Why you should care
Because it’s not just oil that makes the kingdom go.
A landmark year for Saudi Arabia’s stock market will have little to do with Saudi Aramco, the country’s oil giant whose initial public offering plan has been put on hold.
Instead, the world’s three largest index providers will funnel billions and billions of dollars into Saudi stocks after admitting them to benchmarks whose influence has grown alongside the rise of passive investing over the past decade.
The process, which began this week when FTSE Russell and S&P Dow Jones added the stocks to their indexes, raises questions over what investors will be buying given the country’s largest and highest-profile company, Saudi Aramco, remains state-owned.
It also underlines the outsize role that index creators have in directing capital into countries with authoritarian regimes such as Saudi Arabia, which just months ago was accused of orchestrating the killing of journalist Jamal Khashoggi.
The elevated valuation of Saudi stocks has also been helped by the willingness of state-backed funds to prop up the market.
“These are reluctant financial transactions based on compulsion rather than deep conviction,” one Dubai-based banker says of the inclusion of stocks from the kingdom.
When rival index provider MSCI has finished admitting the equities in September, the $536 billion Saudi market, known as the Tadawul, is likely to be the eighth-largest bourse in the all-powerful MSCI Emerging Markets index, with a weighting of around 2.7 percent. The index is tracked by an estimated $1.9 trillion of funds.
Exchange-traded funds (ETFs) created to follow these indexes will be forced to mirror the weighting of Saudi stocks. Actively managed funds will not, but given many fund managers’ reluctance to veer far from their benchmark moorings, many are likely to do so.
Khalid al-Hussan, Tadawul’s CEO, says that around $500 million had already entered the market this week from ETFs, the first phase of an expected inflow of $5 billion. Foreign investors now own 5.1 percent of the market, up from 4.2 percent at the end of 2017. Mazen al-Sudairi, head of research at Al Rajhi Capital, says this implies “ample room” for more money to pour in, given regional markets such as Dubai now have 9 percent foreign ownership.
Emerging market funds have an average exposure of just 0.08 percent to Saudi stocks, according to an analysis of 180 funds with $350 billion of assets by Copley Fund Research, and more than 90 percent have no exposure at all.
Oliver Bell, who manages both the Middle East and Africa and frontier funds for T. Rowe Price, says fund managers “are going to have to look at [Saudi] because of the weighting it’s going to have in EMs. This can become 3 percent of the benchmark in short order.”
Analysts say that even without the Saudi Aramco listing, the fortunes of the Tadawul ultimately depend on an oil price that has rebounded 26 percent this year after plunging in the last quarter of 2018. The biggest sector within the stock market is financials, essentially a play on the health of the Saudi economy, followed by materials — largely petrochemicals and fertilizer.
The Tadawul has jumped 12 percent over the past 12 months, trouncing the 1.7 percent drop in the FTSE All-World index over the same period. That has helped propel the valuation of the Saudi market to 15.1 times forward earnings, compared with an EM-wide average of 12, according to Renaissance Capital.
The elevated valuation of Saudi stocks has also been helped by the willingness of state-backed funds to prop up the market. According to people familiar with the matter, the Public Investment Fund was among those to buy stocks after the fears of international sanctions that followed the Khashoggi killing prompted foreigners to pull $650 million from the kingdom.
Government-related entities now own 40.7 percent of listed securities, up 2 points from a year ago. The intervention is a reminder to investors — both passive and active — of the level of control the government in Riyadh exerts over the country’s economy and capital markets.
The index providers, which decided to admit Saudi stocks before the international outcry that followed the Khashoggi murder in Istanbul last October, have pointed to capital markets reforms the country has made that are necessary before inclusion.
This week’s admission of Saudi stocks marks the “culmination of their [Saudi Arabia’s] efforts to meet the rigorous requirements for inclusion,” FTSE Russell said.
While investing in emerging markets has long involved dealing with authoritarian regimes, some observers argue that the rise of passive investing has allowed fund managers to hand these ethically difficult decisions to a handful of index providers.
“There is almost collusion in including countries where corporate governance is very low and moral hazard is very high [in the indexes], and Saudi really fits that paradigm,” says J.P. Smith, a partner at Ecstrat, an investment consultancy focused on politics, governance and markets. “We have this process of creeping authoritarianism, but people are so in thrall now to the index providers, it’s an abdication of responsibility.”
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