections. We look at past economic conditions and ask if the worst-case scenario happens, what are we looking at? How much variability or volatility will we have in our numbers? A good set of projections should give the investment manager important insights into the value of the business. Overlook’s Earnings Digest. At Overlook, we have always believed that although projections in and of themselves are extremely useful, they need to be tied back into our own portfolio. As a result, we have created our “earnings digest,” which is a compilation of key statistics from our earnings projections on the companies we own in our portfolio. The first category of statistics is factual information about the company. On three pages we can put all the information we need to know about all our companies. This information includes factual data on each company’s size, capital structure, shares outstanding, industry type, growth rate, growth record, debtto-equity ratio, historical growth rate, trading volume, and trading value. The second category of statistics relates to our projections and includes the P/E, enterprise value (EV)/EBITDA, price to cash flow, price to book value, yield, ROE, and operating returns. In the third category, we put our subjective views, which are simply our opinions as they exist at that moment in time. These opinions can be about the relative quality of management, relative attractiveness of the business, or our confidence in our earnings projections, which is based on how much volatility has existed in the business historically. We also keep track of any reasons why we changed our numbers as well as when we changed them so that we can see how current our information is. I can easily determine which of the companies we need to see again, and I can see the trend of our earnings projections. We aggregate all this information about the companies in our portfolio and track it against historical valuations. This process gives us insight into managing the construction of our portfolio. It also allows us to monitor the portfolio and see where the absolute values are, where the red flags might be, how we are doing, or the accuracy of our earnings estimates. Enterprise Value and Operating Free Cash Flow. Globalization over the past 10 years has pushed forward the concept of EV/EBITDA, which measures the market value of the business against the cash flow of the business, as a valuation standard. EV/EBITDA has the advantage of limiting distortions caused by accounting policies because it focuses

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Valuation Fundamentals in Asia on cash flows, which can be important for analysts comparing companies based in different countries. EV/EBITDA does, however, have some critical weaknesses. First, it is not useful for looking at complex corporate structures. As I mentioned previously, in a complex organizational structure, determining where the cash flow is generated is difficult and can mislead investors. The simpler the business structure, the easier and more valuable EV/EBITDA is. Second, the measure is sensitive to the amount of cash and debt a company has. By focusing on EV/EBITDA, we think that analysts are understating the risk of highly leveraged corporations and overstating the attractiveness of a company that has a lot of cash. A third problem is that depreciation is a real cost, and corporate managers may overdepreciate or underdepreciate. Thus, treating depreciation casually as if it is not a meaningful expense is denying reality. Companies need to reinvest to maintain their physical plants. If an analyst is looking at EV/EBITDA, he or she may be overvaluing the business by ignoring the impact of depreciation (or reinvestment). One final problem, particularly with regard to enterprise value and operating free cash flow, is that there are not a lot of benchmarks to measure against and not a lot of historical data. P/E data for U.S. stocks are available back to the early 1900s, but the same sorts of data do not exist for EV/EBITDA. Valuation Criteria. In evaluating stocks, we look for the best company at the cheapest price. We focus on high-return businesses and low valuations; thus, we do not fit into either the value or growth style. This is not a risk-free world, particularly in Asia. So, we use informal benchmarks to help us understand valuation. Our approach focuses on the numbers, because by focusing on the numbers, we believe that we deemotionalize the stock-acquisition process. We aim to buy stocks that have P/Es of 50 percent of the longterm growth rate and 50 percent of the long-term ROE. By long-term growth rate and ROE, we are talking about three to five years, and this ROE, of course, has to be an accounting-adjusted ROE. So, if a company is growing long term at 20 percent and is generating a 20 percent ROE, thus showing that generally it will be able to self-finance that growth, we want to buy that stock at 10 times earnings or less. We also look at private market valuations—leveraged buyouts and management buyouts—as a good source of supplemental information on valuations. Our approach does not incorporate current interest rates. Interest rates, more than anything, are not stable. As a result, we do not value a stock based on today’s interest rates, despite the fact that many peo-

ple are doing it. We also do not use economic value added (EVA), which is in many ways another way of looking at ROE. Companies that have a 20 percent plus ROE over long periods of time create EVA. Likewise, companies with an 8 percent ROE do not create EVA. Why complicate the process with more variables?

Characteristics of Successful Companies Asia has seen a dramatic change in its markets (from bull to bear and back to bull) during the past 16 years. From 1984 through 1997, Asia experienced a period of high price and asset inflation, protectionism of local businesses, favoritism of local businessmen, growth of holding companies, and a corporate love affair with debt. In this environment, banks, real estate, protected utilities, and fearless entrepreneurs were favored. But when the Thai baht broke in July 1997, the Asian investing world changed. Today, the Asian investing world is a world of asset deflation, deregulation, intense competition, outsourcing requirements, shorter and shorter profit cycles, and periods of rapid technological change. In today’s market, investment managers need to look for the characteristics that help determine whether a company will be successful; we define these as operational powerhouses, financial powerhouses, and managerial powerhouses. Operational Powerhouses. The operational powerhouses are the companies that are investing in R&D, not the Asian corporations that hook up with Microsoft Corporation in the hope that they will be able to graft Microsoft’s P/E onto their stock. The operational powerhouses are creating an infrastructure for R&D and are creating brands that can add value, thus positioning the company to get pricing power. These are not companies that are introducing new consumer products every year and reinventing 35 percent of their product line every year just to survive. The operational powerhouses are consistently creating new products and services that add real value, and they have world-class manufacturing skills. One company that we have been impressed with doubled its capacity at less than 20 percent of the initial cost to acquire that capacity. We also like companies that have embraced technology to drive down cost, particularly companies that focus on consumers and that can get pricing power from leveraging technology. Financial Powerhouses. Financial powerhouses are companies that generate consistent highquality ROE after adjusting for accounting items.

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Evolution in Equity Markets That is, they have high asset and equity turnover rates. The greatest development we have seen in Asia since 1997 is that companies are learning to run their businesses with less capital and not rely on debt to fund inventory and receivables. Asian corporations have been able to shrink their balance sheets to create steady, high margins and have learned to cut costs. I love to hear a corporate manager talk about a half or a quarter percentage point savings in cost, because that manager is focused on cost cutting. That manager has a formula for the business and is working each level of the income statement and cost items. A common characteristic of these financial powerhouses in Asia is that they are able to earn consistently high returns on their equity. Managerial Powerhouses. The managerial powerhouses are ones with dynamic managers. We want to see managers who are committed to corporate governance—seeking independent directors on the boards of their companies, not business buddies or golfing buddies. We want to see managers who involve outside shareholders in important issues that are being addressed in their companies, and we want to see managers who do not have a conflict of interest surrounding where they want the stock to be priced. We also want managers to have a detailed and sophisticated knowledge of corporate finance. (A deep understanding of corporate finance can maximize shareholder value with a limited amount of equity capital.) And we want to see managers who understand the importance of self-financing the company’s growth. Managerial powerhouses are companies that are implementing aggressive and progressive employee compensation schemes. We do not want to see stock options going only to the managing director but rather to the entire management team. Having options and shareholders throughout the company creates a powerful force. When a company issues options only to the managing director, it creates an environment that allows the managing director to sell his or her shares and take capital or cash out of the business. Companies that we invest in need to understand the intricacies of employee compensation. Several other factors also exist for assessing whether a company is a managerial powerhouse. Consistent investor relations, dedication to transparency, disclosure, and access to top management—all are extremely important. And when institutional investors or fund managers visit a company, the CEO should spend 5 or 10 minutes with them and support the efforts of the investor relations department. In summary, we look for corporate managers who are dedicated to grinding hard work out every day on a consistent basis.

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Regulatory and Governance Issues Fund managers, investors, and analysts in Asia need to be involved with the regulators, the stock exchanges, and the governments. Asia needs a freely operating market economy. Right now in Asia, we see regulatory favoritism of large corporations, because the laws are made and designed for, and on behalf of, large corporations. The top 15 companies in every Asian country make up such a large share of equity capital in each country that they retain the focus of regulators. The equity capital in these countries needs to be widely distributed; otherwise, there will be a pyramid of wealth that is concentrated in the hands of a few, opening the system to potential abuse. In nonfreely operating market economies, concentration of wealth is typical, and nowhere more so than in Asia. We have governments throughout Asia that have an inherent lack of confidence in the people to run a freely operating market economy. Asia needs forward-thinking market regulation. More than 5,000 companies are listed on exchanges in Asia, but the market regulations are designed to support and promote only the top 50 companies. The real strength of Asia, however, comes from the new companies (the entrepreneurial class), and they are crying out for support from the regulators. There is a bifurcation in Asian equity market valuations. The P/E for a large company in the international indexes is now in the mid- to high teens, but the P/E of a company not in an index is probably below 6. A formal market-making system and forward-thinking market regulations are absolutely critical for Asia if the region’s wealth is to be spread among all the companies and all the shareholders. Moreover, Asia needs enforced corporate governance. Abuses need to be punished to send a message that this behavior will not be accepted. Asia also needs to adopt a corporate governance style more in keeping with developed capital markets—commitment to transparency, accountability, and fairness. The place for such a change could start at the Hong Kong Stock Exchange. For 16 years, the Hong Kong Stock Exchange has not given investors basic financial reports at a reasonable frequency with reasonable disclosure. This is unacceptable. These changes must be made so Asia can move forward and so real wealth creation from equities can be brought to Asia. Fund managers, fund management companies, and individual analysts need to get involved with the regulators to force these critical changes. Only then will the hard work associated with fundamental analysis really pay off.

