Issue: March 2012 / May 2012
Expert Opinion

Offshore exposure: Is it still a valid proposition?

Mapfumo . . . strategic and tactical approaches

Mapfumo . . . strategic and tactical approaches

Mako Mapfumo, senior investment consultant at OMAC Actuaries & Consultants, weighs up the pros and cons.

Amid concern regarding South Africa’s inflationary pressures, local investors are well-advised still to allocate the bulk of their capital (at least 60%) to their local economy. This will help them to hedge away the inflation risk.

However, in some cases due to various reasons, local assets may underperform local inflation and fail to protect investors’ capital. In these cases, offshore exposure is a valuable tool to diversify risk or enhance the performance of portfolios.

The offshore argument has been validated by legislation which increased regulatory limits on assets from 15% to 25% over the past two years. It is important for South African investors to understand that international exposure can serve both as a strategic and a tactical asset-allocation strategy.

  • Benefit from diversification and returns
    Investors can benefit from the diversification advantages of offshore investing over the long term as part of Strategic Asset Allocation. Alternatively, they can enjoy enhanced returns in the shorter term through Tactical Asset Allocation.

    Strategic asset allocation makes use of the benefits of diversification. This strategy requires long-term exposure to asset classes that bring effective diversification benefits to domestic asset classes.

    The two key factors to consider in long-term strategic asset allocation are:

    • The effectiveness of an asset class as an optimal diversifier, and
    • The investor’s tolerance for risk.

    Historically, bonds have been the most effective assets for diversification amongst offshore assets. They’re followed by cash.

    This is because these asset classes move together with foreign currency to an extent that, when local markets are going down, these assets will move in the opposite direction. The effect is to cushion local investors in terms of local currency.

    This phenomenon has become known as the “flight to safety”.

  • Short-term decisions
    In the short-term tactical asset-allocation decisions, other factors (apart from diversification and the risk profile) come to the fore. The key ones are:

    • Valuation gap between domestic and global markets;
    • Exchange rate (view on the outlook for the rand).

  • Long-term decisions
    Offshore equities offer the least diversification benefits over the long term.

    But over the short term this asset class offers the best return-enhancement opportunities, especially when wider valuation gaps exist between local and offshore equity markets.
  • Developed versus emerging markets
    When looking offshore, another key consideration is the selection between developed and emerging market equities. Global equities are generally separated into these two categories. Fund managers have different views on developed markets and emerging markets.

    Some managers believe they can generate ‘alpha’ by investing in emerging market companies. (‘Alpha’ is the risk-adjusted measure of the so-called “excess return” on an investment, commonly used as the measure for assessing the performance of an active fund manager. It is the return in excess of a benchmark index or a “risk-free” investment.)

    These managers argue that there are situations where risk is adequately rewarded in these emerging-market companies. Accordingly, the ability to identify those opportunities will make a big difference.

    A separate cluster of global managers argue that emergingmarket gains are best captured by investing in developedmarket companies that have exposure to emerging-market countries.

    Most global multinational corporations generate a significant proportion of their revenue from their emerging-market operations. These companies are better managed in terms of corporate governance. Hence they are associated with fewer agency problems compared to their emerging-market counterparts.

    Some managers, however, are indifferent about emerging and developed-market companies. They invest in both.

What does OMAC think?

At OMAC, we concur with the view that there is a lot of idiosyncratic risk within emerging-market companies. So we’d prefer developed-market companies, where these companies provide attractive valuations, that tap into the emergingmarket growth story.

However, we also recognize that there are good stock-picking managers who can identify gems, wherever they are in the world, without regional prejudice.

OMAC also shares the view that, for South African investors, the diversification benefits brought about by investing in emerging markets are limited. This is because the South African market is highly correlated with other emerging markets.

Therefore, allocating money to emerging markets should be a short-term tactical asset allocation decision based on compelling valuations.

Mako Mapfumo may be contacted at OMAC Actuaries & Consultants on