The New “Ab”normal: Measuring Volatility is Risky Business

Market pundits suggest we are entering into an era of the “new normal” characterized by low returns and high volatility on risky assets.  Following an earlier article in the Financial Times (FTfm supplement) Stephen Horan, head of professional education content and private wealth management at CFA Institute  and Raghu Mandagolathur of CFA Kuwait, the national Kuwait society, discuss how the financial crisis has encouraged new thinking about what it means for markets to be abnormal and how to measure it.  The GCC stock markets measure very high in terms of volatility, even higher than emerging markets. The high volatility contributes to excessive speculation which reduces market efficiency. The issue is exacerbated by index concentration with few large cap stocks dominating the index. While decline in volatility happens over a long period of time when markets become more efficient, investors would do well to understand its source and take measures to manage it.
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<!--[endif]-->Why is it important to measure market volatility?

Volatility has implications for the future market behavior.  Research shows that abnormally large price movements (whether positive or negative) tend to be followed by relatively high returns.  Investors gain confidence as markets gradually resolve uncertainty instigated by the initial price shock. 

 Moreover, price shocks portend continued high volatility in the near term.  In other words, volatility tends to cluster through time.  So, even if an investor is unable to anticipate the onset of increased market volatility, they can expect it to continue for a while once it begins. 

How do portfolio managers typically measure market volatility?

Investors often think of market volatility in terms of the standard deviation of historical returns, which measures how variable returns have been over some time period.   Options markets provide an opportunity to get a forward-looking glimpse of volatility because the market price of calls and puts is directly related to the standard deviation of returns expected to prevail over the life of the option. However, GCC region is yet to have the benefits of a fully fledged derivatives market. Kuwait has a limited options market with only call options being allowed to be written...

Returns that are one standard deviation away from average are more typical than returns three standard deviations away from average.  Whether based on historical experience or implied by option prices, an asset’s standard deviation provides a benchmark for normal, or typical, variation relative to itself.

Are we in an abnormally volatile era?

The EURO STOXX 50 Volatility index, which measures the forward-looking standard deviation implied by prices of EURO STOXX 50 index options, has been close to its 52-week low, suggesting that market participants anticipate relative tranquility in the near term.   Based on this measure, one might say we are in an era of abnormally low volatility.  All else equal, markets respond negatively when implied volatility increases.

Are there other ways to measure market volatility?

One could think about the variability of returns among individual stocks in an index rather than the variability of broad market index relative to itself.  The more disperse the returns among a group of securities, the greater the opportunity for profitable security selection within that group.  This volatility across securities tends to spike in times of crisis, suggesting that returns from active management can be most pronounced during these times.

In a more eclectic vein, market volatility can be measured using linguistics to quantify the volume, tenor, and variability of sentiment of newswire stories.  This non-traditional, forward-looking approach can be helpful when forward-looking implied volatilities from option contracts are unavailable. 

Finally, volatility can be measured in terms of how asset classes typically behave in relation to one another, sometimes called market turbulence.

What do you mean by “turbulence”?

For example, in relatively tranquil markets, returns on corporate bonds and large company stocks are normally fairly independent of each other.  In turbulent markets, the returns of these asset classes may tend to move together. 

Even if return variability of corporate bonds or large company stocks is not particularly abnormal based on their individual behavior, the market can be turbulent based on the uncharacteristically high correlation between the two asset classes.  Mark Kritzman, CFA, and Yuanzhen Li propose a method measuring turbulence that incorporates unusual correlations in a recent Financial Analysts Journal article.

Are you simply describing the notion that correlations increase in times of crisis?

The concept has broader applicability.  In some cases, correlations decrease in turbulent markets.  For example, returns on high-yield corporate bonds and high-quality government bonds tend to be highly correlated in normal markets when returns on fixed income instruments are dominated by interest rate movements. 

In times of stress, changes in the risk premium dominate price changes, driving down returns on high-yield bonds and pushing up returns on high-quality government bonds in a flight to safety.  The main point is that turbulence is defined as much by abnormal correlation of returns as it is by abnormal volatility.

