Liquidity helps, but UAE stock markets have a long way to go

The UAE has seen a spate of firms raise their foreign ownership requirements ahead of the MSCI upgrade.
The index compiler MSCI included nine UAE companies to its benchmark emerging-markets index. Christopher Pike / The National
The index compiler MSCI included nine UAE companies to its benchmark emerging-markets index. Christopher Pike / The National

Investors and brokers can now trade with greater ease on UAE bourses, as the country’s upgrade to MSCI Emerging Market status brings new capital to exchanges..

But despite the step forward, there is still a long way for the bourses to go before they start to behave like developed-market indexes.

Allocative and informational market inefficiencies will remain – with significant implications for fund managers.

A recent paper by the academics Imen Rejichi, Chaker Aloui and Duc Khuong Nguyen showed that stock exchanges in the Middle East were very far from satisfying the market efficiency hypothesis – in which prices reflect current information about a company’s fair value.

Their paper showed that equity prices on Middle East bourses did not come close to reflecting historical asset prices of companies – and that the UAE’s markets were slightly worse at reflecting asset values than other regional bourses.

Of course, efficient markets are only an ideal – in the real world markets fall far short of this. The idea of a true value for an asset is an abstraction that depends on the perfect knowledge of all individuals concerned.

Investors do not know everything – stated prices reflect the bid and ask price of the last trade, which may well be a result of an individual investor’s whim or unfounded suspicion.

Being able to understand why a share price moves involves being able to understand the thought processes of every individual involved in all transactions in that equity.

Trade on the exchanges is also primarily retail-focused, as BlackRock noted with some alarm in a recent London filing. This has long been the case, but BlackRock pointed out that retail customers are more likely to bandwagon on periods of “speculative froth”.

Dual-board structures, where shareholders appoint a non-executive, advisory board, can help shareholders to police senior management and keep investors informed.

And stricter rules on the disclosure of financial information can prevent share price spikes in advance of market-moving announcements.

The influence of all these factors on equity prices, despite their disconnect with the value of a firm’s underlying assets, is why the economist John Maynard Keynes famously described stock markets as being mainly motivated by “animal spirits”.

These informational issues can be addressed in part by boosting the number of buyers and sellers. In larger markets, the wisdom of crowds is arguably greater.

Call it Condorcet’s Investor Theorem – when a market has more investors in it, it is more likely that most of them will know what is going on.

Which brings us to a second issue – liquidity, where more is generally better. This is where the MSCI upgrade will have the greatest impact, though local barriers to competitive markets remain.

When trades occur only infrequently it is much less likely that prices will reflect the latest valuation of a firm’s assets. The Abu Dhabi Exchange and Dubai Financial Market have low turnover rates – the percentage of the total value of companies on the exchange that was traded in the course of a year – which implies that they are less liquid than both the Saudi Stock Market and the London Stock Exchange.

Foreign ownership limits also constrain liquidity. Free zones aside, ownership laws require that 51 per cent of a company’s equity be owned by Emiratis. This limits the extent to which companies can attract foreign capital. In addition, many companies set their own limits, which are lower than mandatory maximums. However, the UAE has seen a spate of firms raise their foreign ownership requirements ahead of the MSCI upgrade.

The oft-mooted merger of the UAE markets is likely also to boost liquidity considerably.

The efficiency of local bourses matters a great deal for fund managers, as the paper’s authors make clear. Portfolio managers should “conduct a search to determine the fundamental values of interested sectors, and give more weights to undervalued sectors”, they advise.

When markets are inefficient, opportunities for arbitrage abound.

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Published: May 15, 2014 04:00 AM


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