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Winter 2013 / J.P. Morgan Investor Services thought

Winter 2013

Perspectives for 2013Our global economic outlook • Perspectives on China

the rise of mobile technology

J.P. Morgan Investor Services thought / Winter 20132

Welcome to the start of a new year, a time for optimism, planning and beginnings, a time

to assess where we have been and what we are becoming.

This issue of Thought is the first since J.P. Morgan integrated several businesses to

create a more unified structure that offers institutional investors seamless and

robust solutions as well as the vast expertise of our global franchise. The creation of

J.P. Morgan Investor Services signals our renewed dedication to offering an expansive

set of products and services to help you achieve your goals in very efficient, holistic

and optimal ways. Whether it is pre-trade, trade or post-trade, we can guide you

toward solutions to the challenges ahead via our unique industry position and

market-leading capabilities.

To that end, we offer herein our global economic outlook for 2013, developed by senior

economists from our Corporate & Investment Bank. Strategic perspectives on China’s

financial developments are presented by our colleague Jing Ulrich, one of the industry’s

most respected authorities on the Chinese market. This issue also presents viewpoints

on the state of global regulatory initiatives, the Australian pensions business, and

the rise of mobile technology. In addition, we share some interesting ideas about

opportunities for alternatives managers, and we look at transition management in

relation to the emerging markets.

Thank you for reading Thought. Please know that your questions and comments are

always welcome and may be sent to [email protected].

Carlos HernandezChief Executive Officer

Investor Services

Thinking Out Loud

Carlos HernandezChief Executive Officer, Investor Services

Cover image:

“Channels in the Museum of China” (National Museum of China, Beijing) by photographer Fuyu Liu

Whether it is pre-trade,

trade or post-trade, we can

guide you toward solutions

to the challenges ahead via our

unique industry position and


Winter 2013 / J.P. Morgan Investor Services thought 3

More Growth, Less Fear: 2013 Global economic Outlook

J.P. Morgan senior economists forecast that the global economy will accelerate marginally above trend later this year.

Perspectives on China’s Financial System reforms

An in-depth analysis of crucial elements of China’s financial evolution and progress.

the rise of Choice: investor empowerment in Australia’s Defined Contribution Market

Australia offers interesting examples of how investor choice has affected their substantial pensions market.

notes from J.P. Morgan’s Pension Blog

Benjie Fraser’s feature highlights important areas of concern in the worldwide pensions industry.

the regulatory View: Unfinished Business

How will regulatory bodies continue to drive the global agenda in 2013?

Growing Mobile

The use of mobile technologies is gaining ground among institutional investors.

the Case for Operational Alpha in the Alternatives Space

As reporting requirements increase, the alternatives funds industry considers multiple new protocols.

Managing transitions with emerging Market Assets

An overview of the transition process in emerging markets with key issues for consideration.

Winter 2013

J.P. Morgan

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thought

Whether it is pre-trade,

trade or post-trade, we can

guide you toward solutions

to the challenges ahead via our

unique industry position and



Editor’s note: The following is an excerpt of an in-depth economic research report recently published by J.P. Morgan’s Corporate & Investment Bank. To read the complete report, please visit www.jpmorganmarkets.com.

More Growth, Less Fear2013 Global Economic Outlook



The impetus for stronger growth comes as businesses turn more expansionary. Companies became cautious in 2012 against a backdrop of slowing profit growth and heightened uncertainty about the euro area and China. Spending on business equipment contracted in the middle two quarters of last year (see figure 1). Combined with a slowing in hiring and efforts to adjust inventories, business caution pushed global growth to the lowest pace of the expansion. However, global final demand was supported during this period on the back of continued growth in consumer spending. With profits still expanding and policy actions successful in stabilizing euro area stress and Chinese growth, business sentiment began to lift last quarter. The upturn in sentiment will be amplified by the recent aversion of the worst of the U.S. fiscal cliff.

fIGurE 1 GLOBAL BUSineSS eqUiPMent SPenDinG

%q/q, saar; excludes China

The anticipated rebound in investment spending and a turn in the inventory cycle points to better times for the beleaguered global manufacturing sector. After stagnating for much of last year, global manufacturing is expected to rise at a 3.5 percent pace in 2013 (4Q/4Q). Asian economies that lie at the center of the global technology and manufacturing cycle will benefit most.

5

Global growth momentum is building, and we forecast faster growth in the coming quarters. the bar for improvement is not very high as global gross domestic product (GDP) rose at a meager 2.1 percent last year, a percentage point below our estimate of trend. this year growth is projected at a 2.5 percent pace in the first half of 2013, accelerating to a 3.3 percent rate during the second half of the year. if right, the global recovery will mark a turning point in 2013 following two years of subpar performance.


As the year begins, the growth lift will be constrained by two factors. First, the developed market (DM) economies face a large, front-loaded fiscal tightening. In the U.S. an early year drag associated with the expiration of the payroll tax holiday will hold back the economy despite significant private sector healing and improving credit and financial conditions. Our forecast anticipates that a setback in U.S. consumption growth will limit lift in the first half of this year, followed by a return to above-trend global growth during the second half of 2013. In Europe, while we expect fiscal drags to ease some in 2013, austerity will still weigh on growth.

Second, credit conditions are expected to remain somewhat restrictive in Europe and emerging market (EM) economies. A tightening in credit terms and standards was a major factor in the global economy’s poor performance last year. It also helps explain the relative outperformance of the U.S. where credit conditions improved. We believe these drags on the euro area and EM are starting to fade, particularly in the euro area where the European Central Bank’s Outright Monetary Transactions (OMT) program is anticipated to help lift the region out of recession. However, euro area bank deleveraging and the unwinding of easy EM credit in the aftermath of the global financial crisis will take time and is expected to limit the pick up in global growth.

Although growth is expected to quicken, the legacy of two years of subpar performance looms large, creating significant challenges for policymakers. Global inflation is expected to move lower this year, largely as a result of declining core inflation in the DM. Inflation has proved sticky in some DM economies because of institutional rigidities and well-anchored inflation expectations. A sharp increase in goods price inflation, reflecting previous overheating in the EM economies and strong manufacturing activity, also played an important role. This latter source of inflation is now unwinding, with DM import price inflation forecast to slide to near zero over the coming year. With excess slack persisting, DM inflation is set to fall well below central bank objectives this year.

The projected tension between low underlying inflation and the constraint posed by the zero-interest-rate bound represents a unique challenge for DM central bankers. Aggressive fiscal tightening in the U.S. and Europe in the face of high unemployment represents another. Not surprisingly, institutional and political tensions

have escalated amid widespread concerns about the high cost of continued subpar performance on potential output and/or growth, inflation dynamics and debt sustainability. These pressures are particularly acute in Europe and Japan.

DM central banks are responding to these challenges in a number of ways. Central bank balance sheets will expand significantly more. Moreover, there is a major new initiative underway as central banks experiment with communication policy—the signals they send about their objectives and how they will react to changing economic circumstances. The active use of communication policy, with balance sheet activities used to reinforce messages, will be the defining feature of the G-4 central bank landscape in 2013. Recent months already have set the ball in motion. The liquidity backstop provided by the ECB’s OMT program introduced a risk-sharing mechanism that changed the nature of sovereign debt in the region. Last month, the Fed tied its rate guidance explicitly to observable economic conditions in an attempt to augment the perceived diminishing returns of asset purchases. Next up to the plate is the Bank of Japan (BoJ), which is on the cusp of beginning an unprecedented battle against deflation.

In the EM, the recent slow growth phase is, in many respects, a blessing because it has contained inflation in consumer and asset prices. At the same time, this period of subpar growth has exposed underlying vulnerabilities that will take time to resolve. Corporate margins are under pressure as inflation has slowed more than the growth of labor costs. With debt levels elevated and nonperforming loans rising, banks are likely to remain cautious. What’s more, the aggressive actions by G-4 central banks are likely to generate renewed upward pressure on EM currencies, further eroding the competitive position of EM economies. It is unclear whether EM policy-makers can promote a continued rotation in growth toward domestic sources while enacting reforms needed to strengthen their service and financial sectors. While some firming in growth probably would be welcomed, what seems certain is that EM policy-makers will not permit a return of the conditions that prevailed before last year.

Although growth is expected to quicken,

the legAcy of two yeArs of subpAr performAnce

looms lArge, creAting significAnt chAllenges

for policymAkers.


the anatomy of two years of subpar growth

Following a sizable bounce in 2010, the global recovery soured. After expanding a modest 2.7 percent (4Q/4Q) in 2011, global GDP looks to have posted an even weaker 2.1 percent last year (see figure 2). At the start of each of these years, our year-ahead outlook highlighted growth constraints coming from ongoing private sector deleveraging, a broad-based need to adjust public finances, and the European sovereign crisis. However, the outlook also anticipated support from accommodative global monetary policies, healthy EM expansion, and the normalization of depressed levels of activity in the developed economies.

fIGurE 2 reAL GDP

In the event, our forecasts proved too optimistic. During 2011 it was reasonable to attribute part of the slowdown to a set of temporary natural disasters and geopolitical developments—surging agricultural and oil prices, the Tohoku earthquake and Thai flooding—which squeezed household purchasing power and disrupted global supply chains. However, as these forces faded, global growth slowed further.

The euro area was an important source of the global economy’s woes last year. The combination of the region’s slide into recession and deleveraging by euro area banks directly contributed to slower growth across the globe. The systemic threat the region’s crisis posed to global financial stability also weighed on confidence and global asset prices, further dampening demand.

Without downplaying the importance of the crisis, the euro area was not the sole factor explaining global growth weakness in 2012. Indeed, relative to the expectations held at the start of the year, euro area growth was in line with our forecast. The euro area crisis needs to be linked with two related factors to explain last year’s weak growth outcome.

1. eMerGinG MArket CreDit CyCLe tUrneD reStriCtiVe. Each large emerging market economy grew well below trend in 2012. While there are unique characteristics to the growth disappointments in China, Brazil, India and Russia, the turn toward tighter credit conditions was common across the EM. Rapid credit growth in 2010 and 2011 restored a trend interrupted briefly by the global financial crisis and pushed the credit-to-GDP ratio in all three EM regions to new highs. However, a series of developments during the second half of 2011 caused banks to turn more cautious. EM central banks began to tighten policy to combat overheating in their economies and asset markets. In addition, the intensification of the European debt crisis caused Economic and Monetary Union (EMU) banks to pull back from the emerging markets. This effect was magnified by a global investor flight from risk that produced a sharp drop-off in net capital flows to the EM. Finally, slowing global growth produced deterioration in corporate performance and an increase in nonperforming loans. These supply-side developments contributed to a severe slowdown in the growth of EM domestic credit to about 15 percent over a year ago, the weakest pace since late 2002, aside from the 2008-09 recession, although demand-side factors also played a role.

