Improvement in overall market efficiency as a result of MSCI’s reclassification of UAE from Frontier to Emerging Market

Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited
Analysis by Ryan Mahoney, Portfolio Manager at Dalma Capital Management Limited

Dalma Capital Management Limited is a DFSA regulated asset manager operating in the DIFC: the company’s core business is hedge fund management.

MSCI (Morgan Stanley Capital International Indices) is no longer part of Morgan Stanley but is a worldwide, influential and leading provider of investment decision support tools.

The recent reclassification of the MSCI UAE Index from Frontier Market to Emerging Market status, announced as part of the results of MSCI’s semi-annual review meeting held on May 14, 2014 in Geneva, brings positive news to the market and is poised to significantly improve overall market efficiency in the Emirates.
The MSCI UAE Index consists of nine companies, namely: Abu Dhabi Commercial Bank, Aldar Properties, Arabtec, DP World, Dubai Financial Market, Dubai Islamic Bank, Emaar Properties, First Gulf Bank and National Bank of Abu Dhabi.
MSCI’s decision to upgrade UAE reflects a growing realisation of how far the country’s economy and its financial market have rapidly developed in recent years. The change from frontier market to emerging market status reduces the perceived risk of investing in a market and is therefore extremely significant for the UAE.  This change also means that the country’s financial markets are, to a large extent, compliant with the ever increasing global investor relations and corporate governance standards that are a key for improvement in the overall efficiency of a market.
This rise in status will open up a wider pool of investor capital available to tap for both stock markets and companies in the UAE as foreign institutional investors, including passive index tracking funds, start entering the market.  This will result in a positive liquidity boost, not only in the nine scrips mentioned above, but also in shares of other UAE public listed companies.
Ryan Mahoney, portfolio manager at Dalma Capital Management Limited, noted that “Upcoming inclusion into the MSCI Emerging Markets index will act as the marginal buyer in the near term – this is likely to provide further momentum in current bull move.”
In addition to the liquidity boost from foreign investors, depth as well as breadth of the market will increase and internal liquidity will receive a major push as confidence increases amongst local investors.  Overall, the UAE is likely to see a one-time inflow of approximately US$ 440 million from passive funds tracking the MSCI Emerging Markets Index, given the country’s pro-forma weight of around 0.6% in the Index and, according to Fund Tracker EPFR, the total size of US$ 72 billion of passive funds tracking the MSCI Emerging Markets index.
Presence of sophisticated investors allocating to constituents of MSCI’s Emerging Market Indices will also encourage the local stock exchanges, financial market intermediaries and relevant regulatory authorities to develop innovative and more sophisticated product offerings in order to remain in line with their global counterparts.  Moreover, to remain competitive in the global emerging markets’ landscape, there will be a need to offer asset class diversification by providing an alternative to conventional asset classes in the form of hedge funds as well as derivatives and structured products.
There will likely be an increase in the number of listed stocks as private companies have an incentive to list; incentive in the form of greater recognition across the globe.  This not only will increase the size of the market, but will also add to diversity among the existing asset mix. Large companies that are already listed will be tempted to increase free-float in order to qualify for inclusion into the MSCI Emerging Markets Index - this increase in free-float will inevitably result in increased transparency in company operations which would, as a result, further improve market efficiency.
For countries classified as Emerging Markets, MSCI requires that the efficiency of the operational framework be good and tested. Among others, a key requirement of an efficient operational framework is timely dissemination of all stock market information in English to all market participants, which should bring further improvement in market efficiency.
Lastly, on the regulatory front, this status upgrade will continue the UAE government’s successful trend to further push ahead and liberalise access to its financial markets by raising ownership limits for investors and adopting flexible legislative and regulatory frameworks, which is one of the key ingredients of efficiency in any market.

Pressures for Increased Transparency resulting from MSCI’s Reclassification of UAE from Frontier to Emerging Market

Pressures for Increased Transparency resulting from MSCI’s Reclassification of UAE from Frontier to Emerging Market
Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited
Analysis by Ryan Mahoney, Portfolio Manager at Dalma Capital Management Limited

Dalma Capital Management Limited is a DFSA regulated asset manager operating in the DIFC; the company’s core business is hedge fund management.

