By: CANDICE PAINE
The merits of offshore diversification are old hat to most serious investors, but what is potentially a problem is the manner-often a knee jerk reaction in which most investors go about getting this exposure.
What we have seen over time, borne out by statistics from the Association of Collective Investments (ACI), is that it is only when the rand weakens substantially or that offshore investing is the flavour of the month that there is there a stampede to invest offshore.
Behavioural finance demystifies this phenomenon for us, explaining that people chase excess returns after the fact out of greed or fear. The practical reasons for diversifying away from South Africa assets are that foreign exposure lowers portfolio volatility because foreign assets are less correlated with our local assets, i.e. our stock markets do not necessarily move in the same direction or with the same magnitude.
But is it really this simple? People invest in various securities because they believe they can earn greater returns than by simply depositing cash in a bank. This excess return is referred to as the risk premium, so called because you need to be rewarded with a premium if you are taking on more uncertainty, or risk.
As far as this relates to shares, there has been ongoing debate for years as to how this premium is optimally calculated, and includes a range of inputs from expected dividends to country specific risk and business risk. Nonetheless, the equity risk premium (ERP) exists, and is used in the calculation of expected equity returns, namely: Returns = interest rate + ERP.
The most important point for a South African investor to note is that the ERP in emerging markets is higher than that of developed markets because of the greater perceived risk of investing in these countries. Historically, our interest rates have also been higher than those of developed markets-and notwithstanding the recent interest rate cuts, the difference is even more pronounced with developed world official rates at lows last seen in the Great Depression in the 1930’s.
If a share’s expected return is calculated by adding the ERP to what you can earn in a bank deposit, then it stands to reason that expected stock returns in emerging markets are usually higher than those in developed markets.
Added to this are the better growth rates emerging markets are likely to experience compared with the developed markets over the next decade at least, because developing economies are in much better economic shape than developed markets in the wake of the sub-prime crisis. Longer-term structural demographic trends are also in their favour.
Combine these compelling investment drivers and the fact that developed market stock markets are extremely efficient, and hence make it nigh impossible to achieve excess returns over the longer term, and you may be asking the question: Why invest offshore in developed markets at all?
The answer: diversification is still one of the cornerstones to building a robust long-term investment portfolio that offers exposure to different asset classes and local and global economic financial market dynamics.
While the outlook for emerging markets is favourable on both a medium- to long-term basis, there will undoubtedly still be periods when emerging markets, including SA, underperform developed markets, perhaps substantially. For that reason, it’s important to have a counterpoint to periods of underperformance.
In the past, sentiment has been a significant driver of offshore investment trends, with investors rushing offshore when the rand was weak in the early nineties only to experience negative returns for the following decade, because in retrospect it was obvious that the offshore market was expensive at the time. In contrast, local equities, which were more reasonably valued at the beginning of the decade, delivered almost 17% returns a year. This again highlights that investment success is more likely if you base your decisions on underlying investment fundamentals, rather than anecdotal evidence, emotions, or following the herd.
Our analysis of international and global equities indicates that offshore stock markets, particularly in Europe, offer better value than South African shares, and thus we are neutral in local equities and overweight global equities. So from a valuation perspective, and the fact that the rand is at its strongest since early 2008, conditions currently look favourable for investing offshore.
Another factor South Africans also need to take into account when considering investing offshore is whether to build an internationally diversified portfolio that includes exposure to other emerging markets. Previously, offshore diversification for South Africans meant investing solely in developed markets not other emerging markets because they were likely to be subject to the same volatility expected from SA as an emerging market.
However, emerging markets having undergone significant structural change for the better since the emerging market crisis in the late nineties, and with economic power expected to shift gradually to the East, the long-term case for investing in other emerging markets, particularly in Asia, has gained ground.
Whatever the case, determining your offshore exposure needs to be a strategic decision, taking into account the benefits of longer-term investment diversification rather than tactical short-term decisions in response to what could well be temporary market dynamics.
Based on all of the above considerations, it is arguably an opportune time to build up offshore exposure in your portfolio if you have been missing it all along-or disinvested as a result of the poor performance of developed market equities during their “lost decade”.