How might portfolio managers integrate different notion of volatility into practice?

First, portfolio managers can use the variability of returns across different securities to judge the profit potential of active management in a particular asset class and adjust their active or passive strategy weights accordingly. 

Portfolio managers might also spend extra time conducting scenario analyses based on experiences in market crises and focusing on variables that have been historically unstable.  Finally, they can incorporate covariances and other parameters derived from turbulent market periods rather than normally tranquil markets to construct portfolios. 

Awareness Is Key for ETF and ETP Investors

This article was originally published in Arab Times

The asset management industry in the GCC region has shown growth amidst turbulence. The region manages nearly $30 billion in over 325 funds. After Saudi Arabia, Kuwait is the largest market in terms of assets managed under mutual funds. However, the concentration of funds is heavily skewed in favor of active funds with very little presence of index funds or Exchange-traded funds (ETF’s). The absence of institutional investors is a key limitation for local markets. It is estimated that the institutional presence is less than 10% compared to over 25% for emerging markets and over 75% for developed market. Authorities are keen to deepen the stock market through institutional presence especially foreign investors. However, foreign investors typically commence their exposure through passive vehicles like ETF’s. Hence development of ETF’s could be a good thing to attract such investors to the region. Also, development of ETF’s can aid in structuring more robust products than plain vanilla country funds.  Globally, assets of exchange-traded funds (ETFs) and exchange-traded products (ETPs) surpassed $1 trillion near the end of 2009, up some 45 percent year over year.  This article first appeared in FTfm on May 3 2010.

Samuel Lum, CFA, and Mandagolathur Raghu, CFA reviews the dynamics of this growth and its implications for investors.

 

Q. What are some recent developments in the ETF/ETP area?

After a drop in 2008, asset growth for ETFs and ETPs has resumed, surpassing the $1 trillion milestone in 2009. There are now more than 2,600 ETFs/ETPs, with some 4,800 listings on more than 40 exchanges from about 140 providers, and hundreds are currently in the planning stage. Moreover, ETFs and ETPs accounted for around 30 percent of NYSE trading in 2009. 

Providers continue to launch products with new asset class and market exposures, replication approaches, management styles, and legal structures. Other new products include faith-based ETFs, actively managed ETFs, fundamental and other non-cap-weighted index ETFs/ETPs, and the first hedge fund ETF.

 

Q. What is the key difference between ETFs and ETPs?

Although ETFs and ETPs are similar in the way they trade and settle, ETFs typically use an open-end investment company structure, whereas ETPs take the form of notes, commodity pools, partnerships, trusts, or other structures. ETFs have been around much longer than ETPs and their assets and number of listings is much larger.

 

Q. What is the industry backdrop to the recent growth?

Investment banking revenue dwindled after the collapse of Lehman and the bailout of AIG heightened investors’ concerns about counterparty risks embedded in structured products. A cool market for credit and security issuances further reduced revenue. Issuance fees and market-making revenues from ETFs/ETPs represent a growing alternative revenue source.

Index providers also find that ETF/ETP issues complement their core business well. Nonetheless, traditional funds still have 12 times more assets than do ETFs.

  

Q. Do ETFs/ETPs contain counterparty risk? 

ETPs that use direct replication often lend the underlying securities for additional income. Although the counterparty risk exposure to borrowers could be addressed through diversification and tight collateral monitoring, risk management practices have neither explicit requirements nor transparency. 

ETPs that use synthetic replication are usually required to diversify the exposure to a number of counterparties (e.g., European-domiciled ETPs under the UCIT regime). Some ETPs are further collateralized with U.S. T-bills to eliminate counterparty risk. 

Q. How do fees and expenses stack up?

 

Although ETF/ETP fees and expenses are often lower than their traditional index fund counterparts, ETP providers are sometimes able to generate additional income by lending securities and by charging customers the normal bid–ask spread while actually executing at much tighter spreads by crossing or exploiting efficiencies in their trade execution platforms. For example, some U.S. and U.K. brokers have been offering zero-commission trading. In fact, some ETF/ETP issuers are giving rebates, or retrocessions, to private banks and institutional investors. 

