The Middle East appeared somewhat insulated from developments in the US financial markets from early 2007 to the summer of 2008. Following the Lehman bankruptcy, however, the region responded strongly to the deterioration of the US economy. Before the current crisis, the prevailing view held that a growing number of emerging market countries had undertaken reforms that would insulate them from the adverse shocks in the developed world. Helped by a strong rally in commodities, emerging markets have experienced current account and fiscal surpluses, stronger currencies and significant reserve assets. This new reality has contributed to the decoupling hypothesis which is based on the idea that emerging and frontier markets and, by extension the Middle East, are now better prepared to resist violent financial shocks from the rest of the world.

As tensions in financial markets eased, investors were quick to re-discover their enthusiasm for emerging market assets. Since March 9, when the S&P was at its low for the year, the MSCI emerging markets index has outperformed the S&P by more than 25%, despite the MSCI’s largest constituent, the Chinese stock market, having dropped during the same period. Part of the rally in emerging markets has been supported by massive quantitative easing in the US, resulting in a weak dollar, in addition to a recovery in commodity prices as oil moved from $40 to $80 a barrel.

Where do we go from here? The decoupling hypothesis may have proved too optimistic with Dubai World, the emirate’s flagship government-owned holding company, setting the MENA investment story back a bit. As of December 9, Dubai shares have erased all of their investment gains for the year. Dubai World plans asset sales to meet its debt obligations and Moody’s Investors Service has downgraded six Dubai entities. Bonds of Dubai’s state-controlled companies have tumbled to record lows, signalling that borrowers will fall behind on debt payments. Credit-default swap spreads have widened as the rising threat of default on Dubai World bonds increased protection costs around the world. The question on everyone’s mind is: will there be a contagion effect to other markets and assets should the emirate’s investment arm default on its debt?

Asset allocation survey

More than six months before Dubai World put a dent into the MENA investment story, bfinance identified a number of organisational and governance changes in the institutional landscape. Our conclusions are drawn from an asset allocation survey conducted in March 2009 covering 60 institutional investors around the world. Sixty-five percent of our respondents have more than €1bn in assets. About half are (51%) corporate funds, followed by public pension plans (32%), endowments (10%) and insurers (7%). One of the questions we asked in the survey is whether the crisis prompted a review of investment policies and asset allocation. Sixty-percent said yes. We also asked if the crisis would prompt pension funds to review their fund managers. A majority of investors (61%) planned to do so within six months.

We have uncovered key post-crisis allocation trends which have largely played out in recent months. Investors identified emerging market debt and equity as two asset classes that would attract strong inflows. In addition, investors indicated they were ready to redeploy cash into commodities and single hedge funds. Industry data and the pipeline of our searches have largely confirmed these initial findings. Commodity-focused hedge funds attracted the largest inflows in October while total hedge fund assets at the end of October stood at $1.97tr, an increase of $17bn over the month of September, according to HedgeFund.net (HFN). Hedge funds have pulled in an estimated $93.6bn in the last six months. Today, industry assets are estimated at $1tr below the peak set in the second quarter of 2008, according to HFN.

We also asked pension funds to offer their views on active management and FoHFs. Whereas 41% of respondents said they planned to decrease their reliance on active management in the fall of 2008 (the first time our asset allocation was conducted), only 24% said they planned to decrease their reliance on active managers six months later. This reflects a return of risk appetite to markets following the fallout from last autumn’s crisis which fuelled disenchantment with active management.

Yet risk aversion may be on the rise again following the downgrade of Greece by Fitch Ratings in the closing days of 2009. As concerns about sovereign credit escalate we are once again seeing a renewed focus on risk and the use of appropriate risk measures. In a separate survey on risk, bfinance confirmed inherent weaknesses in traditional risk measures, with volatility and tracking error becoming less relevant tools in risk management. We asked 1,400 money managers about their thoughts on the widely-used Value at Risk (VaR) measure and received 140 responses with nearly half saying they were not happy with VaR’s performance in the financial crisis at a time when the management of risk has become a defining issue for investors. When asked what other risk measures they use, 43% of respondents said they use stress-testing in addition to VaR. As the most widely-used measure of risk used by financial institutions, VaR does not explicitly capture risk spill-over between institutions, which has been one of the central characteristics of the current crisis.

From a bfinance perspective, we have variations on the standard measure of VaR making use of conditional VaR (or expected shortfall) and other non parametric or higher moment aware tools such as modified VaR, which takes into account skew and kurtosis, and Omega analysis, which enables the consideration of all moments of a distribution. Another alternative to VaR is to focus purely on the tails of a distribution, an area of particular focus at bfinance. We take an active interest in understanding tail risk both from a statistical and qualitative standpoint.

In addition to a greater awareness on risk, the crisis has highlighted pitfalls in current government structures. Institutional investors will have to better define the lines of responsibility between CIOs, trustees, advisors and consultants. There are indications that they have already started to implement more efficient decision-making trees and improve relevant expertise among trustees with an increase in the use of specialist advisors. Indeed, when asked if pension funds plan to increase their reliance on consultants regarding manager selection, 31% of our respondents said they would while only 3% said they planned a reduction. Our results indicate that unbiased and thorough due diligence is clearly back on the agenda given the emergence of more complex strategies and manager universe, the scale of frauds within the hedge fund industry, more sophisticated analytical tools and increasingly demanding investors looking for customised solutions.

OC and RDL