SANLAM INVESTMENTS: Expert Opinions: Edition: April / June 2019


Offshore equities not the panacea as SA investors believe

So argue Adam Bulkin, Mark Phillips and Peter Urbani of Sanlam Investments.

Those retirement-fund investors in the accumulation stage need to invest for both real (after-inflation) growth and also to preserve and grow their wealth in hard-currency terms. Over 2018, these objectives were extremely difficult to achieve.

The rand lost close on 14% as measured against the US dollar. As a result, along with the dismal performance of most domestic asset classes for the year, many SA investors suffered significant wealth destruction particularly when measured in dollar terms. Once again, offshore investing is front of mind for South Africans wishing to preserve and grow their real spending power.

Conventional wisdom is to utilise shares in SA-listed companies whose operations and revenues are based offshore (so called “rand-hedge” stocks), or shares directly in offshore jurisdictions, to benefit from and protect against rand weakness.

It makes intuitive sense to follow this strategy, since this should achieve diversification and negative or low correlation with a weakening rand and thus with a major driver of the returns of one’s dominant growth asset (domestic, non rand-hedge equities). But are investors following the correct strategy? Does research in fact support it?

The Legae Peresec firm conducted research based on the behaviour and correlations of rand-hedge stocks to the relative strengthening or weakening of the rand during the period 2013 to 2018. It wanted to investigate the hedging power of these rand hedges and the diversification benefits of offshore asset classes.

It found that the relative hedging strength of the rand-hedge stocks seems to vary greatly depending on the magnitude of the currency move and the particular stock, and that the relationship between currency and return is not a direct or linear.

Therefore, the evidence certainly does not support an investment strategy based on a simple, blanket assumption that rand weakness will automatically or necessarily equate to high relative or absolute returns for rand-hedge stocks.

What of other asset classes, such as offshore listed shares? Legae points out that diversification seems to disappear exactly when one needs it most – in extreme events, such as stock market crashes, particularly those brought about by global events. Specifically, it found that local property and global equities provided poor forms of diversification for the local equities market.

However, there were some good diversifiers. US dollar cash and US government bonds, as well as local fixed-income assets, provided protection in global risk-off events when domestic equities sold off.

This research was echoed by Avior Capital Markets. It had analysed the optimal strategic asset allocation needed to achieve the highest probability of outperforming various real return objectives.

Avior concluded that, to achieve the optimal asset allocation for a CPI+5% return objective within Regulation 28 confines, a high allocation to domestic bonds (slightly above 40%), about 25% to domestic equity and property and small allocations to gold and African equities (about 5% or less) was optimal.

Interestingly, the balance, allocated to offshore assets was exclusively to fixed-income assets i.e. US government bonds and US high-yield corporate bonds, with no allocation to global equities. Avior’s research therefore supports that of Legae with respect to the optimal offshore asset allocation being to fixed income assets.

We conducted our own conditional correlation analysis from January 2013 to December 2018 to examine Legae’s and Avior’s conclusions. We broke down this period into three regimes:

  • January 2013 to January 2016, when the rand depreciated by 47% against the dollar and the JSE gained 37%;
  • February 2016 to December 2017 when the rand gained 28,2% and the JSE gained 27,9% cumulatively;
  • January 2018 to December 2018, when the rand fell 13,8% and the JSE returned -8.5%.

We found that the behaviour of asset classes is dynamic and affected by myriad factors. Correlations are different in different regimes. Using historical data simplistically, without forward-looking views and insight into the drivers of historical returns, is therefore not an optimal manner in which to make asset-allocation decisions.

That said, from the perspective of correlations, our conditional correlation analysis is broadly in line with the findings of Avior and Legae. US fixed-income assets were a good negative correlator to domestic equities and therefore protected wealth in hard currency.

Our analysis is therefore generally in agreement with Avior and Legae in that the expectation that US fixed-income assets will act as a good diversifier to domestic equities and protectors of wealth in the case of rand weakness.

Moreover, our analysis confirmed that the behaviour of rand-hedge stocks does not display a stable or directionally clear relationship to periods of rand weakness. It would seem that other drivers of returns for these stocks are more significant.

But our research also highlights that, from a longer-term perspective and taking into account the imperative of driving total returns, there is empirical evidence for utilising global equities (US and Japanese in particular).

We also observe that the drivers of returns of any particular asset are extremely complex and diverse. Thoughtful asset allocation needs to apply forward-looking views and judgment to investment decisions, as well as insights into the causes of observed past behaviour. Correlations are not static. There is evidence to suggest that the negative correlation between equities and bonds may be changing.

In short, a simple extrapolation into the future of asset classes’ past behaviour — without considering fundamental drivers of such behaviour and the ways in which they may change — clearly would be imprudent.

Yet the empirical, historical research (discussed above) supports the contention that a SA investor should be circumspect in the use of both SA-listed rand-hedge stocks and offshore equities to manage the risks of rand weakness and its effect on the returns of domestic equities. Research indicates that assets such as local and global fixed-income assets may be far more effective for risk control.

However, in balancing the requirements of risk and return, global equities have definite merit and should be considered as an element of a well-diversified portfolio.