Investing in Africa is not as risky as you might think

Faced with a general perception that investing in Africa was for thrill-seekers only, African equities fund manager Cornelis Vlooswijk decided to find out the facts. The first conclusion of his research was no surprise. “As one would expect, the volatility of individual African countries such as Egypt, Kenya and Nigeria is indeed very high,” he says.

But that’s not the end of the story. For one thing, Africa as a whole is not as volatile as the individual countries. “A regional African index such as the MSCI Emerging and Frontier Markets (EFM) Africa ex-South Africa—a combination of Egypt, Morocco, Nigeria, Kenya, Mauritius and Tunisia—is much less volatile,” explains Vlooswijk. (See the text box “How we went about discovering Africa’s low volatility” for more on Cornelis’s methodology.)

Now, regional indices are always less volatile than the weighted average of underlying country indices. But in Africa, this effect is relatively strong.

Historical data suggests that African stocks are less risky than most people think

So much so that Africa is actually less volatile than the other emerging markets regions. Vlooswijk discovered that an AFRICA composite (comprising 50% MSCI South Africa and 50% MSCI EFM Africa excluding South Africa with monthly rebalancing) is less volatile than all the regional sub-indices of the MSCI Emerging Markets. That’s not all. “It is also less volatile than the overall MSCI EM,” he says.

Low correlation between African countries

How can this be? The low volatility of the African stock indices can be explained by the low correlation between African countries. This makes sense because in African countries local political developments often have more impact on the earnings and outlook for local companies than what happens either in global financial markets or in other African countries.

“We believe this effect is stronger than for other emerging regions, as most African countries are less integrated into the world economy,” says Vlooswijk.

Indeed, at 0.36, the correlation between South Africa and the combination of the other African countries is low. This means an all-Africa investment fund should be much less risky than funds for South Africa only or for Africa excluding South Africa.

High returns at lower risk

Chart 1 shows that Africa is a positive outlier in terms of risk/return profile. In the ten-year period researched, Latin America had the highest standard deviation and also the highest realized return. This can be explained by its high exposure to industrial commodities. At the other end of the spectrum are developed markets, with a low standard deviation but also low returns.

Africa stands out with a high realized return and a remarkably low standard deviation. Africa had a much higher return than developed markets, with only a little extra volatility. Moreover, compared with both emerging markets and frontier markets, Africa had a higher return and lower volatility.

MDD confirms risk reduction of intra-Africa diversification

In his analysis, Vlooswijk used standard deviation to measure risk. But there is another measure that can be used: maximum drawdown, or MDD. The finding that diversification within Africa reduces risk effectively is confirmed by the MDDs.

The MDD for Africa ex-South Africa is much lower than for the weighted average of the individual countries. And the MDD for the AFRICA composite is lower than for each of its two components. Compared with other regions, Africa scores even better on MDD than on standard deviation.

There’s a strong case for including some Africa exposure in global investment portfolios

MDD had one further revelation up its sleeve. Much to Vlooswijk’s surprise, Africa even has a lower MDD than developed markets. This was because South African, Egyptian and Kenyan banks fell much less than their peers in the developed world in the 2007-2009 downturn.

“While this does not mean that Africa will fare better than developed markets in each global crisis, the historical data suggests that African stocks are less risky than most people think,” he says.

Low correlation with the rest of the world

So far, Vlooswijk’s analysis has focused on Africa’s good risk/return performance on a stand-alone basis. But for global portfolio decisions, the correlation of Africa with other regions is also crucial. And once again, the historical data provides good news for Africa. The correlation of the AFRICA composite with global indices and other emerging regions is relatively low:

• Correlation with developed markets is only 0.69 (much lower than 0.84 between EM and developed)
• Correlation with emerging markets (including Africa) is 0.80; correlation with non-Africa emerging markets is 0.72

This has important implications. “The relatively low correlation of African equities with other equity indices opens up an opportunity to make global portfolios more efficient in terms of risk and expected return,” notes Vlooswijk.

African equities can improve a portfolio’s risk-return profile

Chart 2 shows the effect of adding African equities to a portfolio over the last ten years. Adding 10% or 20% of Africa to a developed markets, an emerging markets or an all countries (80% developed, 20% EM) portfolio would have reduced the volatility of each portfolio.

Despite the favorable historical data, Vlooswijk does not recommend a substantial stake in Africa for a global portfolio. Yes, it would have worked out great from a risk/return point of view in the last ten years, but he points out that coincidence might have played a role in this.

“While we believe that the correlation of Africa with the rest of the world will stay relatively low, we cannot expect Africa to outperform developed markets again by 10% per year in the next decade”, he cautions.

Having said that, the prospects remain bright. “Our expectation that Africa investors will continue to be rewarded for taking risk and the low correlation with other indices, combine into a strong case for including at least some Africa exposure in global investment portfolios,” he concludes.

How we went about discovering Africa’s low volatility

Vlooswijk calculated standard deviations based on monthly returns in euro over the last ten years. He used total returns in EUR from 31 May 2002 to 31 August 2012. For most African markets, there is no data available before May 2002. Despite weekly returns giving more favorable outcomes for African equities, Vlooswijk used monthly returns, as he believes that they provide a more realistic picture. He notes that sometimes African equities react with a small time lag to global events.