2. U.S. COrPOrAteS tUrneD CAUtiOUS. While EM corporates faced tighter credit conditions and narrower profit margins, U.S. corporates generated better performance over the past year. Corporate profits continued to rise, lifting margins to near record levels. Financial conditions continued to ease, as did bank lending standards. Still, the U.S. economy slowed into midyear as businesses turned cautious. Following two years of strong growth, business capital spending slowed sharply during the first half of 2012 followed by a contraction in the third quarter. And private sector job growth flagged during the middle part of last year. This didn’t produce a major disappointment in growth because households lowered their saving rates in the face of weaker income growth. Nonetheless, it served as a reminder that corporates remain skittish and are quick to respond to increased uncertainty or actual shortfalls in demand growth.

7

the euro AreA wAs not the sole fActor

explAining globAl growth weAkness.

indeed, euro AreA growth wAs in line

with our forecAst.

%4q/4q for full years, qtrly avg for half years (trend growth in parentheses, %)

2010 2011 2012 1H13 2H13

Global (3.0) 4.0 2.7 2.1 2.6 3.3

Developed (1.6) 2.5 1.2 0.8 1.1 2.1

uS (2.2) 2.4 2.0 2.0 1.2 2.8

Euro area (1.3) 2.2 0.6 -0.6 0.4 1.4

Japan (0.5) 3.5 0.2 0.4 1.5 2.2

uK (1.5) 1.5 0.9 0.3 1.1 2.0

Emerging (5.5) 7.1 5.5 4.7 5.4 5.6

EM Asia (6.8) 8.5 6.8 6.3 6.6 6.9

China (8.0) 9.8 8.8 7.4 8.1 8.2

EM Asia ex China (5.1) 7.0 4.2 4.9 4.5 5.1

Latin America (3.8) 5.7 3.2 2.6 4.0 3.9

Brazil (3.8) 5.4 1.4 1.7 3.8 3.7

EMEA EM (3.7) 3.9 3.9 1.5 2.5 3.3


The previous discussion highlights that much of the shortfall in global growth last year came from a sharp slowing in business activity, reflecting the combination of tighter EM credit conditions and broader concerns about the outlook. Global business spending and hiring growth slowed around midyear and a sense of corporate caution also affected inventory management, above and beyond what would have been expected amid the climate of sluggish final demand growth. The pullback in business demand resulted in a highly unusual lull in manufacturing, which largely stagnated for all of last year.

Against this backdrop, solid gains in consumer goods spending sustained the economic expansion. Global retail sales volumes rose an estimated 3.3 percent in 2012, roughly the same pace as the previous year, although there was significant volatility in spending growth during the year. The resilience of consumption is explained partly by real income dynamics. Although income growth moderated during 2012—reflecting both slower job growth and fiscal tightening that directly reduced after-tax incomes—a portion of this slowdown was offset by a corresponding decline in consumer price inflation. Consumer resilience also reflected the willingness of households to support spending growth with lower saving rates. This pattern of behavior is consistent with what occurred earlier in the expansion. Household savings rates in the G-3 have been on a modest downward trajectory for most of the past two years. In addition, households have smoothed short-term swings in purchasing power (generated by swings in inflation) via adjustments in saving rates.

A gradual acceleration is under way

In the event, the worst fears were not realized and global growth established a low-level bottom from the second quarter of 2012 to fourth quarter 2012. Viewed sectorally, this stabilization reflected the countervailing demand impulses emanating from consumers and businesses. Viewed regionally, advances in the economies of non- Japan Asia, the U.S., and Latin America offset contractions in Europe and Japan. As a result, firms have seen profits continue to grow and inventory positions gradually become leaner. Combined with the fading of concerns about China and the euro area, these developments are generating a sigh of relief from firms. The acceleration in business spending flowing from this sigh of relief, combined with continued solid gains in consumption, is beginning to boost global growth.

Hard activity data are registering the improvement. Consumer spending on retail sales appears to have ended 2012 on a strong note, with a 4 percent annualized gain

predicted for the three months through December. Household purchasing power received a strong boost when sequential inflation tumbled on the back of declining energy prices and stabilizing agriculture prices. This global purchasing power boost will be magnified by the pipeline of gains in global equity prices. In addition to these drivers, recent spending was boosted by the unwinding of Hurricane Sandy effects in the U.S. and recent transitory disruptions to spending in Japan and Brazil.

The upswing in household spending growth was accompanied by a firming in business spending. G-3 capital goods orders, which tumbled 11 percent from April through September, abruptly rebounded in October/ November, recovering about one-third of the previous drop. This was followed by a turn in G-3 shipments in November. In the U.S., equipment spending is on track for a strong gain in the fourth quarter of 2012, more than reversing the decline from the previous quarter. The picture is less bright elsewhere, but on present trends, the orders and shipments data point to a resumption of growth in global equipment spending in the first quarter of 2013. This demand shift, combined with extreme weakness in global IP in September and October (magnified by one-time factors including Hurricane Sandy), helped firms to make progress on inventory adjustments.

The message of lift is registering even more clearly in our high-frequency barometers of global growth. Our global all-industry PMI index bottomed around midyear and moved sharply higher into year-end. The recovery in the manufacturing PMI is especially significant. The PMI’s leading indicators are signaling that global inventory adjustments are nearly completed—the level of the PMI’s index of finished goods inventory has fallen sharply to a low level, while the index of orders gradually has recovered. This combination normally is a reliable indicator that the pace of manufacturing output growth is picking up (see figure 3). The message of the surveys is strengthened by the simultaneous lift in EM Asian IP and exports. A similar message comes from our global GDP nowcaster. This tool filters information from both

Business caution countered by consumer resilience

much of the shortfAll in globAl

growth lAst yeAr cAme from A shArp

slowing in business Activity, reflecting

the combinAtion of tighter em credit

conditions And broAder concerns

About the outlook.

Bruce kasmanChief Economist, J.P. Morgan Investment Bank


Better is not good

History teaches that accelerations following extended periods of poor global performance tend to be surprisingly robust. Drawing on recent history, the growth lulls registered in 2002-03, 1997-98, and 1992-93 were followed by impressive rebounds in global growth. Despite this track record, we look for only a modest pickup in first-half growth, with global GDP gains averaging 2.5 percent annualized, about 0.5 percentage point better than the second half of 2012. Even with expectations that growth momentum improves as the year goes on, our forecast maintains overall growth for 2013 at 2.9 percent (4Q/4Q). Following two years of subpar growth, the global economy is expected to settle at around trend in 2013.

There are two main factors limiting lift in the global economy:

1. DM FiSCAL POLiCy reMAinS tiGHt. The biggest obstacle to more robust near-term global growth is the U.S., where the pace of fiscal tightening is set to intensify temporarily this quarter, delivering a near-term setback to growth. Although the tightening is front-loaded, there will be some degree of drag throughout the year. The pace of fiscal tightening also will remain strong in the euro area and the UK, although in the case of the euro area, somewhat less intense than in 2012.

2. CreDit COnDitiOnS SLOW tO tUrn in eUrOPe AnD tHe eM. Although the euro area is forecast to exit recession during the first half of 2013, growth will remain subpar in the face of continued fiscal tightening and banking system stress. In the emerging markets, access to credit also is likely to remain somewhat restrictive. The combination of swollen balance sheets and rising nonperforming loans is likely to keep banks cautious. The latest Institute of

International Finance survey of EM bank loan officers illustrates these points. EM banks continued to modestly tighten lending standards, even as their access to international funding has stabilized. An extreme example where swollen balance sheets and rising NPLs are constraining credit is Brazil, where aggressive central bank easing and exhortations to banks to increase lending have had limited effect. Aside from Brazil, most EM central banks would resist a return to rapid growth in the economy and credit. Indeed, this was a factor in the limited amount of policy easing in 2012. n

the business surveys and our various global activity indicators to produce a more informed estimate of real-time GDP growth. The nowcaster estimate of December growth is on track to rise to above 2.5 percent, more than a percentage point above its average reading during the previous three months.

fIGurE 3 GLOBAL MAnUFACtUrinG OUtPUt

%3m/3m, saar; w/Nov 12 est

Joseph LuptonSenior Global Economist, J.P. Morgan Investment Bank

David HensleySenior Global Economist, J.P. Morgan Investment Bank

Source: J.P. Morgan

much of the shortfAll in globAl

growth lAst yeAr cAme from A shArp

slowing in business Activity, reflecting

the combinAtion of tighter em credit

conditions And broAder concerns

About the outlook.

Source: CEIC, CSRC

15

10

5

0

-5

-10

-1594 96 98 00 02 04 06 08 10 12


CHinA’S FinAnCiAL SySteM reFOrMS

P E r S P E C T I v E S O N



The most conspicuous imbalance in China’s financial system is the prominent role played by bank intermediation in growth, with bank credit accounting for close to 80 to 90 percent of funds raised by the corporate sector. This bank-centric model of finance was effective in mobilizing savings to satisfy investment needs during China’s earlier stages of development but has placed the private sector and smaller firms at a disadvantage.

China’s equity and bond markets remain relatively small but have developed imbalances of their own. Although the private sector now accounts for more than 60 percent of gross domestic product (GDP), state-owned enterprises have benefited disproportionately from initial public offering (IPO) fundraising and account for approximately 80 percent of stock market capitalization.

When comparing the depth of China’s financial system to those of more developed market economies, the most notable differences are the relatively small size of outstanding debt securities and a near-absence of securitized loans. A pilot program allowing major banks to securitize credit assets was launched in 2005 but scrapped in the wake of the subprime mortgage crisis. The government has recently reintroduced a bank loan securitization program with a quota of RMB50 billion.

One of the main aims of the current round of reforms is to increase the proportion of direct financing as a share of total social financing—a measure that includes items such as entrusted loans, trust loans, bankers acceptance bills, corporate bond

financing and equity raising by non-financial enterprises, in addition to regular bank loans. According to data from the People’s Bank of China (PBOC), bond and equity fundraising (by non-financial companies) together accounted for only 16.1 percent of total social financing between January and

November 2012, although this represented an increase from 14.1 percent in 2011. As part of plans to build Shanghai into an international financial center, direct financing has been targeted to reach 22 percent of total social finance in Shanghai’s financial market by the end of the 12th five-year plan.

