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In this article LMG CEO/CIO Erik L van Dijk explains why he believes that MENA markets will be far more important for international investors than they used to be in the years that lie ahead of us. Liberalization measures in Saudi Arabia that will make investments in the Tadawul a lot easier for foreigners will play a pivotal role. But it is not just that. MENA Markets happen to be the ones that benefit most from the general switch from market-value-based to fundamental focus that index investors around the world are currently going through.
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WHY MSCI UNDERESTIMATES THE IMPORTANT OF THE MENA REGION EVEN AFTER THE MOST
RECENT INDEX CHANGES
By Erik L van Dijk, CEO/CIO
July 7, 2013
The most recent changes in the MSCI Indices were interesting ones, especially from a MENA point of
view. Not so much because of the downgrade of Greece (from MSCI Developed to MSCI Emerging
classification), but more so because of what happened to three already classified MENA markets
(Morocco, Qatar and UAE). And maybe even more so because of what did not happen yet, but what
is most likely to be the big thing any time soon: a re‐classification of Saudi Arabia from ‘nothing’ in
MSCI terms to ‘something very visible and investable’.
LMG Emerge believes that one of the key problems that MSCI (and international investors!) need to
tackle is the fact that market‐value‐based indices that still dominate investment behaviour of old‐
school (often institutional and Western) investors have gradually lost their appeal and ability to
generate risk‐adjusted returns vis‐à‐vis more fundamental indices. The fundamental index idea
stems from Robert Arnott’s research, albeit that Arnott first applied it to within‐country equity
indices.1 The essence of it is that ‘Market Value’ is just one of the many variables that are important
when picking the right investments. There are many more. And even worse: market values tend to
be higher when prices have gone up a lot or too much, i.e. indices based on them have a tendency to
overshoot.
LMG Emerge applies Arnott’s ideas at the overall market level. In our country index calculations
‘Market Value’ is just one of the variables we look at. Other are ‘GDP at purchasing power parity
price levels’, the ‘External Financial Position of a country corrected for its gold and foreign reserves
1 See Arnott, Hsu & West, ‘’The Fundamental Index: A Better Way to Invest’’, 2008.
as a percentage of GDP’, ‘Public Debt as a percentage of GDP’ and the ‘Relative Number of Stocks in
the MSCI Index’ (as a market breadth indicator).
Chart 1 compares the top‐10 markets on the basis of market value (MSCI) with the top‐10 markets
when using the LMG approach:
Chart 1; Comparison of a global market‐value‐based and fundamental index
Source: LMG Emerge 2013 – Situation per end‐of‐June 2013.
When we started to work on LMG’s innovative asset allocation system back in the 1990s – built in
close cooperation with Nobel Prize Laureate dr Harry Markowitz2 – practitioners were basically not
interested in Emerging and Frontier Markets: both on a market‐value‐ and GDP‐weighted basis the
world consisted of some 15 relevant countries. When using a market‐value‐weighted index, we are
basically still acting as if we live in that world today. But things have changed. The economies and
financial markets of Emerging and Frontier countries have developed tremendously; and our
fundamental index in Chart 1 shows clearly what has happened. The relative weight of the 10 largest
stock markets has gone down from about 85 to 54 percent. In other words: investors do have to
diversify their assets over many more countries than in the past, with liquidity, political and other
risks hindering them much less than up until the 1990s. Chart 2 shows that this trend is clearly visible
in the MENA region.
2 See Markowitz & Van Dijk, ‘’Single‐Period Mean‐Variance Analysis in a Changing World’’, Financial Analysts Journal, March/April 2003.
Country Region MSCI Index % Country Region MSCI Index %
1 USA North America Developed 48.41% 1 USA North America Developed 22.99%
2 Japan Asia/Oceania Developed 8.17% 2 Japan Asia/Oceania Developed 6.69%
3 United Kingdom Europe Developed 7.85% 3 China Asia/Oceania Emerging 6.06%
4 Canada North America Developed 3.71% 4 United Kingdom Europe Developed 3.82%
5 France Europe Developed 3.42% 5 India Asia/Oceania Emerging 2.72%
6 Switzerland Europe Developed 3.33% 6 Canada North America Developed 2.47%
7 Germany Europe Developed 3.13% 7 Germany Europe Developed 2.35%
8 Australia Asia/Oceania Developed 2.91% 8 France Europe Developed 2.33%
9 China Asia/Oceania Emerging 2.05% 9 South Korea Asia/Oceania Emerging 2.26%
10 South Korea Asia/Oceania Emerging 1.64% 10 Brazil Latin America Emerging 2.13%
84.62% 53.82%
Fundamental IndexMarket Value Index
Chart 2; MENA comparison of a market‐value‐based and fundamental index
Source: LMG Emerge 2013 – Situation per end‐of‐June 2013.
