Absolute Return Investing Arrives in MENA

Foundations in place for expansion in the region

Originally published in the January 2010 issue

Although fundraising remains somewhat challenged due to the tough economic conditions following the 2008 credit crunch, prevailing circumstances and recent market recoveries are nonetheless conducive for launching a Middle East North Africa directional absolute return strategy. This is due to a number of reasons.

Record low equity prices (even despite recent rallies during March and August 2009), severe market inefficiencies and very attractive company valuations continue to make this the most opportune time to invest in what looks like the beginning of a new market cycle. This is further supported by the fact that more than 25% of MENA equities are currently trading below book value. Even though cash flow analysis in tough times becomes the barometer for corporate soundness over traditional book value measures, it is the case that current miss-pricing and distressed valuations are masking companies that offer hidden values, notably large cap companies including real-estate and construction companies.

Existing and new investors have been discouraged and disappointed by the performance of specialist long-only managers in 2008. The severe deterioration in NAV has meant losses in some cases of more than 50%. Despite this, given prevailing low equity valuations and the potential upside from here, investors will continue to seek a net long strategy of some form. However, to prevent the repetition of NAV destruction achieved by most long-only strategies in 2008, some investors will prefer a strategy that is able to capture expected upside potential in public equities but one that is also absolute return driven in nature with true embedded risk management parameters in order to manage volatility and minimize any downside especially as early cycle days remain a bumpy ride.

The expansion of regional prime brokerage activity by large international banks and today’s availability of instruments including leverage, synthetic shorts and access through total return swaps, and index derivatives for hedging make it possible to run an absolute return strategy. And thanks to the credit crunch timing could not be more suitable for start-up asset management companies and hedge funds as these large brokers are now more susceptible to the idea of cooperating with start-ups providing them with select prime brokerage services. Furthermore, the controversial subject of counterparty risk can now be mitigated by the use of a network of brokers, an argument that is now accepted by most brokers. This is clearly an advantage for start-up hedge fund managers today.

Finally, although we have seen an influx of foreign institutional investors including some hedge funds into MENA markets that started in Q4 2007, the bulk of absolute return or alternatives investors are still missing for the most part. In 2007, MENA markets were placed on a global pedestal at least from the perspective of frontier emerging markets. This fact coupled with current depressed valuations following the 2008 credit crunch is sure to bring new foreign investment especially from funds of hedge funds for the foreseeable future. Over $1 trillion remains in the hands of FoHF managers and over $1.8 trillion remains in hedge funds in total as per a recent Hedge Fund.net report. This represents an opportunity in itself especially in a region that lacks a true MENA specialist alternative investment manager with core talent, proven long-term track record and a compelling investment strategy.


Investment philosophy and rationale
The investment process of GulfMENA is based on more than two market cycles of experience (1995-2008) and has been modified further to complement these markets as they enter a third but more mature and robust market cycle.It takes into consideration the stage of development of the markets and the nature of economic drivers affecting the corporate earnings growth of underlying listed companies. It also observes evolving dynamics affecting market performance such as the entry of a new breed of foreign investors that includes hedge funds, prime brokers and the instruments they use, such as SWAPs, synthetic shorts and derivatives. Top-down macro thematic and dynamic asset allocation (for both tactical and strategic) remain at the core of the investment process. When managing SHUAA Capital’s single strategy, the Gateway Series, this proved to be the ideal investment approach as demonstrated by our 8-year track record from 1 March 2001 to 30 June 2008. This will continue to represent our core strategy and play a pivotal role in the investment process going forward. Several things explain the rationale behind the process and its overlays and investment components.

The majority of listed companies in the MENA region remain in basic and simple forms of industry. They continue to rely heavily on domestic activity fueled by petrodollar government spending (i.e. cement, banking, real-estate, construction, telecom and services). It is unlikely that bio tech firms or computer chip manufacturing companies or other equally sophisticated industries will be established in the foreseeable future. Furthermore, very few companies are exposed to external factors and changing global trends (petrochemicals, fertilizers and a few export oriented companies in places like Egypt, Jordan and Morocco). Companies within vital economic sectors such as oil and gas, aviation, transportation and utilities remain mostly in government hands including recently announced renewable energy projects. As such, the majority of listed companies continue to rely heavily on government spending for their growth which is a function of oil revenues, budget surpluses and expansionary fiscal disciplines. Similarly political stability, government reforms and fiscal prudence continue to either drive or hinder bottom line corporate earnings growth in non-oil producing Arab countries like Lebanon, Morocco and Egypt. The oil play and government spending scenario covers the bulk of listed companies in the region (over 80% of market cap) and explains why a top-down macro thematic approach remains pivotal to generate alpha in the years to come.

