Developing an Appropriate Benchmark Index for African Equity Fund

LAGOS, Nigeria, Capital Markets in Africa: Although most investors have adopted a preferred benchmark or index to measure or track the performance of developed markets, agreeing on benchmarks for emerging and frontier markets still needs to be established. The International Finance Corporation (IFC) coined the terms emerging markets and frontier markets and was the pioneer in creating equity indices in these markets. S&P Dow Jones Indices (SPDJI) acquired Africa Indices from the IFC in 2000 and now offers the most comprehensive index suite available with live history dating back to 1998. Selecting the most appropriate benchmark for an Africa Equity fund has been one of the most challenging, taking various factors into account as these markets develop and grow.

The two main factors to consider when developing or selecting any benchmark or index is the tradeoff between representativeness and tradability. As one increases the universe of stocks that represents an index, one typically finds that the tradability or use of the index becomes less efficient. Similarly, when only selecting highly liquid or tradable stocks one does not capture the true representation of the market.

Most index providers will construct indices by maintaining a good balance between liquidity of stocks and capturing a large percentage of the market. Reading the methodology documents supplied on index providers websites is always a good start to understand how the indices are constructed.

Indices are mainly used for two reasons, benchmarking and index products. Indices used for benchmarking purposes tend to be broader indices where fund managers can select stocks they expect will outperform the market, while indices used for index products tend to be more liquid indices and concentrated indices. Due to the lack of stocks in Africa, one naturally finds that most of the liquidity is concentrated in the largest stocks.

S&P Dow Jones Indices coverage for Africa includes South Africa, Egypt, Morocco, Tunisia, Botswana, Ghana, Côte D’Ivoire, Nigeria, Kenya, Mauritius, Namibia, Zambia, Zimbabwe as well as African companies listed on developed exchanges like Australia, Canada, France, UK, Switzerland and the USA. (African companies listed on developed exchanges need to derive a significant portion of their earnings and operations out of Africa to qualify for inclusion.)

Broad indices like the S&P Pan Africa and S&P All Africa indices offer a full universe of stocks without applying extremely strict liquidity, size and capping adjustments to the universe. These indices as well as similar indices from other index providers with less coverage, have however been criticized for the fact that sector and country exposure is not well diversified due to African economies still growing into mature well diversified economies.

Outside of South Africa one will find that financial and telecommunication companies dominate listings. Most Africa equity funds aim not to invest more than 30% to 40% in a particular country or sector, and some adhere to a 5/10/40 rule whereby no stock can be more than 10%, and the sum of all stocks larger than 5% can’t be more than 40% in a fund. SPDJI addressed these concerns and requirements by introducing capped versions, where the index is capped on a country, sector and stocks level to minimize being over-exposed to a particular sector or geographical area.

Although having capped indices seem to have addressed diversification concerns, a larger concern relates to liquidity in Africa, as many exchanges excluding South Africa still only have a small number of equity listings as seen in the above tables. Primary listed Africa stocks excluding South Africa only represent 16% of the S&P Pan Africa BMI Index. Another important factor to take into account when looking at Africa Indices, is the inclusion of a free-float factor. Free-float methodology excludes closely held shares such as those held by pension funds and governments. The percentage of closely held shares is rarely traded and should not be included in the available universe.

SPDJI have introduced indices that incorporate addition liquidity criteria and these indices are typically referred to as “SELECT” indices. The constituents selected for these indices not only have to meet specific average or median trading values per day, but also trade a specific amount of days out of all trading days. The Select indices also follow a capping approach in order to maintain the desirable representation and diversification. Indices like the S&P South Africa 50, S&P North Africa 15, S&P East Africa 10, S&P West Africa 25 and S&P Southern Africa ex-SA 10 represent the largest and most liquid stocks for each of the main geographical areas.

Investors with a particular investment strategy or objective that is not aligned to a standard Africa index can look to work with index providers to construct a custom index. Custom indices can be constructed to incorporate regional, size, liquidity, turnover, rebalancing, currency, tax and many other unique requirements a client might need. 

Investors seeking fair and equitable measurement should be aware of the various indices available to Africa Equity Funds, and make sure that their fund manager has selected a benchmark with similar representation and liquidity requirements, as well as risk-return characteristics. Having to pay performance fees against a cash plus-target, like LIBOR, should no longer be seen as appropriate for an Africa equity investment with the wide range of free float capital market benchmarks available.

Contributor’s Profile
Zack Bezuidenhoudt is head of client coverage, South Africa and Sub-Saharan Africa, at S&P Dow Jones Indices. The group focuses on business development, sales, and ongoing client relationship management. Zack works proactively with existing and prospective clients in the region to deepen their knowledge of equity, fixed income, and strategy indices and to better understand their future indexing needs. 
Prior to joining S&P Dow Jones Indices, Zack worked at Old Mutual Investment Group as a business development executive with a focus on business and product development for Old Mutual Global Index Trackers. Zack also worked at Alexander Forbes Asset Consultants and Barclays Africa as an asset consultant and head of performance surveys, after starting his career at ABSA Asset Consultants in 2005. Zack has a BSc in Financial Mathematics from the University of Pretoria, as well as a CIPM from the CFA Institute and a Claritas® Certification from the CFA Institute.