eBusiness Weekly
On June 22, 2022 the Securities and Exchange Commission of Zimbabwe announced the launch of the derivatives market in Zimbabwe with the initial focus on stock futures, stock options and stock indices futures.
This development will add another alternative avenue through which investors can invest in the Zimbabwe capital markets. Investors can take exposure to equities, commodities, interest rate and currencies without the need to have a significant capital outlay initially.
The RBZ in its recent monetary policy interventions statement highlighted that there is work in progress towards the establishment of the forward market instruments to provide investors with more options to invest and manage their risks.
Potential Boom Bust Cycle
Our take is that the creation and introduction of these innovative products will lead to a boom in the Zimbabwe financial markets, as investors both retail and institutional get caught up in the euphoria and excitement of investing in new investments products. We think there will be a boom- bust cycle associated with these products with initially high investment returns during the introductory stage.
Early/ Introductory Phase
The early stage of the cycle will likely be characterised by high returns from these ETFs as investors pile up funds into these investment instruments.
The high returns will lead to (1) increased allocation of investable funds by investors which leads to increased demand for these instruments, (2) the high returns earned by early movers will attract other investment banks/market makers to enter the sector and create more ETFs, this will lead to the growth phase. Our take is the market is currently in the introductory phase of the cycle.
Growth Phase
With the market/ investors used to these products, there is going to be increased appetite for ETFs and this will lead to the growth phase.
The characteristics of this phase will be increased allocation of investment funds to these investment products as a proportion of overall portfolio. In addition, the market will see an increase in the number of ETFs being created and listed resulting in oversupply of ETFs. The investment returns from these products remain positive.
Decline Phase
The expectation of high investment returns from ETFs will lead to irrational exuberance emanating from the creation of more ETF products leading to over concentration of risk and poor risk management practices.
The over concentration on ETFs will result in negative returns as investors start to realise that their expectations of high risk adjusted returns aren’t coming true. This may come as a result of the arbitrage opportunity that exists in the ETFs market, itself a result of the structure around their creation.
The negative returns may arise from poor selection of underlying securities that will make up the basket of various ETFs, arbitrage profits earned by AP which reduces the premium or discount that may exist between the ETF prices and the NAV of basket of securities, and oversupply of ETFs which will dampen the appetite for these instruments by the investors.
This will result in a shake out period which will see some ETF closing and the market consolidation with only the best performing ETFs surviving.
ETFs a boon for authorised participants arbitrage opportunity.
Exchange traded funds play a critical role in the rise to passive investing.
Some authors argue that the shift to passive investing is welfare improving, given the drop in transaction cost and the improvement in portfolio diversification that index funds provide.
It is also thought that the rise in passive investing is symptomatic of improved market efficiency as profit opportunities for active managers shrink.
ETFs by their peculiar nature do not conform to the traditional view of passive funds for buy and hold investors. This is because ETFs provide intraday liquidity to their investors, hence they attract high frequency demand which translates into price pressure on the underlying securities due to the arbitrage relation that exist between the ETF and its basket.
This trading activity is potentially destabilizing for the underlying securities’ prices. To compound this effect the lower trading costs of ETFs relative to the underlying securities can increase the rate of arrival of demand shocks to the market.
In particular trading strategies that were non-existent or too expensive without ETFs suddenly become available and/or affordable thanks to these instruments. Noise trading can therefore leave a bigger footprint on security prices because of ETFs suggesting that ETFs may pose new challenges to the efficient pricing of the underlying securities.
Thus, ETFs generally attract short term investors because on average ETFs are significantly more liquid than the basket of the underlying securities in terms of the bid-ask spread, price impact and turnover, making the ETFs preferred habitat of high turnover investors.
ETFs are traded in the secondary market by retail and institutional investors in a similar fashion as closed end funds. However, unlike closed end funds, new ETFs shares can be created and redeemed resulting in a either an increase or decrease in supply of the ETFs available to the market.
Because the price of the ETF shares is determined by the demand and supply in the secondary market it can diverge from the value of the underlying securities (the Net Asset Value).
This scenario creates an opportunity for arbitrage for some institutional investors called (Authorised Participants or AP) who are dealers that have signed an agreement with the ETF provider can trade bundles of ETF shares (called creation units) with the ETF sponsor.
An Authorised Participant can create new ETF shares by transferring the securities underlying the ETF to the ETF sponsor. These transactions are done on the primary market for ETFs.
