Urvesh Desai, Portfolio Manager, Old Mutual Investment Group
Local investors may be tempted to have an “everything offshore” mindset following the relaxation of foreign exchange controls by National Treasury to allow regulation 28 compliant funds to invest up to 45% of their assets offshore. However, they should exercise caution when making this decision as achieving the optimum balance of offshore versus onshore exposures across cash, bonds, equity and property asset classes can be a complex consideration.
Deciding to move more assets offshore is not only making a call on global assets versus South African assets, but also a call on the rand.
DIVERSIFICATION MATTERS
There are four main arguments for diversifying a portfolio offshore. First, investors can gain exposure to more companies and industries that are not available locally. The local equity market is concentrated in the financial and mining industries with virtually no exposure to technology industries, like semiconductors, hardware, software or even biotech. The second argument centres on diversification and spreading your risk among many economies, countries, and currencies. In particular, investors enjoy the security that comes from holding assets in hard currencies such as the euro, pound or US dollar. Third, investors believe they can potentially earn higher returns globally than are on offer locally. And finally, there is the notion that taking on greater offshore exposure reduces risk.
THE RAND EFFECT
While we can agree that portfolio diversification makes sense, few appreciate how much of a diversified portfolio’s outperformance derives from the relative performance of the rand versus offshore currencies rather than asset allocation. A South African investor’s experience of global assets is therefore significantly impacted by the rand, which can be particularly volatile.
For example, when a South African investor has a large proportion of assets invested globally, and the rand depreciates, returns on these global assets in rands are boosted. But when the rand appreciates, returns on these global assets can be significantly depressed, pulling the portfolio down.
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INFORMED OFFSHORE ALLOCATIONS
While it can be tempting to invest up to the maximum offshore limit, determining optimum offshore versus onshore exposures in the context of rand volatility can be challenging.
This is especially important for conservative funds or investors who want to preserve capital over the short term. For these risk-averse investors, the optimum global asset allocation tends to be much lower than the regulated cap and one cannot afford to introduce too much capital volatility through foreign currency exposure.
Within the MacroSolutions investment team, we have assessed the impact of the new allowances on optimal asset allocations across our portfolios. We use an approach that is a blend of art and science, employing both fundamental and quantitative elements in our decision making.
The team’s asset allocation optimisation process uses data gathered over decades and begins with a systematic look at thousands of different allocations; assessing how often the required return of a portfolio is achieved; and considering the various risk metrics associated with the long-term asset allocations – including capital preservation where required.
The key take-out from this analysis is that the optimal global exposure for a standard regulation 28 compliant balanced fund is around 35%. This is the case even though the global exposure can now go up to 45%. Having higher global allocations can actually compromise the risk-return characteristics of the fund.
PROCEED WITH CAUTION
While the higher offshore limit allows for much greater flexibility in asset allocation, it does not justify immediately moving global asset allocations up to the maximum offshore limit. Pension fund trustees and other decision makers must proceed on the basis that even when making changes to a fund’s static asset allocations, this is an active decision that will materially impact the returns achieved by the portfolios.
Being able to allocate a larger proportion of assets globally increases the flexibility that our portfolios have, but the volatility created by changing currency exposures can compound any bad asset allocation decisions.
At MacroSolutions, we spend time analysing what the optimum static allocations are for our funds. However, while these allocations are useful for framing what level of allocation is likely to be successful over 20- and 30-year time horizons, we understand that these allocations take no cognisance of the current investment environment or level of the rand and other investments. The actual asset allocations of our funds are based on the outlook for asset classes as well as the currency. This considers both the investment environment (what we call “themes”) and financial market valuations (what we call “price”).
Presently, this requires structuring portfolios to be cognisant of global liquidity tightening; interest rate hikes and higher yields in the US; the ongoing rotation out of growth stocks; high valuations of US equities; and the attractiveness of valuations of South African bonds and equity, among other factors.
Before making an impulsive investment decision, it is advisable to partner with an asset manager that has a long track record in navigating global and local markets.