Why You Need An Africa ETF

by on August 21, 2009 | ETFs Mentioned:

“The only man I envy is the man who has not yet been to Africa, for he has so much to look forward to”.

- Anonymous 19th century quote

Van Eck's Africa ETF Is An Interesting Investment PlayInvestors are showing increased interest in using indexing in general (and ETFs in particular) as an efficient and pragmatic way to invest in international markets. Investors have been gradually realizing the importance of long-term international exposure, but the trend has been accelerated because of the recent strong performance of overseas markets relative to the United States, as well as the fact that growth in real U.S. GDP has slowed significantly. As the reality of the “new normal” in the U.S. sets in, investors are looking beyond their borders to improve returns.

Recent upward trends in economies around the world have given investors confidence that the sky is not falling, and that we may have avoided the worst case scenario. Recent news about Germany, France, and Japan emerging from the global recession have acted as catalysts in increasing investors’ appetite for risk. As equity markets gradually recover from the economic beating they took in the global slump, investors are looking for opportunities that will allow them to recover at least a significant portion of their losses. While most ETF investors gain international equity exposure through developed European and emerging BRIC economies, there are several other opportunities available, including the far East and Latin America. But the most intriguing of all international investments may be Africa.

The ETF with the highest exposure to Africa is the Van Eck Market Vectors Africa Index ETF (AFK). AFK seeks to replicate the performance of the Dow Jones Africa Titans 50 Index, which provides exposure to publicly-traded companies that are headquartered in Africa or that generate the majority of their revenues in Africa (in addition to having minuscule Canadian an Australian exposure).

AFK

While a number of ETFs offer exposure to South Africa (it is included in most emerging markets ETFs), AFK has holdings in several less developed African nations, including Nigeria, Egypt, and Morocco. The regional breakdown of the fund is as follows:

Country

AFK is most heavily weighted towards the banking, basic resources, and telecommunications sectors, as shown in the graph below:

Sector

AFK has generated a YTD return of about 28%, and has a net expense ratio of 0.88%. Although correlation was close to one during the recent economic crisis (some would argue just when it was needed the most), African markets have historically exhibited much weaker relationships with developed markets. Unlike many ETFs that focus solely on the South African market, AFK offers more diversified exposure to the continent’s economies.

Cases For Investment In Africa

There are several reasons for investors to be bullish on an investment in Africa now, including tremendous growth potential and an abundance of desirable natural resources.

  • Tremendous growth potential: The continent contains 15% of the world’s population on 20% of its land mass. Economic growth in Sub-Saharan Africa has averaged 6% since 2004.
  • Wealth of resources: Africa has a very high concentration of the worlds natural resources, including 40% of the worlds gold reserves and 30% of minerals reserves.
  • Demand from China: Exports to China have increased by 40% since 2002. China has also been a creditor of sorts to many African countries, providing loans and financial support to countries in need. China’s need for Zambian copper, Nigerian oil, Tanzanian timber, and South African platinum will only increase if its economy eventually surpasses that of the U.S., as many analysts speculate it might.
  • Improved stability: Data shows that many Sub-Saharan countries have emerged from frequent economic and political instability, perhaps none as clearly as Ghana.
  • Profitability: Firms are highly profitable in the region which, in part, can be attributed to low labor costs and improvements in operational efficiency. The average annual return on capital of the companies examined in a recent Harvard study was 65% to 70% higher than that of comparable firms in China, India, Indonesia, and Vietnam.
  • Low correlation with developed markets: African stock markets have a weak correlation with other important international indexes, which means that investments in Africa may offer risk reduction benefits to investor portfolios. Even within Africa, the correlation between equity markets in different countries is low, increasing the diversification opportunities within the region.

Barriers To Success

An investment in an African ETF is, of course, not without its risks. There are a number of significant barriers to the continent’s economic growth, many of which have proved difficult to overcome in recent years.

  • Corruption: The practice is still rife and in many nations there is an apparent lack of political will to deter it. In addition, returns are not reasonably ensured or sustainable because costs can often escalate for reasons unrelated to business operations (i.e., political reasons).
  • Inadequate amount investment in education: Neglect of the educational priorities can lead to a lack of trained or trainable human resources, a major deterrent for foreign investors who seek high levels of productivity.
  • Lack of infrastructure: Transportation and communications infrastructure and equitable trade and employment practices are sine qua non to supporting corporate investment.
  • Inefficient bureaucracies: There is a seemingly endless amount of red tape that makes it difficult for businesses to set up. For instance, in Cameroon, it takes a potential investor around 426 days to perform 15 procedures to gain a business license.

The U.S. Chamber of Commerce conducted an interesting survey, the results of which highlighted the most crucial barriers discouraging investors from investing in Africa. Top management decision makers in 30 leading U.S. multinational corporations participated with a majority being executives of U.S. Fortune 100 corporations. Perceived barriers included:

  • Lack of rule of law (corporate, societal, and criminal)
  • Lack of a sufficient middle class of consumers
  • Lack of a supportive business framework

Risky Play Just Might Be Worth Making

Investment in Africa isn’t for everyone, and may only be appropriate for those with the highest of risk tolerances. While major issues remain that must be addressed before the continent can enjoy true economic prosperity, several steps in the right direction have been taken in recent years. The impression many investors hold of Africa as poor, corrupt, and lawless no longer holds, and continues to be constantly revised. For those looking beyond the usual suspects for international diversification and superior risk-adjusted returns, it might be worth giving Africa a second look.

Mutale Mubanga contributed to this article.

Disclosure: No positions at time of writing.