As a result, large caps continue to dominate the markets especially in terms of liquidity and contribution to the bottom line growth of aggregate earnings. They are primary beneficiaries of government spending and contracts being awarded in the region, especially in the Gulf Cooperation Council which accounts for over 85% of MENA market capitalization. Most large caps are likely to have government shareholdings. This is why large caps continue to represent a main source for growth and value generating the bulk of alpha for the investment team. This also explains our fund’s ability to offer weekly liquidity since it is concentrated on liquid large caps.


MENA Economic Integration
Economic integration is also becoming more apparent within MENA economies and Arab markets are emerging as a single asset class, potentially forming a mega economic block. This might explain why, at times, these markets may exhibit positive correlations and suffer from contagion effects. However, during normal market conditions, and where there is no global credit crunch, market fragmentation reflected by more than 15 stock exchanges continues to offer low interregional correlations. It is the ideal ground for fund managers seeking diversification and adopting a dynamic asset allocation approach (country, sector and theme), a main characteristic of our investment strategy. A case in point is Kuwait’s performance in 2009 (-14.15%) versus Saudi Arabia (+30.05%).

One of the team’s key strengths and distinguishing tributes is its ability to identify value in under-researched MENA companies. Small and mid-cap markets (i.e. with companies worth under $100 million) are still in the early stages of development. They are immature and relatively illiquid. Many still do not offer true value and most suffer from small free floats which hinders any potential M&A activity. Yet this is a segment that is growing and may, over the next few cycles, offer true alpha generation on a pure standalone basis. Currently, however, there is only capacity for a few such plays in the region. If limited to 20% of NAV (as an overlay only) it will not affect overall fund liquidity but will surely enhance fund performance. There are now over 500 companies that are below $100 million in market cap, which are mostly under researched. GulfMENA will dedicate an overlay strategy to this segment with a pure bottom-up approach for companies that offer a true value proposition and can qualify as a special situation (i.e. be it turnaround or event driven).

During 2007-2008 MENA markets became a hot spot for a new breed of foreign investors including hedge funds, funds of funds, family offices and global asset managers. This was fueled by newly introduced prime brokerage activity offering wide sell side coverage on leading stocks and facilities such as total return swaps, derivatives, futures, options and synthetic shorting instruments on a few stocks and select Arab indices. As a result, volatility which is typical in emerging markets surged to new heights. Managing volatility and understanding market momentum need to take centre stage within any investment strategy in the future. This in itself represents an opportunity for idea generation in a multitude of trading strategies. Hence why our investment strategy will include an overlay that will help minimize portfolio volatility and benefit from some trading tactics. The background, rationale and testing of this component is explained below.

Furthermore, oil futures, options and the dollar, among other instruments introduced recently, offer interesting correlation plays. These instruments will be deployed through an overlay hedge strategy when needed in order to hedge positions and ensure consistent positive returns. Buying a put option on oil to hedge against positions in Saudi is an example which works well when short-term correlation between Saudi equities and oil prices is high. The hedge will focus on the dollar amount that could be lost in the event that long positions are stopped due to tight risk management controls adopted by the strategy.

The changing landscape and inherent volatility places higher emphasis today on portfolio construction and risk management techniques. For example, tight controls with stop losses and rolling stops will be observed at all times. Portfolio construction rules also place emphasis on liquidity criteria and the division of our investable universe into tiers. There are specific guidelines to follow within each tier category and more specifically within each overlay. Despite liquidity rules, particular emphasis will be placed on capacity override rules which will be observed at all times.

Irrelevant of which strategy GulfMENA will introduce in the future, our investment philosophy relies on the conviction that risk management will form the basis for achieving long-term superior returns if we consistently observe and review the three pillars of our approach to investment: risk management, liquidity and capacity rules and portfolio overlay hedge strategy.

Investment strategy
Following the MENA equity crash of 2005-2006, we realised the need for an absolute return type strategy which would better suit investing in these markets. Given the few available shorting instruments at the time, and while still at SHUAA Capital, I incubated an internal portfolio, the ‘Arab Momentum Fund’ with $20 million of company capital. The portfolio’s main engine was a proprietary model that had been developed over several years during the time I managed SHUAA Capital’s activelong-only equity funds. The model centred on momentum analysis and trending, sending multiple signals derived from market dynamics such as liquidity, volatility, volume analysis, technical patterns and formations.

