Where Do We Go From Here?
By Steven Vale

FTSE International, one of the world's major index providers, is reshaping its indexes and itself as it prepares for what it expects to be a dramatically different financial world in the future. The author offers a look at expectations inside the company that are helping drive those changes: Will you buy a mutual fund from BMW or Microsoft?

CERTAINTY 1 - THE WORLD WILL CHANGE

What makes this industry so exciting is that it is constantly re-inventing itself. Unlike, say, the sciences, we cannot assume that what worked in the past will necessarily keep working in the future.

The first issue to consider is globalisation, its effect on markets and investment management companies.

GLOBAL EQUITY MARKETS

Global equity markets are becoming more integrated and evidence suggests that the pace of this trend may indeed be accelerating. The number of recent high-profile, cross-border mergers is striking. Government economic policies in developed markets are pushing in the same direction. Examples include the introduction of the Euro, the operation and potential expansion of NAFTA, and similar pressure for eastward extension of the EU. Underpinning this is hard statistical evidence of higher correlations among equity markets (see Indexes, Issue 3 - Ed.).

 Since individual countries cannot easily swim against the tide, the only way the globalisation trend of the past 20 years could effectively be reversed would be through a series of multinational policy changes. This seems highly unlikely.

Globalisation still has political momentum and is putting down increasingly deep economic roots. Globalisation means that the bargaining power of large multinational companies in relation to national government is likely to increase. Indeed, it is interesting to note that the annual revenues of some of the world's largest companies are already as big as those of medium-sized European governments, which typically raise and spend between 40% and 50% of GDP(Figure 1).

Over the next ten years, while government tax revenues and spending will grow much in line with nominal GDP, the revenue of some already large companies will grow much faster through expansion and consolidation. By 2010, there could be a dozen megacompanies operating in Europe with bigger annual revenues than the Dutch or Spanish governments.

The rise of the megacompanies creates issues for index calculators. Many investors are unhappy with the concentration in many national-based indexes [see p. 44] and the resultant risk. For example, by the middle of 2000, following the expected completion of the BP Amoco/Atlantic Richfields, Vodafone/Mannesmann and SmithKline/Glaxo mergers, these three companies, if no modifications are made, will account for approximately 30% of the FTSE 100.

To governments, the most tangible sign of the importance of these megacompanies is the size of the tax cheque they write each year. But through cross-border M&A activity tax domiciles can change overnight. Governments with unattractive tax regimes will find their golden geese flying the nests. Market forces will ensure that corporate tax harmonisation in Europe works in a downward direction.

We believe that attempts by index calculators to pigeonhole these mega-companies as "belonging" to a single country are largely futile and do, in fact, create a problem for investors. Investors' holdings in multinational company stocks are becoming divorced from the economic geography of the underlying businesses and are instead being driven by the sometimes meaningless country classifications given to companies by index calculators.

Finance directors of multinational companies have also expressed considerable frustration that the country they choose to list their shares determines the way they are perceived by investors. They want to be compared against their global competitors. They do not want index membership to be a consideration when they are planning global mergers.

 At the same time, the world's economy is not yet global, although it will increasingly become so over the next decade. Investors around the world currently have a preference for holding stocks in companies operating in economies which are familiar to them. This bias, however justified, needs to be reflected in a simple structure for asset management and investment performance benchmarks. This is why the FTSE Multinational index series was launched in October 1999. These new indexes let investors distinguish clearly between companies primarily exposed to local or to global economies.

Fund managers carrying out their M G N P V research on a global basis are also finding that the current set of country-based indexes and asset classes are not a reflection of real life. Their analysts make stock selection decisions between multinational companies operating in global industries. For example, they may prefer Exxon Mobil to BP Amoco. However, the requirements of the benchmark index may be to bias investments towards certain country indexes. If the benchmark favours the UK at the expense of the US, the total portfolio may have a lower weighting in Exxon Mobil, the company that they preferred. The quality of their skills at selecting multinational companies is being masked by asset allocation requirements.

MARKET EVOLUTION

Salomon Smith Barney recently estimated that the pan-European market would be capitalised at over US$20 trillion by 2009 (at the start of 1999 pan-European capitalisation was US$7.4 trillion), with Europe ex-UK worth almost US$16 trillion. As a result, Europe's share of the global equity market would increase from 32% to 42%.

The Europe ex-UK market is likely to grow faster than the UK market. Paradoxically though, continental European investment returns will be lower than their UK counterparts unless they are willing and able to make the major shift from bonds into equities.

Europe ex-UK will be an attractive area for equity investment over the next decade. It would be a sad irony if domestic European investors were to miss the performance potential on their own doorstep. But we believe they are likely to catch the wave, and implement an historic allocation shift into equities.

