ROUNDTABLE: Movers in Mena (part 1)

Industry heads in the Gulf region come together to discuss the major issues facing them and how to best operate in today’s marketplace. (part 1)

Sven-Olaf Vathje
(partner & managing director, The Boston Consulting Group

Amin El Kholy (head of asset management, Arqaam Capital)
Sean Daykin (head of investment funds, Emirates NBD Asset Management)
William Wells (head of intermediary sales, Middle East, Schroders)
Eric Swats (head of asset management,Rasmala Investments)

Funds Global: What is the risk appetite of Gulf investors in the wake of the financial crisis and shocks to the Gulf economy? Are Gulf investors as keen on local-market funds as, for example, the Chinese are?

William Wells, Schroders: People have certainly turned down their expectations for their returns on investments. They are still looking for higher returns but feel they’re not going to achieve the 30% or 40% that they used to expect. Now an expected return between 10% and 12% is more realistic. In light of this, people are also moving away from structures where they have to tie up capital. They’re looking for more liquid, transparent products as opposed to some of the private equity or hedge fund strategies they might have used before, where there were longer lock-ins.

Eric Swats, Rasmala: We’ve seen an increase in safe or secure securities. However, investors are still looking to invest in the regional names they feel comfortable with. This can be anything, like, for example, deposits. If you sit in the UAE [United Arab Emirates] or Qatar, deposit rates are very high. This means there is a material hurdle for asset management firms to attract money out of deposit alternatives.

The fixed income markets of the region have also grown quite substantially over the past twelve to 18 months, with a fair amount of issuance from high quality issuers, for the most part. So, we see a number of investors looking to participate in these more secure, safe investments, and also looking to add fixed income and sukuk investments. They’re for more asset allocation advice and risk management from their providers.

Sven-Olaf Vathje, Boston Consulting: Ultra-high-net-worth individuals are redefining their risk appetite. They are reassessing what is a normal return level to expect, because for many of them this is the first time they are experiencing risk in such a tough way.

In their asset allocation, we are seeing a trend for increased exposure to the Middle East, but the question is how will this exposure be achieved? On a longer-term perspective, we observe a repatriation of funds to the Middle East. Private equity has benefited from this, as has real estate. There are many regions within the Middle East that are still regarded as good investment grounds for wealthy individuals and potentially also for funds.

What this means for the funds industry depends to some extent on what the industry itself is offering. Historically, managed portfolios have been regarded with some caution. This is because the value proposition of those funds often did not go beyond convenience. Truly value-adding fund characteristics – eg an innovative investment style – could be helping a successful growth of funds in the region.

Sean Daykin, Emirates DBD: I agree with Eric, the high interest rates on deposits make it very difficult for funds to compete. People want low risk products and so they’re looking at fixed income, but the rates you get on fixed income, while higher than deposits, are not seen by investors as sufficiently high given the extra risk. But rates are coming down, which is positive. In terms of regional equities, we’ve gone through two bear markets over the last four years, so investors are fairly cautious on equity markets, particularly retail investors. On the retail side there is still interest in India and China as themes, because the expatriate population is very keen on those sorts of markets. Gold is also a market that holds attraction. Many India expats love to play in gold so we’re seeing a lot of interest there. We are also seeing an interest in segregated mandates for high-net-worth individuals in Mena [Middle East and North African] equities. Historically, in the bull markets investors wanted to buy individual equities and then in bear markets they wanted to go back into funds. Right now we’re seeing segregated clients coming back in and trying to customise their solutions, so it’s an interesting market.

Amin El Kholy, Arqaam: I agree about increasing interest in segregated mandates. Many GCC investors had their fingers burnt by regional funds, typically single-country funds launched by large retail banks, because they were missold or the risks not clearly explained. This unfortunately tarred all funds with the same brush. Some investors were not willing to accept the fact that these are actually relative return funds. The investors rode the wave and when the market crashed had to face the risk side of the coin. This applied to the retail market, particularly, and some of the less sophisticated high-net-worth individuals.

On the institutional side, which has traditionally been somewhat thin, some very sophisticated sovereign wealth funds and others are beginning to look more at benchmark mandates in the region, and looking at the GCC. In the past, they looked internationally. In view of this, they are being very careful with regard to manager selection, whether it’s a mandate or a fund.

