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Analysis of Diversification Benefits of Investing in the Emerging Gulf Equity Markets
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by Abraham Abraham, Fazal J. Seyyed and AU Al-Elg, Department of Finance and Economics,King Fahd University of petroleum & Minerals, Dhabran 31261, Saudi Arabia
Abstract
The emerging stock markets of the Gulf region where equity returns are positively correlated with oil prices potentially provide valuable hedge against oil price risk faced by investors from the oil consuming economies. Low correlations of Gulf equity market returns with the U.S. stocks provide significant portfolio diversification benefits to investors both from developed and emerging markets. Analysis of the S&P 500 index along with Gulf equity markets indicates substantial benefits to investors in combining set:urities from these markets in enhancing return and reducing portfolio risk. Using the monthly return data Markowitz (1959) mean-variance efficient asset allocation suggest 20% to 30% investment in the Gulf equity markets. The stability of the Gulf region currencies compared to other emerging markets, where local currency returns can easily be wiped 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 rising cross border capital flows, not only amongst the developed markets but more recently into the emerging markets of Latin America and the Far East. Portfolio diversification that spans international markets is now a widely accepted investment practice around the globe. Previous research [Harvey (1995); Clasessens, Dasgupta, and Glen (1995); Barry, Peavy Ill, and Rodriguez (1997)] using IFC's (International Finance Corporation of the World Bank) Composite Index for emerging markets, show returns that are generally high, and exhibit low correlations with the developed markets. Barry et a1. provide substantive evidence of low correlations between the U.S. stock returns and the equity markets included in the IFC's.Emerging Markets Data Base (EMBD). The low correlation coefficients with the U.S. market suggests that portfolio diversification across the developed and emerging markets can significantly benefit .investors in achieving enhanced returns with lower risk. As long as returns among countries maintain less than a perfect positive lockstep relationship, investors will gain from international diversification. Lower the correlation coefficient, greater the potential advantages of diversification, a la modem portfolio theory (MPT). Speidell and Sappenfield (1992) report rising correlations among the developed markets and hence suggest that emerging markets with low correlations will become increasingly important as vehicles for effective diversification. The correlation between the ,S&P 500 and the developed markets represented in the EAFE index (Europe, Australia, and Far East) is over 0.60. The rise in correlations among the developed markets is due to economic convergence and interdependence, the increasing role of institutional portfolio trading and growth in index funds, and the integration o{..Jinancial markets resulting from rapid transmission and assimilation of information l1ow. Clusters of countries that are closely linked through common economic factors exhibit relatively stronger correlations.
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Empirical evidehce on the benefits of international diversification are well documented, though much of this literature has been directed at the developed economiesJ~nd the newly liberalized economies of South Asia and Latin America. More receptl~e oil dominated economies of the middle eastern gulf region have launched a numoer of initiatives to liberalize their [mancial markets and adopted measures aimed at domestic eco
nomic policy reforms. These markets have by and large remained outside the purview of .
academic and investor interests. This study fills this gap by specifically examining and
"evaluating the diversification potential of investing across the U.S., Bahrain, Kuwait, and Saudi Arabian equity markets. The S&P 500 stock index is used as a surrogate for developed equity markets. Markowitz (1959) mean-variance efficient asset allocation is used to delineate proportions of investments in each of the markets.
Unofficial estimates of 'petrodollar' investments originating from the Gulf region is placed at over $800 billion. Although the oil producing Gulf States are rapidly dive.l'Sifying into non-oil sectors, the level of economic activity remains heavily dependent on oil revenues. This dependence is reflected in the performance and variability of the equity markets, 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 -<>,4% over the five-year period with a standard deviation of 21.0%. The correlation coefficient of oil prices with equity returns is positive for all markets, but is only statistically significant for major oil exporting countries of Sau4i Arabia and Kuwait. These Gulf.markets therefore provide a valuable hedge against systematic oil price risk to investors fTom the developed oil consuming countries. Likewise, domestic investors can achieve significant diversification benefits from investing in developed equity markets of non-oil producing countries such as 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 fTeely invest in foreign securities either directly or through mutual funds. The increasing number of successful international mutual fund of'; ferings in the Gulf markets points to growing investor recognition of this diversification potential.
The subsequent sections of this paper proce~d as follows. Section II provides an overview of the Gulf stock markets of Bahrain, Kuwait, and Saudi Arabia. Sections III and IV describe the monthly indexretums and variability of each market followed by evaluation of correlations among the markets. Section V presents the results of meanvariance efficient asset allocation across markets based on available data. Section VI summarizes and concludes.
