The ins and outs of offshore investing
Considering South Africa’s stock market represents only around 1% of the world’s total listed equity market capitalisation, having some offshore equity exposure is a logical choice – otherwise you are missing out on 99% of the available opportunities, and some fantastic ones at that. However, studies have found that investors in both developed and emerging markets exhibit home bias: the tendency to allocate a disproportionately large percentage of one’s portfolio to domestic assets, relative to their weighting in the global market. Various reasons have been put forward to explain this behaviour, including:
- Expectations: Local investors tend to be more optimistic about their local market, compared to foreign investors.
- Comfort: People feel comfortable investing in local companies that they are familiar with.
- Liability hedging: An individual’s ability to fund their liabilities is increased when using local assets whose value increases and decreases in lockstep with the liabilities.
In South Africa, we have the added effect of regulations, which effectively impose a home bias on retirement savings products (like retirement annuities) by limiting their offshore allocation to a maximum of 25% of asset value. An extra 5% may be allocated to African countries (excluding South Africa).
Furthermore, the perception that offshore investing is complicated and expensive persists. While it certainly can be both of these things, fortunately it doesn’t need to be. Unit trusts, such as those offered by Prudential, provide investors with a simple, convenient, and cost-effective means of gaining exposure to a broad range of global assets.
WHY INVEST OFFSHORE?
For South African investors, there are several benefits to investing outside the country’s borders:
Nobel prize-winning economist Harry Markowitz famously described diversification as “the only free lunch”. Research has shown that diversifying across geographic regions, asset classes, industries, and currencies is an effective way to decrease portfolio volatility, and thereby improve risk-adjusted returns.
Sector and Industry Exposure
Investing offshore enables you to gain exposure to sectors and industries that may be small or non-existent in your home market. Take, for example, the technology sector in the United States – boasting the likes of Facebook and Alphabet (Google’s parent company), this sector includes companies that have no peers in South Africa.
Offshore investments serve as a hedge (i.e. protection) against a depreciating rand. This could help if you normally buy a lot of imported goods, or take many foreign holidays. While one might expect offshore investments to deliver superior returns (in rand terms) during periods of local market uncertainty and political turmoil, this won’t necessarily always be the case. As we’ve seen over the past 12 months, a period where we’ve seen higher political uncertainty and an economic slowdown, the rand has appreciated significantly against major currencies. This has negatively impacted the rand returns of offshore investments. As such, it’s not advisable to use offshore investments to speculate on currency movements (a notoriously difficult task), but rather to ensure a globally diversified portfolio.
Ultimately, the optimal offshore allocation for your portfolio will depend on your unique circumstances and the long-term financial plan you’ve developed with your financial adviser.
HOW TO INVEST OFFSHORE?
Within a unit trust context, there are essentially two avenues available to gain offshore exposure:
The first option is to invest directly offshore in foreign-domiciled funds. When investing in such funds, you are required to convert your rands into the currency of the chosen fund and make a deposit into a designated offshore bank account. Foreign-domiciled funds typically have higher investment minimums than rand-denominated funds, and do not permit debit orders.
The Reserve Bank allows taxpayers in good standing (and over the age of 18) to invest a maximum of R10 million offshore per calendar year, provided a Tax Clearance certificate is obtained from SARS.
In addition, individuals are granted an annual discretionary offshore allowance of R1 million per calendar year, where a Tax Clearance certificate is not required.
An advantage of investing directly offshore is that when you sell your investment, you may choose to have the redeemed amount paid out in foreign currency to your offshore bank account (if you have one), rather than receive rands. Another advantage is that, once you take your funds offshore, you are free to invest in any offshore product or investment manager of your choice. Investing in rand-denominated funds limits you to a range of local providers of FSB-approved products.
The second option is to invest indirectly offshore in rand-denominated funds that have mandates to invest in foreign assets. You invest rands, which the unit trust management company then converts into foreign currency using its foreign exchange capacity. The South African Reserve Bank’s exchange control regulations permit local management companies to hold a maximum of 35% of their retail assets under management in foreign assets.
All rand-denominated funds are priced in rands, and when you sell units, the redeemed amount will be converted back into rands and paid into your local bank account.
Many management companies have established rand-denominated funds that invest into their foreign-domiciled funds. Funds of this nature are termed “feeder” funds, and you will likely see the word “feeder” in the fund name.
The advantages of investing in rand-denominated funds include: 1) you don’t need to purchase foreign currency; 2) you don’t need to obtain a Tax Clearance certificate; 3) there is no maximum investment limit; 4) you are able to set up regular debit orders; and 5) investment minimums are typically lower than foreign-domiciled funds.