Diversification in a low-return environment

Change is the only constant, and investors need to respond to each shift that occurs around them – even if that response is to analyse the data available to them and stay the course. The current shift is away from the high-return environment that we’ve enjoyed over the past few years, towards much lower returns – and smart investors will identify a strategy to mitigate the inevitable negative impact of this scenario. One way in which to do this is to ensure your investment portfolio is sufficiently diversified.

In a globally connected world, these shifts and trends impact how investors in South Africa should decide how best to position their portfolios. Should local investors consider offshore investing?

Hedging against the rand

Since the 1970s, the rand has lost over 90% of its value against the dollar in nominal terms. It would therefore come as no surprise that most people would list hedging against further currency depreciation as one of the greatest benefits of investing offshore. 

In some instances, it’s those very same people who may have recommended investing in the Bric (Brazil, Russia, India and China) nations. These emerging economies with favourable population dynamics did not suffer from the indebtedness of many of their developed market counterparts.

The fact that the Russian rouble and Brazilian real depreciated by more than the rand over the last five years highlights the importance of “where” in the equation. Suffice it to say the reasons for the rand’s plight, such as political risk and commodity sensitivity, are well-documented so I won’t elaborate further. 

The point is this: given the constraints of exchange control, investors should maximise the potential of diversification through investing in uncorrelated assets, and a weak rand is only a part of a broader consideration. The best approach is a multi-specialist one that grows your money across borders, overcoming any blind spots lurking in a single market.

Comparing SA to the rest of the world

Another way of looking at this is to consider the South African equity and bond markets relative to the rest of the world. When viewed in this context it becomes clear a home bias really and truly limits what you can invest in. SA represents a mere 0.2% of global debt indices with only 60 securities out of 20 708 in the broader Barclays Multiverse Index, and our GDP is just 0.51% of the world’s economy.

Having spoken to many clients over the years, it’s apparent that South African investors are woefully underweight in offshore assets. If diversification has been a productive strategy for a nation whose stock markets represent half the globe’s market cap – the United States – how much stronger is the argument for South African investors, where the JSE is a mere 0.63% of the investable universe?

Put differently, we believe the 25% permissible offshore within pension funds is not sufficient diversification (bearing in mind most of an individual’s net worth is probably in their house and other local assets).

Should foreign equities and bonds be included, we would only observe a diversification benefit if portfolios generated superior returns, lower risk, or both. We assess this by calculating real rand returns versus real risk as measured by annualised standard deviation of real returns, also known as volatility. If the return per unit of risk rises when adding foreign assets, the portfolio is being enhanced.

In an increasingly interconnected world, an ability to see the bigger picture in these ways reduces risks, enables real time responsiveness, and optimises growth, for business and for investors.

We think it doesn’t make sense to take on risks which are easily diversifiable. To this end certain sectors are not well represented in SA. Using information technology (IT) as an example, SA simply does not have the depth and variety of technology companies available to American and European investors. Other sectors which are almost non-existent or poorly developed are healthcare and utilities – although it is worth noting that this is not a specifically South African or emerging-market challenge.

Broader global indices are much more diversified. 

We believe that investors should look at a broad range of benefits provided by offshore investments. Hedging against currency depreciation should not be the sole purpose. Spreading assets across several countries as well as accessing opportunities in sectors and companies which may not be available locally just makes sense. Our status as an emerging market tends to make our exchanges more volatile than First-World bourses and this is sometimes compounded by factors which are difficult to forecast, like a drought or politics.

Be careful

A word of caution, however: the next 10 years may look very different compared to the last decade. The rand is considered one of the most undervalued currencies in the world. Any strengthening from current levels will undoubtedly have an adverse impact on future returns of non-South African assets. While it’s notoriously difficult to forecast the rand, it’s worth highlighting that it has historically bounced back from such extreme or oversold levels.

To put it into perspective, after being abroad for a while, I recently met up with work colleagues and was amazed by how cheap alcohol and Big Macs are in SA. I did some research and found a survey that showed that the cost of beer in a neighbourhood pub is cheaper in Johannesburg than most places in the world! According to
www.expatistan.com a pint only costs a quarter of an equivalent beverage in London (although this data is pre-Brexit). I can endorse this survey and verify its accuracy, so you can either drown your sorrows because the rand is weak, or enjoy the quality of life that a weak rand enables!

Either way, a prudent approach to investing offshore from current levels would be to follow a staggered approach to increasing exposure.

Kent Grobbelaaris portfolio manager at Stanlib.

This article originally appeared in the 16 March edition of finweek. Buy and download the magazine here.

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