Key points:

• The Schroder ISF Middle East Fund is managed by Rami Sidani
• Team includes Maha Soueissy, Maya Bou Kheir (MENA) and Chris Colunga (Turkey)
• Expects outperformance of 6% against Emerging Markets in 2H 2010

Launched in 17 December 2007, the Schroder ISF Middle East Fund has returned 0.63% year-to-date, as at 30 June 2010. We interviewed Schroder Investment Management (‘Schroder’) behind the fund to find out how things work.

IFAST: How long have you (the fund manager) been with the fund?
Schroder: Allan Conway joined Schroders in October 2004 as Head of Emerging Market Equities.  Rami Sidani joined in July 2008 as a named fund manager for Schroder ISF Middle East and assumed responsibility as Head of MENA equities.  Maha Soueissy and Maya Bou Kheir also joined Schroders in July 2008 as Middle Eastern equity analysts.  Chris Colunga, a Europe, Middle East and Africa (EMEA) analyst, who covers Turkey for this strategy, joined Schroders in September 2007. 

IFAST: Have there been any changes to the team in the last 12 months?
Schroder: There have been no changes to the team since 2008.

IFAST: How many people are on the team and how does the team work out investment decisions?
Schroder: The chart below shows the matrix structure of our emerging markets equity team which is responsible for the all the Emerging markets funds including the SISF Middle East.
 

Specific responsibilities for the Middle Eastern countries other than Turkey are shown below:

Allan Conway, Head of Emerging Market Equities, leads our dedicated team and is a named fund manager for the Schroder ISF Middle East alongside Rami Sidani our regional head of MENA. The emerging markets team comprises 34 investment professionals with an average of 14 years’ investment experience: 7 fund managers, 24 analysts, an emerging markets strategist / fund manager, and 2 dedicated product managers.  Of this emerging markets team, one fund manager and three analysts contribute directly to the Middle Eastern equities strategy. Further support is provided by another 2 fund managers on the team.

Our fund managers concentrate on the management of portfolios and we aim to minimise their engagement in other activities such as marketing or administration.  They have clearly defined roles: each fund manager is responsible for their own countries and markets as shown in our matrix structure chart above.   These distinct fund managers’ functions improve accountability and ensure good integration of decision-making amongst the team.  All team members attend the monthly strategy meeting at which country allocation is discussed and, every quarter, policy weightings decided, and fund managers work closely with the relevant analysts when constructing portfolios for each country.

Fundamental to our approach to research roles is a belief in the value of specialisation.  Our analysts are organised on a country basis, to allow them to become experts on a limited number of economies and markets.  Analysts are regularly accompanied on company visits by one of the global emerging markets fund managers, or by the head of the Latin America, EMEA or MENA desks in the relevant regions. 

The emerging markets team has a dedicated strategist / fund manager, Nicholas Field, who is based in London, the hub of the team.  Nicholas contributes to all meetings, in particular the monthly strategy meetings at which the outlook for each country in the universe is discussed in turn and, every quarter, country allocation is decided.  In addition, he is an on-the-spot resource for our fund managers, for informal discussions to assist them in their investment decisions.  He is also responsible for maintaining the quantitative country model.  Our emerging markets strategy analyst, Abbas Barkhordar, provides support to Nicholas and researches certain frontier markets.

Our dedicated emerging markets resources are further supported by Schroders’ central economics team, which is based in London.  This team supply our fund managers with independent macro-economic research, interpreting current economic information, thereby providing a consistent economic view which underlies all our research efforts worldwide.

IFAST: Do you have your own money invested in the fund? Why or why not?
Schroder: Key personnel are encouraged to invest in Schroders products including their own funds.  It is not our policy to disclose the amount that individuals invest in their own funds.

