Many pundits enthusiastically welcomed Enoch Godongwana’s decision in February to allow retirement funds to invest up to 45% of their assets offshore. And while this provides investors more choice, there are also risks to maximising this limit. Phakamisa Ndzamela investigates.

In February, Finance Minister Enoch Godongwana, a man of pensionable age, stood up
in Parliament and announced the great offshore liberalisation of pension funds. Until that point, retirement funds could only invest a maximum of 30% of their savings offshore, with another 10% specifically for investment on the African continent.

In one fell swoop, Godongwana changed this, hiking the overall limit to 45% which could now be invested offshore, with no separate limit for Africa and overseas.

It was a move widely cheered, since it allowed all institutional investors – such as pension funds, linked and non-linked business of life insurers and collective investment managers – to offer the public a much higher offshore component for their savings.

As Allan Gray’s Earl van Zyl put it, “this is positive for South African investors over the long term, as it allows for greater diversification and flexibility to benefit from the global opportunity set.”

Yet amidst all the backslapping, it seems the risks from hiking the offshore limit to this extent may have been vastly underestimated.

Those tasked with oversight of retirement funds would do well to acquaint themselves with the catalogue of threats entailed in this change. For a start, it is likely to put pressure on the currency.
“There is potential for the rand to weaken as retirement fund money is externalised over time,” states Darryl Moodley, Head of Tailored Investments at Sanlam. “We expect most of the money taken offshore to be funded from the sale of local equity holdings. This may put downward pressure on JSE stock prices.”

The rand has already come under no small amount of pressure in recent years. By May 2008, shortly before the global financial crisis began, one dollar would have cost you R7.58; 12 years later, in May 2020, a dollar would have cost R17.50.

Today, as Today’s Trustee went to print, the rand was trading at about R16 to the dollar.
And this is no small amount of cash either. In a research note, analysts from RMB Morgan Stanley warned of “potential outflows from the SA pool of assets of up to R550bn to R800bn”.

Sangeeth Sewnath, Deputy MD of Ninety One, told Business Day that he expected the outflows to range from R400bn to R600bn over the next five years, warning that this may lead to the closure of rand denominated offshore feeder funds.

“In SA, we sell a lot of offshore feeder funds, which are sold on the back of having capacity that is higher within the investment collective scheme than individual retirement funds,” notes Sewnath.
Unless Treasury hikes the limit for these feeder funds beyond 45%, allowing them to keep their competitive advantage, they “may be forced to close”.

This move also comes at a time when the economy is brittle, with unemployment now at 34.5% officially. Analysts warn that if this much-needed capital is shipped overseas – rather than invested in local infrastructure which could create jobs – SA’s Covid battered economy may take longer to recover.

Marius Oberholzer, Head of Stanlib’s Multi-Strategy team, says that for this reason, the decision to raise the limit was unexpected. “It did surprise us, given the investment needed to fund infrastructure and growth in SA, and given the fiscal position of the government. The timing so soon after the pandemic seemed odd from a policy maker’s perspective,” Oberholzer says.

He isn’t kidding about the government’s fiscal position. In his 2022 budget, Godongwana reported a budget deficit of 5.7% of GDP, or R355bn. Just the cost to service debt sat at R268.3bn. Ismail Momoniat, National Treasury’s Deputy Director-General for tax and financial sector policy, tells Today’s Trustee that the previous offshore limit was perhaps too low. But, he emphasises, pension fund trustees still have to determine a proper – and safe – investment policy.

Eugene Botha, Deputy Chief Investment Officer at Momentum, says that while 45% “does appear to be on the higher side of the discussion around an appropriate level of offshore exposure,” he believes the consensus was that 30% was too low.

So it would seem there did need to be some sort of change – the question is, has Godongwana gone too far, given the potential risks it opens up?

Pressure on asset prices

It’s no academic concern that as asset managers switch a greater chunk of assets into offshore funds by selling local stocks, this alone could also put pressure on stock prices.

Sanlam’s Moodley warns of this “potential value destruction, caused by investors reacting to short term performance, as asset managers position their portfolios in response to the change.” At the moment, he says, South African bonds offer positive real returns compared to most global developed market bonds, and were well supported by the higher interest rates in SA.

But the new shift in offshore allowances could threaten that.

SA bonds and the rand tend to be highly correlated. So there does appear to be an increased downside risk with bonds, notwithstanding the longterm SA sovereign risk,” he comments

It’s a risk that could be managed, however, if asset managers are able to resist the temptation to max out the new offshore limit.

Coronation, for example, warns that it wouldn’t be prudent to ratchet up offshore exposure to 45%, even though institutions now can. “We believe that a long-term average allocation of around 35%-38% to foreign assets is appropriate for most SA retirement funds, depending on their needs,” the company tells Today’s Trustee.

Much, of course, depends on how this all plays out.

