Equity Emigration
By Lars Hamich

European Monetary Union (EMU), the introduction of the euro and the harmonization of European trade and economic policies have irreversibly changed the European investment landscape in an unprecedented manner: The emigration of European equity is now under way.

Phase 1--the emigration from domestic to regional investing--is in progress, while Phase 2 --the emigration from regional to regional sector investing--is gaining momentum. Phase 3--the emigration from regional sector to global sector investing--is just beginning.

The circumstances behind this emigration and the challenges it holds for retail and institutional investors, financial-product designers and European index providers are presented here. Also presented are data confirming the rate and extent of this emigration of European equity.

Domestic --> Regional Investing
The euro's launch initiated European equity emigration from domestic to regional investing:

• The euro effectively created a single equity market with a capitalization of about 4,500 billion euros--nearly four times larger than its largest component, France (1,300 billion euros). By any measure, this was a quantum leap in investment opportunities.
• By eliminating the foreign-currency risk within this new 12-country market, the euro has dissolved the distinction between domestic and nondomestic investing. Consequently, the Eurozone countries are easing the legal restraints on nondomestic investing.
• The European equity exchanges also responded to the new investment land-scape by forming alliances to provide more efficient and economical trading platforms. Most impressively, EUREX-- created by the merger of DTB (Germany) and SOFFEX (Switzerland)-- is now the largest derivatives exchange in the world. European exchanges are harmonizing trading hours, trading parameters and clearing and settlement procedures, and offering cross-memberships between the various stock exchanges.

With one stroke, new investment opportunities were created, new investment freedoms enabled and new investment platforms generated. Investors were provided with an unbeatable opportunity more choice with less risk at lower cost meeting their age-old demands for more diversification and higher performance. It is this convergence of supply and demand that accelerated the first-phase emigration of European equity from domestic to regional investing.

The challenge for investors relatively unfamiliar with European investments was clear: How to gain rapid but controlled exposure in the new market without compromising the twin investment goals of diversifica-tion and performance?

The financial product designers' answer was disarmingly simple: exchange-traded and OTC products based on regional European equity indexes. The challenge for product designers was not how but which which regional indexes would be suitable benchmarks and underlying indexes for their products?

The European index providers responded with very different solutions. The Dow Jones STOXX Indexes' market-driven solution focused on the requirements of investors and product designers. The Dow Jones STOXX indexes comprehensively cover Europe and the Eurozone by market capitalization, size, style and sector. In  addition, these indexes are globally integrated with the Dow Jones Global Indexes.

Because what gets measured, gets done, the choice of a benchmark index is indicative of the investment strategy pursued. Only 1% of the 73 financial institutions surveyed by Merrill Lynch in December 1999--handling declared funds totalling 2,000 billion euros-- indicated that they would be using a  national/domestic benchmark index by year-end 2000; 87% intended to use a regional European benchmark, of which 23% were already using the Dow Jones STOXX indexes, a remarkable market share for regional indexes.

The European derivatives markets also confirm the emigration of European equity from domestic to regional investing. Between December 2000 and February derivatives -- are also growing at a greater rate than those based on domestic indexes. Indeed, the market shares of many domestic indexes have been shrinking since 1997, most notably for the CAC 40, FTSE 100 and SMI indexes. Other products also confirm the domestic to regional equity emigration. At the end of the first quarter of 2000, the the 2001, nearly 5.5 million futures contracts worth approximately 250 billion euros and approximately 3.5 million options contracts worth over 125 billion euros were traded. At the end of February 2001, the open interest on the Dow Jones EURO STOXX 50 futures contract was 30.1 billion euros and the open interest on the Dow Jones EURO STOXX 50 options contract was 85.9 billion euros. This makes the futures contract Europe's sec-ond- largest with a 21% market share and the options --also Europe's second-largest -- with a 22% market share (Figure 1). Among the regional indexes, the market shares of the Dow Jones STOXX blue-chip indexes were in excess of 95%.

As further confirmation, the volumes and open interests of the regional derivatives -- particularly the Dow Jones EURO STOXX 50 Dow Jones EURO STOXX 50 index already had a 25% market share of the European structured retail products market. The Dow Jones STOXX indexes could also claim a significant portion of the 22% market share represented by index baskets in the European retail-product market, as well as a large part of the 21% market share represented by sector baskets. OTC products based on the Dow Jones STOXX indexes have an approximate value of 123 billion euros.

To meet the increasing demand for regional index products, exchange traded funds based on the Dow Jones STOXX blue-chip indexes were launched for the first time in Europe in April 2000. Recently, ETFs based on the Dow Jones STOXX sector indexes were also launched.

In the past 12 months, the combined assets under management for these products reached 1.5 billion euros and the average daily trading volume was more than 150 million euros. This represents a 10% turnover rate for the entire European ETF market.

Regional --> Regional Sector Investing
The emigration of European equity from regional to regional sector investing was spurred by EMU and the harmonization of trade and economic policies:

• Import duties were eliminated and product specifications standardized, allowing the majority of European businesses access to new markets. No longer limited to domestic growth, they are now free to increase their market share via cross-border expansion.
• Foreign ownership restrictions have been eased and nationalized industries privatized, allowing more aggressive companies to increase market shares quickly via strategic mergers and acquisitions.
• Market-share increases enable these companies to exploit economies of scale, reduce costs and increase profit margins.

