Written by: Brian Thomas – Co-portfolio manager and Analyst at Laurium Capital
Bloomberg Finance LLP, the ubiquitous information provider of all things financial, defines a benchmark as "A standard against which the performance of a security, mutual fund or investment manager can be measured." It goes a little further, stating that "Generally, broad market and market segment stock and bond indices are used for this purpose".
The idea behind a benchmark is that it should be broadly representative of the market in which the asset manager is investing. For South African equities, one would think that it should be a simple task to decide what the benchmark should be. An aggregate of the listed shares on the Johannesburg Stock Exchange (JSE), would seem to be a good starting point for the index, and so it is. But it’s not that simple. This article attempts to explain the rationale underpinning the various indices that exist in the equity market in South Africa, their evolution and the logic of their construction.
Investors in South Africa may be forgiven for the fatigue and confusion that they may feel around the multitude of benchmarks that exist in the country. Since the turn of the century, there have been four main benchmarks for clients to evaluate South African asset managers – the All Share Index (ALSI), the Top40, the Shareholder Weighted Index (SWIX) and now the Capped SWIX.
It’s important to emphasise that the benchmark is the standard used to evaluate the relative skill of the asset manager. Some managers will construct portfolios very close to the benchmark weight, while others will construct benchmark agonistic portfolios, with the view that their ability to pick stocks, over time, will outperform the standard. No matter the portfolio investment strategy, the benchmarks remain same.
The computation of a benchmark should be performed by a body independent of the asset manager. In South Africa, it is the responsibility of the FTSE-JSE and is not up to the individual manager to derive the benchmark. It is fair to say though, that through various industry bodies the asset managers may make representations to the FTSE-JSE around what they feel would be a fair benchmark that is representative of the broad market, but importantly, is also in the interests of their clients.
Let’s go back to the rationale that an equity benchmark, in its simplest form, should be the aggregation of all the shares that are listed in a market. It would seem fair that the shares are weighted by their size in the market. Hence, the most commonly-derived benchmark globally is the market capitalisation weighted index, where the largest companies as measured by market capitalisation hold the largest positions in the benchmark and the smallest companies by market cap, hold the smallest positions.
Whilst a pure market-cap weighted benchmark, intuitively, is appealing and seems to be the most intellectually honest way of constructing a benchmark, there are various arguments that can be made against a pure market-cap weighted index as being the best representation of the broader market. Many of these arguments are often brought to the fore in the classic debate between active and passive managers, this article does not intend to stray into an active versus passive debate although there will be some elements that will undoubtedly creep in.
In large open markets such as the USA, Europe and Japan with very large stock markets, the argument for a pure market-cap weighted index is the strongest. In these markets, capital moves freely, companies with the best earnings potential are rewarded with the highest share prices which, over time, will naturally lead to the largest market caps. An excellent example of this would be the likes of Apple, Facebook, Amazon, Netflix and Google (listed as Alphabet) which, ten years ago, were a shadow of their current market caps. Through their prospects, they have grown into positions where they now dominate the top five positions in the S&P500. Importantly, in these large open markets there are many stocks to choose from and as result the index is not dominated by any one stock. In the USA for example, although Apple is the largest company in the world, its weight in the S&P500 index is a little over 3.5%, and the same can be said for the majority of the developed market benchmarks.
South Africa is not a large open market. The number of stocks listed on the exchange is a fraction of those listed on developed market exchanges, and because of exchange control there is not perfect capital mobility. This lack of perfect capital mobility has resulted in a few quirks in the South African market which do not exist in most developed markets. These quirks have been a contributing factor to the number of benchmarks that have evolved over the years.
When I first started in the markets nearly 18 years ago, the main benchmark was the JSE All Share Index (ALSI), which basically had every share listed on the JSE in it, weighted by market cap. The issue with this was that
shares in many of the smaller companies were difficult to buy as they were very illiquid and virtually never traded.
As a result, the Top40 Index evolved as a benchmark that was widely adopted by most market participants. This benchmark was the top 40 shares listed on the JSE by market cap, which by implication meant the most liquid and most investable.
As the technology boom of the 1990s gave way to the resources boom of the early 2000s, a number of South African companies applied to have their primary listings moved to London. The rationale was simple; the small South African market at the time was not able to support their ambitious growth and they required capital from these large open markets. The likes of Anglo American, Dimension Data, Old Mutual and South African Breweries moved their primary listing to London, allowing them to tap the world’s large liquid capital markets for capital to support their growth ambitions.
When companies have a listing in two places, the market force of arbitrage drives the price of the shares in each market to be equal. In 2002, such had been the success of these offshore listings, fuelled by the start of the commodities bull market, the likes of Anglo American and BHP Billiton began dominating the South African market, as their market caps swelled as did their weightings in the various indices.
