The ability to invest more offshore due to the relaxation of foreign exchange controls over recent years broadened the opportunity set available to South African savers. In our view, this larger investment opportunity set will support returns while lowering volatility. However, while it has the potential to deliver a more attractive outcome, it may also pose an additional risk to local savers if not correctly managed.
Offshore assets now make up a sizeable portion of most individual investors’ portfolios as well as most 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.
The South African investor has also become more discerning about the value proposition offered by their investment managers given that there is far more choice both of offshore manager and underlying investment strategy compared to even a decade ago. Clients want to partner with a best of breed manager who can compete on a global stage and have an experienced and well-resourced investment team and diversified business model.
Diversification – but at what price?
Portfolio construction theory relies heavily on the concept of diversification, which maintains that holding assets with a low correlation to one another can deliver returns at low or lower volatility. Low or lower volatility is associated with lower ‘risk’. Conceptually, this is an attractive proposition. The proverbial free lunch comes to mind. Diversification is regularly cited as the primary or even only argument for allocating a portion of savings offshore. Most studies achieve optimal offshore allocations of around 30%, the top end of what is currently allowable under Regulation 28. In practice, however, the facts may provide only limited support for this argument.
Two crucial aspects are important to consider: how uncorrelated are the assets in question and which historical returns are used for calculation purposes? Are they really as poorly correlated as the theory of diversification postulates? If not, or not significantly, is the major tenet of diversification and by implication, allocating investment capital offshore not in question?
The second and related aspect to consider is that of prospective returns: do the potential investments offshore provide for fair, reasonable or even superior return payoffs? Or, stated differently, are investors sacrificing returns in their search for lower volatility? If this is indeed the case, lower returns – and lower volatility – may more easily be achieved through a more defensive investment strategy within the home market.
As is so often the case, the answer is somewhat more nuanced than a simple for or against. In our view, the diversification argument only holds when paired with returns that are on par or superior to what may be achieved at home. In other words, our motivation for investing offshore relies heavily on attractive stand-alone investments while mitigating the risk of the overall portfolio of investments.
A completion approach, whereby assets that present both as compelling stand-alone investments and which are complementary to those assets already held, is the best justification for investment outside the home market.
Larger opportunity set requires additional resources
The size of the SA market pales into insignificance compared to both the size (market capitalisation and number of instruments) and breadth of investments (asset and sub-asset classes) available globally. A larger opportunity set naturally allows investors greater choice of investments and hence making investments accurately aligned to their respective and distinct investment strategy.
However, the resources required to effectively make investment decisions in a large, less familiar market may act as a serious handicap to SA investors hoping to achieve a superior outcome to local-only investments. Offshore investing necessitates deep resources, specialist skills and experience across a broad range of asset classes and investment strategies.
In addition, pension fund regulations make specific provision for investing in Africa excluding SA. This limit was recently increased up to 10% of the overall fund. The principles set out previously apply equally. Diversification is a necessary but not sufficient criterion in allocating capital on the continent outside of SA. A larger and more flexible investment universe in the first instance provides opportunity. Unlike indirect exposure attained via local companies with operational exposure on the African continent outside of SA, there is an increasing universe of investments (both listed and unlisted and no longer just confined to equity assets) that have very different fundamental drivers.
Again, if considered in context (with all the associated risks such as liquidity, currency and the political environment), Africa may well feature in local pension funds. Substantial resources need to be employed to appropriately understand, select and monitor these investments.
Implicit exposures not adequately considered
Global investing confronts investors with a level of complexity that managers (and by implication, local savers) are not exposed to within the confines of the SA market. While complexity and deep markets provide opportunity, they are equally capable of adding rather than reducing risk and return to South African investors.
Furthermore, SA investors do expose themselves to risks not adequately considered or not considered at all. One such example is that of currency risk, a natural consequence of allocating capital across different global regions. When investing locally, the impact of currencies’ moves on returns is only indirect: the returns achieved in the local markets are returns achieved in rand.
Global investing requires the constant movement in exchange rates to be considered not only when translating global returns (and volatility) into rands, but also the impact exchange rate movements have on the investment case and portfolio risk. A portfolio of global investments will generally result in exposures to assets denominated in a multitude of different currencies. Volatility may very likely have a material impact on returns to local investors. A weaker yen may obliterate any positive returns to investors in Japanese equities; market shocks may impose a similar reaction across most or all other emerging market (EM) currencies alongside the rand, thereby adding to risk and volatility through any exposure to EM assets rather than offsetting or diversifying risk explicit in local rand investments.
Our approach to multi-asset investing takes these opportunities and risks into consideration and we explicitly manage them in our allocation to non-SA assets. We are clear that the long-term liabilities that we target are local and rand-based. Global currencies form an important driver in achieving these.
Fixed weight allocation – appropriate use of opportunity?
Some investors seem satisfied that as long as they have global investments, whatever the proportion, across a mix of more cyclical and defensive assets, their objective of superior, risk-adjusted returns will be achieved. Far from it, unfortunately. A static or fixed allocation to global assets is neither appropriate nor optimal. While on a stand-alone basis, this seems practical, offshore investors should always consider their global investments in the context of their overall, SA-dominated portfolio. In our view, an allocation to a stand-alone or independent global specialist equity or even multi-asset strategy falls well short of investing globally for local investors. We advocate a more flexible approach where the rest of the portfolio is explicitly and constantly considered. Asset allocation and instrument selection should be responsive to varying market and macro cycles across all aspects of the portfolio, both domestic and foreign and in combination.
Investors are best served by an integrated or a holistic approach to building the portfolio, rather than opting for bolt-on, stand-alone or even third-party allocations managed without thought for the overall portfolio. Integrated management demands dynamically varying allocations to different asset classes, regions and sectors, always informed by the impact on the portfolio as a whole. Third-party allocation is particularly prone to delivering portfolios with higher levels of risk, which are often unrecognised, or which are not managed appropriately, resulting in low return, high volatility outcomes.
If not correctly managed, investing offshore may broaden the investment opportunity set, but pose an additional risk to local savers. Based on our experience, we concluded several years ago that an allocation to offshore assets using 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.