Compared to stock markets in developed economies, the South African stock market is tiny. Our entire market consists of only 387 shares. Of those, only 50 are big enough to have a meaningful impact on the performance of the market. By contrast, the New York stock exchange boasts 2,800 listed companies.
Most South African investors are familiar with the Top 40 index and its associated investment products. This index tracks the performance of the 40 companies that are large enough to have an impact on the performance of our entire stock market. In addition, it often forms the foundation for a number of sector-specific sub-indices. In the index business this is sometimes called the “starting universe”. To make a sector-specific sub-index, the index provider starts by looking at which companies in the Top 40 meet certain criteria, such as belonging to a specific sector.
As we discussed in The Fat Wallet Show, having a tiny market presents some challenges when it comes to branching out of broad-market indices. Since we don’t have many local ETFs and so many of them share the Top 40 as starting universe, it’s not always true that adding an ETF to your portfolio will result in more diversification. In fact, since one company is often represented in the Top 40 and one or more of the sub-indices, adding ETFs could introduce concentration risk.
|Company||Top 40||DIVI||FINI||INDI||RESI||Rands invested||Percentage of holdings|
In every instance in the example above, adding a sub-index increased your exposure to a single company compared to the broad-market index. The opposite is also true, however. If you held only a sub-index, adding a broad-market index will most likely dilute your exposure to a single share. Adding ETFs only increases diversification when the ETFs don’t represent the same geographical market. Holding the S&P500 and the Nasdaq ETFs will likely land you in the same position, whereas holding the S&P500 and the Satrix Top 40 will increase the amount of companies you hold.
As with any investment strategy, simply being aware enables you to make better decisions. While this post is intended to caution investors against taking on too big a holding in a single company, it can also be used to increase your exposure to a certain company or sector slightly without taking on single share exposure. This might be useful in tax-free investment accounts and self-managed retirement annuities where single-share investments aren’t allowed.