MSCI (Morgan Stanley Capital International Indices) is no longer part of Morgan Stanley but is a worldwide, influential and leading provider of investment decision support tools.
On 14 May 2014 MSCI announced the results of its semi-annual review meeting. As expected, the UAE and Qatar indices were reclassified from Frontier Markets to Emerging Markets.
This brings positive news to the market in terms of increased investor confidence, greater visibility of UAE companies to sophisticated investors worldwide, increase in foreign portfolio investment directed towards the UAE and improvement in overall market efficiency. The upgrade and the assets that come with it are also likely to lead to pressures for increased transparency in order to achieve consistency with the market accessibility criteria set forth by MSCI for constituents of its Emerging Markets Index.
A country’s market accessibility is judged on the basis of four factors that include: openness to foreign ownership; ease of capital inflows and outflows; efficiency of the operational framework, and stability of the institutional framework. “To remain consistent with the Emerging Markets criterion and gradually move towards the ultimate goal of being classified as a Developed Market, the UAE and Qatar will need to deliver the required improvements in all four factors assessing market accessibility,” concludes Elliot Carol, portfolio strategist at Dalma Capital Management Limited.
With regard to openness to foreign ownership, the MSCI upgrade will require local markets to have an increased focus on providing a level playing field for both international and local investors. Foreign ownership limit levels will inevitably need to be enhanced, with equal economic and voting rights being provided to foreign investors. In addition, the upgrade will necessitate that equal rights are provided to all minority shareholders.
The UAE is largely compliant with the ease of capital inflows and outflows factor; the country has already implemented a high degree of foreign exchange market liberalisation due to the existence of a developed onshore and offshore forex market. There are also no restrictions, as such, on inflows and outflows of foreign capital to and from the local stock market. Minimal restrictions are applicable to repatriation of foreign direct investment as well.
The key challenge will be improving efficiency of the operational framework and, just as importantly, maintaining it.  Barriers to entry for investors will need to be lowered significantly, by minimizing the registration requirements for international investors as well as documentation/approvals required for setting up local accounts in order to decrease the overall time required for opening and funding an account. The legal and regulatory framework governing the financial market, stock exchanges and the various other financial markets participants will need to be improved, including ease of access to information (particularly in English), reduction of ambiguity and prompt enforcement of laws and regulations, as well as consistency amongst all of these factors over time.
A competitive landscape that encourages unrestricted investor access to derived stock market information, data and investment products will also be required; for example the provision of independently calculated indices or the creation of baskets of securities used in the creation of financial products. Likely the most important factor in improving transparency will be increased pressure for the timely disclosure of complete stock market information in English and under reasonable commercial terms to all market participants as well as the robustness and enforcement of accounting standards. These improvements will likely lead to reduced information asymmetry amongst investors and other market participants.
Constant improvements will be considered necessary in the market infrastructure as the UAE continues its path to “developed market” status. A well-functioning clearing and settlement system, based on international standards including delivery versus payment, the absence of pre-funding requirements and the possibility to use overdrafts will need to be in place. Availability of omnibus structures will be a key consideration. An efficient mechanism that prevents brokers from having unlimited access to an investor’s accounts, in order to guarantee the safe keeping of its assets will in all likelihood become mandatory and would require competition amongst local custodian banks as well as the presence of global custodian banks.
In addition, to ensure high quality of services offered to investors – such as cost efficient trading and ability to execute block trades at the same price for the various accounts of a fund manager – steps to increase competition amongst brokers will be inevitable. A framework for off-exchange transactions and in-kind transfers will likely be needed. Finally, there will be pressures to put in place an efficient mechanism to allow short selling as well as extensive use of stock lending, along with a robust but practical regulatory framework governing those activities.
Concerning the stability of the institutional framework – which deals with basic institutional principles such as the rule of law and its enforcement, the stability of the "free-market" economic system and track record of government intervention with regards to foreign investors – the requirements remain modest for countries classified as both Emerging and Frontier Markets. 
Any country aiming to acquire the Developed Market status in the long term inevitably needs to focus on improving the stability of its institutional framework as well.

MSCI Emerging Markets Upgrade for the UAE and Qatar: Likely Effects

MSCI Emerging Markets Upgrade for the UAE and Qatar:  Likely Effects

Written by Zachary Cefaratti - Risk Officer at Dalma Capital Management Limited, a DFSA regulated Hedge Fund Manager in DIFC

The decision by MSCI to upgrade UAE and Qatar to Emerging Markets status from Frontier Markets status is likely to have profound, positive effects on domestic equity markets.  The upgrade will cause the investor base in domestic equities to broaden widely and could significantly increase liquidity of domestic stocks, such as DP World.

There are several factors that will cause these positive effects - firstly, Exchange Traded Funds (ETFs’) that track indices are highly popular investment tools utilised by investors around the world, primarily in the United States and Europe.  BlackRock, the world’s largest asset manager, operates 18 ETFs that track MSCI Emerging Markets under the iShares brand.  The combined average daily trading volume of iShares’ Emerging Market ETFs exceeds $3 billion and combined assets under management exceeds $44 billion, which compares to only $11 million daily trading volume and $825 million under management for the single iShares equivalent Frontier Markets ETF.  This means that constituency in the MSCI Emerging Markets countries should automatically create increased liquidity and a broader investor base for the UAE and Qatar. 

This may be just the tip of the iceberg; many ETFs, Closed End Funds (CEFs’), Mutual Funds and other globally held investment products track countries defined as “Emerging Markets" by MSCI, S&P and Dow Jones compared to very limited holdings of “Frontier Markets” countries.  Furthermore, many global institutions (such as foreign sovereign wealth funds, pension funds and endowments) have investment mandates, which define their maximum allocations to Emerging Markets, Frontier Markets and so on.  These large institutional investors typically have much larger allocations to Emerging Markets than to Frontier Markets and rely on MSCI, S&P and Dow Jones to define which countries are “Emerging Markets".

With the broader and larger investor base that is caused by the MSCI upgrade, equities in the UAE and Qatar are likely to see greater average daily trading volumes, decreased average volatility, decreased gap risk, more resilience to internal and external shocks or black swan events and greater transparency.  All of these market factors have the potential to improve overall domestic market efficiency. 

