It is becoming increasingly clear that African listed equity may serve as a complement to any general investor’s portfolio. With sufficient analysis to determine where the real risks lie, the growth potential and diversification benefits of African markets are significant motives for capital allocation, for those with a long-term view.

With the quality and availability of information having increased significantly over the past five years, it has become easier to prove the attractiveness of listed markets in Africa. This trend serves as a further reason for investors to look beyond the poor liquidity and political instability that characterise some African markets and benefit from what has been labelled the final investment frontier. Listed markets in Africa have been promoted to the global investment community primarily on the basis of portfolio diversification benefits, by virtue of their low correlation to developed markets, and their attractive valuations with seemingly endless growth potential associated with a burgeoning consumer base.

“It is vital that investors on the lookout for attractive returns are able to measure the accurateness of these endorsements,” says Deon Smith of RisCura Analytics.

The participation of exchanges in organisational structures such as ASEA (African Securities Exchanges Association), the promotion of regional integration and the general focus on and drive for increased governance and transparency are slowly increasing the efficiency of African listed markets – resulting in deepening liquidity and lower concentration, Smith says.

“However, there is still much to be done to mitigate logistical inefficiencies inherent in these markets such as the size and variety of transactional costs, spreads on cross-currency transactions, and regulatory road blocks.”

Diversification is the key

The correlation matrix below is built off monthly USD returns of the various MSCI TRI (total return indices) over the period 2004 to present. By using the MSCI index series as a proxy for market performance, it becomes clear that diversification can be achieved by investing in African markets, particularly Nigeria, Tunisia and Morocco, which show low correlations with developed markets, emerging markets and the BRIC nations, with Kenya and Egypt following suit.

African markets stand out by the appearance of lower correlations (greener colours) for the African Indices versus those of the developed markets, emerging markets and the BRIC nations. “The BRICs and other emerging countries are understandably more correlated to the developed markets (> 0.8).”

“In a ‘risk on’ environment, Africa should be seen as an appropriate safe haven given the above correlations. However, contrarily, capital flight occurs back to the developed markets and shorter-term correlations tend to one. The net result is somewhat of a lagged period of negative volatility, allowing correlations to stay low.  Investors miss out on the expected benefits associated with these low correlations,” Smith says.

The 24-month rolling correlations to the MSCI World Index below begin to tell a story of the diversification pros of country-specific allocations. “Two years on from the crisis of 2008 we see diversification benefits originating from low correlations as a result of the return differentials of African countries to their more developed counterparts during the 2008/09 period of negative volatility. Additionally, in comparison to the frontier markets’ correlation to the MSCI World from mid-2008, African countries (excluding South Africa) consistently show lower correlations over time, further indicating the niche role which they play in this regard.”

Therefore, one can conclude that diversification may be achieved by looking to African markets.” However, is this the right kind of diversification, or are you paying a premium in the form of adding additional risk to the portfolio?” Smith asks.

The risk/return scatter (inception 2004) of monthly returns below sets out to answer this question. All the African orientated indices (with the exception of South Africa) outperformed the developed world at a risk threshold lower than that of emerging markets, indicating that one does not necessarily achieve diversification at the cost of additional volatility.

– Deon Smith
Head of Business & Product Development, RisCura

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