analysis of diversification benefits of investing in the emerging gulf equity markets

Analysis of Diversification Benefits of Investing inthe Emerging Gulf Equity Markets

by Abraham Abraham, Fazal J. Seyyed and Ali Al-Elg, Department of Finance and Eco-nomics, King Fahd University of Petroleum & Minerals, Dhahran 31261, Saudi Arabia

Abstract

The emerging stock markets of the Gulf region where equity returns are positively corre-lated with oil prices potentially provide valuable hedge against oil price risk faced by in-vestors from the oil consuming economies. Low correlations of Gulf equity marketreturns with the U.S. stocks provide significant portfolio diversification benefits to inves-tors both from developed and emerging markets. Analysis of the S&P 500 index alongwith Gulf equity markets indicates substantial benefits to investors in combining securi-ties from these markets in enhancing return and reducing portfolio risk. Using themonthly return data Markowitz (1959) mean-variance efficient asset allocation suggest20% to 30% investment in the Gulf equity markets. The stability of the Gulf region cur-rencies compared to other emerging markets, where local currency returns can easily bewiped out by currency depreciations, is an added attraction for investing in Gulf equities.

I. Introduction

Increasing globalization and integration of financial markets is clearly evidenced by ris-ing cross border capital flows, not only amongst the developed markets but more recentlyinto the emerging markets of Latin America and the Far East. Portfolio diversificationthat spans international markets is now a widely accepted investment practice around theglobe. Previous research [Harvey (1995); Clasessens, Dasgupta, and Glen (1995); Barry,Peavy III, and Rodriguez (1997)] using IFC’s (International Finance Corporation of theWorld Bank) Composite Index for emerging markets, show returns that are generallyhigh, and exhibit low correlations with the developed markets. Barry et al. provide sub-stantive evidence of low correlations between the U.S. stock returns and the equity mar-kets included in the IFC’s Emerging Markets Data Base (EMBD). The low correlationcoefficients with the U.S. market suggests that portfolio diversification across the devel-oped and emerging markets can significantly benefit investors in achieving enhanced re-turns with lower risk. As long as returns among countries maintain less than a perfectpositive lockstep relationship, investors will gain from international diversification.Lower the correlation coefficient, greater the potential advantages of diversification, a lamodern portfolio theory (MPT). Speidell and Sappenfield (1992) report rising correla-tions among the developed markets and hence suggest that emerging markets with lowcorrelations will become increasingly important as vehicles for effective diversification.The correlation between the S&P 500 and the developed markets represented in theEAFE index (Europe, Australia, and Far East) is over 0.60. The rise in correlationsamong the developed markets is due to economic convergence and interdependence, theincreasing role of institutional portfolio trading and growth in index funds, and the inte-gration of financial markets resulting from rapid transmission and assimilation of infor-mation flow. Clusters of countries that are closely linked through common economicfactors exhibit relatively stronger correlations.

Volume 27 Number 10/11 2001 47

Empirical evidence on the benefits of international diversification are well docu-mented, though much of this literature has been directed at the developed economies andthe newly liberalized economies of South Asia and Latin America. More recently, the oildominated economies of the middle eastern gulf region have launched a number of initia-tives to liberalize their financial markets and adopted measures aimed at domestic eco-nomic policy reforms. These markets have by and large remained outside the purview ofacademic and investor interests. This study fills this gap by specifically examining andevaluating the diversification potential of investing across the U.S., Bahrain, Kuwait, andSaudi Arabian equity markets. The S&P 500 stock index is used as a surrogate for devel-oped equity markets. Markowitz (1959) mean-variance efficient asset allocation is usedto delineate proportions of investments in each of the markets.

