Foreign assets play an important role in South African investors’ portfolios, both to enhance investment returns and to provide much- needed protection. At M&G Investments, foreign assets have always been core to our portfolios, serving as key contributors to improving our clients’ investment outcomes. We were therefore pleased when the Minister of Finance announced the relaxation of the offshore limits within the pension fund regulations (Regulation 28), by allowing up to 45% of retirement portfolios to be invested offshore. This represents a large increase from the previous 30% maximum and allows significant additional freedom in constructing investment portfolios.

Risk and return: Determining foreign allocations

Now that foreign assets can have a potentially more substantial impact on SA investors’ outcomes, it’s important to first have a sound understanding of the extra returns and risks that they can add to a portfolio, and then determine whether more offshore exposure (and how much) would help create an optimal portfolio.

Regarding returns, foreign assets provide local investors with access to regions, sectors and industries underrepresented on the JSE – a very valuable, broad and more diverse opportunity set from which to deliver returns. There are, for example, over 8,000 stocks from which to choose listed on the MSCI All Country World Index (ACWI), the most common benchmark for global equities.

In terms of risk, foreign assets are critical in balancing the risks specifically embedded in South African assets, especially within growth assets like equities and, to a lesser extent, property and bonds. They help lower risk by reducing portfolio concentration and the macro and geopolitical risks that emerging economies like South Africa are exposed to.

An important role that we play is to determine the optimal mix of foreign and local assets within each of our portfolios by assessing the risk and return characteristics across local and foreign assets, and the interplay between them. For example, global bonds (especially US Treasuries) have historically provided good protection to balance out the risk of holding local equities.

The optimal mix of these asset classes enables us to deliver on each of our portfolios’ investment objectives, while also balancing the risks inherent to that portfolio. It’s worthwhile noting that depending on the investment objective of the portfolio, the optimal mix of local and foreign assets might differ substantially.

An optimal strategic allocation of 25%

History has shown that the expected returns available from most local assets are meaningfully higher than those from their corresponding foreign equivalents, on a long-term “through-the-cycle” perspective. This is due to the inherently higher risk prevalent in the SA market than offshore assets, since investors demand higher risk premia for holding our equities and bonds.

As such, our aim is to find the appropriate balance between lowering portfolio risk by including foreign assets, while also having an allocation to higher-returning SA assets that allows our portfolios to meet their return objectives. Holding higher levels of offshore assets at the expense of local assets introduces the additional risks of not achieving adequate returns, plus higher currency risk.

Our most recent research has shown that for our balanced funds and other mandates aiming for returns of between CPI+4%-7%, the optimal neutral total asset allocation is approximately 25% in foreign assets. For more conservative multi-asset portfolios, targeting returns of CPI+3%, for example, we found that the optimal neutral asset allocation is somewhat less, at about 20% in foreign assets.

Tactical adjustments of up to 10%

Meanwhile, in managing our funds on a tactical basis, we actively adjust asset class allocations by up to 10% above and below their neutral allocations as valuations change. So, depending on the market opportunities available, our offshore allocations could vary between levels of 15%-35% at any given time.

Currently, in our view South African assets are significantly cheaper than foreign assets, which gives us a bias towards being overweight South African equity and bonds relative to foreign equity and bonds. Our current offshore weighting in most of our funds is therefore below 25%.

Generating more alpha

Before the increase in the Reg 28 limits, we weren’t able to go meaningfully overweight foreign assets to generate alpha if we found valuations attractive – going underweight was really the only feasible option. However, we are now able to go fully overweight as well, which will greatly assist us in generating alpha. In addition, the increased limit gives us more freedom to implement currency hedges, an important tool in managing a portfolio in rands.

Both of these enhancements will assist us in generating more alpha for our clients. For now, however, we have not seen a need to move more funds offshore to implement this higher limit, given that we are happy with our current allocations based on relative asset class valuations.

For more information on investing with M&G Investments, please feel free to contact our Client Services Team on 0860 105 775 or email us at info@mandg.co.za.

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