* UAE and Qatar recently upgraded to emerging market status
* Investors still see frontier characteristics in the two
* Both markets rose strongly before upgrade, then fell sharply
* Middle East still carries high political risk, access barriers
By Carolyn Cohn
LONDON, July 16 (Reuters) - Despite their recent upgrade to the more mainstream emerging market league, United Arab Emirates and Qatar are considered risky enough by many investors that they still treat them like frontier markets.
Erratic price moves, difficulties of accessing the market, and deep political risks, alongside strong growth, are common characteristics of frontier markets, which are less developed emerging markets, and the two Middle Eastern countries still tick those boxes for many.
UAE and Qatar stock markets rallied sharply over the past year in anticipation of the upgrade to emerging market status by index compiler MSCI, with the expectation that more risk-averse investors would buy in.
But since the upgrade took place at the end of May, the markets have fallen sharply.
Problems at Dubai-listed construction firm Arabtec fuelled the market rout. The spiky price action reminded investors why these markets had so recently been categorised as frontier.
“The stocks should not have moved up so much, they should not have dropped so much - we have sat on the sidelines and watched,” said Andrew Brudenell, frontier fund manager at HSBC Global Asset Management.
“This is sometimes how frontier markets behave.”
HSBC Global Asset Management categorises UAE and Qatar as “crossover” markets within its frontier fund, alongside some existing emerging markets where there may be issues about how easily foreign investors can enter, such as Peru and Egypt.
A frontier classification within investors’ portfolios is not necessarily a bad thing.
Frontier stocks have consistently outstripped the more mature emerging markets, jumping 19 percent this year compared with a 6 percent gain in emerging markets . Their higher growth makes them an appealing investment, and a lower starting base in economic development gives them more upside room.
But frontier markets also tend to have more limited market access, often leading to greater volatility, and greater political risk - geopolitical risk can make western investors cautious about the whole Middle East region.
“We do not believe there is much of a difference between UAE and Qatar and the rest of the MENA region,” said Slim Feriani, executive chairman at Advance Emerging Capital. “They are all ‘growth’ markets - investible and interesting markets.”
MSCI announced its plan to upgrade UAE and Qatar just over a year ago, driving a furious rally in these markets.
The MSCI UAE index jumped by 100 percent, though it has since fallen by as much as 20 percent.
Non-Arab foreign investors make up a relatively small proportion of these markets - an estimated 15 percent of the total UAE market capitalisation, for example.
They have remained loyal to the UAE, though stock exchange data shows outflows in the past month from Qatar.
EPFR data shows $30 million in inflows to UAE equity funds last month, their largest monthly inflow this year. Lipper data shows inflows of $114 million into Gulf equity funds over the first five months of 2014.
Favoured stocks include First Gulf Bank and Emaar Properties, though some investors are once more getting worried about a property bubble, as Dubai saw in 2008.
“Concerns about the property market being overheated may well be valid,” said Asha Mehta, lead portfolio manager for frontier equity strategy at Acadian Asset Management.
“We are advocating a diversified approach to the UAE market; the market is bigger than just property.”
Mehta said she would continue to hold, but not add to, UAE and Qatar in her frontier strategy after the countries also get an upgrade in S&P indexes later this year.
Oliver Bell, fund manager for Middle East and Africa at T Rowe Price, says he has a 7 percent overweight position in the UAE, though this is down from 12 percent in May.
But for frontier and emerging market investors, valuations are starting to look high, despite the recent correction.
Investors point to valuations of 16 times earnings for the MSCI Dubai index, compared with 12 times for the emerging index.
“We are fairly positive on both UAE and Qatar, but valuations are no longer as good as they were compared with 12-18 months ago,” said Hedi Ben Mlouka, CEO of Duet MENA.
Other risks to these markets include the potential loss of Qatar’s role as host to the 2022 soccer World Cup following allegations of bribery, along with conflict in Syria, Iraq and the Gaza Strip.
“It’s not impossible things could collapse in Syria or Iraq. Now it’s become a real risk,” said Feriani.
“There is a lot of geopolitical uncertainty. You should not be putting all your eggs in one basket.”
A potential removal of sanctions in Iran could also draw financial capital out of Dubai, a traditional safe-haven market within the Middle East.
But as UAE and Qatar adapt to their new emerging market status, they could face another competitor - Saudi Arabia, which attracts similar investors even though it is not typically considered even to have frontier status, due to the difficulties that foreign investors have in accessing it.
Saudi Arabia’s market capitalisation of more than $500 billion is larger than the UAE and Qatar combined. That means that any opening up could take Saudi Arabia straight to the emerging index, joining UAE and Qatar, though investors say the timing of such a liberalisation is hard to predict.
According to Nina Lagron, senior EMEA fund manager at Amundi: “The stock exchange says it is absolutely ready, but no one other than the king is going to make the decision.” (Additional reporting by Olzhas Auyezov in Dubai; Editing by Will Waterman)