An enticing option

Emerging markets continue to be enticing offshore propositions for South Africans, as the full implications of the easing of investment restrictions, a weakening rand and global volatility, among other factors, begin to click in.

Since 1995 South African investors have been legally able to invest a portion of their assets offshore and over a period since then offshore investment restrictions have been relaxed, most recently in this year’s national budget.

Retirement funds will soon be allowed to invest 20% of assets offshore, up from the current 15%. Most local unit trusts with flexible mandates can already invest up to 20% of their assets outside South Africa. And at an individual level registered taxpayers have been granted a once-off allowance of R2-million, plus an annual combined travel, investment and maintenance allowance of R500 000. In addition, individuals can access rand-denominated foreign unit trusts, or investment policies linked to foreign funds, as another means of obtaining greater offshore exposure.

Against this backdrop, Pieter Koekemoer, head of personal investments for Coronation Fund Managers, argues that the change in foreign investment restrictions, a dramatic weakening in the rand (to levels last seen in 2002) and the extreme turmoil in global markets pose a challenging set of variables for consideration by asset allocators, investment advisors and individuals.

But before deciding on the quantum of assets to take offshore and where it should be invested, one should first consider whether it makes fundamental sense to invest offshore, he says.

Popular arguments include: the proven portfolio diversification benefits of introducing assets that are expected not to correlate existing assets in the portfolio, reduce country risk, hedge future foreign currency payments and gain exposure to investment opportunities that are not available in the domestic market.

Probably the most pronounced of these arguments is protecting the future purchasing power of one’s capital by owning assets in the countries that will produce one’s future imports. Koekemoer says the majority of South African investors have historically used their foreign investment allowances to buy developed market equities, most notably in the United States, the United Kingdom, Europe and Japan. To date, the benefit of following this “conventional” strategy has not been to enhance returns.

Investing in developed market equities at the beginning of any calendar year between 1996 and 2006 would have resulted in lower returns than if one had invested in South African equities over the same period (measured in US dollars), Koekemoer says. Depending on the starting point, the local share market outperformed developed market shares by between 2% and 21% a year. This world-beating performance by local shares reflects a rerating of “South Africa Incorporated”, he adds, as a result of the country’s reintegration into the global economy, the adoption of prudent fiscal policies by government and superior earnings growth underpinned by the country’s best economic growth performance in decades.

“This historical outcome will not necessarily repeat itself in the future and does not singly provide a strong enough argument to avoid including foreign assets in your investment portfolio,” Koekemoer says. “It does, however, seriously question the conventional wisdom of using offshore allocations solely to buy developed market equities and bonds. Evaluating other asset classes in developed markets, such as real estate and hedge funds, as well as additional markets beyond the traditional, seems warranted.”

He adds: “It is worthwhile to dispel the myth that South African investors should avoid investing in emerging markets simply because we live in one. Global emerging market equities have presented one of the few investment options that outperformed South African equities over the past five years. Economies across Asia, Latin America, Eastern Europe and the Middle East have consistently achieved high growth rates over the past decade. This has been achieved on the back of increasing integration into the global economy through export-led growth, the continued deepening of domestic consumer markets, massive infrastructure expenditure programmes and a major boom in commodity prices.”

Typically, Koekemoer says, South African investors are underexposed to emerging market equities. Many investors believe that limited offshore capacity should be used to buy less correlated, and potentially less risky, assets such as developed market equities and hedge funds. After five years of emerging market outperformance, some investors may also be concerned about current emerging market valuation levels.

“We believe that the recent increase in foreign investment allowances offer long-term investors the opportunity to consider adding emerging market exposure to their portfolios. Intuitively it makes sense to expect better longer-term diversification benefits when you broaden the investment universe.”

He points out that there are more than 5 000 shares listed in emerging markets, which are quite often exposed to very different valuation drivers than those of domestic or developed market shares. Adding concentrated and actively managed exposure to businesses as diverse as Russia’s Gazprom, the largest owner of gas reserves in the world, and Cemex, the largest building materials company in Mexico, should provide diversification benefits over time, Koekemoer says.

Trevor Garvin, head of multi management at BoE Private Clients, says that when considering investing offshore, it is important to follow the generally accepted investment principle of appropriate diversification — in accordance with the risk profile and personal circumstances of the investor — rather than investing in any single asset or asset class.

BoE’s four offshore funds (registered in the Isle of Man) are invested across the five asset classes: bonds, property, equities, cash and alternative investments.

Garvin advises investors to be aware of the tax implications associated with offshore investment. Dividend income from offshore funds is fully taxed, unlike local dividend income, which is tax-free. He believes that international exposure is an essential component of a balanced investment portfolio.

“While the exact off-shore weighting will be a function of the personal circumstances and requirements of the investor, research suggests that approximately 30% of an investor’s total investment should be diversified offshore.

“The benefits over the long term can be significant. Globally one has a huge choice of investments, and the opportunity to take advantage of a range of investment strategies, styles and products that have been developed over several years. In addition offshore investment offers a hedge against the political and economic risk associated with an emerging market such as South Africa,” he adds.

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