For the past two decades, the South African equity market has outperformed US assets. This would surely mean that a portfolio with 100% exposure to local equities would have delivered the best returns over this period. Think again. South African equities are not perfectly correlated with the offshore market, which means these different assets will suffer losses at different times. By allocating your capital across both local and global assets, you can manage volatility and avoid significant losses, resulting in a more stable portfolio.
The South African equity market has outperformed US assets over the last 20 years
The local equity market has delivered an annualised return of almost 15% since the introduction of the FTSE/JSE All Share Index in June 1995. The worst-performing asset class for a South African investor to have been invested in over this time was US cash, which delivered an annualised return of just below 9%.
Figure 1: South African and US asset class performance from 1995 to 2016 (in rand)
Source: Thomson Reuters
However, a portfolio with exposure to US equities would have generated a higher return
Figure 2 shows the performance of two multi-asset portfolios making full use of the 25% offshore allowance, compared to a portfolio invested 100% in local equities. The assumption is that all dividend and interest income is reinvested monthly.
- The portfolio in orange (let’s call it portfolio A) is invested 75% in South African equities (the best-performing asset class) and 25% in US cash (the worst-performing asset class). This portfolio only marginally underperformed the all South African equity portfolio, delivering an annualised return of approximately 14%.
- The portfolio in grey (portfolio B) consists of 75% exposure to South African equities and 25% exposure to US equities. Even though the US equity market underperformed the South African equity market over this period, this portfolio marginally outperformed the all South African equity portfolio with an annualised return of about 15%. In other words, by including a lower return equity market in the portfolio, the returns earned were better than those delivered by the South African equity market alone.
(We have not included US bonds in our analysis as US bond yields fell significantly over this time. As such, realised US dollar returns going forward are unlikely to be comparable to those earned over the last 20 years.)
Figure 2: Performance of multi-asset portfolios versus South African equity only (in rand)
Source: Thomson Reuters
The key to this outperformance is managing losses by offsetting risks
Different assets suffer losses at different times, as shown in Figure 3. By allocating capital to different assets, the overall portfolio would have been offsetting risks, resulting in a more stable portfolio value over time. For example, consider an investor who invests R100 in the equity market, which then falls 50%. To get back to R100, the market needs to deliver 100%. Compare this to the investor invested in a more stable portfolio that falls only 25%. To make up the loss and get back to R100, the investor only needs a 33% return. This ties back to the first rule of investing according to Warren Buffett: avoid losing money. You cannot compound what you don’t have.
Figure 3: Different assets suffer losses at different times
Source: Thomson Reuters
Including a mix of assets in your portfolio gives you access to some of the most powerful investment tools
- The value of diversification
Investors need to evaluate the performance of their investment portfolios as a whole. The South African equity market is not perfectly correlated with offshore markets. Different factors drive returns for different assets. The purpose of including several uncorrelated (or low correlation) assets is that some are expected to perform poorly when others perform well, and vice versa. This construction allows for portfolio stability and improved risk-adjusted returns. As a result, including a relatively poor-performing asset such as offshore cash has enabled the investor in portfolio A to earn returns that compare with those of the best-performing asset class, even though the investor had limited exposure to South African equities. - Being able to benefit from the quintessential ‘sell high, buy low’ principle
For illustrative purposes, portfolios A and B were constructed to maintain a fixed asset allocation. In the event of a large drawdown in one of the assets included in any one of the portfolios, the investor would have been able to use the gains from the better-performing assets to gain exposure to the assets that suffered losses. This is an example of the ‘sell high, buy low’ principle put into practice. - Increasing the chances of meeting your investment objectives
An effective investment portfolio is constructed in a way that maximises the probability of meeting a particular investment objective. Including lower risk and offshore assets in a portfolio helps to reduce the volatility of investment outcomes and enhances the probability of meeting the objective. By diversifying well, investors have less exposure to tail risks in their portfolios.
Exposure to international investments reduces volatility, enabling a targeted return
Including foreign assets in a portfolio does not necessarily increase an investor’s expected return, but it reduces the volatility of their portfolio. This means a targeted return becomes more likely. Although many emerging markets offer opportunities for growth, developed market assets generally have more certain values because they are not subject to the same risks as emerging market assets. Politics tend to be more certain, the economies are more diversified, and often the jurisdictions provide better protection for private property rights. This highlights two important points that South African investors must consider when they diversify their portfolio internationally:
- The values and returns from developed market assets are not perfectly correlated with the values and returns from South African assets, so you should not compare the different returns.
- You should expect lower returns from developed market assets than from domestic markets.
It is always a good time to invest offshore, no matter at what level the rand is trading
Any South African investor would benefit from maintaining a consistent and substantial percentage of assets offshore, and it shouldn’t be for the potential for higher returns. An investor who wants to increase the probability of meeting a particular investment objective will benefit from the reduced risk and increased diversification that offshore assets offer, even when these assets’ performance is disappointing. After all, Buffett’s second rule of investing is to never forget the first rule of avoiding losing money. Diversification is always worth it in the long term.
We have four offshore unit trust funds with different investment mandates and risk and return characteristics. For the minimum disclosure documents (fund fact sheets) of these funds, click below. Contact us at service@denkercapital.com if you’d like to invest.
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