One possible negative effect of the upgrade, however, is increased correlation to foreign equity markets; particularly other "Emerging Market" constituents. 
Events in other Emerging market countries, even those with little relation to the UAE, may incite broad selloffs in emerging market assets and funds. For example, a catastrophe in a Latin American country that is also included in the MSCI Emerging Markets index could cause adverse trading activity in emerging market products that would include the UAE and Qatar.  This, in effect, could depress domestic equity markets temporarily even if the foreign event has little or no effect on the UAE or Qatar.
That stated, it will likely be observed that the positive effects of the ‘Emerging Markets status upgrade’ have the potential to outweigh any negative effects.
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Financial Sector Phase Shift – Hedge Fund Investing Leads the Way

Financial Sector Phase Shift – Hedge Fund Investing Leads the Way
Written by Zachary Cefaratti – Risk Officer at Dalma Capital Management Limited, a DFSA regulated hedge fund manager in the DIFC

The financial services sector is rapidly developing within the GCC.  Following the setup of the DIFC (Dubai International Finance Centre) in 2004, the sector as a whole has progressed in the region substantially – with an increasing number of new firms offering a wider range of services.  The most recent acceleration over the last two years is stimulating a phase shift for the market.   Supply is moving swiftly to meet growing investor interest and is being supported by a favourable economic environment, sizeable capital inflows and regulatory reforms. 
At present, hedge funds are the increasingly popular choice for smart heavyweight investors from across the globe and the trend is building.  One of the most notable examples is the Abu Dhabi Investment Authority (ADIA), which currently invests more in hedge funds than any other organisation in the world.  According to research conducted by Preqin, the sovereign wealth fund currently has over $47 billion committed to hedge fund investments. 
In the post financial crisis climate, savvy investors worldwide are choosing to allocate their capital to elegant risk-adjusted strategies that hedge funds offer.  Increasingly sophisticated investors in the GCC are following ADIA’s lead, with the number of investors allocating to hedge funds more than doubling since the crisis according to Preqin.  Hedge Fund investments are primarily stemming from sovereign wealth funds, ultra high net worth individuals, pensions and astute family offices that have identified hedge funds as delivering the efficient and uncorrelated returns demanded by smart money.  Hedge fund activity in the GCC is expanding to meet the needs of investors who are seeking active management expertise and exposure to strategic asset classes.  This growth represents a new phase in the development of the UAE financial market.
The first major phase of development for the Gulf region’s financial services sector came in the 1970s.  The massive influx of petrodollars into the GCC throughout the decade created a seismic shift in power for global finance.  Central banks of the Gulf region emerged as significant providers of funds to the global banking system through petrodollar recycling and, in 1975, the Bahrain Monetary Authority created a new offshore banking centre to service the developing financial needs in the region. 
The next significant phase of development for the financial sector came about as assets from the petrodollar influx were placed into diversified holdings – spanning a much wider range of domestic and foreign industries and asset classes.  Diversification was the impetus of this phase change and the Gulf region broadly expanded its presence as a buyer within the global marketplace.  The financial sector evolved further in 2004 with the opening of the DIFC, which was designed to create a modern financial centre capable of servicing the financial needs of the regional economy.
We are now entering the next major phase of development for the region’s financial sector.  In April 2006 Argent Financial Group International LLP launched the first Dubai domiciled hedge fund under the leadership of Howard Leedham MBE – now CEO of Dalma Capital Management. The market is expanding and generating wider activity that is pushing forward development at a rapid pace.  New investment structures and strategies, flourishing investor interest and premier expertise are fuelling industry growth.  Furthermore, an evolving infrastructure is allowing the sector to strengthen consistently.  Stable regulation and strong economic fundamentals are further contributing towards creating the next chapter of financial sector development for the region.
Erudite investors from across the globe have been moving quickly to adopt the strategies hedge funds offer.   In particular large sovereign wealth funds alongside knowledgeable, experienced family offices and private investors have been investing heavily in the sector.  Investor interest is only increasing as 2014 progresses - stellar but recently wavering domestic equity market performance has reminded investors of the benefits of uncorrelated, diversified investments with shorting capabilities and absolute return profiles, such as those delivered by many hedge funds.
The role of the UAE in the global market is growing and conditions are in place for continued hedge fund growth in the region.  The robust regulation and business friendly attitude of the DIFC make it a likely candidate for attracting the significant financial resources and talent hedge funds provide.  Consequently, many industry participants are forecasting Dubai to be one of global financial powerhouses of the future.


                        

The Effects of US Monetary Policy on UAE Investors and Borrowers

Written by Zachary Cefaratti – Risk Officer at Dalma Capital Management Limited, a DFSA regulated hedge fund manager in the DIFC.
What is really driving the DFMGI index?

www.dalmacapital.com

The DFMGI (Dubai Financial Market General Index) has been one of the best performing indices globally in 2014.  As of June 16, 2014 the index was up 88% year-over-year.  This outperformance is driven by a combination of factors, many of which are influenced from abroad.
The continued historically low interest rates in the US and a strong rebound in domestic economic growth following the 2008-2010 financial crisis can be viewed as the main drivers of the recent rally in the index.  Additionally, the UAE has been a major beneficiary of private capital flows due to its political stability following the Arab Spring.

According to the Institute of International Finance (IIF) real GDP growth in 2014 is forecast to be 4.2%, driven by growth in tourism, transportation and trade.  Hence, in comparison to the developed world, the UAE has benefitted from a more robust recovery post 2010.  This strong underlying economic recovery has translated into a rebound in asset prices for both equity and real estate markets.  Furthermore, the completion of previously stalled projects and preparations for the World Expo in 2020 provide a compelling backdrop for economic growth in the coming years.
The other primary driver of asset prices has been the maintenance of exceptionally low interest rates in the developed world, which has caused investors to search for yield in the faster growing frontier/emerging markets.  With the 10-year US Swap rate currently hovering below 2.8%, investors are implicitly assuming that the United States Federal Reserve (the Fed) will remain accommodative in terms of interest rate policy.  With such low yields available, foreign investors have been attracted to valuations in emerging markets – the DFGMI is no exception.