©2001, Association for Investment Management and Research®

Valuation Fundamentals in Asia

Conclusion Investing in Asia has a lot in common with the advice of the founding father of investing, Benjamin Graham: Fundamental analysis is the key to success. The tools, disciplines, and procedures that we use at Overlook are based on fundamental analysis. The fundamental analysis we practice in Asia is excruciating in its breadth and depth. The first step in the process is to look at accounting policies and then to progress to areas such as cash flow analysis, the

evaluation of corporate management, and finally, the financial valuation criteria. Successful companies in Asia share some common characteristics: They are operational, financial, and managerial powerhouses. But unless investors get assistance from the regulators and governments in Asia, the investment environment will be a difficult one for any investor, even one as skilled and knowledgeable as Benjamin Graham.

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Evolution in Equity Markets

Question and Answer Session Richard H. Lawrence, Jr., CFA Question: Why don’t Hong Kong companies report on a quarterly basis if Thai companies do? Lawrence: If General Electric can produce consolidated results two weeks after the end of the quarter, why does it take five months to get a balance sheet together? The companies we invest with produce management results immediately after the end of the month; otherwise, we do not invest with them. So, the only reason I can think of is that the Hong Kong Stock Exchange is protecting someone’s interest, which historically has been that of the property companies. Question: ROEs are very low in Asia, so is ROE a useful investment parameter when selecting investments? Lawrence: Historically, Asia has had too much easy bank credit. As a result, too many competitors entered the market and drove down the ROEs. Chinese companies have low ROEs because they are competing with state-owned corporations that do not understand accounting and are just selling against variable cost. Part of the problem is that these markets have less discipline and less information, which leads to sloppiness and companies trying to gain market share. As a result, they have been willing to sacrifice ROE, which has come back to hurt them in a big way. This is a major lesson from the bear market. Asian markets need discipline; only then will ROEs move up and the investing environment improve. ROE is still a useful parameter. Investors should not invest in a company with an 8 percent ROE, because in my opin-

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ion, the company is not creating any value.

owned rather than pursue the development of the brand.

Question: Do you think that the entry price is the prime determinant of investment returns?

Question: What can be done to improve value investing in Asia?

Lawrence: Yes. Question: Does the market pay a premium for or recognize good corporate governance in Asia? Lawrence: The jury is still out on that question. Who doesn’t want good corporate governance? But just because investors want it doesn’t mean that the Hong Kong Stock Exchange, the Securities and Futures Commission of Hong Kong, or the governments around Asia are willing to require it or enforce it. As a result, in many cases, good corporate governance doesn’t get rewarded. Question: Apart from Singapore Airlines and Cathay Pacific, why are there so few well-recognized Asian brands? Lawrence: I think there are some other good brands, such as Café de Coral, McDonald’s, and Star Cruise. One of the challenges of globalism is that McDonald’s can come in and create a brand much easier than local Asian companies can. The Vietnamese will find it even tougher to create their own brands, because the brands are taken. One major factor in the lack of Asian brands is that Asian companies have gotten into the game late. Up until the past five years or so, there has been a real lack of understanding of what is needed to create a brand. All too often Asian managers have been happy simply to pilfer the brand they

Lawrence: Asia needs forwardthinking market regulation, such as transparency in disclosures. Investors need to get information on a timely basis, and the information has to be accurate and credible. The Asian markets also need market making, and the liquidity of smaller companies has to be improved. I can’t tell you the number of good Asian companies that we cannot invest in because liquidity is too low. That low liquidity is a big deterrent. Fund managers need to be decentralized to create more of a local investment community, and locals need to be encouraged to invest because they are more likely to buy some of these stocks than international investors. Finally, corporate governance has to be improved to instill confidence in the markets. Question: Do you run a small companies fund? Lawrence: We run a “nonindex” portfolio. We can buy stocks in the indexes, but these Asian companies are running at about 15–20 times earnings, if they’re earning money at all, whereas the nonindex stocks are somewhere between 5 and 8 times earnings. We are rewarded in terms of protection against risk by buying slightly less liquid stocks. We are not a huge fund management company, so we can manage that kind of portfolio. Question: Why hasn’t there been an Asian income fund?

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Valuation Fundamentals in Asia Lawrence: I don’t know for sure. An income fund would make sense because there are a lot of Asian stocks with good yields, and such a fund would begin to address some of the inefficiencies in the market that exist today. Question: Can you give us an example of a business that meets your investment criteria? Lawrence: I’ll just talk about one stock, a company called Café de Coral, the leading fast food operator in Hong Kong. Café de Coral is a clear example of how the Asian crisis affected corporations. Hong Kong Land squeezed the rents up. Competitors came in and squeezed employee pay rates up. Distributors that were providing the company with food also had wage and asset inflation. As a result, Café de Coral’s food costs were going up at

a time when there was a lot of new competition, and it couldn’t raise prices. In the early 1990s, the business just ran out of steam. Then 1997 came, and this deflationary world came into our region and our lives. Rents have been going down consistently. The owner of Café de Coral is creating savings through efficiency and scale economies, and his food costs are going down because he is buying operations that supply him key ingredients. So, he’s taken over more and more vertical integration of this business. This is a business that used to sell at mid-teens in the early 1990s, and the P/E collapsed; now it is selling at 5 or 6 times earnings. It is a classic case in which the business has turned around, but people haven’t really spent any time thinking about it. Café de Coral’s ROE is about 22–23 percent. The owner gener-

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ates HK$350 million of cash flow in the business a year. He puts HK$50 million into opening new stores and HK$50 million into improving his existing stores. So, he’s got HK$250 million of free cash flow. He pays about half of that out in dividends, and he’s using the other half to make acquisitions. He’s gotten into the lunch coupon business in Hong Kong. He’s gotten into catering institutional meals in China for institutions such as Hong Kong Bank and Wal-mart. He’s bought suppliers that are supplying him with bread and meat, and now he’s made overseas acquisitions, buying 300 outlets in the United States. It’s a business that has lots of growth initiatives. It’s really the type of business that we want to focus our effort on; it is ably run by a manager I have known since the late 1980s.

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Valuing Technology Companies: Weaknesses of Traditional Accounting Methods and Strengths of Real Option Applications Robin J.G. Fox, CFA Head of the Technology Sector, Corporate Finance Division Anglo Chinese Group Hong Kong

Traditional accounting procedures, such as generally accepted accounting principles in the United States, do not adequately capture the valuation issues of “New Economy” companies. Wide-ranging suggestions have been made to allow current accounting practices to incorporate the New Economy characteristics of uncertainty and flexibility, and one of the possible remedies is to use real option analysis.

n this presentation, I will discuss the valuation of technology companies by exploring the shortcomings, or what are perceived to be the shortcomings, of traditional accounting methods and the application of real options. I will also briefly discuss the traditional business model of Chinese family businesses and the similarities that this traditional management style shares with “New Economy” companies.

I

Shortcomings of Traditional Accounting Traditional accounting is grounded in a long history that dates back roughly to the time the printing press was invented, so it is not surprising that in this hightechnology age, many people are finding that these traditional accounting methods are no longer as helpful as they once were. These shortcomings can be seen most clearly by looking at “Old Economy” and “New Economy” accounting characteristics. Historical Background. Traditional accounting is about 500 years old. It dates from a document written in 1494, two years after Columbus’s famous voyage, and many of the suggested practices found in this document remain in practice today. In Summa de Arithmetica, Geometrica, Proportioni et Proportional-

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ita, Luca Bartolomes Pacioli presents the practice of accruals, prudence in valuation, double-entry bookkeeping, and the asymmetrical valuation of assets and liabilities—all characteristics of accounting today. The application of these concepts, however, can be difficult in certain situations. Accounting historians have often said that Pacioli’s ideas have persisted even though the reasons for his needing to come up with the ideas have vanished. Some modern valuers of New Economy companies might agree. Eugen Schmalenbach was another influential European accountant who worked in the early part of the 20th century, mainly in Germany, but his ideas influenced accounting throughout Europe. His ideas were significantly affected by the hyperinflation in Germany in the 1920s, which contributed to World War II. Schmalenbach proposed accounting methods that emphasized fund flows over static balances. He advocated marginal costing over full costing, and he pushed for price controls and planning. He believed that marketing expenses should be kept to 10 percent or less of sales revenue, which obviously runs counter to the marketing policies of many Internet companies at the moment. Schmalenbach also emphasized efficiency in production. But as John Maynard Keynes said, “The difficulty lies, not in the new ideas, but in escaping from the old ones, which

