Is there Room for Exchange Traded Funds in the African Context?

LAGOS, Nigeria, Capital Markets in Africa: In the third quarter of 2015, financial commentators were abuzz when industry research group ETFGI announced that the global Exchange Traded Fund (“ETF”) market has surpassed the Hedge Fund industry in terms of size for the first time ever. With assets under management of $2.971 trillion as at the end of Q2 2015, its quarterly growth of $45 billion during the same quarter made it surpass the Hedge Fund industry’s $2.969 trillion.

Nasdaq defines Exchange Traded Funds as funds that track indices like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. Upon purchasing shares of an ETF, you are by default acquiring shares of a portfolio that tracks the yield and return of its so-called native index.

The main difference between ETFs and other types of index funds is that ETFs don’t try to outperform their corresponding index, but simply replicate its performance. They note further that ETFs “don’t try to beat the market, they try to be the market”. These instruments have been around since the early 1980’s but have doubled in size since 2010. In the first half of 2015, it experienced net inflows of $152.3 billion, relative to Hedge Funds’ $39.7 billion.

Various reasons have been given for the explosive growth in this sector. Amongst them has been the inflow of cheap cash via so-called quantitative easing from various central banks such as the US Federal Reserve and the European Central Bank. These funds have caused asset prices to rise since the financial crisis of 2008 and the ETFs have emerged as a lower priced vehicle to partake in the rally relative to more expensive hedge funds and other traditional mutual funds. The old adage of a “rising tide lifts all boats” was quite relevant in such an environment.

The market turmoil experienced since the end of 2015 have made the market start to question the suitability of these vehicles again, given the broad sell-offs that were seen. It is in such markets that the more expensive Hedge Funds with their promises of risk adjusted returns for which they charge higher compensation from their investors claim to be the better alternative.

On the flip side the daily liquidity as well as lower investment size required by ETFs are still seen as a strong incentive for many. Certain asset allocators feel that they can utilize these vehicles in a combination with their own market timing abilities to present a lower overall cost or Total Expense Ratio (“TER”) to their investors. These market timing abilities include geographic allocations, which has played a very important role in especially the emerging market volatility that 2016 has delivered to date.

Looking at ETFs Trending in Africa … 
Africa has for a few years now firmly been on the radar of many a geographic fund allocator. With its economic growth story since the start of the new millennium as well as increased political stability it has shed its image of a “hopeless continent” to that of the “last investment frontier”. At a conference hosted at the start of 2015, the key note speaker mentioned that they no longer need to convince their prospective clients to invest in Africa. The biggest issue their investors has is into which vehicles they should invest, not if they should invest at all.

With the interest seen globally in ETFs it should therefore come as no surprise that these vehicles have also come under the spotlight in the African context.

The African listed investment space is dominated by South Africa. Most emerging market ETFs rely on South Africa for their African exposure, given the greater liquidity and depth that the JSE offers relative to their African peers.

Classifying African Equity Markets … 
Of all African countries, only Egypt and South Africa are deemed emerging market countries by the leading index provider MSCI. They classify Morocco, Kenya, Nigeria, Mauritius and Tunisia as Frontier Markets. Frontier Markets are usually seen as markets with shallow levels of liquidity and depth but for which the expectations are that over time they will develop to portray emerging market characteristics.

According to MSCI’s competitor FTSE, South Africa is classified as an Advanced Emerging Country. Egypt is deemed a Secondary Emerging Country, whilst the other African countries such as Nigeria, Kenya and Botswana are all deemed to be Frontier Markets as well. Egypt is considered by many country classifiers to fall under the Middle East and North Africa (MENA) Region. Sub-Saharan Africa is deemed a different region.

According to FTSE classification only South Africa is eligible in terms of liquidity and depth for “sizeable global investment”, whilst Nigeria only offers “restricted” eligibility.

South Africa with developed ETFs … 
South Africa already has a well-developed local ETF market. At the end of 2015, the value of the sector amounted to almost R80 billion. An investment into the country is relatively easy, but investors that want exposure to the “African story” usually prefer allocations outside of SA, due to the exposure they already have to the country via their emerging market allocation. Hence a further analysis of the Nigeria market is necessary to see if an ETF focusing on this market will be of any worth to a global investor.

In terms of relative market capitalisation, the Nigerian Stock Exchange (NSE) was only 6.721% of South Africa’s Johannesburg Stock Exchange (JSE) as at the end of 2014. Full market capitalisation does not give the full picture though since all shares are not liquid depending on the type of owners. Free float is a better measure to analyse the liquidity of the shares, since free float adjusted market capitalisation only reflect the shares available for trading. The listing of Dangote Cement in 2011, which has a very low free float, but a large full market capitalisation has contributed sharply to the increase in difference between full and free float adjusted market capitalisation in Nigeria.

The shares listed on the NSE also show a rather strong concentration. The top 30 shares represent more than 90% of market capitalisation, in terms of full as well as free float adjusted, whilst 93% of daily trading volumes also occur amongst these shares. Of the said top 30 shares, the largest 10 on average account for 79% of overall volumes traded.

Viability of ETFs in Nigeria … 
At present there is one Nigerian ETF listed in the United States. As at the end of December 2015, it had 24 constituents. Financials were the largest component at 41%, followed by consumer staples with 40.7%. The energy sector only constituted 7% of the holdings, even though Nigeria is such a large producer of oil. This is due to the fact that many of the energy related activities are performed by international companies such as Shell or Chevron who do not have any Nigerian listings. The top 10 shares in the ETF accounts for 74% of the total portfolio whilst for the top 15 is over 92%.

It is obvious that from international investor’s viewpoint the viability of a Nigerian ETF, as proxy for an African allocation outside of South Africa is limited. The constituents are not necessarily an indicator of the underlying economy, whilst the lack of liquidity could be a serious problem should there be another sharp downturn such as the one the country experienced in 2008.

In countries with financial markets developed to such a degree, the preferable route remains private equity funds which are able to take a longer term view as well as target sectors that are partaking in the economic growth story. These funds do come at a higher cost to the investor in terms of management fees as well as much less liquidity due to the usual lock in periods. The needs of the underlying investor should thus be fully analysed to see if they are able to carry such costs and longer horizons.