Figure : 10 Year USD Historical Swap Rate

Figure : USD Swap Curve

Why the US Fed Funds Rate matter for UAE borrowers?

Due to the currency peg between the US Dollar and UAE Dirham, the UAE effectively imports the monetary policy set by the US Federal Reserve.  Although there are many benefits to pegging the UAE Dirham to the world’s reserve currency, a major repercussion of the peg is that the UAE central bank cannot maintain independent monetary policy.
The currency peg forces local interest rates to follow those in the US, even when the economy economic outlooks of the two countries diverge.  The optimal monetary policy of the United States is not necessarily that of the UAE – GDP growth in the UAE has outstripped GDP growth in the US by a large margin and is expected to continue to do so for the foreseeable future.  The combination of strong GDP growth and ultra-loose monetary policy imported from the US has resulted in a strong increase in asset prices.  Given the inability of the UAE central bank to raise interest rates independently of the US, local regulators are forced to rely on macro-prudential regulation, such as limiting borrowing capacity to control overall credit growth in the economy.
“Given the robust outlook for economic growth in the UAE, our view is that the major risk for the local stock market remains a normalization in US interest rates,” notes Elliot Carol, portfolio strategist at Dalma Capital, “The issue of rising interest rates is not a question of ‘if’ but ‘when’.”
When will interest rates rise?

Following the 2008 financial crisis the Federal Reserve has maintained extraordinarily accommodative interest rate policy as measured by the Fed Funds rate.  With the Fed already reducing their monthly purchases of bonds through quantitative easing, effectively making monetary policy ‘less loose’, the next question facing investors is when they will begin tightening and normalize interest rates.

Figure : Effective Federal Funds Rate

The Federal Reserve has publicly stated that they are targeting a long-term inflation rate of 2%.  The most commonly used measure of inflation that the Fed utilizes is Personal Consumption Expenditures (PCE) as measured by the Department of Commerce.  The Fed uses the PCE index because it covers a wide range of household spending.  The chart of the current year-over-year change in PCE demonstrates that the Fed’s key measure of inflation is well below the target of 2%.

Figure : Personal Consumption Expenditures Index y-o-y % change

“Despite inflation remaining below the Fed’s target, the discussion of the normalization of interest rates has recently been discussed in the Fed minutes,” comments Ryan Mahoney, portfolio manager at Dalma Capital, “Current Eurodollar futures point to a 2.1% Fed Funds rate at the end of 2016 and a 2.9% rate at the end of 2017.  Although the tightening cycle will not likely start in 2014, local UAE investors must prepare for a rising interest rate environment.”

The inevitable monetary tightening will probably be the trigger for earnings multiple contractions in equity markets.  Over 60% of the price gains seen in local stock markets over the last year are the result of earnings multiple expansion – meaning local markets would suffer in an environment when earnings multiples are contracting.  Higher interest rates also translate into higher borrowing costs for UAE companies and ultimately lower profitability.  Additionally, higher interest rates would make corporate bonds and sukuks more attractive relative to equities as the equity risk premium is reduced by higher bond yields.  Although there is limited risk for an immediate normalization in US interest rates, prudent local investors will undoubtedly begin considering the exposure of their portfolio allocation to rising rates.

The Dubai Financial Market: Bear Market or Correction?

Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited – a DIFC Hedge Fund Manager
www.dalmacapital.com

July 1, 2014
 As of July 1st, 2014 the Dubai Financial Market General Index (DFGMI) is down 24.3% from its recent peak of 5,374.11, which was reached on May 6, 2014. Clearly, the market has corrected significantly but the question as to whether we have now entered a bear market remains debatable. Although there is no single definition, many market participants consider a correction of more than (20%) over a two month period to be a bear market. Based on this definition, it would appear superficially that DFGMI is now in a bear market.

However, the DFGMI is still up 23.33% on a year-to-date basis and up 83.1% on a y-o-y basis. From our perspective, the current downturn is simply a correction following an extremely strong period performance by the index in 2013.

We continue to believe that the underlying growth outlook for the UAE is positive. The economy continues to grow due to strength in the tourism, trade and real estate sectors. The DFGMI posted a blistering 108% increase in 2013 due to a combination of factors. However, inclusion in the Emerging Market index by MSCI was one of the primary catalysts for the strong price performance of the market as a whole.
“From our perspective, valuation levels were overextended especially in comparison to other emerging markets” notes Ryan Mahoney, portfolio manager at Dalma Capital, “Ultimately, corporate profitability and economic growth will be the key drivers of the market going forward.“
Why Valuations Matter?
We continue to believe that the outlook is positive for the DFGMI. The recent correction reflected a normalization of valuation levels. In general, we view price multiples such as the P/E ratio to be mean reverting. In a sense, valuation levels are like a pendulum. Periodically valuations levels will overshoot their historical average and conversely undershoot, but will ultimately return to their baseline level.

