Inflows of petrodollars, said to amount to $300 billion annually,  set the scene for a buoyant and dynamic environment for Middle Eastern investment management and custody. Deregulation and privatisation have also been a catalyst for investor confidence and innovation across the Gulf region, where total assets are estimated at $2 trillion. This has been reflected in the extraordinary expansion of financial centres in Dubai and Qatar where leading investment and custody banks have flocked in the last two years.

Funds under management are set to grow dramatically say custodians. If the region follows international norms (which dictate that 25% of a market’s GDP is held by investment managers),  the region’s $70 billion under management will grow to $200 billion over the next decade. Assets under custody at the region’s largest providers have grown some 20%, each year over the last three years, say industry observers. HSBC recently demonstrated its commitment to servicing local custody needs when  its opened up a third party custody product.

Mutual funds are one sector where opportunities for expansion looks strongest. Northern Trust, a major international custody player in the region says Bahrain will be a key beneficiary. ‘Bahrain, which has a favourable regulatory environment, has seen investments in mutual funds rise to $6.1 billion at the end of June 2005, representing an increase of 45% compared to $4.23bn at the end of  the second quarter in  2004.’
Ali al-Laith, a vice president at the Gulf Clearing Company, one of the region’s key custody providers, concurs. ‘Funds have been incorporated in Bahrain in growing volume. The market is saturated with liquidity and this needs to be professionally invested, rather than going direct to the stock market. It is best to outsource to a professional investment manager.’

Local investment firms have been among the strongest beneficiaries of this trend. Haissam Arabi, a managing director at Shuaa Capital, says, ‘The demand for asset management and a mutual fund industry is quite recent. The numbers have surged dramatically over the last 3 or 4 years. But they are way below industry benchmarks. Relative to more developed markets like Singapore and Malaysia, the Gulf recent has  along way to go.’

Arabi continued, ‘there is some scope for hedge funds. Arab investors like to keep their money close by them in the Gulf, and that has given rise to the need for a one-stop investment and asset management shop. As you reform the structural and legislative framework, you will provide the structures for short-selling. In due course, fund managers will introduce hedge funds that they can package within the Arab market.’ Nigel Sillitoe, the director of business development in the Middle East for Mellon Global Investments, sees the same trend. ‘There is a growing interest in hedge funds of funds. They are correlated to other markets. The more sophisticated family offices and institutions. have been aware of hedge funds over 10 years. Every hedge fund manager is today marketing his wares in the Middle East.’

Synthetic products and derivatives are now much sought by sophisticated and larger investors says Nadine Chakar, chief executive at ABN AMRO Mellon. ‘There is a massive trend towards exchange traded and OTC derivatives type of trading. Five years ago, you would clear a couple of contracts a day, today we clear thousands of contracts. Everybody is taking advantage of  new instruments. It is like a tidal wave. We are seeing quite a bit of hedging and overlays.’ Middle Eastern investors prefer active strategies, says Nigel Sillitoe.  ‘Indexation isn’t so popular here. They still believe in active management. So they would rather appoint an active manager over a passive one.’

Strategies pursued by many Middle Eastern investors reflect ingrained  caution. An awareness that the oil reserves on which their financial success depends have a limited shelf life dictates strategy. Chakar, ‘Their main concern  is preservation of capital and investing for the future. They tend to be extremely conservative, extremely disciplined in what they do. They don’t lose track of their end goal. Central banks in particular tend to be conservative as their mandate is preservation of capital. They are entrusted with the nest egg of the whole nation and they are very cautious in who they deal with and what they deal in.’ 

• This is best exemplified by investment strategies pursued by the national oil funds for
• ‘future generations’. These exist in all the Gulf states and are modeled
• on a fund with a similar purpose in Norway. Middle Eastern countries typically set
• aside 10% of their oil surplus for the fund, which is regarded as sacrosanct. According
• to Hani Kablawi, a managing director with Bank of New York in Abu Dhabi, ‘When
• a country is blessed with more liquidity and capital than is necessary to keep
• in its balance of payments, it creates a fund that is a penny saved for a rainy day.
• Preservation of capital is chief among the goals of oil funds, which  differ from
• country to country in terms of make-up, charter and policy. They don’t all look the
• same and act the same. One needs to differentiate foreign currency reserves of central
• banks and oil funds.’ 

Conservatism and caution is also stimulated by the region’s political exposure, which remains of key concern for investors and custodians in the region. The Middle East may be buoyed up by powerful economies but its vulnerability to international pressure, especially from the United States, have induced a sense of defensiveness.

One local fund manager and stockbroker put it this way, ‘Prior to September 11, there was a different mentality among Arab investors.. The phenomenon of investing every dollar in the region and in the Arab world is new, and that only happened following September 11. Prior to that, most money would be invested overseas in London, US and Europe. The shift happened not just because of politics, but also because of greater liquidity and lower interest rates in the region. The Gulf is now perceived as a value proposition.’

