Index or passive investing is an investment approach where a fund seeks to duplicate the returns of the market. This approach seeks to replicate the market return, forgoing the potential upside which active managers can provide through a rigorous research process. We acknowledge that passive investing may be a good fit for some investors, particularly in developed markets where liquidity is more readily available. At Mazi Asset Management (Mazi), we fundamentally believe that an active investment approach is the best way for investors to achieve long-term investment goals.
As specialist investors in frontier African markets, we have found that the indices that exist within our investment universe struggle to meet the basic needs of a passive investor. This is because globally produced indices aimed at frontier African markets are unable to effectively reflect the potential investable universe.
These indices fail for a few reasons, one of which is the “one-size-fits-all” style of index construction. Most providers employ a global index construction methodology and replicate this across all markets, regardless of specific market’s size or level of development. African capital markets are under-developed and suffer from several practical and informational inefficiencies which index providers are unable or unwilling to account for.
The rigorous investment process at Mazi allows us to uncover these issues and helps us mitigate these risks. A recent engagement with a leading global index provider further reaffirmed our research process. We presented our research to the index provider, exposing inaccuracies in the data the provider was using to construct the index.
How our research made a global index provider look inward
The index provider in question had included a stock which carried a significant weight in the index even though the stock did not meet the index provider’s own index construction methodology. The weight of the stock ballooned after inclusion driven by a rapid rise in the stock price - a function of the company’s very limited free-float and lack of tradability.
The company’s free-float - the shares which are available for trading on the market - was well below the 5% threshold for inclusion in the index. Our analysis of the company showed the free-float was less than 2% of its shares, with 98% of shares held by the owner/founder and Board of Directors. Bloomberg’s data at the time incorrectly showed a free-float of 35%. This was not surprising since providers lean on the likes of Bloomberg and Reuters for their market data, which we have found can oftentimes be inaccurate for African markets.
Our research on the company uncovered fundamental flaws in the company’s business model and shareholding structure which we believe prejudices minority shareholders. The company did not meet our tenets for sound investments, and we do not hold the stock in our portfolio despite its growing weight in the index concerned.
We presented our findings to the index provider, who heeded our advice and subsequently announced they will be removing the stock from the index during its next index rebalancing. The stock in question carried a significant weight (above 10%) in the index, which will be reduced to 0%. The practical effect of this decision would force passive investors to sell the stock and redeploy their capital across other companies within the index. This is extremely difficult, to put it mildly, under current market conditions where repatriation of funds remains a challenge.
This combined with the clear informational deficits that exist within the index illustrate that the primary investor value proposition is not necessarily as it seems. In the case of an index fund, it would be nearly impossible to reliably replicate the return of such an index.
As investors in frontier African markets, we understand the importance of these types of challenges. We believe that investors should also be aware of the risks involved when investing in these markets. Avoiding costly mistakes begins with conducting fundamental research and due diligence. In addition to research, investors need to be patient to realise the potential the African continent has to offer.
At Mazi, we have extensive experience dealing with these challenges and are able to navigate through tough market environments. We believe that the challenges in these markets also present significant opportunity for the astute investor. The Mazi investment process and our extensive on-the-ground research across the continent allows us to uncover these opportunities for our clients.
