The Cairo stock exchange has been closed for over a week already as the citizens of the country protest the rule of President Hosni Mubarak. As the world watches intensely the developments on the streets of Egypt and speculates about a domino effect that may impact other authoritarian regimes in the region, fund managers and brokerage houses have begun to propel predictions about how financial markets will respond to the turmoil in the Arab world.
While the disruption of trade in Cairo has prompted ING Investment Management Luxembourg to temporarily suspend the net asset value of its Middle East and North Africa fund and Van Eck to temporarily halt creation orders for its US-listed Market Vectors Egypt Index ETF (EGPT), there are a number of indications that something is brewing behind the closed doors of the Egyptian Exchange.
Earlier this week, a London-based brokerage house sent one of the first buy signals for Egyptian equities. In addition, the aforementioned Van Eck Egypt ETF received a surge of creation orders on January 28th. It was not able to execute them as the Egyptian stock markets shut down starting January 30th and consequentially it now holds 40% of its total portfolio in cash.
While fund managers may find it premature to put forward a confident market outlook at this point, there is a sense in the financial markets that Egypt’s crisis will create investment opportunities. At the same time, there is the realisation that the Middle East and North Africa region (MENA) is very much a hotbed of political risk.
If there is one lesson from the Egyptian crisis that it is not too early to derive, it is that in this part of the world destabilising events can develop faster than most analysts had expected.
“If anything, the situation in Egypt highlights how volatile this part of the world is and underscores the importance of understanding the risks your portfolio is exposed to,” said Morningstar Director of European ETF Research Ben Johnson.
Hedging Against Political Risk
“Political risk is one of the risks investors accept when investing in frontier markets, and part and parcel of investing in the region,” commented Ghadir Abu Leil-Cooper, manager of the Baring MENA fund, which as of September 30, 2010, invests over 18% of its £12.1 million assets in Egyptian equities.
Indeed, considerations of political instability are embedded in the analytical process of many MENA funds, but the implicit agreement is that it is impossible to completely insulate a portfolio against it.
This is precisely why building a diversified MENA portfolio is vital if you wish to invest in the region. “We do not advocate single country funds,” said Schroders' Head of Global Emerging Markets Equities, Allan Conway. As of December 31, 2010, the Schroder’ ISF Middle East fund Conway co-manages allocates 9% of its EUR 195m assets under management to Egypt-based investments.
The disparity in Egypt weightings evident in the portfolio allocations of the Baring and Schroders MENA funds is not uncommon within the sector. The benchmark indices these two particular funds use also have different weightings for Egypt. This actually means that compared to its benchmark, the Schroders ISF Middle East fund has taken a neutral view on Cairo-listed equities.
One clear benefit of having a diversified MENA portfolio is that the degree of political risk faced across the Arab world is very different. Countries with large populations, many young unemployed citizens and significant pockets of poverty, such as Egypt, Tunisia and Morocco, are much more susceptible to economic and political tensions. Further, the sharp increase in food prices of late has made the fragile balance in these states harder to maintain.
The oil-rich Gulf states, however, are much more economically and politically stable. In these resource-rich economies, poverty is a notable issue among immigrant workers, but much less so among citizens. The economic environment is therefore a more helpful indicator of the volatility of the various MENA states than the presence of an autocratic regime. The potential for civil unrest to spread in the Gulf countries is limited, Conway points out.
Stemming from this notion of a two-tier economic growth across the Arab world is the fact that hedging political risks is only one consideration in building a diversified MENA portfolio. There is also the combined benefit of limiting exposure to a single set of economic, stock market and social risk factors.
Different Plays for MENA Equity Markets
Open-end Funds
Open-end funds such as Schroders ISF Middle East or JPM Emerging Middle East Equity, both of which have earned a four-star Morningstar rating (a performance-related quantitative rating) are of course only one way to tap into the wealth and growth of the Arabic economies.