 

Q. What are tax considerations for European, Asian, and other non-U.S. investors?

For U.S. investors, tax efficiency is often cited as an advantage of ETFs/ETPs because the creation and redemption process for shares is treated favourably from a tax perspective. For European, Asian, and other non-U.S. investors, however, distributions from certain U.S.-domiciled ETFs could be subject to a withholding tax of up to 30 percent, depending on the tax treaty and specific investor circumstances.

European, Asian, and other non-U.S. investors in European- or Asian-domiciled ETFs may not be subject to a withholding tax. Other considerations (e.g., liquidity, counterparty risk) could counterbalance the tax considerations.

 

Q. Are there tracking-error issues?

As previously documented in this column, some inverse and leveraged ETFs/ETPs, especially those that track a geared multiple or inverse of a particular index, have failed to track their benchmarks, sometimes by wide margins. As an alternative, many advisers try to help clients borrow and short ETFs/ETPs instead of using leveraged ETFs/ETPs. 

Investors will also need to assess the risk that the provider may fail to meet local regulatory requirements. At least one index ETF has started trading at a discount to net asset value because of regulatory breaches.

 

Q. Are ETPs and ETFs a viable tool for fund managers?

ETFs and ETPs can be efficient, low-cost tools for implementing a sound investment strategy. Fund managers and portfolio managers, however, must be aware of the unique counterparty risks, tracking errors, and tax considerations that vary from product to product and that might otherwise be overlooked in this fast-growing industry.

After the crisis-Hurdles remain for gulf banks

The GCC banking sector is an important segment of GCC financial sector. From a modest asset base of $314b as of end of 2003, the total assets for the sector grew to an astonishing $ 966 b by the end of 2009, implying an annual growth of 20%. The banking sector is dominated by domestic players due to regulatory protection. The sector enjoys a large market opportunity set primarily due to absence of non-bank finance companies. Hence, one can find banks actively pursuing asset management, investment banking, stock broking ,etc. GCC banking sector is inherently helped by certain fundamental advantages like benign demographics that is not only young but also wealthy. The region is still under penetrated when benchmarked with western banks. While the sector cruised along nicely all these years, a major brake occurred during the fourth quarter of 2008, after which the sector continued to witness tremendous challenges.

Asset quality deterioration has led to unprecedented levels of provisioning during the last two years which dented the profitability, especially that of Islamic banks. Exposure to troubled sectors (like real estate, construction and financial services) coupled with bad corporate governance can stand as main reasons. While the sector was hit by the global financial crisis, the general assessment is that it has shown more resilience than expected. As per IMF assessment, regional banks withstood the onslaught better due to their low exposure to structured products and derivatives (both on and off balance sheet). On an average, banks in GCC held 18% of their portfolios in securities as of end-2008 of which exposure to equities/derivatives is just 1%. Also, regional banks enjoyed high capital and profit leading to larger buffers. In addition, timely help from central banks reduced the impact.

However, looking forward, the days of easy money (through high spreads) are gone with high level of risk aversion setting in among banks. This will lead to lower credit growth. While credit grew by an astonishing 30% during the last few years, it will be prudent to assume that this rate will atleast halve going forward. With other avenues for capital deployment being weak, deposit growth will continue to be strong adding further pressure. The potential for fee income has also reduced. Ambition to foray beyond borders will also be reviewed in this challenging time.

