Euromoney GCC asset management guide: Gulf economics and the asset management industry

This is one of seven articles that made up the Euromoney Guide to Asset Management in the GCC, distributed June 2008 with Euromoney magazine

The Gulf represents one of the most exciting opportunities for asset management anywhere in the world. At a time when global markets are being rocked by credit problems and an uncertain economic outlook, the Gulf Cooperation Council (GCC) presents a compelling range of drivers: growing wealth, at a sovereign and individual level, fuelled by a record oil price; growing sophistication in investment; liberalising regulatory environments across the region; and stock markets that show little correlation to global equities.

At the heart of the Gulf’s appeal is its strengthening economic position, and it sets a framework for the growth of a vibrant asset management industry. National income growth averaged 19% in the six GCC nations (Saudi Arabia, Kuwait, Qatar, the United Arab Emirates, Bahrain and Oman) in the four years to June 2007; over the same period, GCC governments added US$500 billion to their net foreign assets despite huge spending on projects. In the Middle East generally, GDP doubled between 2002 and 2007, and is projected by Morgan Stanley to reach US$1.045 trillion in 2008, representing a compound annual growth rate of 16%; and within that, the GCC is not only by far the biggest chunk (Saudi Arabia is 37% of regional GDP) but is growing in influence – Qatar, Kuwait and the UAE raised their share of regional GDP collectively from 27.5% in 2002 to 35.4% in 2007, according to Morgan Stanley.

Additionally, the Gulf is one of those rare parts of the world where the age dependency ratio is declining: it’s a young region, with its population entering a demographic sweet spot, and more and more people of a working age.

In large part, it’s all about oil. The Middle East provides 62% of global oil reserves and 31% of global production, according to Deutsche Bank; the GCC alone was already generating a current account surplus of over 30% of GDP in 2007, and that’s before oil topped US$100 per barrel. According to the National Bank of Kuwait, GCC hydrocarbon export revenues climbed 47% in 2005 and another 20% in 2006, reaching US$360 billion in the last of those years, and that, again, is based on a far lower oil price than today. A cross section of analysts and the IIF suggests that the break-even prices for oil producing countries are between US$25 and US$42 per barrel in the various GCC countries – and ‘break-even’ simply means the revenue required to balance the budget. Analysts say that government spending is generally based on the assumption of $50 a barrel. “At $51, you’re putting another dollar into the sovereign wealth fund for every barrel of oil,” says Daniel Smaller, managing director for sales and distribution at Algebra Capita, an independent fund manager in Dubai. “So at $110…”

According to data from the IMF and HSBC, every US$1 increase in the oil price, sustained for one month, means an additional US$500 million of revenues for GCC producers. If one considers the difference between oil at US$60 a barrel, and at US$80 per barrel, it equates to a GCC economy US$200 billion bigger, or 25%; a fiscal surplus US$100 billion bigger, or 90%; and a current account surplus US$100 billion bigger, or 70%. “If oil dropped to US$50, the economy would continue to grow at a very healthy rate,” says Tarek Sakka, CEO of Ajeej Capital, a recently formed independent fund manager in Riyadh, referring to Saudi Arabia; at double that level, the wealth effect is immense.

Consequently, governments have been able to pledge huge amounts for capital expenditure in the region – commonly cited figures, if somewhat vaguely sourced, are US$500 million in the next two years, and $2 trillion in the next 10. And it’s not just oil that is providing such a boost. Non-oil GDP is rising too. To take Kuwait as an example, NBK says that financial services, transport and storage, communications, construction and manufacturing have all achieved double-digit growth for three years in a row. And in Saudi Arabia, Brad Bourland, chief economist at Jadwa Investments, forecasts the non-oil segment of the Saudi economy to grow at between 7 and 8% through 2010. “The boom continues to build and spread to the private sector,” he says. “From what it originated as – an oil price driven boom, which means government revenues and mega projects – it is now spreading to more non-oil, with private sector enthusiasm across the board. The outlook’s very bright.”