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Valuing Technology Companies ramify, for those brought up as most of us have been, into every corner of our minds.”1 Old Economy Accounting Characteristics. Accounting methods used for the Old Economy— generally accepted accounting principles (GAAP), whose origins are firmly grounded in historical precedent—focus on tangible assets more so than on intangible assets. Accounting for the Old Economy deals asymmetrically with uncertainty—recognizing expected losses but ignoring expected gains. Gains are only recognized when reasonable certainty exists that they will occur or, most prudently, when the cash arrives. Old Economy accounting also focuses on legally based transactions, such as sales and purchases and capital expenditures. It does not deal well with contingent events, such as the failure of a drug to pass clinical tests or the failure of software to pass beta testing. These types of contingent events are characteristic of modern technology companies, the New Economy companies. New Economy Accounting Characteristics. The companies of the New Economy operate very differently from those of the Old Economy; thus, the valuation methods needed to assess the two are quite different. The price-to-book ratio of the S&P 500 Index is about 5.0, but its P/E is around 25. So, about four-fifths of a company’s value is missing from its balance sheet, which is a lot of money. Increasingly, investors and analysts are feeling a general uneasiness about the perceived usefulness of traditional financial reporting. Furthermore, there has been a steady deterioration in the statistical association between stock prices and key financial variables, such as earnings, book value, and cash flow. The implication is that the role of accounting-based information in investors’ decision making is decreasing, which is not a particularly good state of affairs. Accounting data are relevant to the market values of pure Internet stocks in the United States, but the relationship is not linear. Some new academic studies explore this subject. John R.M. Hand, a University of North Carolina professor, looked at the period between the first quarter of 1997 and the second quarter of 1999, just before the Internet bubble burst.2 Hand concluded that book values are relevant to the pricing of Internet stocks, but it is a log linear relationship rather than linear. He also found that 1

John Maynard Keynes, The General Theory of Employment, Interest and Money (London: Macmillan and Company, 1936).

2

John R.M. Hand, “Profits, Losses, and the Non-Linear Pricing of Internet Stocks,” Working Paper, University of North Carolina (June 10, 2000). A copy of this working paper can be found at http://itr.bschool.unc.edu/faculty/hand/body_papers.html.

negative net income was highly relevant to valuation. Demers and Lev looked at business-to-consumer (B2C) Internet stocks in the United States.3 They concluded that nonfinancial indicators—such as reach, (the ability of a company to attract visitors to its Web site), stickiness (how long visitors stay at the site once they get there), and customer loyalty—are relevant to valuation. They also noted that an Internet company’s ability to sustain the rate of cash burn is an important factor in valuation. Those numbers, however, are not available unless a company undertakes financial reporting on a quarterly basis. Demers and Lev observed that in the second quarter of 1999, when the equity market started to decline, companies suddenly became more conservative about capitalizing R&D expenditures and customer acquisition costs. One explanation of the apparent disconnect between price and book value is that, although GAAP requires that capital expenditures for expenses such as R&D and marketing be expensed, the capital markets recognize this practice for the accounting conservatism that it is. One of the reasons intangibles cannot be capitalized, according to the accounting profession, is that they are nontradable assets. But this characteristic of intangible assets is no longer absolute. Intangibles can now be traded on some Internet sites. On yettocome.com and pcx.com, for example, users can trade patents and licensing and even professional know-how that is not legally protected. Therefore, I would argue that the nonrecognition of intangibles on the balance sheet, based on the fact that intangibles are not traded, is no longer accurate. Accounting professionals also point out that royalty income, an intangible, is relevant to investors in companies that own significant rights to intellectual property, but companies vary in their reporting of royalty income.

Beyond GAAP: Accounting for the New Economy Traditional GAAP-based accounting has some serious shortcomings when it comes to looking at New Economy companies. Several practices have been proposed to deal with the problems within the GAAP framework, and several other practices that extend beyond the existing GAAP framework have been suggested. In addition, several new methodologies are attempting to address the problems of valuing New Economy companies. 3

Elizabeth Demers and Baruch Lev, “A Rude Awakening: Internet Shakeout in 2000,” Working paper (September 2000). A copy of this working paper can be found by clicking on “Research” at http://www.ssb.rochester.edu/fac/demers/.

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Evolution in Equity Markets Proposed New Economy Accounting Practices. In an attempt to correct for the shortcomings of traditional accounting measures, several alternatives that go beyond GAAP have been proposed. ■ Knowledge-based focus. Technology companies place great value on knowledge and the process of acquiring knowledge, technical expertise, applicable patents, licensing, and so forth. Thus, specific accounting protocol for knowledge-based enterprises is one alternative to GAAP. The knowledgebased accounting process can be divided into three stages: discovery and learning, implementation, and commercialization. This approach can be used for many New Economy companies, such as Internet and biotechnology companies, but it also can be used for some Old Economy companies, such as aerospace, chemical, oil, and pharmaceutical companies. For a knowledge-based enterprise, the problem with GAAP is that the principles do not convey relevant and timely information about the product innovation process (i.e., the business model that is critical to the survival and success of the enterprise). This failure is arguably responsible for the decrease in usefulness of accounting statements. ■ Innovation- and risk-based focus. Risk is an integral part of the innovation process and plays a major role in the accounting treatment of innovation, particularly in the expensing of intangible assets. Money is spent on R&D with the risk that no new product may result, but the expense must still be incurred. Several definite portfolio effects arising from innovation risk influence financial reporting. These risks decline as the R&D process moves along from initial discovery to product innovation. Thus, in the early stages, risk is high. But, for example, once a drug passes clinical testing, the risk of the drug not being commercially feasible is low. Most drugs that do not make it to the market drop out of the development process at an early stage, before clinical testing. The same can be said of beta testing of software. Risk has traditionally been a problem to be avoided or mitigated, not a factor that adds to a company’s value, but as option theory shows, risk or volatility in options increases the value of an option. For example, options on stocks and bonds with high volatility (based on the volatility of the underlying asset) are relatively more valuable than options on assets with lower volatility. Thus, adopting accounting procedures that incorporate the risks inherent in the innovation process on the balance sheet would allow for a more accurate measurement of a knowledge-based company’s value. ■ Networking focus. Traditional accounting methods do not reflect the profound impact of net-

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working on business enterprises. Networking is an integral part of knowledge creation and acquisition in the discovery phase of product innovation and is also of increasing value to the company as the network increases in size. The traditional barriers between competitors, suppliers, and customers are breaking down because of the Internet. It is now much harder to define who is a partner and who is a competitor when looking at the relationships between Internet companies that are forming alliances. The effect of the Internet on business networking is definitely changing the way companies operate, but this change is not yet reflected in accounting practices. Possible New Economy Accounting Practices. Several possible approaches exist for improving the accounting for New Economy companies: revise GAAP, institute economic capital models of financial accounts, and create nonfinancial path matrixes. ■ Improved GAAP. GAAP has undergone significant revamping in the past two or three decades, but it still centers on legally based transactions. The strength of GAAP lies in its objectivity; its weakness lies in diminished timeliness and decision-making relevance because legal-based transactions lag crucial product developments in modern enterprises. Thus, the value of a company may improve as a result of a technological development not yet reflected in a legal transaction. For some time, therefore, a disconnect exists between financial reality and accounting practice; the financial accounts slated to reflect the impending legal transaction do not provide any information about the impact of the transaction. These issues could be potentially resolved by abolishing the pooling-of-interests method for corporate acquisitions, allowing the capitalization of in-process R&D and marketing costs, and separating charges attributable to real losses associated with a restructuring (or reorganization) from the economies of scale and improvements in efficiency that spur the restructuring. ■ Economic asset-based accounting. Another option for improving the financial reporting of New Economy companies involves an economic assetbased accounting system. A lot of talk has centered on this topic and has involved such concepts as economic value added (EVA), shareholder value, and cash flow return on investment (CFROI). Currently, GAAP accounts do not provide sufficient information to construct economic profit models, and an economic asset-based accounting system would make doing so possible. Economists accept that the value of an asset is determined by the benefits it is expected to generate. This view is recognized in the theoretical precepts of the GAAP framework but is

