December 8, 2003	Monday	Shawwal 13, 1424

On December 2, 2003, citing economic stability, Standard & Poor’s (S&P) revised its outlook on Pakistan to positive and indicated that the country’s rating may be raised. Pakistan’s current S&P rating stands at “B” (compared to China: BBB, India: BB). According to the international rating agency, the outlook change reflects improved fiscal performance under Prime Minister Mir Zafarullah Khan Jamali’s government.

“Since coming to power about a year ago, the Jamali-led coalition government has generally remained steadfast in practising prudent economic management,” said S&P in its statement.

Rating agencies such as S&P provide evaluations of the credit and investment risk of investing in countries for the benefit of various users, like lending agencies, investors and corporations. Such ratings reflect the risk premium investors attach to investing in a particular class of security. S&P’s rating outlook assesses the potential direction of a long-term credit rating over the intermediate to longer term and its recent statement is a welcome sign that investors are once again opening up to the idea of Pakistan.

As such, this outlook change by S&P bodes well for Pakistan’s investment case. With around $20 billion of market capitalisation, Karachi’s stockmarket remains one of the smallest among emerging markets. To put things in perspective, this compares to Hong Kong’s market cap of $250 billion, Bombay’s $170 billion, to cite a few. It is apparent Pakistan’s market is not large enough to justify independent coverage and analysis by foreign portfolio managers. Past experience of relying on domestic outfits for research has not left a good taste either.

Based on market capitalisation, Pakistan is allocated a small weight in an emerging markets portfolio.In the annexed table of country allocations of the MSCI (Morgan Stanlay Capital International)Emerging Markets Free Index (an equity benchmark for emerging market stock performance), it is apparent Pakistan gets minimal allocations in international portfolios. When such a small allocation is split among major stocks, it becomes unfeasible to initiate coverage of the market.

In the context of a global portfolio, fund managers are often confronted with the dilemma of a 10 to 15 per cent allocation for Asia, which must further be divided among individual markets. When this exposure among different countries is broken down further, markets like Pakistan get a negligible allocation. For such a small allocation, fund managers do not find it worthwhile to spend time and resources on research. They would rather not invest in such a market. This is why Exchange Traded Funds (ETFs) offer good utility as substitute investment products as these offer investors exposure to such markets.

Index Holdings by Country Country Allocation South Korea 18.89pc, South Africa 13.59pc, Taiwan 13.39pc, Mexico 7.86pc, Brazil 7.66pc, Hong Kong (China) 7.00pc, Malaysia 5.99pc, Russia 4.93pc, India 4.85pc, Philippines 0.52pc, Morocco 0.33pc, Pakistan 0.30pc.

An ETF is an index fund listed and trade on an exchange like a stock. It enables investors to gain broad exposure to an entire stockmarket and specific sectors with relative ease and at a lower cost than many other forms of investing. Like stocks, these investments are subject to market risk and fluctuate in value.

ETFs are also transparent, in that the components are disclosed every trading day and may appeal to a broad range of investors. The major players in this market have historically been large institutional investors seeking to index core holdings or pursue more aggressive market timing and sector rotation strategies. However, since smaller institutions and retail investors can trade in small lots, they can invest on essentially the same terms as larger investors.

Presently, investors have an array of 281 ETFs with 369 listings on twenty-seven exchanges around the world that are now available to track equity indices on a country, regional, or sector basis. Assets under management (AUM) for ETFs total about $150 billion.

Marketing Pakistan: Foreign investment is essential for marketing Pakistan’s image internationally as, in addition to being a source of capital, it offers benefits like exposure to a broader investor base and creates new channels for marketing the nation’s products and services.

In this light, the SECP and the KSE must study and assess the benefits of a KSEI-ETF for Pakistan’s stock market. For settlement and administrative purposes, the KSEI-ETF will be a more efficient way of investing than purchasing a basket of individual stocks to track the KSE100 index. It can also be a core holding in a multi-asset portfolio, providing a level of diversification that would otherwise be time consuming and expensive to attain by purchasing the underlying shares.

Other benefits of ETFs will be attractive marketing features for the KSE. ETFs can form the core holding in a portfolio with the aim of reducing portfolio risk. These products can be used to implement sector rotation and sector allocation strategies as well as adjust sector or country exposure. Furthermore, ETFs can be used to hedge sector, country or regional exposure. They can be sold short to hedge a portfolio of stocks, allowing an investor to preserve a portfolio while protecting it from overall market losses. Lastly, as the components are disclosed every trading day, ETFs offer greater transparency.

Encouraging Trends in Asia: The benefits of ETFs are increasingly being realised across Asia. In China, for example, the Shanghai Stock Exchange (SSE) is seeking permission to launch its first exchange-traded fund by the end of this month. The SSE has applied to the China Securities Regulatory Commission for approval to launch an ETF based on the Shanghai-180 index. The move is part of SSE’s broader programme to widen its product offerings and increase trading volumes. It also hopes to attract foreign portfolio investors as part of China’s emerging qualified foreign institutional investors scheme.

The Philippine Stock Exchange is looking at ETFs as well and has released a set of draft rules. Earlier this year, India launched the SENSEX SPIcE ETF, a fund designed to track the BSE-30 SENSEX. Given Pakistan’s smaller market, a KSE100 Index-based ETF (KSEI-ETF) can be an attractive and investable alternative.

An opportunity ahead: The IIF expects emerging economies to receive a net inflow of $139 billion this year. FDI is the biggest component of these flows, expected to total $109 billion. According to estimates, around 48.50 per cent of the total net inflows have been routed to Asia/Pacific. This trend is most likely to witness further growth in 2004.

Pakistan can see a piece of this action by structuring ETFs, which have opened a whole new panorama of investment opportunities to both individual investors and institutional money managers. The outlook change and potential rating upgrade by S&P has set the tone for strengthening the case for investment in Pakistan. Now, a new and appealing investment vehicle is needed.

Due to its smaller market capitalisation, Pakistan will continue to get smaller allocations until its market grows. Till such time, ETFs can serve as an additional channel for allocating funds into the stockmarket. The KSE-100’s stellar performance since 2002 should be leveraged, marketed and strategically-presented to promote investment in Pakistan. ETFs can be an effective way of marketing the idea that there is promise in the country as reinforced by S&P’s positive outlook on Pakistan.

Note: An obligation rated ‘B’ is more vulnerable to non-payment than obligations rated ‘BB’, but the obligor currently has the capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitment on the obligation.