MARCO BARBIERI: Evaluating the optimal offshore allocation for retirement funds
While risk considerations are vital, many investors overlook the cost of offshore diversification
The optimal offshore allocation for a retirement fund has been a highly debated topic, particularly since the amendment to regulation 28 of the Pension Funds Act in 2022. Based on these changes, pension funds are now allowed to invest up to 45% of their assets offshore, with a further 10% allocation to the rest of Africa, from a previous limit of 30%.
The relaxation of these limits has been received positively by the market, as it affords capital allocators increased flexibility and a larger opportunity set from which to choose from. However, it also tends to be seen by many as a target rather than a limit and used as a mechanism to externalise capital by investors that are wary of the risks which local assets are facing.
While we agree that risk considerations are critical to portfolio construction, we believe many investors overlook the cost of offshore diversification, the difference in optimal asset allocation between a local and an offshore domiciled investor and ultimately, the prospective returns of assets when building a portfolio.
Prospective returns are typically elevated after an asset class or region has underperformed and these returns are normally “released’’ by the market over the subsequent years. Unless an investor is equipped with asset and security valuation models, it is unlikely that they would appreciate when assets are attractively valued.
What does history suggest?
Over the past 60 years, local equities have outperformed all other main asset classes that pension funds are broadly exposed to in rand terms. The FTSE/JSE all share index, based on our calculations, has delivered an annualised rate of return of 16.2% since 1960, outperforming global equities (MSCI world index: 14.5%), global bonds (Global aggregate bond index: 11.5%) and local bonds (FTSE/JSE all bond index: 9.7%).
While it is true that such outperformance has come at a higher level of volatility (with a standard deviation of 20.1% vs 16.5% for global equities), it has also been achieved with a higher level of consistency when considering returns on a five-year real rolling basis, with local equities delivering negative real returns only 10% of the time vs 28% for global equities.
The past decade, however, has been a different story. Global equities have easily outpaced all local asset classes, with average annualised real returns of +10.7% against, for example, local equities, which have achieved 6.0% real. On a risk-adjusted basis, global equity’s outperformance over this shorter period is even more pronounced.
Interestingly, when we attempt to infer the best blend of assets, using a risk-return optimisation model, the outcome is highly influenced by the choice of period considered. Based on our calculations, if we use the full sixty-year period, the best risk-adjusted performance for a balanced fund would have been achieved by a portfolio containing 40% offshore assets, 22% of which would be made up of global equities.
However, an optimisation which takes into account only the past 10 years would yield a recommended offshore component well in excess of 45% of the portfolio. Conversely, had we considered the decade between 2000 and 2010, during which SA equities outperformed global assets handsomely, the skew would be back towards SA assets.
Investor perspectives and the cost of offshore diversification
Another important aspect when considering a fund’s offshore allocation is an investor’s return perspective. Some investors advocate for much higher offshore allocations based on how small the SA investment pool is as a percentage of global accessible assets.
While this argument holds from a diversification perspective, it does not capture the point that asset class risk-return characteristics depend on the investor’s base currency. An SA domiciled investor, who requires a rand return, should be predominately exposed to domestic assets to achieve improved risk-return outcomes, whereas a US investor must weigh the risks of exposing his capital to emerging market currency volatility, despite potential excess returns.
Finally, we note that the cost of global diversification is often overlooked. In the absence of risk considerations, history tells us that over the past 60 years, any incremental exposure to offshore assets would have been an overall drag to performance.
Where does this leave us?
We believe that investors should be particularly careful of extrapolating the asset class performances of the past decade into the future as a justification for heavy foreign exposure. Simply stated, this approach fails to capture what potential returns asset classes might offer right now.
As a manager that has our clients’ capital equally invested between SA and foreign geographies, we believe that we offer a deeply unbiased perspective on this topic and our asset allocations are based solely on our research framework.
With this in mind, based on our stock-by-stock modelling approach, which incorporates prospective earnings forecasts on 100 SA and 100 offshore stocks, and incorporates a higher cost of equity to accommodate SA risk, we have been favouring SA exposure of late relative to our previous large offshore allocations. Our rand modelling has also been clear that the domestic currency is deeply undervalued.
• The writer is director of SA Equities at Northstar.
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