GCC banks were laid back in the past in a protected environment leading to poor customer service and product offering. On an average, the ratio of product-per-customer ratio is two to three in the GCC compared to eight or nine in the western retail banks as per AT Kearney study. The banking sector faces large competition with limited potential in the domestic market and the gradual relaxation of regulatory restrictions. Most banks operated within their country of operations and had limited branch network thereby keeping a control on infrastructure costs. Also, through expat hiring banks kept its costs low even in areas like information technology. All this enabled GCC banks to enjoy a low cost-to-income ratio compared to other banks in the western world. Also, GCC banks enjoyed high capital cover and a stable shareholder base which in some countries could be the respective government providing cheap and stable capital and deposits. But going forward, GCC banks may have to face some change in paradigm leading to vanishing of these advantages. The WTO would bring in more pressure for the local regulators to allow entry of foreign banks. Also, post financial crisis, regulators will lay more emphasis on encouraging the development of local capital markets as depending only on the banking sector could be dangerous. This is likely to reduce the overall dependence and importance of banks as the main financial intermediary.Click here for the original article

The GCC Equity Research Dilemma

This article was published on Gulf news. you can read here

If you are a foreign investor looking to invest in a market, the first thing you look at is availability of “Research”. Research at an economy level, sector level and stock level will be the first point of evaluation in what is called as “secondary research” process. After ascertaining the view points by analysts, you then embark on “primary research” where you form your own opinion through interaction with various stakeholders including the company.

GCC has two major limitations in that sense. They are “under researched” and “hard to research”. The second factor may explain the first factor but they are not mutually reinforcing. While the “under researched” status is typical of any emerging/frontier markets, it is the second factor (hard to research) that is quite a local attribute.

Let us look at some statistics. At “Markaz” we publish an interesting piece on a monthly basis titled “GCC Equity Research Statistics” as per which only 100 GCC companies had research coverage out of a universe of 750 stocks. In other words, only 13% of companies enjoy research coverage with Qatar at the highest of the table (25%) and Kuwait lowest (5%). This may look very discouraging but is not out of trend. A recent Crisil report (Indian credit rating agency) states that only the top 100 of the nearly 3500 actively traded stocks receive some sort of research coverage in India. That’s just 3%.! Things look better when viewed from a market cap perspective. In that sense, nearly 57% coverage is noticed for GCC with Saudi Arabia ranking at the top (70%) and Bahrain at the lowest (26%). The high level of coverage in terms of market capitalization may be due to skewness in market structure dominated by large cap stocks. For eg., in the case of Saudi Arabia the top 6 companies (out of a universe of 136) account for 50% of the market cap while the top 18 companies account for 75% of the market cap. In a skewed market, it is possible to achieve scale in research in terms of market cap but not in terms of companies.

Let us examine this “hard to research” factor further. Access to companies and its management is a primary requirement to carry out equity research. Management discussions form an important element while giving research recommendations (buy, sell or hold). Even in situations where companies are proactively meeting analysts and provide forward looking guidance, still analysts get it right only 50% of the time or even less than that. You need the following to come up with credible research:

•Timely disclosure of performance
•Detailed disclosure
•Management discussions and view points
•Regular analysts meetings &
•Unbiased opinion


GCC companies on an average take time to bring out their results especially if it is yearend (requiring audit seal). For e.g., by the end of March 2010, only 67% of GCC companies declared their Q409/annual 2009 results with Kuwait at just 20%. This is nearly 3 months after the finish of the period. Even where results are available, only high level top line numbers are made available for quarterly performance (except the Q4) which makes it difficult to subject them to a detailed analysis. In many cases, they are posted as one/two liners on the stock exchange website in Arabic making it completely impossible to assess the performance. Hence, late reporting of financials coupled with weak reporting of financials makes it that much harder to form credible opinion.

Annual reports are a good place to articulate management thinking and “wish list” for the future. Warren Buffet set a new standard of extremely detailed management discussion which is now an international event where shareholders travel miles to listen to him and read his annual report giving it the same respect as any other reputed investment textbook. While it is harsh to expect such levels of discussion in GCC, most of the management discussion (labeled as chairman’s letter) is quite pedantic and repetitive in nature.

