Higher offshore limits should support returns while lowering volatility
Changes to the offshore investment limits announced in this year’s budget speech have increased the maximum (non-SA) allowance of a Regulation-28 fund to 40%, comprising 30% non-African investments and 10% to Africa (ex-SA). Investec Asset Management welcomes the increased limits as they broaden the opportunity set available to South African savers and are more closely aligned to our own estimates of the optimal geographical allocation of SA savings. In our view, this larger investment opportunity will support returns while lowering volatility. Twenty years ago, institutional investors could only invest up to a maximum of 10% outside of SA. Multi-asset funds were thus predominantly local investments, exposed only to the SA economy and local market dynamics. Today, the non-SA exposure makes up a meaningful stake of any member’s retirement savings. The recent announcement raises the prospect of further increases to non-SA exposure. While this has the potential to deliver a more attractive outcome, it may also pose an additional risk to local savers if not correctly managed.
Below, we set out the key considerations in managing long-term retirement savings for South African investors in the context of increased global flexibility. In short, this opportunity requires greater responsibility from asset allocators and trustees of retirement funds in making investment decisions.
What are the risks when managing local and foreign assets independently?
Offshore assets now make up a sizeable portion of retirement funds. Yet, these assets are often managed independently by third-party managers as stand-alone portfolios. When separating the on- and offshore asset allocation and asset selection decision, the combined portfolio may generate a suboptimal risk-return outcome. By not explicitly recognising and managing the interdependence of various parts of the portfolio, investors are exposed to:
- Increased volatility of the overall portfolio as a result of unintended risks.
The risk is highest where exposures or investment themes are replicated across different parts of the portfolio, independently. For example, adding more emerging market (EM) risk to a multi-asset portfolio may be an attractive investment and a good diversifier for a global investor, but not necessarily for an SA fund. When offshore and onshore assets are too closely correlated, the overall portfolio could have too much exposure to an asset class, equity sector or specific macroeconomic factors. Increasing the overall volatility in a portfolio could result in significant potential downside risk.
- The inability to act in a coordinated and consistent manner to new and changing investment opportunities.
Material changes within the on- or offshore component of the portfolio, will have an impact on the return profile of the overall portfolio. Where such changes are made independently, often by different investment managers due to separate mandates and/or different objectives, the resultant portfolio may lack a clear and risk-aware positioning. Even a broad, philosophical alignment between different managers is not enough to adequately manage the overall portfolio when decisions are taken independently.
- A lack of proper risk control. When clients, their consultants or investment managers outsource the on- or offshore assets to different managers, the access to real-time information of underlying investments can be severely compromised. The lack of see-through data makes proper risk control of the fund near impossible. In such cases, underlying assets may only be known to clients or even the manager of the portfolio after long delays. Material exposures or near identical bets may be unknown to the manager of the portfolio.
- Cost implications. Outsourcing the offshore portion of a portfolio to other offshore managers could result in additional layers of investment management fees.
In summary, a combination of stand-alone strategies tends to result in a suboptimal outcome. The risks pointed out above are further amplified in light of the increased capacity to allocate capital offshore.
Factors to consider when selecting a fund manager
As the domestic and global assets form part of a single integrated portfolio, an investment manager should ensure that the assets are complementary. Hence, appointing a manager that has the ability to manage the on- and offshore assets of a retirement fund holistically is crucial. Here are some important questions to consider when assessing fund managers:
- Has the manager clearly defined its geographic approach?
Is there a consistent philosophy and process with regard to managing domestic and offshore assets and therefore in terms of the overall portfolio? Does the manager currently have full insight into all assets held and decisions being implemented in the portfolio it manages for clients?
- Does the manager have the necessary skill set – both locally and offshore – to be an effective allocator and selector of both domestic and global assets?
- Does the manager have a static, passive approach to the asset allocation and/or selection of global assets? Such an approach may not be sufficient to enhance total risk-adjusted returns for pension savers.
A holistic approach to managing offshore and onshore assets
In managing the Investec Balanced strategy, we believe maximising returns for our investors in a consistent and risk-aware manner is key. We continuously seek to improve and refine our investment process. Over the last few years we have made significant enhancements to the way we manage our offshore assets within the Investec Balanced strategy, mindful of key strategic considerations:
- Increases to the Regulation-28 offshore allowance over time
- Material changes to market composition and investor participation
- Enhancement of risk management and portfolio construction
- Full integration of our local and offshore investment team
Our review concluded that the allocation to independent/stand-alone strategies or third-party managers was clearly suboptimal, as outlined above. We follow a holistic approach, considering our offshore investments on a total portfolio basis. Besides meeting our investment criteria, investments are selected and sized on the back of their fit with the rest of the portfolio to achieve a consistent and coherent overall multi-asset strategy.
Figure 1: A holistic investment approach in the Investec Balanced strategy
Source: Investec Asset Management.
At Investec Asset Management, this holistic approach is supported by the fact that we have access to a broad internal skill set of asset allocation and asset selection professionals who cover the global investment markets. Our globally integrated investment team, based in London, Cape Town, New York and Hong Kong, has the depth and breadth to uncover compelling investment opportunities that are appropriate for SA investors. In this way, our SA clients benefit materially from the collective investment insights from our global investment team, with portfolio construction implemented in a targeted, holistic and ‘SA-client specific’ manner.
How do we manage our completion strategy within the Investec Balanced strategy?
Irrespective of where the assets might be listed, we follow our clearly defined completion approach which is based on two core dimensions:
- Investment opportunity – how compelling is the investment case? Based on our investment philosophy, we consider valuation, fundamentals and trends in investor behaviour.
