Mena’s investment credentials have been under the microscope recently, following the slew of political uprising across the region. With the region already a niche portfolio option, falling as it does within the emerging and frontier markets categories, Mena-facing investors are more likely to err on the side of caution when it comes to regional allocations.

Capital Generation Partners (CapGen), which advises a number of investors representing more than $2.5bn worth of assets, is one of many key players to reduce their Mena-linked allocations recently. Its current emerging markets exposure stands at 15-20%, down from 25% this time last year. “We are pretty cautious about the prospects for emerging markets,” says Cap- Gen’s CIO Ian Barnard. “Our clients still own very substantial amounts in emerging markets exposure, but at the margins we have advised them to reduce and move it back into OECD markets.”

While this allocation downscaling will certainly affect Mena, it is likely to have a larger effect on Latam and Asia-based fund managers, which have traditionally taken up the majority of CapGen’s emerging markets allocations. However, the company “doesn’t ignore Mena,” says Barnard, and while there are reasons to exercise caution with Mena investments, there are also reasons to stay interested.

“Mena is an aggregation of a number of relatively small markets at very varying stages of development,” he says. “Brazil and China’s economies, for example, offer more accessible, more intermediated investment markets. If you look at Mena there are clearly straightforward fixed income and long equity opportunities available but for more specialist and active management and active management strategies I don’t think the market is as well developed as it is in the other two emerging market regions.”

In Barnard’s view, the main issues keeping investors at bay are Mena’s relatively high cost of capital and recent regional unrest, adding that a lack of understanding of the region’s “relatively small markets” can be an obstacle to foreign investors in particular. “It’s a real specialist who can distinguish the Omani from the Saudi market,” he says. “I think with the GCC there is this feeling that because they are so closely linked, if there is a threat to Bahrain for example, it may spill across into all the markets.”

However, he adds that the risks on offer in non-GCC Mena can be quite interesting. “I think there is a chance to earn a higher cost of capital there because they haven’t had the same degree of capital stimulation.”

Emerging markets strategy

Representing a number of high-net-worth individuals, as well as family offices, endowments, and institutions, CapGen’s partners personally advise its clients on the performance of their assets. As a result, they must be able to justify their investment decisions at a granular level. Barnard operates a ‘stay rich plus’ strategy across his portfolios, with the aim of preserving capital and generating a modest positive return over most time frames. This is done by diversifying investments by geography, sector and market cap size, and it is through portfolio diversification that local and regional fund managers come into play.

“If a strategy is relatively simple, for instance, doing large cap equities across emerging markets, we would choose a global manager or a regional manager,” says Barnard. “If we are looking at a strategy or an activity that is more concentrated, involves more research or active management or in some way is just less benchmark- following, then our tendency would always to be to go with local managers.”

Barnard says CapGen is keeping an open mind to Mena’s markets and carries out regular searches for local fund managers. Although the company doesn’t have any searches out at the moment, Barnard says: “We are always interested in talented, trustworthy investment fiduciaries in emerging markets either to supplement our approved list of managers or if we find somebody is very good, to displace somebody who is currently on that list.”

When it comes to eligibility criteria, emerging markets fund managers are not expected to meet higher or lower thresholds than any other fund managers. In Barnard’s view, honesty is the most valued quality of a local fund manager, as well as skill and strong strategies. “We don’t generally have a top-down allocation between emerging and developed markets,” says Barnard. “Our starting point when constructing a portfolio is not the division between OECD and emerging market portfolios, although it is one of the things that we measure.”

The global economic climate is certainly driving some of CapGen’s current investment decisions. Barnard believes it is important to draw a distinction between economic growth and financial markets’ performance, as this can sometimes be mistaken for market returns available to external financial investors. “Just because an economy is growing quickly, it does not mean that foreigners are making a lot of money out of it,” he says.

This seems to be the case with global emerging markets, which may or may not be able to cope positively with monetary normalisation in the OECD. “Financial markets’ performance has tended to go in line with GDP growth and people have therefore drawn a causal link, as though markets have gone up because there has been low GDP growth,” says Barnard. “There is an alternative explanation which is that emerging financial markets have performed well because there has been an extraordinary monetary tightening across the world, starting with the US economy. If monetary normalisation takes place, will these financial markets survive? I am not sure.”

Mena option

Despite its bearish approach towards emerging markets, in the long run Barnard sees things picking up for Mena fund managers. “Paradoxically, Mena might be seen as a more of a current opportunity,” he says, adding that African markets are of particular interest to his investors.

“But the difficulty many institutional investors may have, particularly those who invest very substantial amounts of capital, is finding managers who have markets that are large enough to be able to deploy significant amounts without going to generalised pan-regional or global investment managers. My personal opinion would be that there may be more opportunities in Mena because when you look at prices in the Asian and Latam markets they are pretty full across many asset classes.”

So, if Mena has so much potential, what needs to happen to encourage increased interest from the likes of CapGen Partners? “We would have to see a particular surprise to lead to a price correction,” says Barnard. “As a rule, we like to buy things that other people are not buying so if emerging markets became unpopular and we saw a significant price correction then that might well be the moment when we seek to expand exposure in traded strategies.”

All things considered, the company’s investment outlook on Mena could change sooner rather than later. CapGen reviews its model portfolio on a quarterly basis in order to assess the best available investment strategy, and this may result in a swing back to emerging markets, including Mena. The partners operate by a rule that they do not move allocations by individual percentage points, as shown in its recent 10% reduction in emerging markets exposure.

“Compared to institutional investors we have been relatively early, relatively aggressive and relatively entrepreneurial in our exposure to emerging markets over the past 12 months,” says Barnard. “At the moment, I see as much downside as I seem upside risk in emerging markets.”

It remains to be seen how CapGen’s outlook will change, and whether Mena will disprove the trends when it comes to emerging markets.