International Journal of Humanities and Social Science                  Vol. 3 No. 21 [Special Issue – December 2013] 
195 
 
The Framework for Index Funds in Kenya 
 
Akama, Thaddeus Onyinkwa  
Jagongo, Ambrose (PhD) 
School of Business, Department of Accounting 
Kenyatta University, Nairobi, Kenya 
 
 
Abstract 
 
The study set out to assess the institutional and regulatory framework for index funds in Kenya. The study 
examined the presence of factors that would support the introduction of index funds. The need for the study 
emanated from the apparent inability of fund managers to outperform the market as represented by an 
unmanaged index. This study builds on the passive versus active management strategies in the Kenya capital 
market. The study looked at the importance of index funds to the financial system and how the index funds would 
benefit the investing public. It also examines the Kenyan investor profile to see whether it matches the investor 
characteristics associated with Index funds. The structure of the capital market and the characteristics of fund 
managers were examined to find out whether they support passive or active investment strategies. Focus was also 
placed on the current state of the legal and regulatory framework and how well investors are protected in the 
Kenyan market. Finally, the capital market was examined to determine the existence of Index funds’ critical 
success factors. There was sufficient evidence of the existence of factors that form the framework for index funds. 
However, a number of issues such as inefficiency of the capital markets, lack of adequate regulation and investor 
protection need to be addressed for the successful introduction of Index funds into the Kenyan Capital market. 
 
Key words: Index funds, passive investment, active investment 
 
Background 
 
Everyone with money to invest is faced with the same problem of forming and managing a portfolio of financial 
assets (Jacob and Petit, 1988).  The science of investment analysis, choice and evaluation is primarily driven by 
risk and expected return (Sears and Trennepohl, 1993).  An important investment management development is the 
Index fund, which is a special type of mutual fund that seek to increase the value of the portfolio in line with a 
benchmark index through partial or fully replication. Recent developments have seen the emergence of index 
funds that reflect personal benchmarks (Moneychimp, 2005), closet indexing where active managers buy stocks 
that  have the largest impact on the index and enhanced indexing where managers add value by over or under 
weighting particular stocks (Custodio, 2005). Currently there are no index funds in Kenya. In the last few years 
there has been an emergence of a number of unit trusts including, Old Mutual, African Alliance, British 
American, Stanbic and Commercial Bank of Africa schemes. 
 
Statement of the Problem 
 
Active management is an attempt to ‘beat’ the market by taking advantage of certain market irregularities to 
achieve higher returns. In contrast, passive management or indexing invests in exactly the same securities and in 
the same proportions as an index on the premise that it is difficult to beat the market (Russell, 2005).  Portfolio 
returns in active management are expected to exceed the return of a passive benchmark portfolio, net of 
transaction costs on a risk-adjusted basis (Reilly and Brown, 2000). In exchange for management fees, investors 
expect professional expertise that generates an above-market return. However there have been increasing concerns 
amongst investors on the inability of fund managers to outperform the market. Jensen (1969) showed that mutual 
fund managers had no ability to outperform an unmanaged index and under-performed the market by an amount 
about equal to the amount of their expenses and fees. This study therefore sought to assess the framework for 
index funds in Kenya. 
 
Hypothesis 
 
The study hypothesized that a framework does not exist for the introduction of index funds in the Kenyan Market.  
 
 
The Special Issue on Social Science Research            © Center for Promoting Ideas, USA           www.ijhssnet.com 
196 
 
Objectives of the Study 
 To assess the institutional framework for index funds in Kenya. 
 To assess the regulatory framework for index funds in Kenya. 
 
Literature Review 
 
Passive Investment Strategies 
 
Passive investment strategies arose in the 1970’s (Sears and Trennepohl, 1993) with the first domestic common 
stock index fund being introduced in 1971 (Sharpe, Alexander and Bailey, 1996). Replication of the targeted 
stock index is attained through (1) full replication technique where all stocks in the index are bought weighted in 
accordance to their market values proportion of the index; (2) the sampling approach where purchases of a subset 
of the index are made which are designed to minimize deviations from the index, and; (3) Partial replication 
which involves the selection of a subset weighted in accordance with the industries represented in the index.  
 
Active mutual funds spend time and effort selecting individual securities or timing their movements into and out 
of the market thereby have greater costs compared to index funds (Jacob and Petit, 1988).  Kiplinger (2003) 
attributes the lower costs of index funds to minimal turnover and therefore less taxable capital gains, staying fully 
invested and lack of stock analyzers and stock pickers to pay. Index fund investing is however not decision-free as 
the investor needs to select which indexes to track, which particular index funds to track them with, how much to 
allocate to each and when to rebalance (Newberry, 2000).  
 