Furthermore, the Authorised Participant can redeem ETF shares and receive the underlying securities in exchange, while some funds be created and redeemed in cash.
To illustrate the arbitrage process through the creation/ redemption of ETF shares, we distinguished the two cases of :- (1) an ETF premium (the price of the ETF exceeds the NAV) In this case of a premium Authorised participants have an incentive to buy the underlying securities, submit them to the ETF sponsor and ask for newly created ETF shares in exchange.
Then the AP sells the new supply of ETF shares in the secondary market. This process puts downward pressure on the ETF price and potentially leads to an increase in the NAV, thereby reducing the premium (2) an ETF discount (the ETF price is below the NAV In this case of a discount, APs buy ETF units in the market and redeem them for the basket of underlying securities from the ETF sponsor.
The APs can the sell the securities in the market, thereby resulting in positive price pressure on the ETF and probably negative pressure on the NAV which reduces the discount.
Investment Implications
Our view is that the boom bust cycle will take a long time to play out, at which point many investors would have earned significant returns from investing into ETF shares. As a result, our strategy is for investors to participate in the ETF shares market and if possible, take advantage of the arbitrage opportunities that may exist as a result of divergence between ETF prices and the NAV of the underlying securities making up the basket of each ETF through their authorised participants. However, we always urge for caution on the part of investors as there are risks in these instruments hence the need to guard against complacent optimism.
Beware of taking too much risk — falling in complacent optimism The advent of ETFs as an innovative investment instrument in Zimbabwe that is attractive to both retail and institutional investors, we urge caution on the part of investors. One of the benefits being sold to investors is that ETFs will provide your portfolio with diversification.
Our view is that the underlying assets in most of these ETFs are stocks that are listed on the ZSE, which makes the ETF a derivative instrument whose value is primarily determined by the performance of the securities in the underlying basket.
As an asset class the stocks are broadly affected by the same fundamental value drivers, as result ETFs based on stocks provides little benefits in terms of diversification.
The correlation between the returns and risks of investing in direct stocks and ETFs maybe high which exposes investors to concentration risk, thus, as a proportion of overall portfolio the percentage allocation/ exposure to equities increases to levels that may lead to significant losses if there is a negative down turn in the market.
Every investor has an asset allocation, whether they think in those term or not. Holding nothing but cash is an asset allocation or only individual equity investments is also an asset allocation, albeit a highly concentrated one with limited diversification benefits.
The question is not whether one has an asset allocation or not but rather if your asset allocation is in line with your needs and rewards you adequately for the risk you are taking.
We thus just urge caution on the part of investors so that they are fully aware of the level of risk they are taking as they start investing in ETFs and other investment instruments that are coming into the market.
In particular we believe investors should build teams of advisors who are able to help them navigate the new investment landscape without taking undue risk which exposes them to significant losses if markets move against them.
Portfolio Considerations
We advocate for real diversification across broad asset classes namely, equities, bonds, real estate, private equity, commodities and currencies.
This diversification should be premised on thorough understanding of the fundamental value drivers of each asset class, where we are in terms of the economic cycle, the risk and rewards considerations of the investors.
We still expect equities to outperform other asset classes and will consider buying value stocks on any corrections that might happen on the equities market.
Our take is that equities will see a period of uncertainty as markets try to make sense of the developments in the economy and hence search for signs of stability to finally bottom out and create a new base.
While risk remains elevated, equities will still have support of high corporate profits, strong Government spending though subject to potential headwinds from high inflation risk and drop in consumer spending power due to erosion of their purchasing power due to inflation.
ETFs and other derivative instruments that are coming into the market may deepen the capital markets thereby increasing activity on the equities market which we think most retail and institutional investors are traditionally comfortable investing in.
The emergence of the gold coin as an alternative investment asset provides investors with another vehicle through which they can diversify their portfolio holdings and get exposure to the commodities market.
We anticipate that there will likely to be an ETF created which will have gold coins as the underlying security and this will broaden the scope of investing in the market.
Furthermore, as investors seek for risk adjusted returns our view is that it is time for institutional investors to start taking private equity investments as an alternative asset to focus on as it has potential to generate high risk adjusted returns for their portfolios in the medium to long term.
These Capital Markets Insights were prepared by Vukani Simuka Capital, a private equity firm that focuses on providing evidence-based research using both fundamental and technical analysis supported by its strong business analytics and modelling in order to come up with an investment opinion.
For feedback email Martin Jinya : [email protected] and Tendai Jameson Mtombeni :[email protected]