Unofficial estimates of ‘petrodollar’ investments originating from the Gulf regionis placed at over $800 billion. Although the oil producing Gulf States are rapidly diversi-fying into non-oil sectors, the level of economic activity remains heavily dependent on oilrevenues. This dependence is reflected in the performance and variability of the equitymarkets, which tend to follow changes in oil prices. Table 1 presents annualized returns(1993-98) of each of the four stock markets along with the average spot price of crude oil.Oil prices experienced an average annual rate of change of –6.4% over the five-year pe-riod with a standard deviation of 21.0%. The correlation coefficient of oil prices with eq-uity returns is positive for all markets, but is only statistically significant for major oilexporting countries of Saudi Arabia and Kuwait. These Gulf markets therefore provide avaluable hedge against systematic oil price risk to investors from the developed oil con-suming countries. Likewise, domestic investors can achieve significant diversificationbenefits from investing in developed equity markets of non-oil producing countries suchas Japan in the Far East, the major European markets, and in the US. While foreign in-vestor access to the Gulf markets remains somewhat restricted, domestic investors and in-stitutions in the Gulf region can freely invest in foreign securities either directly orthrough mutual funds. The increasing number of successful international mutual fund of-ferings in the Gulf markets points to growing investor recognition of this diversificationpotential.

The subsequent sections of this paper proceed as follows. Section II provides anoverview of the Gulf stock markets of Bahrain, Kuwait, and Saudi Arabia. Sections IIIand IV describe the monthly index returns and variability of each market followed byevaluation of correlations among the markets. Section V presents the results of mean-variance efficient asset allocation across markets based on available data. Section VIsummarizes and concludes.

II. Overview of the Gulf Equity Markets

The financial markets in the Gulf regions are dominated by commercial banks. Stockmarkets are relatively small in terms of market capitalization, listed companies are few,most securities are infrequently traded, and trading volume is low. In addition, the accessto the Gulf markets for direct investment in equities until recently was only permitted toits nationals and limited access to nationals of the Gulf Cooperation Council (GCC)states. Increasing capital requirements to fund budget deficits and economic develop-ment has encouraged the regional states to launch capital market liberalization and broadranging structural reforms, allowing foreign investors greater access to the financial mar-kets. In recognition of the growing importance of these markets, the IFC has recently in-

Managerial Finance 48

cluded the equity indexes of both Bahrain and Saudi Arabia in its emerging marketdatabase.

The Saudi stock market with 74 listed companies, is the largest bourse based onmarket capitalization ($43 billion in 1998) in the Gulf region. Trading in shares takesplace over the counter through banks and is facilitated by the electronic trading system.Compared to other emerging markets, the overall share turnover ratio is low. Accessibil-ity to foreign investors is very restrictive. Only recently non-Saudi investors have beenallowed to invest indirectly through the purchase of mutual fund shares. The KuwaitStock Exchange is a centralized auction market with 75 listed companies and a marketcapitalization of $18.5 billion as of 1998. Following the Al-Manakh (curb market) crisisof 1982, the market was reorganized and stringent regulations governing disclosure, reg-istration, margin trading, and requirements for brokers were implemented. The reorgan-ized market emerged as the most vibrant market in the region for active trading. Themarket suffered another setback as a result of Gulf war in 1990. The market reopened inSeptember 1992 for trading. Bahrain Stock Exchange has 42 listed companies with mar-ket capitalization of $7 billion as of 1998. Trading takes place on the exchange floor fa-cilitated by electronic trading and newly established clearing and settlement house. Newlegislation allows GCC state investors unrestricted, and non-GCC foreign investors up to49% stake in listed companies. Although small by international standards, the BahrainStock Exchange is positioning itself to be a major player in the Gulf financial markets.

III. Monthly Index Returns and Standard Deviations

The data for this study comprises monthly index values for each of the three Gulf Marketsand the S&P 500 index for the U.S. All indexes are value weighted denominated in the lo-cal currency of each country. The exchange rate in the three Gulf markets has ranged


Table 1. Annualized Index Returns and Oil Prices (1993-988)

___________________________________________________________________________________Percentage Change in Oil Prices and Market Indexes

Crude Oil Oil Saudi USYear Price** Price Bahrain Kuwait Arabia S&P 5001993 $15.68 -13.5 24.5 9.8 -5.2 6.81994 15.39 -2.0 -23.9 -1.9 -33.8 -1.21995 16.73 8.4 -13.7 22.5 6.9 29.21996 19.85 17.1 15.4 28.5 11.5 19.31997 18.80 -5.4 40.6 14.8 24.2 26.51998 12.24 -42.9 -5.8 -37.1 -32.6 23.2----------------------------------------------------------------------------------------------------------------------------

-

Average -6.4% 6.2% 6.1% -4.8% 17.3%Standard Deviation. 21.0 24.7 23.6 23.9 12.0Index returnCorrelation withcrude oil prices 0.52 0.90* 0.85* 0.21