11

Financial Market Depth Comparison — Year-End 2010 (% of GDP)

U.S. Japan Western EU China

Public Debt SecuritiesFinancial Institution Bonds

Stock Market Capitalization

Non-financial Corporate BondsSecuritized Loans

Non-securitized Loans

Source: Chatham House, BIS, Dealogic, SIFMA, S&P, McKinsey Global Banking Pools, McKinsey Global Institute Analysis

116

75

119

31

77

44

72

220

31

1810

106

72

69

115

110

1915

162 10

127

28

97

China’s Total Social Financing (RMB bn)

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

2008 2009 2010 2011 11M 2012

RMB+FX Loans

Trust + Entrusted Loans

Bank Acceptance Bill

Corporate Bond

Non Financial Enterprise Equity

Source: CEIC

Duration Profileof Dim Sum Products

Maturity of OutstandingDim Sum Products (RMB bn)

2-5 years; 38%

>5 years; 4%

≤6 months; 15%

1-2 years; 21%

6-12 months; 22%Source: Bloomberg

0

10

20

30

40

50

60

70

80

90

100

2012-2H 2013 2014 2015 2016 2017-

Source: J.P. Morgan research by Joseph Leung, CCXI

China Bond Investors (2011)

Outstanding Bonds by Type (as of year-end 2011)

Fund House 8% Special Member 9%City Comm Bank 7%

Local Gov Bond 3%

Others 1%Corporate 2%

Central Gov Bond 34%

Commercial Paper 4%

Other Banks 4%Trust Cooperatives 3%Others 3%

Insurance Company 11%

LGFVs 9%

Policy Bank 31%

MTN 10%

National Bank 55%

Non-Policy Financials 6%

License Approval & Quota Allocation for China’s QFII Program

Source: CEIC, CSRC

Number of institutionslicensed by CSRC

(RHS)

Quota approved(LHS, USD billions)

USD11.9bn

USD1.92bn

14

12

10

8

6

4

2

0

60

50

40

30

20

10

02004 2005 2006 2007 2008 2009 2010 2011 Nov-12








116

75

119

31

77

44

72

220

31

1810

106

72

69

115

110

1915

162 10

127

28

97


0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

2008 2009 2010 2011 11M 2012

RMB+FX Loans



Corporate Bond


Source: CEIC



2-5 years; 38%

>5 years; 4%

≤6 months; 15%

1-2 years; 21%


0

10

20

30

40

50

60

70

80

90

100

2012-2H 2013 2014 2015 2016 2017-





Local Gov Bond 3%



Commercial Paper 4%



LGFVs 9%

Policy Bank 31%

MTN 10%

National Bank 55%



Source: CEIC, CSRC


(RHS)


USD11.9bn

USD1.92bn

14

12

10

8

6

4

2

0

60

50

40

30

20

10

02004 2005 2006 2007 2008 2009 2010 2011 Nov-12

For decades, China’s financial system effectively mobilized savings to satisfy the nation’s investment requirements. However, since the country’s transition to a more sustainable growth trajectory will depend on higher consumer spending and the development of the nation’s service industries, a more balanced system will be needed to improve capital allocation.


China’s equity markets do not reflect the broader economy

Due to the prominence of large SOEs within the listed universe, China’s equity markets are not representative of the broader economy. The banking sector is especially overrepresented, since nearly all major Chinese banks are now listed. There are also disparities between market capitalization and earnings, with banks’ share of earnings nearly double that of the sector’s share of market capitalization. Sectors associated with the consumer economy are especially underrepresented in the equity market in terms of both earnings and market capitalization. The composition of China’s listed company earnings will evolve in the coming years, especially as more consumer-related companies become listed and if interest rate reforms temper the earnings growth of China’s banks.

the securities regulator’s reform agenda

In early 2012, the newly-appointed China Securities Regulatory Commission (CSRC) Chairman Guo Shuqing renewed the regulator’s commitment to market reforms and set out the following priorities:

inCreASinG tHe rOLe OF DOMeStiC inStitUtiOnS—The CSRC will encourage long-term institutional investors, including state and corporate pension funds, insurance companies, national endowment insurance fund, as well as housing funds to increase the proportion of capital markets investments in their portfolios. China’s provincial pension funds (with approximately RMB2 trillion in assets) and housing funds (with approximately RMB2.1 trillion in assets) will also be encouraged to invest in A shares. State media has reported that pension funds may be allowed to invest up to 30 percent of assets in the domestic market.

reFOrM OF LiStinG/DeLiStinG MeCHAniSM—The CSRC will pursue reforms in the IPO pricing mechanism and underwriting process to prevent excessively high IPO prices and subsequent speculation and market manipulation. Moreover, the administrative approval process for IPOs will be streamlined by reducing

32 percent of the approval criteria. The regulator has also pledged to revise delisting rules to allow for swifter removal of companies that fall short on minimum criteria (e.g., positive net assets, minimum annual revenue or trading volume).

iMPrOVinG COrPOrAte DiViDenD PAyOUtS—The CSRC has pledged tighter regulation of listed companies that have not distributed promised dividends or that have long refused to declare a dividend. In May 2012 policymakers further pledged to increase SOE dividend payout ratios.

StrenGtHen CHinA’S PriCe- SettinG ABiLity FOr key COMMODitieS—The regulator has allowed the launch of silver futures on the Shanghai Futures Exchange and will explore the introduction of other new products such as a market for crude oil and other major commodities.

exPAnSiOn in OtC MArket— A CSRC official indicated last May that small and medium-sized non-public companies will be allowed to have their securities traded on a national over-the- counter market in an expansion of a pilot program that started in 2006 in Beijing’s Zhongguancun technology hub.

Zhongguancun technology hub, situated in the northwestern part of Beijing city and often referred to as China’s Silicon Valley.



Lower entry barriers for foreign investors

In recent months, Chinese regulators have also shown a greater inclination to reduce entry barriers to the domestic capital markets for foreign investors.

qFii: ACCeLerAteD qUOtA APPrOVAL—The CSRC announced in April 2012 that it would raise the total quota for the Qualified Foreign Institutional Investor (QFII) program from USD30 billion to USD80 billion. China last increased the ceiling to USD30 billion from USD10 billion in 2007. In the downbeat market environment, regulators have accelerated the review and approval of QFII investors and awarded higher investment quotas to licensees (Qatar Holding LLC was awarded a USD1 billion investment quota on November 21). A total of 64 foreign institutions have been granted QFII licenses this year compared to 29 institutions in 2011 and 13 in 2010, with total investment quota of USD11.9 billion granted during the year-through-October, compared to USD1.92 billion in 2011. Shanghai is also said to be planning to introduce the QFII program in local futures, gold and derivatives markets during the period from 2011 to 2015. The move has been outlined in the latest plan for Shanghai’s foreign investment published on the Shanghai Municipal Development and Reform Commission website.

rMB qUALiFieD FOreiGn inStitUtiOnAL inVeStOrS (rqFii)—First introduced in December 2011, the RQFII program is the only channel through which institutional investors may channel offshore Renminbi toward the Mainland Chinese capital markets. During 1H2012, investor reaction to the first wave of RQFII products was subdued, considering that the scheme’s rules required a minimum 80 percent allocation to fixed income and capped the amount of equities held in a fund at 20 percent, meaning

that RQFII products were primarily fixed income funds offered by little-recognized subsidiaries of Chinese asset management firms. Since July of last year, four Hong Kong-based RQFII managers—China AMC, E Fund, China Southern (CSOP) and Harvest Global Investors—have launched exchange-traded funds (ETFs) under a widening of the scheme, tracking the CSI 300, FTSE China A50 and MSCI China A indices. These ETF products hold physical securities as opposed to previously available synthetic ETFs and provide investors direct exposure to the A-share market

13








116

75

119

31

77

44

72

220

31

1810

106

72

69

115

110

1915

162 10

127

28

97


0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

2008 2009 2010 2011 11M 2012

RMB+FX Loans



Corporate Bond


Source: CEIC



2-5 years; 38%

>5 years; 4%

≤6 months; 15%

1-2 years; 21%


0

10

20

30

40

50

60

70

80

90

100

2012-2H 2013 2014 2015 2016 2017-





Local Gov Bond 3%



Commercial Paper 4%



LGFVs 9%

Policy Bank 31%

MTN 10%

National Bank 55%



Source: CEIC, CSRC


(RHS)


USD11.9bn

USD1.92bn

14

12

10

8

6

4

2

0

60

50

40

30

20

10

02004 2005 2006 2007 2008 2009 2010 2011 Nov-12

at a lower total expense ratio. In response to the positive reception by investors, approvals of RQFII quotas have been fast-tracked since July, and at the request of authorities in Hong Kong, the quota for the RQFII program has recently been expanded to RMB270 billion from the previous ceiling of RMB70 billion. By the end of October, 21 financial institutions had been allocated a total RQFII

investment quota of RMB48 billion. The CSRC is considering Taiwan as a second destination for the RQFII program.

The gradual lowering of entry barriers to foreign investment should support market development by boosting competition and increasing the presence of longer-term investors (from just over 1 percent of trading at present). Regulators are also reportedly considering further liberalizations, such as allowing foreign hedge funds to participate in the QFII program and creating a new mechanism to allow foreign pension funds to invest without going through the QFII channel.

Another priority for policymakers is









116

75

119

31

77

44

72

220

31

1810

106

72

69

115

110

1915

162 10

127

28

97


0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

2008 2009 2010 2011 11M 2012

RMB+FX Loans



Corporate Bond


Source: CEIC



2-5 years; 38%

>5 years; 4%

≤6 months; 15%

1-2 years; 21%


0

10

20

30

40

50

60

70

80

90

100

2012-2H 2013 2014 2015 2016 2017-





Local Gov Bond 3%



Commercial Paper 4%



LGFVs 9%

Policy Bank 31%

MTN 10%

National Bank 55%



Source: CEIC, CSRC


(RHS)


USD11.9bn

USD1.92bn

14

12

10

8

6

4

2

0

60

50

40

30

20

10

02004 2005 2006 2007 2008 2009 2010 2011 Nov-12

to develop a well-functioning bond market with a broader base of both issuers and investors. Commercial banks are currently the largest investors in the market, while the central bank, the Ministry of Finance and the various policy banks account for the lion’s share of bond issuance. A more streamlined regulatory framework could spur the development of the corporate bond market while a broader base of investors could generate demand for high-yield bonds and create a more viable channel for private firms to raise funds. In these two regards, the following recent developments are noteworthy:

riSinG COrPOrAte BOnD iSSUAnCe —The Chinese corporate bond market has experienced a surge in fundraising in the last couple of years, mainly due to new regulations that shortened the approval process to one month in cases where issuers satisfied at least one of four criteria:

• AAA-rating

• bond issuance of less than three-year tenor where the issuer is AA-rated

• net asset value of at least RMB10 billion

• net assets of over RMB200 million and have applied for access to the electronic fixed income trading platform at either the Shanghai or Shenzhen exchange

The three regulators of the corporate bond market (PBOC, NDRC and CSRC) have decided this year to establish an inter-ministry coordination mechanism to improve consistency. With central government

encouragement, more small and mid-sized companies opted to raise funds from the domestic bond market in 2012—the net corporate bond financing component of China’s total social financing increased by 68 percent in the January to November 2012 period.