Observing valuation data, we can see that at the beginning of 2013 the TTM (Trailing Twelve Month) P/E ratio for the DFGMI (blue line) was far above that of the MSCI Emerging Market Index (MXEF) (grey line). However, as the DFGMI marched upward throughout 2013 and the first half of 2014 the valuation premium became excessive. The overvaluation of the DFMGI becomes even more apparent when comparing directly to the Abu Dhabi Securities Market General Index (ADSMI, orange line).
“Although a valuation premium for the DFGMI relative to the MXEF is warranted, the discrepancy became too large to be sustainable,” observes Elliot Carol, portfolio strategist at Dalma Capital, “Given the recent correction in the market, we view the DFMGI as being much more attractively valued at current levels”
What are the future prospects for the Dubai Financial Market?
The IMF is currently forecasting that the UAE will achieve 4.75% GDP growth in 2014. The growth backdrop is positive with both the tourism and hospitality sectors performing strongly. While Abu Dhabi’s economy is supported by public spending projects, Dubai’s services sector has been the main driver of the rebound.
While the performance of the DFMGI has been exceptional, the recent correction will bring valuation levels back in alignment with other emerging markets. Overall, we maintain a positive bias on the UAE economy and the DFGMI, although we did view the rapid rise of the market in 2013 and the first half of 2014 to be unsustainable from a valuation perspective. We believe the market will consolidate at current levels and expect improved corporate earnings growth to be the catalyst to drive the market higher as opposed to an expansion in valuation multiples.

Buy the rumor, sell the news - MSCI Upgrades UAE and Prices dip as investors take gains

Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited
Analysis by Elliot Carol, Portfolio Manager at Dalma Capital Management Limited
Dalma Capital Management Limited is a DFSA regulated asset manager operating in the DIFC; the company’s core business is hedge fund management.

www.dalmacapital.com

On 11 June 2013, MSCI announced its plan for a possible upgrade of its UAE Index to Emerging Markets status from Frontier Markets. On 14 May 2014 MSCI confirmed this reclassification during its semi-annual review meeting held in Geneva. As part of this change, the following nine UAE companies will be included in the MSCI Emerging Markets Index: Abu Dhabi Commercial Bank (ADCB), Aldar Properties (ALDAR), Arabtec (ARTC), DP World (DPW), Dubai Financial Market (DFM), Dubai Islamic Bank (DIB), Emaar Properties (EMAAR), First Gulf Bank (FGB) and National Bank of Abu Dhabi (NBAD). The change in index constituents will take effect on Jun 01, 2014.

Despite the positive impact inclusion in the index is likely to have, the four trading days following this announcement both the DFM General Index (DFMGI) and ADS Market Index (ADSMI) have witnessed a sharp decline in price levels of 12.5% and 5.3%, respectively. This is in contrast to an increase in index levels of a staggering 125.5% and 40.6% for DFM and ADS between the original MSCI announcement on 12th June 2013 and the recent announcement on 14th May 2014. The recent price action indicates selling pressure, post confirmation of upgrade, by investors seeking to realise capital gains.

“In the very short term, the technical (chartist) outlook is quite bearish. May 19th saw the breakdown of a double top-reversal pattern,” commented Ryan Mahoney, a Portfolio Manager at Dalma Capital Management Limited, adding “The close of DFMGI below 5000 is a possible indication that the 10-week uptrend is losing momentum. The next key support zone is between 4720 and 4760 – in the near term, we believe we are likely to see a drop to this level. If support consolidates in the bottom of this range – there is room for a continuation of the larger bull trend. Should the index break below 4665, this would indicate a broader correction which could continue to 4212 finding major support at 4000.”

Data Source: Bloomberg Professional
 “Analysing the data from a bottom up perspective, a price trend similar to that observed in the broader DFM and ADS indices can be seen in the stock prices of the nine companies that are now constituents in the MSCI Emerging Markets Index” observes Elliot Carol, Portfolio Strategist at Dalma Capital Management Limited. “This indicates that impact of the MSCI UAE upgrade was already priced in by investors, who took the opportunity to realise capital gains when the news was confirmed, a classic example of ‘buy the rumor, sell the news.’”
Average daily volumes pertaining to the DFM, ADS as well as the nine stocks mentioned above have significantly increased after MSCI’s announcement on 14th reconfirms selling pressure by investors seeking to realise gains.

A Demystification Of Hedge Funds And The Risk For Investors

Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited – a DIFC asset manager specializing in Hedge Fund management.

www.dalmacapital.com

A demystification of hedge funds and the risk for investors

As investors in the GCC become increasingly sophisticated and continue to institutionalize there have been pioneers, early adopters and latecomers in the development of an alternatives (hedge funds) portfolio.  The region’s pioneers have been the sovereign wealth funds, with ADIA as the world’s largest single investor in hedge funds.  Some large and sophisticated family offices have followed the prudent lead of the Sovereign Wealth Funds along with a handful of corporates, foundations and wealth management firms – but regional allocations to the asset class still ominously lag their western peers at a time when the world’s institutional investors are increasing their hedge fund allocations.

Why sophisticated investors are selecting hedge funds?

The year 2014, which we previously proposed would be the ‘year of the hedge fund’ is already seeing large flows into the asset class and in 2015, the industry may manage more than $3.3 trillion according to a report by Boston Consulting Group.  The forces compelling inflows today are the same as those driving flows to hedge funds historically – they are primarily related to risk management.

