Stock market indices are one of those background elements of the investment ecosystem that people rarely interrogate closely. The FTSE/JSE all share index, or one of its variants, is a useful tool to report on market performance for the day. When we dig a bit deeper, we find additional-use cases that are fundamental to the investment management process, and discover that perhaps index construction and index weighting are more important than they initially appear to be.

A fund benchmark is an important example. Fund managers will select a benchmark for their fund or mandate, and equity funds will typically use an equity index for this purpose. A performance benchmark is often used to determine management fees; the fund manager whose investment delivers better returns than the index is entitled to charge an additional performance fee. There are two ways to “beat the benchmark” — be overweight on a stock that delivers above-benchmark returns, or to be underweight on a stock that delivers poor returns.

Outperform benchmark

Fund managers will therefore closely monitor the weight of particular companies in their benchmark index. Most benchmark indices use a market-capitalisation weighting approach. Market capitalisation represents the total value of all the issued shares of a company. This is normally adjusted to reflect the shares that are actually available to investors to trade, thereby excluding strategic holdings, and director and trust holdings.

A company with a large market capitalisation will have a larger weighting in the index than a company with a smaller market capitalisation. Consider Naspers, which has a huge market capitalisation of R950bn. In the FTSE/JSE Swix all share index, Naspers has a weight of nearly 17%. Investors who are bullish on future Naspers performance would therefore want to invest more than 17% of their total portfolio in Naspers to outperform their benchmark.

Diversification is a key principle in investment management, and few investors would be comfortable with 20%-25% of their fund invested in a single asset. Most investors are risk averse and would never consider putting such a large portion of their portfolio at risk on a single counter. To provide an alternative benchmark index for investors with this view, FTSE/JSE introduced a capped all share index in 2004, and a capped Swix all share index in 2016.

Concentration risk

These indices restrict the weight of individual companies in the index to 10% on a quarterly basis. Fund managers that choose to use these particular indices for their fund benchmarks can still choose to go overweight or underweight on individual stocks, but are no longer forced to build up such significant concentration risk in Naspers if they have a bullish outlook.

Since its introduction in 2016, many local equity managers have chosen to use the capped Swix all share index as their fund benchmark to manage their concentration risk more effectively.

In September, Naspers transferred its global internet assets into a newly listed company, Prosus, which has a weight of nearly 3% in the uncapped version of the index. Naspers is a majority shareholder in Prosus and holds 74% of its total shares. This majority shareholding tends to dominate the overall valuation for Naspers — its 74% stake can be valued at R1.26-trillion using market prices, greater than the total market capitalisation of Naspers itself. This phenomenon is often referred to as a valuation discount for holding companies, and in extreme cases like this the company is valued lower than one of its individual parts.

Because of the dominant way the Prosus valuation affects the Naspers price, some investors believe a Naspers investment provides almost identical economic exposure to a Prosus investment, even though they are two separately listed companies.

In the capped Swix all share index, Naspers and Prosus have a combined weight of about 13.5%, with Naspers being capped at the 10% level. For those investors who have chosen to use this capped index as their benchmark, many believe the capping process should instead be applied to the two companies jointly, thereby capping the combined weight of Naspers and Prosus at 10% to reflect the underlying economic exposure. Before the Prosus listing, the Naspers index weight was capped at 10%, but the capped index exposure to the underlying global internet assets has increased by more than a third due to the Prosus listing.

Picture: WALDO SWIEGERS/BLOOMBERG
Picture: WALDO SWIEGERS/BLOOMBERG

The JSE has engaged with clients and there appears to be widespread support to change the index rules. FTSE/JSE has therefore published a proposal to the market to allow all index users to understand the effect and submit comments.

The proposed changes only affect the capped indices, with no fundamental change to the broader index series, and is expected to almost exclusively affect investors using the capped indices as performance benchmarks.

• Randall is JSE director of information services. The consultation paper is available on the exchange's website. Comments can be submitted until November 22.