The model proved extremely useful in producing alternative trading strategies and ideas including opportunities for equity arbitrage and shorting. However, the second most important outcome was the model’s ability to act as an early detection system or EDS especially when it came to identifying opportunities within under-researched small and medium size companies as well as identifying overall market directions that would be extremely useful to strategic asset allocation decisions and trading ideas for existing core holdings. The model had the ability to screen more than 1,600 companies, namely, all of the MENA market capitalisation, including large cap companies. The model’s capability in identifying event-driven and turnaround stories would give buy-side analysts a time advantage during which they could investigate and conduct full fundamental analysis, provide recommendations to increase positions and decide how to treat the position (e.g. as core strategy, as special sits or neither.)

Based on this model, GulfMENA’s analysts and fund manager will spot and take advantage of opportunities long before the systematic fundamental screens discover them. Furthermore, the model allows the fund manager to partially position and take advantage of the momentum play (i.e. as part of the alternative trading strategies component with momentum set targets and rolling stop-losses but not at the same position size that is otherwise allowed by the other overlays) until the analysts are able to conclude their deliberations. The success of the incubator strategies, the EDS factor and the proprietary model supporting it therefore proved to be instrumental to any core strategy.

In August 2008, following the incubator’s record of successful performance GulfMENA decided to launch a directional absolute return strategy that would invest in MENA public equities. The main approach continues to build on the core directional top-down macro thematic and fundamental bottom-up stock selection where the track record was successful and the investment process was proven. This approach remains pivotal for capturing alpha in MENA markets given their reliance predominantly on government spending and oil revenues as the main engine of growth in corporate earnings, especially for large caps. However, the strategy is modified further to include two other overlays or investment components: an alternative trading strategies component (using the proprietary model of the incubator) and a special situations component (aided by the incubator’s model as an early detection system). Combining the two additional components with the core strategy aims at significantly boosting alpha and achieving better diversification results through the overlays. In turn, this will optimize returns on a risk adjusted basis yet without jeopardizing overall liquidity of the fund or the investment strategy.

The core strategy will have a long bias with opportunistic short extensions. All investment components (i.e. core plus alternative plus special situation) are then wrapped by an overlay hedge strategy and a unique portfolio risk management platform. The latter will be instrumental in achieving absolute return results while keeping overall liquidity in the fund or in the investment strategy high. Combining strict risk measures, including rolling stop-losses with liquidity parameter and capacity control monitors and override rules simultaneously will give GulfMENA and its risk management platform a unique edge, while the overlay hedge strategy (which will cover no more than 10% of NAV) will ensure minimal portfolio volatility and consistent positive returns when the fund manager deems these necessary to use.

The core investment component will ultimately represent up to 70% of the fund’s NAV and is predominantly large cap focused, which should keep overall liquidity high and allow the fund manager to offer weekly fund liquidity.

Exposures through a typical cycle
Our flagship fund, GulfMENA Arab Opportunities Fund Limited, is designed to take advantage of current short-term market inefficiencies, whilst being able to capitalise on long term directional opportunities. The fund is literally designed to work during all stages of a market cycle capturing full upside during the bull period and hedging the downside during the bear period. It will adhere to stringent risk management and portfolio construction parameters such as stops and rolling stops in addition to an overlay hedge strategy that is designed to minimise volatility aiming at preserving investment capital during all market conditions. It will also observe strict liquidity criteria and capacity over-ride rules which are built into the strategy to ensure high liquidity levels that allow it to be open-ended and to offer weekly liquidity, unique to most hedge funds.

Absolute returns funds in Gulf/MENA

In general, equity focused absolute return strategies in developed markets tend to rely heavily on derivatives. Their aim is usually to secure consistent incremental alpha while entirely eliminating beta from the portfolio.

One example is pair trading where fund managers go long high yielding stocks and short low yielding stocks. But to enhance the yields spreads, absolute return managers then gear up using high leverage and ultimately end up generating bond-like returns.

Our strategy is different. Gearing does not exceed 20% of the fund’s NAV and is mainly used to bridge subscriptions and redemptions. The strategy has the tolerance to take on board market risk when risk is warranted and focuses predominantly on direct equity investments; at times, it uses derivatives for hedging purposes. The result is a flexible chameleon type strategy that suits the different stages of a market cycle. It could almost be considered relative value when markets are bullish and directional and it is a typical hedge fund strategy when markets are bearish and non-directional.

Shorting issues and accessing Saudia Arabia
Shorting is currently possible through synthetics offered by most prime brokers. It is costly and the universe is limited. However, inventories are expanding and are estimated at $20 billion. Getting access to Saudi Arabia, the region’s biggest market, has moved ahead significantly. In 2008, Saudi Arabia passed a law allowing non-Saudi investors access to its market without any restrictions throught total return swaps. The idea behind this is to offer foreign investors 100% access and the full economic benefits of the underlying equities without forfeiting voting rights.