Dynamic connectedness, hedging effectiveness and investor sentiment among South African sector indices.

Abstract

Over the past two decades, the interconnectedness of markets has surged, intensifying the imperative to understand risk transmission in cross-market portfolios. Similar trends have been seen across different sectors within the same markets. Amidst a myriad of catalysts, investor sentiment has emerged as the most influential force in propelling this connectedness. This study assessed South African sector connectedness, hedging effectiveness, and susceptibility to investor sentiment using a proxy-based composite sentiment index from July 2009 to December 2022. The ADCC-GARCH model, the Diebold and Yilmaz (2015) spillover index and the t-copulas extension were used to gauge dynamic connectedness and hedging effectiveness among sector indices, contingent on prevailing market-wide investor sentiment. The findings show that dynamic connectedness varies among sector indices in the South African market. During financial turbulence, the interconnectedness intensifies due to heightened volatility, resulting in significant spillovers. The financial and industrial sectors were net transmitters, whereas the rest were the net recipients of risk. The consumer services sector had the highest hedging effectiveness when paired with other sector indices. The inclusion of sentiment improved the measurement of dynamic connectedness and hedging effectiveness, as sentiment-augmented models were statistically more robust. This indicates that sentiment significantly influences the dynamic connectedness and hedging effectiveness among indices in the South African market. This study's novelty lies in creating a composite sentiment index specifically designed for the South African market. Further, this study focused on individual sectors rather than broad markets, offering a more granular analysis. Its findings provide valuable insights to investors, portfolio managers, and policymakers, enhancing their understanding of the sectors' intricate dependencies and vulnerability to sentiment. This enables the implementation of optimum diversification, risk management and portfolio optimisation strategies. Through the creation of an investor sentiment measure, an examination of sector-level interconnections, and consideration of the distinctive attributes of the South African market, this study delivers significant insights for both market participants and researchers. The findings have implications for investors, firms and policymakers. They reveal that sectoral return volatility often persists due to irrational trading behaviours, emphasising the need for policymakers to implement regulatory measures to manage volatility shocks effectively. Investors and firms can use these insights to optimise portfolio strategies and improve risk management. Increased volatility connections during economic downturns highlight the importance of understanding how different sector indices react to external shocks for assessing portfolio risks. For policymakers, the findings offer insights into financial risk distribution, information efficiency, and market stability, aiding in the preventing of sector contagion and stabilising financial systems. Firms should consider how capital dynamics are influenced by volatility and factor in sentiment when making investment decisions.