Think twice before increasing your offshore asset allocations
Local investors may be tempted to adopt an ‘all offshore’ mindset following the National Treasury’s relaxation of exchange controls to allow regulation 28 compliant funds to invest up to 45% of their assets abroad. However, the optimal global exposure for a Regulation 28-standard balanced fund is closer to 35%, according to analysis by analysts at Cape Town-based asset manager Old Mutual Investment Group (OMIG), who warn that investors should exercise caution when making a decision. decision to go offshore given that achieving an optimal balance between outbound and outbound exposures in the cash, bond, equity and real estate asset classes can be a complex consideration.
There are four main arguments for diversifying an overseas portfolio.
First, investors can gain exposure to more companies and industries than there are locally.
The local stock market is concentrated in the financial and mining sectors and has virtually no exposure to technology industries such as semiconductors, hardware, software or even biotechnology. The second argument centers on diversification and spreading risk across many economies, countries and currencies. In particular, investors appreciate 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 those offered locally. And finally, there is the idea that greater foreign exposure reduces risk.
We all agree that portfolio diversification makes sense, but few appreciate how the outperformance of a diversified portfolio stems from the relative performance of the rand against foreign currencies rather than the allocation of ‘assets. A South African investor’s experience of global assets is therefore heavily influenced by the rand, which can be particularly volatile.
For example, when a South African investor has a large proportion of globally invested assets and the rand depreciates, the returns on those global rand assets are boosted. But when the rand appreciates, returns on these global assets can be significantly depressed, dragging the portfolio down.
Therefore, while it may be tempting to invest to the limit offshore, determining optimal offshore versus onshore exposures can be difficult in the context of rand volatility.
This is particularly important for conservative funds or investors who wish to preserve their capital in the short term. For these risk-averse investors, the optimal global asset allocation tends to be well below the regulated cap and one cannot afford to introduce too much capital volatility through foreign currency exposure.
Conservative portfolios also require less diversification to fulfill their return mandates, as they tend to have less exposure to risky assets anyway.
OMIG’s MacroSolutions team assessed the impact of the new allocations on optimal asset allocations in portfolios.
We use an approach that is a mix of art and science, using both fundamental and quantitative elements for our decision making.
The team’s asset allocation optimization process draws on data collected since the 1970s and begins with a systematic review of thousands of different allocations; assess the frequency with which the required return of a portfolio is achieved; and taking into account the various risk parameters associated with long-term asset allocations, including capital preservation, where appropriate.
The main conclusion of their analysis is that the optimal global exposure for a balanced fund complying with standard regulation 28 is around 35%. This is the case even if the global exposure can now go up to 45%. Having higher global allocations actually compromised the fund’s risk-return characteristics.
Total equity and growth exposures (which include real estate) in OMIG’s balanced portfolios remain unchanged after the Treasury announcement, at 65% and 70% of the fund respectively.
So, while the higher offshore limit allows for more flexibility in asset allocation, it does not in itself justify moving global asset allocations up to the maximum offshore limit immediately. Pension fund trustees and other decision-makers should assume that even when making changes to a fund’s static asset allocation, it is an active decision that will have a significant impact on returns achieved by their portfolios.
The ability to allocate a greater proportion of assets globally increases the flexibility of our portfolios, but the volatility created by changing currency exposure can compound any poor asset allocation decision.
Many investors and policymakers may have short memories and poor track records when trying to make calls on expectations of rand strength or weakness. In 2006/7, following a strong performance of the rand against the dollar, investors were reluctant to go abroad.
As a result, their portfolios were overexposed to the rand during the ensuing multi-year decline. The opposite happened after the rand fell sharply in 2015. When the rand had already weakened, investors then wanted to move assets offshore. The rand then strengthened by more than 30% over the next two years.
Deciding to move more assets offshore is not only appealing to global assets versus South African assets, but also appealing to the rand.
At MacroSolutions, we spend time analyzing what are the optimal static allocations for our funds. However, while these allocations are useful in defining the level of allocation likely to be successful over 20 and 30 year time horizons, we understand that these allocations do not take into account the current investment environment or the level of the rand. and other investments. The actual asset allocations of our funds are based on asset class outlook as well as currency. This takes into account both the investment environment (what we call themes) and financial market valuations – what we call price.
Currently, this requires structuring portfolios to be aware of the global liquidity crunch; interest rate hikes and higher yields in the United States; the continued rotation of growth stocks; the high valuations of US equities, as well as the attractiveness of South African bond and equity valuations, among other factors.
Urvesh Desai is a portfolio manager at OMIG.