We have previously written about the undesirable risk characteristics of the FTSE/JSE Shareholder Weighted Index (SWIX), not only as it pertains to choice of equity index for exposure to market linked returns, but equally as important, as a choice of benchmark around which to pivot when pursuing active investment strategies.
One of our flagship factor-based products, the Satrix Momentum Unit Trust, is constructed using the SWIX as its point of departure and underlying performance benchmark index. In light of our findings regarding the SWIX’s feasibility as a diversified benchmark choice, we have decided to move toward pivoting the Satrix Momentum Unit Trust around a Capped SWIX benchmark instead, as this change will provide the fund with a more efficient expression of the Momentum factor as well as a substantially more diversified overall portfolio. The planned implementation of this change will occur on the last trading day of July, which is in-line with our next rebalance.
In this article we aim to motivate this imminent change by providing insight into various risk measures that in our view are important considerations when choosing appropriate benchmarks.
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 incumbent preferred South African equity benchmark of the SWIX (launched in 2003) was designed to alleviate concerns related to the accessibility of shares for local investors, coupled with the challenges of high concentration and poor diversification of the previously favoured ALSI. The true reason was likely closer to 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 due largely to the stratospheric increase in the weighting of Naspers and other Industrial counters.
The launch of the FTSE/JSE’s Capped SWIX in November 2016 has, in our view, provided a superior option to investors without the adverse risk characteristics of the incumbent SA equity benchmarks. An obvious question to ask is why are we focusing on risk measures, as the benchmark choice debate should surely be focusing on an historic return comparison? In our view, return outcomes are merely the symptom of underlying risks, and thus understanding the source and nature of all risks of a benchmark is key to inform the overall return experience.
Why is Capped SWIX a superior benchmark?
The first important measure we consider is concentration, which we define  as the extent to which stock weights skew away from an equally weighted (or perfectly diversified) portfolio. A portfolio with high concentration has extremely large weights in a few stocks / sectors, thus exposing itself to very unique and undiversifiable risks. An alternative to overcome 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, it has globally been a popular choice for investors in regions where giant global stocks are listed in smaller stock exchanges.
Based on our analysis, the Capped SWIX  represents significantly more favourable concentration measures. While SWIX concentration systematically rises to 7% over the prior three years, the Capped SWIX remains stable below 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.
Figure 1: Concentration of ALSI, CAPI, SWIX and Capped SWIX
Source: Satrix calculations
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
Similarly, the forward looking risk characteristics as at 15 June 2018 show that Capped SWIX is more favourable on all fronts from a risk perspective relative to both ALSI, CAPI and SWIX.
Table 1: Risk decomposition as at 15 June 2018
Source: FTSE/JSE, MSCI Barra
It is also worth noting that while the Capped SWIX doesn’t have the lowest total risk, it has by far the lowest idiosyncratic, or undiversifiable risk across these equity benchmarks – which is the key risk an investor should try and mitigate. The index’s weighting of the top 10 shares also illustrates this point.
Impact to the Satrix Momentum Unit Trust
In moving from a SWIX to a Capped SWIX benchmark in the Satrix Momentum Unit Trust, we believe that we are accomplishing dual objectives. Firstly, we are improving the overall risk character of the portfolio by reducing the concentration as well as enhancing the diversification of the portfolio. This is a natural consequence of employing the Capped SWIX as a benchmark, given its superior risk characteristics relative to other equity benchmarks. Secondly, we are also enriching the extraction of the Momentum signal from the Capped SWIX benchmark, given the improved ability to transfer information from a more diversified index.
We believe the benchmark change will benefit the overall client experience by providing a more predictable, efficient and transparent investment outcome. We remain committed to the existing portfolio construction process for the Satrix Momentum Unit Trust, through focussing on extracting and embedding a strong momentum character into the fund, while employing robust risk management overlays onto the portfolio to mitigate unique risks with a momentum strategy.
We currently manage a number of mandates (assets in excess of R4bn) that have recently switched their base benchmark from SWIX to Capped SWIX for the implementation of our Satrix Momentum Index. While these mandates have seen some absolute performance differences over the short-term as a result of this change (depending on how Capped SWIX has performed relative to SWIX), the relative performance of our Satrix Momentum Index which tracks the Capped SWIX has been very similar to the relative performance of the Satrix Momentum Unit Trust relative to the SWIX. Through the cycle, we expect the same, if not an enhanced, level of alpha within a small margin of error based on this benchmark change.
 We measure concentration using the Herfindahl-Hirschman Index (HHI), calculated as the sum of the squared equity weights.
 We reconstructed the FTSE/JSE Capped Index constituents ourselves employing a capping methodology consistent with the FTSE/JSE to backdate the constituents 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).
POSTED : 4 JULY 2018