Investors Demand Good Products

Tapping into the vast investor pool of money available in the Middle East is not an easy task. It is also not very different from marketing and selling funds anywhere else in the world, say the experts. While there is a debate about the merits and need for a local presence as well as the use and need of intermediaries, the majority of people in the fund industry working in the region agree that the approach will be roughly the same as anywhere else.

Although there is a tendency to lump the countries of the Gulf Co-operation Council for the Arab States of the Gulf (GCC) together, they are quite separate entities with their own approach to regulation. The GCC, created in May 1981, is made up of six countries – Bahrain, Kuwait, Oman, Qatar, the Kingdom of Saudi Arabia and the United Arab Emirates (UAE) – and covers around 630 million acres (2.5 million km2).

Each of the six countries has its own laws, rules and regulations. The idea of the grouping is to encourage co-operation and harmonisation on a wide range of issues. The GCC agreements specifically target taxation and give a framework to ensure GCC nationals are taxed in each of these separate jurisdictions as if they were nationals of that jurisdiction itself.

According to research by PricewaterhouseCoopers, in response to the rapid economic development and increased investment interest in the region, there has been a move towards the development of modern investment laws and regulations throughout the region.

Qatar, through the Qatar Financial Centre, has established or revamped, its financial services industry regime.

Dubai in particular (an emirate of the UAE) has taken some significant steps to establish a new regulatory framework. It has issued specific collective investment legislation to encourage the establishment of hedge funds and the active management of those funds from a designated financial services centre, in particular the Dubai International Financial Centre (DIFC).

The Dubai Financial Services Authority (DFSA), an independent regulator of the DIFC, has issued a code of practice for hedge funds. This sets out best practice standards for hedge fund operators through nine key principles aimed at addressing risks inherent in the operation of hedge funds.

There are two potential options for establishing a fund or a fund manager in the UAE: (i) under the supervision of the UAE Central Bank (an onshore registration) or (ii) the DFSA. Onshore registrations are unattractive because of a number of local restrictions, so the majority of funds and fund managers generally opt for establishing in a free zone. At present, the only free zone specifically aimed at the financial services industry is the DIFC, regulated by the DFSA. It has issued legislation regulating the fund management industry within the DIFC.

The Collective Investment Law, enacted in 2006, gives the framework for regulating funds and permits the operation of various types of funds in the DIFC including hedge funds. It limits the promotion of products, sets out requirements for risk assessment and audits and gives details on specific oversight roles.

The law also contains several restrictions relating to the distribution of some foreign funds. Generally, the restrictions apply where the foreign fund is not located in a recognised jurisdiction; this is defined as one not recognised by the International Organisation of Securities Commissions.

Bahrain claims to be a leader in the hedge fund race. While it does not get the same level of publicity, Abdul Rahman Al Baker, executive director of financial institutions supervision at the Central Bank of Bahrain, is keen to promote his country as the centre for the GCC’s nascent hedge fund development.

The first hedge fund market in Bahrain was by the Man group in 1982. Since then, legislation has developed and the territory allowed the first locally incorporated hedge fund to open in 1992. It has also updated its laws on hedge funds and allows a variety of incorporation, including special purpose vehicles.

Despite these claims, however, most people first think of Dubai and specifically the DIFC when talking about the hedge fund industry in the region.

Robert Law, managing director at Carne Global Financial Services (Dubai) based in the centre, says funds looking to attract local investors need to remember that there are specific laws and rules applying in each jurisdiction, although he agrees the rules for Dubai are detailed and fairly well developed. Other jurisdictions in his view do not have as extensive legislation although most have established some sort of framework.

Aiming High

From a general standpoint, he thinks marketing hedge funds to Middle Eastern investors is generally aimed at the high and ultra high net worth individuals, typically more open to riskier investments. He believes the easiest and best way to sell funds is through a local intermediary who has extensive and detailed information about the specific jurisdiction and investor behaviour.

He thinks investors in the region are open to the concept of hedge funds and are likely to invest in them. However, the financial crisis has not left the region unscathed and he thinks there is far less appetite for risk and a more conservative investment attitude surfacing.

Hedge funds approaching family offices, he says, will find it difficult to penetrate. They will need to be patient and use connections to build up relationships in the region in order to make sales.

He is a strong proponent of the idea of having an office in the region and believes it is easier to develop relationships that way, saying this shows a commitment to the region rather than having someone fly in and out.