PriVAte PLACeMent OF HiGH-yieLD SMe BOnDS—The Shanghai and Shenzhen Exchanges have announced a pilot program that will allow non-property and finance-related SMEs to list high-yield bonds through private placement. Bonds issued under the pilot must have maturities of no less than one year and interest rates not higher than three times the PBOC benchmark lending rate.

FOreiGn inVeStMent in tHe

interBAnk BOnD MArket—In August 2010, foreign central banks, HK/Macau settlement banks and foreign banks involved in RMB settlement were allowed to invest in China’s interbank bond market. Starting in March 2012, the PBOC allowed foreign participants to use RMB as the investment currency. However, the trading volume by foreign entities remains very thin relative to overall transaction volumes.

China’s bond market

14 J.P. Morgan Investor Services thought / Winter 2013


Strong fundraising momentum in the offshore market

A second way in which China’s bond market is evolving is in terms of increasing RMB bond issuance in the offshore market, primarily in Hong Kong. The market for so-called “dim sum” bonds grew rapidly in the past two years, but momentum slowed in 2012 as expectations for RMB appreciation have become more modest and the interest rate on CNH (offshore Renminbi) that an issuer must pay has risen to about 3 percent compared to 1.5 percent last year.

DiM SUM BOnDS—The total value of dim sum bonds issued in Hong Kong amounted to RMB99.8 billion in the January to August period of 2012, an increase of 34.8 percent over the same period in 2011.

CDs—CDs have emerged as a core component of the dim sum product suite, accounting for 14.3 percent and 43.8 percent of total outstanding dim sum products in 2010 and 2011, respectively. In 2012, CDs accounted for the majority of the increased value of outstanding dim sum products—or 61.7 percent of all dim sum products issued in 1H2012. Chinese banks’ Hong Kong subsidiaries issued approximately 80 percent of all offshore RMB CDs, with the rest issued by Hong Kong and multinational institutions.

Jing UlrichChairman of Global Markets, China, J.P. Morgan Investment Bank








116

75

119

31

77

44

72

220

31

1810

106

72

69

115

110

1915

162 10

127

28

97


0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

2008 2009 2010 2011 11M 2012

RMB+FX Loans



Corporate Bond


Source: CEIC



2-5 years; 38%

>5 years; 4%

≤6 months; 15%

1-2 years; 21%


0

10

20

30

40

50

60

70

80

90

100

2012-2H 2013 2014 2015 2016 2017-





Local Gov Bond 3%



Commercial Paper 4%



LGFVs 9%

Policy Bank 31%

MTN 10%

National Bank 55%



Source: CEIC, CSRC


(RHS)


USD11.9bn

USD1.92bn

14

12

10

8

6

4

2

0

60

50

40

30

20

10

02004 2005 2006 2007 2008 2009 2010 2011 Nov-12

We see the current period of leadership transition as marking a new wave of policy experimentation aimed at addressing structural imbalances within the financial system, the most conspicuous of which is the prominent role played by bank intermediation in growth. The current system has put China’s small and medium-sized enterprises at a particular disadvantage. According to government estimates, SMEs generate about 65 percent of GDP and 80 percent of the

country’s jobs but have received only about one-fifth of bank loans.

In March 2012 the State Council designated Wenzhou as a pilot region for sweeping financial reforms, at the center of which are measures to lower entry barriers for private capital in the financial sector, reduce funding costs for SMEs and encourage qualified informal lending companies to develop into legitimate village and township banks. The Wenzhou financial reform is the most ambitious to date, but notable initiatives are also underway in other regions of the country. Although they are regional in nature, these experimental reforms may pioneer the establishment of a financial system that can better cater to China’s conception of a more balanced economy. n

outl

ook

15


In the early years, a one-size-fits-all, “balanced” investment approach was the industry mainstay. Today, increased choice allows investors to exercise preference for retirement fund, asset allocation, investment philosophy and even individual security selection. Choice, among other factors, has contributed to investor empowerment, which brings opportunities and challenges. Investor empowerment is a natural step as the Australian pension sector responds to market turbulence and shifts toward higher levels of member engagement. However, choice also has delivered consequences for large funds and for investor returns. The outcomes have not always been optimal for the policy goals of the savings system or the individual participants. Furthermore, the proportion of investors within mainstream funds that exercise choice has remained a minority. Less than a quarter of total fund assets are invested in accordance to investor choice decisions.

the effects of increased competitionOne of the many factors driving this change is the increased strength of fund competition. Since 2005, investors have been empowered to select their own fund and even to opt out of the fund system altogether and set up their own savings vehicles. These self-managed super funds (SMSFs) have provided an alternative to mainstream fund offerings. As competition has increased to retain investors, funds are seeking additional scale to drive down costs and increase product investment, and smaller funds are being absorbed into larger more viable entities. The increased competition has driven a renewed focus on investor needs and a greater level of product innovation within the sector. This trend looks likely to only increase as fund rationalisation and market competition for investors continues to intensify. In this environment the proportion of engaged investors exercising choice, while small, represents the contestable market for investor switching and opting out. To remain engaged with investors, funds will continue to focus on member needs through delivering choice.

investor empowerment in Australia’s Defined Contribution Market

The Rise of Choice

In the past two decades, Australia has witnessed a revolution in the size, structure and complexity of its retirement savings sector. This rapid change has resulted in assets of more than AuD$1.4 trillion, making it the fourth largest funds’ market in the world.1 Simultaneously, investors have gained access to levels of choice and control that were never foreseen in the early stages of the retirement sector—not in the traditional, not-for-profit industry fund segment that serves most Australian workers for retirement savings.

1 IBISWorld’s “Superannuation Funds Market Research Report,” December 2012, www.ibisworld.com.au

16


Historical structuresIn the early eighties, the majority of retirement savings were carried in defined benefit funds. This changed with a public policy shift in the early nineties to move open-ended investment risk and retirement liabilities to the investor. This policy change was accompanied by the broadening of coverage to the point where the vast majority of Australian workers have been covered by mandatory contributions into retirement accounts since 1991. Funds were structured as single diversified or balanced options and investors were largely restricted to the default fund for their employer or industry. As a result, the level of investor engagement was extremely low. Early choice offerings were limited to the selection of risk weightings via broad bundled packages or asset allocation selection through asset specific offerings. The motivation for funds was the recognition that they were unable to assess individual investors’ risk appetites or investors’ non-retirement asset circumstances. Introducing some choice for investors was seen as a more principled approach given that the retirement savings risk rests with the investor. Further defining this period were mandatory contributions to a single fund option.

Historical changesThe first signs of fundamental change came in the mid-nineties with the option for a small portion of the market to opt out of formal funds and create their own SMSFs. The size of the market selecting this alternative was initially small—around four percent of overall assets—yet they represented a key concession to investor right of choice and a source of potential investor leakage from traditional funds.

The second wave of change was driven by the investor’s ability to nominate the fund of their choice. In 2005 legislation allowed most Australians fund choice—the ability to move retirement savings accounts between funds or into the SMSF system. This concession introduced competition for investor balances with funds needing to grow to deliver scale benefits and further improve their ability to retain investors. Choices in areas such as sustainable investments or environmental, social and governance dimensions were developed. The introduction of “ethical” choices permitted funds to build brand visibility and sympathetic investment values. Generally these options have remained niche, yet they represent the increased willingness of the sector to respond to broader social trends to lift investor engagement and retention.

The majority of investors remained in the default alternative (either failing to exercise choice or consciously

choosing the default). Nonetheless, increasing investment flows began to move toward the SMSF sector, especially from engaged participants in the system. Investors leaving funds were disproportionally older, had larger balances and were motivated to gain control of their retirement savings. The SMSF segment has grown by 89 percent in the five years to 2011 versus 45 percent growth for the retirement savings sector as a whole. With more than AUD$480 billion in current assets (well over 30 percent of the system), SMSFs have moved well beyond their starting market share to become a major influence. As a proportion, 86 percent of participants exiting the formal fund system for SMSFs were motivated by a desire to gain increased control of their investment outcomes. Poor returns and the erosion of trust in financial institutions drove investors to seek greater control over their financial destinies.

Managing choice to build market shareInnovative funds such as AustralianSuper, the largest broad industry fund in the retirement segment at over AUD$50 billion, saw an opportunity to offer investors control and yet remain within the safe harbour of the broader fund environment. The launch of AustralianSuper’s Member Direct platform, allowing a level of direct portfolio oversight at the investor level, has attracted considerable interest and allowed their investors an alternative to a full SMSF and at a much lower cost. Through this they have become one of the first larger industry funds to offer the full range on the investor choice spectrum in order to retain investors and build scale.

Examples such as AustralianSuper, which are driving benefits of scale and competition to retain investors and stem the flow to SMSFs, are now motivating funds to empower investors and increase product choice. The fundamental “right to choice” for a mandatory defined contribution market still holds some authority. Nonetheless, academic studies showing poor investment outcomes has in some instances deterred funds from promoting these options against their professionally managed default options. In addition, the regulatory framework made it clear that fund trustees retained a fiduciary obligation to their investors even where they had relinquished control over investment selection. These

17


factors constrained promotion of choice alternatives within large traditional funds, and with the proportion of investors in funds exercising choice remaining at around 20 percent,2 it appeared that demand was limited.

today’s evolving fund challengesThe industry—with its long tail of small funds serving niche industries and investor segments—is being remodelled to emphasise scale and long term viability, offering investors liquidity, cost savings, breadth of investments and the stability to ride out financial storms. Industry thinking, as well as expressed government policy, is requiring funds to demonstrate this scale and so focus on investor acquisition and retention. The industry is starting to resemble traditional consumer markets by focusing on the customer.

With the significant proportion of investors being unengaged, the battle for investors has been driven by the needs of the 20 percent of engaged members who have exercised choice already and who are a flight risk, both to SMSFs and to retail funds that offer broader, more tailored choices than traditional industry funds. In order to compete, the majority of industry funds are now offering asset choice, blended investment mixes and, as in the case of AustralianSuper, a number of “fast follower” funds (i.e., mass customisation of portfolio choice across a broad retail investor base). This allows investors to select from a menu of industry and retail fund offerings, asset classes, pre-mixed options and their own investment selections.

