FM, KWT: Kuwait Upgrade From 'Frontier' To 'Emerging' Unlikely Bullish For Either Fund
- Late last year, MSCI upgraded Kuwait from a "Frontier" to an "Emerging Market" status, and iShares launched the iShares MSCI Kuwait ETF.
- Around seven years ago, we saw a similar upgrade and iShares launch on two neighboring markets: Qatar and the UAE, with both benchmarks delivering negative total returns since.
- Kuwait remains heavily exposed to the oil cycle, and its 64% allocation to financials means you can't model Kuwait's returns without modeling its banks.
- Bottom line, the Kuwait ETF portfolio has a relatively low return on equity rate and valuation ratios that aren't that cheap, so does not seem like an attractive standalone investment for now.
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In late 2020, MSCI upgraded Kuwait from "Frontier Market" to "Emerging Market" shortly after BlackRock launched the iShares MSCI Kuwait ETF (BATS:KWT) in September. Kuwait was by far the largest component in the MSCI Frontier Markets index with a 36% weight, which might be why BlackRock decided to keep a 19% allocation to Kuwait in its iShares MSCI Frontier and Select EM ETF (NYSEARCA:FM), at least for now, even after Kuwait's removal from the MSCI FM index. Among the two largest emerging markets ETFs, the iShares Core MSCI Emerging Markets ETF (IEMG) and Vanguard Emerging Markets ETF (VWO), the upgrade so far only means about a 0.5% allocation to Kuwait. That said, 0.5% of the US$150 billion in assets in just these two ETFs means roughly 7x as much is allocated to Kuwait through this 0.5% of the emerging market ETFs than by FM and KWT combined, so the upgrade is likely to mean far more for Kuwait than for EM ETF investors. In this article, I take a brief look at the background and market of Kuwait and its neighbors, and explain what I think would be required for Kuwait to outperform.
A Brief History of the Gulf Economies
In this article I will refer to "Kuwait and its neighbors" and the "Gulf" or "GCC" (Gulf Cooperation Council) countries or economies somewhat interchangeably. The main neighbors I refer to are those that also have iShares ETFs tracking them, namely iShares MSCI Qatar (QAT), iShares MSCI UAE (UAE) and iShares MSCI Saudi Arabia (KSA).
The GCC countries have complex histories and lopsided economies, but there are a few key highlights investors in KWT or FM need to focus on, three of which are highlighted by the below chart:
- All four GCC economies charted below saw their GDP per capita growth surpass the US's in the two decades that saw the biggest rise in oil prices: the 1970s and the 2000s.
- All four GCC economies saw GDP per capita decline significantly when oil prices declined significantly in the early 1980s and again since 2014.
- Kuwait was uniquely devastated by Iraq's military invasion in 1990, but seems to have quickly bounced back.
Source: Google Public Data, World Bank
By the end of the 1970s, when all four of these economies had a higher GDP per capita than the United States, Kuwait was briefly home to the third largest stock market in the world behind the US and Japan, as narrated by the Federal Reserve Bank of Cleveland. When bank profits seem to be a much more significant factor than oil prices or foreign invasions, I occasionally wonder how Kuwait might compete with Qatar or the UAE to be the "Singapore of the Middle East," and this MSCI upgrade and iShares launch is one of those occasions that have me looking. First though, let's review how investors in Qatar and the UAE have fared since those two markets were upgraded from FM to IEMG.
MSCI's Upgrade of Qatar and the UAE
The components of QAT and UAE were officially removed from the MSCI Frontier Markets Index and added to the MSCI Emerging Markets Index on May 30, 2014. BlackRock happened to launch these iShares QAT and UAE about one month earlier at the end of April 2014, and the below chart plots the total return of investing $10,000 each into these ETFs through the beginning of April 2021.
Although QAT has fallen less than UAE, both seem to have been clearly hit by the decline in oil prices that started later in 2014. Oil prices remain well below where they were in early 2014, and given how much lower global production still seems to be below its pre-COVID peak, it seems difficult to expect the world will see pre-2014 oil prices again anytime soon.