II. Overview of the Gulf Equity Markets
The financial markets in the Gulf regions are dominated by commercial banks. Stock markets are relatively small in terms of market capitalization, listed companies are few, most securities are inftequently traded, and trading volume is low. In addition, the access to the Gulf markets for direct investment in equities until recently was only permitted to its nationals and limited access to nationals of the Gulf Cooperation Council (GCe) states. Increasing capital requirements to fund budget deficits and economic development has encouraged the regional states to launch capital market liberalization and broad ranging structural reforms, allowing foreign investors greater access to the [mancial markets. In recognition of the growing importance of these markets, the IFC has recently in
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Table 1. AnnuaUze(flndex Returns and Oil Prices (1993-988)
		Percentae:e Change in Oil Prices and Market Indexes	.,,:-	
			-_.	
	Crode Oil	Oil			Saudi	.....US	
Year	Price..	Price	Bahrain	Kuwait	Arabia	S&P 500	
1993	$15.68	-13.5	24.5	9.8	-5.2	6.8	
1994	15.39	-2.0	-23.9	-1.9	-33.8	-1.2	
1995	16.73	8.4	-13.7	22.5	6.9	29.2	
1996	19.85	17.1	15.4	28.5	11.5	19.3	
1997	18.80	-5.4	40.6	14.8	24.2	26.5	
1998	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	12.0	
Index return						
Correlation with						
crude 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 $
cluded the equity indexes of both Bahrain and Saudi Arabia in its emerging market database.
The Saudi stock market with 74 listed companies, is the largest bourse based on market capitalization ($43 billion in 1998) in the Gulf region. Trading in shares takes place 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. Accessibility to foreign investors is very restrictive. Only recently non-Saudi investors have been allowed to invest indirectly through the purchase of mutual fund shares. The Kuwait Stock Exchange is a centralized auction market with 75 listed companies and a market capitalization of$18.5 billion as of 1998. Following the AI-Manakh (curb market) crisis of 1982, the market was reorganized and stringent regulations governing disclosure, registratiQn, margin trading, and requirements for brokers were implemented. The reorganized market emerged as the most vibrant market in the region for active trading. The market suffered another setback as a result of Gulf war in 1990. The market reopened in September 1992 for trading. Bahrain Stock Exchange has 42 listed companies with market capitalization of $7 billion as of 1998. Trading takes place on the exchange floor facilitated by electronic trading and newly established clearing and settlement house. New legislation allows GCC state investors unrestricted, and non-GCC foreign investors up to 49% stake in listed companies. Although small by international standards, the Bahrain Stock Exchange is positioning itself to be a major player in the Gulf [mancial markets.
III. Monthly Index Returns and Standard Deviations
The damJ'or111is study comprises monthly index values for each ofthe thre~ Gulf Markets
and the S&P 500 index for the U.S. All indexes are value weighted denominated in the local currency of each country. The exchange rate in the three Gulf markets has ranged
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Mii'nagerial Finance
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trom pegged to the U.S. dollar as in the case of Saudi Arabia and Bahrain and stable for
Kuwait during the study period. Hence the computed returns, except for transac.tio§,costs,
are equivalent in dollar terms as well as the local currency unit. The stable c~ty factor is an attractive feature for global investors looking for diversification opportunities in the emerging markets. In many of the emerging markets substantial gains in local currency terms are wiped out by declining currency values. The importance of the currency factor is 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 markets. 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. P~.nel
A of Table 2 presents results for the entire period (1993-98). As expected, the emerging markets of the Gulfregion exhibit significantly greater variability of returns than the U.S. equities. One reason for the greater variability of equity returns is a non-diversified economic base, which remains heavily dependent for growth and expansion on oil prices. However, contrary to the conventional wisdom, the higher return volatility is not accompanied by higher rates of return. All the Gulf markets trail the U !S. returns by a wide margin, 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 observe any 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 returt,)s for Bahrain, while the drop in oil prices starting in 1998 adversely affected returns for both Saudi Arabia and Kuwait.
