Benefits of JSE index harmonisation

In addition to cutting through complexity, analysts say, the consolidation of the ‘vanilla’ and ‘Swix’ indices into one set of benchmark indices will be good news for liquidity on the JSE. It’s hoped that it will also lead to cost savings for investors over time.

A widely accepted index is a sign of a healthy market. Not only does it allow investors access to index-tracking products that allow broad market exposure, but active investment managers also use an index as a benchmark against which performance can be measured.

An index should be widely accepted, investable and representative of the opportunity set. In pursuit of these objectives, various competing and overlapping indices have been developed for the JSE over the years. The landscape has become muddled, even as the Capped Swix All-Share Index has become the de facto headline index for the JSE.

The vanilla indexes include the FTSE/JSE All Share Index (ALSI), FTSE/JSE Top 40 Index, as well as various industry, sector, total return, and capped variants. Each of these indices has a corresponding Swix (shareholder weighted) variant, such as the FTSE/JSE Swix All Share Index and the FTSE/JSE Swix 40 Index. There are capped versions (maximum exposure to one share), too, making for a very confusing benchmarking system.

Harmonisation “is a really good thing”, says Kelin Pottier, Solutions Strategist at 10X Investments. “Before now, every investor had to choose their benchmark from this whole skittle-box of SA equity benchmarks. You could go All-Share, you could go Swix, you could go Capped Swix, Capped All-Share. You could go Top 40, Swix Top 40, Capped Swix Top 40.” He adds, “There was never a neutral representation of the local market. It also created enormous complexity in trying to assess and compare the performance of different asset managers who all use different benchmarks.”

Too many complications

The unique characteristics of the local market, including concentration risk resulting from the dominance of certain heavyweight companies, have prompted the evolution of diverse indices over the years.

According to the JSE: “The FTSE/JSE Africa Index Series is designed to be locally relevant for South African investors, and as such has some idiosyncrasies when compared to global benchmarks.”

The idiosyncrasy that March’s harmonisation talks to is the so-called Grandfathering clause. This special arrangement for certain dual-listed SA companies was agreed by the Reserve Bank during the apartheid era. It is now effectively done away with as the Swix and the vanilla indices have been collapsed into one.

As most South African investors know, National Treasury and the JSE classify companies as either local or foreign (also known as inward-listed) for exchange control purposes. That also determines whether local or global free float is used for the purposes of index placement. During the apartheid era, certain South African companies, under threat of sanctions, moved their primary listings abroad, mostly to London, and did inward listings to the JSE.

These homegrown companies tended to still have big operations in South Africa and local pension funds held a fair amount of their equity. There were concerns that if they were re-categorised as foreign, local pension funds would be forced to sell down their holdings to remain compliant with Regulation 28’s offshore limits. This would potentially prejudice investors and because the Reserve Bank feared a big flow of domestic assets offshore, these companies motivated to maintain their classification as local – the Grandfathering clause.

Even though many of their shares were trading in other markets, the Grandfathered companies’ global free float of shares was used to determine their weight in the index. Investors couldn’t invest in those companies to the extent they are weighted in the index. “This is not an investable universe for those who were being judged against it,” says Pottier. “They were comparing fund managers who could invest only, say, 10% in one company against the benchmark, where 25% of the returns were driven by one company.”

Pottier adds, “Even if I bought the whole market, I would still not be buying as many shares in the company as I would need to hold to match the benchmark.” In response, the JSE launched the shareholder-weighted index (Swix), which weights the company according to the total number of shares available to trade on the local stock exchange. This is a fairer representation of the investable local universe and, as the JSE FAQ document explains, “over time, the Swix approach was adopted by institutional managers and investors as the local benchmark”.

When Naspers started its rise, the fund management community became concerned with the increasing concentration exposure in the Swix All Share Index. At its peak, Naspers’ weight in the Swix reached roughly 25% of the index. Morningstar’s Dodd says, “The Swix generally worked as a suitable South African equity market benchmark, up until the meteoric rise of Naspers saw the concentration risk in the Swix increase.” At its peak, Naspers’ weight in the Swix reached roughly 25% of the index. In response, the JSE launched the Capped Swix, which restricts shares to a maximum weight of 10%, in 2016.

The Capped Swix became the preferred industry benchmark for the South African equity market, but its adoption has not been universal, with many managers still benchmarked to the ALSI and the Swix. “The different weighting and capping methodologies across these indices have resulted in some vastly different return outcomes,” he says.

Dodd says that index harmonisation is important for several reasons, including the reduction of confusion among investors and making the comparability of domestic-only South African Equity fund performance more consistent. Harmonisation should also result in a reduction in the number of index-tracking products being offered, which, Dodd adds, “provides the opportunity for product providers to improve economies of scale and potentially lower fees”.

Fixing the mismatch

Bradley Preston, Chief Investment Officer at Mergence Investment Managers, says one of the issues this harmonisation will fix is the mismatch that resulted as the majority of institutional fund managers used the Capped Swix and Swix indices as their benchmarks while the liquid derivatives markets in South Africa are based on the Top 40 Index. “This mismatch has meant that a large volume of derivatives have traded over the counter in South Africa and not on the exchange.” Preston sees the harmonisation potentially aligning these two markets so that the liquid equity benchmark and the liquid derivatives benchmark are the same, which “should be positive for JSE volumes and liquidity in the SA derivatives market”.

Abdul Basit Oldey, Head of Trading for Camissa Asset Management, agrees that index harmonisation should reduce market fragmentation and could improve liquidity. Also, he pointed to recent data published by Alexander Forbes, showing that nearly 90% of the assets under management included in their equity survey are already aligned to the Swix index variants, saying “this may be a reason for the upcoming harmonisation holding less weight among market headlines”.

Welcoming the change, Alexforbes Investments Deputy Chief Investment Officer Senzo Langa, says, “The index harmonisation is positive, as the Swix free float methodology will now be applied to all the JSE counters, allowing for centralised liquidity, which is great for the market, especially for the passive and derivative market.”

He adds, “The biggest point of contention is that performance has favoured the old construct to a tune of 1-1.5% p.a. over the past 10 years when comparing ALSI versus Swix, which suggests a risk premia for companies with international exposure. We welcome the change, expect dispersion of returns in balanced managers, and some innovation on accessing ‘the lost’ rand hedge bias.”

However, industry sources says market participants have known about the changes for a while, and some have responded proactively by launching their own versions of indices that match the soon-to-be industry standard. Also, bearing in mind the harmonisation that has already taken place, not too much disruption is expected. Finally, Dodd’s question “How did the South African equity market do last year?” will have a straightforward answer.

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