___________________________________________________________________________________

* Correlation is significant at .05 level.** Average spot price of crude oil (Arabian Light) per US $

from pegged to the U.S. dollar as in the case of Saudi Arabia and Bahrain and stable forKuwait during the study period. Hence the computed returns, except for transaction costs,are equivalent in dollar terms as well as the local currency unit. The stable currency factoris an attractive feature for global investors looking for diversification opportunities in theemerging markets. In many of the emerging markets substantial gains in local currencyterms are wiped out by declining currency values. The importance of the currency factoris highlighted by the Mexican peso crisis of December 1994 that caused more than 50%fall in the equity indexes of Mexico and adversely affected the performance of other mar-kets. The Far East currency crisis is a recent reminder of the currency effect on interna-tional portfolio returns.

Table 2 presents comparative average monthly rates of return and standard devia-tions of monthly returns for the Gulf stock market indices and the S&P 500 index. PanelA of Table 2 presents results for the entire period (1993-98). As expected, the emergingmarkets of the Gulf region exhibit significantly greater variability of returns than the U.S.equities. One reason for the greater variability of equity returns is a non-diversified eco-nomic base, which remains heavily dependent for growth and expansion on oil prices.However, contrary to the conventional wisdom, the higher return volatility is not accom-panied by higher rates of return. All the Gulf markets trail the U.S. returns by a wide mar-gin, with Saudi Arabia experiencing a negative average return over the sample period.The entire period return data is split in two sub-periods 1993-95 and 1996-98 to observeany significant temporal changes. The results are shown in panel B and C of Table 2.U.S. equities dominate in term of risk and return consistently even over the sub-periods.The second sub-period shows a marked improvement in returns for Bahrain, while thedrop in oil prices starting in 1998 adversely affected returns for both Saudi Arabia andKuwait.

This implies that the price of risk as measured by the ratio of excess returns to riskis considerably lower in the Gulf markets when compared with the US. However, giventhe imperfect return correlation across the markets, as shown in the next section, diversi-fication holds significant potential benefits to investors in achieving a higher return perunit of risk. Results presented by Henry(2000) on the experience of the recently liberal-ized economies of Asia and Latin America show that stock markets surge on average by25% as a result of reduced levels of risk following liberalization.

IV. Correlation of Returns with US Markets

International portfolio diversification depends on the correlation of equity markets acrosscountries. Within the portfolio context, the portfolio risk declines whenever two assetswith correlation coefficient of less than 1.0 are pooled. The lower the correlation be-tween the two asset classes, the greater the risk reduction from combining securities. Theemerging markets of the Gulf and the developed U.S. market each can be viewed as dis-tinct asset class for investment. In general, the security returns from the emerging mar-kets are characterized by higher volatility but poorly correlated to the returns of themature markets. Hence combining securities from the two markets leads to substantial re-duction in portfolio risk For example, Barry, Peavy III, and Rodriguez (1997) using theIFC emerging markets data base (EMDB) reported low or negative correlation of emerg-ing markets returns with U.S. stocks. The equity return correlations of S&P 500 for theperiod 1990-95 were found to be negative for several countries including, India, Turkey,Venezuela, and Zimbabwe and close to zero for many others. The negative correlation


with Venezuela is of interest because its economy like the Gulf oil producing states de-pends on oil prices. Barry et al’s study did not include any of the Gulf stock markets, be-ing unavailable in the EMDB when the study was conducted.

Table 3 shows the correlation coefficients of Gulf market returns among them-selves and with the U.S. stocks.

The correlation of S&P 500 stock returns is negative for both Bahrain and Kuwaitand close to zero for Saudi Arabia, indicating significant potential diversification bene-fits. The correlation coefficients among the Gulf region markets are understandably posi-tive since the underlying economic factors are common to the regional markets. The


Table 2. Monthly Index Returns and Standard Deviations

_________________________________________________________________

Panel A: 1993-1998Average Standard

Return(%) Deviation(%)US (S&P 500) 1.44 3.30Bahrain 0.52 4.11Kuwait 0.51 4.18Saudi Arabia -0.40 4.26

Panel B: 1993-1995

US (S&P 500) 0.97% 2.10%Bahrain -0.36 3.51Kuwait 0.84 3.91Saudi Arabia -0.89 4.52