Innovation plays an important role in construction of passive portfolios that are not based on a published index. 
Reilly and Brown (2000) present customized passive portfolios that complement active portfolios, while 
Mossavar-Rahmani (1988) note passive portfolios constructed to track the performance of customized benchmark 
for investors with special needs. 
 
Active Investment Strategies 
 
Active investment strategies attempt to ‘add value’ by profiting from forecasted market movements primarily 
through the use of three approaches namely: market timing approach, management style and factor model 
approach (Sears and Trennepohl, 1993). Market timing strategy focuses on capturing gains in a bull market and 
avoiding losses in a bear market.  Reilly and Brown (2000) recognize three generic market timing themes: of 
shifting funds into and out of stocks; shifting funds among different equity sectors, industries or investment styles; 
and stock picking. 
 
In management styles, a top-down strategy is concerned with industries that are expected to outperform the 
market with emphasis being placed on the big picture rather than individual companies (Chand, 2005). In contrast, 
the bottom-up strategy involves selection of individual stocks that are undervalued and are expected to outperform 
the market with little or no emphasis on the larger picture (Chand, 2005). Factor model strategies select stocks, 
based on factors such as book/price ratio, earnings/price ratio and earnings variability, with the help of computers 
using the Arbitrage Pricing Theory.  
 
Passive Versus Active Investment Strategies  
 
Though a 20-year study in 1989 showed that the S&P Index outperformed more than 80% of the active fund 
managers, investors continue to hire active managers believing they can spot the manager who will outperform 
the index (Elton and Gruber, 1995).  
 
Sharpe (1975) reported that the yearly market timer must be correct 75 percent of the time in order to outperform 
a buy-and-hold portfolio. Droms (1989), extending the study of Sharpe, found out that it was much more 
important to forecast correctly in a bull market than in a bear market. Jeffrey (1984) concluded that the potential 
gains from timing do not compensate for the potential underperformance if the investor is wrong. Sy (1990) 
reported that small investors with no particular skill in market timing would probably lower their portfolio returns 
by attempting to time the market. Chang and Lewellen (1984) found no evidence that fund managers had market 
timing and security selection abilities. However, for holding periods beyond a year, expected returns on stocks 
and long-term bonds have been found to be weakly predictable (Fama and French, 1987; Keim and Stambaugh, 
1986; and Poterba and Summers, 1988). Reilly and Brown (2000) found active management strategies dominate 
indexed portfolio strategies in terms of total funds under management. The findings further revealed that the 
indexed sector was growing quite rapidly with equity indexing far more popular than fixed income indexing.  
 
International Journal of Humanities and Social Science                  Vol. 3 No. 21 [Special Issue – December 2013] 
197 
 
Many investors are happy to pass up a chance of outpacing the market by a point or two for the guarantee of 
matching it – the risk and worry associated with active management outweighs the possible benefits (Kiplinger, 
2003). 
 
Contemporary Issues on Index Funds 
 
Ferris (2000) proposes that indexing will lead to self destruction of markets since all investable funds will wind 
up in stock prices comprising the index leading to insane prices for bankrupt firms with billion-dollar market 
capitalization. Graff and Dugan (2005) faulted this argument pointing out that only 16% of all new investment 
dollars in 1998 came into S&P 500 index funds.  
 
Ferris (2000) argues that if everyone were to put his or her money into a market-capitalization index fund, the 
index would grow ever more and more top-heavy due to the need to buy big-cap stocks until there will be only 
one stock left. The S&P 500 would become S&P 1! Graff and Dugan (2005) countered this argument noting this 
is unlikely to happen since 90% of all equity mutual funds are actively managed. Concerns over the contribution 
of indexing to market inefficiency were raised by Ferris (2000) noting that the prices of stocks in an index have 
stopped driving the index, but rather the index is now driving the prices of stocks. Graff and Dugan (2005) 
recommended the use of index funds even in inefficient markets.  
 
Index Fund Success Factors 
 
The success of index funds hinges on the continued inability of active fund managers to outperform an 
unmanaged index. Richards (2005) notes that though a fund manager might have a phenomenal record the 
investor is not buying his history but rather his tomorrow and nobody knows what tomorrow’s record will 
be.Increasing market efficiency makes it even harder for active money managers to outperform unmanaged 
indexes. Lower net transaction costs coupled with reduced commission costs due to low turnover add value to 
index funds (Browne, 2005).  
 