Funds Global: So is there a misselling scandal bubbling away underneath the surface?

Kholy: There used to be an issue when selling funds through retail channels that the staff in the branches were not able to explain the risks. Certain bad practices were prevalent way back in 2004 and 2005 but we’re past that now. The new generation of funds is better structured and presented. An interesting development is the launch of ETFs, for example. People are wondering when the retail market will pick up on these products. The natural retail clients of ETFs are those who are paying high fees for funds which are in the end just tracker products, rather than the investors who trade directly in stocks and would want to trade ETFs frequently. Until ETFs are promoted as an investment vehicle these investors will continue to pay 2% and in some cases performance fees for similar or worse performance than ETFs.

Funds Global: Do sovereign wealth funds and pension funds in the Mena, GCC region feel any political pressure to invest locally and support local economies and developments?

Daykin: Both institutions and individuals are starting to move more into having regional portfolios rather than just country exposure. Five years ago it was about having a country manager with a country fund. Recently you’re seeing more regional products, whether they be GCC or Mena. People are starting to realise that by taking a broader opportunity set, they can have a portfolio that is much better diversified.

Kholy: There’s a precedent as far as that is concerned. The KIA [Kuwait Investment Authority] which owned large stakes in listed Kuwaiti companies, instead of exiting directly in the market actually launched a number of funds with local managers based on these positions. Having the KIA as a co-investor helps give confidence to other investors in the fund. Currently, there isn’t a tradition in the GCC of regular investment for retirement through the capital markets, be it locally or abroad. This is mainly due to well-funded government pension schemes. So anything that can help encourage that is probably useful, but that will take a certain amount of initiative. The sovereign wealth funds can provide the know-how to this type of initiative. I see a growing role for SWFs in contributing to the development of their domestic capital markets based on their expertise globally.

Swats: There is a lot more that can be done in terms of developing these markets, aside from the sovereign wealth funds allocating money. Much of it has to do with the regulatory framework of the exchanges. The right framework would allow them to move up to par with international standards. This would bring international investors into the region, as these indices become part of standard emerging market indices. Most of the sovereign governments and the sovereign funds looking to participate in the local economies are doing so through direct investments as opposed to allocating money to financial instruments.

Daykin: But it’s still a problem for international investors to come to this region when you have so many stock exchanges. There isn’t a single ETF where you can just buy the Mena markets in proportion to the GCC, for example. With access to the markets being so difficult, it would be nice to have a centralised exchange where fund managers can come and just open one account and access all the markets.

Swats: ETFs seem to be a growing investment strategy around the world, so one would expect there to be some regional interest. That said, looking at the investment opportunities in the region, it’s not an area where ETFs should be used as there are a lot of inefficiencies in these markets. This is an area where a skilled investment manager, with well-trained analysts using proper risk management techniques should be able to outperform passive indices. You should expect your fund manager to outperform these indices through appropriate security selection efforts. And historically many managers have offered attractive active returns.

Funds Global: Could non-Gulf institutional investors be discouraged from coming to the Middle East because it is a frontier market, which is structured differently? Or does the attraction of the opportunity outweigh any concerns?

Wells: There is increasing interest from international investors in the Middle East markets as a whole. More people are looking at these markets because they’ve seen how other emerging markets have developed and they believe that, in time, the GCC markets will develop into emerging markets.

Last year you saw a very strong rebound in other markets, which hasn’t happened in the Middle East yet. The valuations are becoming more attractive and people are starting to pick up on it. In terms of access, international investors probably favour investing with a name they know and trust, as opposed to using ETFs, which are relatively new to the market.

Kholy: There are certain structural factions of the Middle East markets that are interesting because, unlike other parts of the world, there isn’t really an imperative to attract foreign capital. I recently sat on a panel were the head of one of the exchanges in the region said: “We’ve got to remember what our main mission is. It’s good to have capital markets; they’re there to encourage the economy. But we’re not primarily trying to attract foreign capital, we don’t need it.” Now, you can argue whether having foreign investors is positive or not, but there are some structural hurdles. For example, there isn’t custody in the traditional sense. If you don’t have a proper custody account you are at the mercy of your broker, whether it’s in Saudi or other countries in the region. Improving these structurally deficiencies would make these markets more efficient and attractive for the local investors as well as to international investors. When all these structural issues are addressed you will start getting interest from foreign investors. But the authorities and regulators need to see that it’s actually good for the local markets to address them. I don’t think this message is getting across just yet.