IFAST: How are investment decisions made?
Schroder: Schroders has a dual approach to investing in Middle Eastern equities, using a mix of top-down analysis and bottom-up stock selection.  We look to derive 20% of our added value from country allocation driven by our quantitative model with judgemental overlay and 80% from stock selection driven by in-depth fundamental research.
Our investment process is summarised in the following diagram:

We use a proprietary quantitative model to assist our country allocation process. The model produces a ranking of the countries in the global emerging markets universe (GEM) by scoring them on five groups of factors: Valuation, Growth, Currency/Risk, Momentum and Interest Rates. This model has undergone a thorough backtest and backfit and has a strong track record of success. For the investment process for this fund, the factors and their relative weights in the model are applied to the countries in our customised GEM benchmark. Judgemental overlay is applied to the output of the model by reviewing the country weightings recommended by the model at the monthly strategy meeting, to determine if there are any reasons not to follow its recommendations for GEM countries. Allocation amongst the GEM countries is determined by the fund managers following this judgemental overlay. (Please note that due to the lack of reliable historic data for GEM markets we have not been able to conduct a similar detailed backtest of our model for the GEM universe in particular.  Consequently, the use of judgement is greater than in our standard GEM product.)  

The stock selection process is driven by in-depth fundamental research conducted by our in-house analysts based across the world, which we believe gives us a significant advantage over our competitors.  Our research process is based on company contacts, and there were over 200 company contacts in the GEM region in 2009. Analysts then use proprietary company valuation tools to produce a range of forecasts and valuation measures and grade each stock from 1 to 4.

At the stock level, Rami Sidani constructs the country portfolios, and James Gotto, one of our GEM fund managers, constructs the Turkish portfolio, both working closely with the relevant analysts to identify their highest conviction recommendations. They also draw on discussions with other Schroders professionals and their own judgement.  When selecting stocks they focus on the analysts’ highest conviction ideas, using 1- and 2-rated stocks where possible, and only using 3- or 4-rated stocks for risk control purposes to ensure that each portfolio is within its risk budget (tracking error target for each country of 10%, within a range of 4% to 15%). If 3- or 4-rated stocks are included in the portfolio they must be underweight. Stock selection is a dynamic process and Rami and James are free to make changes to the stocks in their country portfolios at any time.

A decision to sell a stock, independent of those resulting from a country allocation decision, may be prompted by a change in an analyst’s recommendation or a stock price exceeding its fair value.  We also implement a stop-loss policy, which causes a stock to be sold if it underperforms by 15% relative to the local market from purchase price or high since purchase.  In exceptional circumstances we may allow a fund manager to override the stop-loss rule.  Portfolios are reviewed every week to ensure that any overrides are fully discussed and justified.  This is not a guaranteed stop-loss rule, and during periods of market volatility we may temporarily suspend it.

We believe that risk is more actively managed in our investment process than is common in emerging market equity management.  It is a key differentiator of our process and we have controls in place at the portfolio construction stage and a comprehensive set of portfolio reviews.

IFAST: As at 31 May 2010, the turnover ratio for the last 12 months is 121.49%. Can you give more detail on what contributed to this turnover?
Schroder: Under normal market conditions, we expect portfolio turnover to be between 80% and 100% per annum* for SISF Middle East.  Fund turnover increased somewhat over the past 12 months due to Israel leaving the customised MSCI Greater Middle East Index** in September 2009 which meant some portfolio adjustment was required.
*Calculated as the lesser of purchases and sales over average market value.

**This is the MSCI Arabia + Turkey Index, which represents a market cap weighted combination of Saudi Arabia (capped at 20%), Kuwait, UAE, Qatar, Jordan, Bahrain, Morocco, Egypt, Oman, Tunisia, Lebanon and Turkey.

IFAST: Can you give us an example of an investment decision that you made that went well?
Schroder: An illustration of how our stock selection has been successful is provided by Halk Bank in Turkey which added 210 basis points to fund performance during 2009.
Turkey enjoys a very solid banking sector, which has emerged unscathed from the global financial crisis. This is the result of very strict regulations imposed by an experienced Central Bank who have learnt from previous Turkish crises. The banking sector today remains very liquid, with a Loan to Deposit ratio of 85% and a capital adequacy ratio close to 18%. Accordingly, this is a very strong position from which banks can grow their loan book and stimulate growth in the economy.