Panel C: 1996-1998

US (S&P 500) 1.92% 4.15%Bahrain 1.39 4.51Kuwait 0.17 4.46Saudi Arabia 0.08 3.97

Table 3. Correlation Coefficients of Monthly Index Returns (1993-98)

SaudiS&P 500 Bahrain Kuwait Arabia

S&P 500 1.00 -0.10 -0.08 0.02

Bahrain 1.00 0.61 0.34

Kuwait 1.00 0.38

Saudi Arabia 1.00

correlation between Bahrain and Kuwait is stronger than the other two pairs of GulfStates (Bahrain-Saudi Arabia and Kuwait-Saudi Arabia).

To see the risk reduction potential, consider a naïve investment strategy of equalweighted allocation between the four markets. Figure 1 shows that total risk (as meas-ured by the standard deviation of portfolio returns) can by reduced by as much as 40% bypooling the four markets. Investing only in the Kuwait equity market entails a standarddeviation of 4.14%, which monotonically declines as one diversifies into the other mar-kets, to a low of 2.45% when all four markets are included.

V. Portfolio Construction and Efficient Asset Allocation

The idea of incorporating international equities in constructing mean-variance efficientportfolios has gained significant ground over the last two decades. Asset allocation span-ning securities from domestic, developed, and emerging markets are common to mostglobal equity investors now. The percent of funds typically allocated by global investorsto emerging markets now range between 10% to 30%. Using historical monthly returndata on the Gulf and the U.S. equity markets we apply the Markowitz mean-varianceparadigm to estimate the efficient allocation of assets from these four asset classes. Effi-cient allocation is defined as assigning portfolio weights so as to minimize the risk (stan-dard deviation) for a given target return level. Given the superior performance of the U.S.relative to the Gulf markets over the study period (1993-98), efficient portfolios under-standably load heavily on the U.S. markets. Table 4 shows the results from mean-variance efficient asset allocation algorithm applied to each of the three pairs of stockmarkets and investing simultaneously in all four markets.

The optimal allocation for Bahrain and Kuwait indicates roughly similar weightingfor the U.S. securities. In both cases, average monthly return is significantly enhancedand risk is substantially reduced compared to autarkic investing. For Bahrain, monthly


Fig 1. Risk Reduction from Diversification-Gulf and US

Markets

2

2.5

3

3.5

4

4.5

Kuw

Kuw+S

A

Kuw+S

A+Bah

Kuw+S

A+Bah

+US

Sta

nd

ard

Devia

tio

nS

tan

dard

Dev

iati

on

Fig 1. Risk Reduction from Diversification-Gulf and US Markets

Kuw

Kuw

+SA+B

ah+U

S

Kuw

+SA+B

ah

Kuw

+SA

return increases from 0.51% to 1.23% while portfolio standard deviation declines from4.18% to 2.61%. It is interesting to note that despite low returns for both Bahrain and Ku-wait, because of the low correlation the minimum risk portfolio calls for nearly 40% in-vestment in the two markets. Figure 2 shows various combinations of efficient allocationacross stocks of U.S. and Bahrain. Similar results are obtained for Kuwait, Figure 3. TheSharpe reward to risk ratio yields similar results for the two markets. Thus investing inthe developed market such as the U.S. substantively improves risk-return profile for in-vestors from both Bahrain and Kuwait.


Table 4. Optimal Asset Allocation Across Gulf Markets and US

________________________________________________________________________Bahrain U.S. Kuwait U.S. S. Arabia U.S.

Pair-wise allocationOptimal portfolio weights 23% 77% 22% 78% 0%* 100%Portfolio monthly return 1.23% 1.24% 1.44%Port. Standard deviation 2.61 2.65 3.27Sharpe Index value** 0.28 0.28 0.29

Simultaneous investment in all four markets (short selling allowed)Optimal portfolio weights Performance MeasuresBahrain 0.25 Portfolio monthly return 1.56%Kuwait 0.25 Port. Standard deviation 2.95Saudi Arabia -0.32 Sharpe Index value** 0.36US 0.82

* Optimal allocation when short selling is not permitted.** Computation assumes an average monthly risk-free rate of 0.5%.

Fig 2. Efficient Frontier-Bahrain & US

(M inim um Variance

Portfolio.