10-15 years ago, the impetus to invest in hedge funds was to diversify overweight allocations to equities as valuations were historically high and expected returns withered.  Hedge funds provided uncorrelated returns that were expected to mitigate exposure to expected market downturns.  Historically, hedge funds best relative performance was generated when markets faired poorly.  Investors seeking to protect gains from the equity bull market of the 90’s sought hedge funds to manage risk and protect their downside.

Today, expensive bond markets combined with increasingly ‘dear’ equity valuations create a similar – yet in some ways starker backdrop as expected future returns on stocks and bonds fall in step.  Inflows and allocations to hedge funds are therefore likely to be best explained by investors seeking to protect their downside as uncertainty grows amid expensive stock and bond markets.

Risk Matters

Risk is often defined as volatility, but it is certainly not perceived this way by private investors.  The probability of losses, particularly large losses, is a more pragmatic definition of risk for the individual investor – as losses destroy the rate at which capital compounds.  To maintain a portfolio with long run growth, investors must achieve positive return asymmetry – this is where hedge funds excel.

Asymmetric Returns

A marketing phrase often used by hedge funds is that ‘hedge funds produce equity-like returns on the upside and bond-like returns on the downside’.  This statement may be an exaggeration and oversimplification, but it is not entirely untrue based on historical performance of hedge fund indices.  Hedge funds typically generate more modest returns during protracted equity bull markets, but outperform strongly during bear markets delivering a long-run return profile that is more positively asymmetric than the market index.

The key to maintaining superior long-term returns and positive compounding is positive asymmetry, which is achieved through robust risk management and avoidance of significant losses, as losses destroy the rate at which capital compounds.  Positive asymmetry is where hedge funds have delivered for investors by reducing the relative downside investors inevitably experience as financial markets ebb and flow.  The end result is relative outperformance by hedge fund indices on both a risk adjusted an absolute basis compared with major equity indices, such as the S&P 500®.

Risk Management

Hedge funds typically manage risk based on the premise that superior long run returns can be generated through strategic selection of assets.  Most hedge funds seeks to buy assets that they believe will outperform the market and sell/short assets they will believe will underperform.  Short positions and derivatives held by many hedge funds might be considered on a standalone basis to be risky and speculative, but as part of a typical hedge fund portfolio – these assets serve to offer protection or a ‘hedge’ against market downturns or volatility – often reducing risk for investors.

Empirical evidence demonstrates the effectiveness of this approach – with Hedge Fund indices posting long run out performance on both an absolute and a risk adjusted basis when compared to most market indices and other asset classes.  By reducing market correlation and mitigating downside risk – hedge funds have emerged as an essential component of the prudent investor’s portfolio.

Derivative Instruments – The Answer to an Efficient Shorting Mechanism

Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited – a DIFC asset manager specializing in Hedge Fund management

www.dalmacapital.com

In our previous article “Fundamental outlook for UAE markets is strong” published on 8th July 2014, we identified the need for efficient shorting mechanisms on local stocks to help protect the likelihood of formation of ‘bubble’ conditions in the market. (For the uninitiated, ‘short selling a stock” is simply borrowing the item at a particular price on the basis that if the stock price reduces your obligation is simply to give back the stock and not the monetary value for which you borrowed it.) So given the increased focus of international fund managers on this market, such mechanisms are likely to become increasingly important for the UAE, especially given that the domestic market’s fragility that was demonstrated by the recent broad selloff and spike, which was exacerbated by systematic margin covering.

*Source: Bloomberg

When compared to competing global markets the relative riskiness of the UAE market is demonstrated by its high standard deviation of 997 for Dubai and 741 for Abu Dhabi, based on 5 year daily price data as of 15 May 2014.  This is in contrast to the standard deviation range of 7.9 to 626 for the four BRICs nations, 95.6 for Malaysia, 229 for Egypt (both relatively mature emerging markets) and 214 for Singapore (a small but fully developed market).  Comparing standard deviation calculated on 5 year month end data also highlights a similar picture. 

Although ‘risk’ as defined by standard deviation is likely to decline once the local market matures, the development of a healthy derivatives market as an efficient shorting mechanism is an important fact that acts as catalyst to speed up the process.

Established in 2008, NASDAQ Dubai remains the only equity derivative exchange in the UAE.  It currently offers only two products, both cash settled: Index Futures based on FTSE NASDAQ Dubai UAE 20 Index and Single Stock Futures on 20 stocks.  However, the market is still in its infancy stage as it is dominated by OTC trades between a limited number of major investment banks resulting in low liquidity.  Ryan Mahoney, portfolio manager at Dalma Capital Management, was of the view that, “Presence of dedicated market makers (brokers prepared to hold securities to facilitate trades) would provide on screen liquidity and boost overall trading volumes.  Moreover, enhancement in product mix is also required to develop the market further: such as introduction of single stock and index based options.”

Abu Dhabi Securities Exchange also plans to add derivative products to its portfolio in the near term and, in June 2013, again raised discussions of establishing the GCC wide Gulf Derivatives Exchange that was previously proposed nearly a decade ago. Separately, Elliot Carol, Portfolio Strategist at Dalma Capital Management, noted, “Should unique needs exist, alternative asset classes, such as hedge funds and managed futures could participate in this market and represent a viable risk reducing instrument because combining with traditional asset classes offers exposure to special investment strategies..”