- Complementarity – do we expect the potential investment to enhance the risk-adjusted returns in the overall portfolio? Here we consider the relationship with existing assets and potential alternatives across the whole portfolio.
Figure 2: Our preferred investments score well across two dimensions
Source: Investec Asset Management.
As per Figure 2 above, we consider the best investment ideas to be those assets that represent a strong investment case and that display attractive (uncorrelated) risk characteristics (Quadrant 1, top right). For example, we believe Japanese and European equities are currently attractive investment opportunities. They offer significant value against a positive fundamental global backdrop where earnings sentiment is supportive. Besides representing a strong investment case (based on valuation, fundamentals and sentiment), these developed markets provide access to industries that have little or no exposure to South Africa. So these assets meet both criteria, namely investment opportunity and complementarity.
Quadrant 2 (bottom right) represents those assets with a very strong investment case, but a material allocation may not be optimal because the potential investment is highly correlated to domestic assets. For example, in 2017, the outlook for EMs was considered favourable in terms of earnings, valuations and an improving fundamental environment. However, other EM equities are typically highly correlated to SA equities, especially in times of increased global market volatility. By investing in other EM equities we could be increasing the downside risk of our clients’ assets should a period of heightened volatility unfold. We have seen some signs of this during the second quarter of 2018. Therefore, we would need to have an extremely high investment conviction to justify even a modest allocation to assets reflected in this quadrant.
Quadrant 4 (top left) are those assets that would typically complement our existing holdings, but the investment case may not be that strong. For example, based on market trends over the long term, developed market government bonds are highly uncorrelated to SA equities. Holding developed market bonds alongside SA equities would therefore enhance the risk profile of the portfolio, especially in times of increased global equity volatility. This is one of the primary reasons why a number of long-term passive strategies, which ‘optimise’ the appropriate offshore allocation, will typically propose a high allocation to developed market bonds. However, global developed market bonds are currently not a preferred investment choice due to their limited return potential. At present, we only invest in this asset class tactically when there are some perceived risks in global equities.
Our investment process is integrated with our internal global investment team members who manage investments on a cross-asset basis. We are therefore not constrained by a limited skill set confining us to unattractive investments (as per Quadrant 3). In practice, each opportunity will be a balance between the strength of the investment case and the role the investment plays in the total portfolio.
How do our clients in the Investec Balanced strategy benefit from our approach?
By adopting a holistic approach (completion strategy) to our onshore and offshore assets, we have managed to generate attractive risk-adjusted returns for our investors. This is evidenced in Figure 3 which shows the annualised return and risk from the end of March 2014 to the end of June 2018. Over this period, global equities (in rands) were the best performing asset class.1 As shown in Figure 3, Investec ‘Completion’, our high conviction completion approach (which reflects the offshore component of Investec Balanced), resulted in significantly higher returns than that of global equities. That said, this higher return came with higher risk, when measuring the volatility of returns on a stand-alone basis. However, our focus on complementarity is key. By adding our ‘completion’ offshore assets to our domestic-only Balanced portfolio, a better return is achieved, than if we just added global equities (best performing asset class) to the domestic assets. What’s more, our emphasis on complementarity actually reduced the risk for our investors.
Figure 3: Investec Balanced strategy’s completion approach has added to returns and reduced risk
Source: Investec Asset Management, Bloomberg, 31.03.14 to 30.06.18. Investec Domestic Balanced + Completion (75%/25% respective weights, rebalanced monthly); Investec Domestic Balanced + Global Equities (75%/25% respective weights, rebalanced monthly). All returns are gross of fees.
Higher offshore limits for Regulation-28 funds broaden the investment opportunity set available for retirement savers. While this has the potential to deliver a more attractive outcome, it may also pose an additional risk to local savers if not correctly managed. Based on our experience, we concluded a number of years ago that an allocation to offshore assets through the use of independent/stand-alone strategies or third-party managers was suboptimal. In response, we adopted a holistic approach, considering our offshore investments on a total portfolio basis. This implies full sight of all assets and control over them, both local and offshore. Our approach requires constant evaluation of the interaction and correlation of different assets across geographies. We believe this is the only solution to appropriately enhance diversification and therefore the risk-adjusted returns for our investors. This approach has been a key contributor to enhancing the return and reducing the risk for our investors. The positive contribution from our completion approach should continue to contribute to risk-adjusted returns going forward, especially as the ability to increase the allocation to offshore assets has been increased.
1Period is since inception of Investec Completion strategy (31.03.14) to 30.06.18. ‘Broad asset classes’ (annualised returns in rands from 31.03.14 to 30.06.18) references Global Equities (MSCI ACWI, 14.0% p.a.); Global Bonds (Barclays Aggregate Global Bond Index, 7.1% p.a.); Global Cash (US Libor, 7.1% p.a.); SA Equities (SWIX, 7.7% p.a.); SA Bonds (ALBI, 8.0% p.a.) and SA Cash (STeFI Composite, 7.0% p.a.).
All information and opinions provided are of a general nature and are not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an adviser or in a fiduciary capacity. No one should act upon such information or opinion without appropriate professional advice after a thorough examination of a particular situation. We endeavour to provide accurate and timely information but we make no representation or warranty, express or implied, with respect to the correctness, accuracy or completeness of the information and opinions. We do not undertake to update, modify or amend the information on a frequent basis or to advise any person if such information subsequently becomes inaccurate. Any representation or opinion is provided for information purposes only. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Investec Asset Management (Pty) Limited is an authorised financial services provider. Issued by Investec Asset Management, August 2018.