Saudi Arabia and pending MSCI EM inclusion: the usual fade?

image of the field from the above

When attending EMEA or FEM conferences, most investors discuss the pending inclusion of Saudi Arabia in the MSCI EM Index. Anecdotally, most investors seem to avoid the Saudi market, both because of unfamiliarity with the companies and the belief that Saudi Arabia will trace the same performance path that followed recent MSCI EM Index upgrades for the UAE, Qatar and Pakistan. As seen in Chart 1, these markets rallied after the MSCI announcement, but then sold off once they were actually included in the Index. This sell-off was likely driven by the completion of passive inflows and minimal active investor interest, given these markets’ small weightings in the EM index and the existence of better capital return ideas elsewhere (especially in North Asian tech, in the past few years).

Chart 1: Performance for UAE, Qatar and Pakistan, before and after inclusion in the MSCI EM Index

Chart 1

Source: Credit Suisse.

The same scenario is quite possible for Saudi equities, but I am open to the idea that Saudi Arabia will not follow the same path, due to three factors:

  • the size of the Saudi market (US$500 billion in market cap, so it will have a “larger” weight of 2.5% in the EM Index)
  • support from substantial local institutions
  • the unique features of Saudi’s EM inclusion, which differ from those of the three countries mentioned above

To start, the Saudi equity market simply isn’t in the same category as those of the UAE, Qatar and Pakistan. These three markets currently account for just 70, 93 and three basis points, respectively, of the MSCI EM Index. Saudi Arabia is likely to account for 250 basis points of the Index – and that is before the potential inclusion of Saudi Aramco.

Investors could ignore the market, but as seen in Chart 2, the number of qualified foreign investors (QFIs) continues to rise, now standing at over 700, up from 50 three years ago. Secondly, the Saudi market has large local institutions such as the Public Investment Fund of Saudi Arabia (PIF), which, as shown in Chart 3, have become very active in local equities, and now own over 10% of the total market cap. No such situation occurred for the other three EM upgrades.

Chart 2: Number of qualified foreign institutional investors (QFIIs) in Saudi Arabia

Chart 2

Source: CMA and Media Reports.

Chart 3: Saudi Arabian SWF/mutual funds ownership of Saudi Tadawul

Chart 3

Source: EFG Hermes.

Finally, Saudi Arabia’s inclusion is not an “upgrade” from “frontier” status to “emerging.” The Saudi market has previously been classified as “stand-alone,” because it was off limits to all non-Gulf Co-operation Council (GCC) citizens, but nevertheless had very high levels of average daily trading value (ADTV). In this case, then, we have a large, liquid, closed market that is opening up to investors, rather than a small, open market that is being reclassified.

In my view, the situation is similar to that of the Chinese A-share market, which was also a large, liquid market that had been closed to foreign investors and then opened up. Thus, as shown in Chart 4, the Saudi market could be following a path similar to that of the Chinese A-share market.

Chart 4: Performance for Saudi Arabia and China A-Shares post inclusion announcement

Chart 4

Source: Credit Suisse.

Either way, the Saudi market is the most “real” market in the Middle East, with more ideas than the usual list of banks and real estate companies. The pending Saudi inclusion is a two-stage process, taking place in May and August 2019. Fidelity Frontier Emerging Markets Fund, which has exposure to the Saudi market, will be there!

Thanks for reading

Adam J. Kutas, CFA

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