Analysts are viewed more as intruders into the privacy and hence are not normally granted audience. Even if they are granted audience, mostly they end up meeting financial controllers or in a more graceful situation the CFO. Access to the CEO is very limited or at best not available. However, this is different from market to market with Saudi Arabia being touted as the most difficult market to penetrate and engage companies in analyst’s discussions. Where such discussions take place, they are normally devoid of any forward looking guidance and may focus more on past performance. Lack of Arabic speaking analysts, especially locals, may be one factor at play here.

Till a few years back, it was taboo to give a “sell” recommendation lest you run the risk of incurring the wrath of the management through sensitive phone calls splashing all around. Hence, new terms have to be invented to replace the word “sell” (like caution). For e.g., among the 212 research notes published between Jan-march 2010, only 19 were sell while 131 were buy with rest hold. In few cases, it may be due to benign expectation of the stock market. However, in most cases, it is prudent not to issue a sell recommendation.

Rapid opening up of the market to foreign investors in terms of reducing the bar as well as inclusion of GCC markets in the MSCI Emerging market index will change this picture dramatically. Availability and quality of research may not be the criteria for inclusion in the index but once included active trading can happen only based on research coverage. Thanks to the arrival of portals like Zawya, financial information is easy to get by including annual reports. However, positive management attitude is extremely important to reach out to analysts and share information.



It should be noted that many listed companies are either majority family owned or government owned. In the past, these companies were little interested in broad basing their ownership structure and were guarding their control zealously. With no need to look at capital markets as a money raising venue, there was little interest to meet with analysts leave alone share information with. With banks and local shareholders coming under severe strain, companies have to increasingly look to diversity their shareholding and capital raising. Attracting quality institutional investors (foreign) as well as considering capital market as a viable place to raise capital (both debt and equity) will be the future trend for growth-aspiring companies. In both cases, research will form the basic foundation. Over the past few years, presence of foreign investment banks (like Goldman Sachs, Merrill Lynch, Morgan Stanley, Credit Suize, etc) has lent credibility to the research process.

Stock trading is a day time activity for many locals which explain the retail nature of the GCC stock markets. Speculative trading based on “inside information” is quite the norm and forms the bedrock for buying and selling. This leads to heightened volatility. Institutional participation in trading is less than 5%. Increasing research can enable to increase this share which can then attract more research to mid cap and small cap stocks thereby enabling a “positive feedback loop”. In many markets (like Kuwait/Qatar,etc) brokers do not offer sell-side research as investors/traders are not sophisticated enough to demand it. In addition, brokers are not equipped with qualified sell side analysts to carry out and publish updated equity research. In most cases, they issue flash notes on earnings announcements (not exceeding a paragraph).

In advanced economies, the efficacy and utility of broker-dealer “sell side” research has come in for some sharp commentary especially relating to its objectivity. Hence, institutional investors tend to rely more on independent research that may charge for their services but at least enjoy some objectivity. However, in the context of GCC, we are still not yet there even in terms of sell-side research leave alone independent research.

Looking forward, as the market capitalization keeps growing along with gradual relaxation of foreign investment limits, interest by foreign investment banks is bound to increase. This will herald the needed “research culture” which then will be followed by local players who till now view research more as a cost center. Demand for qualified and experienced analysts who specialize in GCC sectors will soar though availability may still be an issue. From a “depth” of coverage, the research will progress to “breadth” of coverage in pursuit of alpha through mid and small cap bets, though it may induce tracking error. However, in a zeal to pursue breadth, companies may be tempted to outsource research to low-cost outsourcers based in India thereby “templating” the process. Pursuit of quantity in lieu of quality may have negative consequences in the longer term in terms of research efficacy. Companies that are ahead on this thought process will gain rapid market share while the rest will be also-rans.

Reasons to be cheerful about new GIPS standards

This article was originally published in Arab Times

The recently released Global Investment Performance Standards (GIPS®) outline new standards for presenting investment performance to potential investors.  Mr. Raghu Mandagolathur, President of CFA Kuwait, discusses these standards and why an investment firm would want to implement them.

