top 40

ETF: Top 40 – why choose?

In ETF Blog, Latest by Kristia van Heerden

The Top 40 index needs no introduction to readers of this blog. Many South African investors got their very first taste of the market through a Top 40 ETF.

Initially the Top 40 index ruled the roost. ETFs tracking this index invest in the 40 biggest companies listed on the JSE by market capitalisation. Each company’s shares are multiplied by its share price to determine the company’s weighting in the index. The bigger the company, the bigger the slice of the index and the bigger its impact on the performance of index-tracking products like ETFs. For many years, this methodology worked in favour of investors as the biggest companies in the index performed outstandingly.

These days, critics of index investing all scurry to point out that a single company, Naspers, represents almost a quarter of the index. Index-tracking products are appealing because they invest in many companies, reducing your risk should one company fail. You would probably not invest a quarter of your investable funds in a single share. Why buy an ETF that gives you so much exposure to just one company?

Let’s not forget the beloved SWIX index. This index only tracks shares held in South Africa by local investors. The theory is that international investors are too eager to cut and run when things get volatile. The index also excludes shares held by other companies, since these shares don’t trade as much as shares held by individuals. These two factors affect the weighting of companies within the index. Currently the SWIX index has a 30% exposure to Naspers, while the Top 40 has just over 23%.

To reduce investor’s exposure to a single company, ETF issuers came up with a product that gave each company in the index the same weighting. An equal-weighted product offers investors two key benefits. Firstly, you buy less of a single company, which reduces your risk should that company perform poorly. Secondly, it gives you the opportunity to really benefit from the performance of the smaller companies in the index. The bottom of the index often houses new entrants to the big leagues. Formerly occupants of the mid-cap index, some of these newbies have nowhere to go but up.

One major downside of equal-weighted ETFs is that investors miss out on giants that shoot the lights out. Remember Naspers, the mammoth of the Top 40? In the past five years, that company’s share price has gone from around R500 to over R3000. If you hitched 25% of your investible income to that horse, you’re probably not complaining.

Thanks in large part to Naspers, the Top 40 and SWIX indices have outperformed the equal-weighted index. The greater performance are the direct result of single-stock exposure risk. There are benefits to each investment methodology. What would happen if you had to split your investment between them?

Sadly, we can only ever look back when it comes to investment performance. Take a look at the chart below, sourced from etfSA.co.za.

Top 40 performanceIf you had invested an equal amount in these three products, you portfolio would have been up 11.83% in the past seven years. You would have missed out on 2% of performance if you had invested exclusively in the SWIX, sure, but your single stock exposure would have been slightly reduced too.

Is this strategy worthy of consideration going forward? It all depends on how much you trust Naspers.

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