Empirical research shows that 80% -90% of investment returns have occurred in spurts that amount to 2%-7% of 
the total length of the time of the holding period. The rest of the time, stocks return has been small. Index funds’ 
success is in part due to staying fully invested with minimum levels of cash (Browne, 2005). Longer holding 
periods and lower turnover results in greater deferral of taxable gains and higher after-tax returns. Jeffrey and 
Arnott (1993) showed that active funds trade so much that even when they do beat the index pre-tax they often 
fail to do so after tax. Since active investment strategies are more expensive than index strategies, the active 
investor is going to have lower returns than the average index investor (Sharpe, 2002). 
 
Investment Strategies in the Kenyan Market 
 
The Kenyan investment market is dominated by a handful of fund managers with diverse investment management 
strategies. Old Mutual’s investment philosophy is based on an unambiguous search for value through 
understanding the potential future income stream of an asset and the value to be placed on that income stream 
(Market Intelligence, 2005). AIG Global Investment Company, the second largest fund manager, focuses on 
producing consistent and superior investment performance through researching on investment opportunities that 
add value to clients’ portfolio (Market Intelligence, 2005). Genesis Kenya, the oldest fund manager, has adopted a 
bottom-up approach which examines all traditional measures of value with emphasis on a stock’s current price 
relative to its future earnings potential within a 5-year horizon (Market Intelligence, 2005). At African Alliance 
Kenya investment management revolves around asset allocation and stock picking guided by an analytical 
research process (Market Intelligence, 2005). None of the key investment managers adopt a passive investment 
management strategy. 
 
Legal and Regulatory Framework 
 
The regulatory framework provides guidance on standards of governance and mechanisms for investigating 
allegations of abuse and mismanagement. It promotes and encourages a greater degree of transparency in the 
administration and management of Unit trusts (FSA, 2005). Kogi (2003) found investor protection sufficient with 
disclosure requirements and screening rules limiting institutional risk.Low liquidity, volatility of returns, low 
levels of activities, lack of credit rating agencies, lack of international integration and mispricing of securities 
characterize the Kenyan capital market. It is necessary that the capital market should be developed in a structured 
way, ensuring that both sides of the demand and supply equation develop at similar paces (Market Intelligence, 
2005).  
The Special Issue on Social Science Research            © Center for Promoting Ideas, USA           www.ijhssnet.com 
198 
 
The Kenyan market has two indexes; the NSE 20-share Index and the AIG 27-share index. Odera (2000) found 
the NSE 20-share index unsuitable for measuring long term market performance as it had understated price rises 
by as much as 12%. 
 
Study Methodology 
 
The population of the study consisted of the Capital Markets Authority (CMA), the Nairobi Stock Exchange 
(NSE), unit trust companies (2), Central Depository and Settlement Corporation (CDSC), investment banks (11), 
authorized depositories (6), venture capitalists (2), stockbrokers/investment advisors/fund managers (38) in the 
Kenyan Capital market. The study used primary data collected using a questionnaire. The completed 
questionnaires were edited for completeness and consistency.  The data was analyzed using Statistical measures to 
produce descriptive statistics. Comparative analysis was done to identify any differences in views from different 
capital market players. 
 
Research Findings and Discussion  
 
Importance of index funds to the financial system 
 
Index funds will promote the structured development of the Kenyan Capital Market, spur economic development 
and attract foreign capital. Granting of tax incentives accelerates the growth and uptake of index funds.  
 
Investor characteristics in the Kenyan financial market 
Investors were found to have little tolerance for price fluctuations and volatility in the stock market. Though 
investors valued liquidity, affordability and lower costs, they had little preference for diversification. Most 
investors were willing to pay higher fees in return for possibility of higher-than-market returns, expert analysis 
and investment advice. Most investors believed that they can spot a manager who will outperform the market but 
surprisingly chose their fund manager by word of mouth rather than by performance or independent analysis. 
 
Capital market framework in Kenya 
 
Inefficiency of the capital market was evidenced by the existence of mispriced securities. The NSE 20 share index 
was found to be an inaccurate reflector of market performance. The prevalence of low analysts’ coverage of small 
companies increased the number of underpriced small company stocks. Moderate charges and levies on trading 
transactions enhanced market liquidity. However, high listing fees hindered capital market development. 
 
