Saudi index add hikes expectations for region

With Saudi Arabia's admittance to the emerging markets club now sealed, money managers are looking ahead to the potentially market-changing listing of the country's state-owned energy company, Saudi Arabian Oil Co.

Last month MSCI Inc. announced that Saudi Arabia had been granted a place in its MSCI Emerging Markets index, beginning in June 2019. The country and its 32 securities will be included in two phases: the first to coincide with a May 2019 semiannual index review by MSCI, and the second to take place as part of the firm's August 2019 quarterly index review.

Once the country is fully admitted, it will account for about 2.6% of the index. In March, FTSE Russell upgraded the country to secondary emerging in its global equity set of indexes.

The move puts Saudi Arabia "firmly on the radar of international investors," said Bassel Khatoun, managing director, frontier and MENA at Franklin Templeton emerging markets equity, Franklin Templeton Investments, in Dubai. "In fact, it makes the (Middle East and North Africa) region difficult to bypass for emerging market investors."

A number of executives covering emerging markets highlighted that about $1.9 trillion tracks the MSCI Emerging Markets index, with about 80% in active strategies and the remainder in passive. The country weighting could lead to about $40 billion in inflows.

"This is unprecedented in the context of historical inflows into Saudi's Tadawul (the domestic stock exchange)," added Mr. Khatoun. He said foreign ownership is about 1.8% of the Tadawul-listed securities. "This is extremely low by EM standards. We expect foreign ownership levels to substantially increase in the run-up to Saudi's official MSCI EM inclusion next year," he added.

But what will really put Saudi Arabia on investors' maps is the potential listing of the country's state-owned energy company, known as Saudi Aramco, in the near future.

"The Aramco (initial public offering) will be a milestone event, stimulating further foreign investment and raising the bar in terms of expectations for corporate governance and transparency in the country," Mr. Khatoun said.

The IPO — if it happens — could increase Saudi Arabia's weighting in the index to 4.4%, with the listing potentially adding a further $50 billion in net flows, he added.

"This would have further huge implications for passive inflows into the Saudi market, particularly as it would be unlikely that half of the new passive money would go into Aramco," said Dominic Bokor-Ingram, portfolio adviser at Fiera Capital Corp. in London. "This could be very positive therefore for the rest of the market."

Mr. Bokor-Ingram said that, from an investment perspective, executives at the firm would "look at the merits of investing in Aramco in the same way as we look at any other company. We do not yet have enough financial or oil reserve data to make an informed judgment."

Others are undecided on the impact of the listing, which was originally touted for the second half of this year but looks more likely to happen next year, if at all, sources said.

"As this could still be a full year away, we have yet to form a full view of how we would participate," said Oliver Bell, portfolio manager in London of T. Rowe Price's Middle East and Africa Equity and Frontier Markets Equity strategy. "But with Saudi investment trips planned for August and likely the autumn, too, we will have a much clearer view toward the end of this year."

Also still unclear is the listing locations for Saudi Aramco. How the listing will play out "is a big question mark," said Yerlan Syzdykov, global head of emerging markets at Amundi in London. "They are doing it in a clever way, trying (different) exchanges, but will probably still do it locally, starting domestic," Mr. Syzdykov said. "We had already been investing in equity and fixed income (in Saudi Arabia) as a frontier market."

Mr. Syzdykov expects Aramco to list on one of the major international exchanges, with the Hong Kong Stock Exchange and the London Stock Exchange both in the running for what could be a $2 trillion listing.

"It is a huge splash in the market — if they play it smart it will attract attention to Saudi Arabia. Aramco gives (the country) the chance to attract global equity players," Mr. Syzdykov added.

Any listing of Saudi Aramco also would benefit the domestic market.

"We remain highly supportive of the government's strategy to diversify its economy away from oil. Proceeds from the Aramco share sale will predominantly be used by the country's sovereign wealth fund (the Public Investment Fund, Riyadh) for investment, signaling an important step in reducing Saudi's reliance on hydrocarbon revenues," Franklin's Mr. Khatoun said. The Sovereign Wealth Fund Institute estimates fund assets of $250 billion.

"And with the Saudi government planning to increase the number of listed companies in the Tadawul from 180 to 250 by 2022, we think this is just the start of a journey to a broader and deeper equity market."

The country's authorities have worked hard to promote Saudi Arabia to emerging markets status, executives said. MSCI acknowledged in its reclassification announcement that the decision followed the implementation of regulatory and operational enhancements in Saudi Arabia's equity market, "which effectively increased the opening of the market to international institutional investors that participated in the consultation."

Among developments, the country's Capital Market Authority and the stock exchange introduced regulation for qualified foreign financial institutions in 2015, with two updates since. Tadawul introduced a T+2 transaction settlement cycle — a two-day settlement of trades; and also introduced other mechanisms to the market to ease access and better align the country's financial system with other, international markets.

Managers are still keeping an eye on developments. "Despite recent advances in opening the market to foreign investors through the (qualified foreign financial institutions) program, Saudi Arabia remains a relatively difficult and costly place to invest directly for smaller investors," said Chris Mellor, head of Europe, Middle East and Africa exchange-traded funds equity and commodity product management at Invesco Ltd. in London.

And there are other considerations. "Economic reform will also need to continue if the nation is to succeed in bringing down its budget break-even price of oil. Another factor to consider is the impact of last year's anti-corruption purge. We have seen several steps taken to reassure investors, but it is important that the kingdom continues on this trajectory. Lastly, any increase in geopolitical tensions will also need to be monitored closely for its impact on investor confidence," Mr. Khatoun added.