Gulf frontier states move up a league

Many countries in the Middle East and Africa remain in the MSCI Frontier Markets index and look to be staying there. But the reclassification was something of a loss for frontiers, bearing in mind the size of the UAE and Qatar’s economies and the fact Qatar is set to host the World Cup in 2022.

However, MSCI announced it would be making the upgrade in June last year, so markets knew it was coming.

Both countries had to meet specific criteria to be upgraded, as Nick Wilson, chairman of the Qatar Investment Fund, explains. “In recent years, the UAE and Qatar made significant progress on the regulatory front, which was an important factor in achieving MSCI emerging market status,” he says. “Changes by the Qatari authorities include lifting restrictions on foreign ownership of shares to fulfil MSCI criteria, while the UAE streamlined its trade-settlement system.”

He lists the qualitative factors required for an upgrade, including room for foreign investors to invest in the stock market, an “efficient and robust” operational framework, easy capital flow and a stable institutional framework.

Among the quantitative factors required to be classified as an emerging market are the size of companies and liquidity in the market. To be part of the MSCI Emerging Markets index, a stockmarket should have at least three companies with a market cap of more than $1.26bn (£736.9m).

The inclusion of the UAE and Qatar in the MSCI Emerging Markets index may also have been expected to provide a boost to the sector, which underperformed significantly in 2013. Mr Wilson, however, suggests the reclassification had a modest impact, as the two countries currently account for 1.06 per cent of the total MSCI Emerging Markets index.

Instead, the upgrade has been felt by the frontier markets index. Mr Wilson says: “The impact on the MSCI Frontier Market index is more substantial, as these two countries accounted for more than 36 per cent in the frontier market index and included 24 securities from Qatar and the UAE.”

But he believes the reclassification has heightened interest in other long-term growth markets in the Middle East such Kuwait and Oman, together with other parts of Africa.

Now that two countries have made the leap to emerging market status, investors may be wondering whether other Mena countries, in particular the Gulf states, are likely to follow suit.

Oliver Bell, portfolio manager at T. Rowe Price, points to Saudi Arabia as an interesting market.

“This is currently classified as neither frontier nor emerging by MSCI. The main reason is the restriction on direct foreign ownership, so you can’t own Saudi shares directly. For that reason it’s not included in the MSCI mainstream indices,” he says.

He admits there have been rumours for several years that Saudi will join the MSCI indices. “So when they do, the key question is will they join the frontier market index or the emerging market index?,” Mr Bell asks.

“Given that it’s a big market, it’s large and liquid, there is the possibility that it could go straight into emerging.”

One thing for investors to consider before investing in Mena is the region’s correlation with emerging markets.

Mr Bell believes this remains one of the most attractive features of investing in frontier markets – the fact that the sector is not highly correlated to emerging markets or the developed markets.

He adds: “In a world where correlations are high – emerging correlations versus developed, and even correlations between different asset classes are very high – frontier market correlations are very low. So we think this region can offer diversification benefits.”

Another advantage of investing in frontier markets in the Mena region now is the domestic demand story that is currently playing out.

Mr Bell elaborates: “Right now, a lot of stock market growth and performance is being driven by domestic demand.

“In spite of some of the worries that we’re seeing about tapering and a slowdown in emerging market growth, none of that has really impacted frontier

markets.

“These markets are really just dependent on their own domestic demand and economic growth.”

Ellie Duncan is deputy features editor at Investment Adviser