Fund managers in Kenya 
It emerged that Kenyan Fund managers cannot consistently beat the market and neither could their management 
fees be compensated by the incremental returns accruing from their management skills. The study found that 
some fund managers depended on technical analysis and the stock picking skills to outperform the market. Market 
timing, stock selection, bottom-up strategy, growth strategies and value strategies were the most favored 
investment strategies while passive strategies, sector/industry rotation and top-down strategies were least 
employed. 
 
Legal, regulatory and political frameworks in Kenya 
 
There was no agreement on the conduciveness of licensing requirements to the ease of entry and exit of market 
players. The study indicated strongly that the current regulatory practice and market structure does not support the 
correct pricing of securities. The study found a lack of a standard model for pricing IPO’s and secondary market 
securities. There was low-level support for enforcement of capital market laws byjudicial and political systems. 
 
Investor protection in Kenya  
 
Heavy reliance on formal investment limits was found to be a sustainable approach to delivering high levels of 
investor protection. Investment safeguards were found to be sufficiently robust to address emerging risks in 
collective investment schemes management. Reduction of financial crimes was credited to the effectiveness of 
Kenyan financial services regulators. The findings caution that relaxation of listing rules could worsen investor 
protection. One interesting finding of the study was that financial crimes such as money laundering were not 
comprehensively covered under the CMA rules and regulations as compared to the Banking Act which had more 
elaborate measures to curb financial crime. The Kenyan financial market lacked alternative systems of dispute 
settlement. 
 
 
 
International Journal of Humanities and Social Science                  Vol. 3 No. 21 [Special Issue – December 2013] 
199 
 
Current state of the regulatory framework in Kenya  
The study found high levels of regulatory compliance. However, the Kenyan financial legal framework weakly 
adhered to international standards. There was inadequate practice of anti-money laundering, professional secrecy, 
insider dealing and market abuse laws. The regulatory framework included mechanisms for investigating 
allegations of abuse and mismanagement.  
 
Critical success factors for index funds in Kenya  
 
A significant number of investors were content to receive a return equivalent to the market return and valued 
surety of achieving a market return over the possibility of above-market returns. The study was inconclusive as to 
whether or not the increased efficiency in the Nairobi Stock Exchange makes it difficult for managers to 
outperform stock indexes. Actively managed funds exhibited high turnover with increased commission costs and 
lower returns. The private sector had adequate capacity to develop and sustain a market index. 
 
Conclusions 
 
Index funds will spur development and increase confidence in the capital market. However, caution needs to be 
exercised in launching index funds as the market maybe immature and poorly regulated to support such 
instruments. Index funds are exposed to price fluctuations which does not augur well with investors’ low 
tolerance level. Kenyan investors are willing to pay higher fees and would therefore favour active management of 
funds over index funds.  
 
Index funds thrive in efficient markets where opportunities for outperforming the market are rare. The 
inefficiency of the Kenyan market creates mispriced securities that offer opportunities for above-market returns. 
These portends negatively on the marketability of Index funds. Increasing research work in the Kenyan Capital 
market will lead to market efficiency by eliminating mispriced securities hence strengthening grounds for index 
funds. Index funds are tailored on a market representative index. Both the NSE 20 share index and the AIG 27 
share index are not seen as being representative of the market. The success of index funds will therefore depend 
on the development of a more representative market index.Market trading costs remain high favouring index 
funds which offer higher returns due to their lower trading costs. However, strong sentiments that fund manager’s 
experience and reputation matters more to Kenyan investors than the cost of their services portends negatively on 
the success of index funds. 
 
Index funds stand a better chance of success by the development of standard models for pricing IPO’s and 
secondary market securities to address mispricings.  Judicial and political systems reform will support the 
enforcement of regulations, create confidence and reduce financial crimes. Alternative systems of dispute 
settlement should be established and regulatory standards elevated to international standards. The Kenyan 
government should encourage Collective Investment Schemes to set up index funds by offering lower tax rates 
and supporting private sector initiatives to develop alternative indexes. Impediments to achieving market 
efficiency at the Nairobi Stock Exchange should be minimized and the current regulatory structure strengthened. 
The transactions costs should be lowered to enhance market liquidity and increase returns.  
 
Recommendations 
 
The government should spearhead the use of Capital Market as an avenue for tapping domestic savings and 
channelling them into profitable investments. All market players should strive to increase the level of awareness 
and participation of investors in the capital market. The regulators should facilitate removal of impediments to the 
efficiency of the capital market. Financial analysts should give adequate coverage to all companies to eliminate 
mispricing of securities. The regulators should introduce proper pricing mechanisms. Market players should lobby 
for enhancement of tax benefits granted to capital market instruments. The private sector should be encouraged to 
develop alternative indexes rather than rely on the NSE 20 share index and the AIG 27 share index. Revisions to 
stock indexes should be carried out frequently to align them to changes in the economy.  
 
