Gulf Cooperation Council Region

How can hedge funds enhance their risk/return profiles?

SULAIMAN T AL-ABDULJADER, COAST INVESTMENT AND DEVELOPMENT COMPANY

Much has been debated about the extent of government intervention and the ideal magnitude of regulatory enforcement in capital markets. The GCC region is no exception, yet with sharp market declines come fundamental opportunities. As investors observe the contagious effects of global financial market breakdowns, it is interesting to place a focus on markets with minimal integration through various market cycles. Hedge funds search constantly for markets with low correlation and substantial growth potential. This article intends to shed some light on a relatively untapped region and explores opportunities in the GCC markets.

Despite the obvious reliance on petrodollars as the main source of governments’ revenue (holding around one third of the world’s proven oil reserves), a closer look into the region’s capital markets seems to identify some key characteristics that are worth analysing in relation to major global markets. Evidently, the GCC capital markets are on the path to becoming a recognised economic bloc. With an aggregate market capitalisation in excess of US$1 trillion and a double digit CAGR, market valuations remain attractive as the average price/earnings multiple is approximately 15.6. Nearly 640 companies are listed on GCC stock markets representing a variety of sectors mainly financials, telecommunications, real estate and construction materials.

The GCC markets are viewed as newly established markets. However, the Kuwait Stock Exchange, the oldest in the region, has become a proxy to the GCC since the late seventies. It was only relatively recently, no more than a decade ago, that the neighbouring markets were officially recognised. The fundamental question then becomes: How can global hedge funds enhance their risk/return profiles? And what are the ideal vehicles for efficient and transparent investments in the region?

GCC markets: why invest?
We begin with the global perspective of the benefits of investing in the GCC markets. Gaining exposure to emerging markets has become a growing asset class in global portfolios. Many studies suggested that region or country allocation is preferred over security selection, especially when it comes to emerging markets.

The benefits of international diversification were long proven by studies such as Solnik (1974), Lessard (1976) and Biger (1979). After the classic Markowitz (1952) modern portfolio theory, Black and Litterman (1992) introduced a model of strategic asset allocation using reverse optimisation. To illustrate the benefits of GCC as an “emerging market” allocation compared with BRIC, we constructed two global all-equity portfolios, one with BRIC as an emerging market and the other with GCC over the same period and spanned over six years. Figure 1 shows the two efficient frontiers and finds the portfolio with the GCC exposure (proxied by Kuwait) to be pushing the efficient frontier northwest.

coast1a

However, the apparent unfamiliarity of global investors with the region’s capital markets requires addressing the key challenges and the options available for a transparent and an efficient access.

Traditionally, global investors are concerned about the heterogeneity of trading rules, time zone differences, trading hours and liquidity. For instance, the Kuwait Stock Exchange applies a ‘unit bracket’ system by which a predefined number of shares are set for a given transaction in the cash market. As a result, an ‘odd lot’ market (also called fractions market) is used to trade number shares not constituting a complete unit. Another possible concern is the various foreign ownership restrictions.

On another note, Saudi Arabia is the only exchange in the GCC that trades on Saturdays and implements a two-session trading day. Global investors would also be concerned about different trading days compared with other developed markets.

The GCC ex-Saudi markets trade Sunday to Thursday. Currently, the derivatives market in the GCC is not fully developed to facilitate trades of different time zones. Kuwait is the only stock market providing long only futures and options trading. That limits hedge funds to indulge in synthetic shorting by applying various long/short strategies. Table 1 illustrates the current stance of derivatives in the regional stock exchanges.

Coast_ table1a

Despite the challenges portrayed above, indexing and index-related products, such as ETFs, are allowing investors ease of access and are seen as the ideal vehicles for investing. Since 2006, GCC capital market participants realised the benefits of indexing not only being a mere benchmarking tool, but rather an adequate benchmark for fund performance analysis and compensation arrangements.

Indexing also provided an independent and a passive approach towards market exposure. Up to June of this year, there were no ETFs replicating the region. Only a few months ago, five ETFs were launched in both the US and London stock exchanges. ETFs can also act as the starting point for other structures that can be extended to global hedge funds such as listed equity derivatives, capital guaranteed notes and quantitative index-linked notes. As the appetite picks up on index-related products, ETFs can become the underlying basket for such products.

Conclusion
As the recent growth of GCC economies has been reflected in the performance of the GCC stock markets, global investors began to appreciate the diversification benefits of investing in the region as part of the ‘emerging market’ asset class.

Strong market fundamentals and predicted economic indicators in the region provide general optimism on future performance. The aggregate market conditions are expected to drive further innovation and stability in the region.

Sulaiman T. Al-Abduljader is Vice President, Coast Investment and Development Company, Kuwait

REFERENCES

Al-Abduljader, S, 2008, “An Empirical Investigation into the Workings of an Emerging Stock Market: The Case of Kuwait”, PhD thesis, La Trobe University
Biger, N, 1997, “Exchange Risk Implications of International Portfolio Diversification”, Journal of International Business Studies 10, pp 64–74
Black, F and Litterman, R, 1992, “Global Portfolio Optimisation”, Financial Analysts Journal 48, pp 28–43
Lessard, D R, 1976, “World, Country and Industry Relationships in Equity Returns: Implications for Risk Reduction through International Diversification”, Financial Analysts Journal 32, pp 32–8
Markowitz, H, 1952, “Portfolio Selection”, Journal of Finance 7, pp 77–91
Solnik, B H, 1974, “Why Not Diversify Internationally rather than Domestically?” Financial Analysts Journal 30, July/August, pp 48–54