How much should you diversify offshore?
Many investors think offshore investments have a better chance of outperforming local markets as the rand should typically depreciate against major world currencies. This perception, coupled with negative sentiment towards the local economy, can tempt investors to take more capital offshore than their risk profile justifies. But a mistake like this can have significant financial consequences.
Investors should keep in mind that South African listed equity markets still deliver competitive returns. Our stock market has been one of the top three equity markets over the past century and we were again reminded of its strength over the past 12 months as equities rose by 21%. Local equities in rand terms outperformed offshore equities by as much as 9% as the rand, contrary to most experts’ predictions, strengthened by 10% against the US dollar over this period.
Taking a longer-term view, South African equities have over the past 10 years performed in line with global developed equity markets in rand terms, returning 11% per year. Over this period, the rand depreciated by 6% per year against the US dollar.
It is important to note that the rand is one of the most volatile currencies in the world and as much as it can depreciate, it can also strengthen. Rand depreciation on offshore investments enhances returns in rand terms, but the converse also applies. So, if an offshore investment produces a 4% return in US dollar, but the rand has strengthened by 5%, the investor ends up with a negative return in rand terms.
It is difficult to predict whether the rand will appreciate or depreciate over the short term, as sentiment is one of the major drivers of our currency market. Neither can the exchange rate be timed. The only certain aspect is that the rand is not always on a one-way downward trajectory. There will be times when the rand is materially oversold or overbought in the short term and investors need to take this into account before simply moving more money offshore.
Over the past two years the rand has strengthened materially against the US dollar and other leading currencies, appreciating by 40% against the US dollar from a record low in December 2015 to its current levels. With a risk on environment, a positive commodity cycle and the Ramaphosa effect, the rand has potential to strengthen even further and if it does it could trade between R10.50 and R11.50 to the US dollar in the next 12 months.
For all these reasons, we believe it is prudent to not always blindly maximise one’s offshore allocation. It is better to be more cognisant of the impact of adverse currency moves on an investment portfolio and size the allocation optimally according to your risk profile.
Most multi asset conservative unit trusts and pension funds have opted to maximise their offshore exposure, investing between 20% and 25% of their portfolios offshore. They have done this quite statically over the past three years, as most investment managers have been very pessimistic about the rand.
We believe such high exposure to exchange rate risk is too large, as a negative return from as much as a quarter of the portfolio can notably dilute the entire return. Risk-sensitive investors and those approaching retirement should be cognisant of the impact of a strengthening currency.
Taking a more cautious approach to offshore investing, our clients with a conservative risk profile have maintained offshore allocations of between 12% and 15%. We believe such an offshore allocation is currently adequate for conservative investors who wish to achieve a return of inflation plus 2% to 3% over a three-year rolling period whilst being cognisant of capital losses over any 12-month rolling period.
While the rand is now trading at much stronger levels, investors should not assume it has had its run and will now weaken again. Rather they should remain aware of further potential of rand strength, especially as the rand remains oversold when compared to the valuation of other emerging market currencies versus the US dollar. Furthermore, developed offshore equity markets, especially the US, are trading at very expensive valuations and could see a major pullback in the short term. It is therefore important to size the offshore allocation appropriately to cater for such a scenario.
GraySwan’s fund of fund unit trust portfolios for private investors have been positioned for rand strength over the past eight months. This has been one of the drivers which resulted in the portfolios being top quartile performers and available at much lower fees than the industry average. We retain these views for the short-term but will make tactical tilts should the risk on environment change.
Our views may have been contrarian to what most experts believe, but they are formulated by our strong risk management culture. As Benjamin Graham, one of the fathers of value investing, said: “The essence of investment management is the management of risk and not the management of returns.”
Risk can be managed well if one is aware of the risks and makes decisions about diversification based on fundamentals rather than emotion.