E(r)=1.05%,SD=2.43%)

0.0

0.4

0.8

1.2

1.6

2.00 2.25 2.50 2.75 3.00 3.25 3.50 3.75 4.00

Standard Deviation

Exp

ecte

dR

etu

rnE

xp

ecte

dR

etu

rn

Fig 2. Efficient Frontier-Bahrain & US

Standard Deviation

Given the negative average returns experienced by the Saudi market during 1993-98, efficient allocation calls for 100% weighting for the U.S. stocks in the absence ofshort selling. This however is an artifact of the ex-post negative returns experienced bythe Saudi Arabian market over the sample period and our use of ex-post realized return asa proxy for expected returns. It is unlikely that ex-ante expected returns were negative,given the overall variability of the Saudi stock market.


Fig 3. Efficient Frontier-Kuwait & US

(M inimum Variance

Portfolio.

E(r)=1.07,SD=2.47%)

0.0

0.4

0.8

1.2

1.6

2.00 2.25 2.50 2.75 3.00 3.25 3.50 3.75 4.00

Standard Deviation

Exp

ecte

dR

etu

rn

Fig 4. Efficient Frontier- Saudi & US

(M inimum Variance

Portfolio.

E(r)=0.75%,SD=2.62)

0.0

0.4

0.8

1.2

1.6

2.00 2.25 2.50 2.75 3.00 3.25 3.50 3.75 4.00

Standard Deviation

Exp

ecte

dR

etu

rn

Exp

ecte

dR

etu

rnE

xp

ecte

dR

etu

rn

Standard Deviation

Standard Deviation

Fig 4. Efficient Frontier - Saudi & US

Fig 3. Efficient Frontier - Kuwait & US

The minimum risk portfolio, however, entails over 30% investment in the Saudimarket. The efficient frontier for the U.S. and Saudi markets are portrayed in Figure 4.When short selling is permitted, in developing mean-variance efficient portfolios for thetwo markets, understandably a negative weighting for Saudi stocks is indicated. TheSaudi stock market rebounded in 1999 through 2000 as oil prices recorded significant in-creases.

Thus if the study period was extended to include the recent turnaround in the equitymarkets, the proposed proportion of investment in the Saudi stocks would be similar toother emerging markets ranging between 10% and 30%.

Investing in all four markets simultaneously with short selling permitted improvesthe risk return profile significantly. The efficient allocation requires nearly the same pro-portions of investment (25%) in both the emerging markets of Bahrain and Kuwait and ashort position in the Saudi market. Again, a substantial proportion of the investment allo-cation in the developed market of U.S. is indicated. The Sharpe’s Index value suggests asignificant improvement in the reward to risk ratio over the pair-wise asset allocation.This improvement is partly due to allowing short selling but mostly a result of diversifica-tion benefits stemming from relatively low correlations among the four stock markets.Figure 5 depicts the efficient risk-return profile when all four markets are included.

VI. Summary and Conclusion.

We have shown that the recently liberalized (albeit partially) equity markets of the oildominated economies of the Gulf region provide significant portfolio diversification po-tential for the global investor. Ongoing structural economic reforms in the areas of inter-national trade, privatization, and incentives for foreign direct investments in the regioncan only serve to further enhance investment opportunities in the future.

Analysis using the Markowitz mean-variance paradigm indicate an allocation be-tween 20% and 30% of Gulf equities in a global portfolio which includes the U.S., and is


Fig 5. Efficient Frontier-Gulf & US

(M inimum Variance

Portfolio.

E(r)=0.8%,SD=2.18%)

0

0.4

0.8

1.2

1.6

2 2.2 2.4 2.6 2.8 3

Standard Deviation

Exp

ecte

dR

etu

rn

Exp

ecte

dR

etu

rn

Fig 5. Efficient Frontier - Gulf & US

Standard Deviation

consistent with evidence reported for the emerging markets of Asia and Latin America.The low correlation of Gulf equity market returns with the U.S., and the positive correla-tion with oil price changes, make these market valuable hedges against oil price riskfaced by the oil consuming economies Very importantly, the stable/pegged exchangerate regime vis-à-vis the U.S. dollar in the region eliminates currency risk concerns thatotherwise plague investments in typical emerging markets.

Acknowledgement

Support provided by KFUPM is gratefully acknowledged.


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