Hedge funds by their very purpose generally both long and short the market – in some cases even market neutral – and most seek mitigated or even positive exposure to systematic risk.  Many hedge funds exploit arbitrage (each way) opportunities and, as such, may be low risk investments.  In case of macro focus, rather than micro, managed futures could also prove to be an attractive alternative asset class because correlation with equities is low and often negative, and correlation with bonds is less than 0.5.

If used for purposes other than hedging, many alternative assets have potential for generating significantly higher returns. However, risk will be increased is leverage is utilised. In most cases, though, derivatives (contracted pricing) are utilized to limit riskiness and may be combined with traditional assets to increase risk adjusted return. Increased hedge fund activity can be especially promising in a market dominated by traditional, long only, market oriented and largely passive portfolios of stocks and bonds – which may be susceptible to bubble formation. However, the situation as it pertains to local markets is ‘chicken & egg’.  In order to gain hedge fund participation, which could serve to increase volumes and liquidity whilst decreasing risk; the local market is unlikely to enjoy such presence unless short sale mechanisms are introduced.

Improvement in overall market efficiency as a result of MSCI’s reclassification of UAE from Frontier to Emerging Market

Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited
Analysis by Ryan Mahoney, Portfolio Manager at Dalma Capital Management Limited

Dalma Capital Management Limited is a DFSA regulated asset manager operating in the DIFC: the company’s core business is hedge fund management.

MSCI (Morgan Stanley Capital International Indices) is no longer part of Morgan Stanley but is a worldwide, influential and leading provider of investment decision support tools.

The recent reclassification of the MSCI UAE Index from Frontier Market to Emerging Market status, announced as part of the results of MSCI’s semi-annual review meeting held on May 14, 2014 in Geneva, brings positive news to the market and is poised to significantly improve overall market efficiency in the Emirates.

The MSCI UAE Index consists of nine companies, namely: Abu Dhabi Commercial Bank, Aldar Properties, Arabtec, DP World, Dubai Financial Market, Dubai Islamic Bank, Emaar Properties, First Gulf Bank and National Bank of Abu Dhabi.

MSCI’s decision to upgrade UAE reflects a growing realisation of how far the country’s economy and its financial market have rapidly developed in recent years. The change from frontier market to emerging market status reduces the perceived risk of investing in a market and is therefore extremely significant for the UAE.  This change also means that the country’s financial markets are, to a large extent, compliant with the ever increasing global investor relations and corporate governance standards that are a key for improvement in the overall efficiency of a market.

This rise in status will open up a wider pool of investor capital available to tap for both stock markets and companies in the UAE as foreign institutional investors, including passive index tracking funds, start entering the market.  This will result in a positive liquidity boost, not only in the nine scrips mentioned above, but also in shares of other UAE public listed companies.

Ryan Mahoney, portfolio manager at Dalma Capital Management Limited, noted that “Upcoming inclusion into the MSCI Emerging Markets index will act as the marginal buyer in the near term – this is likely to provide further momentum in current bull move.”

In addition to the liquidity boost from foreign investors, depth as well as breadth of the market will increase and internal liquidity will receive a major push as confidence increases amongst local investors.  Overall, the UAE is likely to see a one-time inflow of approximately US$ 440 million from passive funds tracking the MSCI Emerging Markets Index, given the country’s pro-forma weight of around 0.6% in the Index and, according to Fund Tracker EPFR, the total size of US$ 72 billion of passive funds tracking the MSCI Emerging Markets index.

Presence of sophisticated investors allocating to constituents of MSCI’s Emerging Market Indices will also encourage the local stock exchanges, financial market intermediaries and relevant regulatory authorities to develop innovative and more sophisticated product offerings in order to remain in line with their global counterparts.  Moreover, to remain competitive in the global emerging markets’ landscape, there will be a need to offer asset class diversification by providing an alternative to conventional asset classes in the form of hedge funds as well as derivatives and structured products.
There will likely be an increase in the number of listed stocks as private companies have an incentive to list; incentive in the form of greater recognition across the globe.  This not only will increase the size of the market, but will also add to diversity among the existing asset mix. Large companies that are already listed will be tempted to increase free-float in order to qualify for inclusion into the MSCI Emerging Markets Index - this increase in free-float will inevitably result in increased transparency in company operations which would, as a result, further improve market efficiency.

For countries classified as Emerging Markets, MSCI requires that the efficiency of the operational framework be good and tested. Among others, a key requirement of an efficient operational framework is timely dissemination of all stock market information in English to all market participants, which should bring further improvement in market efficiency.

Lastly, on the regulatory front, this status upgrade will continue the UAE government’s successful trend to further push ahead and liberalise access to its financial markets by raising ownership limits for investors and adopting flexible legislative and regulatory frameworks, which is one of the key ingredients of efficiency in any market.

Pressures for Increased Transparency resulting from MSCI’s Reclassification of UAE from Frontier to Emerging Market

Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited

Analysis by Ryan Mahoney, Portfolio Manager at Dalma Capital Management Limited

Dalma Capital Management Limited is a DFSA regulated asset manager operating in the DIFC; the company’s core business is hedge fund management. Dalma Capital Management provides services to professional and/or qualified clients only. The Company does not currently open or make available its unified return investment models or the Dalma Unified Return Fund to third party investors and Zachary Cefaratti is a Risk Officer at Dalma Capital Management Limited

MSCI (Morgan Stanley Capital International Indices) is no longer part of Morgan Stanley but is a worldwide, influential and leading provider of investment decision support tools.On 14 May 2014 MSCI announced the results of its semi-annual review meeting. As expected, the UAE and Qatar indices were reclassified from Frontier Markets to Emerging Markets.