As Momentum’s Botha, puts it, “there are still a lot of unknowns, and we will have to evaluate how investments are allocated and re-allocated.”

But if those are the wider risks to the country’s macro-economy, the change in the rules could also introduce greater risk into an individual’s retirement fund.

Coronation insists that shunting a greater percentage of a fund into foreign assets exposes that pensioner to greater currency risk – a critical point since the income he or she will get from the fund to live on will have to sustain a lifestyle measured in rands.

If, for example, you have a large amount of assets in a fund exposed to say the US, and the rand appreciates against the dollar, this will eat away at the value of those investments, and the returns of that fund. Some asset managers may try to hedge this risk – but this comes at an extra cost.
“It is important for retirement funds to establish risk budgets that are aligned to their members’ investment objectives and risk tolerances, and to manage their offshore exposure within these risk limits,” Coronation says.

And then there is the question of fees. Typically, asset managers often charge higher fees to manage offshore investments, which could also eat into returns.

Sanlam says this is because of the fact that there is less scale in offshore investments, while the cost of research and monitoring is higher. Still, notes Momentum, these costs have fallen over time, and are almost in line with what it costs to manage a local fund.

In many cases, this discrepancy isn’t huge, but it’s something to consider.

Allan Gray’s fees for local and offshore unit trusts, for example, are pretty similar. The fee is based on performance, and amounts to 1% for hitting the benchmark for local assets, and 1.1% for hitting the benchmark on offshore assets.

A response to a brittle economy

You can, of course, understand the call for the offshore cap to be hiked.

For years, as the rand weakened, individuals pressured their asset managers to put more of their retirement savings into hard currency assets, thinking it would protect them against a frail local economy, and consistently weakening rand.

Stanlib’s Oberholzer says the research clearly shows that the demand for SA assets has been on the wane for years. Many assets managers responded by ploughing greater amounts of capital into the dual listed companies on the JSE with operations overseas, such as Richemont, Prosus, Anglo American, BHP Billiton and British American Tobacco.

“The increased focus on offshore [assets] likely means that SA Inc [stocks] — our small and midcap names — continue to suffer through the trend of delistings or merging. It is hard to [imagine] that the JSE’s glory days lie ahead without significant structural changes,” he says.

This was as much a push factor as the spluttering local economy. During the Jacob Zuma years, from 2009 to 2018, local economic decisions were a mess, as the state spent far more than it had. Eskom’s blackouts spun out of control, and the country’s sovereign rating was downgraded into junk status. A series of corporate scandals – Steinhoff, VBS Mutual Bank, and Tongaat – didn’t help.

At the same time, says Oberholzer, there was a flight of skills out of SA, while the rising cost of capital affected corporate profits. It meant the appetite for companies to invest in rebuilding the local economy was limited. Nonetheless, he says, simply chasing foreign currency returns isn’t the panacea that some make it out to be.

“Many markets have fared worse than South African equities and bonds for a number of years, despite our issues. The allure of offshore markets for asset managers in search of potential [yield] is appealing, but it requires significant investment and time,” he says.

Which doesn’t mean it can’t work. Sanlam’s own financial models, for example, show that in high growth balanced portfolios, the risk/return profile is maximised in cases where the offshore exposures are between 35% and 45%.

Ultimately, the investment strategy will still be based on the returns a fund can get – irrespective of whether this return comes from investing locally, or overseas. Anyway, says Allan Gray’s Van Zyl, it’s difficult to assess whether hiking the offshore limit will have a negative effect on asset prices over the long term.

More important than the increase in the offshore limit will be the relative attractiveness of South African securities compared with offshore. As long as local markets offer attractive long-term return prospects relative to their risks, there will be demand from local and offshore investors [irrespective] of the offshore investment limits,” he says.

A hedge against SA’s shrinking JSE

For a start, says Jason Lightfoot, a Portfolio Manager at Futuregrowth, this higher 45% limit does open a wider array of opportunities for investors, which allows them to diversify their risk.

Sanlam’s Moodley agrees, arguing that it gives people greater freedom to invest where they like, while reducing the concentration of SA-specific assets in a portfolio.

“It will improve the likelihood of clients achieving their retirement goals, through better risk
diversification and an increased access to managers who might be managing non-traditional investment strategies
,” he says.

As it is, SA represents a tiny percentage of the global universe of investment opportunities. And the JSE doesn’t necessarily offer sufficient exposure to global investment trends – particularly when it comes to technology stocks. Coronation echoes this view, pointing out that the hike in offshore investment limits needs to be seen in the context of a shrinking universe of shares listed on the JSE, which drastically reduces investor choice.

As it stands, there are about 315 stocks listed on the JSE – down sharply from 601 in 2001. Yet, the stocks that do remain are worth more than ever, which is why the total market capitalisation of all the shares on the JSE now amounts close to R20 trillion – up 15% from 2020.

