Why aren't active fund managers flocking to Saudi stocks?

Reputational risk and high valuations of Saudi shares are keeping active fund managers at bay, says analysis.

    The inclusion of the Saudi Stock Exchange (Tadawul) in the MSCI Emerging Markets Index has prompted billions of dollars in inflows from so-called 'passive' funds, but actively managed funds are keeping their distance, according to Copley Fund Research [File: Faisal Al Nasser/Reuters]
    The inclusion of the Saudi Stock Exchange (Tadawul) in the MSCI Emerging Markets Index has prompted billions of dollars in inflows from so-called 'passive' funds, but actively managed funds are keeping their distance, according to Copley Fund Research [File: Faisal Al Nasser/Reuters]

    Inclusion in the MSCI Emerging Markets Index is tantamount to winning the jackpot for a developing-market stock exchange. That's because as the composition of the index changes, so-called "passive" funds that attempt to mirror that index will snap up the newly included shares, driving up their price.

    This year's inclusion of the Saudi Stock Exchange (Tadawul) in the MSCI developing-economies equity benchmark prompted billions of dollars of inflows from passively managed funds. But funds that employ a so-called "active" management strategy that relies on research, forecasts and the judgement of managers are not feeling the same love for Saudi shares, thanks to high valuations and reputational risks, an analysis by Copley Fund Research showed.

    The Tadawul - the region's largest stock exchange - completed the second and final phase of joining the MSCI Emerging Markets Index in August, with its "weighting" set at 2.8 percent.

    Stocks listed in Saudi Arabia will also be included in other indexes, and the Tadawul says it has attracted billions of dollars in recent months.

    However, the stocks have found little love from active global emerging-market funds, 85 percent of which have yet to invest any money at all, found Copley CEO Steven Holden, analysing monthly filings from 193 such funds with a total of around $350bn in assets under management.

    One reason investors wanted to keep their distance was the murder of journalist Jamal Khashoggi by Saudi operatives in the kingdom's Istanbul consulate a year ago, Holden said.

    "High valuations, a relatively small investment universe and reputation risk a year on from the Khashoggi debacle are of foremost concern for investors," Holden said.

    Global emerging funds remain starkly underweight in Saudi assets, with an average holding of just 14 basis points, the biggest underweight in assets among developing countries after China and Hong Kong, Holden said.

    MSCI upgraded Saudi Arabia from "stand-alone" to "emerging" market in June 2018 and concluded the process at the end of August.

    More than $1.8 trillion of assets were benchmarked against MSCI's Emerging Market Index by June 2018, the index provider said. This would include passive as well as active investments.

    The Saudi benchmark enjoyed a stellar start to the year, climbing more than 20 percent in the first four months of 2019.

    However, escalating trade tensions, unsteady oil prices and rising geopolitical risks have weighed heavily on the market since then. The index is now up just 1.4 percent since the start of the year. MSCI's Saudi domestic index has risen 1.9 percent over the same period. MSCI's wider emerging benchmark added just over three percent.

    An attack on key Saudi oil facilities mid-September, sharply highlighting the kingdom's economic vulnerabilities, roiled Saudi markets.

    "There are certain geopolitical risks in Saudi Arabia and we see that with the attack on the oil installation," said Marshall Stocker, a portfolio manager at United States-based investment management firm Eaton Vance. The jury was still out on what effect the kingdom's reform plans would have, he added.

    Index provider FTSE Russell is also adding Saudi to its emerging and global equity indexes in a year-long, five-step process set to conclude in March. Its weighting will be 2.86 percent in the emerging and 0.31 percent in the global benchmark.

    Index inclusion and foreign investor cash will also be key to Riyadh's plans to sell about five percent of its oil giant Aramco in an IPO and reinvest the proceeds in new industries.

    In a filing at the end of August, Tadawul said foreign investors had accounted for a fifth of trading activity in the first seven months of the year. In September, foreigners bought a net 5.69 billion riyals ($1.52bn) of stocks, Tadawul added.

    Looking at the individual stocks listed, Holden found that Al Rajhi Banking & Investment Corporation has emerged as the most popular. US financial institutions TIAA-CREF and USAA and asset manager Robeco all bought into the stock over the past six months.