The asset management industry in the GCC is rapidly evolving.  It is currently home to more than 325 mutual funds with nearly $ 125 billion under management including managed accounts.  Kuwait has established itself as a key hub within the region, and is currently home to around 65 funds (or 20% of the total) with an estimated assets under management of $58 billion.  Kuwait also boasts the oldest stock exchange in the region, probably the third largest in terms of market capitalization. Consequently Kuwait continues to develop a vibrant and growing domestic and international investment community with the presence of nearly 100 investment companies.  

If Kuwait is to continue to attract the very best investors from both home and abroad, to evolve and grow its investment industry, we must promote high standards of performance measurement and presentation, to help promote better transparency, market integrity and fairness. The importance of setting standards in performance reporting has become paramount.   

But what standards should we use and how should they be introduced?  At CFA Kuwait we believe GIPS® provide a suitable framework to help raise standards of investment management in Kuwait and around the GCC.

What are the Global Investment Performance Standards (GIPS®)?

GIPS are voluntary ethical standards for the calculation and presentation of investment performance.  Their genesis dates back to the 1980s when unscrupulous investment managers presented their best-performing portfolios to prospective clients in hopes of winning their business. 

This performance was generally not representative of the firm’s overall investment results for that strategy.  The focus of the GIPS standards, therefore, is the presentation of performance to prospective clients who want reliable performance metrics based on the principles of fair representation and full disclosure. 

 

What areas do the GIPS standards cover?

The GIPS standards address such topics as input data, calculation methodologies, composite construction, performance presentation, and disclosures in both traditional and alternative asset classes.  The Standards are continually evolving to meet the needs of a dynamic industry.  Interpretations are developed and issued on an ongoing basis to assist firms in implementing and applying the Standards.

 

What is a composite?

A composite is an aggregation of portfolios managed in accordance with similar investment mandates, objectives, or strategies. All discretionary fee-paying portfolios must be included in at least one composite, and composite performance must be calculated and presented as the asset-weighted average of the performance of the portfolios within the composite.  Investors are thus presented with performance that is truly representative of a firm’s investment results for a particular strategy.

 

Do the standards apply to public equity funds and private equity funds in the same way?

Many provisions of the GIPS standards apply to both public and private equity investments.  However, the GIPS standards also include specific requirements and recommendations for private equity (as well as real estate).  Most private equity investments are made through limited partnerships in which the investment manager controls the timing of capital drawdowns and distributions.  The GIPS standards require the use of a different calculation methodology, the internal rate of return, that reflects the timing of those cash flows.

 

What is new in the 2010 edition of the GIPS standards?

The recently released 2010 edition of the GIPS standards introduces several important new concepts.  Firms will be required to value investments based on fair value rather than market value.  Although fair value and market value are often the same for liquid securities, liquidity may dry up at times and market values may not be available or reflective of the true value of the investment.  For investors, it is essential to know what their investments are actually worth. 

New provisions have also been added to address risk, including a requirement for firms to present the three-year standard deviation of composite and benchmark returns.  This is not the most sophisticated nor, for some strategies, the most appropriate measure, but it establishes a foundation for comparability.  The decision to include provisions related to risk is a clear statement that performance includes both risk and return and investors must evaluate both.

 

Do the GIPS standards prevent fraud?

Although the GIPS standards are not specifically designed to prevent fraud, the Standards require firms to present only the performance of actual assets under management and not hypothetical or model performance.  In addition to requiring firms to adhere to all applicable laws and regulations, the Standards prohibit the presentation of any performance information that is false and misleading.  The comprehensive policies and procedures required by the GIPS standards give investors additional comfort regarding a firm’s infrastructure and operational controls.

How do firms demonstrate compliance?

Firms can claim compliance once they have met all the requirements of the Standards and prepare a compliant performance presentation.  Firms can also have an independent verifier assess if the firm has complied with the composite construction requirements of the GIPS standards and if the firm’s policies and procedures are designed to calculate and present performance in compliance with the Standards.

 

Why should investment firms implement the GIPS standards?