This brings positive news to the market in terms of increased investor confidence, greater visibility of UAE companies to sophisticated investors worldwide, increase in foreign portfolio investment directed towards the UAE andimprovement in overall market efficiency. The upgrade and the assets that come with it are also likely to lead to pressures for increased transparency in order to achieve consistency with the market accessibility criteria set forth by MSCI for constituents of its Emerging Markets Index.

A country’s market accessibility is judged on the basis of four factors that include: openness to foreign ownership; ease of capital inflows and outflows; efficiency of the operational framework, and stability of the institutional framework.“To remain consistent with the Emerging Markets criterion and gradually move towards the ultimate goal of being classified as a Developed Market, the UAE and Qatar will need to deliver the requiredimprovements in all four factors assessing market accessibility,” concludes Elliot Carol, portfolio strategist at Dalma Capital Management Limited.

With regard to openness to foreign ownership, the MSCI upgrade will require local market stock have an increased focus on providing a level playing field for both international and local investors. Foreign ownership limit levels will inevitably need to be enhanced, with equal economic and voting rights being provided to foreign investors. In addition, the upgrade will necessitate that equal rights are provided to all minority shareholders.

The UAE is largely compliant with the ease of capital inflows and outflows factor;the country has already implemented a high degree of foreign exchange market liberalisation due to the existence of a developed onshore and offshore forex market. There are also no restrictions, as such, on inflows and outflows of foreign capital to and from the local stock market.Minimal restrictions are applicable to repatriation of foreign direct investment as well.

The key challenge will be improving efficiency of the operational framework and, just as importantly, maintaining it. Barriers to entry for investors will need to be lowered significantly, by minimizing the registration requirements for international investors as well as documentation/approvals required for setting up local accounts in order to decrease the overall time required for opening and funding an account. The legal and regulatory framework governing the financial market, stock exchanges and the various other financial markets participants will need to be improved, including ease of access to information(particularly in English),reduction of ambiguity and prompt enforcement of laws and regulations, as well as consistency amongst all of these factors over time.

A competitive landscape that encourages unrestricted investor access to derived stock market information, data and investment products will also be required; for example the provision of independently calculated indices or the creation of baskets of securities used in the creation of financial products.Likely the most important factor in improving transparency will be increased pressure for the timely disclosure of complete stock market information in English and under reasonable commercial terms to all market participants as well as the robustness and enforcement of accounting standards. These improvements will likely lead to reduced information asymmetry amongst investors and other market participants.

Constant improvements will be considered necessary in the market infrastructure as the UAE continues its path to “developed market” status. A well-functioning clearing and settlement system, based on international standards including delivery versus payment, the absence of pre-funding requirements and the possibility to use overdrafts will need to be in place. Availability of omnibus structures will be a key consideration. An efficient mechanism that prevents brokers from having unlimited access to an investor’s accounts, in order to guarantee the safe keeping of its assets will in all likelihood become mandatory and would require competition amongst local custodian banks as well as the presence of global custodian banks.

In addition, to ensure high quality of services offered to investors – such as cost efficient trading and ability to execute block trades at the same price for the various accounts of a fund manager –steps to increase competition amongst brokers will be inevitable. A framework for off-exchange transactions and in-kind transfers will likely be needed. Finally, there will be pressures to put in place an efficient mechanism to allow short selling as well as extensive use of stock lending, along with a robust but practical regulatory framework governing those activities.

Concerning the stability of the institutional framework – which deals with basic institutional principles such as the rule of law and its enforcement, the stability of the "free-market" economic system and track record of government intervention with regards to foreign investors – the requirements remain modest for countries classified as both Emerging and Frontier Markets.

Any country aiming to acquire the Developed Market status in the long term inevitably needs to focus on improving the stability of its institutional framework as well.

Zachary Cefaratti

Zachary Cefaratti is a Risk Officer at Dalma Capital Management and a director of the Dalma Unified Return Fund. He has over 10 years of professional experience in financial services and specializes in quantitative and computational analysis of asset returns. Zachary Cefaratti's primary responsibility is to maintain, update and ensure adherence to the Comprehensive Framework for Prudential Risk Management (CFPRM). Concurrently, Zachary Cefaratti graduated with a Double BA from Franklin University Switzerland in International Banking & Finance and International Business Management, with undergraduate and post-graduate work at in portfolio mathematics, accounting and economics at the London School of Economics (LSE), Foster School of Business and the University of Pennsylvania, respectively. Zachary is a US Citizen who is resident in Dubai.

Dalma Capital Management provides services to professional and/or qualified clients only. The Company does not currently open or make available its unified return investment models or the Dalma Unified Return Fund to third party investors. Past performance cannot be relied upon as an indication of future results. Dalma Capital Management Limited is a DFSA regulated asset manager operating in the DIFC: the company’s core business is hedge fund management. Zachary Cefaratti is responsible for back and middle office functions at Dalma Capital Management and supports the CEO in business development within the DIFC, GCC, Cayman Islands, United States and Europe.

Zachary Cefaratti, risk officer at Dalma Capital Management Limited, a DFSA regulated hedge fund manager in DIFC, said the decision by MSCI to upgrade the UAE and Qatar to Emerging Markets status from Frontier Markets status is likely to have profound, positive effects on domestic equity markets.