The new reality comes with challenges. Superannuation funds more than ever have the responsibility to facilitate choice through providing education and impartial financial planning advice on tailoring the investment mix and through the delivery of controls and transparency on the risks and exposure of investments. The market is now focussing on new values above the traditional role of industry trustees to protect and grow investors’ retirement savings. With competition has come the need to focus on seeking new investors to bolster scale, to develop strong research and metrics around investor needs and retention drivers, and to invest in brand and marketing strategies. Part of this new reality will continue to be a proliferation of product innovation and investor choice that will see the not-for-profit sector start to converge toward the retail funds that have always competed for investor balances. n

Seamus CollinsSenior Relationship Manager, Australia & New Zealand

2 Australian Government’s “A Statistical Summary of Self-Managed Superannuation Funds,” 10 December 2009, www.supersystemreview.gov.au

increAsed choice Allows investors to

exercise preference for retirement

fund, Asset AllocAtion, investment

philosophy And even individuAl

security selection.

choice, Among other fActors,

hAs contributed to investor

empowerment, which brings

opportunities And chAllenges.


Benjie FraserGlobal Pensions Executive

Notes from J.P. Morgan’s pension blog…

Better governance remains top of the agenda for most pension sponsors. In a recent pensions’ survey conducted by Towers Watson,* a sizable number of respondents voiced the need to focus more energy in the area of governance, particularly in light of evolving regulatory demands. In addition, the survey results identified two of the greatest perceivable risks facing pensions in the next couple of years—regulatory compliance and investment volatility.

Board structures, managing conflicts of interest and training are key areas of focus for all levels of the industry including trustees, sponsors, supervisors and the legal profession. But nowhere is the new pensions’ landscape more observable than at the trustee level where the minefield of regulations and legal cases makes retaining a good talent pool an increasingly challenging business. recent studies

confirm the direct influence of competency at the trustee level as a measurable factor toward improving overall fund performance, making governance all the more critical.

With new regulations there is the potential impact of fewer but better trained trustees, the ability to develop a core of independent chairs of trustees with strong outside business acumen and, last but not least, scope for these individuals to exercise better purchasing power for the fund in terms of underlying costs. Above all, a huge focus for regulators is to improve trustee knowledge and awareness. Accreditations, self-assessments, formal training programmes within the annual trustee cycle are all becoming the norm. Education is the watch word. Are there different standards of governance protocol being applied globally?Of course. n

Excerpt from a recent posting. To learn more or to comment, please visit www.jpmorganpensionblog.com.

Note: the J.P. Morgan Pension Blog is a secure, online community for pension fund trustees and managers.

Transparency. The big one.


* December 4, 2011, Towers Watson, “The New Governance Landscape – Implications From the 2011 Towers Watson U.S. Retirement Plan Governance Survey”


ore than four years on from the collapse of Lehman, the regulatory revolution is in full swing and shows no sign of easing. The sheer scale of reform is daunting for all market participants. While the G20 took the lead in mandating reforms, the Eu and u.S. took on a timeline for implementing such reform that could be described as somewhat ambitious. However, activity in response to the financial crisis has not just been confined to Europe and the u.S., nor have mandates for reform only been initiated by the G20. IOSCO, for example, responded to the financial crisis by setting out principles for the regulation of short-selling and hedge fund oversight, as well as reporting on the impact on emerging markets and their policy responses. IOSCO also launched a Strategic Direction Task force to ensure it maintained its pivotal role in setting the international standard for securities regulation. The fSB, established in the wake of the crisis, has also played a critical role.

DODD-frANK—DEADLINES AND DELAyS

In the U.S., the Dodd-Frank Act was introduced in July 2010 with primary focus on the safety and soundness of the financial system. It is quite a broad piece of legislation, and it implements changes that, among other things, affect the oversight and supervision of financial

institutions, introduce more stringent regulatory capital requirements, affect significant changes in the regulation of over-the-counter derivatives, implement changes to corporate governance and require

registration of advisers to certain private funds. Two years on and the detailed rules are being churned out by the relevant

regulatory agencies. As of January 2, 2013, a total of

237 Dodd-Frank rulemaking requirement deadlines had

passed. Of these 237 passed deadlines, 142 (59.9%) have been

missed and 95 (40.1%) have been met with finalized rules. In addition, 136 (34.2%) of the 398 total required rulemakings have been finalized, while 129 (32.4%) rulemaking

requirements have not yet been proposed. As noted by SEC Commissioner Daniel Gallagher last September: “It is not an exaggeration to say that the Commission is handling ten times the normal rulemaking volume....Any one of the rules we promulgated in the last three months would have been considered the ‘rule of the year’ just five or six years ago. The pace is unrelenting, and the substance is critically important to the U.S. capital markets. We need to get a lot done fast—no question about it—but it’s even more important that we get it right.”1 The only areas where the rules are complete and final are those relating to investment advisers and private funds, where seven rulemakings have been finalised, and the Collins amendment, where six rules have been finalised.2

EurOPE’S PrOGrAMME Of rEfOrMS

In Europe, the post-crisis reform programme has been approached in a different way. Rather than one all-encompassing piece of legislation, a number of specific measures have been proposed by the EC, including AIFMD (Level 1 had been completed and Level 2 was adopted by the

1 Commissioner Daniel M. Gallagher, “SEC Priorities in Perspective,” SIFMA Regional Conference, Charlotte, N.C., 24 September 2012, www.sec.gov

2 Davis Polk’s “Dodd-Frank Progress Report,” September 2012, www.davispolk.com

M

THE rEGuLATOry vIEW

unfinished Business


Commission at the end of December 2012 but still needs to be reviewed by the co-legislators, the Council and the Parliament); MiFID 2, (the final MiFID 2 text remains to be agreed at the time of writing); EMIR, Level 1 came into force on August 16, 2012 and the regulatory technical rules remain incomplete at the time of writing.

For European asset managers, a new revision to the UCITS directive has been on the cards for some time as AIFMD began to take shape. On July 3, 2012, the EC published three proposals as part of a consumer protection package: PRIPs; a revision of the Insurance Mediation Directive (IMD II); and UCITS V. These measures are designed to rebuild consumer trust in financial markets. UCITS V focuses on a depositary’s duties and harmonisation of the minimum administrative sanctions, as well as introducing rules on remuneration policies.

Three weeks later, and the day after ESMA had issued its “Guidelines on ETFs and other UCITS issues,”3 the EC published a consultation paper on what is being dubbed “UCITS VI.” The consultation paper is broad and seeks the views of industry stakeholders on matters such as the use of derivatives and strategies being adopted, use of efficient portfolio management techniques (also covered in ESMA’s guidelines referred to above), depositary passport, counterparty risk and counterparty risk mitigation in the

context of OTC derivatives transactions, liquidity management and money market funds.

The EC also solicits views on the impact of preventing exposure to non-eligible assets by, for example, adopting a look-through approach for investment in transferable securities, financial indices or closed-ended funds. The EC is also using this consultation to solicit views on changes to UCITS IV (mergers and the notification procedure) as well as long-term investment. The latter echoes some of the thoughts offered in the paper, “Rethinking Asset Management,” produced earlier this year by CEPS and ECMI,4 where the authors urged the EC to introduce a new long-term vehicle to give retail investors access to “relatively illiquid asset classes to channel part of their long-term

savings including part of their retirement savings.” UCITS VI certainly seeks further harmonisation in the UCITS space and the questions for the industry are fundamental: has the UCITS label been stretched too far vis-a-vis its principal target market, the retail investor? Should there be more tightening of the rules? Asset managers also have concerns around the impact that MiFID 2 could have on their distribution models with the EC’s proposals, including a ban on monetary inducements where advice is given on an independent basis.

IMPACT ON INSurErS AND PENSION fuNDS

Insurers and pension funds have not been left out of European policymakers and regulators’ sights. Solvency 2, a pre-crisis initiative

3 ESMA Consultation Paper, ESMA/2012/44, 30 January 2012, www.esma.europa.eu

4 “Re-thinking Asset Management: From Financial Stability to Investor Protection and Economic Growth,” by Mirzha de Manuel, CEPS-ECMI Researcher, 19 April 2012, www.ceps.eu

AIFMD Alternative Investment Fund Managers Directive

CEPS Centre for European Policy Studies

ECMI European Capital Markets Institute

EIOPA European Insurance and Occupational Pensions Authority

EMIR European Market Infrastructure Regulation

ESMA European Securities Markets Authority

FSB Financial Stability Board

IORP Institutions for Occupational Retirement Provision

IOSCO International Organization of Securities Commissions

MiFID Markets in Financial Instruments Directive

PRIPs Packaged retail investment products

SEC Securities and Exchange Commission

UCITS Undertakings for Collective Investment in Transferable Securities

rEGuLATOry SHOrTHAND


for insurers, is still wending its way through to finalisation. At present, the EC has suspended negotiations on this dossier pending a study as to whether there should be a distinction between the capital set for bonds to be held for the long-term versus those bonds that are intended to be traded. The study will not be concluded until March 2013, so there may be further delay to the introduction of Solvency 2.

Meanwhile, in October EIOPA launched its Quantitative Impact Study (QIS) on the impact of the holistic balance sheet (HBS) on IORPs. Many in the pensions’ community have serious concerns about the introduction of HBS for pension funds; the action is similar to Solvency 2 and many funds in Europe believe it could have negative consequences for the European economy and for the ability of employers to maintain their commitment to workplace pensions. Compagnie Financière du Groupe Michelin responding to EIOPA’s consultation ahead of the launch of the QIS said “...even assuming there was such an issue as systemic risk of pensions not being paid out, we do not see how a capital requirement would be helping towards resolution. In fact, the cure would be worse than the illness in this case: the more money companies have to tie up to pay pensions, the more their financial viability will be threatened.”5

IMPACT ON BANKS

The regulation of banks has been a critical element of the post-crisis reforms, with more stringent bank capital and liquidity standards set through the Basel Accord process and strengthened resolution regimes

and resolution planning for global systemically important banks (G-SIBs), ending what is termed “too big to fail.” In its report to G20 leaders in June 2012,6 the FSB noted that encouraging progress had been made by leading jurisdictions including the U.S., UK and EU to put in place or propose effective resolution regimes; however, the FSB also stated that much further work was required to develop resolution strategies and plans, and cross-border co-operation agreements needed to ensure the resolvability of the G-SIBs.

One of the concerns often voiced when major reform is introduced is that there may be unintended consequences, and with a globalised world the impact on developing economies can be substantial. To this end the FSB, in conjunction with the World Bank and IMF, released a report to G20 finance ministers and central bank governors on the impact of the current reform programme on such markets.7 The report indicates that most markets outside the G20 have only recently begun the process of implementing or considering the implementation of internationally agreed reforms. This is not surprising given that certain of the reforms are more relevant and critical to advanced economies than to developing markets, for example, policy measures for OTC derivatives or G-SIBs. Also, the report notes that there is widespread support for the reform objectives with a number of countries that are less financially

developed or internationally integrated markets reporting that they do not expect there to be a significant impact from the implementation of these reforms. On the contrary, some countries had concerns about spillovers and/or extra-territorial effects from, for example, higher capital requirements for large banks in the EU.

