Gulf markets are starting to realise they need to tap institutional investors, but regulators will need to undertake structural reforms to make exchanges more attractive
Among the GCC states, institutional participation is highest in the Kuwait Stock Exchange
Source: NCB Capital
The retail investor is the mainstay of most of the bourses in the Middle East and North Africa (Mena) region. Individuals, rather than collective investment vehicles, are the driving force determining market behaviour.
The institutions that dominate stock markets in developed countries, such as large insurance firms and pools of pension and mutual funds, remain in a minority in all bar Egypt.
Retail investors account for about 85 per cent of Saudi market turnover and for other Gulf markets, it is a similar figure. At 29 per cent, institutional participation is highest in the Kuwait Stock Exchange, according to an April 2010 report by NCB Capital, the investment arm of Saudi Arabia’s National Commercial Bank.
Institutional money is important, it’s usually more sticky than retail money, as it not withdrawn so readily
Georges Elhedery, HSBC
This has left Mena exchanges susceptible to the swings associated with retail investors’ more limited risk horizons. In the downturn, retail investors’ risk aversion sent markets across the region tumbling. In boom times, it has had the opposite effect, with individuals piling into markets that then exhibited the worst features of bubble economies.
Retail investor confidence in the region is more attuned to current events, with the effect that fluctuations in the share price can build a momentum that contradicts sound fundamentals. There are other negatives too. In the Gulf, many retail investors are leveraged and saddled with debts that need to be paid off. This means that in today’s market climate, when valuations are lower, they lack the liquidity to take investment positions.
|GCC social security institutions|
|Institution||Assets under management ($bn)|
|Saudi Arabia||Public Pension Agency||116.7|
|Kuwait||Public Institution for Social Security||40.5|
|Bahrain||Social Insurance Organisation||9.3|
|Oman||Public Authority for Social Insurance||2.2|
|Qatar||General Retirement & Pension Authority||1.6|
|UAE||General Pensions & Social Security Abu Dhabi Retirement Pensions & Benefit Fund||3|
|Source: NCB Capital|
The estimated 48 per cent decline in trading volumes in 2010 in GCC bourses is a reflection of this structural imbalance. GCC stock markets’ underperformance compared with the benchmark MSCI emerging markets index, which rose 16.4 per cent last year, also highlights this weakness. With only Egypt and Morocco included on that index, the region as a whole is missing out on the institutional inflows that are associated with emerging market investors. One development that could boost equity institutional inflows into the Mena region would be the re-classification of the region as an emerging market by index provider MSCI. “Until this happens, a lot of institutional money is prevented – by mandate – from coming into the region,” says Georges Elhedery, co-head of global markets, Mena, at the UK’s HSBC. “This institutional money is important, it’s usually more sticky than retail money, as it’s not withdrawn so readily when there is a downturn.”
With political turmoil sweeping the region, it is no surprise that many Mena investors have taken fright. GCC market capitalisation fell by 14 per cent from the start of the year to early March, with Saudi Arabia’s Tadawul All-Share Index losing SR82bn ($29bn) of its capitalisation in February alone. It was the largest drop since June 2010.
|Pension fund participation in markets|
|Value of equity holdings in listed companies ($m)||Percentage of equity market capitalisation|
|Source: NCB Capital|
With individuals leading the sell-off, it has cleared the path for institutional investors to move in and buy at some attractive valuations. Ironically, the crisis may prove to be a short-term driver for the growth of institutional investors. Individuals’ retreat from the market and greater caution about equity market trading have by default boosted the relative influence of institutions on Mena stock markets.
Institutional intervention in equity markets
“One thing that has been happening as a result of the crisis is that big institutions, whether sovereign wealth funds or government pension funds, have been becoming more active in the equity markets,” says Jarmo Kotilaine, chief economist at NCB Capital.
“In particular, during moments of correction, they have come in partly due to political considerations or as a bid to boost confidence, but also legitimately in many cases to exploit a good buying opportunity.”
The retraction of retail investors is not in itself enough to build strong markets with more stable investment flows. Markets across the region need to do much more to make their exchanges more attractive to institutions.
The inability to hedge, amid limited derivative product availability, means that investors find themselves exposed to downside risk and unable to profit from falls the value of shares. Bourses such as the Abu Dhabi Securities Exchange and the Saudi Tadawul plan to introduce short-selling instruments, as an essential prerequisite to deeper capital markets.
Gulf markets are starting to realise that they need to tap institutional investors if they are to rid themselves of the curse of boom and bust.
Over time, institutions have been growing incrementally in importance, in terms of visibility and the level of trading in GCC markets. But they are not able to match the most developed market in the region, Egypt, where more than half of trading on the stock exchange is accounted for by institutions. When the political crisis struck Cairo in January 2011, institutional investors exploited plummeting valuations with some neatly timed buys.