While the JSE is deeply worried about this trend, a higher offshore limit gives investors scope to diversify into stocks that have soared on global exchanges, but wouldn’t here. Elon Musk’s electric car company Tesla is a case in point: while it has lost plenty of ground over the past year, over five years the stock is up 771%. However, Oberholzer remarks that you still need the right skills to pick global stocks properly. And along with this, he says, you need the ability to manage the complexity of the administration required – like calculating cross-border taxes, while considering currency movements.

Busisa Jiya, the new CEO of the Association for Savings and Investment (ASISA), doesn’t see this new change as inherently bad. He points out that a person sitting in SA will spend his or her returns, which have been made offshore, here in the local economy.

“For example, if you invested in US shares and they gave you a return and you are sitting in SA, you may wish to buy a home with some of those returns, which in itself is contributing to the South African economy,” Jiya observes.

Perhaps. But does it not send a poor message to offshore investors that local asset managers feel they need to invest overseas since there’s not enough opportunity at home?

Moodley replies that the country’s travails themselves send a negative message. “The well-documented challenges that the SA economy faces, and the ongoing political travails, has resulted in a prevailing negative sentiment towards SA as an investment destination. As a result, our equity and bond markets have experienced net foreign investor outflows for a prolonged period of time,” he states.

To reverse this, Moodley says, the economy must be opened up and government policy implementation must be consistent. And the changes to Regulation 28, through lifting the offshore investment limit, actually send the right message that SA is opening up.

It will go some way to improving sentiment to encourage foreign investors to return. That being said, we do expect net outflows out of our equity market in the near term – at least until clear and stimulatory growth policies are enacted by government.”

Another critical point is that this move doesn’t make SA an outlier globally; it simply puts the country on a par with many others.

Momentum’s Botha says that historically, SA has been one of the countries with the most restrictive constraints when it came to exchange controls and offshore exposure. “As part of an interconnected global economy, there has been pressure on government to liberalise exchange controls from multi-lateral institutions,” he says.

Rather than a sign that asset managers have “lost faith” in the country, Botha agrees that it’s an indication of a willingness to partner with global economies in a flexible way. And if anything, it sends a positive message that the government plans to reduce exchange controls further. Van Zyl underscores Botha’s point, and says SA had a relatively low offshore investment limit compared to OECD countries anyway.

Changes in the limits should not be interpreted as a signal about the opportunity in SA markets,” he says. “There are too many factors at play for us to say for sure that raising the offshore investment limits will by itself cause investors to lose confidence.”

Ultimately, while there are risks to pushing your offshore investment to the limit, this change will benefit funds, if handled deftly.

Is the grass greener offshore?

The question remains, however, a crisp one: has an investment in offshore assets in recent times trumped that in local assets? The answer appears to be “yes”.

Sanlam says that for the five years to May 2022, global equities provided a 14% return per year (in rand terms), compared to a 9.8% return for local shares. Over 10 years, global equities provided an 18.2% per year return, outperforming the JSE’s all share index, which rose 11.2% per year.

The returns earned globally have been significantly higher than those earned locally,” says
Moodley. “To the extent that the 30% offshore limit has constrained asset managers. Retirement fund members have therefore lost out on this growth.”

Conversely, SA bonds have outperformed global bonds significantly over the 5- and 10-year periods – a reflection of the country’s higher-than-average interest rates.

Read together, this illustrates that the risk someone is willing to take depends on their circumstances.
For a more conservative investor, or someone close to retirement age, the performance of bonds markets is more important than equities, as the focus is on protecting capital.

For Botha, the issue isn’t whether the grass is greener on the other side, but whether greater exposure to the global markets offers an opportunity to diversify away from SA’s political and economic risks.
Anyway, says Van Zyl, you obviously can’t say global markets will keep outperforming SA – history shows it is cyclical: periods of outperformance are often rapidly followed by underperformance.

And so much depends on which fund you choose.

For example, Allan Gray’s Equity Fund, which can invest offshore, generated returns of 6.4% per year over five years, and 9.9% over 10 years to May 2022. Yet Allan Gray’s Orbis Global Equity Feeder Fund, which invests 100% of its assets offshore, provided a return of 8.8% per year over five years and 16.3%per year over 10 years.

The results confirm what has been true for South African listed equities versus global equities generally over the last 10 years, which is that global equities have outperformed SA equities,” says Van Zyl.

But his point is that this reflects recent history only.
Over the very long term – 120 years – South African equities generated very attractive real returns for investors, in excess of what most offshore markets produced over the same period,” he comments.

Which illustrates just why it would be so risky for pension funds to immediately throw everything they can into the offshore investment basket, now that Godongwana has lifted the ceiling. Obviously, this new limit gives pensioners more choice – but it’s not the holy grail many have made it out to be.