Whilst the reforms heralded by G20 may be on their way to completion, there are more to come, and not just in the guise of UCITS VI or IORPs 2. In a speech entitled, “Making financial centres contribute to the wider economy,” given on 6 September 2012,8 Commissioner Barnier described his vision for the role that European financial centres should play. Acknowledging that the reform programme instigated at G20 was nearing completion, the Commissioner signalled a further round of regulatory action to come, with focus on what he termed sustainable growth. He addressed the serious inadequacies that were exposed by the financial crisis, such as regulatory gaps, inadequate supervision, poor corporate

5 Response from Compagnie Financière du Groupe Michelin on QIS of EIOPA’s Advice on the Review of the IORP Directive, page 3, 30 September 2012, www.eiopa.europa.eu

6 “Overview of Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability,” 19 June 2012, www.financialstabilityboard.org

7 “Identifying the Effects of Regulatory Reforms on Emerging Market and Developing Economies: a Review of Potential Unintended Consequences,” 19 June 2012, www.financialstabilityboard.org

8 Commissioner Michel Barnier, “Making financial centres contribute to the wider economy,” European Financial Centre Round-table, Brussels, 6 September 2012, http://ec.europa.eu


a) assess vulnerabilities affecting the global financial system and identify and review on a timely and ongoing basis within a macroprudential perspective, the regulatory, supervisory and related actions needed to address them, and their outcomes;

b) promote coordination and information exchange among authorities responsible for financial stability;

c) monitor and advise on market developments and their implications for regulatory policy;

d) advise on and monitor best practice in meeting regulatory standards;

e) undertake joint strategic reviews of and coordinate the policy development work of the international standard setting

bodies to ensure their work is timely, coordinated, focused on priorities and addressing gaps;

f) set guidelines for and support the establishment of supervisory colleges;

g) support contingency planning for cross-border crisis management, particularly with respect to systemically important firms;

h) collaborate with the International Monetary fund (IMf) to conduct Early Warning Exercises;

i) promote member jurisdictions’ implementation of agreed commitments, standards and policy recommendations through monitoring of implementation, peer review and disclosure.

extract from Article 2 of the FSB Charter

www.financialstabilityboard.org

Encouraging progrEss has been made by leading

jurisdictions including the u.s., uk and eu to put in place or

propose effective resolution regimes,

. . . but much further work is required to develop

resolution strategies and plans and cross-border

co-operation agreements.

governance and short-termism in financial institutions, opaque markets, and overly complex products, particularly derivatives. The Commissioner believes bringing Europe back to the path of sustainable growth requires taking on some challenges which include building modern digital, energy and transport infrastructures; supporting the development of innovative technologies; tackling climate change and population ageing. The Commissioner recognises that meeting these challenges will require long-term financing and, given the severe fiscal constraints, he believes that financial centres have a key role to play in this regard.

The Commissioner sets out three tasks that financial centres should undertake:

• Provide a stable platform for institutional investors, such as pension funds and insurers, to match their long-term liabilities with long-term assets

• Offer safe and profitable vehicles for household savings

• Support sustainable, green and socially-responsible economic growth

The EC is now examining how to ensure the financial sector is playing its part and will consult on this soon. This indicates that the current

round of regulatory change will not be followed by any lessening of the pace; indeed this may be only the beginning. For industry stakeholders, in particular pension funds and asset managers that play such a vital role, it will be vital to understand exactly what is intended and to engage early in the debate and influence formulation of policy.

In the U.S. too, the regulatory agenda is moving beyond just Dodd-Frank with money market

reform, updating regulation of transfer agents and other initiatives signalled for action. It will be essential of course to ensure that there is coherence amongst rules made in the U.S., Europe and other parts of the world—and the work of G20, FSB, IOSCO and others play a vital role in this context. n

Sheenagh Gordon-HartIndustry and Client Research Executive


hile most senior investment managers

routinely use mobile devices to check email,

read the news and perhaps jot down some notes,

relatively few have migrated toward mobile applications

for the more specialized functions of their profession.

“Wall Street professionals largely view the iPad and

mobile apps as a convenience factor, rather than a

game-changer,” wrote Wall Street & Technology Senior

Editor Melanie Rodier in a feature last quarter.1 She

noted that most executives use apps on a daily basis

but typically confine the use to apps from providers of

financial information and general news. What is less

clear is whether the current state of mobile use in the

investment industries is limited by the demands of the

community or the capabilities of the existing apps.

To answer this question, we’ll explore which devices

your fellow investment officers are using, what they

are using them for now, and where they hope the

technologies will take them in the near future.

tHe USe OF MOBiLe DeViCeS

HAS GrOWn rAPiDLy

tHrOUGHOUt tHe WOrLD,

AnD tHe GenerALLy

teCH-SAVVy inStitUtiOnAL

inVeStMent COMMUnity iS

CLeArLy nO exCePtiOn.

MOSt PrOFeSSiOnALS nOW

CArry A SMArtPHOne,

A tABLet Or BOtH. MAny

HAVe MADe tHeSe tOOLS

An inGrAineD PArt OF

DAiLy BUSineSS PrACtiCeS,

At LeASt in tHe

GenerAL SenSe.

w

1 &3 Melanie Rodier, Wall Street & Technology, “Is the iPad Mini Really A Game-Changer For Wall Street Execs?,” October 29, 2012, www.wallstreetandtech.com

How, When and Where Mobile Devices Are Used by institutional investors

Growing Mobile



WHO iS USinG WHAt, WHen?

The once ubiquitous BlackBerry no longer dominates the mobile technology landscape for investment professionals. According to a study commissioned by S&P in July 2012, 2 39 percent of investment professionals use a BlackBerry for work, only slightly edging out the 36 percent who use an iPhone. (In their personal lives, however, Apple is now clearly on top, preferred by 58 percent of respondents.) Apple’s iPad tablets are also gaining traction. A third of respondents say they use them for personal use, and another 32 percent intend to buy one. Only 14 percent, however, currently use their iPads for business.

Whether pad, pod or phone, most investment professionals say they use their mobile devices while traveling or commuting, rather than during regular office hours. As the notion of “office hours” evolves to encompass a broader spectrum of work schedules and locations, an increase in the use of mobile technologies may be expected.

tHe BUSineSS PUrPOSe OF MOBiLe DeViCeS

Investment professionals use mobile devices in much the same manner as most other professionals—to communicate with colleagues, keep their calendars, take notes and stay abreast of business and financial news. Aside from email, professional investors tend to shy away from applications that involve storing potentially sensitive information on their devices. They are more likely to access industry reports, research a company or share information of a less proprietary nature.

BArrierS tO FUrtHer USe

Security concerns are an obvious barrier to broader adoption of mobile apps in the daily workflow of institutional investing. In addition to all the security concerns of any Internet-enabled device, mobile devices can be lost or stolen. While not as much of a concern for iPad users, smartphone screen sizes also pose certain limitations for apps that contain detailed information (particularly for users with weathered eyesight).

The greatest barrier to current use, however, may have little to do with the innate limits of the devices.

25

2 S&P Capital IQ, “Mobile Usage Survey,” August 15, 2012, www.standardandpoors.com

on thE idEal businEss app

i would ExpEct somEthing that combinEs thE dEpth of

information of a wEbsitE with thE innovativE dEsign

and functionality of a mobilE app.

susAnne hAury von siebenthAl,

chief investment officer, publicA

“”

How, When and Where Mobile Devices Are Used by institutional investors

Growing Mobile


Until quite recently, there have been few apps specifically designed to help senior investment officers review their funds’ performance. There were even fewer that took full advantage of the intuitive iPad interface. This lapse has not gone unnoticed in the investment community. For example, Susanne Haury von Siebenthal, chief investment officer of the Swiss pension fund, PUBLICA, is an avid iPad user in her personal life. In a recent interview, she expressed doubt that most vendors would be able to develop a truly intuitive application that takes full advantage of the Apple platform.

LiVinG UP tO tHe POtentiAL

So, what would a CIO like Ms. Haury von Siebenthal look for in a business app? “I would expect something that combines the depth of information of a website with the innovative design and functionality of a mobile app,” she said. Then you would have to convince her that there was no risk of exposing confidential information, even if she were to lose her phone or iPad. Next, you would have to offer a convenient way to access a composite performance overview, allowing her to drill down into individual accounts over whichever time periods she chose. She also believes that it’s important to deliver daily data, so that she can see how portfolios are impacted on difficult days when she’s on the road.

In laying out the requirements for an ideal app, Ms. Haury von Siebenthal stressed that the user experience is nearly as important as the information it delivers. Noting that the data is already available on her desktop, she believes mobile technology would gain great utility if

it had “the intuitive structure that a good app provides.” This would unchain her from her desk and let her bring key information along when she goes out to speak with her fund managers and her investment board. Ms. Haury von Siebenthal also stated that she is intrigued by the notion of someday incorporating mobile devices into PUBLICA’s business continuity plans.

tHe MOBiLe trADinG FLOOr

While there may be a future for mobile trading apps, it is not here yet. Certainly, individual traders use their smart phones to access market information and communicate with clients and colleagues, particularly in the pre-market hours. While some trading apps are already available to institutional investors, the days of a fully virtual trading floor, with access-anywhere mobile technologies, are likely a bit further down the road.

tHe FUtUre StArtS tHiS MOntH

There is little doubt that mobile devices will continue to both supplement and supplant desktop-based applications. In 2013 wireless devices could surpass PCs as the most widely used method for accessing retail brokerage accounts.3 Institutional investors will almost certainly be close behind, at least utilizing mobile technologies to access and share the information they need to understand and enhance their performance. n

Oliver BergerBusiness Development Executive, EMEA

J.P. Morgan currently offers its clients more than a dozen mobile applications at www.jpmorgan.com/mobile. from banking to research and other services, the list keeps growing.

In the fourth quarter 2012, J.P. Morgan’s Investor Services launched a new iPad app that provides investment executives with information about their fund’s performance and custody detail. The new tool, called J.P. Morgan ACCESS® Securities, offers composite performance data with drill downs into risk measures, fact sheet reporting, allocations and other pertinent information at the fund level. Designed with a clean, efficient navigation, and utilizing the same security protocol used at the firm’s client portal, the app is intended to make it easier to access vital performance data and customized reports anytime, anywhere. The development plan entails creating new releases with increased functionality and features based on client input. J.P. Morgan ACCESS Securities can be found in the Apple App Store.

the

J.P.

Mor

gan

entr

ies


T H E C A S E f O r operational Alpha I N T H E

Alternatives spaceCOuNTErING A POTENTIAL PErfECT STOrM

As regulatory reporting requirements ramp up, the alternatives funds industry considers multiple new protocols. Confronting this “perfect storm” of complexity, fund managers are employing new operational models to help them better strategize to capture alpha. But some things are simply beyond your control— and that’s where the trouble can start.

