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How much offshore is enough or too much?

May 16, 2022 • Old Mutual

In this series, our Old Mutual Wealth Investment Managers answer some hard questions and demonstrate how they do the hard thinking and work so that you don't have to. Their answers are based on an in-depth understanding of the local and global economy, financial markets, and the driving forces that will shape tomorrow.

Roland Gräbe, Head of Old Mutual Wealth Tailored Fund Portfolios unpacks Regulation 28, diversification and getting the most from your offshore allocation.

For more information visit:
https://www.oldmutual.co.za/wealth/hq-investment/

Old Mutual 00:02

Investing your wealth is a journey that demands skill, in depth knowledge, experience, and conviction from the investment manager. From you, the investor, it demands time, patience, and trust in your investment manager's ability. While investing is certainly rewarding, it can be complex. You will have questions along the way, and we're here to help you find the answers.

Ian Fraser 00:46

Roland Gräbe is Head of Tailored Fund Portfolios at Old Mutual Wealth, overseeing a DFM or Discretionary Fund Manager, creating and managing multi-management investment strategies for the retail market. He works closely with financial advisors directly, and Roland studied actuarial science and then completed the CFA charter. He's also a certified financial professional. That is a preface to get the podcast underway today. Roland, baie welkom, good to have you with us on the podcast today. Thanks for teeing us up for some education here.

Roland Gräbe 01:25

Thank you very much, and looking forward to it.

Ian Fraser 01:27

Okay, let's talk about this rather complex topic. And as we chatted off microphone beforehand, I might jump in and ask you to contextualize what you're talking about, should I be unsure. So, I'm going to start with that in mind, and very high level speak about Regulation 28. Pension funds, etc. and Regulation 28. We're talking about diversification and getting the most from your offshore allocation, certainly when it comes to those pension funds, etc. But I want to start with Regulation 28. It's changed recently. But what is it and what has changed?

Roland Gräbe 02:06

Ian, so Regulation 28 is a set of regulatory guidelines that limit and guide pension fund investment. And it sets limits to your exposure. You're allowed exposure to equities, bonds, cash, and importantly, it limits the amount of money that can be invested outside of South Africa.

Now, in terms of what has changed: up to February this year, the typical pension fund investment strategy could only go up to 30% offshore. And in February this year, this limit has been increased to 45%, which is quite a substantial difference from before. And practically, this just means that pension fund money - and this includes your pension, provident fund savings, retirement annuities - these investments can now take on a lot more exposure into offshore markets.

Ian Fraser 03:00

Right. Okay. These are obviously good changes if you're looking to get more money offshore and expose to alternative asset classes outside of the country. Am I correct?

Roland Gräbe 03:11

Absolutely. We do view the change as a positive one, because the only change is that you have more options available.

Ian Fraser 03:19

Okay. And then just to backtrack one step, who is exactly affected by this? Is this just pension funds?

Roland Gräbe 03:27

Yes, but I think we need to be clear that it is not just people who save for retirement through an employer. So, that is typically active participants in a pension or provident fund, where contributions is paid from the salary. It's also important for people who make their own retirement savings arrangements through a financial advisor. And that would typically take the form of contribution towards a retirement annuity.

So, if you enjoy any kind of tax benefit because you're saving towards your retirement, this legislation affects you. And maybe also to just clarify, this doesn't affect pensioners who are already drawing money if it's from a living annuity. Living annuities fall outside of Regulation 28. So, if you've got living annuity investment, there is no restriction on your offshore exposure.

Ian Fraser 04:19

Okay, then that follows on naturally onto the next question for me, which is that allocation, let's break it down and kind of unpack that just briefly. I'm sure it's super involved, but how does offshore allocation impact your investment strategy if you are in this position?

Roland Gräbe 04:37

Okay, so this is where things get really interesting. South Africa - and if we think of investment opportunities and stock markets, for example, South Africa represents a tiny slice of the global opportunity set, right. So, if you look at GDP economic production, South Africa is under 1% of the global market. If you look at the possible shares that you can buy in companies, we represent less than 1% of the global market cap. And if you look at the JSE itself, we basically have around 100-150 investable companies.

