How Saudi Arabia’s inclusion in major indexes will affect emerging market exposure

Some of the world’s major indexes are bringing Saudi Arabia’s public equities into the mix, a move that could alter the landscape for emerging market investments.

As of June 2019, MSCI Inc. will include its Saudi Arabia index in the MSCI emerging markets index. The 32 securities from the country will make up a weight of approximately 2.6 per cent in the index.

International investors were impressed by the speed of change in the accessibility of the Saudi Arabian equity market, as well as the level of commitment demonstrated by the financial regulator and the Saudi Stock Exchange, noted Sebastien Lieblich, MSCI’s managing director and global head of equity solutions, in a press release. “Their expectation now is that the current privatization effort in Saudi Arabia will continue to grow the investable opportunity set available to them and hence, all other things being equal, contribute to an increased weight of Saudi Arabia in the emerging markets index in the future.”

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The FTSE Russell is also making a change to Saudi Arabia’s status. As of March 28, 2018, the provider of stock market indexes reclassified it as a secondary emerging market within its FTSE global equity index series. It noted that several changes within the country drove the viability of the change.

For one, Saudi Arabia is making significant efforts to diversify its economy away from its heavy reliance on oil, noted FTSE Russell in a press release. In addition, its financial regulators have collaborated with FTSE to make it easier for foreign investors to operate and access capital markets within the country. Similar to the MSCI, it will make up 2.7 per cent of the index; however, the anticipated initial public offering of its national oil company, Saudi Aramco, could boost that weighting significantly to 4.6 per cent and drive up the exposure to the Middle East within the emerging market index.

In the past, Saudi Arabia’s efforts towards reform made little difference to North American investors as there was only one real play to make in the region: petroleum-based commodities and tangential investment plays, says Elliot Hentov, head of policy and research in the official institutions group at State Street Global Advisors. Today, however, the region is seeing real change, he says.

“Across all markets, to be honest, there is a lot of policy stagnation. And few places are doing what they need to be doing to find that real reform or progress. But there is one area of the world where something is happening pretty dramatically and, whether you like it or not, you have to acknowledge that it’s really momentous,” says Hentov. “It’s not fake reform, there are really things happening, and that’s Saudi Arabia and the gulf.”

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Bond and equity market reform is happening at the same time, he says. Saudi Arabia and the countries immediately surrounding it boast high investment grade bonds. “You’ve got high investment grade in a world with excess demand for safe assets.”

Historically, the problem with these securities has been the low number of issuances and enough corresponding domestic demand to eat up what was available, says Hentov. “Oil prices were low the last three or four years and it really has pushed them, particularly Saudi Arabia, to issue in large volumes and also issue in large U.S. dollar volumes and to perhaps even start to issue along benchmark issuances.” Suddenly, a hefty supply of investment grade bonds is available, he says. “That’s a nice additional segment investors can have in their portfolios.”

In addition, Saudi Arabia is structuring its debt issuance in a more formalized way, he says. Since the country hasn’t previously operated with a debt management office, the introduction of one makes the issuances more frequent and the yield curve more predictable. “This makes the trading easier, it makes the pricing easier and it provides a little bit more liquidity because people feel confident there is another issuance coming,” says Hentov.

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On the equity side, the opening up of the market presents an exciting opportunity, he says. “That market by [emerging market] standards is large, but it was rigidly closed off to foreign investors. Then two years ago they started a quota system for foreign investors . . . but now they’re doing something more. They’ve applied for index inclusion and they got it.”

Saudi stocks are in for a gold rush because of investors looking to mimic those indexes, says Hentov. “That forces index investors to buy and it forces active managers to buy it as well if they want to measure their strategy against the [emerging market] benchmark. Even if they are not replicating the benchmark, they’ll have to have some Saudi exposure so the deviation is not too crazy.”