October 2010

HEDGE FUNDS: Catch you if you fall

climberMena'€™s fledgling hedge fund industry has an opportunity to prove that absolute-return managers can protect clients from downside risk, finds Nick Fitzpatrick. The eagerly awaited restructuring of Dubai World’s debt problem, which sent stock markets in the United Arab Emirates (UAE) into freefall when the state-run property company defaulted last year, could be the trigger for a rally in Gulf and wider Mena stock prices. At least this is the position of Andrea Nannini, of HSBC Global Asset Management’s frontier markets team.
He says: “There is an incredible amount of value in stocks in the Gulf, especially in the UAE. I think the undervaluation is mainly due to the uncertainty about the final outcome of the ongoing [Dubai World] restructuring, even though it has been agreed upon in principle by the key creditors, and uncertainty about further restructuring at other entities.”
In January, more than 25% of Mena equities were trading below book value. Coupled with other factors, such as market inefficiencies, it could be said there was never a greater time to take a directional
bet on Mena equities, and that the anticipated direction of that bet is most emphatically upwards.
After all, without the problems of Dubai World, Gulf and other Mena shares could have followed their frontier-market counterparts to dizzying heights. HSBC’s New Frontiers Fund, a long-only strategy, had risen around 71% in the twelve months to the end of March, for example.
If, as some feel, Mena markets have entered a new economic phase and are set to project upwards for a sustained period once Dubai’s debt is faced down, it will be a testing time for Mena’s fledgling hedge funds. Will they be able to demonstrate the power of absolute-return investing in a rising market when even long-only, relative-return managers could, in principle, hardly fail to make top returns too?
Well, there exists the view that Mena investors have been disappointed by specialist long-only managers since 2008 when net asset values deteriorated in some cases by more than 50%. Investors understand the current drivers for a long strategy of some form, but if possible they will seek to limit downside value destruction using sophisticated risk management. This is where Mena specialist hedge funds are setting out their stalls.
The first Mena-focused hedge fund, the Cayman-based Mena Admiral Fund, was launched from London in 2006 by Mena Capital – a firm founded by a former asset management chief at Arab Bank in Dubai, Khaled Abdel Majeed.
Insparo Asset Management, founded in London by Mohammed Hanif, a former emerging market distressed debt specialist at Bluebay Asset Management, launched its inaugural fund, the Cayman-domiciled Insparo Africa & Middle East Fund, in
May 2008.
Since the Dubai Financial Services Authority introduced hedge fund regulations along the lines of European principles – such as requiring investment management and fund valuation duties to be segregated – a small number of hedge funds have sprung up in and around Dubai’s trade zone, the Dubai International Financial Centre. These include Gulf Mena Alternative Investments, a specialist hedge fund firm that launched the Gulf Mena Arab Opportunities Fund in October last year, and the Arqaam Capital Alpha Fund launched last year also by Arqaam Capital, an integrated investment bank and asset manager. Stopping short
These funds will be looking to limit downside damage in order to deliver market-beating returns no matter how the underlying markets behave, which is, of course, the whole principle of absolute-return investing.
But hedge funds around the globe typically employ their ability to short sell securities in order to limit price erosion and boost overall returns. Yet the Mena hedge funds operate in a region where short selling is, at best, limited.
“People hear the words ‘hedge fund’ and straight away they think of shorting stocks,” says Amin El Kholy, head of asset management at Arqaam Capital. He notes that regulators in the region prohibit shorting but that short positions can be copied using swaps.
He adds: “If you are a hedge fund operating in a market that is performing well and you are a good stock picker, and if you can use derivatives to take short positions, then it is not so important to be able to physically short.
“What is important is to be able to deliver the correct risk-return profile, and this is made possible by using derivatives and other risk controls.”
If there is a lack of physical shorting then an investor might expect a less hedge fund-like fee. Arqaam is offering this. El Kholy says: “Our management fees are 1.5%, which are in line with long-only funds in region. We are not on the 2% route.”
