The returns of two liquid equity benchmarks in South Africa with the same target market have been significantly different YTD as of Oct. 26, 2018. Over the period, the S&P South Africa 50 has declined 8.8% while the FTSE/JSE Top 40 has fallen 12.6%—a difference of over 380 bps—a considerable performance gap over a fairly short period of time. This difference may be explained by idiosyncratic risk and a single component included in each index.
Idiosyncratic Risk Can Hurt Performance
Idiosyncratic risk occurs when a single stock or asset drives portfolio performance for reasons apart from macroeconomic forces. Stocks often underperform, can free fall due to scandal, and may even declare bankruptcy. The opposite may be true on the upside, when company valuations gain by multiples over relatively short periods of time. However, in a well-diversified portfolio, the effect of these moves are typically contained due to the offsetting performance of other assets. In the case of the FTSE/JSE Top 40, however, there is one stock—Naspers—that has largely driven the direction of the index YTD.
Naspers Moves an Index
Naspers forms approximately 20% of the FTSE/JSE Top 40, whereas in the S&P South Africa 50, the stock weight forms half of that—about 10%.[i] Naspers owns a 31.1% share of Tencent, and while its share value has dropped 36% YTD, indices (and portfolios) with outsized exposures to Naspers have suffered as a consequence. Exhibit 1 illustrates the YTD performance of each index alongside the performance of Naspers and Tencent. The exhibit shows that large single-stock exposure has been a driving force behind the varied performance of the two indices.
Capping Mitigates Single-Stock Risk
Capping is not a new concept for indices and can potentially be a way to avoid outsized single-stock exposure. For the S&P South Africa 50, each stock is limited to a 10% single-stock cap, which is applied quarterly in order to enhance diversification and meet the needs of market participants who are subject to regulatory requirements regarding single-stock concentration. The result is that in the S&P South Africa 50, the top three stocks compose roughly 30% of the index. In contrast, the same three stocks make up over 42% of the FTSE/JSE Top 40’s weight.[ii] The inclusion of 10 additional stocks in the S&P South Africa 50 likewise helps to further diversify the index and spread out risk across 25% more companies.
While the recent decline of Naspers highlights the potential benefits of greater diversification in the S&P South Africa 50, the improved performance is not limited to recent history. Exhibit 2 shows that the benefits of diversification have historically led to greater total returns, lower risk, and therefore improved risk-adjusted returns across the examined periods.
[i] Figures as of Sept. 28, 2018.
[ii] Figures as of Sept. 28, 2018.