In short, MSCI's upgrade and BlackRock's launch of QAT and UAE were probably just unfortunate timing ahead of an unforeseeable crash in oil prices, but given that oil remains 92% of Kuwait's exports and 40% of its GDP, oil remains a dominant factor for KWT investors as well.
Comparing Yields and Valuations of GCC ETFs
Although YCharts does not yet show KWT's dividend yield, its website shows a 30-day SEC yield of around 2.6%, making KWT's yield comparable to QAT, cheaper than KSA, and much more expensive than UAE. We see a similar pattern when we look at price/book ratios (especially relevant given the high allocation to financials), where KWT and QAT both trade around 1.5x book vs. KSA at 2.3x book and UAE at just under 1.1x book.
A Deeper Look Into KWT
Looking under the hood of KWT, the first and most important detail I notice is that, despite its name, KWT does not actually track the MSCI Kuwait Index, but rather a benchmark called the MSCI All Kuwait Select Size Liquidity Capped Index. The broader diversification of the latter index may have been required to meet US-listed ETF requirements, but is more significantly different from the "base" index than most cases I've seen:
- MSCI Kuwait only tracks seven stocks, while KWT's benchmark tracks 32
- KWT's portfolio has a higher P/E and lower P/B than the index, which means the weighted average return on equity (ROE)** of KWT is much lower (around 4.4% for KWT vs 7.1% for MSCI Kuwait vs 12.2% for FM).
- KWT's benchmark has underperformed MSCI Kuwait by 2%/year over the past 3 years and over 3%/year over the past five years.
Next, looking at KWT's holdings, we see a portfolio that's fairly typical of many emerging and frontier market ETFs in that the major allocation is to big banks, 40% of Kuwait's being in just two banks: the National Bank of Kuwait (or NBK) and Kuwait Finance House (or KFH). Neither seem to have ADRs or foreign tickers on Seeking Alpha yet, so for now, reading the financial reports directly from these two investor relations websites is probably our best starting point to understanding what may drive KWT's returns going forward. Understanding the difference between just these two names is especially important when comparing KWT vs FM's exposure to Kuwait, since NBK has almost twice the weight of KFH in FM, while NBK's weight is only a quarter more than KFH's weight in KWT, due to cap in KWT's benchmark.
I usually get excited when a new single country access product comes on the market, even if it simply separates out the top exposure I already get in a broader ETF. I would get even more excited if Kuwait's upgrade also would get it removed from FM, along with Vietnam, so that FM would be left with purer exposure to frontier markets I don't have ETF access to yet (next of which are Morocco, Kenya, and Romania, followed by Nigeria, which does have an ETF), but FM and KWT are what we have for now. As far as KWT goes, I would first look at KWT's exposure to oil, followed by a look at the top two bank stocks KWT holds as though I were buying shares of those two banks directly. Even if these two banks were to look as good as Singapore's banks, KWT seems to have watered down exposure to these two banks in a way that significantly lowers the ROE of the portfolio, and it's not cheap enough for a <5% ROE to be attractive. So bottom line, I'll continue holding onto to FM and be maintaining most of my Kuwait exposure that way, and giving KWT a pass for now.
** Return on Equity = Earnings / Book value of Equity = PB Ratio / PE Ratio, these latter two being available on the MSCI and iShares pages.
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This article was written by
Tariq Dennison TEP runs a registered investment adviser focused on international clients and portfolio strategies. His marketplace service "The Expat Portfolio" shares his on-the-ground experience as an expat investing in diverse foreign markets. Tariq is the author of the book "Invest Outside the Box: Understanding Different Asset Classes and Strategies". He lives in Central Europe, and teaches two classes at the Masters in Finance program at ESSEC Business School in Singapore.
Analyst’s Disclosure: I am/we are long FM, IEMG, VWO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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