The benefits of investing offshore and the impact of the exchange rate on returns.
At Resolute Wealth, we are firm advocates of the benefits associated with investing offshore and have been actively advising our clients over the years to ensure that they have an adequate offshore asset allocation within each of their portfolios. The levels of offshore exposure will differ for each individual and their circumstances, however, the benefits are there for everyone to enjoy. South Africa has lately been described as the 1% country, where our share market makes up less than 1% of the opportunities available globally and our GDP contribution to the world sits at roughly 0.5%. While we may sit back at family braai’s and discuss how lucky we are to live in such a beautiful country, it would be naive of us to think there are not more (and possibly better) opportunities out there we should be taking advantage of. Luckily, we have world-class offshore platforms and access to global markets that are accessible from as little as R30,000 and we have the capabilities to facilitate the entire process for you of converting your rands into foreign currency, obtaining tax clearance if necessary and discussing the various options out there to ensure you select the most appropriate solution from a tax, inheritance and estate planning point of view. While we are certainly aware of the volatility of our currency against global developed countries, the long-term trend is that we lose roughly 6.5% per annum against the USD, so while short-term fluctuations in the currency may negatively affect the rand value of your investment, we expect the full benefits of offshore investing to shine over the long term.
Below is an article written by Paul Hutchinson from Ninety One, where more detail is given on the reasons why we feel offshore investing can be a hugely beneficial part of any South African’s portfolio.
Investors are regularly reminded of the wisdom of investing offshore and not adopting an investment strategy that focuses only on South African assets. There are a number of compelling reasons for investing offshore. Briefly, these include:
Diversification benefits – investing in international assets allows for greater diversification, which is a key investment principle for reducing risk. In addition, investing in international markets provides access to countries, currencies, asset classes and industries that are not available locally.
Reduced emerging market risk – South Africa remains an emerging market, albeit with pockets of first world industries (e.g. banking and mining) and infrastructure (e.g. roads, ports and railways). By world standards though, we are a small, open economy with a relatively illiquid and volatile stock market.
Interestingly, while the FTSE/JSE All Share Index makes up less than 1% of the world’s market capitalisation, South Africa’s gross domestic product (GDP) comprises only approximately 0.5% of the world’s GDP. Why is the size of market capitalisation compared to GDP so high in South Africa? The reason is that our country was amongst the earliest adopters of a market exchange aimed at raising external capital to finance business activity, which happened to be mining at the time. (The JSE was founded by Benjamin Woollan in November 1887 to provide a market place for the shares of South Africa’s many mining and financial companies that resulted from the discovery of the Witwatersrand goldfields in 1886.) It was not until more recently that financial markets geared towards raising external capital became a feature in many other emerging markets, including Russia and China.
Why is this relevant? Index trackers and many global portfolio managers base their allocation to a particular emerging market on relative market capitalisation, not GDP. It is likely that other emerging markets will, over time, see a proportional increase in their market capitalisation in line with their relative GDP, thereby reducing South Africa’s relative market capitalisation. Ultimately, this change will likely mean less capital flows to South Africa, which will put pressure on the rand.
Reduced currency risk – all things being equal, economic theory states that one can expect a currency to depreciate in line with the differential between that country’s inflation rate and those of its major trading partners. With inflation around the mid-point of the South African Reserve Bank’s 3 – 6% target, South Africa’s inflation rate exceeds the inflation rates of its major trading partners. Therefore, over time, we can expect the rand to depreciate against these currencies.
Figure 1 illustrates the overall deteriorating performance of the rand against the US dollar since 1972. The graph also uses the theory of purchasing power parity (PPP) to illustrate the relative cheapness or expensiveness of the rand against the dollar over time. (PPP is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries.) When the dark green line in Figure 1 is above the green line it suggests that the rand is cheap and vice versa. The pink and grey lines represent two standard deviations (SD) – cheap or expensive. This simply means that we expect the rand to trade within these bands about 95% of the time.
Currently, therefore, PPP is suggesting that the rand is on the cheap side. However, it is important to consider South Africa’s worsening terms of trade, general risk aversion and continued US dollar strength. All these factors are potentially negative for the rand.
Figure 1: US dollar/rand purchasing power parity
Source: I-Net Bridge, Bloomberg and Ninety One SA (Pty) Ltd as at 12.08.19, Log Scale.
Maintenance of ‘hard’ currency spending power – it is important for South Africans who travel abroad or who purchase imported items (or any product or service priced in an international currency) to ensure that they maintain (and grow) their spending power in real terms.
A long-term view is required to fully benefit from offshore assets’ return potential
While the case for investing offshore is compelling, it is important to consider where the return from an international investment could come from: the exchange rate and/or the underlying foreign investment. The impact of exchange rate risk on a foreign investment should also be an important consideration. Many South Africans got burnt when they invested offshore in 2001 and 2002 when the rand traded at around R12 to the US dollar. As a result, South African investors now tend to have an underweight exposure to foreign investments.
Studies have shown that when considering the historical returns of foreign investments, the impact of the exchange rate is uncertain and volatile, and that when measured over shorter time horizons, the exchange rate can have a significant impact on the investment return in rands. Research indicates that it is only over longer time horizons that the underlying investment contributes more to the return than the exchange rate. Therefore, we are of the opinion that when investing offshore, investors need to take a long-term view to fully benefit from the return potential of the international assets in which they are invested.