You can reduce your risk by investing a portion of your portfolio offshore

You can reduce your risk by investing a portion of your portfolio offshore. But to do this effectively, you have to base your offshore investment decisions on fact not sentiment.

By combining both local and offshore asset classes you can reduce the overall volatility of a portfolio. Even if the foreign asset is as volatile as the corresponding local asset, its lack of positive correlation with the South African asset means that a portfolio holding both of the assets will have a lower volatility than one holding the local asset only.

Michael Moyle, Head of Real Return at Prudential Portfolio Managers says that “the key to the risk-reducing properties of offshore assets lies in their low or negative correlations with South African assets”.

Put differently, domestic and foreign assets respond differently and to different degrees to the same change. This means that by combining different asset classes (local and offshore), you are able to reduce the overall volatility of a portfolio.

The table below shows risk and return measures for two portfolios: one consists of domestic assets only and the other one consists of a combination of domestic and foreign assets.

The calculations are based on asset class returns for the period 1 January 1981 to 31 December 2008. The annualised returns are higher for the global portfolio (17.3%) relative to the domestic portfolio (16.3%) and the standard deviation is lower (7.4% versus 8.3%) for the two portfolios respectively. When you look at a measure called efficiency (an indicator of unit of return achieved per unit of risk), it reinforces the fact that the global portfolio has a higher efficiency measure (2.35%) than the domestic portfolio (1.96%).

While a global portfolio may not necessarily always have the higher return, it should have lower risk.
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“South African investors tend to buy and sell foreign assets based on moves in the rand exchange rate. In 2000 and 2001, foreign unit trusts experienced net inflows as the rand weakened 95% against the US dollar. In 2002 – 2004, these funds experienced net outflows as the rand returned to pre-2000 levels.”

In hindsight, this had the net effect of destroying value and many investors lost money and crystallized these losses. “In spite of this, a result of human behavioural biases, many investors still tend to base offshore investing decisions on an emotive basis and the exchange rate for the rand,” says Moyle.

From a longer-term strategic perspective, Moyle confirms that “Prudential invests offshore to diversify our portfolios and reduce risk. This longer-term outlook and rationale for investing offshore forms the basis of our strategic decision-making framework.”