Why invest offshore at all?
The merits of offshore diversification are old hat to most serious investors, but what is novel is the manner in which most investors go about getting this exposure. What we have seen over time, borne out by statistics from the Association of Collective Investments (ACI), is that only when the rand weakens substantially is there a stampede to invest offshore. Behavioural finance demystifies this phenomenon for us, explaining that people chase excess returns after the fact out of greed or fear. The practical reasons for diversifying are because foreign exposure lowers portfolio volatility due to foreign assets having a lower correlation with our local assets i.e. our stock markets do not necessarily move in the same direction or with the same magnitude. But is it really this simple, asks Candice Paine, head of Glacier Research.
People invest in various securities because they believe that they can earn greater returns than they can earn by simply depositing cash in a bank. This excess return is referred to as the risk premium, so called because you need to be rewarded with a premium if you are taking on more uncertainty aka risk. As far as this relates to shares, there has been ongoing debate for years as to how this premium is optimally calculated and includes a range of inputs from expected dividends to country specific risk, business risk and beyond. Nonetheless, the equity risk premium (ERP) exists and is used in the calculation of expected equity returns. (Expected equity returns = interest rate + ERP)
The most important point for a South African investor to note is that the ERP in emerging markets is higher than that of developed markets. Historically, our interest rates have also been higher than those of developed markets. If a shares expected return is calculated by adding the ERP to what you can earn in a bank deposit, then it stands to reason that expected stock returns in emerging markets are usually higher than those in developed markets. Throw in the tenet that developed markets are extremely efficient and hence make it nigh impossible to achieve excess returns over the longer term and you may be asking the question 'Why invest offshore at all?'
Well, most of the great returns South Africans have enjoyed from offshore investing have been due to the crazy exchange rate fluctuations we have seen in past years. The current perception is that in the recent past the currency has stabilised and so we wont see returns like that again. The currency is definitely more stable, but it is not as stable as you may think. While we arent seeing the sudden devaluations in excess of 65% as witnessed in the period 2000 to 2001, the currency has lost almost 17% since the beginning of 2006 and 27% since the beginning of 2005 against the US dollar. Add to this global equity market dollar returns which lately have been in excess of 10% pa and you are looking at satisfactory performance. Given that portfolios should be constructed for the longer term, even in the unlikely event of the currency stabilising completely, the foreign currency returns are not bad returns to have banked in the past couple of years. Your offshore exposure needs to be a strategic decision taking into account longer-term market relationships rather than tactical ones which exploit a particular view of the near term future.
At the time of writing this article, the rand-dollar exchange rate has firmed to levels last seen in the middle of 2006. This is an excellent time to buy offshore exposure for your portfolio if you have been missing it all along. Further, if you use the ACI figures as a contrarian indicator, very few investors spotted this blessing, so you may have an opportunity to lead the pack.
