Are Saudi equities ready to go mainstream?
Index providers have been held back by accessibility issues
Many will find it a bit of a mystery that Saudi equities still do not form part of the most important international benchmarks. Despite solid macro-economic credentials, a market that has outperformed emerging and global equities for the past 20 years is still kept out by major index providers. If you buy a global equities ETF or index fund today, whether it has exposure to emerging markets, developed markets or otherwise, the chances are that you will have no direct investment in Saudi Arabia.
This can seem somewhat odd as the Saudi market has a number of things going for it. It is large, representing between 40 and 60 per cent of the total available market capitalisation in the region, depending on index methodology. It is also liquid with an average daily volume above $1 billion over the past year, although this is a number that used to be significantly higher in previous years. It also counts some of the most important companies in the region: of the top 20 regional companies, 13 are from Saudi Arabia. Any investor seeking to find diversification opportunities by going global should seriously consider including this market in their investment universe.
However, index providers have previously been held back by accessibility issues because of significant restrictions on foreign investors. Although it was possible to find a way into the Saudi market via derivatives, little progress was made on direct access until the Capital Market Authority decided to introduce the Qualified Foreign Investor (QFI) programme in 2015. Even then, there were a number of specific criteria to fulfil before an institution could gain full access to the cash market.
At that stage, things were certainly moving in the right direction even if the process could be overly bureaucratic. But that was only a starting point. Since then, many criteria have been relaxed and a new version of the rules launched in September 2016. Many investors saw this move as giving a really positive signal.
In the meantime, momentum for greater access has kept going on other fronts. First, there was an upgrade at the technical level. Improvements such as the introduction of a T+2 settlement cycle and the implementation of a state-of-the-art delivery versus payment system are part of that effort. Second, the announcement of the possible listing of Saudi Aramco, potentially the world's largest listed company, has captured international investors' attention.
Even without the listing of the national energy champion, Saudi Arabia could potentially represent about 2.5 per cent of the MSCI EM global index. Aramco would boost that number even more and make it a much harder market for most investors to ignore. Almost as importantly, it would raise the international profile of Saudi Arabia and show that the reform plan is gaining traction.
All of this makes it likely that at least some of the index providers will make the move soon regarding Saudi Arabia's inclusion. The FTSE was very close to taking that decision at the end of September but decided to wait until next year. They mentioned that they were expecting more details on the reform of the custody model, which should be made public at the beginning of 2018.
But the most important is the MSCI as many exchange traded funds and index funds follow their indices. The MSCI currently has the Saudi market under review and is consulting its clients to evaluate if access is sufficient. Depending on the outcome of this consultation, they can decide to include the Saudi market in their emerging index, or to wait for additional improvements.
The impact of an infusion of passive money is far from negligible. Passive products have gained significant market share over the last few years, and an index inclusion is sure to create a significant inflow of foreign money. Morgan Stanley estimates this could represent an inflow of about $36 billion, or around 15 per cent of the free-float adjusted market capitalisation. Other sources reach similar estimates. Such an inflow is likely to have a significant impact.
Markets which are set to become part of global indices tend to outperform in the 12 month run-up period as investors try to position themselves gradually. But that will only happen before the actual index inclusion, which could occur in stages and is not likely to take place before 2019 anyway in the case of MSCI. That said, there is a secondary effect. As a significant country graduates to become a global market, research coverage tends to increase; both in terms of quality and quantity, and international investors prepare themselves by dedicating more of their time to meeting companies on the ground and discovering this "new" market. The Saudi Equity market is bound to benefit in more ways than one.
The journey ahead is still rather a long one. Recent news from the Kingdom has led some to believe that the reforms were too ambitious and likely to stall. A more optimistic interpretation would be that they were always likely to take more time than expected, and a more realistic calendar will help them to become reality eventually. Political reforms are ultimately inseparable from market modernisation.
From a stock market perspective, the indicators to watch will be whether or not the Saudi Aramco IPO takes place, and if the QFI programme continues to make progress. With those two elements in place, it is highly likely that Saudi equities will continue their internationalisation and give more weight to the region as a recipient of global equity flows
The writer is head of global emerging equities at Union Bancaire Privée. Views expressed are his own and do not reflect the newspaper's policy.
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