El Kholy says the “target peak-to-trough drawdown period” – or worst expected drop – in the Arqaam fund is 15% in any given 12-month period.
“If we start a losing period and get close to this limit, we have strategies to hedge that risk out and reduce our exposure.”
He adds: “This fund is aimed at people that are very averse to losses and it is how we run the risk management around a concentrated portfolio that will differentiate us.”
Here lies the crux of Mena hedge fund investment. Asset managers who are selling absolute return funds to regional investors are not just selling hedge funds to an inexperienced absolute-return clientele, but potentially providing these clients with their first significant experience of investing in public markets regardless of the strategies. For those clients who made their initial foray into public equities prior to the 2009 debt crisis, the losses of the order experienced after that event would have been a shock. Therefore preserving gains is critical, especially if Mena’s upward trajectory proves to be a bumpy one.
The four-year-old Mena Admiral Fund, offered by Mena Capital, indicates this is possible. Its annualised return since launch is 6.6% compared to the -15.70% of the MSCI Arabian Markets benchmark. Volatility is 15.2% compared to the 27.6% of the benchmark.
However, some of Admiral’s performance, in fact most of its March 5.2% gain for example, was derived from non-Mena stocks, particularly London and Toronto companies, although the firms have the majority of their business in the Mena region.
Inexperienced investors in the region will still have to face shocks. Although the Admiral fund fell just 6.5% in 2008 while the MSCI Arabian Markets fell 56.0%, the fund fell 8.6% in 2009 while the MSCI Arabia was up 17.3%.
Trying to allay investor fears about price erosion is one thing, but hedge fund investing does traditionally require a reasonable nerve given the entrepreneurial nature of the investments many of the investment managers look for.
Take Iraq. The Admiral fund invests in a company called Gulfsands Petroleum, which is listed on the alternative investment market of the London Stock Exchange. Gulfsands is exploring options in Iraq that may lead to capturing currently flared natural gas – that is, gas that is burnt if deemed unfeasible to use or transport – to produce electricity that can then be sold to industrial plants. Gulfsands has been a core holding for the Admiral fund over the past year or more. By March this year the company had delivered a 40% return. As well as explorations in Iraq, it also has productive operations in Syria and the Gulf of Mexico (GOM), and exploration interests in Tunisia and Italy.
Meanwhile, the Arqaam fund has scope to invest in Iran, says El Kholy. “Sometimes in the region liquidity is a restriction even though there may be opportunities. But Iran has a pretty active exchange, although there needs to be a clarification about the repatriation of profits.” On the upside
The strategy of the Arqaam Alpha Fund is simply to make a return on the secular upside in the Middle East, which is powered by reform, demographical and globalisation themes, as well as the oil story, says El Kholy.
“We have a five-to-ten-year view and during this time the market opportunity will mainly be on the long side.”
Arqaam Capital launched the fund last year but relaunched it on December 1, 2009 with a new team and new strategy.
“The fund launched initially with pure seed money and it wasn’t an easy time to raise capital,” says El Kholy, who joined in October last year to rebuild the fund and the team after a period of turnover.
He points out that the fund started out with $2m (€1.56m) in December 2009, and assets under management stood at $30m at July 1 this year.
When certain Gulf markets are upgraded from frontier market status to join the MSCI emerging market universe, El Kholy expects there will be more flows, including from clients outside of the Mena region.
“When a country is included in broad benchmarks, history teaches us that more interest and more cash flows from it.”
Earlier this year, there were expectations that MSCI would reclassify the United Arab Emirates (UAE) as an emerging market, though this did not happen.
El Kholy says: “I do expect a number of markets to go into the MSCI emerging market index in the next three years, like Saudi Arabia, the UAE, Qatar and Kuwait.”
By then, Mena hedge funds of the type launched in recent years should have sufficiently long track records for potential investors to evaluate.
And by then, the Dubai World debt problem will hopefully have cleared too. ©2010 funds global

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