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Valuing Technology Companies not reflected in the guidelines that apply to the recording of specific transactions in particular accounts. Economic asset-based accounting would remedy the GAAP conservatism relating to assets by valuing assets based on the benefits they are expected to generate. Another characteristic of economic asset-based accounting is the symmetrical nature of liabilities (i.e., value is determined by expected sacrifices). Assets are generally recognized at a much later stage than are liabilities—again, the influence of the principle of conservatism—and assets are uniquely subjected to a large array of nonoperational conditions of reliability and verifiability before they are recorded. Acceptance of the economic asset-based accounting system requires the adoption of an economic definition of an asset without the hindrance of reliability and verifiability restrictions. Several merits of such a system are that it provides much more valid profitability estimates, it enables more thorough managerial planning, and it facilitates the financial reporting for new technologies. All of these changes would make for meaningful balance sheets. ■ Path matrixes. A third possibility for an accounting system that meets the needs of New Economy companies is one that uses nonfinancial path matrixes. Nonfinancial path matrixes are accounts that record information related to the consequences of management decisions. The path from capabilities to consequences (not shown in conventional financial information) is a major determinant of success in the New Economy and must be a fundamental premise of any new accounting system. For example, the cash flows attributable to the purchase of intellectual property are not reflected in financial accounts under current accounting methods. With a path matrix system, those flows would be separately and distinctly recorded. Attempts to Address Problems of Estimating Company Value. Some well-known approaches attempt to address the problems of GAAP and conventional economic profit models. The financial and accounting professions have made progress on several fronts—for example, devising non-GAAP methods of valuation such as EVA, CFROI, and the concept of shareholder value. Various accounting task forces have been set up to review accounting rules—one by the U.S. SEC, one by the U.S. Financial Accounting Standards Board, and one by AIMR. Company managers are increasingly discussing non-GAAP measurements in annual reports, such as earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation, and amortization (EBITDA). And the use of balanced scorecards (i.e., nonfinancial information presented

for assessing the value of companies) has increased as well. A simple EPS-based valuation, a major tenet of conventional financial reporting, has several problems. For instance, different accounting methods and standards are used to calculate EPS, so no consistency exists among companies or countries. And although these standards are converging, no consensus exists yet. With the globalization of business, this lack of consistency is a problem. In addition, no investment requirements exist, such as the amount of capital that must be invested to maintain the present level of sales, in the calculation of EPS. And finally, EPS ignores the time value of money. Another school of thought says that “cash is king,” but research shows that historical free cash flow calculations are not as good at predicting cash flow in the future as are accrual-based calculations, such as EPS. This finding is logical because accruals take into account future benefits and liabilities. The idea is that it is possible to estimate future cash flows to assets. Often, discounted free cash flow valuations rely heavily on residual value—a valuation of the company after the explicit forecast period—which requires accurate forecasting of cash flow. Calculating residual value cannot be done without having an accurate EPS calculation from the past from which the future can be extrapolated. Also, economic profit models require an accurate estimation of the cost of equity, which is often difficult to determine in early stage technology companies. A company’s cost of equity can be extrapolated from that of other companies in the same sector if they exist, but little actual historical information, which is necessary for calculating the cost of equity, is available for start-up companies. Table 1 shows the standard way of calculating the cost of equity. It relies on a risk-free interest rate, which currently in Hong Kong is about 6 percent on short-term government securities. The MSCI Hong Kong Index, which excludes HSBC, produces an expected market rate of return of 15 percent, a historically high number. And if the company has a beta greater than 1, the total cost of equity on an unleveraged basis will be even higher than 15 percent; in this example, the cost of equity is 28.5 percent. Thus, the main problem with estimating value using discounted free cash flow models is the uncertainty in calculating the cost of equity and the uncertainty in accurately predicting free cash flows to the company. One way to deal with the problem of value estimation is to consider different scenarios. The value of a company can be calculated based on the weighted average of several forecasts of estimated terminal value. This approach works if the probabilities for

©2001, Association for Investment Management and Research®

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Evolution in Equity Markets Table 1. Calculating Cost of Equity in Hong Kong Using the Capital Asset Pricing Model Variable

Value

Risk-free interest rate, government securities

0.0600

Market expected return—annualized

0.1500

Market risk premium

0.0900

Beta of equity

2.5000

Equity risk premium

0.2250

Cost of equity

0.2850

each scenario can be accurately estimated (i.e., if the conditions of certainty and the probability of each outcome are relatively certain). So, under conditions of uncertainty, this approach does not work well. And because uncertainty is high for most Internet start-ups, or any high-technology start-up, scenario analysis is often not feasible for these companies.

Using Real Options Commodity futures and options have been around for a long time. The first recorded transactions in option and forward contracts date back to 12th century Europe. The contracts were between farmers and were written on agricultural commodities. In the 17th century, farmers in Japan and Holland were writing commodity options on rice and tulips, respectively. In the 1970s, the Chicago Board Options Exchange originated financial options, mainly as an alternative trading instrument to commodity options because commodity options had temporarily lost their allure and were suffering from a lack of market interest. In the 1980s and 1990s, the theory of real options was developed. A real option is an option on a real asset, not a financial asset. A financial option is an option on a stock or a bond, and a commodity option is an option on a commodity. A real option could be an option to develop a piece of land, to exercise a patent, or to invest in or disinvest from a business. The value of an option depends on the uncertainty of the underlying asset price, which is usually measured by the standard deviation of return for that asset price. For a real option, the standard deviation of a relevant benchmark index is used to establish the value for the option. For example, a mineral exploration company could choose the future value of crude oil or liquid natural gas or copper futures as a benchmark. Then, the standard deviation of return on a publicly traded commodity derivative written on that benchmark would be used to value the real option. Common types of real options are operating options (e.g., to produce this product or not), investment and disinvestment options (e.g., to buy a company or sell a division), and contractual options (e.g., to develop a

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piece of land or not, or to develop a patent or not). The concept incorporates the kinds of decisions that business executives make all the time. Often, they do not think of themselves as using real options, but that is in effect what they are doing. Handling Uncertainty with Real Options. Using discounted cash flow models in situations of uncertainty has several shortcomings. Detailed forecasts of future cash flows often are given too much credibility. Although the forecasting process appears to be complicated and impressive, it can be misleading. Cash flows under different scenarios are basically subjective estimates, and the scenario possibilities are also extremely subjective. Future investment decisions are often fixed at the outset based on an analyst’s forecast, and in the meantime, the company’s managers are continuously revising and updating their plans. As a result, the estimated cash flows associated with the project can change at short notice, and then the original forecast becomes outdated. Cash flow models are particularly prone to error in the information technology, pharmaceutical, and mineral exploration industries—industries with a strong project orientation, heavy R&D needs, and the possibility of a big payoff for new investment. Even though uncertainty has traditionally been thought of as a negative, including uncertainty in the valuation process can lead to higher asset values. Uncertainty is typical of New Economy companies, because for the New Economy companies to be successful, they must exhibit extreme flexibility so that they can change direction, adopt new business models, and introduce new products rapidly. Flexibility in the business sense is defined as the ability to quickly control variable operating costs. Internet start-ups and high-technology companies have high operating costs and low overhead. Typically, these companies are adroit at adjusting variable costs by shifting from one product line to another. Because option valuation lends itself to situations in which flexibility and uncertainty are widespread, the presence of these characteristics in New Economy companies makes real options a viable tool for evaluating them. In option analysis, a high level of uncertainty can lead to a high level of asset values, provided that managers identify and use their real options to respond flexibly to uncertain events. When a person invests in an option, that person is investing in uncertainty and flexibility. An example of flexibility is when a manufacturing equipment company has designed a production line so that it can be used to manufacture various products, allowing the managers to decide to switch from one product to another. Thus, an option is built into the initial design, and that is a real option. Software developers

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Valuing Technology Companies and Internet media companies have an inherently flexible business model compared with companies operating under the old business model, characterized by large capital expenditures that cannot easily be changed. For example, the ability of a software development company to change from developing applications for a PC to applications for a palmtop is entirely different from an oil company that builds a catalytic cracker for US$500 million and then decides that the equipment is not needed. Real options allow for the pricing and purchase of flexibility. Figure 1 depicts the “cone of uncertainty” and the contrasting valuations of the real option methodology and the traditional discounted cash flow methodology for a typical New Economy company. When the traditional discounted cash flow valuation method is used, as uncertainty increases, the value of the business declines. If real option valuation is used, provided the managers use their real options sensibly, uncertainty increases the value of the business. So, under real option valuation, uncertainty increases the value of a business or an operating division, which is a revolutionary idea that most people do not agree with.

tion of a company’s exposure to external uncertainty when real option theory is used. If a manager introduces real option management into a company’s strategic planning function, doing so will increase the value of the company whether it is valued using a real option or a discounted cash flow model. Thus, managers can add value by operating in this framework.

