Know your index

I recently wrote about how Naspers* had a weighting in the local Top40 index of 21.55% as at end-December (the latest data I can find), whereas British American Tobacco (BAT) was weighted only 2.07%. In other words, if you put R100 into a Top40 tracker, 2 155c would go into Naspers and 207c into BAT.

This has caused a flurry of questions from people about how this works, as BAT has a market cap (total value of all listed shares) of some R1.4tr, while Naspers is only slightly larger at R1.6tr. 

This is because the JSE uses local shareholder weighting to determine initial weightings for the index.

But let’s go back to the beginning of how an index is constructed. 

Firstly, one decides on a universe. In the case of the Top40, this is the 40 largest shares on the JSE, but there is a caveat here. 

A locally traded stock has to have at least 5% of its shares held via the JSE. 

Importantly, it could be a foreigner holding the shares – but they bought them via the JSE. 

In the case of Naspers, which currently only trades on the JSE and therefore has 100% of its shares held via the JSE, one can’t buy them anywhere else (at the moment). BAT, on the other hand, also trades on other exchanges. 

It has more than the required 5% of shares listed on the JSE, but well below 100%. Glencore has a market cap of almost R900bn, but its local JSE-holding is below the 5%-threshold. 

Hence, while Glencore is a top-ten stock in terms of size, it is not included in the Top40.

Once a stock is above the local JSE-holding threshold, it can be included in the Top40 index, but only the locally held shares are used for its market cap. 

Therefore, BAT is a tenth of Naspers within the index, rather than being almost the same weighting.

This may seem like an odd idea, but it actually does make sense. 

Including the full market cap when most of the shares are not locally held would seriously distort the index away from what is actually happening on our market. 

The point of an index is to track what is happening to those stocks that actually influence the index. 

If BAT and Glencore were both included at their full market cap, we’d have stocks driving the index higher or lower but based on offshore trading.

This leads to my next important point: Know your index. 

I am a huge fan of passive exchange-traded funds (ETFs) that simply track an index. 

As the latest S&P Passive vs. Indexation (SPIVA) shows, over three and five years the index beats more than 85% of active fund managers.

So, the boring ETF actually does very well when compared to the experts. 

But we need to understand how the index is being put together.

For example, in the 4 April edition of finweek I wrote about the four different broad offshore ETFs offered on the JSE. 

Largely they’re the same – global ETFs based in US dollars. 

But there are some significant differences between some of them that will mean different returns and different risks.

That said, don’t panic if you don’t know everything there is to know about the index underlying your ETF. 

As long as you’re picking broad-based indices you’re going to do just fine with your investments over time. 

You can also visit the ETF issuer’s website to get more details on the underlying index and how it is put together. 

But the main lesson is that we need to be careful of the more niche ETFs based on smaller sub-indices, as we need to be very sure that we do understand what goes into the indices.

*finweek is a publication of Media24, a subsidiary of Naspers.

This article originally appeared in the 9 May edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.