Dubai’s First Hedge Fund Blossoms

Argent's Constans Crescent Investment Fund demonstrates local commitment

Stuart Fieldhouse
Originally published in the October 2006 issue

The almost manic speed with which Dubai has been transforming itself from what one former colleague of mine called “Milton Keynes in the desert” into a world class financial hub, has many bankers and fund managers frantically booking space in one of the brand new high rises that soar above the desert landscape.

The hedge fund industry, by contrast withthe long-only sector, has been a little more sceptical. Given that much of their distribution in the region is achieved through established relationships with private banks and family offices, the promise of future marketing opportunities in the GCC area has little allure.

But at the same time, there is an awareness that there is now more money in the Middle East seeking legitimate avenues of investment than ever before, thanks to the high oil price and a loss of confidence in US-based investments in the post 911 era. According to Dr Omar Bin Sulaiman, Director General of the DIFC Authority, the region has $1.9trn looking for a home.

What could potentially prove to be a landmark event was the issue of the first licence to a hedge fund by the DIFC (Dubai International Financial Centre) in March of this year. Argent Financial Group International, the UK subsidiary of Argent Financial Group, was given leave to operate as an authorised firm in Dubai, paving the way for the launch of the first DIFC hedge fund in August 2006.

The Constans Crescent Investment Fund is a geographically-focused, multi-strategy fund focused on investment opportunities in the greater Middle East/North Africa/South Asia region. It invests primarily in a broad range of publicly listed securities across the capital structure of selected companies in the countries of the GCC, Levant, North Africa, Turkey, and Pakistan. The fund’s objective is to generate consistent absolute returns from a diversified portfolio of securities.

“As London is the established financial powerhouse of the world, Dubai is very likely tomorrow’s global financial powerhouse,” says Howard Leedham, Senior Managing Director of Argent Financial Group. “The incredible vision to ‘build it, and they will come’, is being verified with the arrival of every Emirates Airlines flight. The creation of a ‘zero tax’, financial city with its own international regulatory and legal standing, ready to serve the countries of the GCC and beyond, is innovative and efficient.”

Argent is being very bullish about its new Middle Eastern base: Leedham is already talking about launching “several hedge funds” out of the DIFC, and sees Dubai as potentially becoming the hub of Argent’s entire group of companies. “The possibility of relocating the company’s global headquarters into the DIFC is an evolving and increasingly real consideration,” he says.

This would be no small coup for Dubai: the Argent Group of companies currently manages in the region of $2.5bn in assets over various strategies for both onshore and offshore investors. It now operates from a number of bases around the world, which it has established in over a decade since it was founded, including offices in five US states, and a Financial Analyst platform in Mumbai which will support the launch of Constans Crescent with research and intelligence.

“There was a general feeling that if we were going to launch in Dubai, then we had to be domiciled there from a credibility point of view,” says Tara Armes, Global Marketing Manager for Argent Financial Group International. “Hedge funds aren’t new in the region, but DFSA [Dubai Financial Services Authority] regulated and DIFC domiciled funds are.”

Armes’ view is that establishing a fund in Dubai is a demonstration of faith on Argent’s part that “the DIFC is going to be around for a long time.” Indeed, even the fund’s portfolio manager is operating out of the 8000 square feet of office space the company has leased in the DIFC. It would have been a lot easier to set up the fund in the Cayman Islands, but instead Argent took the time to work with the DFSA, Dubai’s financial regulator, to put the pieces in place to allow for a fully-regulated hedge fund launch.

Two years ago, it would have been arguable that the DIFC was simply not ready to tackle the tricky subject of hedge fund regulation, something that was vexing the best regulatory brains in Western Europe (and the US) at the time. Indeed, the centre’s representatives candidly admitted to this correspondent that their priority in 2004 was to put together the legal building blocks required for a mutual funds regime.

A blank sheet of paper

Dubai’s regulator has been working from something of a blank sheet in this respect: just as the desert represented a virgin canvas for enthusiastic city planners and architects, so the body of law that the DIFC would need to draw up had to be built largely from scratch. In this it has relied heavily on professionals within those firms considering setting up there, and it has been an opportunity for these firms to work with a reputable regulatory agency to procure the formula that would suit them best.

“Being the first real hedge fund group out there, it has been part of our job to educate the market as well, to bring new innovations to the market, hedge fund strategies, alternative investment strategies, and I think that was a commitment we made to the DIFC and to the region,” says Zeeshan Ali, the manager of Argent’s new fund. “If you look at the DFSA regulations, they have reached a level of transparency and stringency that far exceeds anything else you see regulated from abroad.”

Constans Crescent

Ali’s Constans Crescent fund is pursuing a long/short equity strategy within the Islamic world, stretching from Morocco to Pakistan, and from Turkey to Saudi Arabia. The fund is primarily buying public equities, and will be positioned to take advantage of multi-directional market movements in order to capture returns, regardless of market direction.

The range of countries within its mandate have varying degrees of correlation, and widely differing economic profiles. While Turkey has seen massive interest from emerging markets fund managers in recent years, and Egypt was popular in the 1990s, many of the markets Argent will be investing in are rarely represented in the portfolios of conventional emerging markets specialists.

Significantly, Central Asia’s Islamic countries are not on the list at the moment, partly due to the nascent nature of capital markets in that part of the world, and partly because those firms favour a London listing when they go in search of capital.

The region is known to be volatile, and has been criticised in the past for its lack of liquidity, but Ali points out that Saudi’s exchange trades in excess of $5bn per day, on the back of only 80 listings. Turkey trades $800m per day, Pakistan $400m. “If we were to focus on any one country in the region, it would probably be a valid concern, but given that broader mandate we have, across these various sub-regions, you have adequate liquidity to support fund sizes in the billion dollar range.”

