The value of investing offshore
Overview
Since the dawn of our democracy South Africans have had a special focus on offshore investments. Having been previously unable to externalise assets, widening of the opportunity set has had a natural appeal. The restrictions on offshore investment have been progressively relaxed over the years, starting out at 5% in the mid 90's and growing to 30% (with an additional 10% to Africa) in 2018.
Most recently in the February 2022 budget, the regulatory offshore limit was further relaxed to a single limit of 45% (although disclosure on African investments is still required). With offshore assets growing from zero to potentially almost half of a portfolio, it is important to consider what allocation to offshore assets is most suitable for investors.
The pros and cons of offshore
The value of diversification is widely advertised by the investment industry and is intuitively akin to the adage of not putting all your eggs in one basket.
South Africa accounts for 0.5% of the world's GDP and around 0.4% of the world's market capitalisation (source: Bloomberg World Exchange Market Capitalization Indices), so diversifying beyond its borders seems a sensible approach. Access to foreign markets widens the available opportunity set and gives investment professionals a broader set of options to choose from when making investment decisions. There are additional asset classes, sectors/industries, a wide variety of companies and a broader range of investment vehicles or instruments. Additionally, various markets will have different underlying drivers and conditions, from valuations to the stage of a market cycle.
However, it is by no means a foregone conclusion that this broader opportunity set will result in superior investment outcomes. Appropriate selection and combination of these investment opportunities is no mean feat, and with the literal world at your disposal the task can be overwhelming. Whilst these risks are present in local investments as well, the wider universe and complexity increases the potential for negative outcomes and thus caution is recommended. A good risk mitigation strategy is to keep things simple, stick to the stated investment process and philosophy, avoid investments which cannot be adequately understood, and focus on aligning portfolios to the investment objectives.
The Rand volatility can further complicate matters and return profiles of offshore investments are heavily influenced by the currency, thus requiring careful consideration. Over time the Rand tends to depreciate (adding to the value of offshore investments in local currency) and importantly it does tend to weaken during times of market stress (see Figure 1 above), cushioning the impact of ailing offshore assets in the overall portfolio. This is not always the case though, as demonstrated by the Rand strength during much of the recent market volatility amidst the Russia - Ukraine conflict.
Offshore exposure is an important tool in an investor's toolkit, but it is fraught with difficulty and should not be approached lightly. It is however a worthwhile pursuit and has demonstrated value to investor portfolios over time.
Does offshore exposure align to client goals?
An important philosophy within FNB Wealth & Investments is an unwavering commitment to designing investment solutions which are aligned to client needs and goals. This starting point greatly influences how our portfolios are both constructed and managed.
Clients have a variety of needs, meaning that the role of offshore exposure can be viewed through different lenses. Most clients will have primarily South African liabilities and a desire to maintain the purchasing power of their assets while growing capital over time. To these clients, offshore exposure serves the general purpose of diversification as mentioned earlier in this note. However, if a client intends on educating their children offshore, then hard currency exposure (e.g. US Dollars, Euros and Pounds) has the effect of matching those liabilities, protecting their assets against a devaluation relative to their foreign liabilities, and the magnitude and nature of offshore exposure in their portfolio will differ.
Whilst these are simple examples the point is that there isn't a single answer as to the "right" level of offshore exposure, and clients' objectives will very much influence the optimal result. The regulations now allow greater flexibility and what remains is to test the impact this expanded flexibility can have on portfolio outcomes. If the new regulations can materially affect outcomes, then a considered approach to how we allocate offshore is required - starting with how we define the universe of offshore assets, all the way to the consideration of hedging currency risk.
Analysing the value of offshore exposure within a portfolio
In our approach to building client solutions, we produce a range of risk profiled solutions with different real return targets, as can be seen in Figure 2 below. These portfolios have both risk and return objectives to ensure clients' journeys are clearly defined in order to better manage their experience. For simplicity we will refer to these as Low, Medium and High risk/return portfolios, where the High risk/return portfolio is akin to a traditional "Balanced Fund".
The focus on both risk and return is especially relevant when considering offshore allocations, as increasing offshore exposure introduces additional volatility (primarily through the volatility of the Rand) creating the danger of breaching risk limits or failing to meet return targets - if the offshore allocation is made carelessly or is too high for the risk profile of the fund. The ultimate solution therefore depends on the ability of the portfolio to protect against some of this currency volatility, via traditional methods like currency derivatives or an alternative approach aimed at importing pure dollar denominated returns into the portfolio outcome.
The effect of a Rand-based investor holding global equities is shown below - while over the long-term, the devaluation of the Rand has resulted in an augmentation to total returns, it also increases the breadth of potential outcomes, especially over the shorter term. Strong offshore equity performance could be coupled by a weakening Rand, giving strong returns - but weak offshore equity performance could also be coupled by a strengthening (or stable) Rand, only serving to exacerbate those weak returns.
Our analysis, considering real return targets and risk constraints, shows that there is value in a marginal increase in portfolio allocation to offshore assets in the low and medium risk portfolios. That the scale of the changes is small is unsurprising, as the risk budgets are smaller in these portfolios, and our allocations were already much lower than the previous 30% limit. In addition, the investment horizons are significantly shorter for these solutions - and in the shorter term, currency volatility has a greater effect on the likelihood of benchmark outperformance due to the impact on entrance and exit offshore asset prices. Including new, alternative sources of yield in the investible universe also shows value - especially since we know that in times of crisis correlations increase dramatically, holding offshore assets which offer diversification benefits is of great importance for ensuring capital protection.
However, the analysis in the high-risk portfolio is interesting and provides two potential answers. If no currency hedging is possible then the ideal long-term strategic allocation is around 35% - already an increase to our current positioning - but if currency hedging is possible then exposure can be taken even further to the maximum 45%.
Importantly, these are long term strategic allocations used as "anchors" or reference points, and in the short-term tactical tilts around these exposures are applied depending on prevailing market conditions. With the new regulatory limits, a strategic offshore allocation of 35% can now allow for meaningful tactical tilts, either with or without implementing currency hedging mechanisms - allowing for increased offshore exposure at times of Rand strength, or a reduced preference for local assets based on, say, prevailing valuations.
The volatility introduced by the foreign currency exposure is not necessarily a bad thing - since historically holding US Dollars has resulted in a yield pickup of 6% p.a. However, the journey can be as important as the destination, as shown in Figure 5 below.
Foreign currency exposure should be taken with risk management principles in mind - and specifically with reference to the intended investment horizon. The graph above illustrates the dramatic impact the volatility of the currency can have over short periods. Even though there was little difference to the total return over this two-year period, implementing prudent currency hedging would have tempered drawdowns and been a more resilient strategy.
Conclusion
Our approach to investing offshore is premised on the benefits of diversification and access to alternative investment ideas, but regulatory changes now allow us to take greater advantage of opportunities offshore. While client needs and a focus on outcomes-based strategies are key drivers of how we include offshore assets in our solutions, our approach will still consider principles of holistic portfolio management, taking into consideration the additional risk introduced and the appropriateness of this for the intended investment horizon.