Brain Luck, partner and head of research at The Capital Partnership (TCP), disagrees. His company, set up in 1998 to provide sophisticated investment services to the families of its founding partner, has offices in London and Dubai. TCP Group’s ultimate holding company is incorporated in the DIFC. It is an advisor to a number of leading regional institutions and family groups.

“To be honest,” admits Luck, “there is no particular difference between investors in the Middle East compared to elsewhere. It is more of an investment type, which is the same as in the West.”

Last year, NCBC, the investment banking arm of National Commercial Bank (NCB), Saudi Arabia’s largest bank with around $14 billion of assets under management, acquired TCP to help build up its services in the wealth and asset management side.

NCBC sees the acquisition of TCP as part of its strategic plans to bring new capital equity absolute return products to the Middle East and North African region. On the other hand the acquisition allowed TCP, which retained its name, to expand significantly its distribution network in the region. It also gave TCP access to the resources of NCBC and NCB for seeding managers and new product development.

TCP offers customised funds of funds, trust structuring, family governance, portfolio analysis and estate planning. The company believes Islamic investors are looking for access to both traditional structures and Shariah-compliant funds.

Luck believes the focus for hedge funds now is on institutional investors as the speculative money from family offices and high net worth has “dried up as it has elsewhere. People do not have a speculative mindset, more circumspect and cautious.”

He thinks as tensions ease, people sitting on cash will continue to look at hedge funds. “The more speculative element has ended. It [risk appetite] is just not there as much. There is not necessarily less interest in hedge funds, just that it will just be a more cautious approach,” notes Luck.

He says investors are more circumspect and cautious throughout the region, in line with investors in the rest of the world. Luck says the ultimate test, however, is whether the investment opportunity is a good one. "These are clever investors. They know what they are doing. Their approach to due diligence is the same as anywhere."

As to having an office, going through intermediaries or just visiting the region sporadically, Luck has advice based on his own experience and observations.

"I think the region has long been seen as a quick win: set up an office and people will buy your products. That’s not true at all. It is worth dealing with someone who knows the region well. But it would be the same as anywhere."

"If a US hedge fund wants to set up in the UK, it needs to build relationships or develop existing ones. A new hedge fund can come in here and set up but don’t expect investment without effort and building trust. People here are looking for the top investments. They are sophisticated people. It’s not a ‘build it and they will come’ place. You need a considered and long-term approach, and more than anything else, a good product," notes Luck.

At Conyers Dill & Pearman, associate Fawaz Elmalki agrees in part with Luck. He does not think it is essential to have an office but for some investors, like sovereign wealth funds and high net worth individuals, investing in hedge funds with no management office in the Middle East could be problematic. Investors, he says, like to see a long-term commitment. Elmalki also points out that the Cayman Islands, Bermuda and the British Virgin Islands are the most popular fund jurisdictions for hedge funds sold in the Middle East and he does not expect that to change.

Tough Money

Elmalki says it is still difficult to raise capital in the Middle East at the moment. He says there is money on the sidelines and investors in the region like those elsewhere, waiting. He expects they will want more transparency, greater risk controls and have a preference for more liquid assets when they do return to the markets. Like Luck, Elmalki says investors will want to see a proven track record before investing and believes Middle East investors appreciate the time managers take to build relationships. “Trusting relationships are key in the Middle East. To do that and show a commitment to the region takes time, especially when dealing with family offices and high net worth individuals. So developing a trusting relationship is the foundation of success,” he concludes.

Although the GCC has not been immune to the global recession, with assets under management shrinking for the first time since 2002, there is still opportunity in the region.

An analysis1 by Ernst & Young identifies seven significant investor segments in Islamic markets. First is the mass affluent individuals with liquid wealth of US$50,000-$500,000 who have a high propensity to invest in Shariah-compliant products. In 2008, the value of liquid assets for this group in the GCC was US$135 billion, and this is expected to grow to US$222 billion by 2013. Between 70% and 90% of investors prefer Islamic products, with Saudi investors much more likely to demand Islamic investments than investors from other GCC states. This group tends to focus on mutual funds using local service providers; they particularly like annuity- and insurance-linked products that require small monthly contributions.

High net worth individuals (HNWIs) are defined as people with financial assets of at least US$1 million. In general, this group prefers Shariah-compliant products but decisions are taken on product quality. Ultra HNWIs (UHNWIs) are individuals with financial assets over US$30 million. As a group, they are similar to the HNWI segment, preferring Shariah-compliant products where they are available. In 2008, the total wealth of HNWIs and UHNWIs in the Middle East was US$1,400 billion. This is expected to grow to US$2,800 billion by 2013.

