Cerulli: Saudi Opening a Landmark for International Asset management

In terms of the actual commitment of capital, a total of just $126 million of Saudi Arabian stock market assets are held under the QFI framework, barely 0.03% of the Saudi market – and $115 million of that came from the transfer of existing holdings through the previous P-note structure for investment. In other words, it’s money that was already there, just synthetically rather than in the underlying stock. Putting that to one side, the total accumulated net investment under QFI is a negligible $9.2 million.

But one should be cautious about reading too much into these six-months-in numbers, for several reasons.

Firstly, clearly, it’s early days. Al-Ghamdi was sharing these numbers at a multi-city roadshow designed specifically to attract institutional money, and it would be fairer to see what the number is in another six months, once the many people who attended have had a chance to consider their position. Secondly, Saudi hasn’t taken a scattershot approach to attracting money and in fact has deliberately made it difficult to get in in order to attract the right kind of money, money that doesn’t rush: prior to the roadshow, Al-Ghamdi had been in Tokyo trying to get pension fund money, which is the sort of capital that takes a long time to commit but, once it does, is very sticky and durable.

Thirdly, one has to sympathise with the timing of the Saudi market opening: it coincided with a plunge in the oil price that has only got worse ever since. In fact, surprisingly, very little of the Saudi market offers direct exposure to oil (though petrochemicals are a fixture), but that doesn’t change perception that this is a lousy time to seek exposure to the Gulf.

Fourth, there are some complexities of regulation that need to be ironed out before some big names commit. Franklin Templeton and Lazard, for example, are both holding back on an application while they seek to gain clarity on a rule that says that any individual pension fund can only be represented by one QFI – so, for example, if Calpers wanted to be exposed to Saudi, it could only have one broker or fund manager invest on its behalf, and if a second manager under its instruction (perhaps one with a broad emerging market mandate, for example) wanted to put some money in Saudi too on Calpers’ behalf, it would not be allowed to do so. There is a process to apply for exemptions, but the idea is putting some fund managers off.

There is also some uncertainty about how the practicalities of stock buying will work for international investors. Saudi operates on a T plus zero model, meaning settlement takes place on the same day the trade is made; that works fine in a domestic retail-dominated market, but doesn’t work for foreign institutional investors who are used to the T + 3 model commonplace in most developed markets. In practice, it means they will need to pre-fund trades by depositing money with a local custodian (a situation that is believed to be benefiting HSBC, as the only institution in town that can say it is both a truly entrenched local sub-custodian and a global custodian).

Also, there is a feeling that the big money won’t commit to Saudi until the market is part of the MSCI Emerging Markets index. Saudi is very keen for that to happen, and hopes it will do so as soon as it is eligible in 2017, but MSCI itself has told the author that 2017 would be the earliest possible time and is by no means a foregone conclusion. Nevertheless, it is unlikely to be much later than 2018, and when it happens, Saudi, the UAE and Qatar (both of which have stepped up to the index in recent years) will all be part of the emerging markets index, representing far too big a bloc for fund managers – and not just passive managers – to ignore.

What does all this mean for cross-border domiciles like Luxembourg? In time, there will be opportunity for structuring to take place in here, in order to build vehicles for investors to gain exposure either directly to Saudi Arabia or to broader MENA portfolios. But now is probably not the time to do so. Regional funds that may end up having direct Saudi exposure, however, are in some cases already UCITS registered in Luxembourg or elsewhere; one version of Schroders Middle East Fund, for example, is domiciled in Luxembourg. Additionally, some domestic Saudi Arabian houses offer UCITS versions of their funds already: NCB Capital, for example, offers a Saudi Arabian Equity Fund and a GCC Equity Fund registered with the Central Bank of Ireland.

For Saudi-specific investment, Blackrock has clearly decided that the best way to offer exposure at this stage is through a New York-listed ETF: passive exposure to the whole market for those who want to dip a toe in the water, perhaps as a contrarian position for investors who think the oil price can go no lower.

Investors on the ground – particularly at domestic Saudi Arabian houses – say that passive exposure is not the way to approach Saudi, partly because the quality of companies and disclosure varies dramatically (one manager recalls being marched out of a factory by security while attempting a due diligence visit), and partly because it isn’t a particularly good time to be exposed to hydrocarbon-related stocks like petrochemicals (notably Sabic, by far the largest listed stock in the country). Fund managers tend to find better value in consumer stocks, and in the well-capitalized banking industry; National Commercial Bank’s 2014 IPO was the second-biggest in the world that year after Alibaba despite being entirely domestic.

Managers who want to take active positions can now do so through QFI, or can invest in mutual funds offered by big Saudi Arabian institutions such as Al Ahli (the fund range from NCB Capital) or Al Rajhi. Managers in the Gulf and, theoretically, worldwide can offer these products on a badged basis if there is demand for them; for a time, this was the only way to gain exposure to the Saudi market at all for international investors. These offerings can be quite sophisticated, including equity funds, income funds, alternatives, structured products, discretionary portfolio management and equity builder certificates. There are some sector-specific funds available, and Islamic finance is the dominant form of investment in the country, at least at the retail level.

One other important point to remember is that fund managers have already been able to gain synthetic exposure to Saudi Arabia for quite a while – and they still can. Saudi offers a sort of P-note approach, a swap mechanism that gives exposure to the performance of a stock, but not the underlying security (and consequently no voting rights). This is not the cheapest or most efficient way of gaining exposure, and stops an investor being an active participant at AGMs, but it does work, and some fund managers have opted to stick with it for the moment rather than going through QFI certification. What they can’t do, though, is be both: fund managers have to be entirely QFI making direct investments in Saudi securities on the exchange, or entirely synthetic. No middle ground – half of one, half of the other – is permitted.