Passive investing is the current darling of the financial markets – everyone wants to invest in – or sell – passive products.

Exchange traded funds (ETFs), which are largely passive products designed to track equity, commodity and bond indices, have shown explosive growth since the 2008 global financial crisis. Although they have been around for just 25 years, the international ETF sector has grown to significant levels.

At the end of November 2015, the industry managed a record US$3 trillion, from 275 providers listed on 63 exchanges in 51 countries, according to UK research group ETFGI.

ETFs allow investors to buy and sell exposure to a basket of equities or a market index without owning the underlying shares or bonds. If these products did not exist, the only way to track an index would be to buy one share in every company making up the index. Their popularity is largely due to their low costs and transparent pricing. According to Blackrock, the world’s largest provider of ETFs, they offer ‘efficient, low-cost diversification, combined with flexibility and liquidity’.

These benefits make them ideal products for local and global investors in Africa. They could also potentially promote the development of the continent’s financial markets through diversification. Africa’s young demographic, growing middle class and massive demand for infrastructure, combined with more rapid economic growth than the developed world, make it an attractive investment destination. However, investment opportunities are limited, often by the small number of listed companies and government bonds as well as the lack of liquidity and low trading volumes on many of Africa’s exchanges.

The continent needs more investors to grow its markets. However, to attract more investors, it needs more investment opportunities. As ETFs begin to play a major role globally, they may have a place in helping capital markets in Africa to grow.

In 2014, a PWC survey of executives who account for more than 70% of global ETF assets found more than three-quarters of respondents expect ETF assets to at least double, reaching US$5 trillion or more by 2020. Europe and the US are expected to continue to dominate the ETF landscape but the highest rates of growth will be found in the less mature markets.

‘ETFs will grow slowly in Africa, as you first need liquidity in equity markets. Sophisticated investors with the money you want to attract to the economy are not going to pay wide spreads’

The survey report singles out Asian markets as a driver of the growth, while suggesting significant potential in Latin America, the Middle East and Africa, which have only recently been introduced to ETFs. ‘The fact that [Africa, Latin America and the Middle East] currently account for only 2% of global ETF assets only serves to illustrate the potential for growth in these markets, as investors familiarise themselves with the benefits of ETFs,’ the report states.

For the most part, the growth in ETFs is expected to be driven largely by institutional investors – mainly pension funds, insurance companies and hedge funds. Besides South Africa, the pension fund pool in sub-Saharan Africa is small but growing rapidly due to the introduction of private pension systems, as a result of regulatory reforms.

For instance, Ghana’s pension fund industry grew fourfold over a six-year period, reaching US$2.6 billion by 2014. Meanwhile, in Nigeria the industry has tripled in the past five years. It has US$25 billion in assets and 6 million contributors, according to an AssetMan.net article. As per capita income increases and more people work in formal employment and contribute to pension funds, the pension fund industry will grow.

‘We are in the early stages of huge growth in pension pools. So far, only 5% to 10% of the population in sub-Saharan Africa is thought to be covered by pension funds, whereas North Africa has already hit 80%,’ says AssetMan.net. ‘Pension fund assets are still tiny in comparison to GDP, which in turn is growing fast in many African countries.’

Pension funds, however, have limited investment opportunities. They are largely compelled to invest in domestic assets, limiting them to government bonds, property and a handful of equities on the local exchanges, according to a report by advisory firm AON Capital.

‘ETFs can help provide alternative investments for pension funds and simultaneously further develop financial markets in Africa by providing a convenient, liquid and cost-efficient way to access certain markets and passive asset exposure,’ says AON. ‘Further, the open-ended and liquid nature of ETFs makes them ideal vehicles for the growing pension and institutional fund sector in Africa.’

‘ETFs can help provide alternative investments for pension funds and simultaneously further develop financial markets in Africa’

The opportunity is not yet widely available to pension funds, as South Africa is the only African country with a well-developed ETF market. This is because a number of criteria need to be fulfilled before ETFs can operate effectively in a market, says Len Jordaan, head of ETFs at asset manager Stanlib.

‘There’s a misnomer around ETFs that if you issue them on a country’s stock exchange, they will automatically increase the liquidity,’ he says. ‘But you need a base level of liquidity on the exchange before you can list an ETF. Many African exchanges don’t have that in place.’

