Autumn 2014

VOLATILITY: Avoiding landmines

Ebril Iraqi KurdistanFrom war in Iraq to yo-yoing stock prices in the UAE, the Middle East region has been blighted by volatility this year. We asked fund managers how they responded to these trying times. George Mitton reports. The fundamentalist Islamic group ISIS (the Islamic State of Iraq and Syria) first gained mainstream media attention when they raised their black flag over the rooftops of Mosul in June. Since then the Sunni militant group has surprised by its rapid advances and shocked by its brutality – the murder of hundreds of followers of the Yazidi religion and the beheading of the American journalist James Foley were considered turning points in their bloody campaign. Suffice to say the rise of ISIS has complicated matters for those managing Iraqi equities.  Stocks on the Iraq Stock Exchange lost between a tenth and a half of their value in June, though the general index of the exchange had partially rebounded by late August. The recent events are a familiar reminder that MENA, perhaps more than any other region in the world, is subject to tremendous volatility. Whether it is civil war in Syria or the revolutions of the Arab spring, events in this region continue to frustrate the ambitions of financial analysts. How can fund managers deal with this volatility while continuing to generate good returns? EDUCATION
The Iraq Fund from emerging market manager FMG, one of a handful of specialist funds to invest exclusively in Iraqi equities, was hit by the recent volatility – its net asset value fell by more than a fifth in the second quarter, which its manager Henrik Kahm describes as the most dramatic three-month period since the fund began operating in 2007. Kahm, who is based in Sweden, says that when news was reported of the gains made by ISIS, he received lots of calls from worried clients. “All of them thought the world was falling apart, that it would spill over into a Middle East war,” he says. Kahm had to face questions about the very basis of his reasons to invest in his fund – that Iraq’s huge oil supplies would turn it into a superpower producer in the coming decades, driving up GDP for years to come. If the oil fell into the hands of the anti-western extremists, investors should prepare to lose everything, right? Kahm says this view is alarmist. In the face of worried client calls, he describes his role as largely educational, trying to give a more balanced account than the newspaper headlines. Yes, the rise of ISIS has caused FMG to downgrade the earnings outlook for some of its companies, but he says  that rise has been checked by the twin forces of the Kurdish peshmerga in the north and the Iraqi Security Forces, which have since secured the major cities and suburbs around Baghdad. Crucially, he says, the vast majority of the country’s oil wealth remains out of ISIS’s hands. “The ISIS troops were never near any of the larger oil fields, nor have we seen evacuations of the larger oil companies, BP, Shell, Exxon, etc,” he says. NO LIQUIDITY
It must be said that Kahm had few options other than to soothe investors’ fears. Liquidity is low on the Iraq Stock Exchange and for a fund of FMG’s size – its value is $20 million, which compared to the capitalistion of the exchange is large – short-term trading is difficult, especially given that the ISIS-driven volatility occurred during the hot summer months, when trading usually goes through a lull. Knowing he would struggle to buy or sell in those conditions, Kahm had little option but to stay the course. That said, most of FMG’s clients had no other options, either. Because liquidity in Iraq is so low, FMG structured its fund to provide only monthly liquidity, with a notice period on redemptions of 45 or 90 days depending on the share class. A few clients did demand redemptions during June, but they had to wait to get them. The experience reveals that, sometimes, the best response to a volatile situation is to do nothing. If the fund’s investment process is sound, its value ought to recover. Kahm says he is hopeful that if a non-sectarian government comes to power, “we would start seeing negotiations, mending of the wounds”. In the long-term, he claims he has not changed his bullish forecast of strong GDP growth driven by oil exports. CONTRACTORS
It is not only conflict that causes volatility in MENA markets. In the UAE, one of the big stories of the year has been the dramatic rise and fall of stocks in Arabtec, the Dubai-based construction firm famous for executing projects such as the Burj Khalifa, the world’s tallest building. Volatility boxThe company’s stock price tripled in value between the start of the year and hit a peak in mid-May, before a plunge in June wiped out almost all of the gains (the price has since partially recovered). Arabtec is such a large component of the Dubai Financial Market that its trajectory moved the whole index, causing volatility to shoot up and throw many portfolios off balance. For many fund managers, it was a frustrating time, as huge swings in the value of a single stock dominated the market and upset their portfolios. However, the volatility was a chance for some investors to differentiate themselves, such as Amer Khan, portfolio manager of Dubai-based Shuaa Capital, whose fund did not own Arabtec. “Even before it started posting massive gains, we weren’t satisfied with the valuation,” he says, of the stock. When the Arabtec stock started making large gains, partly driven by an aggressive expansion plan announced by former chief executive Hasan Ismaik in January, Khan still maintained
his scepticism. “There wasn’t a lot of clarity about execution of backlog they were winning.  “Although the backing from Abu Dhabi [the investment fund Aabar owns a 21% stake] was substantial, there were questions, a lot of execution risk.” When Ismaik left Arabtec at the start of June, ushering in the collapse in the stock price, Khan’s fund posted a decline of 10% compared with a benchmark loss of about 18%, meaning he beat the market by a significant margin. In many ways, his experience reveals the value of maintaining a healthy scepticism and sticking to a disciplined process in spite of the hype. “Our process focuses on predictable cash flows,” he says. “For Arabtec, the predictability wasn’t there. Yes, there were contracts. Yes, the future looked bright. But exactly how it would come about and how they would execute were unclear.” ISLAMIC WISDOM
There were other fund managers who avoided the stock. Akber Khan of Al Rayan Investment, who manages the Al Rayan GCC Fund, did not own Arabtec – because he was not permitted to.  His fund is sharia-compliant and is forbidden to invest in contractors such as Arabtec because they have large receivables which they typically fund with conventional loans. (Conventional loans which pay interest, or riba, are forbidden
in Islam.) Akber Khan says the principles of Islamic finance, which are based on the Koran, are “basically an additional risk management framework”. Although some fund managers may feel the restrictions limit their ability to generate returns, he has found that his firm’s Islamic index actually outperforms the conventional one. “The success of a manager is not just picking the rock stars, it is also avoiding the landmines,” Akber Khan says.  “Sharia compliant managers end up avoiding a lot more than conventional managers.” It is a mordant analogy in a region so prone to warfare, but fund managers who deal with volatile assets would do well to remember it. ©2014 funds global mena

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