Think twice before increasing your offshore asset allocations

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, the optimal global exposure for a standard Regulation 28 compliant balanced fund is closer to 35%, according to analysis conducted by analysts at Cape Town asset manager, Old Mutual Investment Group (OMIG), who warn that investors should exercise caution when making the decision to go offshore given that achieving the optimum balance of offshore versus onshore exposures across cash, bonds, equity and property asset classes can be a complex consideration.

There are four main arguments for diversifying a portfolio offshore.

First, investors can gain exposure to more companies and industries than are 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.

We all agree that portfolio diversification makes sense, but 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.

Therefore, while it can be tempting to invest up to the 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.

Conservative portfolios also require less diversification to deliver on their return mandates as they tend to have a lower exposure to risky assets anyway.

OMIG’s MacroSolutions team has assessed the impact of the new allowances on optimal asset allocations across portfolios.

We use an approach that is a blend of art and science, employing both fundamental and quantitative elements to our decision making.

The team’s asset allocation optimisation process is done on data gathered since the 1970s, 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 their 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 actually compromised the risk-return characteristics of the fund.

Total equity and growth exposures (which includes property) in OMIG’s Balanced portfolios remain unchanged following the Treasury announcement, at 65% and 70% of the fund respectively.

So, while the higher offshore limit allows for much greater flexibility in asset allocation, it does not itself 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 their 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.

Many investors and decision makers can have short memories and poor track records when attempting to make calls on expectations of rand strength or weakness. In 2006/7, following a strong performance by the rand against the dollar, investors were reluctant to go offshore.

Consequently, their portfolios were too exposed to the rand during the subsequent multi-year decline. The reverse took place following the rand’s strong decline over 2015. After the rand had weakened already, investors wanted to then move assets offshore. The rand subsequently strengthened by more than 30% in the next two years.

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.

At MacroSolutions, we do 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, as well as the attractiveness of valuations of South African bonds and equity among other factors.

Urvesh Desai is a portfolio manager at OMIG.