Offshore exposure - how much is enough?

We welcome National Treasury’s decision to increase the offshore allowance to 45% for Regulation 28 funds, as it broadens the investment opportunity set. Over the last few years, global equities have been our preferred asset class in our flagship Quality multi-asset funds, the Ninety One Opportunity Fund and Ninety One Cautious Managed Fund. While there is a limited pool of quality South African businesses in which to invest, the global universe offers us much more choice. In South Africa, we have approximately 60 stocks to consider as potential investment ideas, after we’ve filtered out the ones that don’t fit our quality investment style. On the global front, this number jumps to 300 once we’ve done our initial screening of the global equity universe. What’s more, global companies on average tend to be of a higher quality than the stocks available in the local market, where there is an overconcentration of resource companies and highly leveraged businesses, such as banks and insurers.

Having built a global business over more than 30 years, Ninety One is well placed to uncover the best offshore opportunities for investors. More than 250 investment professionals cover markets and asset classes across the globe, serving clients in 112 countries. Importantly, we don’t work in silos – the Quality team invests both locally and globally and can also leverage off the best, philosophically consistent investment ideas from our global teams. Because we manage the local and offshore assets in our multi-asset funds, we are able to look at the portfolios holistically, ensuring that the holdings complement one another and that there isn’t an overconcentration of risk. Complementarity has become even more important now that the offshore limit is 45%.

If there were no constraints, what would a fully flexible portfolio look like?

The Quality team is often asked how we would construct a multi-asset portfolio if there were no asset class restrictions. We have explored this question in our modelling work, considering how we would maximise risk-adjusted returns on a five-year basis. Unsurprisingly, high-quality global equities receive the greatest allocation in our unconstrained model portfolio (63%), as seen in Figure 1. SA bonds are next with a weighting of 26%. There is an allocation of 5% to cash and only 2% of the portfolio goes to SA equities. A small component would be spread across global bonds, SA inflation-linked bonds (ILBs) and credit.

Figure 1: Managing portfolios without restriction
We have no bias towards investing locally or offshore

Source: Ninety One.

Some observations:

• There are better growth prospects outside of South Africa. While our economy recovered strongly from the depths of the COVID crisis, the overall growth picture remains lacklustre (less than 1% in real terms). What’s more, growth assets outside of South Africa tend to be of a higher quality with an increased certainty of cash flows, hence the skew towards global equities.
• SA bonds offer one of the highest real income opportunities in the world. Investors can earn a real yield on SA bonds of about 4.5%. Bond yields in developed markets offer a much lower yield, with the US and Germany’s real yields deeply negative. Our bond yields are also much more attractive than most of our emerging market peers.
• Increased exposure to growth assets offshore adds more volatility as a result of currency moves. The large allocation to global equities is balanced with a material weighting in domestic income-generating assets. But currency hedging is key to control risk: one third of the currency exposure needs to be hedged.

Unpacking currency risk in a portfolio

Historically, investors have viewed the dollar-rand exchange rate as a source of return in a portfolio. Over long periods of time, the rand has consistently depreciated against the dollar, and in risk-off environments such as during 2008 and 2020, the rand weakened considerably. However, this long-term return has come with significant bouts of shorter-term volatility, and even extended periods of rand strength (for example, 2001-2011). As a result, the currency represents one of the worst risk-adjusted returns for a portfolio, even though there are significant benefits to exploit. The currency risk is well illustrated by plotting the rand returns and risk (volatility) for local and global assets, and the SA Multi-Asset High Equity and Low Equity sectors over the past 10 years (Figure 2).

Figure 2: Adding offshore exposure introduces more volatility

Source: Morningstar – 10 years to 31 March 2022.

Some observations:

• SA cash produced a return of 6%, with very little volatility over the past 10 years.
• Given the scarcity of economic growth in South Africa, we have for many years invested in global-oriented companies and have balanced this exposure with income-generating assets within South Africa.
• SA bonds have proved to be an excellent asset class. Over the past 10 years, domestic bonds achieved a similar return as the average Multi-Asset High Equity fund and at the same volatility.
• Because of the volatility of the rand, global cash and bonds have been more volatile than SA equities! (See block on the right-hand side of Figure 2). While global investors regard global cash as a risk-free asset, this is not the case for rand investors due to currency moves.

It is clear that offshore assets introduce more volatility to a portfolio. Therefore, without an appropriate currency strategy, a fully flexible investment approach that allows for unfettered access to offshore markets is not suitable when managing portfolios for local investors.

Mitigating currency risk in our portfolios

Adding offshore exposure to our multi-asset portfolios is a function of our bottom-up assessment of a particular asset. We then think about the currency risk that the asset introduces, with a focus on managing volatility in our portfolios, rather than attempting to generate outsized returns on currency moves. Our approach seeks to balance the benefits of the rand in a risk-off environment, against its inherent poor risk-adjusted returns through the economic cycle. We manage this by employing a currency hedge on some of the offshore exposure to maximise the risk-adjusted returns of the overall portfolio. Even before the higher offshore limit came into effect, we were making use of a currency hedging strategy. As our portfolios’ offshore exposure grows, we expect to increase the currency hedge because increased currency exposure does not improve the risk-return characteristics of the portfolio.

So, what does a wider opportunity set mean for us?

We will continue to invest on a bottom-up basis with a focus on risk and quality, and as a result, shifts in our asset allocation will be the outcome of the opportunities that are available to us. Had the offshore limit been raised during normal market conditions, we would have already reduced exposure to SA-listed equities and increased our weighting in equities listed offshore.

Global markets face multiple headwinds: increasing interest rates in the US as a result of rising inflation, the Federal Reserve shrinking its balance sheet, the Russian/Ukraine war and the lingering shadow of the COVID pandemic. We expect to increase the offshore allocation of the Ninety One Opportunity Fund as the environment normalises or valuations offshore become more attractive. Our expected allocation for this fund would be 37% in global equities, 28% in SA equities, 27% in SA bonds and 8% in SA cash (Figure 3). The higher offshore allocation would occur in tandem with an increase in the currency hedge in the portfolio.

Given the lower risk profile of the Ninety One Cautious Managed Fund and its 40% cap on equities, we do not anticipate raising the offshore exposure materially in the short term. Over time, we expect the offshore allocation to increase as and when global fixed income opportunities become more attractive.

Figure 3: What are the likely changes to our positioning?

Source: Ninety One.

In conclusion

We are excited about the additional flexibility and broader opportunity set that National Treasury has granted local investors. In our view, investors should take full advantage of this flexibility, especially given the lacklustre expected growth locally. However, currency risk needs to be appropriately managed. We anticipate further increases to our offshore exposure as opportunities emerge. While market conditions are currently difficult, we remain focused on building portfolios of high-quality assets that will provide sustainable returns over the long term and prove to be resilient in down markets.

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