Compliance with the GIPS standards signals to the marketplace that a firm is committed to integrity and enhances a firm’s credibility when competing for assets.  Because the GIPS standards are global, compliance provides firms with a passport to compete with other firms worldwide. In addition, firms that implement the Standards may strengthen internal controls and increase the consistency of their performance data.

An earlier version of this article appeared in the international edition of the Financial Times (FTfm supplement).  In addition to Mr. Mandagolathur’s comments,  Mr. Jonathan Boersma, executive director of the Global Investment Performance Standards at CFA Institute and Mr. Philip Lawton, CFA, CIPM, head of the CIPM program, also both contributed to this article.

Kuwait can learn from Saudi capital market law

This article published in FT. click here to read

A capital market law passed recently by the Kuwaiti parliament has quickly become a hot topic. But, given the global and regional market turmoil and the huge losses suffered by local investors, this potentially critical development is being met with much scepticism.

The reason is that, except for Saudi Arabia, there is little empirical evidence to estimate the effect the new law is likely to have.

The Saudi CML came into effect in 2003 and statistics before and after this provide some clues on future performance in Kuwait, whose bourse has a market capitalisation in excess of $100bn. Many of the provisions of the Kuwait law mirror those of Saudi Arabia and, if Kuwait follows through as the Saudi regulator has done - a big "if" - the conclusions are broadly positive and sceptics may be confounded.

At a broad level, the number of companies listed on the Saudi exchange increased from 73 in 2004 to 136 in 2009, a near 90 per cent jump. Liquidity, as measured by average daily value traded, jumped from a modest $160,000 in 2004 to $1.3m in 2009, albeit with the help of oil prices.

More importantly, Saudi companies today are more prompt in disclosing their quarterly performances than previously. At the time of writing, nearly 95 per cent of Saudi companies had declared financial results for the fourth quarter of 2009 as against only 8 per cent for Kuwait.

The Saudi bourse has also experienced a qualitative jump in terms of stocks that dominate trading. Prior to the CML era, it was not uncommon to find penny stocks predominating.

The Saudi initial public offering market, which has stimulated frenzied interest among local investors, also received a fillip in terms of the number and size of issues. Public offerings (including private placements) swelled from $5.5bn in 2006 to $19bn in 2009.

The number of complaints received by the Saudi Capital Markets Authority, the regulator, dropped 75 per cent between 2006 and 2008, testimony to its increasing effectiveness. Voluntary investigations by the authority increased 82 per cent, mostly in the area of manipulation and insider trading. Officials even monitor websites to check abuses relating to stock recommendations.

The number of brokers (or authorised persons) swelled from a meagre eight in 2005 to 110 by 2008 and half of those were authorised to conduct all activities, such as dealing, managing, custody, arranging and advising.

Saudi Arabia is thus an interesting pointer to the potential shape of things to come in Kuwait. Not that such a result will necessarily be repeated, especially in areas such as stock numbers, where the Kuwait market has an abundance, with more than 200 shares listed.

Many of the shares (85 per cent) are micro caps with negligible trading, and at present belong to a distressed segment of financial and real estate companies.

However, the new law may offer a solution in terms of altering market structure by easing privatisation and consolidation. The hope is that this would then improve the composition of stocks that dominate trading volume. Last year, the top five traded stocks in volume terms on the Kuwait bourse enjoyed a cumulative market cap of just 1 per cent of total market value, as against 25per cent in Saudi Arabia.

Much of the debate centres on the composition of the CMA board, a five-member team to be nominated by the prime minister, and the speed with which the authority is set up.

It will be large in terms of manpower - the Saudi CMA employs nearly 500 staff - and needs planning and execution. Finding local talent is not a problem in Kuwait, but if the agency is not marketed properly, the local trading community might view it more as a policing exercise than part of genuine regulatory reform.

Measures such as this may eventually help Gulf Co-operation Council nations to close the gap with other emerging markets in terms of depth, breadth and performance. The underperformance of the region during 2009 relative to emerging markets should argue for such law changes.Click here to read the original article