Licensing requirements should support the ease of entry and exit of market players.  There is a need for the 
judicial system to support the enforcement of regulations and legislations in the Kenyan capital market. The 
resource capacity of the Capital Market Authority needs to be improved to ensure effective policing. Listing rules 
should not be relaxed but alternative systems of dispute resolution need to be put in place. The legal framework 
needs to be improved to international standards. The regulatory rules should promote innovation and provide 
more flexibility for the development of new approaches to deliver returns for investors.  
The Special Issue on Social Science Research            © Center for Promoting Ideas, USA           www.ijhssnet.com 
200 
 
References  
 
Arnott R.D., Kelso C., Kiscadden S. and Macedo R., 1989, Forecasting Factor Returns: An Intriguing Possibility, 
Journal of Portfolio Management, Vol. 16, fall, pp 28-35 
Bernstein P.L., 2003, Points OF inflection: Investment Management Tomorrow, Financial Analysts Journal, 
Jul/Aug  
Chang E. and Lewellen W.,1984, Market Timing and Mutual Fund Investment Performance, Journal of Business, 
Vol. 57, Jan, pp 57-72 
Collective Investments Schemes Regulations, 2001, Government of Kenya 
Droms W., 1989, Market timing as an Investment Policy, Financial Analysts Journal, Vol. 45, Jan/Feb, pp 73-77 
Elton E.J. and Gruber M.J.,1995, Modern Portfolio Theory &Investment Analysis, 5th Edition, pp 687 – 703 
Fama E.F. and French K.R.,1987, Dividend Yields and Expected Stock Returns, Unpublished Manuscript, 
University of Chicago  
FSA, Financial Services Authority, Common Investment Funds - A basic guide to their regulation,  
www.fsa.gov.uk , 2005 
Ferris J.M., 2000, Index Bomb: A popular Investment Theory Knocks Markets Out Of 
Whack,www.thestreet.com/funds 
Graff T.D.D. and Dugan J.M., 2005, Why Critics of Index Funds Are Wrong, Cavanaugh Capital Management, 
IndexFunds.com, Inc, www.Hussman.com,  
Jacob N.L. and Petit R.R., 1988, Investments, 2nd Edition, Richard Irwin Inc 
Jeffrey R., 1984, The Folly Of Stock Market Timing, Harvard Business Review, Vol. 62, Jul/Aug, pp 102-110 
Jensen M., 1969, Risks The Pricing of Capital Assets and The Evaluation of Investment Performance, Journal of 
Business, Vol. 42, May, pp 167 - 247 
Keim D.B. and Stambaugh R.F., 1986, Predicting Returns in the Stock and Bond Markets, Journal of Financial 
Economics, Vol. 17, Dec, pp 357-390 
Kiplinger Washington Editors, 2003, Boring, boring, boring: Index Funds aren’t very exciting. All they do is 
make money, Kiplinger’s Personal Finance Magazine, March Vol. 57, pp 34-38 
Kogi W., 2003, The Future of Collective Investment Schemes in the Kenyan Capital Market,  
Malkiel B., 1973, Efficient Market Hypothesis, A Random Walk Down Wall Street 
Market Intelligence, 2005, Kenya’s Investment Market: How Fund Managers are shaping it up, Apr/May, PP 14 
– 33 
Mossavar-Rahmani S., 1988, Customized Benchmarks in Structured Management, Journal of Portfolio 
Management 13, # 4, summer, pp 65-68 
Newberry J., 2000, Safe Harbor Over Time, ABA Journal, Vol. 86, Issue 6June, pp 92 
Reilly F.K. and Brown K.C., 2000, Investment Analysis and Performance Management, 6th Edition, The Dryden 
Press 
Sears R.S. and Trennepohl G.L., 1993, Investment Management  
Sharpe W., 1975, Likely Gains From Market Timing, Financial Analysts Journal, Vol. 31, Mar/Apr, pp 60-69 
Sharpe W.F., Alexander G.J. and Bailey J.V., 1996, Investments, 5th Edition, Prentice –Hall of India, ,pp 880 – 
964 
Sy W., 1990, Market Timing: Is it a Folly? Journal of Portfolio Management, Vol. 16, summer, pp 11-16