HNWIs and UHNWIs tend to seek safe assets and capital preservation. Their Shariah sensitivity depends on preference of the decision-maker, with between 70% and 90% of investors preferring Islamic products, although they are prepared to invest in conventional products when there is no viable Islamic alternative. These groups are unlikely to invest through mutual funds and like to use discretionary portfolios with local and international specialised asset managers with whom relationships have been developed. Big-ticket appetite allows access to structured products but they demand opt-out clauses when investments are made in conventional products to avoid haram (forbidden) industries and excessive leverage

Figure 1: Global Islamic Funds Industry

Source: Eurekahedge, Zawya, Ernst & Young analysis

 Figure 2: Target Market of Annually Launched Global Islamic Funds (Number of funds)

Sources: Zawya, Eurekahedge, Ernst & Young analysis (496 Islamic funds)

Figure 3: HNWI and UHNWI: Segment seeking Adequate Returns and
Hassle-free Redemption Arrangements (US$ trillion)
Note: In 2008, the total wealth of HNWI and UHNWI in the Middle East was $1,400 billion. This is expected to grow to $2,800 billion by 2013. Asian HNWI and UHNWI had total wealth of $7,600 billion in 2008. This is expected to grow to $11,100 billion by 2013. Growth rate of 7.9% assumed for Asia-Pacific and 15.3% for the Middle East (based on historical growth rates)

Source: Capgemini and Merrill Lynch World Wealth Report 2006, 2007, 2008;
Ernst & Young analysis

The quasi-institutional grouping includes Awqaf (children) and endowments. Awqaf tends to focus on long-term real estate and cash holdings with Shariah compliance being a necessity. University endowments are becoming more prominent, with the main aim being long-term capital growth, notes Ernst & Young.

This is a burgeoning new segment requiring capital preservation and fund management. The estimated market size in 2008, was $100 billion and this is expected to grow.

The most notable Awqaf specific foundations/bodies in the GCC include Kuwait Awqaf Public Foundation (KAPF); Awqaf and Minors Foundation (AMAF); Sharjah Awqaf General Trust (SAGS); Qatar Endowment Authority (QEA); Ministry of Islamic Affairs, Endowments, Da’wah and Guidance (MIAEDG); Ministry of Religious Affairs (MARA); and Ministry of Justice and Islamic Affairs (MOJIA). Several Awaqf funds have also been structured as endowment funds with the principal aim of developing academic institutions. For example, the King Abdullah University of Science and Technology (KAUST) Endowment Fund has $10 billion, considered to be the sixth largest endowment fund in the world. Bahrain’s Awqaf Fund for Research, Education and Training in Islamic Finance was established in March 2008 with capital of $5.8 million.

For Awqaf and endowments, real estate is the dominant asset class with a small allocation to equities.

Institutional investors include Takaful (an Islamic insurance concept), a growing part of the Islamic investor community. Takaful constitutes a large institutional segment with liquid assets requiring Shariah-compliant products. In 2008, the value of investable assets of Takaful operators stood at $7.2 billion; this is expected to grow to approximately $11.2 billion by 2012.

Shariah compliance is a necessity. However, a lack of depth in Islamic investments, particularly in the fixed-income asset class, forces many operators to reinsure large portions of their risk. Due to the long-term nature of their obligations, this segment is drawn to opportunities for capital appreciation.

Although sovereign wealth fund (SWF) investments have taken a hit, they still represent a significant part of the investment landscape. Most SWFs do not have a strictly Islamic mandate but do adopt ethical investment strategies.

Figure 4: Shariah sensitive Investable Assets in the GCC and Asia
by investor segment in 2008 (US$ billion)

Note: Total investable assets and Shariah-sensitive portion for investor segments are assumed using sources found in the investor segmentation and key market sections of the report and supported by industry interviews. Wealthy individuals and pension funds are for the GCC, Malaysia, Indonesia and Pakistan; Takaful operations are for the GCC and Malaysia; SWFs are for the MENA and Asia; and Awqaf is for the Middle East.

Source: Industry Interviews, Data Monitor, Ernst & Young analysis
Click on the image for an enlarged preview

Figure 5: Sovereign Wealth Funds: Large Investor Group utilising
only Sophisticated and Proven Fund Managers

Note: In 2008, it is estimated that SWFs lost approximately 25%of their value due to the downturn in equity markets and other asset classes. However, their reserves have been replenished by current oil and other revenues. Estimated losses could exceed over $700 billion.