Figure 2. Modifying Exposure to External Uncertainty Value

Real Option Valuation

Traditional Discounted Cash Flow Valuation

Uncertainty

Figure 1. The Cone of Uncertainty Value

Real Option Valuation

Traditional Discounted Cash Flow Valuation

Uncertainty

Using Real Options to Moderate Risk. People widely agree that options can be used to moderate risk, which applies to real options as well as financial options used for hedging underlying instruments. The presence of real options in strategic investments allows managers to reduce the likelihood of undesirable outcomes and increase the likelihood of desirable outcomes. A skillful use of real options modifies the exposure to external uncertainty and increases the value of strategic investments; real options moderate risk. Figure 2 shows the modifica-

Valuing Real Options. Much less information is needed to produce an option valuation than to produce a detailed discounted cash flow valuation. But before using real option theory, managers should start with a simple and transparent framework that identifies all potential business choices. The strategic plan should be designed to include all the company’s divisions and all available financial market information and should have a long time horizon. Above all, managers must emphasize the framework and not the details of the strategic plan. To value an option, the following should be known: • the current value of the underlying asset, • the time to the decision date, • the investment cost (or exercise price), • the risk-free interest rate, • the volatility of the underlying asset, and • the cash payments, or noncapital gains, to holders of the underlying asset (the yield of the asset). The following do not need to be known to value an option using real options as a valuation tool: • probability estimates, • the expected rate of return for underlying assets, • the expected rate of return of the option, and • risk adjustments to the discount rate.

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Evolution in Equity Markets Framing the application of real option theory requires several steps. Unlike a traded option, the real option has no specific contract and must be identified through analysis and judgment. Each source of uncertainty and the associated cash flows and convenience yields should be identified so that a mathematical expression can be created. Next, the marketpriced sources of uncertainty must be compared with the relevant financial markets, and a review must be done for transparency and simplicity. Many option calculators are available to check the accuracy of the model. If the volatility estimates are set to zero in the option valuation, the resulting valuation should be identical to that of a discounted cash flow valuation for the same project. An option’s value can be calculated in one of three ways: partial differential equations, a dynamic programming binomial model, and simulations. Partial differential equations, such as the Black–Scholes option-pricing model, are easy to use but can accommodate only a limited number of uncertain elements (about three). The Black–Scholes model is not transparent, and valuations are not available at different stages in the calculation. The dynamic programming binomial model is much better at handling complex decisions and can accept constraints. The binomial model uses a risk-neutral approach, can handle leakages of value, and is transparent so that intermediate values are visible. Simulation models, such as the Monte Carlo model, can handle complex decision rules, but they are path dependent and not ideal for American options or sequences of options. When to Use Real Options. When should a real option not be used? Traditional tools, such as discounted cash flow models, must be used when there are no options in the decision-making process. Also, when the probabilities of different, but possible, outcomes of a business strategy or project can be estimated with relative certainty, scenario analysis is well suited to the valuation process. In such cases, there is no compelling reason to adopt a real option valuation approach. Real options are appropriate, however, in numerous circumstances. They are useful in contingent investment decisions or when sufficient uncertainty exists to justify delaying a project. For example, high-technology company assets normally decline in price over time, so an investor in a technology project often has to decide whether to invest now and get in at an early stage of development or wait for the cost of the assets to decline. (Costs of hardware and software are falling all the time.) Another instance in which option analysis should be used is when value is better captured by the possibilities of future growth than by current cash flow, when uncertainty is suffi-

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ciently large to make flexibility a consideration, or when it is likely that management will change a strategy mid-course. An option can be regarded as a strategic investment, and other strategic investments exist—such as insurance investments, modular investments, platform investments, and learning investments. Insurance investments reduce exposure to uncertainty. Modular investments build options through product design, enabling a plant to switch from one product to another. Platform investments are funds spent in R&D to produce a concept that can be used to launch different products. Learning investments are made to obtain information that would otherwise be unavailable. Risks of Real Options. When using real option theory, total risk must be considered. In discounted cash flow models, the risk is normally systematic risk. But systematic risk is only part of the total risk of an option. Real options have risks that are not defined by a set of traded securities in the financial commodity markets. For example, the risk of failing to develop a new technology is a private risk borne by the technology firm. Many real assets leak value in the form of annual cost cash flows or by paying a convenience yield (i.e., a low dividend). Both positive and negative cash flows affect the yield of the asset. Dividends, rental payments, interest, royalties, and license payments are positive cash flows. Storage costs, taxes, insurance costs, licensing payments, royalty payments, and convenience yields are negative cash flows. Therefore, leakage effects must be allowed for in the mathematical model (either a binomial model or a simple Black–Scholes model) used to value a real option.

Models for Valuing New Economy Companies Several models are available to value New Economy companies. One model called Continuous Time Stochastic Valuation addresses the differences in valuation caused by variations in time horizon. Another model, shown in Figure 3, conceptualizes the effect of the time that elapses before investing in product development on the value of the ultimate asset. The first decision a company must make about a development stage product is the length of time before continuous investment is dedicated to that product. Because the price of technology assets generally adjusts downward rapidly, waiting can be advantageous to the investor. Once investment is begun and funded over a defined period of time, the investment is sold, listed, or capitalized for value V at point T.

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Valuing Technology Companies Figure 3. Information Technology Development Project Development

Wait

Start Investing

Invest I

0

Receive V

T

An investor would take the same approach for a product acquisition as for product development, as illustrated in Figure 4. The decision to invest is made at Time 0, but the actual investment, K, is not made until a later date. The cash flows, C, from K are received by the investor over a continuous time span ending with time T.

Figure 4. Information Technology Acquisition Acquisition

Wait

0

Invest K

Receive C

ity, financial efficiency, and operational flexibility (an easy change from one product to another) characterize CFBs. These companies generally do not have a high regard for human resources management, and little credence is given to creativity in middle management. Still, these businesses are successful because they have an ideal structure for exploiting the opportunities in the imperfect markets of Asia, and the strength of the CFB network in a region of scarce information is quite valuable. They have also tended to use low value added manufacturing and trading operations, which the multinationals have avoided. I recently analyzed a number of private Asian companies in the technology sector, and I detected certain characteristics in the new Asian business model that mirror many traits of the traditional Asian business model. The companies are, not surprisingly, very flexible, frequently have globally or regionally competitive products, and are not constrained to one market. They differ from the traditional business model in that they have a flat management structure and often are not family controlled. The contributions of middle managers, such as marketing managers who add value by creating and keeping customers, are now more highly regarded.

Conclusion

T

New Economy Company Example In Asia, one does not have to look far to see examples of the New Economy business model. A traditional Chinese family business practices a management style that is characterized by networking and flexibility, two characteristics associated with the New Economy companies. Ironically, the Chinese family business (CFB) model is anything but new. CFBs— which range from small, free-standing retail outlets to regional or global conglomerates—exist in every kind of industry and account for a large proportion of the GDP in Southeast Asia. The majority of the CFBs are small and closely networked with other CFBs, mainly through the personal connections of the owners. They tend to be focused on one product or market with little importance given to marketing or branding. Centralized decision making, cost sensitiv-

Accounting standards are becoming globalized. Eventually, global standards will, in all likelihood, resemble U.S. standards. This change will take time because the development of New Economy business models is happening much faster than accounting standards are changing. Moreover, the complexity of analytical work required by investors and intermediaries will have to increase to keep pace with the changing business models. Technology companies are selling shares to the public at much earlier stages than Old Economy companies did, so the shares are sold at a much riskier stage of development. Thus, more thorough work is required on the part of analysts. Real options are now being used in technology companies as a framework for evaluating various business models and are used extensively by mineral exploration companies in quantifying investment opportunities. At this juncture, however, the real option approach has not been extended to the valuation of technology companies. The real option methodology remains difficult to practice, but more frequent and transparent financial reporting will help.

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Evolution in Equity Markets

Question and Answer Session Robin J.G. Fox, CFA Question: If under zero uncertainty the real option value is the same as discounted cash flow, why not try to create a proper index using various research methodologies and simply adjust the discounted cash flow for that index of uncertainty? Fox: The way to do that is to use scenario analysis as I discussed, but I am not suggesting that you have to use one particular method over another. I was trying to illustrate some of the methodologies presented in the material that I have read recently and have started to use in theory on some of our projects. Question: Is real option theory used widely in the industry, and has experience proven that it works? Fox: A leading European house with origins in Switzerland published a piece of research on using real option theory a few months ago. The paper was fairly straightforward, and I think it will be viewed as increasingly important as the academic research on this topic proliferates. Normally, the academic research leads, and then the practitioners follow. I should point out that this theory has developed over about 20 years. The capital asset pricing model was developed in the early 1960s but was used seriously only starting in the 1980s. I suspect the same thing will happen here. We are just at the start of the practical use of this quantitative approach. Question: Do real option models better support the traded prices observed in the market— for Internet and dot-com compa-

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nies specifically—than discounted cash flow models do?

panies than for complex, multidivisional companies?

Fox: In some cases, they probably do. We are handicapped at the moment by a shortage of financial information necessary to make useful decisions, so real option theory is one way of exploring and analyzing the business models of different companies. Unfortunately, at the moment it is difficult to use real option theory other than in a qualitative sense; to use it quantitatively we need better information. When you are talking about pricing, you are talking about a quantitative outcome. It may be that you can put the information to better use if you know the company well—you understand the management, are an insider, and through the information you glean can make a quantitative estimate. If you are an outsider and the management is secretive, however, you won’t be able to use it because you do not have the adequate inputs to make a useful valuation.

