/MANAMA (Reuters) - In the boom years before the global financial crisis, Gulf Arab sovereign wealth funds invested most of their petrodollars abroad. When markets fell, they propped up major Western firms and snapped up bargains.
But what about regional markets, which still lack the liquidity and depth to lure international institutions?
Highlighting the extent to which regional markets have been overlooked, a recent study by Bahrain-based Securities & Investment Company showed that 95 percent of the Gulf's $2.7 trillion in investable assets are allocated abroad.
That figure includes $1.4 trillion controlled by Gulf sovereign funds and contrasts with many developed and emerging markets, where large government-owned institutions like pension funds are a major source of liquidity.
Bankers, funds and analysts say it is time for Gulf Arab sovereign funds to plough money into the region's underdeveloped capital markets, because if they are unwilling to take the risks involved, who can blame Western institutions for staying away?
"Even if the sovereign funds were to put a fraction of their allocations into local markets this would significantly enhance the inherent liquidity within our markets," Shehzad Janab, head of asset management and advisory at Dubai-based Daman Investments, said.
Despite the growing appetite for high-yield emerging assets amid low interest rates and sluggish growth in the United States and Europe, Middle East markets have remained off the radar for all but the most adventurous global investors.
Secondary bond markets lack depth in the Middle East and asset managers are deprived of institutional investors like the pension funds and insurers that are a mainstay of fixed income markets in the West. Marred by a lack of liquidity, lack of transparency and lack of institutional investors, Middle Eastern stock markets are volatile and largely unpredictable.
Many Gulf sovereign wealth funds were created with the intention of investing income from oil exports, which dominates their budgets, into a diverse range of assets that would guarantee lasting returns for post-oil generations.
While Gulf Arab governments have spent billions on developing their infrastructure, asking their sovereign wealth funds to pour oil money back into domestic markets, classified as "frontier" by international investors due to their low sophistication and high risk, is another matter.
While many investors may consider direct investments by sovereign funds to be too risky, some suggest that channelling funds through professional asset managers would boost liquidity, particularly in the bond markets, without causing volatility.
"During tough times, institutions, including sovereign funds could have created liquidity by participating in regional funds. That would have helped enable a professional set of investors," Mohammed Ali Yasin, chief investment officer at CAPM Investments in Abu Dhabi, said.
"By diversifying into four, five funds, the benefits would have been felt across the market."
That would also help revive the local asset management industry, hard hit by redemptions and lack of inflows as international investors have shunned the region since 2008.
The total assets under management of some regional equities funds declined by as much as 80 percent in the last two years, SICO said. In the second quarter of 2010 alone, Gulf markets saw net outflows of around $29 million compared with net inflows of around $1.1 billion in the same period last year.
Others say the focus should be on creating more sovereign funds with a mandate to invest within the region.
"What you need to do is...establish new sovereign funds with a stated objective of investing domestically in companies with characteristics you want to promote and obviously, those would be smaller amounts than they invest abroad," Mohieddine Kronfol, managing director at Dubai-based Algebra Capital, said.
Already, sovereign funds like Abu Dhabi Investment Council (ADIC) and Emirates Investment Authority hold significant stakes in companies such as National Bank of Abu Dhabi, Emaar Properties and Emirates Telecommunications.
But these stakes were left over from widespread state ownership in the UAE rather than investments made with a view to boosting homegrown companies.
One concern for local investment firms is that many Gulf sovereign funds have been developing in-house investment tools since the global financial crisis, in an effort to reduce their reliance on asset managers and investment bankers.
"When I talk to the sovereign wealth funds I get the message, we are doing it ourselves, we don't need to go through a JP Morgan, or UBS, or Deutsche," said one Gulf-based banker who did not want to be identified.
"Whether this is practical or not is another question, whether they have the technical capabilities that the other houses, the established investment banks have."
(Editing by Lin Noueihed)