Middle East loses its allure for foreign managers

Cerulli Global Edge, January 2010

Two years ago international fund managers were excited at the possibilities arising in the Middle East. Soaring oil prices were driving exceptional economic growth; stock markets had proven themselves uncorrelated to those in the rest of the world; the region’s vast sovereign wealth funds – including by far the biggest in the world, the Abu Dhabi Investment Authority – were showing an increasing willingness to give their portfolios out to external managers to run; and the biggest market of them all, Saudi Arabia, was starting to open up to the world.

In the time since, much has gone wrong. The Middle East’s stock markets did stay uncorrelated for the opening months of the financial crisis – but then fell just as far as everywhere else, only faster. “What world markets had experienced in six months, we experienced in six weeks,” says one local fund manager ruefully. The oil price plunged from US$140 a barrel to US$37 before recovering (to US$82 at the time of writing), and not all economies have followed the rest of the world in emerging from the global crisis. Dubai, in particular, is still in the thick of debt restructuring problems, while Saudi, the main prize in the region, has been mired in high-profile defaults.

The fundamental problem for foreign fund managers, in a nutshell, is this: the foreign money that was coming into the Middle East has to a large extent left, and, worse, it hasn’t come back. International capital fled all emerging markets as the global financial crisis kicked in, but many of them – especially in Asia – have enjoyed a surge of returning capital as institutions have regained risk appetite. But the money doesn’t seem to have returned to the Middle East.

At the heart of this problem is the fact that the Gulf Cooperation Council (GCC) nations don’t appear in the major international indices that global capital usually track. A year ago the expectation was that Kuwait and the United Arab Emirates would be added to the MSCI Emerging Markets index, which would have prompted a huge increase in the volume of funds that would have sought allocation in the region in order to match their benchmarks. But that no longer appears to be on the cards, at least in the short term. The region’s biggest market, Saudi Arabia, won’t be added to an index until it becomes easier for foreigners to own shares in the country: at the moment, a proxy security called a P-note is used to create synthetic exposure to Saudi stocks, rather than foreigners being able to own the securities themselves. (Even that’s an improvement: until recently foreigners could only get Saudi exposure by buying a Saudi Arabian mutual fund.)

And if international capital isn’t going there, the local money isn’t proving as easy to get as many had hoped. Few foreigners want to go after retail money, which can only really be reached by the widespread local bank distribution networks. The sovereign funds of Abu Dhabi, Kuwait, Qatar and (through its central bank) Saudi Arabia are still among the most powerful institutional investors in the world, but were burned badly in the crisis, with several having bought into US banks far too early; nursing their wounds, they have started to focus more on investing in their own region than the west, which doesn’t help international asset managers pitching for their business. Additionally, they have raised the bar on the strength they require in their counterparties, which has the effect that investment managers either need a very strong parent or a long-standing and happy existing relationship with the fund in question. The barriers to entry, high already, have got higher. For many fund managers, the real target is the large family offices that exist in places like Saudi Arabia, Kuwait and the UAE, though the suspicion remains that the real money there goes straight through the private banks of Geneva, Zurich and London rather than being captured and serviced on the ground in Riyadh, Abu Dhabi or Kuwait City.

That said, there is still a decent investment case for the Middle East, and until Dubai’s near-default on its Nakheel sukuk in December (see separate article), there was a growing sense that the region offered some of the most tempting valuations in world emerging markets. The fundamentals, although interrupted, are still impressive: Middle East GDP doubled between 2002 and 2007, according to Morgan Stanley; national income in the GCC nations averaged 19% growth in the four years to 2007, with per capita GDP averaging 15% growth through that period; and population demographics are in a sweet spot with a total labour force of 185 million expected by 2020 and a declining age dependency ratio, according to the International Labour Organization. Despite oil’s fluctuations, those pre-crisis trends should continue as the region emerges from crisis – and although the falls in oil prices didn’t help Gulf economies, the truth is most of them break even (in terms of balancing the budget) at between US$25 to US$45 per barrel, meaning there is still plenty of revenue to support infrastructure development.

So how should fund managers play the region? The trend pre-crisis was for more and more fund managers to set up in the region – typically an office in Bahrain or the Dubai International Financial Centre – and staff it at first with a sales presence. These groups would typically then target institutions rather than retail, or would supply local banks with product (sometimes white labelled, sometimes co-branded) to distribute through those local branch networks. Only a handful ever put manufacturing on the ground here: examples are Schroders, which runs a Middle East fund that is sold both internationally and regionally; Credit Suisse; ING; and Deutsche, which has pulled back from asset management globally and has reduced its manufacturing presence in Dubai. Another approach was taken by Franklin Templeton, which bought a 25% stake in the Dubai-based boutique, Algebra Capital, and uses that for its product manufacturing needs. Several other groups offer Middle East expertise to those who need it – private clients, for example – or use London-based teams for whatever Middle East stock exposure they need in global or regional portfolios. For the moment, there’s little reason to advocate international managers pushing further into the region than they already have.

The argument as to which centre foreign fund managers should use has died down as economic activity has faded. Bahrain remains the place with by far the most registered foreign funds; Dubai has probably attracted the most foreign names, albeit often with a skeleton presence; and Qatar, despite successes in other areas of its financial centre, has only really attracted one big name on the asset management side – Axa.

Saudi Arabia is a separate case. Saudi is the market that matters most in the Middle East: the largest economy, the largest domestic mutual fund industry, the most oil, the richest people. Foreigners have historically been limited in their involvement in this country, but several have stakes in local partnerships: HSBC (in SABB), Goldman Sachs (in NCB Capital, the investment banking arm of National Commercial Bank), RBS (in Saudi Hollandi, through the old ABN Amro business), Credit Agricole (in CAAM Saudi Fransi, a JV with Banque Saudi Fransi), and BNP Paribas (in The Saudi Investment Bank). Each of these therefore have a stake in highly active local funds management businesses, with the HSBC/SABB and Goldman/NCB Capital (through its Al Ahli range) among the most powerful in the country, although they don’t have overall control either of the revenues or the direction of the businesses.

On top of that, the arrival of a new regulator, the Capital Market Authority (CMA), in 2003 led to major changes in the financial services industry in Saudi Arabia, and has included the issuance of dozens of new licences in recent years. Many of these have involved foreign partners, among them Credit Suisse, Morgan Stanley, JP Morgan and Merrill Lynch (now part of Bank of America). In practice, many of these licences are being used more for brokerage than for asset management, but they do have the right licences to grow businesses in this area and one of the key developments of the next few years will be the methods they use to do so.

In sum, the Middle East still has the same potential it always did, but global fund managers will see little reason to build a substantial presence on the ground without evidence of two things: foreign money wanting to be deployed in Middle East markets, and Gulf sovereign wealth funds wanting their investment managers to be based in the region.