Swats: Asset managers in the region can find gathering assets into their retail funds difficult. The banks can capture money more easily because their clients are often happy to take some money out of deposits and consider moving it to the bank’s funds. Therefore we’ve seen a number of asset managers putting their strategies to work within vehicles that allow them to capture foreign investor participation more easily. For example, we’ve seen a number of groups launching Ucits III-type funds, which is something local managers wouldn’t have considered before.

Funds Global: Do you see more IPOs coming to the market in the next couple of years to increase the number of stocks ?

Vathje: The availability of investable financial assets is going to be driven by new supply coming to the equity capital markets from family groups or from some of the government holding companies. One consequence of the global financial crisis is that there is a stronger focus on professionalism and corporate governance within many of these companies. For many, the crisis served as a wake-up call to the fact that just focusing on one channel, like, for example, bank lending, as a source of financing is not enough. From the currently very low levels of IPO activity we, therefore, expect that the IPO market is going to pick up again in the near future. Also, the IPO pipeline may be strengthened by some firms shedding non-core assets.

In addition, we expect more supply in the debt market. The bond markets in the region have historically been rather illiquid. Most of the few regional issuances have occurred in London or other foreign jurisdictions, though a good portion of these bonds often ended up in the portfolios of regional investors. Over the next three to five years we should see a pick-up on the bond side, especially for convertible bonds and asset-backed structures.

Funds Global: Will there be more of an appetite for local bond funds before there’s an appetite for local equity funds?

Daykin: Yes I think so. Investors are quite risk averse at the moment and although they don’t want to go into equities, they are probably more likely to put money into fixed income funds. We’ve already seen quite a bit of flow into those markets. Historically, people tended to own two or three bonds and now they’re selling those and buying fixed income funds to get better diversification.

Vathje: It is a good time for fund ventures to be active in the bond markets. Investors increasingly understand that bond investments are not risk-free, and that a professional approach around bond selection and management is also needed. This is the classic domain of fund managers.

Wells: We’ve seen quite a few blow-ups in the last couple of years so the need for professional credit analysis is key.

Daykin: Last year you saw significant inflows into individual bonds through the retail banking channels. However, they have realised the additional challenges and risks of selecting individual instruments and and are now looking to utilise bond funds to give much more diversified exposure.

Swats: While the fixed income markets in the GCC are still nascent, we think there’s enough there to put bond funds together. We launched a GCC fixed income fund a little over a year ago, which has performed very well and attracted a certain amount of interest. When you look at the GCC issuers you get a profile that is very different to that seen anywhere else.  You have issuers with relatively strong credit ratings sitting within emerging or frontier economies.

Daykin: But it’s a very inefficient market compared to equities. Bond markets here are even more inefficient, in terms of some of the yields. For example, sovereign yields are higher than corporate yields in some countries. There are certain things that just don’t work that well in terms of pricing. Partly it’s about liquidity.

Kholy: There could be problems around expectations. The general investor perception is that fixed income is a ‘safe’ product. They don’t expect any surprises, but as we’ve seen in 2009 you can have shocks and high volatility. It’s a matter of treading with caution and managing those expectations.

Wells: Looking at it from the perspective of an international investor, we’re in favour of emerging market debt products looking into the Mena region because there can be great opportunities. As these markets develop further you will see more investors looking at diversifying their portfolios into the Mena markets.

Funds Global: There is a great need for infrastructure development here, but with bank lending drying up and high-net-worth individuals moving away from the private equity market, where’s the finance going to come from for all the infrastructure development needed? Could this be lead to support for development of the bond market?

Swats: Many of the issuers coming from Abu Dhabi have earmarked these monies for different types of infrastructure projects. Even Qatar is looking to develop the oil fields and assets related to tourism.

Daykin: I heard that they’re not going to launch any federal UAE bonds, which is a slight shame. We have Dubai sovereign issues and Abu Dhabi sovereign bonds, but there isn’t an Emirate-wide bond market yet. If they started launching something like this and began issuing a range of maturies, for example, this would really help develop the bond markets here. At the moment you have individual spot bonds issued but it’s not particularly coherent in terms of structure.

End of part 1

©2010 funds global

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