Amid continuing rumours of a likely merger with the Dubai Financial Market, the Abu Dhabi Securities Exchange (ADX) now tops the Gulf league for investor confidence, according to a new survey by the local investment bank Shuaa Capital. And Dubai does almost as well.

The Abu Dhabi exchange is trying to bolster confidence by improving its systems … and regulations

More than half the investors questioned by Shuaa said the Abu Dhabi bourse was under-valued and almost as many expected it to see a rise in prices over the next six months. For its UAE neighbour, the figures were similar.

The findings suggest there is a latent pool of investment interest in Abu Dhabi’s exchange. This would surely grow if the merger goes ahead, creating a more diverse and liquid market.

For 10 years, Abu Dhabi has ploughed a solitary furrow, mostly overshadowed by its Gulf rivals, particularly the Dubai markets.

Stock exchange size limitations in the UAE

Management at the exchange has sought to carve out a niche role – for example, through the promotion of the ADX as a regional venue for the listing of exchange traded funds (ETFs).

Our main problem is that the [UAE] markets are too small. Having these two exchanges together will be better

Rashed al-Baloushi, ADX

This strategy has certainly had some success, but has not been able to overcome the fundamental limitations of size and variety of investment options available. However, the research from Shuaa suggests sentiment may now be starting to shift in a more bullish direction.

This could partly reflect the growing indications of a sustained recovery in the UAE economy in the wake the global downturn and the Dubai debt crisis of late 2009.

Shuaa’s upbeat findings are perhaps also a reflection of the particular strengths of the Abu Dhabi economic model: solid oil revenues; a well-resourced public sector; and strong service and industrial enterprises, many of them government-backed.

The emirate’s distinctive corporatist and interventionist economic structure has provided a bedrock of stability and this is underpinning wider business confidence. Nonetheless, the ADX still has major questions to answer about how to extend its role and broaden the range of listed stocks and funds. This in turn would help to attract more investors and deepen the liquidity behind the market.

“The major challenge that we face is the global crisis,” says Rashed al-Baloushi, deputy chief executive and director of operations at the ADX. “After the crisis, sentiment is cautious.”

Al-Baloushi says that the projections of 3-3.2 per cent economic growth in the UAE for 2010 have not been mirrored in the performance of the bourse.

“The market does not react. Why? Because the correlation between our market and the global indices is tight,” he says.

In a highly globalised economy, the UAE cannot escape the influence of the international financial climate. A survey carried out by the exchange in July found that 60 per cent of the population was content with the state of the local economy, and most of those who buy stocks on the ADX are retail investors.

The exchange has successfully helped to foster local investor involvement by establishing centres and branches in Zayed City and Al-Ain in Abu Dhabi, and also in the emirates of Fujairah, Ras al-Khaimah and Sharjah.

Small investors, with their own savings at stake, may not have access to sophisticated risk management instruments, so they tend to adopt a cautious stance.

International standards for Gulf stock exchanges

The exchange is trying to bolster confidence by improving its systems and its approach to regulation. But this is a slow process.

“The ADX is trying to apply all the international standards,” says Al-Baloushi. “But the process of introducing these can be complex. We need to coordinate with the central bank and there is still some overlap and confusion.”

New codes of corporate governance for companies have also been drawn up. The role of the ADX in this process has been to seek companies’ views on what the new standards should be. It then submitted them to the authorities, who then drew up the final version of the rules on issues such as the introduction of a clear separation between the board of a company and its executive management.

Observers have for some time seen the ADX as a natural candidate for some sort of international partnership, similar to that between the Doha Securities Market and NYSE Euronext. But this seems to be off the agenda, at least for now. When pressed about possible ties to other exchanges, Al-Baloushi says that no talks have been held with any potential foreign partner. He is less dismissive about the possibility of a merger with Dubai.

Al-Baloushi makes it clear that nothing has yet been decided, although the US’ Goldman Sachs is understood to have prepared a feasibility study on the merger and its impact. However, during a visit to London in mid-October, Al-Baloushi said: “Our main problem is that the markets are too small.”

One of the “weaknesses” of the Abu Dhabi exchange, he said, was that only 66 stocks are listed. “We in the UAE believe that having these two exchanges together will be better,” he said.

Institutional investors

Among the major challenges facing the ADX is the need to diversify away from its current heavy reliance on small retail investors with limited resources and capacity to take a strategic long-term view.

“We are trying to attract as many institutional investors as we can because we believe that by doing that we will create more stability and liquidity,” says Al-Baloushi. The UAE has 51 banks, including 28 foreign institutions, with combined assets of $430bn. If the stock market could attract just a fraction of that capital, it would give a huge boost to liquidity.

“We do have strong banks, but they need to be involved more and more,” Al-Baloushi says.

The ADX has already found a receptive audience for this argument among some local banks.

“The market is not liquid enough and the volumes of trade are very small,” says Mahmoud al-Aradi, head of financial markets at National Bank of Abu Dhabi (NBAD).

“I think we need to give the foreign investors a little more confidence – liquidity is vital for them, as they often need to move large amounts of money very quickly. That is where we as local financial institutions have a role to play. We can be a major source of the added liquidity.”

NBAD is already playing its part. In March, it launched an ETF that gives investors exposure to 25 major stocks across the UAE and is listed on the Abu Dhabi exchange. In April, it announced plans for a second ETF, with part of its licence and management fees to be allocated to the Global Fund to fight Aids, tuberculosis and malaria.

But the exchange may need to develop a more sophisticated range of products if it is to persuade other well-resourced local banks or foreign investors to take a greater interest in the equity market.

“We need derivatives and options, so you can hedge,” says Al-Aradi.

“Middle East markets would also benefit if they were included in more international investment indices, which would make it easier for foreign portfolio investors to include them.”

Al-Aradi also says the government needs to take a lead in generating interest in the market.

“I think that a relaxation of rules on foreign ownership of companies in the UAE would stir more foreign investor interest in the Abu Dhabi exchange,” he says.

“And to add range and depth to the investment options on offer, we need government entities to start to list some of their stocks as well.”

He points to the example set by Australia, which was able to transform its market through state intervention. Rules governing investment by public sector pension funds were liberalised, allowing them to buy stocks and bonds, and thus injecting fresh liquidity into the investment market.

UAE wealth

In theory, there is plenty of regional and national capital available to be attracted into the ADX. Pension funds are clearly an option. One UAE analyst says that at present Saudi Arabia’s General Organisation for Social Insurance is the only such institution to invest on a substantial scale in the equity markets.

Another potential source of investment liquidity is the Gulf’s sovereign wealth funds. Abu Dhabi Investment Authority and other sovereign funds in the region naturally seek to place a large proportion of their capital abroad in their drive to diversify national income away from a reliance on hydrocarbons.

But the analyst argues that their resources are so huge that they could easily channel a small amount into domestic equity markets, without undermining their overall strategy or risk position.

The gradual transformation of the GCC into an integrated regional market should in time facilitate cross-border investment into the ADX by pension funds and other public investors.

But a merger with another bourse within the UAE or the wider region would be a much faster way of raising the liquidity on the exchange.