Fox: No. The approach for a multidivisional company is to value each division on a separate basis. So, if you have a complex company with different divisions, then you can have a different model for each division.

Question: In the short run, is real option theory of greater use to management in deciding how to create shareholder value than having outside analysts value the company?

Question: To what extent does real option valuation theory depend on the cost of capital?

Fox: Yes. There is a lot of private equity investing, and a serious private equity investor can get access to the management accounts of the company, whereas an outside analyst cannot get access. On the other hand, real option theory can be used by analysts when they have access to a company’s books. Question: Is real option theory of greater use for single-product com-

Question: Is real option theory used by managers in the private equity market? Fox: Real option theory is just beginning to be accepted and used in the context that I am proposing. Currently, the theory is used predominantly by oil companies to value oil exploration projects and by other mineral exploration companies. There are a lot of quantitative models that can be used for valuation as an alternative to the real option model. They are mathematically complex and outside the scope of this talk, but you can get software, such as Mathematica, to do the math for you.

Fox: Options do not, in themselves, require the cost of capital for valuation. But there are several ways to incorporate this concern. The uncertainty factor in valuation that makes real option theory so appealing can be based on the amount of money to be invested or the value of the investment at the end of the day. Assuming there is a discounted cash flow input in the calculation, it will require a cost of capital input, but this input is not normally required by the option calculation itself.

©2000, Association for Investment Management and Research

Valuing Technology Companies Question: Once some sanity has returned to the markets, do we forget all about this real option valuation and go back to basics?

and accept that we must pay a premium for companies whose earnings are even more uncertain now than in the past?

Fox: No. This way of looking at a business, given the changes of the New Economy, means that companies are more flexible than they were in the past. That flexibility creates more uncertainty about the outlook. Thus, this way of looking at the valuation of businesses and of companies will be increasingly used. Still, the theory must be refined. The academics are still arguing about different models, but I think the concept is here to stay.

Fox: No. We’re not going to throw all of our experience out the window. It’s still relevant to business decisions where cash flows are reasonably certain. For example, if you have an electricity generating company, such as a power station, where the demand for electricity correlates closely to industrial production or GDP, you can make a reasonably accurate estimate of cash flow over a long period of time. That kind of decision lends itself to doing a discounted cash flow valuation. But for a software developer or an Internet company that can switch

Question: Must we throw all of our experience out the window

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from one business to another, who knows what the cash flows will be? There are ways of applying real option theory to value the company under certain circumstances. It’s difficult to apply, but one of the reasons why valuations have gone up so much is because people are giving a value to uncertainty. Options do rise in value with increasing uncertainty, and real options can be used to explain why in an environment of increasing uncertainty some companies are more valuable than they would be if they were valued on a simple discounted cash flow basis. Keep in mind, however, that uncertainty only creates value if management is flexible, which is characteristic of New Economy companies.

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The Future of Global Trading Greg Robinson Managing Director ITG Australia Melbourne, Australia

Technology will determine the future of global trading. It has been the primary catalyst for the changes that have occurred to date and will be the architect for new market structures and networks. Institutional investors have been profoundly affected by the entrance of and frequent domination by the retail investor (primarily as a result of technology) in the online, real-time trading environment of today. Institutional investors must adapt by implementing such strategies as intelligent trading order management systems and adaptive behavior techniques to improve performance.

o one knows exactly what the future holds for global trading, except that getting there will be an intriguing ride. What is known is that technology is the driver and is transforming the structure of markets and how people trade. My discussion will have a U.S., or nonglobal, bias because the U.S. markets in certain ways are further afield than the European or Asian markets in dealing with some of the inevitable changes. Thus, I will examine exactly how markets are changing, the ramifications for institutional investors, and the responses required of investors for adaptation to the new trading environment.

N

Background In the “good old days,” two-tiered information was characteristic of the stock exchanges, but that situation is changing with the advent of retail investors who actively participate in the market and the introduction of increasingly sophisticated technology. The old stock exchanges had physical floors, isolated pools of liquidity, limited hours, and regional and fragmented markets. The trend in the United States and worldwide over the past 5–10 years has been toward a consolidation of markets. Australia, for example, had half a dozen stock exchanges 100 years ago, and then by 1987, the number dropped to one, which is typical of most markets. Exchange consolidation has been driven by economies of scale that have developed from improved communications technology, whether railroads or the telegraph, and the elimination of regulatory and institutional barriers. Some deviation, however, from this long-term trend has taken place.

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Many niche markets, such as alternative trading systems, have developed because changes in regulation have allowed niche markets to grow, particularly in the United States.

Market Trends Market changes can be grouped into one of three categories: market structure, regulation, or trading environment. Changes in market structure are represented by automation, globalization, demutualization of previously member-owned exchanges that were run totally for the benefit of the members. Changes in regulation have resulted in the increasing harmonization of international regulations, and thus, the possibility of competition has increased dramatically. Finally, the trading environment has been changed by information technology. E-Markets. Electronic markets are proliferating, but some resistance to change remains in even the biggest and highest volume markets in the world, principally the NYSE. This resistance arises from a belief that the physical floor serves a purpose. But now that a number of electronic markets exist around the world, academic studies comparing the efficiency of floor-based and electronic markets can be done. A few of these studies have shown that running an electronic market does not create a deficit in efficiency— whether looking at liquidity, spreads, depth, information efficiency, speed of information transmission, or changes in volatility.

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The Future of Global Trading Electronic markets make it possible to have increasing contestability in execution. An obvious consequence of electronic markets is automation, which lowers sunk cost barriers and allows new entrants to undercut prices. The implication is higher levels of competitive behavior because more people are able to compete. Exchanges historically have presented a range of monolithic, bundled services that have collectively been associated with the functions of a stock exchange. It is now possible for new competitors to come in and target particular areas of traditional exchange functions—whether it is a single transaction, the price discovery mechanism, or clearing. Thus, the potential exists for new entrants to cherry-pick what were previously bundled stock exchange functions. Demutualization. Demutualization is a trend that continues to gain momentum in the trading world. It is the separation of membership from ownership: Members no longer need to physically turn up on the trading floor. The number of market participants is no longer limited, and participation is actually encouraged by the increasing automation of the exchanges, so the concept of membership being associated with physical forms of market access is dissipating. Automation of exchanges permits the phenomenon of demutualization. Demutualization also allows the governance structures of stock exchanges to adopt organizational structures that are more like those of traditional corporations. Ironically, achieving automation may actually require demutualization. Funding and refunding and continually improving and upgrading electronic markets as the capacities and the functionality grow can often require huge capital infusions. Traditional members of a stock exchange may not be inclined to continue to reinvest in the market but, rather, adopt an “if it isn’t broken, don’t fix it” approach. A demutualized exchange, however, has access to capital to continually invest in new technology. The need for consistent infusions of capital is an important driver for this process. Several examples of demutualizations in recent times exist. These include the Stockholm Stock Exchange (1993), Helsinki Stock Exchange (1995), Amsterdam Exchanges (1997), Borsa Italiana (1997), the Australian Stock Exchange (1998), the Singapore Stock Exchange (1999), the London Stock Exchange (2000), and the Hong Kong Stock Exchange (2000). Note that the Scandinavian stock exchanges were affected fairly early by the demutualization trend, and now they are appearing as players in the London Stock Exchange takeover. So, perhaps to some extent this activity can be attributed to first-mover advantage.

A demutualized stock exchange implies a heightened level of competition. For-profit exchanges are more likely to compete aggressively and seek new opportunities in other lines of business; traditional member-owned exchanges are less inclined to act as progressively. For-profit exchanges look for new products. These exchanges may compete with previous customers, owners, or investing institutions by offering different styles of investment products or different brokerage services, in terms of offering execution services directly or quasi-directly to the users. New entrants then can, as I mentioned earlier, compete as a niche provider by unbundling the previously bundled stock exchange functionality. Thus, the advent of technology and the changes in organizational structure of exchanges provide the opportunity for a temporary increase in the fragmentation of liquidity pools around the world. I would also argue that technology is the key to finding reconsolidation in global trading, whether it occurs within a single computer or synthetically through a consolidation of global liquidity pools. Regulation. Changes in regulation are promoting intermarket competition. Such changes are putting pressure on costs and are promoting high levels of transparency and access. One result of these changes is greater retail participation in the market. In addition, spreads are getting smaller, and intraday volatility is increasing.

