KUWAIT/DUBAI/LONDON, Oct 2 (Reuters) - Inclusion in an emerging market benchmark and surging oil prices have helped Kuwaiti stocks outshine their regional peers in the past three months, but some major active emerging-market investors are waiting on the sidelines for more reforms.
Kuwait's main index is up nearly 9 percent in the third quarter, beating other Gulf markets, including oil producers Saudi Arabia and Abu Dhabi, and edging past Qatar, the MSCI emerging market index and Russia.
More good news could be in store. Next year, U.S. index provider MSCI will decide whether to reclassify its Kuwait index from the current frontier-market status to its widely used emerging-market benchmark. Analysts estimate such a move could trigger passive fund flows of $2 billion.
"We expect investor pick-up to be supported by the country's safe-haven qualities within the wider emerging-market backdrop," said Salah Shamma, head of investment, MENA, Franklin Templeton Emerging Markets Equity.
Index provider FTSE Russell will include 12 Kuwaiti stocks in two phases - September and December 2018 - which will result in a weighting of just over 0.5 percent in its FTSE Emerging All Cap index. Franklin Templeton's Shamma calculates this will translate into passive inflows of $1 billion.
Boursa Kuwait, which took control of the Kuwait stock exchange in early 2016, introduced a number of reforms such as relaxing listing rules, delisting companies seen unfit for public investment and segmenting the market with different disclosure requirements.
But not all funds are convinced about Kuwait's equities story, which was a long time coming for the region's oldest bourse. The Kuwaiti economy has benefited from a surge in oil prices, which rose percent to a four-year high on Monday . Depending on oil can be a disadvantage, however.
"We have been looking at Kuwait for quite some time but it is a one-trick pony: oil, oil, oil," said Wim-Hein Pals, head of emerging markets at Rotterdam-based fund manager ROBECO, which manages about $25 billion in emerging-market funds.
He said Kuwait is not interesting enough in a diversified emerging-market portfolio for anyone who can find dynamic oil companies in other markets.
"It will remain on our radar and if we find something like an oil company at attractive valuations, we will jump onto it," said.
Like its Gulf neighbours, Kuwait has kept its national oil company, Kuwait Petroleum Corp, out of public markets. The exchange's trading is dominated by financial services and real estate companies.
"Certainly, if you wanted to put in large amounts of money and a large percentage of your portfolio, you would end up with very, very big positions in not very many companies," said Andrew Brudenell, frontier markets portfolio manager at Ashmore in London.
Saudi Arabia was the only Gulf country that promised to list its national oil giant, Aramco, but that move was shelved, dashing investor expectations about more privatisation in the kingdom and in the Gulf region.
Other funds contacted by Reuters said they will start looking at Kuwait after it has been added to the MSCI emerging market index.
"The whole region has been witnessing a major transformation when it comes to markets operationally and improvement with friendliness to investors," said Fadi Al Said, director, fund manager, head of the MENA investment team at Lazard Asset Management.
Kuwait may have to do more to diversify its economy and widen its appeal to investors to sectors beyond real estate and banking, said Ali Al-Salim, co-founder of Dubai-based Arkan Partners, a consulting firm specialising in alternative investments.
"Investor interest in Kuwait is limited by our stock markets diversity. Seven out of the 10 largest listings are banks," Al-Salim, a Kuwaiti national, said.
"Seeing how consumption is a huge part of Kuwait's local economy, it would be nice to see more public consumer-orientated listings," he said. "This would require many more family-run businesses to go public, and today there's not a clear case for them wanting to."
Politics in Kuwait could also be tricky. The country has an influential parliament, where government officials are often grilled about policy moves.
The government has been pushing lawmakers to speed up legislation aimed at increasing the liquidity at Kuwait's General Reserve Fund, one of two funds managed by the Kuwait Investment Authority, and approve a law to allow the government to issue long-term sovereign bonds.
Kuwait has yet to implement a value-added tax, but the bill that would enable more diversified revenues for the government is highly controversial and expected to face a public backlash.
"What MP will approve tax? If you approve tax, you will not get voted in next year, but Kuwait needs far-sighted people," said a Kuwaiti banker, who declined to be named.
A senior banker said the government is becoming more receptive to foreign portfolio investment.
"Before they were looking at it, like no, we have money and we invest outside," said Abdul Wahab Al-Majed, chief executive of Kuwaiti lender Boubyan Bank. "And now they know the difference that this money can do for it. Especially now for the stock exchange."
(Additional reporting by David Dolan, editing by Larry King)