The Japanese market boomed into equities in the 1980's. In the 1990's, it was the US market's turn to shine. For the next decade, the signs are pointing to continental Europe instead.

Along with the decline in national country-based indexes, national stock exchanges are also likely to decline in importance and eventually disappear over the coming years. Well before the recently announced merger with Deutsche Borse, Gavin Casey, Chief Executive of the London Stock Exchange, was already on record as stating that he believed the London Stock Exchange would no longer exist in its current form in three years' time, having either acquired, or merged with, other stock exchanges or technology companies.

For many investors there are now many alternative and far cheaper ways of trading than through traditional mutually owned exchanges. This is particularly true in the US, where online trading and electronic communications networks account for a growing share of equity trading.

There is certainly demand for a single pan-European blue chip stock market and a number of existing European exchanges have been discussing combining to create such a market. However, we believe this is only the first step. Initially there will be de-regulation and a number of alliances between existing actors, then new entrants will change the rules and the number of national exchanges will reduce. These new entrants will provide new services, offering speed or lower price, for example. While the need for a pan-European blue chip exchange is clear, we do not believe that the platform for this currently exists. What might such a platform look like? We could easily see the London Stock Exchange, for example, merging again, but this time with a technology company supplying the computer-enabled communication required.

GLOBAL INVESTMENT MANAGEMENT?

As the borders between markets come down and we move to a single pan-European market (and eventually maybe even a single global stock market with 24-hour trading), will investment management become a global business? We do not believe that any investment company has yet got close to the level where it can really claim to be global. Having offices in 15 countries is not enough. Being global means that your brand name is, like Coca-Cola or Kodak, recognised everywhere and that you are a leader in your business field in almost every country in the world. No investment manager can claim to have reached that stage in more than a handful of countries. But it is not difficult to anticipate the likely key factors for success.

Critical to success will be a global brand name at a retail level. It is commonly recognised today that the growth rate of defined-contribution type funds or pure retail funds will be faster than for defined-benefit. As governments put more and more of the responsibility for retirement provision on the private sector, the private sector in turn will push that responsibility down towards the ultimate beneficiaries. For firms with businesses largely geared to the institutional market this represents a formidable challenge. They will have to follow the responsibility downward.

Success will require a wide-reaching distribution network, reaching down to the individual. This represents one of the biggest hurdles of all, and a highly expensive one. Many major fund management firms are attempting to build up their networks by buying up companies in the same field, or banks and insurance companies. But is this a wise move or an expensive mistake? Will the distribution network of the past be the distribution network of the future?

Twenty five years ago in the US, banks appeared to have a lock on distribution. Today they have given way to the Charles Schwabs of this world. In the UK, we see the traditional banks and insurance companies being threatened by the likes of Virgin, Marks & Spencer, Sainsbury and Tesco. We find it hard to believe that the continent will prove any different. Is there any reason to believe that relationships with customers through high-cost branch networks are secure, particularly in the face of much more cost-effective distribution systems such as the Internet?

Would it not make more sense for an investment management company to partner with an organisation which already has the necessary brand name? Take a seemingly far-fetched example: BMW. Yes, but it is a global brand name. Acompany which is used to translating its story into different languages and cultures. It even has a branch network through its distributors and it is close enough to the financial services industry through its motor credit operations. Or you could try Microsoft; pick your favourite. The point is, potentially allied companies will all share some common characteristics. They will have a truly global brand name; they will have capital; and they will have an ability to assist in the distribution process through technology (Microsoft) or through marketing (BMW). They will not necessarily need to be investment companies in their own right.

Selling more directly to the end public will lead investment managers to be more cautious of the claims they make on performance and change their focus more and more towards risk control and consistency (the "investment promise"). This will mean that investment performance is unlikely to be the sole differentiating feature in the future as long as you meet your investment promise. Increasingly, what will count will be the packaging of products, marketing and low costs.

Consequently, our vision of the global investment manager of the future is one which will not necessarily be tied to the bank or insurance sectors, nor is it likely to be independent. The cost of building this kind of global capability is just too high. Instead this firm is likely to be tied to an established brand name; it will need access to vast sums of capital; its leaders will be much more concerned with packaging, marketing issues, and technology to squeeze costs and improve operating efficiency, and less concerned with trying to find the illusion of the next high-performing superstar fund manager.

Index providers will be obliged to take the evolving wants and needs of such investment managers into account.

Alongside a few mega-firms will be a large number of boutiques or delicatessens, whose needs will also have to be met. These firms will be able to stand aside from the struggle to reach scale all around the world. For them, as with any boutique, investment creativity and performance will be much more important. There is every reason to believe that many of these firms will have a bright future, but many will also fail. The analogy today would be restaurants. Many small restaurants come and go; some survive for the long haul, but whether we like it or not, McDonald's keeps going. More problematic will be the future of the firms in the middle, those too big to be a credible delicatessen and too small to be a credible supermarket.

