New frontier escapes the effect of the credit crunch

Originally published in the October 2008 issue

In recent months, the United States and Western Europe equity, bond, commodity, currency and property markets have not been good options for investors. Volatility combined with investors’ hesitancy to invest new money has meant that many hedge funds have had to look elsewhere for sources of alpha. Asia might seem a likely place to turn to, but by and large they have suffered tremendously too in recent months. As a result, many hedge funds and private equity funds have been looking at the Middle East as a source of new investment opportunities.

The new frontier?
Dubai, and the Dubai International Financial Centre (DIFC), has become the flagship locally for the Gulf Cooperation Council (GCC) and Middle East and North Africa (MENA) region in terms of financial services. The Dubai Financial Services Authority (DFSA) has played a pivotal role in this development. Its robust regulatory approach, based on the UK’s Financial Services Authority (FSA), means that anyone wanting to set up offices in the DIFC must meet stringent regulatory requirements and best practice standards. The advantage of being based there is to be acknowledged as a serious market participant not just in the Emirates but throughout the region. In addition, those licensed to base in the DIFC benefit from the networking and other less tangible factors of a like-minded group concentrated in one area and those not located there may find they become marginalised. Indeed finance has become a principle focus for Dubai as part of a movement away from dependency solely on oil dollars. A strong, locally regulated regional centre for finance is positive for the local economy and the MENA region.

There are other ongoing initiatives designed to cement the DIFC’s position as a centre of excellence for financial services. There is the stated intention to build a ‘hedge fund hotel’, the vision being to create a hedge fund community on the ground to offer new and innovative products, especially as new types of instruments come to the market. The advent of ETFs, which may be coming, followed by the opening up of the local market to more hedge-type strategies would be a welcome step forward.

There is also the Family Office initiative, with recent regulatory changes aimed at facilitating and encouraging family offices to enter into the environment. Clearly such entities add great liquidity and would benefit from easy access to the community and available expertise. (On this note, a recent Barclays and Economist Intelligence Unit report shows that high net worth individuals are more likely to increase risk in times of increased volatility. The timing could be very good for those with risk appetite). Additionally, Dubai is in a position to plan its economic and cultural development, at least to an extent. As well as creating a strong financial environment, Dubai has physically expanded at a frenetic pace with hotels, offices, residences and leisure facilities rising out of the sand almost weekly. A variety of sports venues including a special zone, tourism, media, IT and numerous other projects are either in development or on the drawing board, and these expansion plans highlight the positivity coming from the region in a world where everyone else has been forced to do a certain amount of soul searching.

This growth is set to continue with Merrill Lynch predicting that GDP will hit US$220 billion in 2008, up 6.4% on the previous year. Non-oil foreign trade averaged 73% of GDP over the last three years and this development has meant that foreign investors have more confidence in the region, encouraging them to set-up offices and, in turn, creating a virtuous cycle, strengthening the economy.

Opportunities abound
The expansion in the region has been facilitated by the cooperation of local businesses and government, as well as foreign companies providing investment, expertise and ideas. The combination of development of infrastructure and high levels of foreign investment makes the region attractive to many investment managers, both traditional and alternative. The rapid pace of development has created abundant investment opportunities; from property to natural resources, mining, minerals and alternative energy. In addition the market for tourism has expanded rapidly with new hotels springing up all the time. Attractions such as Disneyland, Legoland, the ski slope, world class sporting events, the QE2 and many others are blossoming. All of this means that investment managers have a plethora of opportunities to create alpha and at the same time to participate in the development of the region.

Dubai in particular has respondedwell to this increased level of investment interest, by creating an environment which enables managers to be exposed to these opportunities and which helps to ensure fair play. The stringent admission criteria from the DFSA for those who wish to locate in the DIFC and their regulatory infrastructure goes a long way towards this goal, and may have had no small part to play in the fact that Dubai has not felt the effects of the credit crunch as sharply as other economies.

Increased appetite for alternatives
With the increase in wealth experienced by the region, there has been an unprecedented increase in the interest in alternative investments. Many have set up funds that either invest in the Middle East as part of the strategy, or are completely focused on the region, taking advantage of the boom in construction and the newly relaxed conditions around investing in the Dubai and other MENA stock exchanges. Additionally, the development of Shar’ia compliant products has given high net worth individuals in the region access to products similar to ones which Western investors are used to. Middle East-specific products have also been developed, for example Sukuk bond funds have received widespread acceptance, although not without some controversy. There is also some speculation that in the not too distant future other opportunities may appear, for example the ability to short the local markets. In fact, the Dubai Multi Commodities Centre Authority (an agency of the Dubai Government) announced in June this year that it is going to seed the first Islamic Fund of Hedge Funds. According to the Middle East Economic Digest, foreign investment funds have boosted their exposure to the largest stock markets in the MENA region by more than US$1 billion in the first seven months of the year. Such changes could pave the way for hedge funds to play a greater part in the development of regional markets.

The wider picture
Dubai is by no means the only place in the GCC that offers investment opportunities. Saudi Arabia, Bahrain, Qatar and Kuwait as well as the UAE are all in the World Bank’s top 50 most open economies. Increased political stability in traditionally unstable states means that the development seen in the UAE and other nearby countries is starting to happen in places like Lebanon and Libya.

The MENA region is in an enviable position of stable economic and structural growth and, although many states are moving away from dependency on oil money, there will still be an overwhelming need from the West for oil. The combination of stable medium term oil dollars and the pace of economic development means that the MENA region offers investors an immediate and a longer term source of alpha in a world that can change radically over the course of a single day. THFJ

Jim Quinn joined the Lionhart Group as a consultant in 2006 and has been involved in setting up the newly opened Dubai Operation