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Part 1: The risk-busting benefits of offshore diversification

This story is sponsored

It goes without saying that the year 2020 was a tumultuous one for investors.

As governments across the world moved to protect their citizens from the rapid spread of the Covid-19 pandemic, people were affected in nearly every aspect of their lives.

The economic crisis sparked by a humanitarian crisis sent stock markets, both locally and abroad, into a momentary free-fall, creating an additional and understandable anxiety for investors.

This has added fuel to a passionate debate in the local investment community, with a growing call for South Africans to externalise a significant portion of their wealth abroad.

At Discovery, we believe that it is always a good time to consider the many benefits of gaining an optimal offshore exposure in your investment portfolio.

In fact, this holds true no matter where in the world you may call home.

But it is crucial that any investment decision is motivated by fundamental — not emotional — considerations. The strong recovery of both the local and global equity markets are testament to this. 

In this two-part series, we analyse the empirically motivated, risk-busting benefits of offshore diversification that holds true, throughout the ages.

A tale of two portfolios

To consider the evidence, we constructed two simple, hypothetical portfolios. The first, Portfolio One, comprises purely local equities, as measured by the Johannesburg Stock Exchange’s (JSE’s) All Share Index.

The second, Portfolio Two, is still majority held in the JSE, but with an arbitrary, moderate, 25% offshore exposure in the United States Standard and Poor’s 500 (US S&P 500) Index, a widely followed gauge of US equities, with returns priced in rands.

We tracked the performance of these portfolios over the decade from May 2011, in rolling three-year returns. These three-year rolling returns describe what an investor’s annualised return would be after three years, had they invested on any investible day in the last decade.

The graph below plots the frequency of these annualised three-year returns on the vertical (Y) axis against the annualised return outcome described on the horizontal (X) axis.

For the portfolio with some offshore diversification, the distribution of these returns was, unsurprisingly, shifted to the right. A diversified portfolio was more likely to net a higher return than a purely local portfolio.

Yet, we should not expect the near future to resemble the recent past. It might be misleading to suggest that investing in offshore assets necessarily achieves this enhanced return outcome, regardless of the period of analysis.

Accordingly, we looked back further into the past and calculated rolling returns for the two decades from May 2001. 

What emerges is a distribution of returns for the two portfolios where the highest point of the curves, representing the most likely return outcomes, are similar for both the local and diversified portfolio.

This is as the JSE experienced a strong bull run, a high-growth period, in the first decade of the millennium, offsetting its relative underperformance as compared to the US markets in the decade following. However, in that particular case, the spread of returns around the peak was narrower. By diversifying a portfolio, the likelihood of extreme returns (up or down) reduces.

This has the effect of increasing the certainty of return outcomes. 

As we increase certainty, we reduce risk.

When viewed from a South African perspective, gaining access to offshore markets reduces risk through diversification, but also opens access to, quite literally, a world of investment opportunity. 

The local equity market represents less than 1% of the global equity markets and has a poor exposure to recent high-growth themes and sectors, such as technology. Logic dictates that investors should seek to optimise their portfolios by placing their money in assets with the best likelihood for improved, risk-adjusted returns. If we follow this logic, then both the theory and evidence confirm that putting all one’s eggs in as small a basket as South Africa simply does not make sense.

The downside of down

As we have illustrated, investors who place a portion of their wealth in offshore assets should expect a reduction in risk. This is indicated by volatility or standard deviation, over the long term, as compared to those who hold purely local assets.

However, most investors view risk as the potential for losses, the down, rather than unexpected gains above the mean, the up

When considering investment risk, therefore, what we are really concerned about is downside volatility. This is a measure that indicates how quickly, and severely, the price of an asset can drop, and how significant losses might be.

To illustrate this, on the graph below, we calculated the monthly returns for the two portfolios over the last decade and plotted only those returns, which were: 

The first observation is that when equities abroad show losses, equities locally also tend to show losses. This is due to the close relationship between global equity markets.

Yet where markets dipped, the purely local portfolio, Portfolio One, typically experienced more dramatic losses, as compared to a portfolio with offshore diversification.

The universal, timeless benefit of offshore diversification, therefore, is that it is possible to achieve the same, or better, returns with a reduced volatility and a lower expected likelihood of losses in one’s portfolio.

As the renowned economist Harry Markowitz famously said: “Diversification is the only free lunch in investing.”

Craig Sher is an executive general manager and head of R&D at Discovery Invest 

For more information, visit: https://www.discovery.co.za/investments/offshore-investing

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