The South African equity market has unique characteristics that not many investors are aware of, and its unusual nature is reflected in common market indices. Recent changes in how these indices are structured have implications for both active and passive investing strategies.
Equity markets are typically measured by market-capitalisation-weighted indices, such as the FTSE/JSE All Share Index (Alsi) in South Africa and the S&P500 in the US, in which the largest shares have the largest weight. These indices measure the performance of selected stocks on a Stock Exchange and are used to assess how well investors’ money is being managed.
Active and passive benchmarking
Active investing involves selecting individual stocks in an attempt to outperform a given market. Although active managers often use indices as benchmarks against which to measure their performance, they may opt to use a non-investible benchmark such as CPI plus, or a category average – for example, the average return of funds in the general equity category.
Passive investing, on the other hand, involves buying an index – where you buy the shares in the same proportion as their weightings in the index, and the reward for holding those assets over the long term is the equity risk premium. Of necessity, the investment benchmark is an investible index.
A typical local market
South Africa’s market structure is unusual in that it is dominated by large secondary-listed companies that have their primary listings on foreign exchanges. This impacts the way that our local indices are constructed and the performance of index-benchmarked investments.
Typically when you build a market-cap-weighted index (the S&P500 is a perfect example) you take the largest companies that have primary listings on a certain exchange. In contrast, the Alsi has very large companies that are secondary listed – counters such as BHP Billiton, SAB (which became AB InBev), Anglo American, etc.
The reason the Alsi had this large component of secondary listings was because the SA Reserve Bank effectively granted an exemption that allowed indices to hold certain secondary-listed – effectively foreign – companies at their full market cap. This created a number of unusual scenarios in our equity indices and it’s why we have a bifurcated index market, with indices such as the Swix (the shareholder-weighted index), which represents local shareholders and effectively downweights the dual-listed shares.
However, we’ve recently seen some of these secondary-listed companies being restructured and losing their exemption. Examples are global miner BHP Billiton and Swiss luxury goods company Richemont.
Global companies restructuring
BHP Billiton was restructured late last year. It has had a very large weight in the Alsi – about 12%, on average, over the last five years. Its weight was disproportionate because the Alsi took into account its global market capitalisation, which included shares held on the London and Australian exchanges. When the company restructured, and the exemption effectively fell away, index providers were required to use the Swix weighting. Almost overnight the weight of BHP Billiton went from 12% to 2%.
We’ve seen the same with Richemont, which effectively unbundled its legacy depository receipt programme. When it restructured, Richemont fell from over 20% of the Top 40 Index to less than 4%.
These are massive shifts in our local market and how it is represented in terms of index exposure.
Simpler environment for investors
The upshot for investors as this process unwinds, we believe, will be a more simplified index environment. Investors will be able to simply allocate to an index and know what they are getting. It will also probably mean that the Alsi becomes more representative of the South African equity risk premium.
This comes at the same time as a relaxing of Regulation 28 of the Pension Funds Act, which governs offshore exposure in retirement funds. Many investors have historically allocated to dual-listed “rand-hedge” shares as a function of their inability to diversify offshore. Now they don’t have to hang on to these rand-hedge exposures anymore; they can actually go and buy a globally diversified basket of equities.
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