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What is the Appropriate Index Construction Methodology for African Equity Investment?

Journal 36: Global Finance and Regulation

Daniel Broby, Morgan Lochhead

Investment in African equities is at a nascent stage. The continent has come late to globalization and its capital markets are underdeveloped, illiquid, and overlooked. That said, readers of the Journal of Financial Transformation will be aware that increasingly investors are focusing on African equities due to the mispricing of risk and above-average expected returns. They see such exposure as way to benefit from the impressive demographics, a new sense of optimism, and above-average GDP growth that is projected for the region.

Bekaert et al. (1998) show that the risk associated with emerging markets, as measured by the standard deviation of returns, is higher than the risk in developed markets. They also show that the returns have been correspondingly higher in the time frames examined, and the hope is that Africa will duplicate this phenomenon as it develops. The question of how one best goes about capturing this financial transformation is therefore of practical importance to both fund managers and index constructors alike. Discussions in Goltz and Le Sourd (2010), Haugen and Baker (1991) and Masters (1998) are all relevant.

The challenges of selecting an appropriate African equity index were documented by Broby and Passmoor (2012). Essentially, current index offerings do not capture the investable universe or are skewed by market capitalization to the dominant South African market. It is not surprising, therefore, that investor interest in alternative index-weighting methodologies compared to market capitalization is on the increase. In particular, approaches such as equal weighting or fundamental weighting could be better suited for this universe of companies, due to the limited diversification inherent in the data set.

There are other approaches to weight stocks in an index, such as that of achieving the highest risk/reward efficiency [Amenc et al. (2010)], of constructing maximum diversification benchmarks [Choueifaty and Coignard (2008)], or that of achieving the lowest possible index volatility [Nielsen and Aylursubramanian (2008)]. These, however, are not as frequently used as the three methodologies investigated in this paper.

In a market capitalization approach, as documented by Pope (2009), the weight of a company in an index is determined by taking the share price and multiplying it by the number of shares outstanding. An equal weighted approach, by contrast, weights all the constituent companies at the same weight on the date the index is constructed or rebalanced [Dash and Loggie (2008)]. A fundamental approach, meanwhile, weights stocks by metrics such as sales, cash flows, book value, and dividends.

As a result of different weighting decisions, index construction methodology has implications for returns. Blitz and Swinkels (2008) argue that, in using subjective factors, an index-weighting decision can be an unconscious call on which companies have greater performance potential than others. At the end of the day each of the index methodologies has advantages and disadvantages, especially in an African context.

The most widely adopted approach is that of market capitalization. This is because the capital asset pricing model [Sharpe (1964)], a widely used model for evaluating the performance of managed portfolios, suggests that the optimal portfolio would be a combination of all traded assets in proportion to their weight [Goltz and Le Sourd (2010)].