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This implies that the price of risk as measured by the ratio of excess returns to risk is considerably lower in the Gulf markets when compared with the US. However, given the imperfect return correlation across the markets, as shown in the next section, diversification holds significant potential benefits to investors in achieving a higher return per unit of risk. Results presented by Henry(2000) on the experience of the recently liberalized economies of Asia and Latin America show that stock markets surge on average by 25% 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 across countries. Within the portfolio context, the portfolio risk declines whenever two assets with correlation coefficient of less than 1.0 are pooled. The lower the correlation between the two asset classes, the greater the risk reduction trom combining securities. The emerging markets of the Gulf and the developed U.S. market each can be viewed as distinct asset class for investment. In general, the security returns trom the emerging markets are characterized by higher volatility but poorly correlated to the returns of the mature markets. Hence combining securities trom the two markets leads to substantial reduction in portfolio risk For example, Barry, Peavy III, and Rodriguez (1997) using the IFC emerging markets data base (EMDB) reported low or negative correlation of emerging markets returns with U.S. stocks. The equity return correlations of S&P 500 for the period 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
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Table 2. Monthly Index Returns and Standard Deviations
Panel A:
1993-1998
,.-'
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US (S&P 500) Bahrain Kuwait Saudi Arabia
Average Retum(% )
1.44 0.52 0.51
-0.40
Standard
Deviation(%) 3.30
4.11
4.18
4.26
Panel B:
1993-1995
US (S&P 500) Bahrain Kuwait Saudi Arabia
0.97% -0.36
0.84 -0.89
2.10%
3.51 3.91 4.52
Panel C:
1996-1998
US (S&P 500) Bahrain Kuwait Saudi Arabia
1.92%
1.39 0.17 0.08
4.15%
4.51 4.46 3.97
with Venezuela is of interest because its economy like the Gulf oil producing states depends on oil prices. Barry et ai's study did not include any of the Gulf stock markets, being unavailable in the EMflB when the study was conducted.
Table 3 shows the correlation coefficients of Gulf market returns among themselves and with the U.S. stocks.
Table 3. Correlation Coefficients or Monthly Index Returns (1993-98)
					Saudi	
		S&P 500	Bahrain	Kuwait	Arabia	
-	,					
S&P 500	1.00	-0. to	-0.08	0.02	
Bahrain		1.00	0.61	0.34	
Kuwait			1.00	0.38	
Saudi Arabia				1.00	
The correlation of S&r 500 stock returns is negative for both Bahrain and Kuwait
and closj,JO-refo for Saudi Arabia, indicating significant potential diversification bene
fits. TIie correlation coefficients among the Gulf region markets are understandably positive since the underlying economic factors are common to the regional markets. The

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correlation between Bahrain and Kuwait is stronger than the other two pairs of Gulf
States (Bahrain-Saudi Arabia and Kuwait-Saudi Arabia).	~
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Fig 1. Risk Reduction from Diversification-Gulf and US Markets
4.5
	4
3.5
	3
2.5
	2
	+~
To see the risk reduction potential, consider a naive investment strategy of equal weighted allocation between the four markets. Figure 1 shows that total risk (as measured by the standard deviation of portfolio returns) can by reduced by as much as 40% by pooling the four markets. Investing only in the Kuwait equity market entails a standard deviation of 4.14%, which monotonically declines as one diversifies into the other markets, to a low of 2.45% when all four markets are included.
V. Portfolio Construction and Efficient Asset Allocation
The idea of incorporating !nternational equities in constructing mean-variance efficient portfolios has gained significant ground over the last two decades. Asset allocation spanning securities from domestic, developed, and emerging markets are common to most global equity investors now. The percent of funds typically allocated by global investors to emerging markets now range between 10% to 30%. Using historical monthly return data on the Gulf and the U.S. equity markets we apply the Markowitz mean-variance paradigm to estimate the efficient allocation of assets from these four asset classes. Efficient allocation is defined as assigning portfolio weights so as to minimize the risk (standard 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 understandably load heavily on the U.S. markets. Table 4 shows the results from meanvariance efficient asset allocation algorithm applied to each of the three pairs of stock markets and investing simultaneously in all four markets.
The optimal allocation for Bahrain and Kuwait indicates roughly similar weighting for the U.S. securities. In both cases, average monthly return is significantly enhanced and risk is substantially reduced compared to autarkic investing. For Bahrain, monthly

Volume 27 Number 10/11 2001
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Table 4. Optimal Asset Allocation Across Gulf Markets and US
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Pair-wise allocation Optimal portfolio weights Portfolio monthly return Port. Standard deviation Sharpe Index value..
Bahrain U.S.
.u.s..
Kuwait U.S. S. Arabia
23% 77%
1.23%
	2.61
	0.28
22% 78% 1.24% 2.65
0.28
Simultaneous investment in all four markets (short sellimz allowed)
ODtimal Dortfolio weiehts	Performance Measures
Bahrain	0.25	Portfolio monthly return
Kuwait	0.25	Port. Standard deviation
Sa~di Arabia	-0.32	Sharpe Index value..
