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.