Obtaining sensible exposure to South African equities at low costs is not as simple as picking an off-the-shelf index. It requires careful design so that it fits into an investment strategy and incorporates the appropriate implementation approach to execute successfully.
The All Share Index1 (ALSI) is probably the first market indicator that comes to mind when we think about the South African equity market. It is typically the index that is cited most often to describe what has happened in local markets and it is published across all forms of media.
Over the past decade it has, however, lost popularity as a benchmark for SA equity funds as it historically held more resources than a typical equity fund would. This was partly due to a few large resource shares which are dual listed and therefore includes global investors on offshore exchanges in the market cap of these shares. In the early 2000’s the Johannesburg Stock Exchange (JSE) came up with two possible solutions to this problem, namely the Capped All Share Index (CAPI) and the Shareholder Weighted Index (SWIX). The CAPI simply capped the exposure to any single share to 10%, while the SWIX stripped out all foreign shareholding to reflect South African investor’s holdings only. The SWIX index has probably become the most popular benchmark for SA equity funds whether it be the large cap SWIX 40 or the recently launched Capped SWIX which aims to reduce the exposure to single shares such as Naspers.
The evolution of SA equity benchmarks has largely been driven by consultants who need to evaluate fund performance and fund managers who need to outperform benchmarks. This is in part due to a relatively small uptake in index and enhanced index funds in the South African market. Apart from some of the new "Smart beta" factors very few benchmarks were designed by fund managers to provide specific exposures (including broad market exposure). For example, all the SA indices mentioned above include listed property shares (around 4%) – while most equity fund managers won’t hold any listed property as their funds are typically used within balanced mandates which have separate property allocations.
Tailoring an equity benchmark to provide sensible market exposure
The funds in the Nedgroup Investments Core Range were designed to fulfil the need for low cost multi-asset unit trusts portfolios which can be used as standalone solutions or combined with traditional active portfolios. Extensive research went into designing the portfolios to provide sensible exposure to five different local and global asset classes (equities, listed property, bonds, inflation linked bonds and cash). This included tailoring an equity benchmark to provide broad market exposure with sufficient diversification when combined with the other nine asset classes.
Some of the important considerations in designing the Core Range’s SA equity benchmark:
- Double counting on listed property shares in a multi-asset portfolio
Listed property shares fall within the Real Estate subsector of Financials and are therefore included in all the major SA equity benchmarks. In a multi-asset portfolio which has a separate allocation to listed property one therefore runs the risk of having the same shares in both the SA equity and listed property allocations. To avoid double counting on the listed property shares, especially the five largest shares, we exclude all Real Estate Investment Trusts (REITs) from the equity benchmark.
- Single security risk
The recent Steinhoff shock illustrates the importance of managing the risk to any single security within a portfolio. Within the Nedgroup Investments Core Range we manage this risk by capping the maximum weighting to any one share within the equity carve out to 10%. For example, Naspers is capped at 5% in the Nedgroup Investments Core Diversified Fund that has a strategic equity allocation of 50%. The table below illustrates the impact of capping Naspers in the event that its price drops by 90%.
- Broad market coverage
The 40 largest shares on the JSE make up nearly 80% of the SWIX index by market capitalisation while the remaining 20% is distributed across over 120 mid- and small- cap shares. To date most equity index funds have only covered the large caps and have not provided broad market coverage which includes mid- and small- cap shares. There is, however, extensive academic research that shows that broad market coverage offers better returns at lower volatility2. From the perspective of the Nedgroup Investments Core Range, the broader diversification leads to an increase in the reliability of outcomes. We have illustrated these benefits in the following charts.
In the preceding charts we can clearly see how a broad market index such as the SWIX can deliver up to 1.2% per annum more than the SWIX 40 while reducing the volatility by up to 1.1%. Over longer time periods it is able to deliver superior risk adjusted returns more consistently.
Implementation - bridging the gap between theory and practise
An index is fundamentally a theoretical construct. It is not something one can invest in directly and it needs to be replicated by investing in the underlying shares that makes up the index.
The index merely provides the rules to follow in weighting the underlying holdings. The key to harnessing some of the benefits highlighted above is how well one can implement the strategy. This requires bridging the gap between theory and reality.
For example, the broad market coverage of the SWIX has many advantages when compared to its large cap counterpart - the SWIX 40. However it does come at the price of having to deal with less liquid, smaller-cap shares which may not trade very often.
In the Nedgroup Investments Core Range the implementation considerations were incorporated into the design of the portfolios. The design of the benchmarks for each of the asset classes is accompanied by a flexible and patient trading strategy that aims to minimise risk and costs. One of the great benefits of managing the Nedgroup Investment Core Range as multi-asset portfolios is that the fund manager has oversight of the whole portfolio and manages all the asset classes with the aim to achieving the portfolios real return objectives. This also means that the fund manager can manage the tracking error versus cost trade-off and the liquidity within asset classes on a portfolio level.
1 The full name of this index is the FTSE/JSE All Share Index. All indices mentioned in this article are FTSE/JSE indices and we have therefore omitted it in their names.
2 Fama and French, "common risk factors in the returns on stocks and bonds", Journal of Financial Economics, 1993.