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African ETF investors beware: active fund management usually wins in emerging markets

By David Whitehouse
Posted on Tuesday, 4 June 2019 10:04

South African banking shares have plummeted on the Johannesburg Stock Exchange REUTERS/Philimon Bulawayo

African exchange-traded funds continue to proliferate, offering the prospect of new capital inflows for African companies and increased access to emerging and frontier markets for investors. But are ETFs really the right way to play Africa's growth themes?

ETFs are baskets of securities that can be bought and sold on a stock market. They generally track a benchmark and offer a low-cost passive investment approach. Investors in Africa have an ever-expanding range of such vehicles to choose from. In February, Absa Corporate and Investment Bank launched South Africa’s first range of volatility-managed ETFs, which aim to limit the volatility created by the underlying assets in the basket. Investors can choose different risk levels: high growth, moderate and defensive.

The way forward for developing countries like South Africa, according to Steven Jon Kaplan, CEO at True Contrarian Investments in New York, is to make more exchange-traded funds available to investors in established markets. He cites the iShares MSCI South Africa and Franklin FTSE South Africa ETFs as having greatly increased investor interest in South Africa. “Probably at least one additional US exchange-traded fund of small- and mid-cap South African shares could be created which would attract additional capital,” he says. European and other exchanges could also be used to garner investor interest, he says.

Intuitively, there are problems with tracking an index in emerging or frontier markets relating to exchange rules and corporate governance. ETFs in Western countries are based on the assumption of full liquidity. That may not be the case in frontier markets.

  • A case in point is MTN Nigeria: as The Africa Report argued in May, the company’s “listing by introduction” created an artificial market price for the shares without liquidity, ensuring steady price increases.
  • The losers are the tracking funds that must obtain the shares, but have no way to do so – until MTN Nigeria’s institutional shareholders decide that the price is right to sell.
  • The biggest companies in African national indices are often legacy state-owned enterprises. Many of these have not shown that they could compete with private rivals in the absence of government support. These companies may not be best placed to benefit from African growth themes.

Do your own research

For regionally specific emerging market ETFs such as African ones, the bar is high. It’s likely that an African ETF would have to comfortably outperform a general emerging markets ETF for a sustained period before fund managers would consider it.

Perhaps most fundamentally, African-listed companies are far less researched than their counterparts in Europe and the US. Western corporate governance is hardly perfect, but the bad apples are likely to be thrown out sooner because more people are analysing the companies. In that context, it makes sense that active strategies, which often struggle to justify their fees in developed markets relative to cheaper passive products, outperform in emerging markets.

Steve Holden of Copley Fund Research shows, in a piece published on Smartkarma in January, that active management usually wins in emerging markets.

  • Last year was an exception to the rule: absolute returns for active emerging markets funds were the worst since 2011 and, relative to the iShares MSCI Emerging Markets ETF, active funds had their first average underperformance since 2008.
  • Since its inception in May 2003, Holden calculates, the iShares MSCI Emerging Markets ETF has underperformed the average emerging markets active fund by 32.3%, returning 319% compared with 352% for the active fund average.

Bottom line: ETF investors need to understand what exactly their product is tracking – and consider the evidence that an active approach usually wins in emerging markets.

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