Let’s say you are a large global alternatives manager with multiple fund vehicles and products, running the gamut from traditional equities to complex structured products. Of course, you transact with multiple counterparties and therefore maintain multiple accounts with them. In essence, you have exposure to those counterparties on both an intra-day and an ongoing basis.

unfortunately, if any of your counterparties go the way of Peregrine financial, Mf Global, Lehman Brothers or any other now-bankrupt entity, you will be exposed to a process you no longer fully control. This can ultimately lead to significant losses for both you and your investors—to include both absolute losses, opportunity costs and losses incurred due simply to the time value of money.

27Winter 2013 / J.P. Morgan Investor Services thought


to bEgin to find thE right

solution for thEir fund,

altErnativEs managErs

must considEr all of

thEsE protocols.

Trading with counterparties that suddenly declare bankruptcy is only one of many pitfalls that worry today’s alternatives managers as they seek to manage systemic risks beyond the more obvious cases of fraud or gross negligence. Add to this the risks associated with the current politically-charged environment reproving Wall Street for “corporate greed” and “undeserved bailouts”—and it is no wonder that alternatives managers have the sense that they are confronting a potential perfect storm.

On closer examination, it’s clear that the elements of this perfect storm are focused on data and information as everyone wants greater transparency. Today, alternatives managers are the targets of frequent demands from investors and regulators—as well as other industry participants intent on “getting a leg-up” in setting new reporting and communication protocols.

Confronting a perfect storm

Sadly, while we may be awash in innovative technology such as iPhone, Blu-Ray technology, Twitter and Facebook, the search for a common protocol—a unified alternatives reporting framework for the industry —has proven elusive.

While several new protocols exist, the industry has not yet settled on the winner—nor has it agreed upon harmonized disparate reporting structures or even streamlined reporting processes.

A closer look at the essentials (see figure 1) of the five most frequently-discussed protocols out there today illustrates the rising tide of complexity that fund managers face. In addition,

guidelines and protocols overlap—both of the governmental and non-governmental variety.

To begin to find the right solution for their fund, alternatives managers must consider all of these protocols, listen to their investors and then think carefully about their own particular structure and resources.

Since this will require substantial investments in both managerial time and focus, alternative managers may want to consult with a fund administration provider who can help them parse through all of this complexity.

Protocols abound

28 J.P. Morgan Investor Services thought / Winter 2013


Form PF reporting

Open Protocol enabling risk Aggregation standard (OPerA)

institutional Limited Partners Association (iLPA)

regulatory reporting for hedge and private equity funds that are subject to registration under Title Iv of the Dodd-frank Wall Street reform and Consumer Protection Act

Launched in August 2011 by an industry group as a means to align transparency reporting formats and methodologies to benefit investors; co-chairs Albourne Partners and Thomson reuters

Standardized reporting templates for investor reporting and transparency; includes capital calls, distribution and standardized quarterly reporting templates

This is the regulatory record of—among other things—performance, counterparties and risk exposures.

Designed to assist hedge funds to report risk information in a standardized fashion

Enables GPs and LPs to communicate more efficiently by reducing processing times and ongoing monitoring expense

www.ilpa.org

• Significant data requests requiring consistent methodologies and asset class definitions across multiple counterparties

• Quarterly or annual reporting requirements depending on fund type and size

• First wave filers (US$5 billion or more in regulatory assets under management) filed August 29, 2012

A singular example of complex reporting. Consider numerous other schema that need to be harmonized including other u.S. regulatory filings, e.g., Form ADV, CPO-PQR (dual SEC/CfTC registrant CPOs could satisfy certain CfTC filing requirements by filing form Pf with the SEC), and foreign Account Tax Compliance Act (fATCA), as well as other non-u.S. standards, e.g., Alternative Investment fund Managers Directive (AIfMD) or the Qualified Domestic Limited Partner (QDLP) scheme in China allowing non-Chinese hedge funds to raise Chinese assets etc.

www.sec.gov

OPErA-maintained risk and performance templates for exposures, var and sensitivity analysis

www.theopenprotocol.org

voluntary but required by some investors: capital call and distribution notice templates, investment thesis, investment structure, capitalization, financial results, valuation methodology, risk assessment, etc.

international Private equity and Venture Capital Valuation Guidelines Board (iPeV Board)

industry Benchmarking:

HFri indices, HedgeFund.net, Preqin and Barclays indices

Investor reporting guidelines intended to be applicable across the entire range of private equity funds—broadly defined and inclusive of venture capital funds

These schema provide a level of transparency for alternatives sub-segment investing

Allows managers to globally harmonize information presented to investors through a principle-based approach focusing on content instead of format

As the alternatives industry matures and becomes more institutional, investors will look to alternatives to play specific roles in their respective portfolios. These schema will allow for better stewardship (e.g., macro, relative value, etc.).

• Voluntary

• Directly comparable investment information (name, currency, total commitments, term, investment period, hurdle rated, carried interest calculation)

• Historical performance completely and fairly represented

• Guiding principles of relevance, transparency, consistency, and accuracy

• Allows investors to track relative performance by region and strategy type

• Also allows for views on asset flows by strategy and manager size

The European equivalent to the IPEv board is the European Private Equity and venture Capital Association (EvCA)

www.privateequityvaluation.com

www.hedgefundresearch.com

www.hedgefund.net

www.preqin.com

www.barcap.com

Protocol Description Why it’s important reporting Highlights Special notes

fIGurE 1: FiVe MOSt iMPOrtAnt PrOtOCOLS


Strategic models support operational controlsIndustry-wide, alternatives managers faced with these new reporting standards, requirements and protocols are seeking a solution in a strategic framework to help them control operational variables, due in part to the very success of the alternatives industry. This is because the industry’s move to more transparency has largely been fueled by increased governmental scrutiny and institutional allocations to alternatives. Allocations are a natural evolution of the institutional investor space, given the significant risk/reward and diversification benefit to investing in alternatives.

Consider Altegris’s “The Case for Liquid Alternative Investments,”1

which notes that from January 1997 through March 2012, a traditional portfolio with 60 percent U.S. stocks and 40 percent bonds underperformed the same portfolio that injected 30 percent into alternatives strategies— by a noteworthy 25 percent.

Furthermore, the analysis showed that this traditional portfolio had an annualized standard deviation of 10 percent and a maximum drawdown of -31 percent, whereas the portfolio

with alternatives had an annualized standard deviation of 7 percent and a maximum drawdown of -22 percent for the same period.

Which portfolio to invest in may seem like an obvious choice, but experienced allocators know that this decision really depends on a whole host of other variables that allow for the above risk return profile to actually materialize.

Fortunately, one of the most critical variables that alternatives managers can control is operational process and soundness. Once this is understood, the question then becomes how to manage and enhance this critical variable, while allowing for alpha generation in today’s hyper-transparency- focused environment.

It may help to stand back and consider which general, strategic models your fund should adopt for managing your operations (see figure 2 next page), based on some key factors such as fund size and complexity:

1. Insource with Service Provider Oversight Model—Very large funds with US$5 billion plus in assets often-times adopt a model where it insources —with provider oversight. Because it has the resources to support a large

back and middle office with significant technology outlays, complexity is less of a driver of the decision. As it gets more complex, a third-party fund administrator can provide more value because it can help the business scale.

2. Insource/Outsource Model—The middle group uses its own systems but leans on service providers for key capabilities. This can be true for funds across asset sizes and complexity levels. For example, a $500 million fund may not be able to fund all the systems it needs plus a data warehouse, but it can run an operationally savvy business nonetheless by using a fund administrator to help in mirroring books and records. Of course, as a fund’s complexity increases, it will show more interest in outsourcing—and the provider’s brand becomes more important.

3. Outsource Model—Finally, if your fund doesn’t have an end-to-end operational platform, you need to pick a robust service provider partner. In this third model, regardless of size of the fund, your administrator’s brand and strong capital base is most important because of the reassuring signals it sends to your investors.

30

1 June 2012, www.altegris.com



Georges ArchibaldGlobal Thought Leadership Strategist, Investor Services

Model

Manager uses their own data warehouse, systems and middle and back office to solve for diverse reporting and transparency schema

Typically need to leverage third-party service providers as official books and records but maintain shadow books and records and tic-and-tie to their providers to ensure consistency, managing breaks, etc. as they come up

insource with Service Provider Oversight—very large funds with uS$5 billion plus in assets typically adopt this model

Manager has their own systems but may have gaps in data and a smaller middle and back office staff

Given some scale, managers can make this model work over the medium term

insource/Outsource—uses their own systems but leans on service providers for key capabilities

Manager relies entirely on third-party providers and has a very lean operational staff

Benefits The ability to scale, given a well-rounded service provider selection; also, this approach defrays some of the cost of administration to investors, thus freeing up some management company fee revenue to augment investment staff and focus on delivering investor alpha

Outsource—funds without a robust operational platform need a service provider partner

Description

required for Success A comprehensive data warehouse should allow managers to file regulatory reports, compile risk information that will drive portions of regulatory reporting, streamline investor communication and allow investors the ability to accurately benchmark a manager’s performance versus segment peers

High quality, blue-chip service provider partners can validate a manager’s process, but the manager ultimately maintains very strong control over the process

Investors will push for more—and more independent— operational staff because of the check and balance function that the middle and back office provides, an important key condition to institutional growth

fIGurE 2: tHree StrAteGiC MODeLS

Drawbacks Manager will need to continually invest in people and systems necessary to fulfilling these multiple requirements; scalability also becomes an issue as new products are launched and the organization needs to accommodate a new product type requiring different expertise (e.g., bank loan product, registered product, hybrid fund product, etc.)

Slightly less control, some opportunity for duplication; funds adopting this model need to work with a provider to address ideal operational structure

A double-edged sword; depending on fund size it can be difficult for investors to absorb these costs because they subtract from fund performance

What works for your fundOf course, even a cursory glance at these models will show that there is no perfect way to run your alternatives operations. Furthermore, these models by no means represent the only way to think about your operations strategy; they are merely illustrative of some possible scenarios, costs and benefits. What actually works best for your fund will depend on your unique position in the market, among other factors.

What is very clear, however, is that in order to take advantage of current institutional inflows into the space, it behooves alternatives managers to consider such emerging models as a critical step toward providing consistent and accurate reporting across their organizations. To do this well against a landscape of increasing regulatory demands and competing protocols requires a great deal—

knowledge of the rules applicable to different markets, understanding about how to harmonize information and the ability to draw that information from one central source.