The Gulf is not a picture of uniform underdevelopment. Regulatory change has fostered the role of institutions in terms of their size, numbers and market participation.
“One of good things is that now across region you more or less have a properly regulated insurance sector,” says Kotilaine. “If you look at Saudi market, the premiums are going up pretty steadily, supported by various compulsory policies. This means that year after year, these companies will have a bigger pool of money to play with, even though the starting point is modest.”
Another recent phenomenon is that investors are becoming more receptive to mutual funds. GCC-domiciled funds investing within the region have estimated assets of some $24bn, comprising nearly 70 per cent of the assets of the regional public subscription collective investment schemes, according to NCB Capital.
Overall, however, these improvements will not be enough to transform equity markets in an environment of elevated risk aversion.
Gulf government funds
Regional institutional investors are dominated by government funds, with the main public sector pools of capital comprising sovereign wealth funds (SWFs), central bank reserves and state-controlled pension funds.
These bodies sit on sizeable pools of assets, with the nine leading state-run pension and social insurance organisations in the Gulf states estimated by NCB Capital at $170bn. The largest are Saudi Arabia’s Public Pension Agency (PPA) and its General Organisation for Social Insurance.
These public agencies are growing both in absolute and relative terms, but in order to create a more institutionalised market, additional investors are needed and that can only be achieved by way of pension reform.
An eventual conversion of mandatory end-of-service schemes into funded occupation pension policies could provide significant gains, for example.
“All these trends are pointing in the right direction, but you not really seeing a significant systemic shift. In order to get a proper institutional market you need pension reform. And that has not happened,” says Kotilaine.
Although government pension funds such as the Saudi PPA have become more active, the region has not witnessed the emergence of significant voluntary pension schemes. In emerging markets, such as Chile and Hungary, it has been the evolution of the private pensions industry that catalysed institutional investment in their respective stock markets. This has not happened in the Mena region and few believe it is about to happen.
Fiscal incentives such as beneficial tax treatment for private pensions are lacking. Only the prospect of insolvency is likely to trigger a more concerted move to create funded pensions in the region.
Foreign asset managers also want to see more action to develop different investment sectors and increase the scale of local exchanges to build a marketplace for institutional investors. “The key issue here is the ability to access a broad range of stocks in the region where there is good governance, transparency and reporting standards –that’s absolutely key,” says Nick Tolchard, head of Dubai-based asset management firm Invesco Middle East, part of Invesco Asset Management.
“Ignoring whether now is the right time for Mena equities, structural change is something the global asset management industry needs to see happen as these markets are so narrow.”
SWFs, particularly in the Gulf, could also emerge as a source of stable investment flows. Some of the largest SWFs are starting to chase yield more aggressively.
“From a global perceptive, SWFs are the main investors in the region and they are the institutions that have the greatest commonality with the global asset management industry,” says Tolchard.
However, the SWFs’ mandate is to channel excess liquidity accrued in the largest oil producing states into buying overseas assets. This prevents a more prominent investment profile in domestic capital markets. With mature developed markets in Europe offering attractive valuations, there is even less incentive for SWFs to invest within the Mena region.
Stock exchanges in the Middle East could do well to follow Egypt’s example, where institutional investors have been prominent since the mid-1990s, attracted to what is regarded as the most transparent market in the region.
Boosting transparency in the Middle East
Analysts advocate a simple focus on boosting transparency as a key first step. “The most important thing here is to do with transparency and corporate governance issues,” says Angus Blair, head of research at Cairo-based Beltone Financial.
“The Gulf states remain, in relative and absolute terms, very poor compared to Egypt and other emerging markets, in terms of the quality and amount of disclosure. Management teams’ communication with investors, in general, is still surprisingly poor.”
During the political unrest in Egypt, the central bank did an excellent job of keeping the markets moving, says HSBC’s Elhedery.
“When the foreign exchange market re-opened, we did not see the Egyptian pound dip,” he says. “What we saw there was a region that understood the international markets and were in constant communication with market participants. Clearly, this paid off and such activities will, in the long term, give institutional investors comfort in Mena markets.”
Over time, the Mena region will be unable to resist the global trend that has seen insurance, pension funds, mutual funds and the other essential props of portfolio investment materialise.
Rising populations and increased wealth will create the need for formalised investment vehicles, whether life insurance policies or private pensions. But the region’s authorities could do much more to minimise their markets’ exposure to retail investors’ heightened risk perceptions.
Another bad year for regional bourses could provide the incentive to undertake the kind of structural reforms that would help form a more stable investment culture, which would be to the benefit of investor and markets alike.