There is some correlation between the performance of these markets, and the price of oil, and it is something that Argent has looked at when considering the launch of this strategy, but Ali sees a typical lag factor of six to nine months,and in addition, “a lot can happen [in that time], so it is hard to make any correlation trades using that patten. But definitely in the Gulf markets you see a correlation over time, to the price of oil, but less so in other regions, where there is less dependence on hydrocarbons as a source of GDP.”

With the prospect of oil prices staying high, Ali is expecting to see continuing transfer of wealth from governments in the oil-producing countries into private hands, along with more primary issuance: there is apparently a huge pipeline of companies looking to go public in the region in the next 12-18 months, particularly in the Gulf region.

In 2004-05 a slew of IPOs came to market, and have performed extremely well since listing. Since the beginning of this year, some of that has been cut back, but Ali still reckons there is plenty of liquidity in the market looking for a home, and is confident that more successful IPOs will emerge going forwards. “That’s going to be the primary driver of the oil wealth,” he says.

“As London is the established financial powerhouse of the world, Dubai is very likely tomorrow’s global financial powerhouse”

Sabre rattling, and its effect on equities

Marketing a fund like this is always going to present some difficulties when selling to investors outside the Middle East who are regularly exposed to hysterical headlines relating the latest political crisis to shake the region. Israel’s bombing of Lebanon, Iran’s sabre-rattling with the USA, and the ever-present threat of a general breakdown of political integrity in Iraq, are all contributing to a strong negative sentiment on the part of institutional investors in Europe, the US, and East Asia.

“It’s definitely got be part of your investment viewpoint,” Ali accepts. “Let’s take the Lebanon situation: when that news was first developing, there was a slight sell-off from most of these markets in the MENA (Middle East/North Africa) region, and obviously Lebanon got hit the hardest. But most of these markets rebounded very quickly, even before there was any ceasefire announced; you’re seeing these markets being very resistant to geopolitical events. Obviously, if it had spilled over into a broader conflict, then it would be a different situation, but the fact that it was contained within Lebanon, these markets, after their initial reaction, pretty much shrugged it off and moved on. That’s not to say that the situation with Iran would not suggest greater turbulence in the markets, but those are assessments that are made when making investment decisions in the region, and it has to be part of the toolkit of fund managers focused on the region.”

Shorting in many of these markets remains difficult: Turkey stands out as one of the few exceptions where it is easy to obtain a short position, as many regional bourses are opposed to directional shorting.

Argent is one of the pioneers in this respect, developing shorting mechanisms using OTC swap structures. In its discussions with investors, it is offering hedging mechanisms. Experienced investors in Middle East and North African securities have been through a pronounced boom/bust cycle in equities since 2002, seeing much of the value gained in the previous four years wiped out by losses in the first half of 2006.

Ali sees them being more open now to ways volatility can be limited: “They’re looking for a consistent return pattern,” he says. “There’s a strong interest in any hedging mechanisms that allow them to do that.”

The primary driver for the research team is a bottom-up one, looking for the best companies to invest with across the region. The principal research activity is carried out in Dubai, with support from the platform in Mumbai. Argent has 10 analysts currently focused on the region, as well as making country, macroeconomic, and geopolitical calls. Company visits are a key part of the investment process: the quality of management teams is improving, as big family groups bring in more Western-educated managers to oversee the future of their companies.

“The generational transition going on in the Middle East is an important fact to highlight,” Ali comments. “You’re getting a more sophisticated pool of managers and owners, not only in their internal operations, but in the way they interface with the investment community as well.”

Sectors that have dominated the Middle East historically are banking, construction, and telecoms, which comprise 40-60% of the listed market cap, particularly in the Gulf markets, although more sectoral diversity prevails in non-Gulf countries like Turkey and Pakistan.

These sectors have been behind the amazing performance of regional equities in 2002-05, but higher beta banks have suffered during the downturn this year, while telecoms have held up fairly well. Ali feels there was a near-term bottom to the market over the summer, and is expecting a rally across the board in many sectors as we near the end of the year.

Ali anticipates the fund will average 30-40 securities in the portfolio, a combination of long and short positions. He points out that regional markets can move quickly, and in tandem with one another, so there’s something to be said by being more concentrated in portfolio exposure: “You get the diversity by going across the various markets in the region and through the hedging mechanisms.”

Argent has been actively watching the regional equities market since it opened the doors to its Dubai office in March. The Constans Crescent fund has been trialled via the usual back-testing, stress-testing, and paper-trading, and started managing Argent seed capital in June, awaiting regulatory approval at the end of August. Although the firm cannot currently comment on its performance achieved during this period, it is pleased with the results.

On the marketing side of the equation, Tara Armes has been surprised by the level of interest from investors in Europe, partly due to the volatility in the market, and the numbers regional markets have been able to punch out in the last five years. “I think, initially, institutional investors will wait to see the track record,” she says. Argent is planning to soft close the fund at between $200m-$250m in order to assess the overall risk and infrastructure involved with the portfolio. It may re-open later, and on paper could have the capacity to grow to $1bn, but Armes is offering no guarantees in this respect.

Whatever the outcome of Argent’s deliberations, the real winner here is the DIFC, which can now offer other hedge fund managers a home within the region, particularly those who want to focus their activities on regional markets, or are seeking some form of operational bridge between the Middle East/Eastern Europe, and the Asian markets. Expect a small club of hedge funds to be in place in Dubai before too long.