CERTAINTY 2 - WE WILL ALL GET OLDER

Europe's aging demographic structure has been well documented and has a number of implications. It implies subdued consumer demand since the post-war baby boom generation, on reaching its forties or fifties, is likely to have a higher propensity to save, rather than borrow and spend, as retirement approaches. This in turn implies a rapid build-up in personal sector savings and investments.

Europe's existing pattern of long-term investment falls into two camps. In some countries, such as the UK, the Netherlands, Switzerland and most of Scandinavia, funded pension provision is well-established and accounts for a high proportion of personal sector financial assets. In the other camp are countries like France, Italy and Spain, where pensions are largely unfunded and mutual funds, along with insurance products, are the main alternative vehicle for long-term private savings.

The per-capita level of mutual fund and pension fund assets ranges widely among countries (Figure 2). Overall levels of investment in pension funds and mutual funds in France, Germany, Italy, Portugal and Spain are comparatively low at US$12,000 per capita or less (source: William Mercer). It seems likely that over time these levels will converge towards the higher per capita sums found in the northern European countries.

Along with the growth in investment over the next decade, the other main development will be a change in the asset mix. In 1998, in Europe, only UK pension funds had more than a 50% weighting in equities. Most other countries' pension funds had a sub-25% weighting. Even at the current underdeveloped level of pension provision in continental Europe, an increase to a 50% equity weighting would create an extra US$450 billion of equity demand. If continental European mutual funds also went to a 50% equity weighting, this would channel another US$480 billion into equities, making US$930 billion in all (source: Salomon Smith Barney estimates). And this takes no account of the potential increase in equity allocations by insurance companies, private banks and other asset managers, or in direct investment by individuals.

In addition to the reallocation of existing assets, new money inflows to pension funds and mutual funds are unlikely to reflect the historical asset mix, but will probably show a great bias towards equity investment. Overall, the incremental demand for equities by continental European investors is likely to be strong over the next decade.

 This growth in the demand for equities by continental European investors, coupled with the launch of the Euro and globalisation, lies behind the recent explosion in the number of Euroland and pan-European equity indexes available to investors. As these Euroland and pan-European indexes rise in importance in the eyes of investors, so there will be a corresponding decline in the importance of country-bias indexes. Many of the European indexes familiar to investors today, such as the DAX 30, CAC 40 and even the FTSE 100, may not even exist in 10 years' time.

GROWTH OF IT AND SHIFTING SECTOR MIX

The structure of GDP has been evolving ever since the industrial revolution began. The recent enthusiasm for Internet stocks may invite comparisons with previous market manias, but behind it there is a valid perception that just as physical services overtook manufacturing, eventually the value of output in the electronic economy may well overtake the remaining physical services.

The stock market is anticipatory and so the future structure of GDP output is reflected in the stock market well before it shows up in national accounts. Examples of "green shoots" which have sprung up over the past decade in the US market include the IThardware, software, systems and Internet stocks. The presence of the equivalent technology sectors in the European market is also on a rising trend, but running behind the US.

This changing industry structure presents a challenge to index calculators who need to monitor these changes and ensure that their industry classification system is up-to-date and reflects the realities of today's (and tomorrow's) economy. Banking, insurance and financial services, retailing, media, leisure and even personal and social services such as education and healthcare risk cannibalisation by the electronic economy. Some services, of course, will remain physical: things like haircuts, restaurants, transport and tourism.

INDEX PROVIDER WINNERS AND LOSERS

In stock market terms, the change in how a service "product" like car insurance or recorded music is packaged, purchased and delivered will sometimes have the effect of taking earnings away from one sector and transferring them to another. It is likely that the sectors which control or operate the infrastructure of the electronic economy will also be able to gain a significant share of the output of the electronic economy.

 It is impossible to predict how these increasingly permeable business frontiers might lead to sectors being redefined and regrouped in equity indexes ten years hence. However, looking on the broad economic group level, we can say that the technology group will be the net gainer from this process, at the expense of consumer goods and service companies. Who will be the winners and losers in the next decade? We believe that the winners in the index market will be no different from the winners in any other market.

Winners will be those companies that adopt a winning strategy of redefining leadership, build a global brand and develop a culture of innovation. By redefining leadership we mean focusing on marketing and packaging, using technology squeeze costs and improve operating efficiency. Building a global brand is very expensive and, for financial services companies, may mean linking up with powerful brands in other sectors. Your brand is also reflected in your workforce culture, which means that to win you need to foster a culture of innovation and inspire change because one of the few certainties is that things will change over the next decade and to survive companies must change too. The world should learn to expect continuing innovation from us, because innovation will be the key not only to success, but indeed to ultimate survival.