So, the moment we're allowed to diversify our investments outside of South Africa, we're basically stepping into a huge set of different companies, and different risks. If we look at bonds for example, government bonds, we can access very low risk government bonds in places like Europe and the US. Or we can access very high risk government bonds, for example, in a country like Brazil or Turkey. So suddenly, we're not restricted to one country, we can look at all countries. And in terms of asset losses, we can broaden our view.

You mentioned alternative assets. There are obviously things like private equity, hedge funds, timber, a lot of investment opportunities that might not even exist in South Africa. So, you step out of this small pond into a big ocean, and you're suddenly faced with, I think more opportunity, but also more difficult choices. And then importantly, you introduce a new risk, which is currency risk. So now, you're investing your money outside in dollar assets, and you bring it back in terms of performance in Rand terms. And that's where I think things can get very interesting, because you're now also taking a view on the currency.

Ian Fraser 06:36

So, with that in mind, I mean, it sounds - it does sound complicated. And I think it probably starts to get tricky when you bring currency into the equation and you also widen the scope, so that you've got all these new investment opportunities, which you don't necessarily have if you're just investing locally. I'd like to talk about an optimal portfolio. That's a point on one of my questions here that I would very much like to unpack as well, because obviously, you're looking for the best return. But you've got to kind of figure the balance out, I guess. Let's talk about the optimal portfolio. How do you see that?

Roland Gräbe 07:17

Ian, so yes, this is a very interesting topic. Because as investment professionals, we have to ask ourselves, how do we do the best for clients? And also, how do we improve the performance that we give clients? And these can be any kind of investor, anybody saving towards retirement. And in asset management, there is one over overarching guideline with respect to optimal portfolios, and that is, investors prefer higher returns over lower returns, and I think that makes intuitive sense, right? You'd rather earn an interest rate of 7% on your bank account than 6%.

Ian Fraser 08:00

But surely then there's risk as well?

Roland Gräbe 08:02

Yes. And that is the tricky part, is investors really prefer to earn that return at the lowest possible risk.

Ian Fraser 08:11

Gotcha, gotcha.

Roland Gräbe 08:12

And defining investment risk is not so easy, because we often talk about risk in terms of volatility. And volatility just means how much it goes up and down. In the end, I think for investors, investors want to avoid the pain of negative returns. So, in a way, we want to earn a really compelling return for a client. But we don't want to expose the client to the pain of losses.

Now, to come back to your question about what an optimal portfolio is, what we're trying to work out - and this is quite a statistical process - but we're trying to figure out what type of mix of assets would give us the best return at the lowest possible risk. And we try to stress test that, because it doesn't help to just look at history, because history doesn't repeat itself. So, we have to do some statistic modeling and look at things like correlation and independence. But bottom line, an optimal portfolio is one that you're expecting to receive a better return for the level of risk that you take.

Ian Fraser 09:23

And that, Roland, is why you are the actuary, and I am listening.

Roland Gräbe 09:27

So, I should say, even with my actuarial degree, I do not call myself an actuary. For that I would have had to pass even more exams.

Ian Fraser 09:39

My apologies. My apologies in that.

Roland Gräbe 09:41

Ja, that's fine. That's fine.

Ian Fraser 09:44

Ja, certainly you understand more than I do, which is why I'm keeping quiet. Let's talk about currency. You mentioned earlier on the exposure to the dollar, you get your money offshore and you're getting returns in Rands. I'd like to talk about the currency risk here. Unhedged and hedged investing. Do you want to talk us through that?

Roland Gräbe 10:04

Yes, and I'm going to try and dispel myths and also try to break it down in a way that's very straightforward to understand.

Ian Fraser 10:16

I'd love that.

