Sandile Malinga, Co-Head of Multi-Asset, M&G Investments
In the current conditions, diversification in portfolios is especially valuable, and attractive opportunities are presenting in the widely diverging real yields and valuations we are seeing between countries, sectors, companies, issuers and instruments – there are many opportunities, but investors need to be selective in their choices.
Align your offshore allocation to risk return objectives
As with any asset allocation decision, it’s important to consider the optimal allocation most likely to help you achieve your investment objective within the time horizon.
When looking at the various local and global asset classes, you should consider the correlation between them, as shown in graph 1 below. The lower the correlation, the higher the benefit of diversification. As an example, global cash and bonds are negatively correlated to SA nominal bonds and would be good diversifiers for each other as they will most likely move in opposite directions in the market cycle. As a result, diversifying globally reduces overall portfolio risk.
From Graph 2, it is evident how divergent the various single local and offshore asset classes are with respect to the efficient frontier (or optimal risk/return combination, where the highest return is possible for the given risk, and represented by the diagonal line). The best approach is to blend asset classes to deliver optimal risk return for a portfolio.
Our research examining different offshore asset allocations in a portfolio has shown that for our balanced funds and other mandates aiming for returns of between CPI+4%-7%, the optimal “neutral” long term allocation is between 25% to 30%. For more conservative multi-asset portfolios targeting returns of CPI+3%, we found that the optimal neutral long term asset allocation is somewhat less, between 20% to 25%. With weights considerably above or below this range, a fund’s risk return profile becomes less optimal. Key here is that additional foreign currency risk is introduced to a portfolio by increasing its offshore exposure, to a point where eventually the additional return potential added is offset by the risk.
Invest with current valuations in mind
From a portfolio construction perspective, it’s important to start with the long term neutral optimal offshore allocation, for example between 25% to 30%. This allocation then needs to be analysed and adjusted to take into account current absolute and relative asset class valuations, to arrive at an appropriate shorter term offshore weight for the portfolio. This weight will shift over time as we respond tactically to changes in asset class valuations as markets move, taking advantage of short term market mis-pricing opportunities that may arise.
Currently, our portfolios’ offshore allocation remains well below the full allowance of 45% and is a function of the attractive valuations of South African assets. In our current view, South African equities and bonds are significantly cheaper than their foreign counterparts and we’re therefore tactically overweight South African equity and bonds relative to offshore equity and bonds. The current offshore weighting in many of our client funds is just over 30%.
Within global portfolios, we are relatively defensive in our asset allocation positioning and selective in our stock picking. We are positioned neutrally in our asset allocation to equities in multi-asset portfolios, while across global bonds we are neutral duration relative to the Bloomberg Global Aggregate Index, and are also neutral in asset allocation terms. This also leaves us overweight global cash, allowing us to take advantage of cheap valuations when they present themselves.
We’re currently balancing somewhat divergent considerations on the global front: on the one hand, there are concerns that the era of low and stable inflation, which allowed for low and stable short interest rates, may be coming to end, and if 2022 is anything to go by, may be quite traumatic for both bonds and equities. On the other hand, given the rout in asset prices through 2022, a lot of value has been restored in both bonds and equities, creating attractive tactical opportunities. These two offsetting considerations thus leave us broadly neutral at asset class levels. Additionally, among other factors, consumers are holding considerable debt, which could weigh more heavily than expected on household spending, company earnings and growth.
Finally, but also worthy of consideration, is the exchange rate of the rand. Our local currency depreciated around 6% against the US$ in the first half of 2023, and many consider it to be undervalued. This supports a tactical preference for South African assets over global assets and avoiding buying relatively expensive global assets now at an expensive exchange rate.
Think before going offshore
Offshore diversification offers considerable benefits, but the extent to which you can capture those benefits also depends on how and when you diversify. It’s not simply about taking extra cash offshore right away. It’s about carefully considering all the alternatives: your underlying local investments, relative asset class valuations (both local and global) and the rand exchange rate. So before making any changes to the offshore weightings in your portfolio, speak to your financial adviser about diversifying offshore within the context of your holistic portfolio.