Investing overseas: capital preservation in uncertain times
Derry Pickford, Macro Analyst at Ashburton Investments.
Two esteemed US Economics Professors, Maurice Obstfeld and Kenneth Rogoff called it one of the six great puzzles in macroeconomics: “home bias”. Why do investors keep so much of their portfolios in domestic assets? We look at how this approach can make investors vulnerable in times of crisis and consider how investing overseas can mitigate this risk.
Theory and practice
In standard financial theory, investors with similar appetites for risk should have very similar investment portfolios regardless of which country they live in. An investor who lives in New York for example, who doesn’t have any special insight into which stocks will perform better than others and wants as diversified a portfolio as possible, could have around one tenth of a percent of their equity portfolio in the South Africa-based mobile telecommunications company, MTN Group (MTN). Meanwhile, an investor who lives in Durban could also have a similar proportion in MTN; that way risk is diversified as much as possible. Yet in practice, the New York investor may have no MTN exposure and the Durban based investor possibly a lot more. Why is that?
Familiarity of domestic stocks can cloud judgement
Investors like familiarity. They like names that they have heard of. This gives them comfort but it also tends to deceive them into thinking that they might have special insight into how the shares are likely to perform. These issues effect not only to what extent we allocate between countries but allocation within countries too. For example, in German retail investor portfolios, Volkswagen is far more common than Linde, the industrial gases company with a bigger market capitalisation.
This isn’t because the investors have done in-depth research into the stocks but because they are familiar with the Volkswagen brand and therefore feel that they know something about the company. Sometimes local knowledge may make it worth being overweight your home market. For example, if you feel that growth is going to be particularly robust and it is not reflected into current valuations, this makes it worth being overweight domestic stocks. However, local knowledge needs to be balanced against two key risks.
Firstly, if you are particularly optimistic, why is it that other local investors aren’t similarly optimistic and hence your knowledge isn’t already reflected in valuations? Secondly, the future is always uncertain and however optimistic you might be, there will always be unforeseen risks. If a shock happens to the country in which you live, your employment income, business income and the value of your property will all be adversely impacted. This could be the time when you most need your investments to be healthy: you do not want them to be impacted at the same time.
The advantage of offshore funds
There are two ways of investing overseas, (i) through international funds which are domestically domiciled or (ii) by buying offshore funds. This may seem like an esoteric distinction but offshore funds have one massive advantage: your capital is outside domestic controls. Increases in capital controls might seem like something from the past but when volatility hits currency markets, these controls become an increasingly popular option open to policymakers to help avoid a balance of payments crisis. After the Asian crisis, Malaysia imposed a set of capital controls which made it very difficult for foreign entities to repatriate capital and limited nationals to only $2,600. Although the moves were criticised at the time, many economists now believe that the policies helped promote the recovery and gave politicians much more flexibility in domestic policy. Given Malaysia’s success, it is now an option that other policy makers will consider when they face similar difficulties.
At the end of last year, Nigeria responded to the deterioration in its terms of trade by significantly tightening up controls, making it much harder for residents to get hold of foreign currency through a Bureau de Change and tightening up rules for banks.
However, it is one of the most dramatic episodes of impositions of capital controls which best illustrates the importance of staying offshore. Argentinean households may have felt that they were safely diversifying by having their savings in US dollars. However, under the “corralito”, households had all their accounts frozen and were unable to withdraw more than 250 Peso per week, with withdrawals from foreign currency accounts having to be converted into pesos. Under the “corralon”, these dollar assets were converted into Pesos. Only investors who had invested offshore saw their wealth protected during this crisis.
The brinkmanship from Greece’s new government has resurrected fears that Euro deposits in Greece or held by Greek individuals could be redenominated into a new Drachma. If Greece is forced out of the Eurozone it seems likely that capital controls would have to follow. Therefore, holding a fund which invests in foreign assets might not be enough to protect them. With populist parties gaining ground in other European countries, it may not only be the Greeks who will look for safe havens.
A key lesson to be learnt from the turbulent period that we have had in global markets over the last ten years is that the unthinkable can happen. Given that investing through offshore funds can be cheaper, or at least no more expensive than investing through domestic funds, making sure that you invest offshore may be the closest that you can get to a “no-brainer” for protecting your family’s wealth.