It is interesting to note that a number of OEICs allocate a significant portion of their portfolio to financials. In the case of Schroders ISF Middle East, half of the fund’s top ten holdings are financial companies, representing 24% of the portfolio as a whole. The logic behind this, Allan Conway explains, is that the financial sector in these countries is “typically a mirror of the health of the local economy.” In addition, financial companies often dominate the market where the energy companies are government controlled and not investable. In contrast with developed markets, emerging and frontier markets’ financials are more of a structural play rather than a cyclical one, Conway says: they are in a very good position to take advantage of structural economic changes and growth, which no longer seen in the mature economies.
Exchange-traded Funds
Beyond OEICs, there are both exchange-traded funds and closed-end funds focussed on the Middle East and North Africa, although the number of such offerings is significantly smaller than that of the open-end realm.
There are only four LSE-listed ETFs within the Morningstar Africa and Middle East category. Within the EU, there used to be only one ETF that focussed solely on Egypt, that offered by BNP Paribas and tracking DJ EGX Egypt Titans 20 index, but it was closed in December last year due to a lack of subscribers.
This scarcity of offerings points to a popular debate in ETF investing. There is a discussion among frontier market investors about whether owning a passively-managed vehicle is a wiser move in a volatile market. “This is a common concern for ETF investors in less developed markets,” explained Morningstar European ETF analyst José Garcia-Zarate.
Garcia-Zarate added, however, that regardless of the type of vehicle used to access a market, investors need to understand well the degree of diversification and exposure to various risks in their portfolios. ETFs are certainly an option in emerging markets. However, “just because your ETF is passively managed, does not mean you need to be passive in building your portfolio,” said Garcia-Zarate.
Did You Miss Out on Buying at the Bottom?
Schroders’ Allan Conway, Barings’ Ghadir Abu Leil-Cooper and Daniel Broby, Chief Investment Officer of Silk Invest, all express hope that the current situation will yield long-term benefits and open up opportunities on the Egyptian market.
Silk Invest, whose African Lions fund and the Arab Falcons fund both hold approximately 15% in Egypt, has already rebalanced its portfolios to sell holdings in Saudi Arabia, Bahrain and Qatar in order to raise cash levels and be in a position to re-evaluate holdings in Egypt once trading on the Cairo stock exchange resumes.
Ghadir Abu Leil-Cooper takes a similar view. “If we do get democratic progress going then we believe Egypt becomes highly interesting from an investment perspective; as asset prices have fallen sharply in recent days it should attract attention,” she said.
Allan Conway is cautious about making portfolio changes with little foresight of the way the political crisis in Egypt will be resolved. “Waiting for a clear picture may mean missing out on buying at the absolute bottom,” he said, but it buys peace of mind. The situation on the banks of the Nile has not yet impacted Schroders’ equity valuations. While it is too early to speak with certainty, a “strong rally is likely in the short term,” Conway says. He also sees the possibility of a re-rating.
Sit Back, but Don’t Relax
Morningstar has always been a proponent of making carefully considered portfolio choices and attempting insulation from the day-to-day market noise. While we also eagerly follow Egypt’s struggle to secure a more representative regime, the scale and scope of this geopolitical situation need not call for an impulsive portfolio rebalancing in response to any given piece of news.
The height of a crisis is not so much the time to rebalance but more the time to make sure you really understand what risks your portfolio is exposed to, said Morningstar’s Garcia-Zarate. There are various channels through which a development on an emerging or frontier market can impact your bottom line. Knowing precisely what the underlying holdings of the funds you have bought into, the weightings of the benchmarks your ETFs are tracking, and to what extent the companies you have stakes in rely on a particular market for supply of raw products, labour or consumer demand are some of the questions that an investor should be able to answer.
It also needs to be said that the correlation between political risk and equity markets performance is not direct. To illustrate this point, Allan Conway leverages the example of Thailand in 2010: crowds on the streets of Bangkok did not relegate the country from the list of best performing markets in 2010, he points out.
And a final point to remember. All sector funds or single-country/-region funds will be exposed to industry- or economy-specific risk and will therefore court higher volatility than broad-based offerings. Morningstar advocates that any such fund should play a niche role within a broader, diversified portfolio to mitigate any such risks.