Impact of Internet The Internet does not change everything, but it certainly does influence how equity transactions are conducted. It allows for faster access to markets from almost anywhere in the world, and it has led to the “democratization” of information. The two-tiered information system (in which institutional investors had access to high-quality, high-frequency information and retail investors were relegated to what bits and pieces they could pick up in the press) is now a thing of the past. This change has taken place quickly. Disclosure rules were changed in the United States with the U.S. SEC’s Regulation FD (effective October 2000), and the trend toward simultaneous publication of investment information to the public and to institutional investors has begun. More information is now available, but is it of better quality? Most certainly, it is cheaper. Many Internet companies are not making money, partly because they are giving away their products via users’ computer screens. Internet-based information comes from varied sources. It originates not only from the companies themselves, the brokering houses, and the subscription services but also from chat rooms and many

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Evolution in Equity Markets basically unregulated sources. Information dissemination is happening quickly. The public can now quickly and easily access investment information. The result is that retail investors want to trade more often. One illustration of the changes that have been wrought by this faster and broader access to information is the change in response time to earnings surprises. Earnings surprise models have traditionally been used as a good tool for identifying sources of excess return for those investors who track analysts’ earnings forecasts. Figure 1 shows the 1983–89 relative return of a given universe of stocks and the outliers in terms of earnings surprises in the approximately three months up to and after the official announcement of earnings. The reaction time of two to three weeks—the signal—was quite persistent and has always been puzzling to quantitative analysts, who have wondered why the signal would persist for so long. Figure 2 shows the reaction times for the same universe of stocks from 1995 to 1998. The reaction time has been reduced to less than a day; it is down to minutes and hours. Does this finding mean that rapidly disseminated information creates a more efficient market? The answer depends on the strength of the reaction in relation to the signal. This is one of the hot issues today in terms of market volatility and the issue that is driving the market efficiency argument. In electronic, fairly transparent, and particularly order-driven markets, which characterize most of Asia’s exchanges, U.S. electronic communications networks (ECNs) do not pose a threat. They are a product

of an inefficient U.S. market structure and will probably turn up in Asian markets as portals to direct access, which will increasingly open stock exchanges. (The Hong Kong Stock Exchange opened up its interface to brokers, which gives the public direct access to the market with all the associated regulatory challenges.) ECNs are an example of a phenomenon that has multiplied like a mushroom as a result of the confluence of several factors: changes in regulation, which basically gave ECNs the right to exist; the availability of technology; regulatory requirements for greater transparency; reduction of charges by price competition for retail business, which has driven new entrants into the ECN market; the fragmentation of liquidity; easy access to information; and an increase in market volume and volatility. Table 1 shows the growth of online trading as a fraction of all retail trading. Online trading at the end of 1999 was nearly half of all retail trading. I do not know what the numbers are for the first half of 2000, but given the recent performance of the technology indexes and the debt markets, online trading has probably slowed down significantly because it appears to be motivated by a secular trend.

Price and Volatility Impact What is the impact on prices as retail investors become more and more active in the market? I have already discussed what has happened in terms of response speed to earnings signals or news (Figures 1 and 2).

Figure 1. Earnings Surprise Analysis, 1983–89 Price Change Index 1.12 1.08 1.04 1.00 0.96

Reaction Time: Weeks

0.92 0.88 –80

–60

–40

–20

0

20

40

60

80

Number of Days (Earnings Report = 0) Negative Outliers

Positive Outliers

Universe

Source: Based on data from R. Butman and DAIS Group.

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The Future of Global Trading Figure 2. Earnings Surprise Analysis: 1983–89 and 1995–98 Price Change Index 1.04 1.12 1.00 1.08 0.96 1.04

Reaction Time: Minutes to Hours

0.92 1.00 0.88 0.96

–80

–60

Reaction Time: –40 to Hours –20 Minutes

0

20

40

60

80

Number of Days (Earnings Report = 0)

0.92

Negative Outliers 1983–89

0.88 –80

–60Positive Outliers –40 –20 1983–89

Negative Outliers 1995–98 0

20 Universe401983–89

60

80

Number of Days (Earnings Report = 0) Outliers 1995–98 Universe 1995–98 Positive Negative Outliers 1983–89

Negative Outliers 1995–98

Positive Outliers 1983–89

Positive Outliers 1995–98 Universe 1995–98

Universe 1983–89 Source: Based on data from R. Butman and DAIS Group.

Table 1. Online Trades as a Percent of All Retail Trades by Year Year

Portion of Total

1997

17%

1998 (first half)

22

1998 (second half)

30

1999 (first half)

37

1999 (second half)

48

Source: Based on data from NYSE.

Investors today sit poised at the keyboard waiting to trade at the drop of a hat. What does that do to markets? What does it do to volatility? The Internet serves as a coordinating device for all these people, and the result is a magnified impact on markets in the short term so that market makers cannot “lean against the wind” when capital is limited. In a market-makerdriven market, such as the NYSE, a whole torrent of buying or selling can be concentrated in a short timeframe. It is now much more difficult for market makers to stand their ground or to step up to the plate with their own capital in a market fiercely going in a single direction, so they step back, which weakens the bid that much more and results in an additional price impact.

Much behavioral research suggests that even educated retail investors can be overconfident. Overconfidence is certainly one explanation for the propensity to overtrade. People who have run portfolios for any length of time know that even low transaction costs can eat away at portfolio returns if the investor trades frequently. Transaction costs are not always apparent, but if an investor is turning over his or her positions frequently or crossing the spread with the trade on the other side, overcoming those costs, in terms of alpha, is difficult. The impact of online traders is proportional to how many there are, and their numbers are growing. Their impact is also dependent on the fact that they respond in common to information signals they receive, perhaps through the Internet. And their impact is proportional to the illiquidity of the stocks in which they are dealing. All these factors have been increasing, and thus, an increase in intraday volatility has resulted. Figure 3 shows rising intraday volatility in the Nasdaq. Quiet trading days are on the left-hand side of the x-axis where the intraday index return volatility begins with a range of 0.3–0.4 percent; busy days are on the right-hand side, ending with all occurrences of volatility in index return greater than 2.6 percent. An important point to note is that the 1999

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Evolution in Equity Markets Figure 3. Intraday Volatility of the Nasdaq, 1996–99 Frequency (%) 70

60

50

40

30

20

10

>2.6

2.5–2.6

2.4–2.5

2.3–2.4

2.2–2.3

2.1–2.2

2.0–2.1

1.9–2.0

1.8–1.9

1.7–1.8

1.6–1.7

1.5–1.6

1.4–1.5

1.3–1.4

1.2–1.3

1.1–1.2

1.0–1.1

0.9–1.0

0.8–0.9

0.7–0.8

0.6–0.7

0.5–0.6

0.4–0.5

0.3–0.4

0

Volatility Range of Index Return (%) 1996

1998

1997

1999

Note: Not all years have data in all ranges.

numbers have significantly higher volatility of returns and are skewed to the right on the x-axis. Figure 3 is a good way of looking at the increasing number of big moves in the Nasdaq.

Information Flow One of the problems that institutional investors must continue to face is coping with information about the stocks in their portfolios, but now that information is coming from a variety of new channels. They will no longer be able to just pick up the phone and ask the brokering analyst for his or her updated view; nor will they simply be able to look at I/B/E/S or consensus earnings. The simple examples in this presentation have clearly shown that prices and volatility in the markets are being driven increasingly by investors (the majority of whom are retail investors) who may be getting their information from nontraditional sources—Internet chat rooms and other information

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that is increasingly being made public electronically. In the United States, for example, U.S. SEC filings and the results of Food and Drug Administration approvals, tests, and drug trials are posted on the Internet. That information is relevant to share prices. How do institutional investors respond to this onslaught of information? Will they continue to rely on their brokers to be quick, or will they build intelligent tools to harvest this new information from whatever source? Although a lot of high-quality information can be gathered over the Internet, a lot of it is suspect. Investors must try to discern the difference when using Internet-based information. For example, a posting in a chat room on March 22, 2000, involved a false earnings warning on Lucent Technologies. The title of the posting was “Lucent Releases Earnings Warning! Damn!” Figure 4 shows that US$7 billion of value was erased from Lucent as a result of this rumor. The stock price dropped 4.6 percent, and the

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The Future of Global Trading Figure 4. Lucent Technologies: Daily Share Price and Volume, February 18, 2000, to April 17, 2000 Share Price (US$) 80

75 70 65

60

55

50 Volume (millions) 100

50

0 2/18

2/25

3/3

3/9

3/15

3/21

3/27

3/31

4/5

4/11

4/17

Source: Based on data from Codexa Corporation and BigCharts.com.

trading volume doubled. Many other examples exist of the power of information, whether the information is fraudulent or real, affecting stocks that are likely to be in institutional portfolios. So, institutional investors need to figure out how to cope with the increasing flow of information. Retail investors have driven many of these market developments, possibly to the detriment, or certainly to the complication, of the lives of institutional investors. Automation, decimalization, and competition among exchanges have resulted in lower explicit costs, such as spreads and other transaction costs. But the implicit costs of increased market volatility—which have a huge impact on the costs of large, institutionalsize trades—are rising. The democratization of information is benefiting the retail investor, and it has made investing more difficult for institutions.

