The shifting diversification attributes of common South African equity benchmarks – Jason Swartz and Jason Liddle, Satrix
With 2016 quickly drawing to a close, one cannot help but sit back and reflect on the quantum of events that have surprised investors this year. From Leicester City winning the English Premier League, to the outcome of the EU referendum (Brexit), to Donald Trump being elected as the president of the United States of America… and everything in between. And in a world of abundant uncertainty, the major challenge facing investors has always been ensuring their capital is at minimum risk of failing to deliver on planned investment outcomes. This task – often simply – requires diversification.
Choosing the right benchmark
For investors in South African equities, the choice of benchmark has been a remarkably ‘risk-defining’ investment decision. The choice between the ALSI (All share Index), SWIX (shareholder weighted index), CAPI (Capped All Share Index) or Top40 (ALSI 40 index) is key in determining the shape of the investor’s experience. The current preferred South African equity benchmark of the SWIX (launched in 2003) was designed to alleviate concerns related to the concentration and diversification of the previously favoured ALSI, as well as the observation that the ALSI was structurally not well represented in domestic portfolios, for various fundamental reasons.
The irony is that just over a decade later, the SWIX now has developed undesirable concentration characteristics itself (see Figure 1 that follows) due largely to the stratospheric increase in the weighting of Naspers. But why, you ask, are we focusing on risk measures? Surely the debate around benchmark choice should be focusing on an historic return comparison? In our view, no.
The role risk plays
1. Concentration risk
Our view is that it is best practice to understand the source and nature of all risks of a benchmark or universe first, as this will inform the return experience. The first important risk measure we consider is concentration, which we define as the extent to which stock weights skew away from an equally weighted portfolio (perfectly diversified). A portfolio with high concentration has extremely large weights in a few stocks / sectors, thus exposing itself to very unique and undiversifiable risks.
Figure 1: Concentration of ALSI, CAPI, SWIX and Capped SWIX*
One alternative to overcoming high concentration has been capping stocks – typically at 10%. While this solution has to be considered carefully as it could lead to a simultaneous increase in exposure to unintended risks, globally it has been a popular choice for investors in regions where giant global stocks are listed in smaller stocks exchanges.
In lieu of the FTSE/JSE launching the much-anticipated capped SWIX index, we reconstructed the index constituents ourselves to assess its characteristics and found this benchmark to embody significantly more favourable concentration measures. While SWIX concentration systematically rises to 5% over the prior two years, the Capped SWIX remains stable around 3%. Interestingly, the SWIX is no longer more evenly weighted than the ALSI and should no longer be considered a more appropriate benchmark on this basis.
2. Diversification risk
Diversification is the second important risk measure. Here we use a relatively new – yet very intuitive – metric called the PDI (portfolio diversification index) which calculates the number of independent sources of risk emanating from the portfolio. It turns out again that while the SWIX has traditionally always comprised 1.5 to 2 more independent sources of risks (implying more diversification) than the ALSI, of late the SWIX’s PDI is lower than the ALSI (implying lower diversification). Conversely, while the SWIX has lost its diversification qualities, the Capped SWIX increases its diversification measure to around 7 independent sources of risk.
Figure 2: PDI’s of ALSI, CAPI, SWIX and Capped SWIX*
It is also interesting to note how well diversified the Capped SWIX is relative to the other equity benchmarks with respect to sector, size and economic cycle weightings (see Table 1). Not only are the sector weights more balanced, thus alleviating the need to constrain sector weightings when they become onerously large, but the cyclical versus defensive risk is reduced enabling the portfolio to be less sensitive to macro-economic swings.
The application of this result is not only relevant for passive investors, but active investors too. In a concentrated or poorly diversified benchmark, a skilled manager may struggle to outperform as he/she would be constrained not only to transfer his/her skill (due to portfolio constraints), but would also struggle to apply their skill in full breadth, given the reduced independent sources of risk in the universe.
Table 1: Segment breakdown of ALSI, CAPI, SWIX and Capped SWIX* (Sep 2016)
In our view, the Capped SWIX effectively addresses the concentration and diversification issues that are inherent in the current version of the SWIX and presents a viable alternative equity benchmark for South African equity investors who are concerned about the risk attributes of the SWIX. An awareness of the risks that are driving your portfolio’s total return will invariably lead to richer and more informed decision making and return experience.
We measure concentration using the Herfindahl-Hirschman Index (HHI), calculated as the sum of the squared equity weights:
*We implement a capping methodology consistent with the FTSE/JSE to backdate the constituents of the Capped SWIX to 2011
Portfolio Diversification Index tries to assess how many independent bets there are using the eigenvalues of the covariance matrix of the returns of individual assets making up a combined portfolio (which is usually estimated from historic data). It is given by 2where λk are the ordered and normalized covariance eigenvalues.
*We implement a capping methodology consistent with the FTSE/JSE to backdate the constituents of the Capped SWIX