A question often asked of us is: 'How much should I invest offshore?' This question has a different answer for each person. Another, perhaps more important, question to ask is: 'Why am I investing offshore in the first place, and what should I be investing in?' Chris du Toit examines some of the options.
Why invest offshore?
Returns of developed market equities have continued to lag behind the returns of emerging market equities. Emerging markets, including South Africa, have enjoyed strong inflows of capital from abroad, supporting valuations on our stock markets and helping the rand to strengthen by nearly 25% versus the US dollar in 2009 and 2010. This strong rand has been one reason why inflation has remained subdued over the last year, as approximately one-third of the items in our inflation basket are imported.
For long-term saving to be successful, the value of your investments must keep pace with inflation, and preferably beat it over the long term. A strong rand tends to drive inflation down; a weakening rand typically leads to higher inflation. To be protected against higher inflation from a weak rand, it may help to be invested offshore as the value of your assets in rand terms should grow as the currency weakens.
We think there is a real risk that the rand may weaken from current levels, and therefore believe that foreign exposure is an appropriate addition to clients' portfolios.
What are the options?
There are many options for investors offshore. Shares are an obvious place to start for people with a long time horizon. It is also important to consider other options when looking abroad. An interesting dynamic is the growing link, or correlation, between share prices globally and the value of emerging market currencies. This link can work against you if you are investing in offshore equities in order to enjoy the benefits of rand weakness.
With emerging markets currently the destination of choice for global investors, there has been an increasing correlation between the performance of shares and the movement in emerging market currencies. Emerging markets are widely perceived to offer investors better prospects for growth at higher levels of risk than developed markets. When investors are in the mood to take on risk, the resulting capital inflows in these markets have caused their currencies to strengthen and their share prices to rise at the same time. South Africa recorded net inflows of R186 billion from foreigners into our stock and bond markets during 2009 and 2010.
When investors become risk averse they sell shares, in their own markets and indeed in emerging markets. As money flows back to developed markets, the currencies of emerging markets weaken. This is illustrated in Graph 1, which shows the FTSE World Index and the rand/US dollar exchange rate, with the exchange rate inverted on the right hand y-axis, in order to better illustrate the correlation. As markets rise, the rand strengthens versus the US dollar, and vice versa.
Being invested offshore should protect you from rand weakness. However, if the losses on equities abroad exceed the extent to which the currency weakens you could still end up with fewer rands in your pocket. Graph 2 illustrates the point. During 2008 the rand weakened by 40% as foreigners sold our shares and bonds. The problem was that they also sold shares elsewhere, leading the FTSE World Index to fall by 40.9% in 2008. Despite the rand weakness, an investment in global equities measured in rand terms returned -17%.
Alternatives to equities
By investing in assets that are not exposed to these market forces, investors can potentially benefit more from rand weakness.
WE THINK THERE IS A REAL RISK THAT THE RAND MAY WEAKEN FROM CURRENT LEVELS
Allan Gray uses the Orbis Optimal SA funds as uncorrelated assets offshore, being alternatives to cash and bonds. The Optimal funds invest in Orbis's underlying shares and remove the exposure to stock markets by selling futures contracts. The returns generated by these funds therefore depend on interest rates (through the way the futures contracts are priced), and the relative out- or underperformance of Orbis's shares compared to world markets. An important characteristic of the Optimal funds, is that their returns are not correlated to major asset classes. Over the last 20 years the correlation of the Optimal funds to global stock markets has been 0, and to bond funds it has been 0.2. Since Orbis's outperformance is unpredictable and not dependent on specific market conditions, the Optimal funds are able to produce positive returns independent of bull or bear markets.
An example of this was in 2008, when the Orbis Optimal strategy denominated in US dollars returned -2.5% in US dollar terms (Graph 3). This allowed investors to benefit from the rand weakening, resulting in a positive 36.5% return in rands. This illustrates how useful an uncorrelated investment can be as part of a broader portfolio, as it can provide positive returns in conditions where most other asset classes experience losses.
Benefiting from currency weakness is always an objective for investors heading offshore. If correlations between the rand exchange rate and global markets remain as high as they have been recently, an uncorrelated offshore asset, such as one of the Orbis Optimal SA funds, may prove to be a useful addition to a portfolio.