US 0.82
~.
0"10. ,,"fOO% 1.44%
3.27
0.29
1.56% 2.95 0.36
. ..
Optimal allocation when short selling is not permitted. Computation assumes an average monthly risk-tree rate of 0.5%.
return increases from 0.51 % to 1.23% while portfolio standard deviation declines from 4.18% to 2.61 %. It is interesting to note that despite low returns for both Bahrain and Kuwait, because of the low correlation the minimum risk portfolio calls for nearly 40% investment in the two markets. Figure 2 shows various combinations of ~fficient allocation across stocks of U.S. and Bahrain. Similar results are obtained for Kuwait, Figure 3. The Sharpe reward to risk ratio yields similar results for the two markets. Thus investing in the developed market such as the U.S. substantively improves risk-return profile for investors from both Bahrain and Kuwait.
Fig 2. Efficient Frontier-Bahrain & US
1.6
1:1
S,,1.2
~
1i 0.8
	....
~
a
~ 0.4
0.0
	2.00
2.25
2.50
2.75
3.00
3.25
Standard Deviation
,~'.
3.50
3.75
4.00

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Afdnagerial~inance
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	,
	. -'
/'
,-.
Given the negative average returns experienced by the Saudi market during 199398, efficient allocation calls for 100% weighting for the U.S. stocks in th~ .~Rsence of
short selling. This however is an artifact of the ex-post negative returns.e~rienced by
the Saudi Arabian market over the sample period and our use of ex-post realized return as a proxy for expected returns. It is unlikely that ex-ante expected returns were negative, given the overall variability ofthe Saudi stock market.
Fig 3. Efficient Frontier - Kuwait & US
,"
1.6
= 1.2
...
i
~ 0.8 ."
~
~ 0.4
~
~
0.0
	2.00
2.25
2.50
2.75
3.00
3.25
3.50
3.75
4.00
Standard Deviation
Fig 4. Efficient Frontier - Saudi & US
1.6
0.0
	2.00
.. hill U1I vadmoe poItlbIb . E !t!-o :75, ,SD-2 62)
= 1.2
...
i!
,;:
1 0.8
	....
u ~
a- 0.4
~
2.25
2.50
2.75
3.00
3.25
3.50
3.75
4.00
Standard Deviation

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The minimum risk portfolio, however, entails over 30% investment in the Saudi market. 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 portfoli<?~Jor the two markets, understandably a negative weighting for Saudi stocks is indicated. The Saudi stock market rebounded in 1999 through 2000 as oil prices recorded significant increases.
Thus ifthe study period was extended to include the recent turnaround in the equity markets, the proposed proportion of investment in the Saudi stocks would be similar to other emerging markets ranging between 10% and 30%.
'Investing in all four markets simultaneously with short selling permitted improves the risk return profile significantly. The efficient allocation requires nearly the same proportions of investment (25%) in both the emerging markets of Bahrain and Kuwait and a short position in the Saudi market. Again, a substantial proportion of the investment,allocation in the developed market of U.S. is indicated. The Sharpe's Index value suggests a significant 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 diversification benefits stemming ITom relatively low correlations among the four stock markets. Figure 5 depicts the efficient risk-return profile when all four markets are included.
Fig S. Efficient Frontier - Gulf & US
1.6
e 1.2
~
=: 0.8
]
~
a- {).4
~
"
o
	2
2.2
2.4
2.6
2.8
3
Standard Deviation
VI. Summary and Conclusion.
We have shown that the recently liberalized (albeit partially) equity markets of the oil dominated economies of the Gulf region provide significant portfolio diversification potential for the global investor. Ongoing structural economic reforms in the areas of international trade, privatization, and incentives for foreign direct investments in the region can only serve to further enhance investment opportunities in the future.
~SiBg 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

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consistent with evidence reported fot the emerging markets of Asia and Latin America. The low correlation of Gulf equity market returns with the U.S., and the posjtMn~orrela
tion with oil price changes, make these market valuable hedges againft"" oil price risk
faced by the oil consuming economies Very importantly, the stablelpegged.-exchange rate regime vis-a-vis the U.S. dollar in the region eliminates currency risk concerns that otherwise plague investments in typical emerging markets.
Acknowledgement
Support provided by KFUPM is gratefully acknowledged.
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References
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