Roland Gräbe 10:17

Let's take the example of cash investments in the United States. So, I think most of us appreciate that interest rates in the US are pretty low right now, let's call it 2% is the best interest that you can earn in a US bank account.

Now, as a South African, you can invest your money in US cash. You can put it into a fund that invests in US cash. And if it's a South African unit trust, you would put your Rands down, they will buy, they will invest it in the US cash. And you will see reporting back in Rands. Now, we already know the dollar return on that investment over the next year is likely to be around 2%. But because you've put in Rands, you bought dollars at a certain price, let's say you paid R16 for the dollar. And now a year later, the currency might have changed, and it might, let's say, now it's R18 for $1. That means your $1 that you bought is now worth R18 instead of R16, so suddenly, you've made a return on your investment that's got nothing to do with interest. It's purely a currency return.

Ian Fraser 11:39

Got you.

Roland Gräbe 11:40

So, the currency is very important. And let's establish a very straightforward rule of thumb. If you invest offshore as a South African, you probably want the currency to weaken, because that means you're making a currency gain, like in my example. And so, you earn the return on your dollar asset, plus you earn a performance for a deteriorating Rand. So perversely, you're actually happy if the value of the Rand falls, because that means your dollar asset has become more valuable in currency that matters to you. So, you remember I mentioned that it's not just about return, it's also about risk.

Ian Fraser 12:19

Yes.

Roland Gräbe 12:19

In this case, what risk means is what if the Rand strengthens to R14 a $1. Now, my R16 that I paid, earned 2% interest, but that dollar is now worth only R14 and I suddenly made a loss. And that risk tends to be - so, the risk on the currency tends to be bigger than the risk on your investment. Whether you buy equities or bonds, or cash, this currency is going to have a very big impact on the value of your investments. And that's why I say, currency risk is really important. Now, you've introduced the concept of hedged and unhedged.

Ian Fraser 13:01

Yes.

Roland Gräbe 13:02

In very simple terms, if you decide to hedge your currency risk, you will earn that 2% return on the dollars you invested, and you will earn either a premium or lose some money hedging the currency. But roughly speaking, you'll get close to your 2% if you hedge the currency. If you decide not to hedge the currency, and you're just investing straight into a dollar fund that translates back to bank, the currency effect will be the driver of your returns.

Ian Fraser 13:32

Very interesting. Very interesting. So essentially, you're protecting yourself one way and you exposing yourself the other.

Roland Gräbe 13:39

Absolutely. And maybe just to add one more thing, Ian, because practically, who makes these decisions for the average listener? So, if you're in a pension fund through work, there will be an investment committee, they will appoint asset managers. These asset managers will make these decisions themselves; they might be split up. But I think the audience that's important to me is people that work with financial advisors and get advice on these matters, will probably make the decision in a conversation with a financial advisor who will probably discuss, "let's take more money offshore for you. Let's keep it the same. Let's reduce it." And in that scenario, the money's invested, usually by buying unit trusts. And in South Africa, unit trusts tend to be Rand dominated investments. By far the majority of investors, if you decide to invest more offshore with your financial advisor, it will include taking more risk on the local currency.

Ian Fraser 14:44

Okay, that's a very nice lead in and a segue to my second last question about the conclusions then that we can draw about all of this information because, I mean, I can hear and I can formulate 10 more questions about just this topic of unhedged and hedged, it's such a deep topic that we can go into. We just don't unfortunately have the time. Let's put it all together now, the conclusions that we can draw. First of all, the offshore allocation that you've been talking about is driven by investor constraints and preference, am I correct?

Roland Gräbe 15:15

Absolutely. So, the right offshore exposure does depend on how much risk you want to take. Typically, a conservative investor is not going to invest massively offshore, where a more adventurous investor might push more towards the maximum.

Ian Fraser 15:30

So, then Roland, more offshore is not necessarily better?

Roland Gräbe 15:35

No, you need think about the right mix for you. Because as you increase your offshore exposure, more and more, you're actually taking predominantly just a view on the currency. And, you know, we've all seen the Rand can weaken massively, but also over a period of years, the Rand could have strengthened, so you're also inviting quite a bit of risk into your portfolio.