The New Competitors The new competitors to stock exchanges include business-to-business (B2B) sites. Companies such as Microsoft Corporation and Yahoo! are sometimes

viewed as much more frightening competitors than the London Stock Exchange, for example. The new entrants do not have a lot of the technological baggage, organizational baggage, or history of broker memberships, and they understand (or can focus on) core exchange functions, such as aggregating liquidity, which is what people are looking for when they trade on the Internet. Internet developments have several implications for the near future. These changes will produce faster markets with an unfavorable impact on volatilityrelated costs. These technological developments will lead to thinner markets with less market depth, single trades having a larger market impact, greater trading and return volatility, higher implicit costs for institutional investors, and a more difficult trading environment overall. Also, market fragmentation—currently a major concern about exchanges—will continue to occur as the competitive environment heats up and as the creation of new electronic markets becomes easier and easier. Competition will also result in new liquidity pools, new ways to place an order, and new execution mechanisms. The new order types, such as

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Evolution in Equity Markets automated volume-weighted average price and short-term improvement, will be the most interesting. And just as a new market might develop for an intermediation function (in terms of filtering information from diverse sources), a new role might develop for intermediaries to consolidate available liquidity, best price information, or contextual information about trading opportunities across a range of regional or global markets.

Needs of Institutional Investors Retail and institutional investors operate differently; hence, their needs differ. Retail investors tend to trade individual names, trade in small size, and pay attention to explicit costs. On the other hand, institutional investors tend to have thousands of global names in their portfolios; therefore, it is almost impossible for them to watch the chat rooms, stay on top of the latest news in every industry, and so on. As a result, institutional investors need to use quantitative trading strategies or other types of trading tools that can respond in real time to continuous information flows and that can also cope with prioritizing sell and buy lists. Monitoring information flow is no longer a job well suited to human beings as the number of information sources continues to explode. And particularly in an institutional portfolio context, automation is needed to manage risk and maintain sector and cash balances while controlling trading costs. Institutional investors must seriously start to address some of the aforementioned challenges. They need intelligent data consolidation, whether the data are about markets or about drivers of markets. Internet delivery options make the most sense for transmitting these data. Portfolio information needs to be accessible without having to put proprietary hardware/software on a desk. Institutional investors must have the ability to harvest Web content and to integrate information into their trade order management systems. These systems should consist of an open and fairly modular environment and allow for data input from a variety of sources. Big market players need to trade from multiple trading desks and to add trading decision support capabilities to the internal trading function. Human beings simply cannot identify the best time to buy or sell a particular stock when markets are experiencing the extraordinary levels of volatility that they are today; that is, they cannot look at one stock and consider the risk of the whole list at the same time. Unfortunately, all of these requirements are difficult to implement.

Future Developments Institutional investors need to be prepared for the almost inevitable future trading changes (some external and others internal). Such changes center around

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24-hour trading, trading implementation, trading strategies, the impact of technology, and consolidation of exchanges. 24-Hour Trading. A hot topic right now is 24-hour trading. A consensus exists that 24-hour trading will allow liquidity to be passed through several time zones. Historically, cross listings, particularly across time zones, have a record of not succeeding. As the new century is dawning, the market business models and exchange structures of the entities working to form alliances are still disparate and poorly aligned. So, the economic incentives for investors and traders are not sufficiently adequate to motivate them to stop trading in one market or at one exchange and pass some of the outstanding order flow to another market. Those problems will be resolved eventually, and the world’s leading large-cap stocks will probably be the first ones that are passed around the three major trading time zones (United States, Europe, and Asia). After that happens, the battle will shift to within each of the time zones to see which network in that zone is the most seamless and thus the likely recipient of this increased liquidity as it flows around the globe. Some aspects of implementing 24-hour trading have practical limitations that need to be addressed. Real-time, position-keeping portfolio systems are needed if an order book or trading list is being passed around the world. Efficient settlement and flexible dealers to cope with trading opportunities are also needed. Several tools are required to provide consolidated direct access to regional markets, and international protocols at the trading and auto-transfer level are also needed. The Financial Information Exchange (FIX) protocol, which was put together by a consortium of brokers in large institutions in the United States, is starting to reach critical mass in terms of usage. It is not a trade order management system and does not solve any of the problems that I raised earlier. But it is at least a standard method for the global transmission and passing of orders and reports among various entities, and its usage should continue to grow. Implementation Issues. Traditionally, the investment process has taken a top-down approach with the actual implementation stage bringing up the rear. The list of trades chosen to rebalance or redirect the view of the portfolio is presented to the dealing desk or the trader for implementation, and typically little additional thought is given to the process from the standpoint of the portfolio manager. Although a great deal of attention is paid to the relative rankings of stocks and forecasted returns, only minor attention is paid to the actual cost of trading a certain name on a particular day versus another name. A lot of

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The Future of Global Trading slippage exists in the portfolio management process between the paper portfolio, the fictional implementation, and what people actually see in their physical portfolios and in their performance numbers. One way to correct that shortcoming is to try and integrate implementation costs (or implementation smarts) into the portfolio construction process. Doing so will become more important as stocks trade for a longer period of time in different markets. Strategies. Institutional investors will also need new strategies to cope with the frighteningly complex, highly sophisticated, and “gee, it must be better now” trading environment. Intelligent systems are needed to integrate the investment strategy and its implementation. The trade order management system should perform optimal routing and liquidity searches across fragmented global markets. It should trade dynamically in response to new information, existing market conditions, and order status. It should conduct portfolio optimization to control costs and risk, which is a sophisticated and difficult task. The system will need links to pre- and post-trade analytical tools and should use adaptive behavior—whether it is human refinement or a structure that adapts itself—to improve performance. Impact of Technology. Not surprisingly, technology is having a major impact on institutional investors. The presence of electronic markets, or Web sites, means that brand recognition and the involvement of large, major market players will be important. Branding is probably more important than how much turnover an exchange has in some ways, although the two concepts are linked. Electronic markets have improved accessibility, which has lowered the barriers to competition. Global competition is the inevitable outcome—an interesting scenario of markets wanting to form alliances and to compete with each other at the same time. Enhanced information now flows from a variety of sources, and the result will be a demand for more sophisticated tools to manage the information.

Because interacting with the markets has become so easy, the opportunity exists for re-intermediation, the bundling of services in a unique manner, and the addition of value through customization. Many online retailers compete based not on what they sell but on their ability to customize their sites for individuals. Easy-to-search-for liquidity allows for lower margins. (It is not a good time to be a stockbroker in that sense.) And liquidity begets liquidity in any market. Therefore, reaching critical mass and earning the first-mover advantage or having a strong brand name is important for future exchanges, institutional investors, and online brokers. Consolidation. The long-term trend of exchange consolidation will dominate short-run fragmentation concerns. Information technology is playing the roles of both God and the devil in this process. The global consolidation of markets by time zone will occur through mergers and acquisitions, strategic alliances, information sharing, and cross-market linkages. Market access will become more seamless, whether the markets initiate this themselves by developing harmonized systems or whether intermediaries do it for them by building technology capable of joining a panregional market.

Conclusion The market is experiencing dramatically reduced interaction costs, both for transactions and information. This development is driving the unbundling of services, especially exchange and brokering services. Economies of scale and scope are also developing, which will suggest and allow for new methods of trading consolidation and bundling of services. The effects of trading networks are changing the trading environment as well, and the number of players and the level of competition will only accelerate the transformation of the markets. Technology is frightening to some, but there is much irony in the fact that the technology driving these inevitable changes in the markets will need to be applied to solve the trading challenges technology presents.

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Evolution in Equity Markets

Question and Answer Session Greg Robinson Question: Is insider information alive and well? Robinson: Gaps in the policing of information leakage prior to formal announcements still exist. Some of that leakage is the result of selective disclosure to institutions, such as the big players getting the better information, but some of that favoritism is leveling out now. I don’t think insider information is going to go away. In fact, the regulators have an even greater challenge today: Do they want to police and prosecute people such as the ones who posted the false announcement on Lucent in that chat room? Where does it end? Question: To what extent are chat room conversations promot-

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ing the desire to create fraud under the guise of freedom of speech and freedom of expression? Robinson: My understanding is that the regulators have taken a dim view of this. Strong laws exist against promoting stocks other than through conventional channels, and the government has set up a few dedicated task forces with the frightening job of trying to monitor chat rooms. Question: In the new world of fragmented exchanges, competitive exchanges, and 24-hour trading, is there an infinitely greater scope for market rigging than has ever been seen before?

Robinson: I have some experience working on a stock exchange floor, and if somebody was doing something strange in a stock, it was apparent because someone would be yelling and changing the price and exchanging tickets. Computers, however, are fairly tireless at doing tedious work by watching thousands of markets or thousands of trades. A lot of markets were built around tools that are far superior to what a human can do. Computers are good at looking for patterns or abnormal occurrences over a time span. The issue of market rigging is probably getting more complex at a faster pace than regulations can keep up with.

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