Investigating the suitability of introducing Index Funds in Kenya

Abstract

The purpose of this study was to investigate the suitability of introducing index funds in the Kenyan capital markets and to formulate a framework for the introduction of index funds. Therefore, the study set out to achieve two objectives: to assess the weak form Efficient Market Hypothesis (EMH) for the Nairobi Securities Exchange (NSE), and to determine whether the current Nairobi Securities Exchange (NSE) stock indices are representative of the Kenyan capital market. These issues emanate from a general problem within the Kenyan capital markets, namely the use of active management strategies that are characterised by hefty management fees as well as other fees. These hefty fees have a negative impact on returns. Index funds are a solution to this problem, because the funds are low in cost and mimic a benchmark index. However, the specific problem is that it is not clear whether factors that are required for the introduction of index funds are in place. Index funds require an informationally efficient market, a market representative index, and an adequate regulatory framework. To this end, the present study sought to address the two objectives mentioned above. The study was carried out from a post-positivism stance, hence the research was a quantitative approach that adopted a correlational design in which timeseries data from the Nairobi Stock Exchange (NSE) was utilised. To achieve the first objective; the serial (auto) correlation test and the variance ratio tests were employed. The linear unit root tests which comprise of the Augmented Dickey-Fuller test, the Philip Perron’s test, and the Zivot Andrews test, were implemented. The runs test was also applied as a confirmatory test. Nonlinear unit root models were also implemented. These comprised of the two regime and the three-regime threshold autoregressive (TAR) tests. Lastly, the Pairwise Granger causality test was applied to test the market representation of the stock indices. The empirical results indicated that the NSE is weak-form inefficient and hence index funds cannot be introduced into the NSE because the Bourse violates the Efficient Market Hypothesis (EMH). On the other hand, three of these indices are representative of the Kenyan capital markets. Thus, index funds can mimic the three indices and be introduced into the market. Based on these results, the framework for the introduction of index funds was formulated. The framework indicated policy suggestions that would enhance informational efficiency within the capital market enabling introduction of index funds.