And, as institutions continue to invest in alternatives, fund managers may want to consider teaming up with a reputable service provider, who can grow and scale with their business. n

31


investment structures matterPooled versus segregated: Investors either hold underlying securities in a segregated account with their custodian or they invest in a pooled vehicle, which offers access to a manager’s expertise but with securities held in the name of the mutual fund. Transitioning assets held in pooled vehicles adds another leg to the restructure—and requires taking an “in-specie” slice of assets from the legacy fund to a transition account for restructuring and/or delivering a slice to the target fund. Because assets are registered in the name of the mutual fund instead of the underlying client, this

introduces what is referred to as “change of beneficial ownership,” or CBO. While most developed markets allow securities to transfer free of payment between accounts, many emerging markets do not. As a result, depending upon the fund, securities for some markets need to be liquidated or purchased directly by the outgoing or incoming fund managers in the market, thus reducing an element of the cost savings one would normally expect to achieve by transferring like assets in-kind. As a generalization, our experience typically sees this non-transferable market amount to be in the 20 percent to 30 percent range.

Plan aheadIn order to implement a restructure, a transition manager needs a custodian-based account to stage the event and settle trades. Whereas in developed markets the custody account opening process is straightforward and relatively fast, some emerging markets require additional documentation. Account opening times vary by government; those markets taking the longest time include India (up to twelve weeks), Venezuela (ten to twelve weeks) and Taiwan (four weeks). The good news is that where an investor already holds segregated assets in their own name,

with emerging Market Assets

Emerging market investments have experienced significant growth in recent years as evidenced by Figure 1 which provides an illustration of mutual fund flows since 2004. In step with this growth in flows, transition management has seen an increase in restructures involving this segment, both from investors moving into these markets as well as investors implementing fund manager changes within their emerging market allocation.

fIGurE 1: CUMULAtiVe MUtUAL FUnD FLOWS AS PerCentAGe OF AUM SOurCE: EPfr GLOBAL, J.P. MOrGAN

Managing transitions

32


INvESTING AND IMPLEMENTING MANAGEr CHANGES IN THESE MArKETS INTrODuCES A LAyEr Of COMPLExITy BEyOND NOrMAL TrANSITION MANAGEMENT CHALLENGES.

opening a transition account for most markets is simple and efficient. Should a “documentation market” be included on the target side in a transition, the client and fund managers have a number of options:

• Postpone the restructure until accounts in all markets are open

• Implement the transition in a phased approach, employing futures or ETFs for the documentation market exposure until the account is ready

• Purchase depositary receipts or a developed market listed line of the specific stock

Naturally, discussions of any substitutions would involve the target fund manager and should be addressed in the planning stage of the event.

In addition to custody account documentation, some markets require that investor identification is submitted at the time of execution. The application process for investor IDs also takes time and will need to be handled in advance of the transition.

As a result of the additional bureaucracy that comes with the inclusion of emerging markets assets, transition managers are seldom used when clients invested in pooled funds only change the managers but not the structure of their investments.

ready, set, trade Once all the boxes have been ticked— i.e., determined the restructure involves segregated securities, the custody accounts are open and investor IDs established— the transition manager assesses the execution requirements and designs a risk-minimizing trading strategy.

In the first instance, it is critical that the transition manager understand the specific market nuances when designing the trading strategy. The following equity market examples illustrate the types of situations one encounters:

(1) An existing portfolio may hold a depositary receipt (ADR or GDR), whereas the target manager may request the local security. This could be an in-kind opportunity and a good transition manager would recognize that both securities are pointing to the same company and would then evaluate the costs of converting an ADR to local shares, versus trading both sides.

(2) Along the same lines, a target manager may request a specific foreign line Thai security, however Thai foreign lines can be thinly traded. In fact, a transition manager should consider liquidity of other associated instruments. Where a “foreign investor limit” has not been reached, the manager could purchase the more liquid local line and convert it to the foreign line required by the fund manager. Non-voting shares (NVDRs) of the same line may also be an acceptable substitute for the target asset manager and may trade more in line with local shares, thus reducing the cost of transactions.

As shown in these two examples, accurately assessing an emerging market event requires a significant amount of thought and consideration in simply evaluating the asset lists.

In addition to the various security choices and assessment of liquidity and timing, the transition manager evaluates any potential cost and risk reduction by

including futures or ETFs. In general, when executing transitions, it is preferable to use the securities within the restructure to hedge exposure. For example, the transition manager would maintain correct market exposure by timing liquid purchases to accommodate illiquid sells. If futures are used, the transition manager should consider whether, for those relevant markets, locally listed (e.g., Taiwan’s TAIEX) or foreign (e.g., SIMEX’s MSCI Taiwan) contracts provide the better hedge.

Another timing issue common with equity emerging market events is staggered cash settlement cycles. For instance, when selling and buying in India, transacting simultaneous sells and purchases in order to manage out of market risk will place the client in a cash overdraft situation. While it is a T+2 settlement market, cash for purchases is required on T+1 and the receipt of cash proceeds from sales does not occur until T+3. The transition manager must devise cash management strategies, as well investment exposure strategies, when transacting in these types of markets.

In addition to timing, settlement methodology also needs to be understood, as not all markets settle on a pure delivery versus payment basis.


nell A. AxelrodExecutive Director, Transition Management

1 For a comprehensive review of emerging market debt, please see J.P. Morgan’s “EM Rerates as an Asset Class: EM Fixed Income Passes a Second Stress Test,” August 10, 2012, www.jpmorgan.com

As with all transitions, the transition man-ager should review the proposed trading strategy with the client. Local connections, execution capabilities and insight can smooth the trading process and minimize information leakage.

Trading emerging markets fixed income, by contrast, is fairly straightforward. Emerging market debt stock is increasing, sovereign debt for many countries trades electronically, and emerging market corporate securities can be quite liquid. Within transitions, we see around 60 percent of investments made in hard currencies and 40 percent in local currency, which helps to minimize challenges associated with local currencies and domestic settlement.1

A comment on style— active versus passiveIn J.P. Morgan-managed transitions, there has been a trend toward highly concentrated actively managed portfolios. In fact, this trend is fairly independent of region, and alongside the typical developed versus emerging split have been a number of “global active” appointments where the portfolio has fewer than 200 names and includes both developed and emerging exposure. Larger, more concentrated positions can take longer to trade. Trading in line with volume, our firm’s estimates suggest that 10 percent of a security’s average daily volume (ADV) can trade with minimal market impact and can trade comfortably up to 20 percent ADV on a given day. Large, concentrated portfolios are typically less liquid and require multi-day trading and block liquidity

sourcing. This has the knock-on affect of constantly re-evaluating current risk relative to the target exposures. The transition sells and buys need to be carefully coordinated to minimize the exposures that can occur with mismatched liquidity profiles.

Passive portfolios can be simpler in a transition for several reasons: (1) a greater number of securities typically required in indexed portfolios result in smaller, more liquid positions and (2) for some markets futures or ETFs with a low tracking error to the benchmark can be used to augment a trading strategy.

Cash is (still) kingEmerging markets introduce a number of challenges when it comes to cash management and currency transactions.

• Mismatched settlement—As noted briefly above, most of the developed world settles on a “T+3” basis and with the same cycle for buys versus sales; this is less standard within emerging markets. In a number of markets, purchases settle prior to sales, making it difficult to trade on a cash balanced basis without supplying cash for pre-funding.

• FX trade implementation—Many emerging market currencies are not freely traded, requiring custodians to execute via local agents. Whereas FX trading is normally an integral part of the transition process, managing currency risk alongside the underlying securities, in emerging markets the transition manager often focuses on the operational risk more than the market risk.

• Additional considerations—There are a number of country-specific rules and regulations to which one must adhere. In the same way that establishing a custody account can carry an increased administrative burden, some countries require specific documentation on cash transfers. Another common feature is that some countries require pre-funding of purchases. Furthermore, taxes can be introduced and changed, as was the case with Brazil’s Financial Transaction Tax introduced in recent years.

Cash flow management is a core part of any transition; transition managers need to incorporate the market-specific requirements when designing the optimal trading strategy.

Forewarned is forearmedIncluding emerging markets within an asset allocation strategy has become the norm. Accessing these markets through funds, ETPs and futures is straightforward and easy. Once the decision is taken to have a larger investment, and via segregated securities instead of mutual funds, advance planning and careful coordination with the help of a transition manager can minimize the risk and cost of initial implementations and future manager changes. n


thoughteditorMichael Normandy

ContributorsErika ArevuoCarly EalesAmir HoosainRebecca StaimanAmanda ThorntonPeter van Dijk

Tom ChristoffersonChief Marketing Officer, Investor Services

thought Leadership Advisory BoardGeorges ArchibaldSusanne BarkanOliver BergerAndrew FarverBenjie FraserBryan W. GrayBrian HydeBob MacriLisa OnoratoJason PaltrowitzShaun ParkesMike ReeceFumihiko Yonezawa

About JPMorgan Chase & Co.

JPMorgan Chase & Co. (NYSE: JPM) is a leading global financial services firm with assets of $2.3 trillion and operations in more than 60 countries. The firm is a leader in investment banking, financial services for consumers, small-business and commercial banking, financial transaction processing, asset management and private equity. A component of the Dow Jones Industrial Average, JPMorgan Chase & Co. serves millions of consumers in the United States and many of the world’s most prominent corporate, institutional and government clients under its J.P. Morgan and Chase brands. Information about JPMorgan Chase & Co. is available at www.jpmorganchase.com.

J.P. Morgan is the marketing name for the businesses of JPMorgan Chase & Co. and its subsidiaries worldwide. JPMorgan Chase Bank, N.A. is a member of the FDIC.

We believe the information contained in this publication to be reliable but do not warrant its accuracy or completeness. The opinions, estimates, strategies and views expressed in this publication constitute our judgment as of the date of this publication and are subject to change without notice. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan Securities Inc. (JPMSI) or its broker-dealer affiliates may hold a position, trade on a principal basis or act as market maker in the financial instruments of any issuer discussed herein or act as an underwriter, placement agent, advisor or lender to such issuer.

“More Growth, Less Fear: 2013 Global Economic Outlook,” pages 4 through 9, is an excerpt of research originally published on January 9, 2013. “Perspectives on China’s Financial System Reforms,” pages 10 through 15, is adapted from research titled, “China: Reforms Take on Greater Urgency,” published on June 11, 2012. Both complete reports may be found on www.jpmorganmarkets.com, the firm’s award-winning research and market data portal for institutional clients.

In the United States: JPMorgan Chase Bank, N.A. is authorized and regulated by the Office of the Comptroller of the Currency. In the United Kingdom (UK) and European Economic Area: Issued and approved for distribution in the UK and the European Economic Area by J.P. Morgan Europe Limited. In the UK, JPMorgan Chase Bank, N.A., London branch and J.P. Morgan Europe Limited are authorized and regulated by the Financial Services Authority.

For more information, visit: jpmorgan.com.

©2013 JPMorgan Chase & Co.All rights reserved.

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