Winter 2013

KUWAIT: After the upgrades

TowersWhat will happen to frontier market funds when the UAE and Qatar become emerging markets? Managers may have to increase their holdings in Kuwait, finds George Mitton.

IN SURFACE AREA, Kuwait is slightly smaller than the island of Fiji, with a population of less than three million. Yet this country is highly significant for regional investors, particularly managers of frontier market funds – at 23% of market capitalisation, it is the largest constituent of the MSCI frontier market index.

Kuwait’s clout in the index will soon become even greater. In spring next year, Qatar and the UAE will leave the index when MSCI upgrades them to emerging markets. Kuwait’s weighting will rise to nearly a third of the index, an effect that will only slightly be offset by the return of Morocco as a frontier market.

Passive and exchange-traded funds (ETFs) will be required to sell stocks in the UAE and Qatar and increase their holdings in Kuwait. Active managers of frontier market funds might be tempted to do the same.
But is increasing their allocations to Kuwait in the best interests of their investors? Some managers are sceptical.

Bader Al-Ghanim is vice president, Mena Asset Management, at Kuwait-based Global Investment House, and he has been underweight on his home country for three years. “I don’t see anything really attractive in Kuwait,” he says. “Most of the stocks are overvalued, even if you look at the blue chips. We don’t own more than four or five names in Kuwait, out of 35 to 40, and we own these because of the requirements of our risk strategy, not because we like the stocks.”

Al-Ghanim says the problem is that high equity valuations in Kuwait reflect the large amount of liquidity in the country, not fundamentals. Like other bourses in the Gulf region, the Kuwait Stock Exchange has performed well this year, rising 35% between January and December. But for Al-Ghanim, this merely underlines how the remaining opportunities are trading at well above fair value. Stocks he favours such as telecoms firm Zain and the National Bank of Kuwait – the biggest single holding in the MSCI frontier market index – are too expensive, he says. He would like to buy Jazeera Airlines, but only if the price came down. The problem, he says, is that despite a succession of plans, the Kuwaiti economy remains undeveloped.

“We’re making surpluses, oil prices are keeping at good levels for us, but nothing is happening on the ground,” he says. “The oil sector is underdeveloped in Kuwait. The petrochemicals sector is non-existent, we only pump oil and sell it. When it comes to real estate, we haven’t been building new cities, we haven’t been investing in infrastructure, and we have a shortage in electricity and water supplies.

“We have no ‘theme’ for the country. Dubai has real estate. Qatar is focusing on sport. We don’t have a theme.”

Those frontier managers who share Al-Ghanim’s pessimism about Kuwait may regret being pressured by the MSCI reshuffle to buy stocks in the market. Some managers may also feel that an allocation of a third of their fund assets to Kuwait will confound the aims of the investors in the fund.

Why? Because when investors choose a frontier market fund, they typically intend to gain exposure to fast-growing, exotic markets; for instance, markets in sub-Saharan Africa, where millions of people are pulling themselves out of poverty and buying consumer goods for the first time, or markets in central Asia, where mining companies are only now beginning to tap vast mineral deposits. Having a third  › of their money invested in Kuwait, an oil-dependent economy where a large proportion of the stock exchange is made up investment companies, is probably not what most people would expect a frontier market fund to do.

Is there anything fund managers can do to resist the tyranny of the benchmark?

“The weight of the Kuwaiti equity market in the frontier market index will by definition increase, even if we consider the entry of Morocco,” says Sebastien Lieblich, global head of index management at MSCI.

“There’s nothing we can do about it, that’s the way the opportunity set for frontier markets is. But, if investors have an issue with the weight of Kuwait, there are ways MSCI can customise the frontier market index.”

MSCI can put a cap on the the weight of Kuwait in the index and redistribute the weight proportionally across the other countries, says Lieblich. The client may feel they have a more balanced benchmark for their purposes if the Kuwait weighting is capped at 25%, for instance.However, Lieblich says MSCI does not promote this kind of customisation, which he describes as arbitrary.

“The MSCI frontier market index is built to give a fair representation of the investment opportunity set. That happens to result in Kuwait having a large weight.”

So what can frontier market fund managers do? Of course, active managers are not required to hug their benchmark. If and when they sell stocks in the UAE and Qatar, these managers could choose to buy stocks in Nigeria or Kenya, in Kazakhstan or Pakistan, rather than increase their holdings in Kuwait. Managers might also use the spare cash for off-benchmark bets. They could buy stocks in countries such as Mongolia, which is not yet in the frontier market index, or invest in Saudi Arabia using promissory notes.

These options are not available to passive funds and exchange-traded funds, which must attempt faithfully to reflect the performance of the index.

Perhaps not all frontier fund managers will need to sell or by, says Michael Orzano, associate director of Global Equity Indices at S&P Dow Jones Indices, a rival index provider to MSCI which in October also announced it would upgrade the UAE and Qatar to emerging markets.

“There are a lot of products out there that combine the smaller emerging markets and the larger frontier markets,” he says. “Anyone managing a fund like that won’t be affected by the change. I think there’s been a trend towards those funds, actually.”

But could there be an even bigger disruption to the MSCI frontier market index in future? What if Kuwait itself was to be upgraded to emerging market status?

Lieblich, of MSCI, says the Kuwait authorities have made significant improvements since 2008, when Kuwait was removed from MSCI’s review list by unanimous agreement in its consultation. Then, market participants criticised Kuwait for lacking a capital market authority (CMA) and for failing to provide rules and regulations in English for international investors. Now, there is a capital market authority in Kuwait that is suitably independent, and the authority is reviewing its regulations.

“The have done a lot of ground work,” he says. “I cannot tell you if they will be included [in the emerging market index] or when, because that’s something we’re still analysing, but we are in a close relationship with the CMA. There is nothing that prevents them in addition to market accessibility questions.”

Losing Kuwait from the frontier market index could prompt another reshuffle by frontier market managers. All things being equal, it would make Nigeria the biggest component in the MSCI index.

If it happens, frontier market managers might have to consider reallocating their money from Kuwait to Lagos.

©2013 funds global mena

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