Source: SWF Institute, Deutsche Bank, Business Week
Click on the image for an enlarged preview

Pension funds as large institutional investors do not have a high propensity to consume Islamic products. However, they are an increasingly important investor class that do engage with Islamic financial institutions.

This is a large investor group using only sophisticated and proven fund managers. In 2008, SWFs were estimated to have lost approximately 25% of their value due to the downturn in equity markets and others asset classes. However, current oil and other revenues have replenished their reserves. Estimated losses could top $700 billion.

The SWF investor segment is not predisposed to Shariah compliance although they do prefer ethical investments. Conventional financial institutions are not excluded from their investment strategies.

The product focus for SWFs is generally through well-established and reputable international brands, with which long-term relationships have been established. They will have single management limits that force multiple relationships. In general, this group likes sophisticated structured product offerings and exposure to international markets as well as products that can compete in terms of price, returns, scale and service quality with best-of-breed conventional offerings.

Pension funds are the fastest growing institutional segment requiring long-term asset managers. They tend to have no Islamic requirements but this does not preclude involvement in Islamic investments. As awareness of Shariah compliance grows, these funds will be increasingly pressured into allocating more to Islamic offerings.

In general, pension funds prefer international investments in listed instruments, conducted through international portfolio managers with a focus on mature markets. They will become involved in alternatives to the cash/money market, which provide attractive returns but are low risk and allow for short tenures. Islamic mutual funds that can provide stable returns through exposure to international equities in mature markets are also attractive to this group.

Figure 6: Pension Funds: Fast growing Institutional Segment requiring
Long-term Asset Managers (US$ billion) - 2007

Note: *2008 data, **2006 data. Estimated market size 2007: $141 billion; change in market size from 2006: -10% Size was estimated for certain GCC countries by taking average assets per employee as a proxy for fund size. Change in market size was estimate for GCC only.

            Source: OECD, Ernst & Young analysis

Figure 7: Key Islamic Fund Domiciles by Number of Funds
(First Quarter 2009)

Note: Six jurisdictions are home to almost two thirds of all global Islamic funds. Two main types of domicile exist: domestic and offshore destinations. Funds based in domestic domiciles are established to gain access to local investors and local assets; funds based in offshore target international assets are established to take advantage of low taxes, fund administration, regulatory regimes and investor perception.

Source: Zawya, Eurekahedge, Ernst & Young analysis
Click on the image for an enlarged preview

 Changing Assets

Asset allocation has changed as increased investments have been made in equities due to attractive valuations. There has been a decrease in allocation to cash/deposits with short maturities, but this still remains a dominant asset class.  Fixed income is dominated by local government bonds but includes limited exposure to international issues.

The prolonged reduction in risk appetite has resulted in a marked shift away from traditional asset classes. Investors are changing their investment strategies. Those interviewed by Ernst & Young tended towards capital protection as the primary aim for investors regardless of return. In the current market climate, it seems investors are investing in low-risk strategies even though these traditionally offer the lowest returns.

Yielding investments providing an income stream are preferred to bullet payments. Generally, interviewees commented that investors have moved to yielding investments.

Investment managers are diversifying their product ranges to meet the changing needs of their investors and to target new investors for market share retention. “Investors want to invest in something where they will not lose money,” one Saudi executive noted in the Ernst & Young report.

A Bahrain executive noted: “There is liquidity in the market but investors are taking a wait-and-see approach.”

The reputation of the funds industry has taken a beating recently, causing investors to withdraw capital. The revision of expected returns has created an air of mistrust, notes Ernst & Young. Shocks to investors have led to a lack of trust as products that have been marketed as safe have proved to be riskier than expected.

Potential investors are looking at the bottom line before deciding to invest.

With global markets tumbling and overall fund performance waning, investors are subjecting asset managers to closer scrutiny. Frequency of valuations has been increased in order to satisfy the need for up-to-date information. Weekly performance updates are now provided to clients to ensure they have constant access to reliable and relevant data.

Investment managers need to defend themselves. Some managers are giving investors details of limits and levels of exposure to toxic asset classes.

With the industry in the spotlight, investment managers need to be proactively engaged in communicating with their clients to address any concerns before they arise, concludes Ernst & Young.

This article first appeared in Hedge Funds Review (Issue 105, July 2009),


1 Islamic Funds and Investments Report 2009: Surviving and adapting in a downturn, by Ernst & Young.