All told, the IMF’s World Economic Outlook predicts 5.9% growth for the Middle East in 2009, and in some nations, notably Qatar and the UAE, analysts sometimes print double digit expectations for near term GDP growth. Perhaps best of all, the Gulf is not at all reliant on the US consumer, hence its decorrelation with world markets. “Look at the number of bullish reasons to invest in the Middle East,” says Smaller. “There’s high growth. In an inflationary environment you want to be in markets with a large attraction to fixed assets, infrastructure, oil and real estate – so the Middle East. There’s an undervalued currency; negative real interest rates, pushing people to invest rather than leave their money in the bank; market multiples below those of other emerging markets but with higher growth; index changes happening; and the fact that it’s not tied to the US consumer. The list goes on.”

So how does all this translate into an opportunity in asset management? In several ways. This increasing wealth is most clearly demonstrated among the region’s vast sovereign wealth funds. None of the Gulf’s SWFs disclose assets under management but they are believed between them to have over US$1.5 trillion under management, with the Abu Dhabi Investment Authority alone believed to have as much as US$875 billion under management, growing by the day. As the next chapter discusses in more detail, these funds are increasingly sophisticated, and committed to the diversification of their wealth outside their home market. That has presented a huge opportunity for international investment managers.

Additionally, growing prosperity in the Gulf has led to a growing mass affluent and retail investor base and also an increasing number of high net worth individuals. These, too, are growing in sophistication, and it is often suggested that the widespread stock market falls of 2006 helped to promote in people’s minds the value of professional management, aiding the funds management industry in reaching out to this client base.

Increasingly, individuals in the Gulf are being encouraged, or obliged, to save. State-run pension funds exist in most GCC states, along varying models but generally taking a mandatory chunk of income and saving it, often with an additional contribution from the state itself. Private sector pension funds are in their infancy but industry professionals expect them to emerge as a force, increasing the pool of institutional wealth to be invested, and again creating an opportunity for well placed asset managers, both local and international.

This shift is generally what has the most dramatic impact on investment management industries: the institutionalisation of individual long-term savings. Consider Australia. It has just over 20 million people yet has by some measurements the third largest asset management industry in the world, with A$1.17 trillion under management in superannuation funds (pension funds) at the end of 2007. This has happened because of the decision in the 1990s to compel retirement savings in tax-advantaged funds by individuals. The rest is just the effect of compounding and time. As Gulf states move towards greater mandatory savings and a more sophisticated pension fund system, the investment management industry should grow accordingly.

The growth of markets themselves also helps. Most GCC stock markets are young; Qatar’s was launched in 1997, and the UAE’s, in their current form (there are two stock markets in the UAE plus a more recent international exchange), in 2000. Most also have few listed securities by developed market standards, with trading dominated by a handful of bigger names. However, the pipeline for new issuance is considerable. SHUAA Asset Management, a Dubai-based fund manager, has estimated that even if GCC stock markets themselves did not move an inch in the next few years, their market capitalisation would double because of the weight of expected IPOs. Stock market valuations are also low by world standards, attracting more investment.

That sort of momentum attracts international attention. And as Gulf economies and stock markets grow, it becomes more and more likely that they will be included in key international benchmarks such as the MSCI Emerging Market Index. The latest thinking is believed to be that MSCI plans to upgrade Taiwan, Israel and South Korea to its developed markets index, and to replace them with Kuwait, the United Arab Emirates and Qatar (a firm announcement on this is expected in June, and any new inclusion would probably be preceded by a full year’s notice). That would require investors who track the index to gain exposure to those markets quickly, vastly increasing the participation of foreign money in local markets and very probably the opportunities for local managers to gain mandates for international counterparts.

Saudi, the biggest market of them all with a market cap of around US$400 billion, is not yet open to foreign investors except through local mutual funds; consequently it won’t be considered for MSCI indices since it’s not considered widely investable. If that changes, the floodgates really will open. “When they open that market, Saudi will see a lot of index investing,” says Shahid Hameed, head of asset management for the GCC at Global Investment House in Kuwait, one of the region’s largest fund managers with US$8 billion under management. “Investors don’t even necessarily need to like Saudi; if they are investing in an index and the index invests in the region, flows will come in.”

And in a global environment like this one, a market that bears little relationship to global equities is particularly welcome. “This region propels ahead on its own dynamics,” says Joel D’Souza, senior investment manager at Commercial Bank of Kuwait. “Kuwait in particular has fared very well compared to what’s happening in the rest of the world.” [At the time of writing the Kuwait Stock Exchange price index was up 17.6% year to date; the Euro Stoxx 50, by comparison, was down 14.5%.]