Halk Bank has the largest sustainable ROE in the Turkish market, strongest loan growth and NPLs have remained under control despite the large exposure to SME's. With one of the lowest loan to deposit ratios amongst its peers it does not need to fight aggressively for deposits, helping to preserve the bank’s margins. With a sustained ROE almost 10% over the cost of capital, Halk is also looking to be an attractive takeover target once again.

IFAST: Can you give us an example of an investment decision that you made that didn’t go so well?
Schroder: Qatar National Bank has negatively affected Fund performance, detracting 87 basis points during 2009. QNB is the largest bank in Qatar offering the best opportunity to gain exposure to the fastest growing economy in the world. Qatar grew by around 10% in 2009 and is expected to grow by another 16% in 2010. Investing in the banking sector is the best proxy to capture this strong growth in the country.

QNB enjoys a robust ROE of 30% and is trading at 2.2 times Price/Book. QNB has managed to grow its loan book by 16% since the beginning of the year and is expected to continue to do so given the strong project finance opportunities in Qatar which are being driven by the massive government spending in the country. We expect Qatar to spend USD 200 billion on infrastructure projects in the next 3 to 4 years, which offers great growth prospects for Qatari Banks.

IFAST: What’s your outlook for MENA in 2010?
Schroder: The MSCI Arabian Markets returned 22% in 2009 (in USD), a significant laggard compared to the MSCI Emerging Markets (EMs) which returned 79% and the MSCI World Index which returned 31%.  This underperformance was chiefly a result of negative market sentiment created by the Dubai crisis towards the end of the year.  In 2010 Arabian Markets have been catching up this performance and the MSCI Arabian Markets has outperformed the MSCI EMs by 6% to end June 2010.  We expect this trend to continue in 2H 2010.  Due to the underperformance in 2009, Arabian Markets are trading at around 11X PER, a discount to historical levels.  Furthermore, at a micro level, we believe many Arabian companies have attractive upside given higher ROE prospects and a lower cost of capital than many of their international peers.  With earnings growth expected to be around 20% this year, we expect good returns over the medium term. 

In the near term, the Middle East region also stands out as a safe haven in an uncertain global market environment dominated by developed market sovereign risk and risk of contagion.  Arabian markets are not suffering from the structural overhang of deleveraging that will be a drag on growth in the developed world.  The challenges in 2009 associated with an over leveraged economy were specific to Dubai, who has now received a $20 billion injection from fellow UAE member Abu Dhabi, and should not be generalised across the Middle East region which is typically characterised by low debt-to-GDP levels.  Over the longer term the Middle East region offers an attractive investment case based on a combination of wealth of natural resources, aggressive plans to diversify economies away from the oil revenue and young, fast growing populations. 

IFAST: What are the risks MENA faces?
Schroder: The single largest risk to the Middle East is a severe prolonged fall in the oil price, below $45-50/barrel, which we believe is unlikely.  Budgets in the GCC are currently conservatively based on a $50/barrel oil price with any excess creating a budget surplus.  Any short term fall in the oil price below this level could easily be covered by large existing cash reserves.  However, a prolonged deterioration in the oil price would put pressure on government-led investment and hamper growth prospects.  Should global growth experience a significantly weaker/double dip scenario caused by problems in Europe, weak US domestic demand or a more significant slowdown in China, then Arabian Markets, similar to much of the developing world, will likely suffer as a result of elevated risk aversion.

IFAST: How much upside do you see in the region and what are the performance drivers?
Schroder: Valuations in P/E terms are at around 11 times, which are attractive and at a discount to the historical average level.  Furthermore, we are expecting earnings growth of at least 20% this year, so a 20% market rally would not lead to stretched P/Es.  We believe these valuation and growth expectations are well supported by a robust investment case as detailed above.

We expect performance to continue to be driven by domestic demand growth and government spending as we witness an on-going diversification of economies away from a reliance on oil revenues.

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