These business-friendly measures have helped rejuvenate European businesses, as -denced by the increasing number of mergers and takeovers involving large European companies. Some 100 such consolidations have occurred since 1998: e.g., Rhone Poulenc and Hoechst forming Aventis, Vodafone Airtouch's takeover of Mannesmann and SmithKline Beecham continuing with Glaxo to form GlaxoSmithKline. These companies now have a sufficiently large market share to support their business strategies and prof-itability. This corporate renaissance provides another unbeatable investment opportunity to increase diversification and performance: sector leaders with higher risk/return profiles.

The challenge for investors unfamiliar with regional sector investing was clear: How to gain rapid, but controlled exposure in sectors with an established performance record and yet with sufficient potential for further consolidation and, therefore, increased profitability? Product designers are issuing exchange -traded and OTC products based on regional sector indexes. Again, the challenge was not how but which: Which regional sector indexes would be integrated with a regional benchmark index and yet be tradable with an optimal liquidity/number of components profile? The Dow Jones STOXX indexes offer 18 tradable sector indexes derived from the 400-company Dow Jones STOXX 400 index that are fully integrated with 18 broad sector indexes derived from the Dow Jones STOXX Total Market Index (TMI) and the 600-company Dow Jones STOXX 600 index. This inte-gration enables investors to effectively benchmark with the broad sector indexes and efficiently invest in tradable sector index products. This feature is driving the second phase of European equity emigration: the movement from regional investing to regional sector investing.

The increasing rate and extent of consolidations confirm the cross-border expansion of European industry. The consolidating and consolidated tradable sectors cover an average of 94% of the market capitalization of the relevant Total Market (TMI) sectors with an average of 50% of the companies. The lagging fragmented sectors --covering an average of 75% of the market capitalization and 27% of the companies-- are indicative of the potential for future  consolidations in Europe.

As a result, the number of regional sector index products is rapidly increasing as issuers and investors move to take advantage advantage of this investment opportunity. Together, these factors confirm that the emigration from regional to regional sector investment is gaining momentum.

Regional Sector --> Global Sector
Investing The accelerating globalization of the supply and demand markets is stimulating European equity emigration from regional sector to global sector investing:

• The easing of trade restrictions has created a global marketplace where many companies --e.g., Nestle and Microsoft --no longer have one significant domestic market but instead generate most of their revenues outside their country of incorporation.
• The easing of foreign ownership restrictions has encouraged many global mergers--e.g., BP-Amoco, Daimler-Chrysler and Deutsche Telekom-Voicestream-- as large companies seek global market shares and global economies of scale.
• Stock exchanges are following by listing companies that are not incorporated in the exchanges' traditional local markets. Multiple listings of large, global companies provide investors with 24-hour access to these stocks and their liquidity.

These global opportunities for commerce and investors are growing rapidly, driven by ambitious companies, visionary investors and sophisticated electronic backbones.

Together, these factors provide new investment opportunities for even greater diversification and performance: global sector leaders with different risk/return profiles. The challenge for investors unfamiliar with global sector investing was clear: How to gain rapid, but controlled exposure in sectors consisting of large companies with global operations?

Again,the product issuers have been quick to respond with exchange-traded and OTC products based on global sector indexes. And again, the challenge is clear: Which global sector indexes are integrated with a global benchmark index and tradable with a small number of large, highly liquid stocks? In addition, investment analysts are seeking small peer groups of large, global companies covering more than one continent for their evaluations, especially for the growth segments. The small number of companies makes the research coverage more manageable and therefore more efficient. In a recent survey, nearly a third of the fund man-agers intend to shift over the next two years to using global sector research based on one integrated family of global sector indexes from one index provider.

Dow Jones Indexes responded to customer demand in the first half of 2000 with the 50-company, blue-chip Dow Jones Global Titans index and in February 2001 with the 18 blue-chip, 30 company Dow Jones Sector Titans indexes. Both the original global index and the newer global sector indexes are consistent and fully integrated with the benchmark Dow Jones Global Indexes. They are continuously calculated 24 hours a day with regional closes for Australasia, Europe and the Americas, as well as a global close.

Both the Dow Jones Global Titans (50 stocks) and the Sector Titans (30 stocks) indexes are tradable because they consist of a small number of large, global, high-profile and highly liquid stocks. This is achieved without compromising the coverage; e.g. with only 20% of the telecommunications companies worldwide, the Dow Jones Telecommunications Sector Titans Index covers about 81% of the worldwide market capitalization. Likewise, in the automobiles sector, 30% of the companies cover nearly 88% of the market capitalization. (Figure 4)

As with the regional sectors, this global approach to index integration and calculation will enable investors to efficiently benchmark against and trade in global blue-chip stocks, both by size and sector.
EUREX launched futures and options based on the Dow Jones Global Titans in April 2001, while ETFs based on the Dow Jones Global Titans and Dow Jones Sector Titans indexes are in the pipeline and ready to go. The number of global sector index products is slowly growing, confirming that that the emigration from regional sector to global sector investing is just beginning. However, the rate and extent of global consolidations are continuing apace, and investor demand is there, waiting for the supply of appropriate investment vehicles. The window of opportunity for both product issuers and investors is still wide open.

Endnotes

1. 'Dow Jones STOXX Index Guide', Version 5.0, March 2000, STOXX Limited.
2. 'Tradable Equity Indexes for an Integrating Europe', by Lars Hamich, Head of the Index Design Committee, STOXX Limited, October 1999.
3. 'Strategy; Fund Manager Survey: Europe', Global Securities Research & Economics Group, Global Fundamental Equity Research Department, Merrill Lynch & Co., December 14, 1999.
4. 'Structured Retail Products; Semi-Annual Review of the European Market: First Half 1999', Global Securities Research & Economics Group, Global Equity Derivatives Strategy Department, Merrill Lynch & Co., July 2, 1999.