Getting a handle on just how big the industry, or the opportunity, is, is notoriously difficult. The easiest thing to grasp is mutual funds that are manufactured and distributed in the Gulf – but even that’s not all that easy, with disclosure requirements quite varied and many funds not disclosing their assets under management.

Nevertheless, in 2007 it was commonly said that there was about US$60 billion in mutual funds in the Gulf (this refers to those actually domiciled in the region). Cerulli Associates, in one of the most detailed studies of asset management in the region yet compiled, put the figure at US$57 billion at the end of 2007, although that figure included Egypt with the GCC nations. There are around 500 funds in this category, almost half of them from Saudi Arabia.

When one considers all mutual funds sold in the Gulf – that is, adding cross-border funds being sold from overseas into the Gulf- Cerulli estimated the figure at US$80 billion to US$100 billion. This figure is harder still to pin down, since foreign managers are under no obligation to report such numbers and in some cases may not separate them out anyway.

A far bigger figure is attained by considering all institutional mandates out of the Gulf, and the addressable assets of the sovereign wealth funds. Cerulli estimated that the total assets in the Middle East – mutual funds, discretionary portfolios, and sovereign funds – total US$2 trillion, and total managed assets US$1.6 trillion. This vast difference between mutual funds and total assets helps to explain why most international fund managers who have ventured into the region have all but ignored retail as an asset class so far, focusing their attention instead on sovereigns, institutions and the wealthy – more lucractive, with more to invest, and easier to reach without an expensive branch network.

In some markets, independently managed discretionary accounts appear to be the dominant class, notably in Kuwait. According to data provided by the Central Bank of Kuwait on the country’s investment companies, at the end of 2007 there were KD19.3 billion in portfolio investment, and only KD3.265 billion in investment funds. “80% continues to be managed on a managed account basis,” says MR Raghu, senior vice president of research at Kuwait Financial Centre, also known as Markaz, an investment manager in Kuwait. Whatever the style, the outlook is good. “Asset management growth is a function of two things: organic growth of the market and growth of the savings rate,” Raghu says. “Organic growth has averaged about 17% in the last five years, and growth in the savings rate about 19%. Adding the two, 35% growth should be normal in asset management here.”

In all parts of the market, the outlook is for impressive growth. The market capitalisation of GCC stock markets was about US$900 billion at the end of 2007; that means the local mutual fund industry represents less than 7% of regional market capitalisation. In other developing markets, the figure is much higher – about 25% in Malaysia, for example. The most optimistic groups, such as SHUAA, say the Gulf’s mutual fund industry should be around US$200 billion, and expect it to get there within five years. Others are more conservative, but still expect considerable growth: Cerulli reckons US$100 billion by 2012, implying a compound annual growth rate of 12.7% in assets under management. And all this has been done without any culture of taxation.

Hassam Arabi, managing director of SHUAA Asset Management, expects the regional mutual fund industry to reach US$200 billion in size in the next few years, but expects the presence of international managers in the same markets to be bigger still, at US$500 billion. “What we’ve seen in the last six months is a huge shift, with lots of money coming in from foreigners,” he says. “Seventy per cent of my client base has shifted to foreign, non-GCC investors.” He says SHUAA grew 113% last year in assets under management, almost 90% of it from new funds coming in from overseas.

Additionally, Gulf nations are well aware that oil is a finite resource and are keen to diversify away from their reliance on it. Financial services is seen by many as an area in which they can build presence and skill. This is visible from the rapidly expanding Dubai International Financial Centre to Bahrain’s Financial Harbour towers and the rising skyline of Doha in Qatar, where all three compete to be the region’s key financial centre (see separate article). But there are few sharper demonstrations of commitment than Saudi Arabia’s King Abdullah Economic City. This is envisaged as a hub for energy, finance and transport, and has been reported as involving SAR100 billion of investment, with the creation of one million jobs and a two million population.

“The industry as we see it is still at a very early stage of development,” says Hameed, at Global Investment House in Kuwait. “Traditionally in our part of the world it has been more about asset gathering than asset management. But now we are at an inflexion point where we are seeing institutions, both regional and international, setting up asset management operations, with product manufacturing capabilities on the ground.”

He adds: “We are traditionally exporters of capital, but now we’re seeing international funds investing in our market. It’s a very important change you are going to be seeing now we have reached a size in market capitalisation and liquidity that attracts international investor attention.”