It may not seem surprising that foreign interest has risen in Saudi Arabia following the easing of foreign-ownership limits. What may have been less predictable was the underperformance of Saudi small-cap companies when sized up against large- and mid-cap firms, and the resulting drag on the performance of some factor strategies in the country. Based on our analysis, investors looking to employ a factor-based approach in Saudi Arabia would have benefited by controlling for exposure to small-cap companies.
Seeing the bigger picture
The MSCI Saudi Arabia Index is a relatively narrow universe having, on average, 32 large- and mid-cap securities. Factor investors have generally looked for a broader opportunity set for constructing factor strategies and, as such, we use the MSCI Saudi Arabia IMI as the basis for constructing factor strategies and our analysis. The IMI universe includes large-, mid- and small-cap companies, and has, on average, more than 70 securities. The chart below shows the annualized active returns of the six main factor strategies in the MSCI Saudi Arabia IMI — value, quality, low size (equal-weighted), low volatility (risk-weighted), high dividend yield and momentum — constructed using the standard MSCI factor-index methodology framework.
Some factors outperformed, small caps hurt performance
Data from Nov. 30, 2016, to April 30, 2019.
Saudi Arabia vs. emerging markets
To put things in perspective, we first looked at the performance of the broad Saudi Arabian equity market. In recent years, the Capital Markets Authority (CMA) and the Saudi stock exchange, the Tadawul, implemented several enhancements that improved market access for foreign institutional investors, including the relaxation of the 20% ownership limit for qualified foreign investors (QFI). Since that time, Saudi Arabian equities significantly outperformed the emerging markets (20.1% for the MSCI Saudi Arabia IMI versus 11.9% for the MSCI Emerging Markets IMI on an annualized basis from Nov. 30, 2016, to April 30, 2019). 1Additional tailwinds, including higher oil prices during this period, likely reinforced investors’ confidence in the government’s ability to support an expansionary budget and higher discretionary spending to stimulate economic activity.
Over this same period, large- and mid-cap companies in Saudi Arabia outperformed small caps by 18.1%, on an annualized basis. The underperformance of small caps was also a drag on the performance of some factor strategies, contributing to a large dispersion in these strategies’ returns, from an annualized outperformance of 2.6% to a significant underperformance of 11.7%.
That said, the performance of factor strategies in Saudi Arabia was in line with past experience in global equity markets. We note that the factors that outperformed the broader market were the pro-cyclical factors — namely, momentum and value — which have tended to outperform in rising markets. In contrast, defensive factors, such as quality and low volatility, underperformed significantly during this period. Quality was hurt by its underweight in financials, which was one of the best-performing sectors.
Low size significantly underperformed
The most significant underperformance, however, came from the low-size factor, which underperformed the MSCI Saudi Arabia IMI by 11.7% from November 2016 to April 2019. While small caps underperformed the standard segment in emerging markets as well during this period, the extent of underperformance was significant in Saudi Arabia. One possible explanation is that, as foreign investors started participating more in Saudi Arabia, their focus may have been more on the large, recognized companies rather than smaller firms.
Saudi Arabian small caps hit harder
The underperformance of small-cap companies was also one of the contributors to the relative underperformance of factor strategies that had a significantly higher active exposure to small caps. As seen in the exhibit below, factor strategies — such as risk-weighted and quality — underperformed, while momentum, which had the smallest proportion of small-cap companies, showed consistent outperformance.
Small-cap exposure contributed to underperformance of risk-weighted and quality factor strategies
Controlling exposure to small caps
Looking at the results of our analysis, we wondered what the impact would have been on an investor who employed a factor-tilt approach that retained the full eligible universe in the index — but tilted the constituent weights in proportion to their target factor exposure and market-cap weight. This approach aims to ensure that small caps would not get disproportionately higher weights in the factor indexes. As seen in the exhibit below, the tilt approach may have helped investors harvest factor premia across the other five factor indexes, including risk-weighted and quality.2
Managing small cap exposure improved performance
With the easing of foreign-ownership limits and other enhancements taken to improve market access, Saudi Arabia has provided more potential opportunities for foreign investors. Over the few years since, the low-size factor has underperformed, and investors incorporating factor strategies would have benefited from controlling exposure to Saudi small caps. We will continue to monitor both broad passive exposure to market beta using MSCI IMI indexes and active allocations to factor strategies built on these broad indexes as more investors gain experience in the region.
1The relaxation of the foreign-ownership limits was reflected in the MSCI equity indexes from the November 2016 Index Review.
2This paper contains analysis of historical data, which may include hypothetical, backtested or simulated performance results. There are frequently material differences between backtested or simulated performance results and actual results subsequently achieved by any investment strategy. Past performance — whether actual, backtested or simulated — is no indication or guarantee of future performance. None of the information or analysis herein is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision or asset allocation and should not be relied on as such.