Ian Fraser 15:59

Ja, ja. Which is exactly what I was gonna ask you. The currency, which you've explained, that risk is always there. If you're exposing it to - no matter what currency it is, not just US dollars.

Roland Gräbe 16:10

Absolutely. And the quantum can be phenomenal, you know, you can make 20 or a 30% gain or loss just on the currency in 12 months easily.

Ian Fraser 16:18

Roland, you spoke about hedged versus unhedged investing offshore. When it comes to unit trusts, which you alluded to earlier on, as somebody who might speak to their financial advisor, and then they would go and make that decision as to what they wanted to do. Interesting that I see here that in the unit trust world, hedged offshore strategies aren't really that common yet?

Roland Gräbe 16:41

No. So, we have very limited vehicles available right now, for investors preferring not to take the currency risk. And what's interesting, our modeling shows that if you want to build an optimal portfolio, you definitely have to consider this as part of your mix. So, I anticipate that local asset managers will more and more start to offer not just an unhedged global equity or global portfolio option, but also start bringing in currency hedging and fully hedged solutions. So, they're going to be expanding the solution set in our industry, in my mind.

Ian Fraser 17:18

That's a useful thing to know. So, I mean, are we talking a year? Are we talking 10 years? What kind of timeframe are we looking at here?

Roland Gräbe 17:25

Ian, I think that's the beautiful part of competition, is there's always a first mover who wants to take the first mover advantage. I don't think it's gonna take long. Currency hedging isn't complicated; it really is more or less a phone call to a bank to quote on your system. And it can also be done over the counter. So, let's just say, it's not the most complicated thing in the world. And I think it won't take long for products to catch up to this.

Ian Fraser 17:54

Roland, let's look to the future then, certainly in context of this conversation, it would seem now with - as we started right off at the top there with Regulation 28, you said exposure up to 45%. Is that correct?

Roland Gräbe 18:07

That's correct, Ian.

Ian Fraser 18:08

Right. So, with 45% being able to be invested offshore, there's a huge divergence in that balanced fund performance, right?

Roland Gräbe 18:17

That will happen, Ian, because right now, most funds sit at around 27/28/29%. Because 30 is pretty much optimal. But if you sit at 30, you're constantly in breach of the regulation. Going forward, I think some funds will stay at 30, some will move to 40. Some will move immediately to 45. And this is going to have quite diverse outcomes. So, I expect balanced funds, and these are the most commonly used and best supported unit trusts in South Africa. I think their performance is going to differ greatly from this point on. Somebody's going to get it absolutely right. And somebody's gonna get it quite wrong.

Ian Fraser 18:58

Sjoe, that's an interesting one, because I mean now essentially you can take all of the factors and put them on the table, but you really can't tell what's going to happen for going forward, right?

Roland Gräbe 19:09

Absolutely. I think none of us know the future perfectly, right.

Ian Fraser 19:14

Exactly. Roland, that is a very interesting conversation. Just back to the beginning of - the genesis of how we started this podcast, Regulation 28 changed from February this year. And that means you can diversify more of your portfolio offshore and all of the ins and outs of it. Super interesting. What a nice chat. Roland Gräbe, thank you so much for being part of the podcast today. We really appreciate your time. And thanks for explaining that so well. It was very clear at the end of it.

Roland Gräbe 19:34

Thank you so much, Ian, really enjoyed chatting to you today.

Old Mutual 19:47

Old Mutual Wealth is a world class investment destination, offering you a wide range of investment strategies and specialist wealth management solutions. Whether your goal is to grow your wealth, generate income, or preserve capital, we select the best and most suitable investments based on your investment strategy and our extensive research and collective insights. It's vital to work with reputable specialists who can effectively structure an investment portfolio that is tailored to your unique needs and objectives. Email us at hardquestions@omwealth.co.za, so that we can help you take your wealth further.