The significance of raising the Regulation 28 maximum limit of offshore allocation to 45% from 30% can’t be overstated. And how investors respond could be the most important determinant of their returns over the next decade, says David McNay.
The end of the year typically provides an opportunity to reflect on the past and consider what lies ahead. The same could be said of one’s investment portfolio. Earlier this year, the minister of finance changed the rules for local retirement funds by raising the Regulation 28 maximum limit of offshore allocation to 45% from 30%. Looking back, the significance of this change can’t be overstated. How investors respond could be the most important determinant of their returns over the next decade.
An analysis of how the higher limit would have changed optimal strategic asset allocations over the last two decades presents some guiding principles for investors going forward. Granted, these are just rules of thumb, since the optimal offshore allocation for any particular investor would reflect their required real return and willingness to hedge currency risk.
Building multi-asset portfolios: not for dummies
Designing multi-asset portfolios to produce reliable, inflation-beating returns is both an art and a science. Science is leveraged to understand the historical correlations between asset classes. This allows one to build portfolios which achieve the most return for a given level of volatility (the so-called ‘efficient frontier’).
To add further complexity to portfolio construction, the new limit is forcing serious investors to simultaneously revisit their offshore allocation and their approach to currency hedging. Meanwhile, there is an art in forecasting how asset classes will perform in the future – considering current valuations and the likely path of policy and macroeconomics.
Using historical market data, multi-asset portfolios were built that would have delivered the best risk-adjusted returns over the last 19 years (assuming the new 45% offshore limit in order to make the findings relevant for investors today).
The work indicated that an investor in 2003 would have been best advised to maximise their offshore allocation and then hedge some of the currency risk. Investors unwilling or unable to hedge the currency should have set their offshore allocation in line with their required return (and tolerance for risk).
The offshore attraction
South Africa is a small corner of the world’s economy and financial markets. The country’s GDP is less than 0.5% of global GDP. The world’s eight largest listed companies have a combined value greater than that of the entire JSE. None of this, however, has stopped South African equities from being a great investment and generating real returns of more than 6% per year over the long term. That said, the last ten years have been a hard on South African stocks. Global indices have left the JSE in the dust.
Over the long term, South Africa equities will likely produce returns in line with global equities, but with higher volatility. South African investors should therefore consider diversifying offshore in all asset classes. Doing so however brings an important variable into play – the rand.
Why hedge the currency?
Hedging the rand improves risk-adjusted returns and broadens the investment universe. Finance theory states that diversification into offshore assets should lower the risk of a portfolio, but the volatility of the rand offsets much of this benefit. Over the last 19 years, the rand has recorded average annualised volatility of about 17% against the dollar.
Hedging the rand removes that currency volatility and earns local investors positive carry. It also increases the universe of investible asset classes by improving the risk-adjusted returns on some which would otherwise look unattractive. This is particularly true for offshore fixed income assets which are less volatile in themselves.
Significantly, over time, the actual depreciation in the rand against the dollar has been more than offset by positive carry. Investors are effectively being paid to take the hedge.
Investors able and willing to hedge currency risk should move toward the 45% offshore limit and then hedge more or less of the rand according to their risk appetite (targeted returns) – more for lower risk portfolios, less for higher risk portfolios. Eliminating currency volatility improves risk-adjusted returns across many offshore asset classes, but particularly in less volatile instruments like global bonds.
A rough rule-of-thumb would be to hedge half the offshore allocation, hedging a bit more in low-risk portfolios and a bit less in more equity-heavy portfolios. This is because the portfolio construction benefits are larger when hedging bonds than hedging equity.
For those unable or unwilling to hedge currency risk, offshore allocation should rise in line with risk appetite, from 20% for the most conservative investors to 45% for the most aggressive.
Simply put, the higher an investor’s targeted rate of return, the greater their offshore allocation should be, and if they can hedge the foreign exchange risk, they should.
David McNay is a senior portfolio manager at STANLIB Multi-Strategy. News24 encourages freedom of speech and the expression of diverse views. The views of columnists published on News24 are therefore their own and do not necessarily represent the views of News24. News24 cannot be held liable for any investment decisions made based on the advice given by independent financial service providers. Under the ECT Act and to the fullest extent possible under the applicable law, News24 disclaims all responsibility or liability for any damages whatsoever resulting from the use of this site in any manner.