Risk appetite is returning to the investment world and nowhere is that more evident than in the Babylon Fund, a hedge fund that invests in Iraq.

Investors have shown growing interest in Iraqi equities recently, according to Bjorn Englund, founder and CEO of Godvig Capital Management, the fund’s management company.

“Triggering factors behind this rising interest are a combination of high economic growth in Iraq, the Iraq Stock Exchange now offering electronic five-day trading sessions and central custody, diversification needs away from investors’ traditional home markets, successful oil auctions where well-known international companies decided to commit themselves long-term into investing into Iraq, and the democratic elections previously this year.”

The Babylon Fund’s investment strategy is based on the fact the Iraqi investment opportunity today is primarily driven by a macro-story, and the most legally safe, transparent and liquid way for international investors to access this macro story is to invest into it via the Iraqi Stock Exchange. This focus is particularly suitable for the Iraqi Babylon Fund because it promises its investors continuous trading possibilities (subscriptions and redemptions), according to Englund.

“We filter out non-compliant stocks where also factors such as size, liquidity, free float, Iraqi-dependency ratios etcetera are included,” he says. “We then make a fundamental analysis (to the ex¬tent possible as specific company data can be old, late or insufficient), mixed with flow, sentiment and other analysis. In the specific portfolio construction phase we also include correlations and diversification needs; among holdings, sectors, assets and fx.”

The resulting fund portfolio consists of 30-40 Iraqi and Iraq-dependant securities diversified between sectors such as banks, hotels, industrials and oil services. Bjorn uses a core-satellite approach where the core consists of large Iraqi blue-chip companies and the satellites smaller and less liquid Iraqi ones. While an average holding weighs 3-4% in the portfolio, with initial exposures typically half that size, when Bjorn identifies good opportunities in an equity, the fund typically invests up to its 10% limit.

“Once a holding runs into the double-digit weighting we are on the sell side to cap its size in order to keep a well-balanced portfolio,” he says. “A controlled approach towards risk diversification is important when investing into high-risk areas where Knightian risks and black swans occur with surprising regularity.”

Beyond the obvious oil sector, the best available investment opportunities have been in the banking and hotel sectors, according to Bjorn. Underlying these opportunities is the fact that Iraq is a country in a transformational stage; in the process of establishing a full-blown market economy after years of war and dictatorship.

“This offers not only a large and virgin market waiting to be tapped, well represented by the fact the total market cap of the Iraq Stock Exchange compared to the overall Iraqi economy is a meagre 3%, but also cheap valuations; Iraqi company key ratios are lower today than 20 years ago, when a dictator ruled and Iraq had finalised one war, was in one civil war and had two Gulf wars ahead of it,” says Bjorn.

Today, Iraq offers a range of risk categories, including security, corruption, political and legal. This is a typical situation for a country in a transformational stage such as Iraq, according to Bjorn. “Many of these risks are both large and often hard to quantify,” he says. “However, we take comfort in the fact this risk level, while high overall, is on a downward trend, the most important sub-categories are improving the fastest and that actions are being taken to keep this positive trend into the future.

“Further, the perceived risk level among international investors is much higher than the factual one, and we are optimistic this perception gap will narrow as the real risk level improves.”

Bjorn foresees investment prospects improving in Iraq. “The transformation the whole society is undertaking, the growth of the economy, the downward trend in risk levels and perceptions thereof and the effects of implementing a market-based economy will unlock new opportunities,” he says. “More transparency and easier access for foreigners will speed up this process.”