Herein lies the quirk of exchange control. With a substantial proportion of the company being listed outside the country, the local asset managers were prevented from accessing those shares that were listed outside South Africa due to exchange controls. Although the market cap of the various dual listed shares had swelled, the South African investment community were not able to access the shares listed in London, which meant that they would be structurally underweight the benchmark of the day the Top40. There was another problem brewing; the small closed market in South Africa had become dominated by the large mining conglomerates, widely recognised as being cyclical, with Anglo American and BHP Billiton’s combined weighting at the end of 2003 a whopping 25.5% of the Top40.
Enter the first capped and shareholder weighted indices. In early 2002, market participants met with the JSE and voiced concerns over the concentration of these large companies in the JSE, pointing out their cyclical nature and the fact that the benchmark which, in theory, should be a broad representation of the market, had become anything but that. The eventual solution after much deliberation was to propose two new indices:
The SWIX index gave investors the broad exposure that a benchmark should do. The weights of Anglo American and BHP Billiton moved from 11.78% and 10.6% in the ALSI to a more reasonable 5.1% and 4.6% respectively on a shareholder weighted basis in the SWIX at the end of June 2015. See Exhibit 1 and 2.
It is instructive to compare the charts above and below this text. The top chart shows the weights in the ALSI. What is fascinating is that at the peak of the commodity bull market in June 2008, Anglo and Billiton’s combined weight in the ALSI grew to 32.6%. At that point in time Naspers had a negligible weight. The bottom chart is drawn on exactly the same scale and is the weighting of the stocks in the SWIX. By shareholder weighting Billiton and Anglo at the peak of the bull market in 2008, the combined weight was a much “safer” 15.8%. In Anglo and Billiton for the eight years from June 2008 to June 2016, the price action was phenomenal. Anglo traded at R548 on 30 June 2008 and 8 years later traded at R141, losing nearly 75% of its value. Billiton fared slightly better trading at R181, down 34% from its June 2008 price of R276.50, and a shade under 50% lower than its peak in July 2017.
It is simple maths that holding a lower weight in the SWIX (than the ALSI) in both stocks saved those benchmarked against the SWIX from their fall from grace. Even managers that consider themselves benchmark-agnostic were tempted to hold positions in Anglo and Billiton when they were over a third of the benchmark they were being measured against.
While the SWIX protected investors from the fall of Billiton and Anglo, investors were handsomely rewarded with the incredible success of Naspers. The chart above shows that at the time the SWIX was conceived Naspers barely made it into the Top 40 shares by shareholder weight. Naspers being only South African-listed is not constrained by any weighting to the shareholder register. What is quite absurd though is that the fortunes of Naspers over the last decade virtually have been driven entirely by their investment in the Chinese internet juggernaut Tencent.
Looking at the Naspers performance, on 30 June 2008, Naspers traded at R171. On 30 June 2016, Naspers traded at R2238.42, 12 times the price it traded at eight years earlier, taking its weight in the SWIX from 1.96% to 17.3% in that time. Its further appreciation in 2017 has seen it climb to R2920 at the end of September 2017, 16.1 times higher than where it traded in June 2008, and a 21.5% weight in the SWIX.
Pensioners, savers and investors in South Africa have been massive beneficiaries of this incredible gain in Naspers. However, we can learn lessons from South Africa and from abroad. It is rare that the top stock in the market currently will be the top stock 10 years from now. Think back to the BHP Billiton and Anglo examples in 2008 in South Africa, to the dominance of Nokia in the Finnish market in the early 2000s, and to the oil giants that dominated the S&P500 10 years ago. Although the fundamentals of Naspers and its subsidiary Tencent look good, a 21.5% weight is too much for responsible fund management. Holding 21% in one stock is akin to putting a good proportion of your eggs in one basket, something that most responsible portfolio managers would not do.
Fortunately, with the development of technology over the 15 years since the Capped Index and the SWIX were first conceived, the FTSE-JSE can blend the concept of capping with the SWIX into the “Capped SWIX” and rebalance the index on a quarterly basis. Each quarter Naspers is down-weighted in this index to 10%, meaning that the other stocks in the index receive a greater weight than they naturally would have. Without getting into complex mathematics it stands to reason that this would be a more diversified index than the SWIX is with Naspers at 21%.
The Capped SWIX as a broader more representative benchmark is a more realistic benchmark for active portfolio managers to be evaluated against. By capping out the index weight of Naspers and, by implication, raising the weights of the other members of the index, the capped SWIX better represents the broader South African market and more closely reflects the balance of stocks that portfolio managers investing in a responsible fashion would follow.
At a pure index level, the contribution to the “risk” (as defined by the contribution to the volatility of the index) is diversified with the use of the Capped SWIX. By example, the risk associated with Naspers in the index, is drastically reduced as its weight is capped, from 32.5% of the total risk in the SWIX to 13.75% in the Capped SWIX. The top 10 contributors to risk in these indices are shown in the exhibits below.
We believe that this benchmark is the most appropriate equity benchmark against which a South African equity asset manager should be evaluated, given its broader spread and lower concentration than the SWIX. Laurium will be moving its equity funds to the Capped SWIX benchmark in November 2017.
Glacier Research would like to thank Brian Thomas for his contribution to this week’s Funds on Friday.