Jordaan adds that an efficient ETF is stimulated by the presence of derivatives markets. ‘Countries without derivatives or short selling will not have a very efficient ETF market.’

This is because the attractiveness of an ETF would depend on the ‘spread’, or the difference between the price at which someone is willing to buy a fund and the price at which someone is willing to sell. A robustly traded ETF would have a narrower spread, while a thinly traded ETF, or one in which the underlying securities were fairly illiquid, would have wider spreads. The narrower the spread, the lower the cost to trade.

According to Jordaan: ‘ETFs will grow slowly in Africa, as you first need liquidity in equity markets. Sophisticated investors with the money you want to attract to the economy are not going to pay wide spreads.’

The Nairobi, Nigeria and Johannesburg stock exchanges are working together to develop the ETF market via cross-listings. The aim is to improve liquidity on Africa’s exchanges and give investors exposure to a range of Kenyan, Nigerian and South African companies through their domestic bourses that they could not previously access.

‘The concept of cross-listing an ETF is the same as cross-listing a share, or listing it on more than one exchange,’ says the JSE. ‘It provides domestic investors with access to opportunities from another market, in the convenient and cost-effective form of an ETF.’

Investors will be able to access broad indices such as the FTSE/JSE Top 40 (which represents the 40 largest firms by market share listed on the JSE); the FTSE NSE Kenya 15 Index (which represents the performance of the 15 biggest companies on the Nairobi Securities Exchange); and the MSCI Nigeria Index (which measures large and mid-cap firms listed on the Nigerian market).

‘ETFs are one of the fastest-growing asset-class categories in the world,’ according to Donna Oosthuyse, capital markets director at the JSE. ‘By collaborating with Africa’s largest stock exchanges, we hope to spearhead this trend in Africa.’

She explains how this initiative is expected to increase liquidity on the three participating exchanges. ‘If an ETF from Kenya or Nigeria, for instance, is listed on the JSE, then the asset manager in Kenya or Nigeria has to buy and sell the constituent shares on the home market, as units in the ETF are bought and sold. This drives liquidity in the home market.’

SubSaharan Africa’s biggest exchange by market value is South Africa’s JSE, followed by Nigeria and Kenya. It has offered ETFs since 2000, and had 70 JSE listed ETFs/ETNs (exchange traded notes) and 24 index tracking unit trusts as at end-November 2015.

Absa Capital, based in South Africa, was the first to cross-list an ETF in Africa, when in 2010 it listed the NewGold ETF in Botswana, the largest ETF on the continent. It has subsequently cross-listed NewGold, which tracks the gold price on other exchanges, including Ghana, Mauritius, Namibia and Nigeria.

The Nigerian Stock Exchange offers seven ETFs and the Namibian Stock Exchange offers four ETFs – all of them secondary listings with the main listing on the JSE. The Nairobi Securities Exchange is moving closer to offering ETFs after introducing the necessary enabling regulation. In October last year, Kenya’s Capital Markets Authority published regulations to pave the way for the introduction of ETFs.

Jordaan believes that the East African country could attract local demand for ETFs. ‘In Kenya, you can only get equity exposure through a stock broker, not a financial advisor, so more people own stocks directly rather than funds like unit trusts. An ETF would probably be attractive to them rather than having to buy five or six individual stocks.’

Investors can gain exposure to Africa via emerging market ETFs. Many of these funds are broadly frontier and focused on emerging markets, with African companies making up a small proportion of their exposure.

However, some of the major global providers of indices to the ETF industry – such as S&P Dow Jones and MSCI – offer a number of Africa-focused indices.

The drawback, says Jordaan, is that while many of them offer investors exposure to the financial sector (as banks are listed on in-country exchanges), investors aren’t exposed to ‘the real African growth story, which is commodities and retailers, as these are mostly not listed on in-country exchanges’.

In other words, ‘the real economy doesn’t always filter into the financial markets’.

Jordaan sounds a word of caution on ETFs: ‘They are not a magic wand to fix an illiquid market.’ He predicts that when African exchanges are able to offer well diversified indexes with relatively low spreads, investors will start to find value in ETFs.

By Gene Michelson
Image: Andreas Eiselen/HSMimages