Local investment has been a particular focus of investment managers, says Andrew Polley, the director for sales and relationship management at RBC Dexia Investor Services Trust. ‘They are investing money within their own countries to create new industries such as  aluminium plants and hotels. They are investing it very wisely and not spending it in a profligate way.’ Middle Eastern investors have also climbed on to the global bandwagon in private equity, says Polley, who points to the setting up of numerous local regional funds.

Pressure to keep funds within the region has given rise to diversification across markets. Investors have moved money into local stock markets where culture, language and economic conditions (in particular dependence on oil) are compatible. One investment manager referred to a ‘contagion’ risk across the region, with market movements spreading across border in form of investment herd instinct. This was particularly pronounced in the recent bearishness in regional markets, which did not respect national borders or local economic conditions.

The quality of the back office available to the retail investor may yet deter some investors to keep their money in local markets. One said,  ‘Asset managers have to improve their conduct, their professionalism and their ability to assess risk. They shouldn’t mis-price or mis-sell. The sector needs legislation to back asset managers in their new responsibility. This will not only help regulate the industry, but also to open doors for innovation among asset managers.’  Jacques Bernard, managing director for asset management, at Unicorn Investment Bank, an Islamic institution in Bahrain, says, ‘Fund administrators have yet to reach international standards in terms of their capability. The big issue is to find a fund administrator that is capable of providing international standards of service.’

This is more of a concern for retail than professional investors says Chakar, who speaks very highly of the quality of Middle Eastern institutions. ‘They challenge us, they are on the cutting edge.’ Hani Kablawi concurs, ‘the institutional investor in this part of the world is very sophisticated. The financial industry has become more complex. The institutional investors have come up the curve of enhancing their understanding of their portfolios and developing their investment techniques.’

Institutional investors like Abu Dhabi Investment Authority (ADIA) which has reputedly between $250 billion and $300 billion under management, the Saudi Arabian Monetary Agency (SAMA) which has reputedly $150 billion under management and the Kuwait Investment Authority (KIA) which has reputedly $130 billion, demand the most rigorous standards of custody and investment management.

These funds are ‘very sophisticated investors’, says Chakar. ‘They have complex investment strategies and we have to be able to service them at a high level. We have to give them real-time information to feed their systems. They expect very complicated and complete reporting.’ Custodians also say that Middle Eastern institutions are ‘ruthless’ in dealing with custodians and investment managers who fail to perform.

Chakar continued, ‘These investors are exceptionally demanding in terms of service. They not only want very large amounts of information so they feel secure that the stock is safe. They are unbelievably detailed. They look at things on a daily, real time basis. The agencies in the Middle East are looking for more detail in  terms of performance, a breakdown of performance, a breakdown of benchmarking, more risk reporting. When you are reporting on derivatives, you have to report on notional amounts, you have to do exposure reporting. They have a lot of systems you have to feed every day, whether on administration or investment are. They want to be as close to their assets as we are.’

Custodians and investment managers facing onerous requirements to meet targets in the Middle East have devised analytics to break out the contribution of the oil price to a portfolio’s performance. Kablawi says, ‘Investors want to know how their returns are constituted and where they came from. A lot of that movement in a multi-currency portfolio might have come from movements in exchange rates in their favour. That institutional investor did not pay that fund manager that kind of money to generate returns off exchange rate movements. If we can drill down and identify how many basis points were derived from positioning them properly on the yield curve, from positioning them in the right sector and with the right convexity, we will satisfy a client demand for greater analytics.’

The pick of the world’s investment and custody brainpower and resources are applied to the handling of the vast quantities of Middle Eastern funds and local institutions have no compunction in changing the faces when they think the mix is wrong. Expert financiers trained in the City of London or Wall Street now comprise a portion of the ex-patriot communities in Dubai, Riyadh or Manama, says Sillitoe. ‘The institutional investors  have become far more professional. They use a growing number of external consultants based in London or the States to advise them on the process of selecting custody or investment strategies. They are buying in data on the good external managers.

‘Ten years ago, it was largely down to a couple of big institutions using a small number of institutional  managers and not straying from that. They felt comfortable with a few big names. Now, they are far more open-minded, so they are broadening the number of external managers, and they are willing to be far more selective.’

Polley concurs. ‘As local portfolios grow, managers need to diversify their range of global custodians. In the old days you could have had a $10b portfolio with a single custodian. But if you have a $100b, it is not a good idea to have the whole lot with a single custodian. You should diversify institutions. Risk management is everything.’

Middle Eastern institutions have retained one traditional practice in this era of fast and furious change. They are no less secretive than they ever were about the sums in their treasury, the people who manage them, and the people who own and distribute them. One custodian said, ‘Only a very few people inside the agency have the data to pull together the individual amounts and see the whole picture.’ Public information about the size of Middle Eastern investment portfolios is widely accepted as scanty and unreliable. Nigel Sillitoe says, ‘this is a difficult market, because the information is not available. It is difficult to know who to contact and if you are a new-comer based outside the region, you will find it very tough.’

Opportunities for custodians in the Middle East are greater than ever before. But they will only come to those firms that persevere and make the necessary investment. The lure of petrodollars may be powerful, but firms will only win a share with a long-term strategy and commitment.