By Joseph Hogue, CFA
The Arab Spring uprisings this year have reminded investors of the need for strategic hedging and risk management. Though not the models of modern day government, the political environment in many of these countries was considered stable and investors were lulled into a false sense of security. This all changed in December of 2010, when the first protests began in Tunisia, and spread quickly across the region. Though regional funds have recovered quite rapidly there is still the threat of further unrest.
With President Obama telling the United Nations that there will be no easy road to peace in the middle east and the Palestinian President putting his country’s statehood to a vote, there is a heightened level of risk within the region. In fact, three unnamed U.S. officials told Bloomberg on Friday that the United States has spent so much time pressuring the Palestinians to back off from its bid and talking with every other nation to oppose it, that little time has bent spent planning to contain the possible unrest that could follow.
According to World Bank data, the region represents about 5.7% of world GDP and 9.9% of the world’s population. Regional funds have outperformed larger market indices in the U.S. and Europe this year and most pay healthy dividend yields. The region’s vast oil reserves and relatively low correlations with developed markets make investment in the region a necessity for diversification and growth.
The MarketVectors Gulf States Fund (MES) seeks to track the Dow Jones Gulf Cooperation Council (GCC) Titans 40 Index. The fund is composed of 38 holdings and charges a net expense ratio of .98%. The fund is extremely concentrated by sector with financials (70.5%), telecom (10.5%), industrials (9.0%), and energy (6.2%). The fund is more diversified on a country exposure basis with Kuwait (35.4%), Qatar (30.4%), U.A.E. (23.0%), Bahrain (5.0%), and Oman (4.7%). The average price-to-book value of holdings is 1.9 times and the fund pays a dividend yield of 5.5%. The fund is down -6.6% over the last year, but investors are only out -2.1% when accounting for expenses and dividends.
The WisdomTree Middle East Dividend Fund (GULF) tracks the company’s own Middle East dividend index. This fund also holds the equities of 38 companies and charges a net expense ratio of .88%. The fund is slightly more diversified by sectors but still concentrated in three primarily with financials (43.1%), elecom (38.2%), and industrials (13.1%). The fund’s country exposures are similar to the MES with Qatar (33.8%), Kuwait (28.2%), U.A.E. (19.0%), Morocco (11.7%), and Oman (5.5%). The fund pays a dividend yield of 5.75%. The fund is down -5.0% over the last year, but investors are only out -.12% when accounting for expenses and dividends.
Seventeen equities are held commonly by both funds making up 56.2% of the WisdomTree fund and 61.0% of the MarketVectors fund. Holdings and country exposures are in fairly stable countries, but this did not help either fund from falling an average of 13.7% over a couple of weeks from February 11th when Egyptian President Mubarak resigned.
The funds are basically the same through most metrics and will track each other extremely closely. Asset correlations since 2008 for the two funds and the SPDR S&P500 (SPY) are shown in the table below. A correlation between the funds of .91 is extremely high and means that their prices will move up and down with each other. A lower correlation of .78 and .50 with the S&P500 for the MES and GULF respectively means an investment in either will provide diversifying benefits for your portfolio.
I prefer the Gulf fund for a couple of reasons. The Gulf fund explicitly calls attention to its dividend and should continue to focus on returning a decent yield to investors. The MarketVectors fund, while it also pays a high dividend yield, does not draw attention to the fact. This means to me that managers have more flexibility to allocate to growth stocks than dividend and could very well cut the dividend in the future.
Additionally, I am always weary of ‘diversified’ funds with concentrated exposures in a specific sector or country. The 70.5% allocation to financials in the MES fund means investors will need to do considerably more due diligence in that sector as the fund will track the industry closely. If unrest does reignite throughout the region, the financials will underperform as foreign and local depositors withdraw money to safeguard assets. Choosing a fund that is relatively more diversified across sectors means that I don’t have to be an expert in Middle Eastern banking as well as a macroeconomist to evaluate the risks involved in the fund. As for the lower expense ratio and the slight outperformance of the GULF fund, that is just icing on the cake.
Over the last year, the MarketVectors fund and the S&P500 are off their highs by 16.0% and 11.0% respectively, while the WisdomTree fund is only off by 10.8%. Of course, the relative outperformance of the WisdomTree fund could always change, but I do not see any reason it would happen. The explicit dividend focus and relative outperformance make the GULF fund a good long candidate against a short in the MES. This strategy, given equal long-short weighting gives the investor the opportunity to earn a few percent on low or no cash invested. For exposure to the region, something a globally-diversified portfolio should have, investors can try a 130/30 long-short strategy. This means buying a position in the GULF fund worth 130% of the total position and selling short the MES to provide the funds needed to cover the additional 30% position. This hedges some of the exposure to the region by shoring the relatively weaker fund. This 130/30 strategy is a fairly common tactic used by hedge fund managers. Even if the short pick outperforms slightly, it should not remove all gains from a gain in the long position. I like this strategy as a way to get a little leverage and enhance returns without increasing volatility dramatically as with some options strategies.