Will a Saudi ETF Attract Investors?

A REVIEW of the 2008 Annual Report of Saudi market regulator, the Capital Market Authority, or CMA, reveals that it aspires to introduce new financial instruments to the capital market such as swap agreements and exchange traded funds (ETFs).

By Farhan Mahmood (OPINION)

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Published: Wed 19 Aug 2009, 12:09 AM

Last updated: Thu 2 Apr 2015, 3:45 AM

The CMA’s decision in August last year allowing non-GCC investors access to the Saudi market through swaps was another step towards gradually opening up the Kingdom’s capital market. Since official data became available in March this year, net purchases by foreigners through swaps have totalled about $389 million.

A review of the country allocations of MSCI Emerging Markets Free Index, an equity benchmark for emerging markets, reveals that, China, Brazil, South Korea and Taiwan account for a combined weight of 58.30 per cent in the index, making them the largest emerging markets. The market cap of this emerging markets index is around $1.99 trillion .

With about $297 billion in market capitalisation , Saudi Arabia is also one of the largest equity markets among emerging countries; in fact, it ranks among the Top 10. However, despite its large market cap and sound economic credentials, Saudi Arabia is not included in international benchmarks as yet; this could change in the next few years. Last month, the Riyadh-based exchange, Tadawul and Dow Jones signed an agreement allowing the index provider to offer indexes on the Saudi market; more such agreements are likely to follow suit.

Currently, as non-GCC investors can only invest in Saudi equities either through swaps or funds, ETFs are viable investment products as these offer investors the opportunity to obtain broad-based exposure to the Saudi equity market. An ETF is an index fund listed and traded on an exchange like a stock, designed for investors seeking returns comparable to a benchmark and to provide liquidity to active traders. Through ETFs, investors are able to obtain market, or “beta” exposure at relatively low cost.

Over the last several years, ETFs have gained popularity and are effective tools for both active and passive institutional managers and retail investors. At the end of December last year, the total global ETF market consisted of 1,590 ETFs with total assets of over $711 billion .

Presently, investors have a wide array of ETFs available to track equity indices on a country, regional, or sector basis. Currently, equity ETF strategies comprise over 83 per cent of the total ETF market. It is interesting to note that US-listed ETFs based on international markets continue to generate the most new assets; an emerging market ETF, iShares MSCI Emerging Markets Index Fund had assets of $31.27 billion. There is strong and growing demand for emerging market ETFs and the inherent benefits of these funds will be attractive for Saudi Arabia’s capital market. Currently being reviewed, the Investment Fund Regulations issued by the CMA provide a workable framework for launching and managing ETFs in Saudi Arabia. With the incorporation of some modifications and changes, a progressive ETF working model should be available under the existing regulations.

There are several benefits of listing a Saudi ETF on Tadawul as a first step, followed by an international listing. First, compared to a mutual fund, an ETF is relatively more transparent as the components of the investment vehicle are disclosed on each trading day and such disclosure often appeals to a broad range of investors.

Second, such an ETF will be available to investors at a lower cost. Unlike an actively managed investment fund looking to create value (or add “alpha”) over the respective benchmark, an ETF is a passively managed investment that provides an investor with “beta” exposure to the underlying asset class. Subsequently, embedded costs in an ETF are lower compared to an actively managed investment fund.

Thirdly, such a Saudi ETF will allow retail investors access to the same product as institutional investors and at a similar cost. Thus, the benefits of economies of scale inherent in an ETF would be passed on to investors.

Lastly, through an ETF, there is potential to broaden the Saudi market’s investor base and raise additional capital. A Saudi ETF is likely to attract new investors to the Kingdom’s equity market, such as pension plan sponsors and asset allocators seeking market exposure. A Saudi ETF will appeal to various types and categories of investors. In terms of investment strategy, a Saudi ETF can also be a “core” holding in a multi-asset GCC portfolio, providing a level of diversification and risk reduction that would otherwise be time consuming and expensive to attain by purchasing the underlying shares.

Through ETFs, Saudi Arabia can continue to attract investment into its equity market from both domestic as well as international investors. Currently, non-GCC investors are restricted from directly purchasing underlying equities. Until such time that these restrictions are relaxed and even beyond, ETFs can serve as an effective instrument for allocating capital to the Saudi stock market.

Farhan Mahmood, CFA is Head of Investment Management at Morgan Stanley in Saudi Arabia. The opinion expressed is that of the author himself and does not represent that of the organisation he represents.

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