Investors keen on opening of Saudi market

Money management executives and institutional investors are preparing for what could be a significant change to the makeup of their emerging markets equity allocations, due to the imminent opening of the Saudi Arabia stock market to qualified foreign investors.

In two weeks, qualified foreign investors will gain direct access to Saudi Arabia's almost $600 billion stock market.

“Saudi Arabia opening up for international investors is actually a big event,” said Rami Sidani, Dubai-based head of Middle East, emerging markets equity, at Schroders PLC. “This is the last large market to open up and become accessible for international investors.”

Since the Kingdom of Saudi Arabia announced the opening of the market this year, “there has been tremendous excitement in the investment community in this new opportunity,” said Sebastien Lieblich, executive director and global head of index management research in Geneva at MSCI Inc. “From that moment onward, we have been contacted by a number of clients interested in us launching as soon as possible an MSCI Saudi Arabia index, which would be reflective of the investments of international investors.”

The sheer size of the market and its liquidity — it has an average daily trading volume of $2.4 billion, according to sources — means Saudi Arabia has the potential to begin playing among the big kids in terms of becoming a target for institutional investment. That volume is significantly larger than Qatar, at $200 million, and the Unitzed Arab Emirates, at $360 million, said Irfan Hasham, Dubai-based chief operating officer, securities services, Middle East and North Africa at HSBC Bank PLC.

“(Its liquidity) is more than many of the well-established global emerging markets,” Mr. Sidani added.

“It is also deep in terms of listings and sectors; there are a number of competitors within sectors,” said Hedi Ben Mlouka, Dubai-based manager of the Duet Frontier fund at Duet Group, which has $5.5 billion in assets under management. “So if you wanted to play Saudi insurance companies, you would find at least seven or eight. There is the depth, diversification and the liquidity, which we don't have to that extent in other markets in the (Middle East and North Africa) region.” A spokesman said Duet will not be applying for qualified foreign investor status in the short-term.

Since 2008, investors have been able to access the market through participatory notes and swaps, so for some, access had not been a problem.

“However, as the market opens fully and allows investors to have direct access, global emerging markets (investors) will start considering exposure to these markets,” Mr. Sidani said. “Historically, some of our flagship funds have faced structural challenges to gain exposure through P-notes, and I expect that international investors will start working on their efforts to be classified as qualified by the Saudi regulator in order to get access.” Mr. Sidani said executives at Schroders, which has been investing in Saudi Arabia since 2008, have started looking into the QFI criteria, “and we should apply soon.”

The opening of the market also will reduce counterparty risk, said Ghadir Abu Leil-Cooper, head of Europe, Middle East and Africa and the frontier markets equity team at Baring Asset Management Ltd. in London. Direct investors will take only investment risk, rather than counterparty risk that occurs with investments via participatory notes or swaps.

Saudi Arabia “has a young population, with five times as many people entering the workforce than exiting in it. Those young people are also moving into the consumption phase, so there is a tailwind behind” investment in companies that play to that theme, Ms. Leil-Cooper said. Those people also need infrastructure in the form of health-care services, savings products and mutual funds. Ms. Leil-Cooper said Barings is looking into the rules, and has not yet made a decision on applying for QFI status. She said the firm is still in the due-diligence stage.

Added to that are the underlying fundamentals of the country, Mr. Sidani said. “The economy ... (has) a lot of natural resources and has very strong purchasing power. (It) is quite insulated from global trends, given that government spending continues to be the main driver.” He said low correlation to global financial markets positions Saudi Arabia as “a great diversification tool in portfolios. In addition to that, there is no sovereign risk from these markets — no public debt and it has massive reserves — plus the currency is pegged to the dollar. That today is a very compelling package in the world of emerging markets,” Mr. Sidani said.

And the country's performance is a draw. The Tadawul All Share index returned 12.97% in the three years through Dec. 31, vs. 14.75% for the MSCI All Country World index. Year-to-date through May 28, the Tadawul index gained 19.04%, vs. 6.11% for the MSCI ACWI.

But there are limitations to consider. The country's Capital Markets Authority has specified that qualified foreign investors must have assets under management of at least 18.75 billion Saudi Arabian riyal ($5 billion), although some might qualify with at least 11.75 billion riyal. All potential qualified investors must have a five-year investment track record.

There are also strict caps. The Capital Markets Authority said a single QFI is limited to owning 5% of a single stock. There is a 20% limit on a single stock across all QFIs, and a 10% total market cap across all QFIs investing in the stock market as a whole.

“June 15 is a significant day, but these restrictions and peculiarities of the market mean overall inflows will happen over time — it will not happen on day one,” Mr. Mlouka said.

Another issue that international investors might find hard to deal with is the country's trade settlement cycle. The period between trade and settlement in Saudi Arabia is T+0. International investors would be more used to T+1 or T+2, sources said.

“Some foreign institutional investors may not be comfortable with the concept of pre-funding, which T+0 effectively requires,” said Mr. Hasham.

However, Mr. Hasham said that is alleviated somewhat by the currency's peg to the dollar, meaning investors are “not exposed to currency risk on pre-funding as they would be in the case of a floating currency. The currency is also fully convertible and there are no restrictions on repatriation, which gives additional comfort.” A spokesman for HSBC said the firm is reviewing options regarding a QFI application, and will make a decision in due course.

What will really propel investment will be the country's inclusion in one of the index providers' emerging markets indexes, Duet's Mr. Mlouka said.

“We believe the Saudi Arabia market would likely have a weight of around 1.6% in (the MSCI Emerging Markets index) and potentially be the 12th largest country in terms of weighting,” Mr. Hasham said.

Were Saudi Arabia to be included in one of the index providers' emerging markets indexes, it could attract aggregate passive inflows of $4.1 billion.

“If Saudi were to be included in global benchmark indices as an emerging market, we estimate this could result in up to $24 billion of passive and active inflows.” Mr. Hasham said. However, he stressed inclusion in the MSCI Emerging Markets index is not expected before 2017.

Saudi Arabia will have to prove it can function as an emerging market before the market is granted entry into that club.“The biggest concern is how the QFI regulation will transition from a regulation to implementation,” MSCI's Mr. Lieblich said. “Will it be smooth? Will there be hiccups? It is all good having regulation that, theoretically speaking, addresses all the points, but we have seen other countries that have very good and sophisticated regulation, but at implementation it sometimes breaks. That is why we never make decisions based on theory. We are giving market participants time to test the waters and to give us some feedback on the accessibility to the market.”