Only 7 of the 16 MENA markets receive a weight larger than 0.01% in the MSCI market‐value‐
weighted approach. The weights of countries like Tunisia, Bahrain and Jordan are not much more
than rounding errors. The overall weight is 0.28%, about the same as the market value weight of
Finland. I doubt if there are many economists who consider Finland to be equally important globally
as the MENA region.
When looking at the LMG Fundamental Index we see that the MENA weight increased by a factor 27,
from 0.28% to 7.63%. And that 7.63% weight makes MENA what it is: a globally important region,
one that has to be taken into account not just in political but also in investment analyses. The
coming downgrade of Morocco – from MSCI Emerging to MSCI Frontier Markets status – seems to
be logical based on Chart 2. The upgrades of the UAE and Qatar – from MSCI Frontier to MSCI
Emerging Markets status – are not illogical, albeit that Kuwait was also a candidate.
Country Region MSCI Index % Country Region MSCI Index %
1 Kuwait MENA Frontier 0.09% 1 IR Iran MENA None 0.72%
2 Qatar MENA Frontier 0.06% 2 Saudi Arabia MENA None 0.64%
3 United Arab Emirates MENA Frontier 0.05% 3 Kuwait MENA Frontier 0.60%
4 Egypt MENA Emerging 0.03% 4 Pakistan MENA Frontier 0.58%
5 Pakistan MENA Frontier 0.02% 5 Oman MENA Frontier 0.52%
6 Morocco MENA Emerging 0.01% 6 Egypt MENA Emerging 0.50%
7 Lebanon MENA Frontier 0.01% 7 Algeria MENA None 0.50%
8 Oman MENA Frontier 0.01% 8 United Arab Emirates MENA Frontier 0.50%
9 Tunisia MENA Frontier 0.00% 9 Qatar MENA Frontier 0.47%
10 Bahrain MENA Frontier 0.00% 10 Iraq MENA None 0.46%
11 Jordan MENA Frontier 0.00% 11 Jordan MENA Frontier 0.40%
12 Algeria MENA None 0.00% 12 Morocco MENA Emerging 0.39%
13 Iraq MENA None 0.00% 13 Syria MENA None 0.38%
14 Syria MENA None 0.00% 14 Tunisia MENA Frontier 0.37%
15 IR Iran MENA None 0.00% 15 Lebanon MENA Frontier 0.32%
16 Saudi Arabia MENA None 0.00% 16 Bahrain MENA Frontier 0.28%
0.28% 7.63%
Fundamental IndexMarket Value Index
What will continue to make the MENA relationship with MSCI and investors a complicated one is the
fact that the two most important countries – IR Iran and Saudi Arabia – are not even in the Frontier
Markets index yet. Together these two account for almost 20 percent of the MENA regional weight
in LMG’s fundamental index. Due to the embargo it is still not possible for most foreign investors to
include IR Iran in their spectrum (if they already want to of course), but we believe that even this
might change in the longer run. What will definitely change much sooner is the investability of Saudi
Arabia due to new measures that are being contemplated in the Kingdom. LMG believes that this
will definitely give a boost to investor attention for MENA, the more so because the liquidity and
market value of the KSA stock exchange (the Tadawul) is already the largest in the region. Its $408
billion total market value is higher than the market caps of 4 of the 5 BRICS countries: only China’s is
higher with $639 billion. In that case both MSCI and investors will not be able to ignore the MENA
region anymore! This good news for the region is further strengthened by a globally growing interest
in Islamic Finance, both by Muslim and Non‐Muslim investors.
So will there be only good news for the markets in the MENA region then in the near future?
Morocco’s MSCI downgrade might be more than offset by the fact that the country will move from a
rounding error within the MSCI Emerging Markets index into a more serious and visible role in the
MSCI Frontier Markets index. But we are worried about one market, unless they do something about
their ‘financial market business model’: Bahrein. Bahrein’s role was until now directly linked to the
problems that many foreigners had with investments and/or living in Saudi Arabia. With the ease of
investing in the KSA going up soon, we believe that Bahrein needs to act or it will be marginalized.